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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-K**

** **

**Annual Report Pursuant toSection 13 or 15(d)**

**of the SecuritiesExchange Act of 1934**

** **

**For the Fiscal Year EndedDecember 31, 2009**

** **

**CommissionFile Number 1-13463**

 

**BIO-KEYINTERNATIONAL, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

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

(Address of Principal Executive Offices) (Zip Code)

 

**(732) 359-1100**

Issuer’s telephone number, including area code.

 

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

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

 

**Securities registered pursuant to Section 12(g) of the Act:**None

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o No x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o No x

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes o  No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer or a smaller reporting company.See definition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

 
| Large accelerated filer o | Accelerated filer o         |
|--------------------------------|----------------------------------|
|                           |                             |
| Non-accelerated filer o   | Smaller reporting company x |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  No x

 

Theaggregate market value of the registrant’s voting and non-voting common equityheld by non-affiliates computed by reference to the price at which the commonequity was last sold, as of the last business day of the registrant’s mostrecently completed second fiscal quarter was $7,410,824.

 

Asof March 24, 2010, the registrant had 77,713,398 shares of common stockoutstanding.

 

Documents Incorporated by Reference: None

 

 

 

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**TABLE OFCONTENTS**

 
|    | PART I                                                                                                         | 1      |
|---------|---------------------------------------------------------------------------------------------------------------------|--------|
|    |                                                                                                                |   |
| Item 1. | Description of Business                                                                                             | 1      |
| Item 1A | Risk Factors                                                                                                        | 8      |
| Item 2  | Description of  Property                                                                                            | 13     |
| Item 3  | Legal Proceedings                                                                                                   | 13     |
| Item 4  | Reserved                                                                                                            | 13     |
|    |                                                                                                                |   |
|    | PART II                                                                                                        | 14     |
|    |                                                                                                                |   |
| Item 5  | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 14     |
| Item 6  | Selected Financial  Data                                                                                            | 16     |
| Item 7  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 16     |
| Item 7A | Quantitative  and Qualitative Disclosures about Market Risk                                                         | 25     |
| Item 8  | Financial  Statements and Supplementary Data                                                                        | 25     |
| Item 9  | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               | 25     |
| Item 9A | Controls and  Procedures                                                                                            | 25     |
| Item 9B | Other Information                                                                                                   | 26     |
|    |                                                                                                                |   |
|    | PART III                                                                                                       | 27     |
|    |                                                                                                                |   |
| Item 10 | Directors,  Executive Officers and Corporate Governance                                                             | 27     |
| Item 11 | Executive  Compensation                                                                                             | 30     |
| Item 12 | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 36     |
| Item 13 | Certain Relationships  and Related Transactions, and Director Independence                                          | 38     |
| Item 14 | Principal  Accountant Fees and Services                                                                             | 39     |
| Item 15 | Exhibits                                                                                                            | 40     |
|    | Signatures                                                                                                          | 74     |

 

**PRIVATESECURITIES LITIGATION REFORM ACT**

 

All statements other than statements of historicalfacts contained in this Annual Report on Form 10-K, including statementsregarding our future financial position, business strategy and plans andobjectives of management for future operations, are forward-looking statements.The words “anticipate,” “believe,” “estimate,” “will,” “may,” “future,” “plan,”“intend” and “expect” and similar expressions generally identifyforward-looking statements. Although we believe our plans, intentions andexpectations reflected in the forward-looking statements are reasonable, wecannot be sure they will be achieved. Actual results may differ materiallyfrom the forward-looking statements contained herein due to a number of factors.Many of these factors are set forth under the caption “Risk Factors”****in Item 1A of this Annual Report and other filings with theSecurities and Exchange Commission. These factors are not intended to representa complete list of the general or specific factors that may affect us. Itshould be recognized that other factors, including general economic factors andbusiness strategies, may be significant, presently or in the future.Except as required by law, we undertake no obligation to update any forward-lookingstatement, whether as a result of new information, future events or otherwise.

 

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**PART I**

** **

**ITEM 1.**                    DESCRIPTION OF BUSINESS

** **

BIO-key International, Inc.,a Delaware corporation (the “Company,” “BIO-key,” “we,” or “us), was founded in1993 to develop and market advanced fingerprint biometric technology andsoftware solutions. Biometric technology is the science of analyzing specifichuman characteristics which are unique to each individual in order to identifya specific person from a broader population. First incorporated as BBG Engineering, the company became SACTechnologies in 1994.  The BIO-key namewas introduced in 2002.

 

We develop and marketadvanced fingerprint identification biometric technology and softwaresolutions. We were among the initial pioneers in developing automated, fingeridentification technology that can be used without the aid of non-automated methodsof identification such as a personal identification, password, token, smartcard, ID card, credit card, passport, driver’s license or other form ofpossession or knowledge based identification. This advanced BIO-keyTMidentification technology improves both the accuracy and speed of finger-basedbiometrics.

 

Since our inception in1993, we have spent substantial time and effort in completing the developmentof what we believe is the most discriminating and effective commerciallyavailable finger-based biometric technology. During the past five years, ourprimary focus has shifted to marketing and selling this technology andcompleting strategic acquisitions that can help us leverage our capability todeliver identification solutions. We have built a direct sales force ofprofessionals with substantial experience in selling technology solutions togovernment and corporate customers.

 

In 2004, BIO-key acquired Public Safety Group, Inc.(PSG), a privately held company that was a leader in wireless solutions for lawenforcement and public safety markets. PSG’s primary technology was PocketCopTM,a handheld solution that provides mobile officers, such as detectives who arenot typically in their vehicles, a hand-held mobile information softwaresolution. Also in, 2004, BIO-key completed a transaction with Aether Systems, Inc.to purchase 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. Their PacketCluster mobile information softwareis integrated with 50 separate State/NCIC databases, as well as other state,local and federal databases.

 

In 2007, BIO-keycompleted a transaction with ZOLL Data Systems, Inc. (“ZOLL”), a subsidiaryof ZOLL Medical Corporation, in which ZOLL acquired substantially all of theassets related to the Company’s Fire/EMS Services division. In 2009, BIO-keycompleted a transaction with InterAct911 Mobile Systems, Inc.(InterAct911), a subsidiary of InterAct911 Corporation, in which InterAct911acquired substantially all the assets related to the Company’s Law Enforcementdivision.

 

As a result of thesetransactions, and as discussed in Note M to the Consolidated FinancialStatements included in this report, we have organized the Company into onereporting segment: Biometrics. During the year ended December 31, 2009,the Company continued to focus on its primary objectives of increasing revenueand managing expenses, by developing leadership technology and applications andby providing its customers with high quality support and service.

 

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**Markets**

 

***Finger-based Biometric Identification***

 

BIO-key is a leader in finger-basedbiometric identification. In partnerships with OEMs, integrators, andsolution providers, we provide biometric software solutions to private andpublic sector customers.BIO-key provides the ability topositively identify individuals before granting access to valuable corporateresources, web portals or applications in seconds. Powered by our patentedVector Segment TechnologyTM our VSTTM, WEB-key® and BSP development kits arefingerprint biometric solutions that provide true interoperability with allmajor reader manufacturers, enabling application developers and integrators toseamlessly integrate fingerprint biometrics into virtually anyapplication.  BIO-key development tools deliver a tangible return on asecurity platform investment that can:

 

· Reducerisk

· Improveuser convenience

· Loweroperating costs

 

BIO-key’s patented VectorSegment Technology (VST) is the foundation for these solutions. BIO-key’sunique solutions provide users with the ability to positively identifythemselves to applications with the simple scan of their finger. Thiscapability is a significant improvement in both convenience and security overother alternatives and provides companies with a cost-effective solution 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 has formedrelationships with providers of biometric logon software including  Softex, Janus Associates, Indigo, IBM andComputer Associates to provide enterprise-ready SingleSignOn systems to manylarge companies in the US and abroad. BIO-key has partnership agreements with leading technology companiesincluding Sagem Morpho, McKesson, LexisNexis, and IBM to deliver advancedbiometric applications for government, civil and commercial clients. Throughits partnership with Oracle, BIO-key has integrated its biometric technologyinto the entire Fusion Middleware and Identity Management software stack tooffer all of Oracle customers a scalable biometric authentication solution.Also, BIO-key has integrated VST to a physical access solution developed anddistributed by its partner NextGenID. This solution has been deployed acrossthe US at many leading companies.

 

·                  *Growthpotential*—As the provider of the core technology, BIO-key’sgreatest growth potential is as a partner with companies that offerapplications that address growing concerns related to quickly and accuratelyidentifying individuals for both commercial and civil applications andthwarting the potential for identity theft.

 

Forexample, BIO-key, along with partners, has deployed biometric logical andphysical access solutions. These include working with Allscripts and IBM toprovide strong network based authentication and with the Pegasus Program toauthenticate users accessing a nationwide information-sharing system designed by and for the nation’ssheriffs. These represent the kind of partnership-based opportunities BIO-keymay see in the finger-based biometric market.

 

**Products**

 

The Company’s biometricidentification technology improves both the accuracy and speed of identifyingindividuals.  The Company’s proprietarybiometric technology extracts unique data from a fingerprint and uses it topositively identify an individual.  Thetechnology has been built to be completely scalable to handle databasescontaining millions of fingerprints. BIO-key achieves the highest levels ofdiscrimination without requiring any other identifying data—like a userID, smartcard, or token.  BIO-key’s coretechnology supports interoperability on over 40 different commerciallyavailable readers.  This interoperabilityis a key differentiator for BIO-key in the biometric market.  BIO-key has full support for industry standardsand received National Institute of Standards and Technology (“NIST”)certification on its ability to support HSPD-12 supported INCITS-378templates.  We believe we have thelargest deployment of ISO standard templates in the world with over 300 millioncreated in Bangladesh.  Extending ourproducts to support standards enables BIO-key to participate in largegovernment projects like Transportation Workers Identification Card (TWIC),Registered Traveler projects, PIV initiatives, and FIXS consortium solutions.We believe our fingerprint identification technology has a broad range ofinformation security and access control applications, including:

 

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·              SecuringInternet sites and electronic transactions

 

·              Securingaccess to logical networks and applications

 

·              Securingaccess to buildings and restricted areas

 

·              Providingfast, accurate member identification services

 

·              Securingmobile devices such as biometric enabled handhelds and PDA’s

 

·              Preventing identity theft through positive useridentification and false alias validation

 

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

 

·                  **Vector Segment Technology SDK (VST)**—BIO-key’s biometric development kit thatprovides developers the ability to take advantage of a highly accurate, deviceinteroperable algorithm. VST is available as a low level SDK for incorporationinto any application architecture to increase security while not sacrificingconvenience. VST runs on Windows, Linux or Solaris systems.

 

·                  **True User Identification**®—BIO-key’s biometric identificationsolution that offers large scale one to many user lookup with nothing but asingle fingerprint. This solution enables customers to perform false aliaschecks and manage fraudulent access to systems. True User Identification leverages commercially available databases,like Oracle, to scale the identification capabilities to millions ofusers.  The solution also runs oncommercially available hardware making it truly scalable for any size system.

 

·                  **WEB-key**®—BIO-key’s biometric securityplatform for managing fingerprint authentication across unprotectednetworks including the Internet. It extends all features and functionalities ofthe VST 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 Service ProviderTM**—BIO-key provides support for the BioAPI(a standards based solution meeting worldwide needs) for a compliant interfaceto applications using biometrics for verification and identification. BIO-keyenhances the traditional use of the BioAPI by adding support for CE devices,supporting identification calls and also providing a single user interface formultiple fingerprint readers.

 

·                  **ID Director**TM—BIO-key’s solution for single sign onintegration with Computer Associates SiteMinder, Oracle’s Fusion MiddlewareSSO, and other solutions, utilizing the power and security of WEB-key. Thissolution provides a simple to implement, custom authentication scheme forcompanies looking to enhance authentication. ID Director can easily add a levelof security and convenience to the transaction level of any application.

 

**Current Business Plan**

 

BIO-key’s current business plan is to:

 

·                  **License its core technology “VST” andTrue 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.

 

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

 

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**Competition**

 

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 and Sagem-Morpho.

 

The majority of sales for automated fingerprintidentification products in the market to date have been deployed for governmentand law enforcement applications.. The consumer and commercial marketsrepresent areas of significant growth potential for biometrics. Additionally,the majority of companies competing for commercial opportunities are in thebusiness of selling scanning devices and these companies tie their algorithm tospecific hardware. BIO-key has created a “device independent” algorithm thatprovides flexibility in choosing the correct device to fit the 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:

 

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

 

·                  *Iris scanning*is viewed as accurate, but the hardwareis significantly more expensive.

 

·                  *Facial recognition* can have accuracy limitations and istypically highly dependent on ambient lighting conditions, angle of view andother factors.

 

The market for biometric technology continues toevolve. Computer breaches, identity theft, phishing and other events in therecent past are driving a large-scale shift to biometric deployments. Inaddition, companies such as IBM, Dell and HP have all introduced computers withintegrated finger scanning devices to complement the conventionalusername/password technique since it is highly susceptible to hackers andsecurity breaches. BIO-key supports these integrated devices for broaderenterprise level security solutions.

 

BIO-key believes that the next wave of opportunity forfinger biometrics is the mobility market where a number of Smartphone and PDAmanufacturers are incorporating finger scanners in their devices for moreconvenient secure access to the handset itself and ultimately forapplications.  Our secure “one to many”technology framework can provide a “finger only” access to any application viathe web or a 3G or local area network.

 

**Marketing and Distribution**

 

BIO-key’s marketing and distribution efforts comprisethe following major initiatives:

 

·                  Over the past few years, BIO-key has strengthened its alliance withOracle and has been recognized as a Certified Partner in the Oracle PartnerNetwork. BIO-key supports the Oracle e-business suite of applications andprovides the biometric enabler for the Oracle Single Sign on product. As anOracle development partner, BIO-key provides the underlying database used fortrue user identification and on demand alias checking. As a developmentpartner, BIO-key participates in Oracle Trade Shows such as Oracle Open Worldand Oracle Apps World.

 

·                  BIO-key has strategic alliances with technology leaders includingOracle, Computer Associates, IBM, AT&T, and others.

 

·                  BIO-key is also promoting biometric technology and its offeringsthrough industry trade shows, public speaking 

 

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engagements, pressactivities and partner marketing programs

 

·                  BIO-key is directing licensing efforts to original equipment manufacturers,application developers and system integrators.

 

·                  BIO-key is continuing to build a reseller, integrator and partnernetwork as well as a direct sales team.

 

**Addressing the Market**

 

Following are the specific marketing/sales programs inplace:

 

·                  *Direct Selling Efforts*— BIO-key’s direct sales force focuses onOEMs and large entities in the commercial and Government markets. The salesteam has extensive sales experience and expertise in emerging biometrictechnologies. The BIO-key sales force is rounded out by Inside Sales, which isresponsible for maintaining and supporting our existing install base, acting asa front-line support for any inquiries on our product line, and facilitatingactivities that make 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.

 

·                  *Strategic Alliance*— BIO-key’s strategic alliances andreseller agreements with other vendors play a significant role in our overallsales efforts. In the past year, BIO-key has initiated and bolstered numerousimportant and promising long-term relationships. Just a few examples include:

 

·                  BIO-key is an active member in CA, IBMand Oracle partner programs, delivering authentication and identificationsolutions integrated with their Identity Management platform to their customersworldwide.

 

·                  BIO-key is focusing on specific verticalmarkets including healthcare where it continues to grow on  successful integration of its identificationtechnology to provide convenient, accurate and fast user identification inpartner solutions including McKesson and Allscripts

 

**Licensing**

 

BIO-key targets both Internet infrastructure companiesand large portal providers as possible licensees for its WEB-key® solution. On the Internetinfrastructure side, BIO-key seeks to partner with Internet servermanufacturers, providers of database and data warehouse engine software,horizontally positioned application engines, firewall solution providers andperipheral equipment manufacturers. On the portal side, BIO-key is targetingfinancial service providers such as credit and debit card authorization andissuing institutions, Internet retailers, business-to-business applicationservice providers (ASPs) and corporate intranets. In the past five years,BIO-key has undertaken a WEB-key ®and VST direct selling effort, and entered into license agreements withOEMs and system integrators to develop applications for distribution totheir respective customers.

 

BIO-key is also addressing the security needs ofapplication providers in the following vertical 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.  Also BIO-key, in conjunction with MorphoTrak,is providing the finger matching platform for the FBI’s Next Generation IAFISsystem, which today is one of the world’s largest biometric systems.

 

·                  *Education*—Educational Biometric Technologies andIdentimetrics have incorporated BIO-key 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 

 

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collecting payments.

 

·                  *Commerce:*LexisNexis has implemented varioussolutions in thousands of locations in over 70 countries using BIO-key’s VSTtechnology to reduce fraud and identity theft.

 

·                  *Patient Records and InformationManagement:*Allscriptshas integrated and deployed BIO-key’s biometric solution as a standard part ofits Enterprise EHR solution.  Theintegrated solution has been deployed at George Washington University, HolzerClinic, Medisync, and many other Allscripts customers. HBOC, one of the largesthealthcare patient records and information management companies, has integratedBIO-key technology into their portal and has deployed their solution in a pilotfor the Baptist Hospital System. Also, the Indiana Blood Center isincorporating BIO-key’s large scale identity assurance platform to provide asafe, secure and convenient means for donors to confirm their identity.  McKesson Provider Services has incorporatedBIO-key’s “one-to-many” finger matching software into their Accudose line ofmedication and supplies dispensing systems solutions and is selling thatequipment to clinics and hospitals nationwide.

 

·                  *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 our intellectual property is importantto our biometric operation:

 

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

 

In May 2005, the U.S. Patent & TrademarkOffice issued us a patent for our Vector Segment fingerprint technology (VST),BIO-key’s core biometric analysis and identification 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.

 

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 theU.S. Patent & Trademark Office has issued US patent No. 7,155,040covering BIO-key’s unique image processing technology, which is critical forenhancing information used in the extraction of biometric minutiae. The issuedpatent protects a critical part of an innovative four-phase image enhancementprocess developed by BIO-key, and represents the third U.S. patent granted tothe company for its biometric technology.

 

OnApril 15, 2008, BIO-keyannounced that the U.S. Patent and Trademark Office has issued US patent No. 7,359,553covering BIO-key’s image enhancement and data extraction core algorithmcomponents. The solution 

 

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protected under thisrecently issued patent provides the capability to quickly and accuratelytransform a fingerprint image into a computer image that can be analyzed todetermine the critical data elements

 

OnOctober 15, 2008 BIO-keyannounced that the U.S. Patent and Trademark Office has issued US patent No. 7,415,605for the company’s “Biometric Identification Network Security” method. Thesolution protected under this recently issued patent provides a defense againsthackers and system attacks, while leveraging the industry standard TrustedPlatform Module (TPM) specification for encryption key management.

 

OnDecember 3, 2008 BIO-keyannounced that the U.S. Patent and Trademark Office has issued US patent No. 7,454,624for the company’s “Match Template Protection within a Biometric Security System”method. The solution protected under this recently issued patent limits thescope of enrollment templates usage and also eliminates the need for revocationor encryption processes, which can be expensive and time consuming.

 

·                  *Trademarks*— We have registered our trademarks (“BIO-key”,“True User Identification”, and  “WEB-keywith the U.S. Patent & Trademark Office.

 

·                  *Copyrights and trade secrets*—We take measures to ensure copyright andlicense 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 and development efforts are concentratedon enhancing the functionality, reliability and integration of our currentproducts as well as developing new and innovative products for biometrics andlaw enforcement. Although BIO-key believes that its identification technologyis one of the most advanced and discriminating fingerprint technologiesavailable today, the markets in which BIO-key compete are characterized byrapid technological change and evolving standards. In order to maintain itsposition in the market, BIO-key will continue to upgrade and refine itsexisting technologies. In 2006, BIO-key announced the launch of IdentityMatch,our fingerprint identification system. IdentityMatch offers a tool for agenciesto store and search fingerprints and the associated demographic data, theability to compare new prints with those previously captured as a low-cost AFISalternative or to be used for a wide variety of routine identificationtransactions not supported by AFIS.

 

During the fiscal yearsended December 31, 2009 and 2008, BIO-key spent approximately $927,000 and$974,000 respectively, on its Biometric segment’s research, development andengineering. BIO-key’s limited customer base during that time did not directlybear these costs, which were principally funded through outside sources ofequity and debt financing.

 

**Government Regulations**

 

BIO-key is not currently subject to direct regulationby any government agency, other than regulations generally applicable tobusinesses or related to specific project requirements. In the event of anyinternational sales, the company would be subject to various domestic andforeign laws regulating such exports and export activities.

 

**Environmental Regulations**

 

As of the date of this report, BIO-key has notincurred any material expenses relating to our compliance with federal, state,or local environmental laws and does not expect to incur any material expensesin the foreseeable future.

 

**Employees and Consultants**

 

As of March 11,2010, BIO-key employed fifteen (15) individuals individuals on a full-timebasis five (5) in engineering, customer support, research and development;four (4) in finance and administration; and six (6) in sales andmarketing. BIO-

 

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key also uses theservices of two (2) consultants (full-time), who provide engineering andtechnical services, and one (1) part-time contracts administrator.

 

**ITEM 1A. RISK FACTORS**

 

Set forth below are the risks that we believe arematerial to our investors. This section contains forward-looking statements.You should refer to the explanation of the qualifications and limitations onforward-looking statements appearing just before our Description of Businesssection above.

 

**Businessand Financial Risks**

 

**Based****on our lack of significant revenuesince inception and recurring losses from operations, our auditors haveincluded an explanatory paragraph in their opinion as to the substantial doubtabout our ability to continue as a going concern.**

 

Due to, among other factors, our history of losses(excluding gains from valuation changes in embedded derivatives) and limitedrevenue, our independent auditors have included an explanatory paragraph intheir opinion for the year ended December 31, 2009 as to the substantialdoubt about our ability to continue as a going concern. Our financialstatements have been prepared in accordance with accounting principals generallyaccepted in the United States, which contemplate that we will continue tooperate as a going concern. Our financial statements do not contain anyadjustments that might result if we are unable to continue as a going concern.

 

**Since our formation, we havehistorically generated minimal revenue and have sustained substantial operatinglosses.**

 

As of December 31,2009, we had working capital of approximately $868,000 and an accumulateddeficit of approximately $50,087,000. Since our inception, we have focusedalmost exclusively on developing our core technologies and, until the fourthquarter of 2004 had not generated any significant revenue. In 2009 we sold ourLaw Enforcement division, losing the benefit of significant recurring revenuestreams. In order to increase revenue, we have developed a direct sales forceand anticipate the need to retain additional sales, marketing and technicalsupport personnel and may need to incur substantial expenses. We cannotassure you that we will be able to secure these necessary resources, that asignificant market for our technologies will develop or that we will be able toachieve our targeted revenue.

 

**We haveidentified material weaknesses in our internal control over financialreporting. If we are unable to successfully address such material weaknesses,we may not be able to accurately report our financial results or prevent fraud.As a result, current and potential stockholders could lose confidence in ourfinancial reporting; this would harm our business and the trading price of ourcommon stock.**

 

After a review of our2009 annual operating results, conducted pursuant to Rule 13a-15 under theSecurities Exchange Act of 1934, as amended, our Chief Executive Officer andour Chief Financial Officer have determined that, as of such date, our internalcontrol over financial reporting was not effective as of December 31,2009.  Effective internal control overfinancial reporting are necessary for us to provide reliable financial reportsand effectively prevent fraud and to operate successfully as a public company.We have in the past discovered, as described above, and may in the futurediscover, areas of our internal control over financial reporting that needimprovement. We are in the process of addressing these issues to ensure thatour internal control over financial reporting are improved. If, however, wecannot provide reliable financial reports or prevent fraud, our reputation andoperating results would be harmed. Additionally, if we are unable to adequately establish or improve ourinternal controls over financial reporting, our external auditors may not beable to issue an unqualified opinion on the effectiveness of our internalcontrols. Ineffective internal and disclosure controls could also causeinvestors to lose confidence in our reported financial information, which wouldlikely have a significant negative effect on the trading price of oursecurities.

 

**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 has received only limited marketacceptance, particularly in the private sector. Our technology represents anovel security solution and we have not yet generated significant sales.Although recent security concerns relating to identification of individuals hasincreased interest in biometrics generally, it remains an undeveloped, evolvingmarket. Biometric based solutions compete with more traditional securitymethods including keys, cards, personal identification numbers and securitypersonnel. Acceptance of biometrics as an alternative to such traditionalmethods depends upon a number of factors including:

 

· the reliability of biometricsolutions

 

· public perception regarding privacyconcerns

 

· costs involved in adopting andintegrating 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 solution

 

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specifically.

 

**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 provide a higherlevel of security for information transmitted over the Internet than existingtraditional methods, unless business and consumer markets embrace the use of ascanning device and believe the benefits of increased accuracy outweighimplementation costs, our solution will not gain market acceptance.

 

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

 

Although we havecompleted the development of our core biometric technology, it has only beenused by a limited number of business customers. Despite extensive testing duringdevelopment, 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.

 

**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 

 

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fingerprint identification 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, expires in December 2011. Mr. Colatostiassists the Company in the areas of strategic planning and corporate finance.In addition, our employment contract with Michael W. DePasquale, our ChiefExecutive Officer, expires in March 2011. Although the contract does notprevent him from resigning, it does contain confidentiality and non-competeclauses which are intended to prevent him from working for a competitor withinone year after leaving our Company. Our success depends on our ability toattract, train and retain employees with expertise in developing, marketing andselling software solutions. In order to successfully market our technology, wewill need to retain additional engineering, technical support and marketingpersonnel. The market for such persons remains highly competitive and ourlimited financial resources will make it more difficult for us to recruit andretain qualified persons.

 

**Wecannot assure you that the intellectual property protection for our coretechnology provides a sustainable 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.Over the last few years, the U.S. Patent Office has issued us a series ofpatents for our Vector Segment fingerprint technology (VST), and our other corebiometric analysis and identification technologies. We cannot assure you thatany additional patents will be issued or that we will have the resources toprotect any patent from infringement. Although we believe our technology doesnot currently infringe upon patents held by others, we cannot assure you thatsuch infringements do not exist or will not exist in the future.

 

**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 significant, recurring revenue (other than revenue fromacquired businesses) and have experienced substantial losses. In January 2006we received approximately $1,000,000 in a private placement convertible debtoffering, and in August 2006 we raised approximately $2,000,000 in grossproceeds through a private issuance of equity securities, of which $1,500,000was received in cash and $500,000 was paid by an exchange of rights to declaredand unpaid dividends. In May 2007 we received approximately $1,800,000 innet proceeds from the sale of our Fire/EMS Services division. In July and November 2009we received $1,000,000 and $750,000, respectively in gross proceeds through theissuance of unsecured promissory notes. In December 2009 we receivedapproximately $11,300,000 in net proceeds from the sale of our Law Enforcementdivision, of which $7,000,000 was paid in cash, and approximately $4,000,000 ofwhich is payable in three annual installments.

 

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 may 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, 2007,and 2009.

 

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 sustainable profitability with respect to the biometriccomponent of our business if we are unable to maintain, improve and develop thewireless 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 technological 

 

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competitiveness and meet an expanding range ofcustomer requirements. As a result of the complexities inherent in our serviceofferings, major new wireless data services and service enhancements requirelong development and testing periods. We may experience difficulties thatcould delay or prevent the successful development, introduction or marketing ofnew services and service enhancements. Additionally, our new services andservice enhancements may not achieve market acceptance. If we cannoteffectively develop and improve services we may not be able to recover ourfixed costs or otherwise become profitable.

 

**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

 

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 31,2009, approximately 35,826,000 shares of our common stock were reserved forissuance upon exercise or conversion of the following securities (at conversionprices applicable as at December 31, 2009):

 

·                  20,724,000 shares upon exercise ofoutstanding stock options and warrants;

 

·                  1,927,000 shares upon exercise of options availablefor future grant under our existing option plans; and

 

·                  10,714,000 shares or more upon conversion of ouroutstanding shares of Convertible Preferred Stock and cumulative dividends inarrears.

 

·                  2,461,000 shares or more upon conversionof the outstanding principal of Convertible Promissory Notes and accruedinterest payable.

 

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

 

**Asubstantial number of our convertible securities are convertible into shares ofcommon stock at a conversion price of $.30 per share. Most of these shares areeligible for public resale. The trading price of our common stock and**

 

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**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 D Convertible Preferred Stock (collectively, the “Preferred Stock”)and cumulative dividends in arrears are convertible into approximately10,714,000 shares of common stock as of December 31, 2009, at a per shareconversion price of $.30. In the event that shares issuable upon conversion ofour Preferred Stock become eligible for public resale, this significantincrease in the number of shares available for public sale may have a negativeimpact on the trading price of our shares and substantially dilute theownership interests of our existing shareholders. In the event that our stocktrades below $.30 per share, in order to raise additional financing we wouldlikely be required to issue additional shares of common stock or securitiesconvertible into common stock at a purchase or conversion price, as applicable,of less than $.30 per share. Any issuance of shares at a purchase price of lessthan $.30 per share would reduce the conversion price of our Preferred Stock tosuch lower price. This would require us to issue additional shares uponconversion of our Preferred Stock and further dilute the ownership interests ofour existing shareholders. To the extent these factors are viewed negatively bythe market, it may provide an incentive for persons to execute short sales ofour common stock that could adversely affect the trading price of our commonstock.

 

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

 

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

 

**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 outstandingPreferred Stock preclude us from declaring or paying a dividend on our commonstock unless a dividend is also declared or paid, as applicable, on ourPreferred Stock. We intend to retain earnings, if any, for use in the operationand expansion of our business and, therefore, do not anticipate paying anydividends 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 believethat approximately 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.

 

**Completion of the Asset Sale may result in dilutionof future earnings per share to the stockholders of BIO-key.**

 

The completion of theasset sale of BIO-key’s Law Enforcement division to InterAct911 Mobile Systems, Inc.in December 2009 may not result in improved earnings per share ofBIO-key.  The sale could fail to produce the benefits that BIO-keyanticipates, or could have other adverse effects that BIO-key currently doesnot foresee.  In this event, the asset sale could result in a reduction ofearnings per share of BIO-key as compared to the earnings per share that wouldhave been achieved if the asset sale had not occurred.

 

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**ITEM 2.**                    DESCRIPTION OFPROPERTY

 

We do not own any realestate. We conduct operations from leased premises in Eagan, Minnesota (6,822square feet), Wall, New Jersey (4,179 square feet) and Westford, Massachusetts(shared services center). We believe our current facilities are adequate forthe foreseeable future.

 

**ITEM 3.**                    LEGALPROCEEDINGS

 

Effectiveas of July 2, 2009, the Company entered into a Settlement and MutualRelease Agreement (the “Settlement Agreement”) with Longview Special Finance, Inc.and Longview Fund, L.P. (collectively, the “Longview Entities”) in order toresolve all matters relating to the litigation initiated by the Longview Entitiesearlier in 2009, in which they  were seeking $2,886,563 in damages and anunspecified amount of interest and attorney’s fees from the Company as a resultof the Company’s alleged improper failure to redeem their outstanding shares ofthe Company’s Convertible Preferred Stock (collectively, the “Shares”) inaccordance with the terms and conditions of such preferred stock. Pursuant to the Settlement Agreement, without admission of any liability orfault, the parties agreed to a payment schedule under which the Company wasrequired to pay a total cash settlement amount of $2,164,922, fifty percent(50%) of which was paid on July 7, 2009.  The remaining portion ofthe settlement amount accrued interest at seventeen percent (17%) per annum andwas required to be paid in full on or before October 30, 2009.  Inreturn, the Longview Entities agreed to a full and complete release of theCompany from all claims that were or could have been alleged in the lawsuit andagreed to relinquish all of the Shares upon receiving final payment of thesettlement amount. From October 30, 2009 until November 12, 2009,interest on the remaining portion of the settlement amount accrued at twentypercent (20%) per annum.  On November 12, 2009, the Company paid infull the entire outstanding portion of the settlement amount, together with allaccrued and unpaid interest, and satisfied all of its obligations to theLongview Entities under the Settlement Agreement.

 

**ITEM 4.**                    RESERVED

 

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**PART II**

** **

**ITEM5.    MARKET FOR REGISTRANT’S COMMONEQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

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.

 
| **2009:**                              | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended  December 31, 2009  |       | $          | 0.30       |       | $          | 0.15 |   |
| Quarter ended  September 30, 2009 |       | 0.26       |       | 0.10       |       |
| Quarter ended  June 30, 2009      |       | 0.17       |       | 0.07       |       |
| Quarter ended  March 31, 2009     |       | 0.11       |       | 0.05       |       |
|                                        |            |            |            |            |            |  |  |

 
| **2008:**                              | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended  December 31, 2008  |       | $          | 0.11       |       | $          | 0.04 |   |
| Quarter ended  September 30, 2008 |       | 0.20       |       | 0.09       |       |
| Quarter ended  June 30, 2008      |       | 0.18       |       | 0.10       |       |
| Quarter ended March 31,  2008     |       | 0.13       |       | 0.10       |       |
|                                        |            |            |            |            |            |  |  |

 

**Holders**

 

As of March 24,2010, the number of stockholders of record of our common stock was 170.

 

**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.

 

**EquityCompensation Plan Information**

 

For information regardingour equity compensation plans, see Item 12 included in this Annual Report on Form 10-K.

 

**RecentSales of Unregistered Securities; use of Proceeds from Registered Securities**

 

(a) On July 7,2009, the Company issued an unsecured promissory note in the aggregateprincipal amount of $1,000,000 to The Shaar Fund Ltd. These securitieswere issued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

 

(b) On November 12, 2009, the Company issued an unsecured promissory note in the aggregate principal amount of $750,000 to The Shaar Fund Ltd. These securities were issued in a private placement transaction exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof directly by the Company without engaging in any advertising or general solicitation of any kind and without payment of underwriting discounts or commissions to any person.

 

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(c) On November 12,2009, the Company entered into a Securities Exchange Agreement with The ShaarFund Ltd. and Mr. Thomas J. Colatosti (the “Holders”), pursuant towhich these investors agreed to exchange 27,932 shares of the Company’s Series AConvertible Preferred Stock owned by the respective Holders, for 27,932 sharesof the Company’s Series D Convertible Preferred Stock at an initial fixedconversion price of $0.30 per share. In addition, the Company issuedconvertible promissory notes in the aggregate principal amount of $737,957 tothe Holders in exchange for all dividends accrued and unpaid on their Series AConvertible Preferred Stock. Also, the Company issued warrants to the Holdersto purchase 5,000,000 shares of common stock at an initial exercise price of$0.30.  These securities were issued in aprivate placement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

 

**Purchasesof Equity Securities by the Issuer and Affiliated Purchasers**

 

None.

 

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**ITEM 6. SELECTEDFINANCIAL DATA**

 

**N/A**

 

**ITEM 7.**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This Management’sDiscussion And Analysis Of Financial Condition And Results Of Operations, and other parts of this Report containforward-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 1A and elsewhere inthis Report. The following should be read in conjunction with our auditedfinancial statements included elsewhere herein.

 

The following Management’sDiscussion And Analysis Of Financial Condition And Results Of Operations (“MD&A”) is intended to help youunderstand BIO-key International (the “Company”, “we”, “us” or “our”). MD&Ais provided as a supplement to and should be read in conjunction with ourfinancial 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 2009performance and a description of the significant events impacting 2009 andthereafter.

 

RESULTS OF OPERATIONSprovides an analysis of the consolidated results of operations for 2009compared to 2008.

 

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 2009.

 

**OVERVIEW**

 

Our Business

 

BIO-key develops andmarkets advanced fingerprint identification biometric technology and softwaresolutions.

 

We were among the initialpioneers in developing automated, finger identification technology that can beused without the aid of non-automated methods of identification such as apersonal identification, password, token, smart card, ID card, credit card,passport, driver’s license or other form of possession or knowledge basedidentification. This advanced BIO-keyTM identification technology improves boththe accuracy and speed of finger-based biometrics.

 

In 2004, BIO-key acquiredPublic Safety Group, Inc. (PSG), a privately held company that was aleader in wireless solutions for law enforcement and public safety markets. PSG’sprimary technology was PocketCopTM, a handheld solution that provides mobileofficers, such as detectives who are not typically in their vehicles, ahand-held mobile information software solution. Also in, 2004, BIO-keycompleted a transaction with Aether Systems, Inc. to purchase its MobileGovernment Division (“Mobile Government” or “AMG”), a leading provider ofwireless data solutions for use by public safety organizations, primarilystate, local police, fire and rescue and emergency medical servicesorganizations. Their 

 

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PacketClustermobile information software is integrated with 50 separate State/NCICdatabases, as well as other state, local and federal databases.

 

In 2007, BIO-keycompleted 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.

 

In 2009, BIO-keycompleted a transaction with InterAct911 Mobile Systems, Inc.(InterAct911), a subsidiary of InterAct911 Corporation, in which InterAct911acquired substantially all the assets related to the Company’s Law Enforcementdivision.

 

# **INTRODUCTION**

#  

As aresult of these transactions, and as discussed in Note M to theConsolidated Financial Statements included in this report, we have organizedthe Company into one reporting segment: Biometrics. During the year ended December 31,2009, the Company continued to focus on its primary objectives of increasingrevenue and managing expenses, by developing leadership technology andapplications and by providing its customers with high quality support andservice.

 

Adetailed analysis of operations can be found below.

 

**RESULTSOF OPERATIONS**

 

**ConsolidatedResults of Operations**

 

**Two Year % trend**

 
| ** **                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **2009**                     | ** ** | **2008** | ** ** |
| **Revenues**                                            | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Services                                                |       | 20                           | %          | 6 | % |
| License  fees and other                                 |       | 80                           | %          | 94 | % |
|                                                    |       | 100                          | %          | 100 | % |
| **Costs and other expenses**                            | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Cost  of services                                       |       | 4                            | %          | 2 | % |
| Cost  of license fees and other                         |       | 17                           | %          | 8 | % |
|                                                    |       | 21                           | %          | 10 | % |
| Gross  Profit                                           |       | 79                           | %          | 90 | % |
|                                                    |       |                         |       |   |   |
| **Operating expenses**                                  |       |                         |       |   |   |
| Selling,  general and administrative                    |       | 144                          | %          | 111 | % |
| Research,  development and engineering                  |       | 39                           | %          | 29 | % |
|                                                    |       | 183                          | %          | 140 | % |
| **Operating loss**                                      |       | -104                         | %          | -50 | % |
|                                                    |       |                         |       |   |   |
| **Other income (deductions)**                           | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Total  other deductions                                 |       | -9                           | %          | 6 | % |
| **Net  loss from continuing operations**                |       | -113                         | %          | -43 | % |
| **Net  income from discontinued operations**            |       | 122                          | %          | 49 | % |
| **Gain  (loss) on disposal of discontinued operations** |       | 190                          | %          | -2 | % |
| **Net  income**                                         |       | 199                          | %          | 4 | % |

 

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***Revenuesand Costs of goods sold***

 
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | **2009 - 2008** | ** ** |
|---------------------------|------------|------------|------------|------------|------------|-----------------|------------|
| ** **                | ** ** | **2009**   | ** ** | **2008**   | ** ** | **$ Chg**  | ** ** | **%  Chg** | ** ** |
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| *Revenues*                | * *   | * *   | * *   | * *   | * *   | * *        | * *   | * * | * * |
| Service                   |       | 482,900    |       | 191,515    |       | 291,385         |       | 152 | % |
| License &  other |       | 1,874,382  |       | 3,188,027  |       | (1,313,645      | )          | -41 | % |
| *Total Revenue*           |       | $          | 2,357,282  |       | $          | 3,379,542       |       | $ | (1,022,260 | ) | -30 | % |
|                      |       |       |       |       |       |            |       |   |   |
| *Cost of goods sold*      | * *   | * *   | * *   | * *   | * *   | * *        | * *   | * * | * * |
| Service                   |       | 82,594     |       | 63,569     |       | 19,025          |       | 30 | % |
| License &  other |       | 421,641    |       | 268,589    |       | 153,052         |       | 57 | % |
| *Total  COGS*             |       | $          | 504,235    |       | $          | 332,158         |       | $ | 172,077 |   | 52 | % |

 

***Revenues***

 

Forthe year ended December 31, 2009, service revenue increased as the Companycontinued to bundle maintenance agreements to its expanding customer licensebase during the period, as well as renewed existing maintenance agreements fromits legacy customers during the period. The percentage of service revenue as aproportion of total Biometric revenue increased from approximately 6% to 20%across the two periods reported.

 

Forthe year ended December 31, 2009, license and other revenue decreasedprimarily as a result of non-recurring sales generated from an OEM customer in2008, however the decrease was offset  byadditional license revenue from existing customers.

 

***Costsof goods sold***

 

Forthe year ended December 31, 2009, cost of services increased from the 2008period due to increased customer support, as needed for the expanding customerbase, however the relative percent of service revenue decreased from 33% in2008 to 17% in 2009.  The Company expectsthese costs will increase in future periods as additional Biometric customersare added.

 

For the year ended December 31,2009, cost of license and other increased from the 2008 period, due to anincrease in costs for temporary outside services required to support specificcustomer orders, hardware costs for an increase in hardware orders and thirdparty software costs, driven by a larger customer base.

 

***Selling, general and administrative***

 
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2009 - 2008** | ** ** |
|------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** ** | ** ** | **2009**   | ** ** | **2008**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Total**  |       | $          | 3,382,613  |       | $          | 3,758,888                 |       | $ | (376,275 | ) | -10 | % |
|            |            |            |            |            |            |                           |            |  |  |  |  |  |

 

The overall decline inthe total SG&A costs for the year ended December 31, 2009 as comparedto 2008 was attributable to a reduction in intangible amortization byapproximately $295,000, payroll expense by $128,000 and a decrease ofapproximately $69,000 in non-cash compensation charges.  The reduction in expenses were offset byincreases in legal fees related to the Settlement Agreement by $30,000, andcommission expenses of approximately $72,000.

 

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***Research,development and engineering***

 
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2009 - 2008** | ** ** |
|------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** ** | ** ** | **2009**   | ** ** | **2008**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Total**  |       | $          | 927,241    |       | $          | 974,182                   |       | $ | (46,941 | ) | -5 | % |
|            |            |            |            |            |            |                           |            |  |  |  |  |  |

 

For the year ended December 31,2009, R & D costs decreased as compared to 2008, primarily due tolower consultant expenses, offset by in increase in non-cash compensationcharges.

 

***Otherincome and expense***

 
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **2009 - 2008** | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **                                     | ** ** | **2009**   | ** ** | **2008**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Interest  income (expense)                     |       | $          | 89,804     |       | $          | (2,552                    | )          | $ | 92,356 |   | -3619 | % |
| Derivative  and warrant fair value adjustments |       | (286,492   | )          | 93,059     |       | (379,551                  | )          | -408 | % |
| Gain  on sale of investments                   |       | —     |       | 119,348    |       | (119,348                  | )          | -100 | % |
| Other  expense                                 |       | (9,393     | )          | —     |       | (9,393                    | )          | N/A |   |
|                                           |       |       |       |       |       |                      |       |   |   |
|                                           |       | $          | (206,081   | )          | $          | 209,855                   |       | $ | (415,936 | ) | -198 | % |

 

For the year ended December 31,2009, the increase in interest income was a result of the Company releasingunclaimed penalty reserves from prior years. Interest expense includes actualcash paid for interest as well as non-cash interest charges for theamortization of debt discounts, deferred charges, and deferred rent. Themajority of interest expense for 2009 and 2008 was associated with NotesPayable (Note L).

 

For the year ended December 31,2009, derivative and warrant fair value adjustments decreased, when compared tothe 2008 period, due to changes in the fair market value of embeddedderivatives and detachable warrants issued with convertible debt in 2004, 2005,and 2009, as well as with additional derivatives recorded as a result offinancings in 2006 and 2009. The fair value of the instruments will fluctuatebased on; our stock price on the valuation date, the debt conversion price, thevolatility of our stock price over a period of time, changes in the value ofthe risk free interest rate, and the time to maturity of the outstanding debtat different points in time. Stock price is the major driver behind themovement in the Company’s balances. As our stock price increased during 2009,the value of these instruments also increased, leading to and adjustment toother expenses; the opposite effect occurred during the 2008 period, as ourstock price decreased, leading to a reduction in the value of theseinstruments, and an adjustment to other income.

 

For the year ended December 31,2008, gain on sale ofinvestments related to the realization of “available-for-sale” securities soldat its market value.

 

**DISCONTINUEDOPERATIONS**

 

On December 8, 2009,we completed the sale of our Law Enforcement division for approximately $11.3million, amounting to a net gain to the Company of approximately $4.5 million.This business had previously been reported as a separate segment in ourfinancial statements. For the fiscal years ended 2009 and 2008, $2.9 million,and $1.7 million of operating income, respectively, net of tax, were reflectedas discontinued operations in the accompanying consolidated statements ofoperations.  Net sales associated with the discontinued operationswere $8.6 million, and $9.5 million for 2009 and 2008, respectively. See “NoteB — Discontinued Operations” for further discussion.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

** **

***OPERATING ACTIVITIES OVERVIEW***

 

Net cash used for operationsduring the year ended December 31, 2009 was approximately $1,655,000. The cash used by operating activities ofcontinuing operations was primarily due to the following items:

 

·     Negative cash flows relatedto a decrease in accounts receivable, and deferred revenue of approximately$757,000, and $468,000, respectively (net outflow of $1,225,000),

 

·     Negative cash flows frompayments with respect to the note payable, and a decrease in accruedliabilities of approximately $268,000,

 

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, 2009:

 

·     TheCompany issued notes in 2005, 2006, and 2009 and preferred stock in 2009, allof which contained embedded derivatives, and associated warrants. In 2009, theCompany recognized losses of approximately $286,000 related to the decrease invalue of the derivatives and associated warrants. The decrease in value isdriven mainly by the decline in value of the underlying BIO-key stock,

 

·     TheCompany recorded approximately $222,000 of charges in 2009 for the expense ofissuing options to employees for services.

 

***INVESTING ACTIVITIES OVERVIEW***

 

Net cash provided byinvesting activities for the year ended December 31, 2009 wasapproximately $6,941,000. The cash provided by investing activities forcontinuing operations was primarily driven by the net cash proceeds from thesale of the Law Enforcement division of approximately $7,000,000.

 

***FINANCING ACTIVITIES OVERVIEW***

 

Net cash used by financingactivities for the year ended December 31, 2009 was approximately$6,206,000. The cashprovided by financing activities of continuing operations was primarily due tothe following items:

 

·     Negative cash flows relatedto payment of short term obligations of approximately $3,915,000, partiallyoffset by proceeds from the issuance of short term obligations of $1,750,000(net outflow of $2,165,000),

 

·     Negative cash flows from theredemption of redeemable preferred stock of approximately $4,004,000.

 

Net working capital ofcontinuing operations at December 31, 2009 was approximately $868,000 ascompared to approximately $283,000 at December 31, 2008, the improvementof which was driven mainly by the Company’s restructuring of its balance sheetfollowing the sale of the Law Enforcement division.

 

Since January 7, 1993(date of inception), our capital needs have been principally met throughproceeds from the sale of equity and debt securities.

 

We do not expect anymaterial capital expenditures during the next twelve months.

 

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We do not currently maintaina line of credit or term loan with any commercial bank or other financialinstitution.

 

***Liquidity outlook***

 

AtDecember 31, 2009, our total of cash and cash equivalents wasapproximately $792,000, as compared to approximately $1,713,000 at December 31,2008.

 

As discussed above, theCompany has financed itself in the past through access to the capital marketsby issuing convertible debt securities, convertible preferred stock and commonstock. We currentlyrequire approximately $400,000 per month to conduct our operations. During 2009, we generated approximately$2,400,000 of revenue. While the Company expects to increase revenue in 2010,there can be no assurance that we will achieve that goal.

 

The Company expects to receive $4 million from themaker of its Note Receivable in three equal annual instalments commencing December 2010.These cash inflows shall be partially offset by approximately $3.1 million dueto the anticipated redemption of the outstanding balance of the Company’sredeemable preferred stock.

 

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 may 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, 2007,and 2009.

 

Due to several factors,including our history of losses and limited revenue, our independent auditorshave included an explanatory paragraph in opinions they have previously issuedrelated to our annual financial statements as to the substantial doubt aboutour ability to continue as a going concern. Our long-term viability and growthwill depend upon the successful commercialization of our technologies and ourability to obtain adequate financing. To the extent that we require suchadditional financing, no assurance can be given that any form of additionalfinancing will be available on terms acceptable to us, that adequate financingwill be obtained to meet our needs, or that such financing would not bedilutive to existing stockholders. If available financing is insufficient orunavailable or we fail to continue to generate meaningful revenue, we may berequired to further reduce operating expenses, delay the expansion ofoperations, be unable to pursue merger or acquisition candidates, or continueas a going concern.

 

**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. In 2008 the Company extended its propertylease at its Marlborough, MA location. Pursuant to the agreement BIO-key was tomaintain a security deposit in the form of an irrevocable letter of credit inthe amount of $40,500. However, BIO-key and the landlord for the propertysubsequently agreed to have BIO-key place the funds in a third  party escrow account, to be returned at theconclusion of the lease term, in August 2011. Pursuant to the sale of theCompany’s Law Enforcement to InterAct911 in December 2009 (see “Note B —Discontinued Operations”), the Company is no longer situated at this location,and expects to fully assign the obligations of the Marlborough premises inearly 2010. Accordingly, the balance is recorded as the current asset, “Restrictedcash” as at December 31, 2009.

 

**CRITICALACCOUNTING POLICIES**

 

Our financial statementsare prepared in accordance with accounting principles generally accepted in theUnited States. The preparation of these financial statements requires that wemake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting periods. We base our estimates on historical experienceand on various other assumptions that we believe to be reasonable under thecircumstances. We evaluate our estimates and

 

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assumptions on an ongoingbasis. Our actual results may differ significantly from these estimates underdifferent assumptions or conditions. There have been no material changes tothese estimates for the periods presented in this Annual Report on Form 10-K.

 

We believe that of oursignificant accounting policies, which are described in Note A of thenotes to our consolidated financial statements included in this Annual Reporton Form 10-K, the following accounting policies involve a greater degreeof judgment and complexity. Accordingly, these are the policies we believe arethe most critical to aid in fully understanding and evaluating our financialcondition and results of operations.

 

*1.****Revenue Recognition*

 

Revenues from software licensing are recognized inaccordance with ASC 985-605, “SoftwareRevenue Recognition. Accordingly, revenue from software licensing isrecognized when all of the following criteria are met: persuasive evidence ofan arrangement exists, delivery has occurred, the fee is fixed or determinable,and collectability is probable.

 

The Company intends to enter into arrangements withend users for items which may include software license fees, and servicesor various combinations thereof. For each arrangement, revenues will berecognized when evidence of an agreement has been documented, the fees arefixed or determinable, collection of fees is probable, delivery of the producthas occurred and no other significant obligations remain.

 

Multiple-Element Arrangements: For multiple-elementarrangements, each element of the arrangement will be analyzed and the Companywill allocate a portion of the total fee under the arrangement to the elementsusing vendor specific objective evidence of fair value of the element,regardless of any separate prices stated within the contract for each element.Vendor specific objective evidence is based on the price the customer isrequired to pay when the element is sold separately (i.e., software licensefees charged when consulting or other services are not provided, hourly ratescharged for consulting services when sold separately from a software license).If vendor specific objective evidence of fair value does not exist for anyundelivered elements, all revenue is deferred and recognized ratably over theservice period if the undelivered element is services, or until sufficientobjective evidence of fair value exists or all elements have been delivered.

 

License Revenues: Amounts allocated to licenserevenues are recognized at the time of delivery of the software and all otherrevenue recognition criteria discussed above have been met.

 

Revenue from licensing software, which requiressignificant customization and modification, is recognized using the percentageof completion method, based on the hours of effort incurred by the company inrelation to the total estimated hours to complete. In instances where thirdparty hardware, software or services form a significant portion of acustomer’s contract, the company recognizes revenue for the element of softwarecustomization by the percentage of completion method described above. Thirdparty hardware, software, and services are recognized upon shipment oracceptance as appropriate. If the company makes different judgments or utilizesdifferent estimates of the total amount of work expected to be required tocustomize or modify the software, the timing and revenue recognition, fromperiod to period, and the margins on the project in the reporting period,may differ materially from amounts reported. Anticipated contract lossesare recognized as soon as they become known and are estimable.

 

Service Revenues: Revenues from services are comprisedof maintenance and consulting and implementation services. Maintenance revenuesinclude providing for unspecified when-and-if available product updates andcustomer telephone support services, and are recognized ratably over the termof 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 provides customers, free of charge or at aminimal cost, testing kits which potential licensing customers may use totest compatibility/acceptance of the Company’s technology with the customer’sintended applications.

 

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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.

 

*2.****Derivative and Warrant financialinstruments*

 

In connection with thesale of debt or equity instruments, we may sell options or warrants to purchaseour common stock. In certain circumstances, these options or warrants may beclassified as derivative liabilities, rather than as equity. Additionally, thedebt or equity instruments may contain embedded derivative instruments, such asconversion options, which in certain circumstances may be required to bebifurcated from the associated host instrument and accounted for separately asa derivative instrument asset or liability.

 

Our derivative instrumentliability is re-valued at the end of each reporting period, with changes in thefair value of the derivative liability recorded as charges or credits toincome, in the period in which the changes occur. For options, warrants andbifurcated conversion options that are accounted for as derivative instrumentliabilities, we determine the fair value of these instruments using theBlack-Scholes or Binomial option pricing model. That model requires assumptionsrelated to the remaining term of the instruments and risk-free rates of return,our current common stock price and expected dividend yield, and the expectedvolatility of our common stock price over the life of the option. Theidentification of, and accounting for, derivative instruments and theassumptions used to value them can significantly affect our financialstatements.

 

*3.Impairment or Disposal of Long Lived Assets,including Intangible Assets*

 

Wereview our long-lived assets, including intangible assets subject toamortization, whenever events or changes in circumstances indicate that thecarrying amount of such an asset may not be recoverable. Recoverability ofthese assets is measured by comparison of their carrying amount to the futureundiscounted cash flows the assets are expected to generate. If such assets areconsidered impaired, the impairment to be recognized is equal to the amount bywhich the carrying value of the assets exceeds their fair value determined byeither a quoted market price, if any, or a value determined by utilizing adiscounted cash flow technique. In assessing recoverability, we must makeassumptions regarding estimated future cash flows and discount factors. Ifthese estimates or related assumptions change in the future, we may be requiredto record impairment charges. Intangible assets with determinable lives areamortized over their estimated useful lives, based upon the pattern in whichthe expected benefits will be realized, or on a straight-line basis, whicheveris greater. We did not record any impairment charges in any of the yearspresented.

 

*4.****Research and DevelopmentExpenditures*

 

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.

 

*5.****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 by ASC740-10, “Income Taxes,”includes the consideration of all available evidence, both

 

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positive and negative,regarding historical operating results including recent years with reportedlosses, the estimated timing of future reversals of existing taxable temporarydifferences, estimated future taxable income exclusive of reversing temporarydifferences and carryforwards, and potential tax planning strategies which maybe employed to prevent an operating loss or tax credit carryforward fromexpiring unused. Because of the Companies historical performance and estimatedfuture taxable income a full valuation allowance has been established.

 

*6.****Accounting forStock-Based Compensation*

 

The Company accounts forshare based compensation in accordance with the provisions of ASC 718-10, “Compensation — Stock Compensation,”which requires measurement of compensation cost for all stock awards at fairvalue on date of grant and recognition of compensation over the service periodfor awards 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 treatseach vesting tranche as if it were an individual grant. The fair value of stockoptions is determined using the Black-Scholes valuation model, and requires theinput of highly subjective assumptions. These assumptions include estimatingthe length of time employees will retain their vested stock options beforeexercising them (the “expected option term”), the estimated volatility of ourcommon stock price over the option’s expected term, the risk-free interest rateover the option’s expected term, and the Company’s expected annual dividendyield. Changes in these subjective assumptions can materially affect theestimate of fair value of stock-based compensation and consequently, therelated 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 vestingrequirements). The estimation of stock awards that will ultimately vestrequires significant judgment. We consider many factors when estimatingexpected forfeitures, including types of awards, employee class, and historicalexperience. Actual results, and future changes in estimates, may differsubstantially from our current estimates.

 

**RECENTACCOUNTING STANDARDS**

 

In September 2009,the FASB issued ASU 2009-13, *MultipleElement Arrangements*. ASU 2009-13 addresses the determination ofwhen the individual deliverables included in a multiple arrangement may be treatedas separate units of accounting. ASU 2009-13 also modifies the manner in whichthe transaction consideration is allocated across separately identifieddeliverables and establishes definitions for determining fair value of elementsin an arrangement. This standard must be adopted by the Company no later than January 1,2011 with earlier adoption permitted. The Company is currently evaluating theimpact, if any, that this standard update will have on its consolidatedfinancial statements.

 

In June 2009, the FASB issued ASC 105-10, *Generally Accepted Accounting Principles*(the“Codification”). The Codification will be the single source of authoritativenongovernmental U.S. generally accepted accounting principles. Rules andinterpretive releases of the SEC under authority of federal securities laws arealso sources of authoritative GAAP for SEC registrants. All existing accountingstandards are superseded as described in ASC 105-10. All other accountingliterature not included in the Codification is non-authoritative. ASC 105-10 iseffective for interim and annual periods ending after September 15, 2009.The adoption of ASC 105-10 did not have a material impact on the Company’sfinancial condition or results of operations.

 

In May 2009,the FASB issued ASC 855-10, *SubsequentEvents*. ASC 855-10 sets forth the period after the balance sheetdate during which management of a reporting entity should evaluate events ortransactions that may occur for potential recognition or disclosure in thefinancial statements, the circumstances under which an entity should recognizeevents or transactions occurring after the balance sheet date in its financialstatements, and the disclosures that an entity should make about events ortransactions that occurred after the balance sheet date. ASC 855-10 will beeffective for interim or annual period ending after June 15, 2009 and willbe applied prospectively. The adoption of ASC 855-10 had no impact on theCompany’s financial condition or results of operations.

 

In April 2009,the FASB issued FSP No. FAS 107-1 and APB 28-1, *“Interim Disclosures about Fair Value of Financial Instruments”,*whichis now part of ASC 825. This FSP essentially expands the disclosure about fairvalue of

 

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financial instrumentsthat were previously required only annually to also be required for interimperiod reporting. In addition, the FSP requires certain additional disclosuresregarding the methods and significant assumptions used to estimate the fairvalue of financial instruments. These additional disclosures were requiredbeginning with the quarter ended June 30, 2009. The adoption had no impacton the Company’s financial condition or results of operations.

 

In February 2009,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 141(R)-a, “*Accounting for Assets Acquired and Liabilities Assumed in a Business Combinationthat Arise from Contingencies”* (SFAS No. 141(R)-a), now part ofASC 805, which simplifies how entities will be required to account forcontingencies arising in business combinations under SFAS 141(R) “*Accounting for Business Combinations*”.FASB decided to amend the guidance SFAS 141(R) to require assets acquiredand liabilities assumed in a business combination that arise from contingenciesbe recognized at fair value, if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, theasset or liability would be accounted for in accordance with FASB Statement No. 5“*Accounting for Contingencies*”(SFAS 5). The provisions of SFAS No. 141(R)-a are applicable to businesscombinations consummated after January 1, 2009 for calendar year entities.The adoption of SFAS 141(R)-a) will have an impact on the Company’s accountingfor business combinations in connection with any future acquisitions.

 
| **ITEM  7A.** | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK** |
|---------------|-----------------------------------------------------------------|

** **

**N/A**

** **
| **ITEM 8.** | **FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA** |
|-------------|--------------------------------------------------|

** **

See financial statementsappearing at pages 42-45 of this report

 
| **ITEM 9.** | **CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

** **

None.

 
| **ITEM  9A.** | **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, 2009 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, 2009, 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 disclosure items,our internal process of review for account reconciliations, our documentationof internal controls and our internal process for preparing our annual reporton Form 10-K for the fiscal year ended December 31, 2009 as beingadequate to provide such assurance.

 

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

 

Our management isresponsible 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 to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

 

Under the supervision andwith the participation of our management, including our CEO and CFO, we haveconducted an evaluation of the effectiveness of our internal control overfinancial reporting as of December 31, 2009, based upon the framework in *Internal Control-Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on this evaluation, management has concluded that our internal controlover financial reporting was not effective as of December 31, 2009. Ourmanagement reached this conclusion after identifying the following two areas ofmaterial weakness in our internal control systems:

 

i                         Inadequateand ineffective application of complex accounting; and

 

ii                     Management did not sufficiently monitorinternal control over financial reporting. Specifically the Company did nothave sufficient personnel with an appropriate level of technical accountingknowledge and experience who could execute appropriate application of complexaccounting with respect to derivatives, warrants and stock option modification.

 

Remediation plansinclude soliciting additional experts necessary to help ensure the accuracy ofthe complex accounting financial reporting.

 

This annual report doesnot include an attestation report of the Company’s registered public accountingfirm regarding internal control over financial reporting. Management’s reportwas not subject to attestation by the Company’s registered public accountingfirm pursuant to temporary rules of the Securities and Exchange Commissionthat permit the company to provide only management’s report in this annualreport.

 

*Changesin Internal Control Over Financial Reporting*

 

During the fiscal quarterended December 31, 2009, the Company’s acting Chief Financial Officer,Thomas Colatosti was replaced by Cecilia Welch.

 

During the fiscal quarterended December 31, 2009, the Company supplemented its review and reportingstructure through the use of outside experts to assist in the preparation ofthe Company’s annual report. The outside experts have also assisted with thereview and testing of the Company’s internal control over financial reportingas of December 31, 2009.

 

**ITEM 9B.**    OTHER INFORMATION

** **

None.

 

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**PART III**

** **

**ITEM 10.**    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE

** **

The following sets forth certain information abouteach director and executive officer of the Company.

 
| **NAME**                      | ** ** | **AGE** | ** ** | **POSITIONS HELD**                                                    |
|-------------------------------|------------|---------|------------|-----------------------------------------------------------------------|
| Thomas J. Colatosti           |       | 61      |       | Chairman of the Board  of Directors                                   |
| Michael W. DePasquale         |       | 55      |       | Chief Executive Officer  and Director                                 |
| Jeffrey J. May (b)       |       | 50      |       | Director                                                              |
| Charles P.  Romeo(a) (c) |       | 68      |       | Director                                                              |
| John Schoenherr  (b) (c) |       | 57      |       | Director                                                              |
|                          |       |    |       |                                                                  |
| Cecilia Welch                 |       | 50      |       | Chief Financial Officer                                               |
| Randy Fodero                  |       | 51      |       | Vice President of Sales                                               |
| Mira K. LaCous                |       | 48      |       | Vice   President of  Technology & Development |
| Charles “Bud” Yanak |       | 53      |       | Vice President of Marketing                                           |

 

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

 

(b)    AuditCommittee Member

 

(c)    CompensationCommittee Member

 

The following is a brief summary of the businessexperience of each of the above-named individuals:

 

**THOMAS J.COLATOSTI** has served as a Director of the Company since September 2002,as Chairman of the Board since January 3, 2003, and as Chief FinancialOfficer from November 17, 2008 to December 21, 2009.  Mr. Colatosti also 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 July 2009, Mr. Colatosti hasbeen serving as Chairman of Commodore Applied Technologies. Mr. Colatostihas served as a Director and President of Good Harbor Partners AcquisitionCorp., a publicly-traded special purpose acquisition company formed to acquirebusinesses in the security sectors. From 1997 through June 2002, Mr. Colatostiserved as the Chief Executive Officer of Viisage Technology, Inc., apublicly traded biometric technology company. Between 1995 and 1997, Mr. Colatostiserved as President and Chief Executive Officer of CIS Corporation. Prior toCIS, Mr. Colatosti had a 21 year career with Digital EquipmentCorporation. Among his executive positions he was  Vice President and General Manager of thecompany’s $1.2 billion Government Systems Division. Mr. Colatosti isconsidered a security industry authority.

 

**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 26 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 education productsand 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 andDirector of MagnaLynx, a semiconductor company specializing in high speed chiplevel communications. Since 1997, Mr. May has served as the Presidentof Gideons 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 to Oracle he served as Senior VicePresident of Business Intelligence and Analytics at Information Resources, Inc.   Mr. Schoenherr has over 25 years ofexperience in the area of business intelligence and strategic planning.  His career includes a number of productdevelopment and management positions.

 

**CECILIAWELCH** has served as Chief Financial Officer of the Companysince December 21, 2009. Ms. Welch joined the Company in 2007 and hasserved since then as the Company’s Corporate Controller. Prior to joining theCompany, from January 2006 to December 2006 she was the Controllerfor Savaje Technologies (acquired by Sun Microsystems), a developer of advancedmobile telephone software. From October 2004 to January 2006, she wasController for Crystal Systems, a manufacturer of sapphire crystals used forindustrial, semiconductor, defense and medical applications.  From December 1988to July 2004, she was the Controller for ATN Microwave (acquired byAgilent Technologies), a manufacturer of automated test equipment. Ms. Welchhas a Bachelor’s degree in Accounting from Franklin Pierce University.

 

**RANDYFODERO** has served as the Vice President of Sales since February 1,2006. From July 2005 until February  2006, he was a sales consultantto the Company. Between July 2003 and July 2005, Mr. Fodero wasthe Vice 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, and 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.

 

**MIRA K. LACOUS** has served as Vice President of Technology & Development of the Company since May 15, 2000. Ms. LaCous has over 26 years of software development/architecture and project management experience with a background that includes successfully bringing numerous technologies to market, including automated voice response systems, automated building control systems, software piracy protection, intranet training materials and testing, page layout and design software, image scanning software and systems, biometric security, biometric algorithms and more. Ms. LaCous is also the author of five US Patented technologies, multiple international patents, and other patent pending solutions.  She has been an officer or director of two other companies; National Computer Systems (NCS), and TEL-Line Systems. Ms. LaCous has a Bachelors in

 

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Computer Science from North Dakota State University.  Ms. LaCous also serves on the Board of Directors of the Minnesota Sinfonia, a not-for-profit arts organization, as its chairperson.

 

**CHARLES “BUD” YANAK**hasserved as Vice President of Marketing of the Company since July 1, 2004. Mr. Yanakhas more than 25 years of experience leading the successfuldevelopment, commercialization, marketing and licensing of technology forsecurity, electronics and industrial companies. He has held executive-levelmarketing positions at organizations including Iridian Inc. as VP of Marketingand Business Development, a leading biometric company; Avery Dennison, a globalsupplier of barcode identification systems; and Mars Electronics IndustrialProducts Group. Most recently, Yanak was vice president of sales and marketingfor BioLink Technologies, an enterprise security company. Mr. Yanak has aBS and MS in Engineering from Drexel University and an MBA from TempleUniversity.

 

**Directors’ Terms of Office**

** **

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

 

**AuditCommittee**

 

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.

 

**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, 2009, all Section 16(a) filingrequirements applicable to the Company’s officers, directors and ten percent(10%) stockholders were satisfied in a timely fashion, except for thefollowing:

 

a)     Thomas J. Colatosti — onelate Form 4 filing with respect to the issuance of a total of 50,000options on February 27, 2009.

 

b)    Michael DePasquale — onelate Form 4 filing with respect to the issuance of a total of 500,000options on February 27, 2009.

 

c)     Jeff May — one late Form 4filing with respect to the issuance of a total of 75,000 options on February 27,2009.

 

d)    Charles Romeo — one late Form 4filing with respect to the issuance of a total of 50,000 options on February 27,2009.

 

e)     John Schoenherr — one late Form 4filing with respect to the issuance of a total of 100,000 options on February 27,

 

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2009.

 

**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.

 

**Internet Address and SEC Reports**

 

Wemaintain a website with the address www.BIO-key.com. We are not including theinformation contained on our website as a part of, or incorporating it byreference into, this Annual Report on Form 10-K. We make available free ofcharge through our website our Annual Reports on Form 10-K (and, whereapplicable, 10-KSB), Quarterly Reports on Form 10-Q (and, whereapplicable, 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.

 

**ITEM 11.**    EXECUTIVE COMPENSATION

** **

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, 2009, for the fiscalyears ended December 31, 2009 and 2008:

 

**SUMMARY COMPENSATION 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**                   |       | 2009             |       | 250,000             |       | —             |       | —                 |       | 93,976                  | (1)        | —                                                 |       | —                                                  |       | 425                                   |       | 344,401        |       |
| Chief Executive Officer                     |       | 2008             |       | 250,000             |       | —             |       | —                 |       | —                  | (1)        | —                                                 |       | —                                                  |       | 775                                   |       | 250,775        |       |
|                                        |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| **Randy Fodero**                            |       | 2009             |       | 170,000             |       | —             |       | —                 |       | 34,938                  | (1)        | 35,339                                                 |       | —                                                  |       | 300                                   |       | 240,577        |       |
| Vice President Sales                        |       | 2008             |       | 170,000             |       | —             |       | —                 |       | —                  | (1)        | 54,916                                                 |       | —                                                  |       | 527                                   |       | 225,443        |       |
|                                        |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| **Mira K. LaCous**                          |       | 2009             |       | 145,665             |       | —             |       | —                 |       | —                  | (1)        | —                                                 |       | —                                                  |       | 248                                   |       | 145,913        |       |
| Vice President Technology & Development |       | 2008             |       | 140,400             |       | —             |       | —                 |       | 8,421                   | (1)        | —                                                 |       | —                                                  |       | 435                                   |       | 149,256        |       |
|                                        |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| **Thomas J. Colatosti**                     | (2)        | 2009             |       | 150,000             |       | —             |       | —                 |       | 74,691                  | (1)        | —                                                 |       | —                                                  |       | —                                |       | 224,691        |       |
| Former Chief Financial Officer              |       | 2008             |       | 109,500             |       | —             |       | —                 |       | 10,874                  | (1)        | —                                                 |       | —                                                  |       | —                                |       | 120,374        |       |

 

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(1)   The aggregate grant datefair value of the option awards was estimated using the Black-Scholes optionpricing model, with the assumptions listed in Note A to the Company’s financialstatements. The amount shown in this column

 

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representsthe grant date fair value calculated under ASC 718

 

(2)   The compensation for ThomasJ. Colatosti is presented in the above table pursuant to Item 402 (m)(2)(iii) ofthe Non-Financial Statement Disclosure requirements of Regulation S-K, as hewould have been classified as one of Company’s two most highly compensatedexecutive officers other than the principal executive officer but for the factthat he was not serving as an executive officer at the end of the lastcompleted fiscal year.

 

**NarrativeDisclosure to Summary Compensation Table**

 

Compensationfor BIO-key’s executives is comprised of three main components: base salary,annual performance-based cash bonus and long-term equity awards. We do nottarget a specific weighting of these three components or use a prescribedformula to establish pay levels. Rather, the board of directors andcompensation committee considers changes in the business, external marketfactors and our financial position each year when determining pay levels andallocating between long-term and current compensation for the named executiveofficers.

 

Cashcompensation is comprised of base salary and an annual performance-based cashbonus opportunity. The committee generally seeks to set a named executiveofficer’s targeted total cash compensation opportunity within a range that isthe average of the applicable peer company and/or general industry compensationsurvey data, adjusted as appropriate for individual performance and internalpay equity and labor market conditions.

 

Insetting cash compensation levels, we favor a balance in which base salaries aregenerally targeted at slightly below the peer average and a bonus opportunitythat is targeted at slightly above the average. The committee believes thatthis higher emphasis on performance-based cash bonuses places an appropriatelinkage between a named executive officer’s pay, his or her individualperformance and the achievement of specific business goals by placing a higherproportion of annual cash compensation at risk, thereby aligning executiveopportunity with the interests of stockholders.

 

Weinclude an equity component as part of our compensation package because webelieve that equity-based compensation aligns the long-term interests of ournamed executive officers with those of stockholders.

 

Thesecash and equity compensation components of pay are supplemented by variousbenefit plans that provide health, life, accident, disability and  severance benefits, most of which are thesame as the benefits provided to all of our US based employees.

 

***EmploymentAgreements***

 

Effectiveas of March 25, 2010, the Company entered into a one-year employmentagreement with Michael W. DePasquale to serve as the Chief Executive Officer ofthe Company at an annual base salary of $250,000, subject to adjustment by theBoard or Compensation Committee. The agreement automatically renews forsubsequent one-year terms, unless terminated by either party. In addition tothe Base Salary, a “Performance Bonus” may be awarded to Mr. DePasquale onthe basis of the Company achieving certain corporate and strategic performancegoals, as determined by the Board in its sole discretion. There is a Change ofControl provision that occurs if Mr. Depasquale is not offered continuedemployment with the Company or any successor, or within five years followingsuch Change of Control, the Company or any successor terminates the Mr. Depasquale’semployment without Cause, then Mr. Depasquale is to be paid his Base Salary andbenefits earned but unpaid through the date of termination, and any prorated bonusearned during the then current bonus year, plus two times his then current BaseSalary. The employment agreement contains standard and customaryconfidentiality, non-solicitation and “work made for hire” provisions as wellas a covenant not to compete which prohibits Mr. DePasquale from doingbusiness with any current or prospective customer of the Company or engaging ina business competitive with that of the Company during the term of hisemployment and for the one year period thereafter. This agreement also containsa number of termination provisions as described in “Termination and Change inControl Arrangements” in this Item.

 

On November 20, 2009,the Company renewed its one-year employment agreement with Mira K. LaCous toserve as the Vice President of Technology & Developmentof the Company at an annual base salary of $140,000, subject to adjustment bythe Board or Compensation Committee. The employment agreement contains standardand customary confidentiality, technical invention provisions, as well as acovenant not to compete which prohibits Ms. LaCous from doing businesswith any current or prospective customer of the Company or engaging in abusiness competitive with that of the Company during the term of her employmentand for the one year period thereafter. This agreement also contains a numberof termination provisions as described in “Termination and Change in ControlArrangements” in this Item.

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer from November 2008 to December 2009, theCompany has entered into a number of consulting arrangements with ThomasColatosti. Under the most recent arrangement, which was entered into on January 12,2010, Mr. Colatosti is to provide services to the Company and itssubsidiaries and affiliates for a two year term ending December 31, 2011at a rate of $5,000 per month. The employment agreement contains standard andcustomary confidentiality and intellectual property provisions. This agreementalso contains a number of termination provisions as described in “Terminationand Change in Control Arrangements” in this Item.

 

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***Stock Option Grants***

 

Inthe event of any change in the outstanding shares of our common stock by reasonof a stock dividend, stock split, combination of shares, recapitalization,merger, consolidation, transfer of assets, reorganization, conversion or whatthe board deems to be similar circumstances, the number and kind of shares subjectto outstanding options, and the exercise price of such options shall beappropriately adjusted in a manner to be determined in the sole discretion ofthe board. Furthermore, these option agreements contain a change of controlprovision as described in “Termination Arrangements” in this Item.

 

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**OUTSTANDING EQUITY AWARDS AT FISCAL YEAR ENDDECEMBER 31, 2009**

 

The following table setsforth for each named executive officer, information regarding outstandingequity awards as at December 31, 2009:

 
| ** **             | ** ** | **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                                                                            |       | —                                                                               |       | — |   | 0.087 |   | 2/27/2016 |   | — |   | — |   | — |   | — |   |
|                   |       | 601,938                                                                            |       | —                                                                               |       | — |   | 0.300 |   | 11/2/2012 |   | — |   | — |   | — |   | — |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Randy  Fodero          |       | 340,000                                                                            |       | —                                                                               |       | — |   | 0.300 |   | 11/2/2012 |   | — |   | — |   | — |   | — |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mira  LaCous           |       | 37,500                                                                             | (1)        | 37,500                                                                               | (1)        | — |   | 0.180 |   | 8/13/2015 |   | — |   | — |   | — |   | — |   |
|                   |       | 45,000                                                                             |       | —                                                                               |       | — |   | 0.470 |   | 7/18/2010 |   | — |   | — |   | — |   | — |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Thomas  J. Colatosti   |       | —                                                                             | (2)        | 50,000                                                                               | (2)        | — |   | 0.087 |   | 2/27/2016 |   | — |   | — |   | — |   | — |   |
|                   |       | 90,241                                                                             | (3)        | 25,000                                                                               | (3)        | — |   | 0.110 |   | 4/18/2015 |   | — |   | — |   | — |   | — |   |
|                   |       | 384,164                                                                            |       | —                                                                               |       | — |   | 0.300 |   | 11/2/2012 |   | — |   | — |   | — |   | — |   |

 

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| (1)    | The  options vest equally in two annual installments commencing August 13,  2009; 37,500 vested on August 13, 2009; 37,500 will vest on  August 13, 2010                                                               |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                  |
| (2)    | The  options vest equally in two annual installments commencing February 27,  2010                                                                                                                                               |
|   |                                                                                                                                                                                                                                  |
| (3)    | 65,241  of the options vested upon grant and the remaining options vest equally  thereafter in two annual installments commencing April 18, 2009; 25,000  vested on April 18, 2009; 25,000 will vest on April 18, 2010 |

 

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

 

Thefollowing are the material terms of each agreement, contract, plan orarrangement that provide for payments to one or more of our named executiveofficers at, following or pursuant to their resignation, retirement ortermination, or in connection with a change in control of the Company.

 

***Termination Arrangements***

 

Effectiveas of March 25, 2010, the Company entered into a one-year employmentagreement with Michael W. DePasquale to serve as the Chief Executive Officer ofthe Company. The Company may terminate the agreement at any time with orwithout cause. In the event of termination without cause, Mr. DePasqualeshall continue to be paid his then current base salary for the greater of ninemonths from the date of such termination or the number of months remaininguntil the end of the term of the employment agreement. There is a Change ofControl provision that occurs if Mr. Depasquale is not offered continuedemployment with the Company or any successor, or within five years followingsuch Change of Control, the Company or any successor terminates the Mr. Depasquale’semployment without Cause, then Mr. Depasquale is to be paid his Base Salary andbenefits earned but unpaid through the date of termination, and any prorated bonusearned during the then current bonus year, plus two times his then current BaseSalary. 

 

On November 20, 2009,the Company renewed the annual agreement with Mira K. LaCous to serve as theVice President of Technology & Development of theCompany. The Company may terminate the agreement at any time with or withoutcause. In the event of termination without cause, Ms. LaCous shallcontinue to be paid her then current base salary for six months from the dateof such termination.

 

On January 12, 2010,the Company entered into a two-year consulting agreement with Thomas Colatostito serve as consultant to the Company. The Company may terminate the agreementat any time with or without cause. In the event of termination by the Company, Mr. Colatostishall continue to be paid his then current base salary for the remaining termof the agreement.

 

***Change inControl Provisions***

 

The Company’s 1996 StockOption Plan (as amended to date, the “1996 Plan”), 1999 Stock Option Plan and2004 Stock 

 

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Incentive Plan (the “1999Plan” and together with the 1996 Plan and 2004 Plan, the “Plans”) provide forthe acceleration of the vesting of unvested options upon a “Change in Control”of the Company. A Change in Control is defined in the Plans to include (i) asale or transfer of substantially all of the Company’s assets; (ii) thedissolution or liquidation of the Company; (iii) a merger or consolidationto which the Company is a party and after which the prior shareholders of theCompany hold less than 50% of the combined voting power of the survivingcorporation’s outstanding securities; (iv) the incumbent directors ceaseto constitute at least a majority of the Board of Directors; or (v) achange in control of the Company which would otherwise be reportable under Section 13or 15(d) of the Exchange Act.

 

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

 

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

 

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**DIRECTOR COMPENSATION FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2009**

 

The following table setsforth for each director, information regarding their compensation for the yearended December 31, 2009:

 
| **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   |       | —                                                    |       | —                 |       | 74,691                  | (2)        | —                                                 |       | —                                                  |       | —                                |       | 74,691         |       |
| Michael W. DePasquale | (1)        | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Jeffrey J. May        |       | —                                                    |       | —                 |       | 6,084                   | (2)        | —                                                 |       | —                                                  |       | —                                |       | 6,084          |       |
| Charles P. Romeo      |       | —                                                    |       | —                 |       | 19,144                  | (2)        | —                                                 |       | —                                                  |       | —                                |       | 19,144         |       |
| John Schoenherr       |       | —                                                    |       | —                 |       | 7,408                   | (2)        | —                                                 |       | —                                                  |       | —                                |       | 7,408          |       |

 

----

(1)    Refer to NarrativeDisclosure To Summary Compensation Table for information pertaining to Mr. DePasquale’semployment agreement.

 

(2)    The aggregate grant datefair value of the option awards was estimated using the Black-Scholes optionpricing model, with the assumptions listed in Note A to the Company’s financialstatements. The amount shown in this column represents the grant date fairvalue calculated under ASC 718

 

(3)   The aggregate number ofstock and option awards outstanding at December 31, 2009 for each of theCompany’s directors are the same amounts as are listed in Item 12 “SecurityOwnership Of Certain Beneficial Owners And Management And Related StockholderMatters” as at February 15, 2010.

 

**NarrativeDisclosure to Director Compensation Table**

 

**Directorswho are also officers of the Company receive no additional compensation forserving on the Board of Directors. The Company’s current policy is to issueoptions to purchase 50,000 shares of common stock to each non-employee directoron an annual basis. The Chair of the Audit Committee receives options topurchase an additional 50,000 shares of common stock on an annual basis.**

** **

OnFebruary 27, 2009, Thomas Colatosti, Jeffrey May, Charles Romeo and JohnSchoenherr were granted options to purchase 50,000, 75,000, 50,000, and 100,000shares of common stock, respectively, at an exercise price of $0.087 per share.Options totaling 25,000 issued to Jeffrey May, immediately vested on issuance,with the remaining options for all participants to vest in equal incrementsover two years. The options expire on February 27, 2016.

 

OnNovember 2, 2009, in conjunction with the sale of the Law EnforcementDivision, the Company cancelled options with an exercise price greater than$0.30 per share and exchanged them for options with a $0.30 exercise price.Thomas Colatosti, Jeffrey May, Charles Romeo and John Schoenherr had optionsfor 200,000, 50,000, 400,000 and 50,000 shares of common stock, respectively,at exercise prices ranging from $1.17 to $1.39 per share cancelled andexchanged for options of 45,455, 11,364, 100,938, and 10,791 shares of commonstock, respectively, at an exercise price of $0.30 per share. All optionsimmediately vested on issuance. The options expire on November 2, 2012.

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer from November 2008 to December 2009, theCompany has entered into a number of consulting arrangements with ThomasColatosti. Under the most recent arrangement, which was entered into on January 12,2010, Mr. Colatosti is to provide services to the Company and its subsidiariesand affiliates for a two year term ending December 31, 2011 at a rate of$5,000 per month.

 

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

 

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| **ITEM  12.** | **SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS** |
|---------------|-----------------------------------------------------------------------------------------------------|

** **

The following table setsforth, as of February 17, 2010, 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                                               |       | 1,479,405                                                         | (2)        | 1.9                              | %          |
| Michael W. DePasquale                                             |       | 1,101,938                                                         | (3)        | 1.4                              | %          |
| Jeffrey May                                                       |       | 241,845                                                           | (4)        | *                                |       |
| Charles P. Romeo                                                  |       | 183,558                                                           | (5)        | *                                |       |
| John Schoenherr                                                   |       | 134,721                                                           | (6)        | *                                |       |
| Randy Fodero                                                      |       | 340,000                                                           | (7)        | *                                |       |
| Cecilia Welch                                                     |       | 13,333                                                            | (8)        | *                                |       |
| Mira LaCous                                                       |       | 82,500                                                            | (9)        | *                                |       |
| Charles Yanik                                                     |       | 27,861                                                            | (10)       | *                                |       |
|                                                              |       |                                                              |       |                             |       |
| All officers and directors as a group (8) persons            |       | 3,605,161                                                         |       | 4.6                              | %          |

 

----

*       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 77,713,398 shares of common stock outstanding as of February 17,2010.

 

(2)    Includes499,405 shares issuable upon exercise of options and 875,000 shares issuableupon conversion of Series D Redeemable Preferred Stock. Does not include50,000 shares issuable upon options subject to vesting.

 

(3,7,10)     Consists of shares issuable upon exercise ofoptions.

 

(4)    Consistsof 241,845 shares issuable upon exercise of options. Does not include 75,000shares issuable upon options subject to vesting.

 

(5)    Consistsof 183,558 shares issuable upon exercise of options. Does not include 75,000shares issuable upon options subject to vesting.

 

(6)    Consistsof 134,721 shares issuable upon exercise of options. Does not include 75,000shares issuable upon options subject to vesting.

 

(8)    Consistsof 13,333 shares issuable upon exercise of options. Does not include 6,667shares issuable upon options subject to vesting.

 

(9)  Consists of 82,500 shares issuable upon exercise of options. Does notinclude 37,500 shares issuable upon options subject to vesting.

 

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The following table setsforth, as of December 31, 2009, information with respect to securitiesauthorized for issuance under equity compensation plans.

 

**EQUITY COMPENSATION PLAN INFORMATION**

 
| ** **                                                  | ** ** | **Number of securities to be issued  upon exercise of outstanding  options, warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of outstanding  options, warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by security  holders     |       | 45,000                                                                                                                                                        |       | $                                                                                                                    | 0.47       |                                                                                                                                                                                                                  | —     |   |
| Equity compensation plans not approved by security  holders |       | 3,903,030                                                                                                                                                     |       | $                                                                                                                    | 0.23       |                                                                                                                                                                                                                  | 1,926,811  |   |
| Total                                                       |       | 3,948,030                                                                                                                                                     |       | $                                                                                                                    | 0.24       |                                                                                                                                                                                                                  | 1,926,811  |   |

 

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 werereserved 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 31,2009, there were outstanding options under the 1996 Plan to purchase 45,000 sharesof 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.

 

The1999 Plan is currently administered by the Board of Directors of the Company(the “Plan Administrator”). The Plan Administrator is authorized to construethe 1999 Plan and any option issued under the 1999 Plan, select the persons towhom options may be granted, and determine the number of shares to be coveredby any option, the exercise price, vesting schedule and other material terms ofsuch option. Under the 1999 Plan 2,000,000 shares of common stock were reservedfor issuance to officers, employees, directors and consultants of the Companyat exercise prices not less than 85% of the last sale price of the Company’scommon stock as reported on the OTC Bulletin Board on the date of grant.Options have terms of not more than 10 years from the date of grant, aresubject to vesting as determined by the Plan Administrator and are nottransferable without the permission of the Company except by will or the lawsof descent and distribution or pursuant to a domestic relations order. Optionsterminate three (3) months after termination of employment or otherassociation with the Company or one (1) year after termination due todisability, death or retirement. In the event that termination of employment orassociation is for a cause, as that term is defined in the 1999 Plan, optionsterminate immediately upon such termination. The Plan Administrator has thediscretion to extend options for up to three years from the date of terminationor disassociation with the Company.

 

The1999 Plan provides for the immediate vesting of all options in the event of a “ChangeIn Control” of the Company. In the event of a Change In Control, the Company isrequired to deliver 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

 

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controlof the Company which would otherwise be reportable under Section 13 or 15(d) ofthe Exchange Act. The 1999 Plan expired in August 2009.

 

As of December 31,2009, there were outstanding options under the 1999 Plan to purchase 500,000shares of common stock, and no shares were 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 31,2009, there were outstanding options under the 2004 Plan to purchase 2,073,189shares of common stock, and options to purchase an aggregate of 1,926,811shares 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 2009, there were outstanding options underthe non plan to purchase 1,329,841 shares of common stock. The terms of theseoptions are substantially similar to the provisions of the 1999 Plan andoptions issued thereunder.

 

**ITEM 13.**    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE

** **

**EmploymentArrangements**

 

The Company has entered intoemployment agreements with Michael W. DePasquale, Mira LaCous, and Thomas J.Colatosti. See **“EXECUTIVE COMPENSATION—EmploymentAgreements.”**

 

**ConsultingArrangement with Thomas J. Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer from November 2008 to December 2009, theCompany has entered into a number of consulting arrangements with ThomasColatosti. Under the most recent arrangement, which was entered into on January 12,2010, Mr. Colatosti is to provide services to the Company and itssubsidiaries and affiliates for a two year term ending December 31, 2011at a rate of $5,000 per month.

 

Under the previousarrangement, which was entered into on November 17, 2008, Mr. Colatosti,provided services to the Company and its subsidiaries and affiliates for theyear ended November 16, 2009 at a rate of $12,500 per month.

 

**Director Independence**

 

The Board applies thedefinition of independent director as set forth in NASDAQ Stock Market Rule 4200(a)(15), as well as Rule 10A-3 under the Securities Exchange Act of 1934,as amended.

 

In accordance with thisguidance, the Board considers Mr. May, Mr. Schoenherr, and Mr. Romeoto be independent. Mr. May and Mr. Schoenherr are the members ofthe Company’s Audit Committee, while Mr. Schoenherr and Mr. Romeo arethe members of the Company’s Compensation Committee.

 

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

** **

The following table showsfees for professional audit services billed to us by CCR LLP (“CCR”) for theaudit of our annual consolidated financial statements for the years ended December 31,2009, and 2008, and fees billed to us by CCR for other services during 2009 and2008:

 
| ** **          | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
| Audit  Fees:        |       |     |       |     |       |
| CCR                 |       | $        | 110,500    |     | $          | 148,400 |   |
|                |       |     |       |     |       |
| Audit-Related  Fees |       |     |       |     |       |
| CCR                 |       | 20,787   |       | 6,800    |       |
|                |       |     |       |     |       |
| Tax  Fees:          |       |     |       |     |       |
| CCR                 |       | 41,473   |       | 51,670   |       |
|                |       |     |       |     |       |
| Total  Fees         |       | $        | 172,760    |     | $          | 206,870 |   |

 

*Audit Fees*consist of fees billed for professionalservices rendered for the audit of our financial statements and review of theinterim financial statements included in quarterly reports and services thatare normally provided by CCR in connection with statutory and regulatoryfilings or engagements. Audit fees also include fees for services provided inconnection with registration of securities, comfort letters, and review ofdocuments filed with the SEC.

 

*Audit-Related Fees* consist of fees billed for assurance and relatedservices that are reasonably related to the performance of the audit or reviewof our financial statements and which are not reported under audit fees. Theseservices relate primarily to mergers and acquisitions due diligence as well asadvisory services as it pertains to the Sarbanes-Oxley Act and related rules andregulations;

 

*Tax Fees*consist of fees billed for professionalservices for tax compliance assistance rendered during the fiscal year.

 

**Audit Committee Pre-ApprovalProcedures**

 

The Audit Committee of our Board of Directors consistsof Jeffrey J. May  and John Schoenherr. The Audit Committee approvesthe engagement of our independent auditors to render audit and non-auditservices before they are engaged. All of the fees for 2009 and 2008 shown abovewere pre-approved by the Audit Committee.

 

The Audit Committee pre-approves all audit and otherpermitted non-audit services provided by our independent auditors. Pre-approvalis generally provided for up to one year, is detailed as to the particularcategory of services and is subject to a monetary limit. Our independentauditors and senior management periodically report to the Audit Committee theextent of services provided by the independent auditors in accordance with thepre-approval, and the fees for the services performed to date. The AuditCommittee may also pre-approve particular 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.

 

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**ITEM 15.**             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 Sheets as at December 31,2009 and 2008

 

Statements of Operations—Yearsended December 31, 2009 and 2008

 

Statement of Stockholders’Equity (Deficit)—Years ended December 31, 2009 and 2008

 

Statements of CashFlows—Years ended December 31, 2009 and 2008

 

Notes to FinancialStatements—December 31, 2009 and 2008

 

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

 

**ITEM 8—FINANCIAL STATEMENTS**

 

The following financial statements of BIO-keyInternational, Inc. are included herein at the indicated page numbers:

 
| Report  of Independent Registered Public Accounting Firm, CCR LLP                                  | 41 |
|----------------------------------------------------------------------------------------------------|----|
| Balance  Sheets as at December 31, 2009 and 2008                                              | 42 |
| Statements of  Operations—Years ended December 31, 2009 and 2008                         | 43 |
| Statement of Stockholders’ Equity (Deficit)—Years  ended December 31, 2009 and 2008 | 44 |
| Statements  of Cash Flows—Years ended December 31, 2009 and 2008                         | 45 |
| Notes to the Financial Statements—December 31,  2009 and 2008                            | 46 |

 

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**Report of Independent Registered Public AccountingFirm**

 

The Board of Directorsand StockholdersBIO-key International, Inc.

Westford, MA

 

We have audited theaccompanying consolidated balance sheets of BIO-key International, Inc.and Subsidiary as of December 31, 2009 and 2008, and the relatedconsolidated statements of operations, stockholders’ equity (deficit) and cashflows for each of the years then ended. These consolidated financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

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 consolidated financialstatements are free of material misstatement. The Company is not required tohave, nor were we engaged to perform, an audit of its internal control overfinancial reporting. Our audits included consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements, assessing the accounting principles usedand significant estimates made by management as well as evaluating the overallconsolidated financial statement presentation. We believe our audits provide areasonable 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, 2009 and 2008, and the consolidatedresults of its operations and its cash flows for the years then ended, inconformity with accounting principles generally accepted in the United Statesof 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, 2009, 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/  CCR LLP                |   |
|-----------------------------|--------|
|                        |   |
| Westborough,  Massachusetts |   |
| March 26, 2010         |   |

 

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**BIO-keyInternational, Inc and Subsidiary**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                         | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                          |       | $                     | 792,426    |   | $ | 1,712,912 |   |
| Restricted cash                                                                                                                                                                                                                                                    |       | 40,500                |       | — |   |
| Accounts receivable, net of allowance for doubtful  accounts of $11,526 and $5,845 at December 31, 2009 and  December 31, 2008, respectively                                                                                                             |       | 847,215               |       | 96,131 |   |
| Note receivable, current portion                                                                                                                                                                                                                                   |       | 1,334,000             |       | — |   |
| Inventory                                                                                                                                                                                                                                                          |       | 14,935                |       | 13,159 |   |
| Prepaid expenses and other                                                                                                                                                                                                                                         |       | 123,911               |       | 54,843 |   |
| Continuing operations total current assets                                                                                                                                                                                                                         |       | 3,152,987             |       | 1,877,045 |   |
| Discontinued operations total current assets                                                                                                                                                                                                                       |       | —                |       | 810,708 |   |
| Equipment and leasehold improvements, net                                                                                                                                                                                                                          |       | 39,243                |       | 25,677 |   |
| Deposits and other assets                                                                                                                                                                                                                                          |       | 8,712                 |       | 7,812 |   |
| Restricted cash                                                                                                                                                                                                                                                    |       | —                |       | 40,500 |   |
| Note receivable, net of current portion                                                                                                                                                                                                                            |       | 2,666,000             |       | — |   |
| Intangible assets—less accumulated amortization                                                                                                                                                                                                               |       | 230,259               |       | 251,812 |   |
| Continuing operations total non-current assets                                                                                                                                                                                                                     |       | 2,944,214             |       | 325,801 |   |
| Discontinued operations total non-current assets                                                                                                                                                                                                                   |       | —                |       | 8,234,436 |   |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                   |       | $                     | 6,097,201  |   | $ | 11,247,990 |   |
|                                                                                                                                                                                                                                                               |       |                  |       |   |   |
| **LIABILITIES**                                                                                                                                                                                                                                                    |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                                                   |       | $                     | 340,241    |   | $ | 252,213 |   |
| Accrued liabilities                                                                                                                                                                                                                                                |       | 708,765               |       | 663,567 |   |
| Deferred revenue                                                                                                                                                                                                                                                   |       | 200,996               |       | 677,966 |   |
| Convertible notes, derivatives and warrants                                                                                                                                                                                                                        |       | 471,483               |       | — |   |
| Redeemable preferred stock derivatives                                                                                                                                                                                                                             |       | 563,599               |       | — |   |
| Continuing operations total current liabilities                                                                                                                                                                                                                    |       | 2,285,084             |       | 1,593,746 |   |
| Discontinued operations total current liabilities                                                                                                                                                                                                                  |       | —                |       | 5,196,805 |   |
| Warrants                                                                                                                                                                                                                                                           |       | 63,901                |       | 12,317 |   |
| Redeemable preferred stock derivatives                                                                                                                                                                                                                             |       | —                |       | 439 |   |
| Deferred revenue                                                                                                                                                                                                                                                   |       | 9,391                 |       | — |   |
| Continuing operations total non-current liabilities                                                                                                                                                                                                                |       | 73,292                |       | 12,756 |   |
| Discontinued operations total non-current  liabilities                                                                                                                                                                                                             |       | —                |       | 19,892 |   |
| **TOTAL LIABILITIES**                                                                                                                                                                                                                                              |       | 2,358,376             |       | 6,823,199 |   |
|                                                                                                                                                                                                                                                               |       |                  |       |   |   |
| Commitments and contingencies                                                                                                                                                                                                                                      |       |                  |       |   |   |
|                                                                                                                                                                                                                                                               |       |                  |       |   |   |
| Series B redeemable convertible preferred  stock: authorized, 1,000,000 shares (liquidation preference of $1 per share);  issued and outstanding 0 and 970,612 shares of $.0001 par value at  December 31, 2009 and December 31, 2008, respectively |       | —                |       | 1,008,224 |   |
| Series C redeemable convertible preferred  stock: authorized, 600,000 shares (liquidation preference of $10 per share);  issued and outstanding 0 and 592,032 shares of $.0001 par value at  December 31, 2009 and December 31, 2008, respectively  |       | —                |       | 6,498,516 |   |
| Series D redeemable convertible preferred  stock: authorized, 100,000 shares (liquidation preference of $100 per share);  issued and outstanding 30,557 and 0 shares of $.0001 par value at  December 31, 2009 and December 31, 2008, respectively  |       | 2,630,593             |       | — |   |
|                                                                                                                                                                                                                                                               |       | 2,630,593             |       | 7,506,740 |   |
|                                                                                                                                                                                                                                                               |       |                  |       |   |   |
| **STOCKHOLDERS’ EQUITY  (DEFICIT):**                                                                                                                                                                                                                          |       |                  |       |   |   |
| Series A convertible preferred stock:  authorized, 100,000 shares (liquidation preference of $100 per share); issued  and outstanding 0 and 30,557 shares of $.0001 par value, at December 31,  2009 and December 31, 2008, respectively       |       | —                |       | 3 |   |
| Common stock — authorized, 170,000,000 shares;  issued and outstanding; 77,713,398 and 67,876,880 of $.0001 par value at  December 31, 2009 and December 31, 2008, respectively                                                                     |       | 7,771                 |       | 6,788 |   |
| Additional paid-in capital                                                                                                                                                                                                                                         |       | 51,187,754            |       | 51,692,103 |   |
| Accumulated deficit                                                                                                                                                                                                                                                |       | (50,087,293           | )          | (54,780,843 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY  (DEFICIT)**                                                                                                                                                                                                                     |       | 1,108,232             |       | (3,081,949 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                                                                     |       | $                     | 6,097,201  |   | $ | 11,247,990 |   |

 

The accompanying notesare an integral part of these statements.

 

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**BIO-keyInternational, Inc. and Subsidiary**

**STATEMENTSOF OPERATIONS**

 
| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                                                     |       |                                        |       |   |   |
| **Revenues**                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Services                                                                 |       | $                                           | 482,900    |   | $ | 191,515 |   |
| License  fees and other                                                  |       | 1,874,382                                   |       | 3,188,027 |   |
|                                                                     |       | 2,357,282                                   |       | 3,379,542 |   |
| **Costs and other expenses**                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cost  of services                                                        |       | 82,594                                      |       | 63,569 |   |
| Cost  of license fees and other                                          |       | 421,641                                     |       | 268,589 |   |
|                                                                     |       | 504,235                                     |       | 332,158 |   |
| Gross  Profit                                                            |       | 1,853,047                                   |       | 3,047,384 |   |
|                                                                     |       |                                        |       |   |   |
| **Operating expenses**                                                   |       |                                        |       |   |   |
| Selling,  general and administrative                                     |       | 3,382,613                                   |       | 3,758,888 |   |
| Research,  development and engineering                                   |       | 927,241                                     |       | 974,182 |   |
|                                                                     |       | 4,309,854                                   |       | 4,733,070 |   |
| **Operating loss**                                                       |       | (2,456,807                                  | )          | (1,685,686 | ) |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Other income (deductions)**                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest  income (expense)                                               |       | 89,804                                      |       | (2,552 | ) |
| Derivative  and warrant fair value adjustments                           |       | (286,492                                    | )          | 93,059 |   |
| Gain  on sale of investments                                             |       | —                                      |       | 119,348 |   |
| Other  expense                                                           |       | (9,393                                      | )          | — |   |
|                                                                     |       | (206,081                                    | )          | 209,855 |   |
| Loss  from continuing operations                                         |       | (2,662,888                                  | )          | (1,475,831 | ) |
| Income  from discontinued operations                                     |       | 2,872,535                                   |       | 1,660,364 |   |
| Gain  (loss) on disposal of discontinued operations, net of expected tax |       | 4,483,902                                   |       | (65,354 | ) |
| Net  Income                                                              |       | $                                           | 4,693,549  |   | $ | 119,179 |   |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Loss applicable to common stockholders**                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Loss  from continuing operations                                         |       | (2,662,888                                  | )          | (1,475,831 | ) |
| Convertible  preferred stock dividends, accretion and redemption gain    |       | (518,749                                    | )          | (1,890,503 | ) |
| Loss  applicable to common stockholders                                  |       | $                                           | (3,181,637 | ) | $ | (3,366,334 | ) |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Basic and Diluted Earnings per Common Share:**                         | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Loss  applicable to common stockholders                                  |       | $                                           | (0.04      | ) | $ | (0.05 | ) |
| Income  from discontinued operations                                     |       | 0.04                                        |       | 0.02 |   |
| Gain  (loss) on disposal of discontinued operations                      |       | 0.06                                        |       | (0.00 | ) |
| Net  income (loss)                                                       |       | $                                           | 0.06       |   | $ | (0.03 | ) |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Weighted Average Shares Outstanding:**                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Basic  and Diluted                                                       |       | 72,553,586                                  |       | 64,159,473 |   |

 

The accompanying notesare an integral part of these statements.

 

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**BIO-keyInternational, Inc. and Subsidiary**

**STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)**

 
| ** **                                                                           | ** ** | **Series A 7%** | ** ** | **Series B 15%** | ** ** | **Series C 15%** | ** **  | **Series D 7%** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** **    | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------|------------|----------------------------|------------|----------------------------|-------------|---------------------------|------------|-----------------------|------------|-----------------|------------|-----------------|---------------|------------|------------|------------|------------|
| ** **                                                                           | ** ** | **Convertible**           | ** ** | **Convertible**            | ** ** | **Convertible**            | ** **  | **Convertible**           | ** ** | ** **            | ** ** | ** **      | ** ** | **Additional**  | ** **    | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Preferred Stock**  | ** ** | **Preferred Stock**   | ** ** | **Preferred Stock**   | ** **  | **Preferred Stock**  | ** ** | **Common Stock** | ** ** | **Contributed** | ** ** | **Accumulated** | ** **    | ** ** | ** ** |
| ** **                                                                           | ** ** | **Shares**                | ** ** | **Amount**                 | ** ** | **Shares**                 | ** **  | **Amount**                | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **Shares**      | ** **    | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| **Balance  as of December 31, 2007**                                            | ** ** | **30,557**                | ** ** | **$**                      | **3**      | ** **                 | **970,612** | ** **                | **$**      | **881,340**           | ** ** | **592,032**     | ** ** | **$**           | **5,776,231** |       | —     | ** ** | **$**      | — | ** ** | **61,153,202** | ** ** | **$** | **6,115** | ** ** | **$** | **52,126,595** | ** ** | **$** | **(54,900,021** | **)** | **$** | **(2,767,308** | **)** |
| ** **                                                                           | ** ** | ** **                | ** ** | ** **                 | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accretion  of preferred stock discount                                               |       | —                    |       | —                     |       | —                     |        | 126,480                   |       | —                |       | 449,444         |       | —          |          | —     |       | —     |       | — |   | (575,924 | ) | — |   | (575,924 | ) |
| Accretion  of preferred stock dividends                                              |       | —                    |       | —                     |       | —                     |        | 148,422                   |       | —                |       | 905,316         |       | —          |          | —     |       | —     |       | — |   | (1,053,738 | ) | — |   | (1,053,738 | ) |
| Accretion  of stock issuance costs                                                   |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | 46,247          |       | —          |          | —     |       | —     |       | — |   | (46,247 | ) | — |   | (46,247 | ) |
| Conversion  of preferred stock and cumulative dividends in arrears into common stock |       | —                    |       | —                     |       | —                     |        | (148,018                  | )          | —                |       | (678,722        | )          | —          |          | —     |       | 6,723,678  |       | 673 |   | 826,067 |   | — |   | 826,740 |   |
| Share-based  compensation                                                            |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | 415,350 |   | — |   | 415,350 |   |
| Net income                                                                           |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | — |   | 119,179 |   | 119,179 |   |
|                                                                                 |       |                      |       |                       |       |                       |        |                      |       |                  |       |            |       |            |          |       |       |       |       |   |   |   |   |   |   |   |   |
| **Balance  as of December 31, 2008**                                            | ** ** | **30,557**                | ** ** | **$**                      | **3**      | ** **                 | **970,612** | ** **                | **$**      | **1,008,224**         | ** ** | **592,032**     | ** ** | **$**           | **6,498,516** |       | —     | ** ** | **$**      | — | ** ** | **67,876,880** | ** ** | **$** | **6,788** | ** ** | **$** | **51,692,103** | ** ** | **$** | **(54,780,843** | **)** | **$** | **(3,081,948** | **)** |
| ** **                                                                           | ** ** | ** **                | ** ** | ** **                 | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Conversion  of Series A to Series D Preferred Stock                        |       | (30,557                   | )          | (3                         | )          | —                     |        | —                    |       | —                |       | —          |       | 30,557          |          | 3,055,700  |       | —     |       | — |   | (3,055,697 | ) | — |   | (3,055,700 | ) |
| Discount  on Preferred Stock                                                         |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | (430,398   | )          | —     |       | — |   | — |   | — |   | — |   |
| Accretion  of preferred stock discount                                               |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | 3,509      |       | —     |       | — |   | (3,509 | ) | — |   | (3,509 | ) |
| Accretion  of preferred stock dividends                                              |       | —                    |       | —                     |       | —                     |        | 128,643                   |       | —                |       | 827,041         |       | —          |          | 1,782      |       | —     |       | — |   | (957,466 | ) | — |   | (957,466 | ) |
| Preferred  stock dividends paid in cash                                              |       | —                    |       | —                     |       | —                     |        | (37,207                   | )          | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | — |   | — |   | — |   |
| Conversion  of preferred stock and cumulative dividends in arrears into common stock |       | —                    |       | —                     |       | —                     |        | (114,598                  | )          | —                |       | (1,271,154      | )          | —          |          | —     |       | 9,836,518  |       | 983 |   | 1,384,769 |   | — |   | 1,385,752 |   |
| Conversion  of preferred stock dividends in arrears into Convertible notes           |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | (737,957 | ) | — |   | (737,957 | ) |
| Conversion  of preferred stock dividends in arrears into interest payable            |       | —                    |       | —                     |       | —                     |        | (14,450                   | )          | —                |       | (134,083        | )          | —          |          | —     |       | —     |       | — |   | 23,324 |   | — |   | 23,324 |   |
| Conversion  of preferred stock and cumulative dividends in arrears into note payable |       | —                    |       | —                     |       | (520,612                   | )           | (390,459                  | )          | (236,595              | )          | (1,774,463      | )          | —          |          | —     |       | —     |       | — |   | — |   | — |   | — |   |
| Redemption  of preferred stock in cash                                               |       | —                    |       | —                     |       | (450,000                   | )           | (450,000                  | )          | (355,437              | )          | (3,554,370      | )          | —          |          | —     |       | —     |       | — |   | — |   | — |   | — |   |
| Gain  on redemption of preferred stock                                               |       | —                    |       | —                     |       | —                     |        | (130,153                  | )          | —                |       | (591,487        | )          | —          |          | —     |       | —     |       | — |   | 721,640 |   | — |   | 721,640 |   |
| Issuance of  warrants                                                                |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | 1,835,000 |   | — |   | 1,835,000 |   |
| Share-based  compensation                                                            |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | 285,547 |   | — |   | 285,547 |   |
| Net income                                                                           |       | —                    |       | —                     |       | —                     |        | —                    |       | —                |       | —          |       | —          |          | —     |       | —     |       | — |   | — |   | 4,693,549 |   | 4,693,549 |   |
| ** **                                                                           | ** ** | ** **                | ** ** | ** **                 | ** ** | ** **                 | ** **  | ** **                | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance  as of December 31, 2009**                                            |       | —                    | ** ** | **$**                      | —     |                       | —      | ** **                | **$**      | —                |       | —          | ** ** | **$**           | —        | ** ** | **30,557** | ** ** | **$**      | **2,630,593** | ** ** | **77,713,398** | ** ** | **$** | **7,771** | ** ** | **$** | **51,187,754** | ** ** | **$** | **(50,087,293** | **)** | **$** | **1,108,232** | ** ** |

 

The accompanying notesare an integral part of these statements.

 

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

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                                                                  |       |                                        |       |   |   |
| **CASH FLOW FROM OPERATING ACTIVITIES:**                                              |       |                                        |       |   |   |
| Net Income                                                                            |       | $                                           | 4,693,549  |   | $ | 119,179 |   |
| Less:                                                                                 |       |                                        |       |   |   |
| Loss (income) from discontinued operations                                            |       | (2,872,535                                  | )          | 709,443 |   |
| Loss (gain) on disposal of discontinued operations                                    |       | (4,483,902                                  | )          | 65,354 |   |
| Income (loss) from continuing operations                                              |       | (2,662,888                                  | )          | 893,976 |   |
| **Adjustments to reconcile net  income (loss) to cash used in operating activities:** |       |                                        |       |   |   |
| Derivative and warrant fair value adjustments                                         |       | 286,492                                     |       | (93,059 | ) |
| Gain on sale of investments                                                           |       | —                                      |       | (119,348 | ) |
| Depreciation                                                                          |       | 29,214                                      |       | 20,779 |   |
| Amortization                                                                          |       |                                        |       |   |   |
| Intangible assets                                                                     |       | 21,553                                      |       | 12,123 |   |
| Discounts on convertible debt related to  derivatives                                 |       | 5,336                                       |       | — |   |
| Allowance for doubtful receivables                                                    |       | 5,681                                       |       | (942 | ) |
| Share-based compensation                                                              |       | 222,097                                     |       | 296,379 |   |
| **Change in assets and  liabilities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Accounts receivable trade                                                             |       | (756,765                                    | )          | 317,744 |   |
| Inventory                                                                             |       | (1,776                                      | )          | (8,280 | ) |
| Prepaid expenses and other                                                            |       | (69,068                                     | )          | (11,892 | ) |
| Accounts payable                                                                      |       | 88,028                                      |       | (233,078 | ) |
| Accrued liabilities                                                                   |       | (268,011                                    | )          | 27,839 |   |
| Deferred revenue                                                                      |       | (467,579                                    | )          | (304,663 | ) |
| Net cash provided (used) for continuing operations                                    |       | (3,567,686                                  | )          | 797,578 |   |
| Net cash provided (used) for discontinued  operations                                 |       | 1,912,970                                   |       | (668,405 | ) |
| Net cash provided (used) for operating activities                                     |       | (1,654,716                                  | )          | 129,173 |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            |       |                                        |       |   |   |
| Capital expenditures                                                                  |       | (42,778                                     | )          | — |   |
| Deposits                                                                              |       | (900                                        | )          | (922 | ) |
| Proceeds from the sale of the business segment                                        |       | 7,000,000                                   |       | (65,354 | ) |
| Transfer of funds from restricted cash                                                |       | —                                      |       | 112,594 |   |
| Proceeds from sale of investments                                                     |       | —                                      |       | 119,348 |   |
| Proceeds from sale of assets                                                          |       | —                                      |       | 10,530 |   |
| Net cash provided by continuing operations                                            |       | 6,956,322                                   |       | 176,196 |   |
| Net cash provided (used) for discontinued  operations                                 |       | (15,593                                     | )          | 442,769 |   |
| Net cash provided by investing activities                                             |       | 6,940,729                                   |       | 618,965 |   |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             |       |                                        |       |   |   |
| Issuance of short term obligations                                                    |       | 1,750,000                                   |       | — |   |
| Repayment of short term obligations                                                   |       | (3,914,922                                  | )          | — |   |
| Preferred stock dividend paid                                                         |       | (37,207                                     | )          | — |   |
| Redemption of redeemable preferred stock                                              |       | (4,004,370                                  | )          | — |   |
| Net cash used for continuing operations                                               |       | (6,206,499                                  | )          | — |   |
| Net cash used for discontinued operations                                             |       | —                                      |       | — |   |
| Net cash used for financing activities                                                |       | (6,206,499                                  | )          | — |   |
| **NET INCREASE (DECREASE) IN CASH  AND CASH EQUIVALENTS**                             |       | (920,486                                    | )          | 748,138 |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF YEAR**                                     |       | 1,712,912                                   |       | 964,774 |   |
| **CASH AND CASH EQUIVALENTS, END OF YEAR**                                            |       | $                                           | 792,426    |   | $ | 1,712,912 |   |

 

The accompanying notesare an integral part of these statements.

 

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

**NOTES TO THE FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

** **

**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, 2009, we had anaccumulated deficit of approximately $50 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 of America, whichcontemplate continuation of the Company as a going concern, and assumescontinuity of operations, realization of assets and the satisfaction ofliabilities and commitments in the normal course of business. The mattersdescribed in the preceding paragraphs raise substantial doubt about the Company’sability to continue as a going concern. Recoverability of a major portion ofthe recorded asset amounts shown in the accompanying balance sheet is dependentupon the Company’s ability to meet its financing requirements on a continuingbasis, and become profitable in its future operations. The accompanyingconsolidated financial statements do not include any adjustments relating tothe recoverability 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 Statesof America, pursuant to the rules and regulations of the Securities andExchange Commission. Intercompany accounts and transactions have beeneliminated in consolidation.

 

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2.*Revenue Recognition*

 

Revenues from softwarelicensing are recognized in accordance with ASC 985-605, “Software Revenue Recognition. 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 amountsreported. Anticipated contract losses are recognized as soon as they becomeknown 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.

 

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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 $250,000.

 

4.*Accounts Receivable*

 

Accounts receivable billedand unbilled are carried at original amount less an estimate made for doubtfulreceivables based on a review of all outstanding amounts on a monthly basis.Management determines the allowance for doubtful receivables by regularlyevaluating individual customer receivables and considering a customer’sfinancial condition, credit history, and current economic conditions. Accountsreceivable are written off when deemed uncollectible. Recoveries of accountsreceivable previously written off are recorded when received.

 

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 relative to the cost of depreciable assets to operations overthe estimated service lives, principally using straight-line methods. Leaseholdimprovements are amortized over the shorter of the life of the improvement orthe lease term, using the straight-line method. Intangible assets other than patentcosts are amortized on the straight-line method over their expected usefullives. Patent costs are capitalized until patents are awarded. Upon award, suchcosts are amortized over their respective lives. If a patent is denied, allcosts are charged to operations in that year. Deferred financing fees relatedto the issuance of long-term obligations are capitalized and amortized tointerest expense over the lives of the related debt using the effectiveinterest 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*                    | * * | * *           | * * |
| Patents                                 |     | life               |     |

 

The estimated aggregateamortization expense of intangible assets for the five years following December 31,2009 is approximately as follows:

 
| **Year ending December 31,** | ** ** | **($)** | ** ** |
|---------------------------------------------|------------|---------|------------|
| 2010                                        |       | 12,000  |       |
| 2011                                        |       | 12,000  |       |
| 2012                                        |       | 12,000  |       |
| 2013                                        |       | 12,000  |       |
| 2014                                        |       | 12,000  |       |

 

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7.*Derivative and Warrant FinancialInstruments*

 

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

 

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.

 

8*.Impairment orDisposal of Long Lived Assets, including Intangible Assets*

 

Wereview our long-lived assets, including intangible assets subject to amortization,whenever events or changes in circumstances indicate that the carrying amountof such an asset may not be recoverable. Recoverability of these assets ismeasured by comparison of their carrying amount to the future undiscounted cashflows the assets are expected to generate. If such assets are consideredimpaired, the impairment to be recognized is equal to the amount by which thecarrying value of the assets exceeds their fair value determined by either aquoted market price, if any, or a value determined by utilizing a discountedcash flow technique. In assessing recoverability, we must make assumptionsregarding estimated future cash flows and discount factors. If these estimatesor related assumptions change in the future, we may be required to recordimpairment charges. Intangible assets with determinable lives are amortizedover their estimated useful lives, based upon the pattern in which the expectedbenefits will be realized, or on a straight-line basis, whichever is greater.We did not record any impairment charges in any of the years presented.

 

9.*Advertising Expense*

 

The Company expenses thecosts of advertising as incurred. Advertising expenses for the years ended December 31,2009 and 2008, were approximately $72,000 and $55,000, respectively.

 

10.*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.

 

11.*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.

 

12.*Earnings Per Share of CommonStock*

 

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.

 

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13.*Accounting for Stock-BasedCompensation*

 

The Company accounts forshare based compensation in accordance with the provisions of ASC 718-10, “Compensation — Stock Compensation,”which requires measurement of compensation cost for all stock awards at fair valueon date 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-free interestrate over the option’s expected term, and the Company’s expected annualdividend yield. Changes in these subjective assumptions can materially affectthe estimate of fair value of stock-based compensation and consequently, therelated 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 vestingrequirements). The estimation of stock awards that will ultimately vestrequires significant judgment. We consider many factors when estimatingexpected forfeitures, including types of awards, employee class, and historicalexperience. Actual results, and future changes in estimates, may differsubstantially from our current estimates.

 

The compensation expenserecognized under ASC 718 increased the Company’s loss from continuingoperations by $222,097 and $296,379 with no effect per share (basic anddiluted), for the years ended December 31, 2009 and 2008 respectively.

 

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

 
| ** **                             | ** ** | **Year ended  December 31,** | ** **    |
|----------------------------------------|------------|----------------------------------------|---------------|
| ** **                             | ** ** | **2009**                               | ** **    | **2008** | ** ** |
|                                   |       |                                   |          |   |   |
| Cost of services                       |       | $                                      | —        |   | $ | 11,275 |   |
| Selling, general  and administrative   |       | 198,201                                |          | 270,073 |   |
| Research,  development and engineering |       | 23,896                                 |          | 15,031 |   |
|                                   |       | $                                      |  222,097 |   | $ | 296,379 |   |

 

*ValuationAssumptions for Stock Options*

 

For the years ended December 31,2009 and 2008, 3,019,258 and 759,272 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,** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Risk  free interest rate             |       | 0.61-3.00                              | %          | 2.95-3.72 | % |
| Expected  life of options (in years) |       | 1.42-6.34                              |       | 4.5 |   |
| Expected  dividends                  |       | 0                                      | %          | 0 | % |
| Volatility of  stock price           |       | 87-123                                 | %          | 87-88 | % |

 

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 

 

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risk-free rate is basedon the U.S. Treasury yield curve in effect at the time of grant for periodscorresponding with the expected life of the option.

 

14.*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 ASC 740-10, “Income Taxes,”includes the consideration of all available evidence, both positive andnegative, regarding historical operating results including recent years withreported losses, the estimated timing of future reversals of existing taxabletemporary differences, estimated future taxable income exclusive of reversingtemporary differences and carryforwards, and potential tax planning strategieswhich may be employed to prevent an operating loss or tax credit carryforwardfrom expiring unused. Because of the Companies historical performance andestimated future taxable income a full valuation allowance has beenestablished.

 

The Companyaccounts for uncertain tax positions in accordance with ASC 740-10*.* During the year ended December 31,2009, the Company released approximately $100,000 in its gross allowance foruncertain tax positions due to decreased accumulated tax losses resulting fromthe Company earning taxable income in 2008.

 

15.*Use of Estimates*

 

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

 

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 and amortization,valuation of deferred income taxes, convertible notes and related discounts,embedded derivates, preferred stock, share-based compensation, and warrantsoutstanding.

 

16.*Comprehensive Income/(Loss)*

 

Comprehensive income(loss) consists of net loss and other gains and losses affecting shareholders’equity (deficit) that, under generally accepted accounting principles, areexcluded from net income (loss) in accordance with ASC 220. The Company,however, does not have any components of other comprehensive income (loss) asdefined by ASC 220 and therefore, for the years ended December 31, 2009and 2008, comprehensive income (loss) is equivalent to the Company’s reportednet income (loss). Accordingly, a separate statement of comprehensive income(loss) is not presented.

 

17.*Recent Accounting Pronouncements*

 

In September 2009,the FASB issued ASU 2009-13, *MultipleElement Arrangements*. ASU 2009-13 addresses the determination ofwhen the individual deliverables included in a multiple arrangement may betreated as separate units of accounting. ASU 2009-13 also modifies the mannerin which the transaction consideration is allocated across separatelyidentified deliverables and establishes definitions for determining fair valueof elements in an arrangement. This standard must be adopted by the Company nolater than January 1, 2011 with earlier adoption permitted. The Company iscurrently evaluating the impact, if any, that this standard update will have onits consolidated financial statements.

 

In June 2009, the FASB issued ASC 105-10, *Generally Accepted Accounting Principles*(the“Codification”). The Codification will be the single source of authoritativenongovernmental U.S. generally accepted accounting principles. Rules andinterpretive releases of the SEC under authority of federal securities laws arealso sources of authoritative GAAP for SEC registrants. All existing accountingstandards are superseded as described in ASC 105-10. All other accountingliterature 

 

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not included inthe Codification is non-authoritative. ASC 105-10 is effective for interim andannual periods ending after September 15, 2009. The adoption of ASC 105-10did not have a material impact on the Company’s financial condition or resultsof operations.

 

In May 2009,the FASB issued ASC 855-10, *SubsequentEvents*. ASC 855-10 sets forth the period after the balance sheetdate during which management of a reporting entity should evaluate events ortransactions that may occur for potential recognition or disclosure in thefinancial statements, the circumstances under which an entity should recognizeevents or transactions occurring after the balance sheet date in its financialstatements, and the disclosures that an entity should make about events ortransactions that occurred after the balance sheet date. ASC 855-10 will beeffective for interim or annual period ending after June 15, 2009 and willbe applied prospectively. The adoption of ASC 855-10 had no impact on theCompany’s financial condition or results of operations.

 

In April 2009,the FASB issued FSP No. FAS 107-1 and APB 28-1, *“Interim Disclosures about Fair Value of Financial Instruments”,*whichis now part of ASC 825. This FSP essentially expands the disclosure about fairvalue of financial instruments that were previously required only annually toalso be required for interim period reporting. In addition, the FSP requirescertain additional disclosures regarding the methods and significantassumptions used to estimate the fair value of financial instruments. Theseadditional disclosures were required beginning with the quarter ended June 30,2009. The adoption had no impact on the Company’s financial condition orresults of operations.

 

In February 2009,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 141(R)-a, “*Accounting for Assets Acquired and Liabilities Assumed in a BusinessCombination that Arise from Contingencies”* (SFAS No. 141(R)-a),now part of ASC 805, which simplifies how entities will be required to accountfor contingencies arising in business combinations under SFAS 141(R) “*Accounting for Business Combinations*”.FASB decided to amend the guidance SFAS 141(R) to require assets acquiredand liabilities assumed in a business combination that arise from contingenciesbe recognized at fair value, if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, theasset or liability would be accounted for in accordance with FASB Statement No. 5“*Accounting for Contingencies*”(SFAS 5). The provisions of SFAS No. 141(R)-a are applicable to businesscombinations consummated after January 1, 2009 for calendar year entities.The adoption of SFAS 141(R)-a) will have an impact on the Company’s accountingfor business combinations in connection with any future acquisitions.

 

**NOTE B—DISCONTINUED OPERATIONS**

 

*LawEnforcement Division*

 

On December 8, 2009,BIO-key International, Inc. (the “Company”) consummated the sale (the “AssetSale”) of its Law Enforcement division (the “Business”) to InterAct911 MobileSystems, Inc. (“Buyer”), a wholly-owned subsidiary of InterAct911 Corporation(the “Parent”), pursuant to the Asset Purchase Agreement dated as of August 13,2009 by and between the Company and Buyer (the “Purchase Agreement”).

 

Pursuant to the PurchaseAgreement, Buyer acquired substantially all of the assets relating to theBusiness, including the Company’s customer contracts, intellectual property,accounts receivable, equipment, inventories, software, technologies,communication systems and goodwill relating to the Business.  Buyer alsoassumed certain specified liabilities as set forth in the PurchaseAgreement.  The Company and InterAct Public Safety Systems, an affiliateof Buyer, have collaborated on many projects in the past, including partnershiparrangements in which products used in the Business (including elements of theMobileCop®, PocketCop®, MobileRescueTM, MobileOfficeTM, and InfoServerTM productlines) have been integrated with those of InterAct Public Safety Systems andsold to law enforcement agencies and other emergency response customers. Outside of those commercial dealings, there are no material relationships amongthe Company and Buyer or any of their respective affiliates other than inrespect of the Purchase Agreement and the related ancillary agreements.

 

As consideration for theAsset Sale, Buyer paid the Company an aggregate purchase price of approximately$11.3 million. Of that amount, approximately $7.0 million was paid in cashat the closing of the Asset Sale, and approximately $300,000 was paid pursuantto the Working Capital Adjustment Schedule in the Purchase Agreement.  Inaddition, Buyer issued a promissory note (the “Note”) in the original principalamount of $4 million in favor of the Company.  The Note is to 

 

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be paid in three equalannual installments beginning on the first anniversary of the closing and willbear interest, payable on a quarterly basis, at a rate per annum equal to sixpercent (6%) compounded annually on the principal sum from time to timeoutstanding.  The Note is guaranteed by the Buyer’s Parent and its owner,SilkRoad Equity, LLC (“SilkRoad”), a private investment firm, and is secured byall of the intellectual property assets of the Business being transferred toBuyer as part of the Asset Sale.  In addition, at the closing of the AssetSale, the Company issued to SilkRoad a warrant to purchase up to 8 millionshares of the Company’s common stock at a cash purchase price of $0.30 pershare.  This warrant will expire if not exercised prior to the fifthanniversary of the closing.

 

Priorto the sale, the Business had been reported as a separate segment. The Businesshas been reported as a discontinued operation and all periods presented havebeen recast accordingly to reflect these operations as discontinued.

 

Revenues and net incomefor the Law Enforcement division Segment for the years ended December 31,2009 and 2008 were as follows:

 
| ** **         | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------|------------|----------------------------------------|------------|
| ** **         | ** ** | **2009**                               | ** ** | **2008** | ** ** |
|               |       |                                   |       |   |   |
| Revenues           |       | $                                      | 8,561,979  |   | $ | 9,496,505 |   |
| Net income  (loss) |       | 2,872,535                              |       | 1,660,364 |   |
|                    |            |                                        |            |  |  |  |  |

 

The carrying amounts ofthe major classes of assets and liabilities aggregated in discontinuedoperations in the consolidated balance sheet as of December 31, 2008 wereas follows:

 
| ** **                                                             | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                             | ** ** | **2008**              | ** ** |
|                                                                   | ** ** |                  | ** ** |
| **ASSETS**                                                             |       |                  |       |
| Accounts receivable, net of allowance for doubtful accounts of $76,553 |       | $                     | 624,891    |   |
| Costs in Excess of Billing                                             |       | 144,551               |       |
| Prepaid expenses                                                       |       | 41,266                |       |
| Total current assets                                                   |       | 810,708               |       |
| Equipment and leasehold improvements, net                              |       | 66,561                |       |
| Intangible assets—less accumulated amortization                   |       | 330,889               |       |
| Goodwill                                                               |       | 7,836,986             |       |
| Non-current assets                                                     |       | 8,234,436             |       |
| **TOTAL ASSETS**                                                       |       | $                     | 9,045,144  |   |
|                                                                   |       |                  |       |
| **LIABILITIES**                                                        |       |                  |       |
| Accounts payable                                                       |       | $                     | 28,781     |   |
| Accrued liabilities                                                    |       | 638,322               |       |
| Note payable                                                           |       | 1,516,651             |       |
| Deferred rent                                                          |       | 6,541                 |       |
| Deferred revenue                                                       |       | 3,006,510             |       |
| Total current liabilities                                              |       | 5,196,805             |       |
| Deferred rent                                                          |       | 11,510                |       |
| Deferred revenue                                                       |       | 8,382                 |       |
| Total non-current liabilities                                          |       | 19,892                |       |
| **TOTAL LIABILITIES**                                                  |       | $                     | 5,216,697  |   |

 

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*Fire Division*

 

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,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. The remaining escrowbalance was remitted to the Company on May 6, 2008.  From the remaining balance, $50,000 was paidas a settlement of a customer claim associated with the discontinued Firebusiness, and $15,354 was paid as related professional fees to settle the claim,resulting in a loss on disposal of the Fire Segment of $65,354 during 2008.

 

Prior to the sale, Firehad been reported as a separate segment. The Fire Segment has been reported asa discontinued operation and all periods presented have been recast accordinglyto reflect these operations as discontinued.

 

Revenues and net income(loss) for the Fire Segment for the years ended December 31, 2009 and 2008were as follows:

 
| ** ** | ** ** | **Year Ended  December 31,** | ** ** |
|------------|------------|----------------------------------------|------------|
| ** ** | ** ** | **2009**                               | ** ** | **2008** | ** ** |
|       |       |                                   |       |   |   |
| Revenues   |       | $                                      | —     |   | $ | — |   |
| Net loss   |       | —                                 |       | (65,354 | ) |
|            |            |                                        |            |  |  |  |  |

 

**NOTE C—ACQUISITIONS**

 

*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 were made fully available for use by the companyon termination of the lease 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 customercredit-worthiness when evaluating the adequacy of the allowances.

 

The Company had certaincustomers whose revenue individually represented 10% or more of the Company’stotal revenue, as follows:

 

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|       | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|-----------------------------------|------------|
|       | ** ** | **2009**                          | ** ** | **2008** | ** ** |
| ** ** | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Customer A |       | —                            |       | 56 | % |
| Customer B |       | 28                                | %          | * |   |
| Customer D |       | 24                                | %          | * |   |

 

----

*                 Less than 10% of total revenue

 

The Company hadconcentrations of customers in certain industry groups which represented 10% ormore of the Company’s total revenue, as follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|-----------------------------------|------------|
| ** ** | ** ** | **2009**                          | ** ** | **2008** | ** ** |
| ** ** | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Government |       | 0                                 | %          | 0 | % |
| Commercial |       | 100                               | %          | 100 | % |

 

The Company had certaincustomers whose accounts receivable balances individually represented 10% ormore of the Company’s total accounts receivable, as follows:

 
| ** ** | ** ** | **As of December 31,** | ** ** |
|------------|------------|-----------------------------|------------|
| ** ** | ** ** | **2009**                    | ** ** | **2008** | ** ** |
| ** ** | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Customer B |       | 59                          | %          | * |   |
| Customer C |       | 16                          | %          | — |   |
| Customer D |       | *                           |       | 21 | % |
| Customer E |       | —                      |       | 51 | % |

 

----

*                 Less than 10% of total accounts receivable

 

**NOTE E—NOTE RECEIVABLE**

 

Note Receivableconsisted of the following as of December 31:

 
| ** **                          | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Note Receivable  — Current     |       | $          | 1,334,000  |       | $          | — |   |
| Note Receivable  — Non-Current |       | 2,666,000  |       | —     |       |
|                                |       |       |       |       |       |
| Total                               |       | $          | 4,000,000  |       | $          | — |   |

 

As consideration for theAsset Sale (see “Note B — Discontinued Operations”), InterAct911 paid theCompany an aggregate purchase price of approximately $11.3 million. Ofthat amount, approximately $7.0 million was paid in cash at the closing of theAsset Sale, and approximately $300,000 was paid pursuant to the Working CapitalAdjustment Schedule in the Purchase Agreement. In addition, Buyer issued apromissory note (the “Note”) in the original principal amount of $4 million infavor of the Company.  The Note is to be paid in three equal annualinstallments beginning on the first anniversary of the closing and will bearinterest, payable on a quarterly basis, at a rate per annum equal to sixpercent (6%) compounded annually on the principal sum from time to timeoutstanding.  The Note is guaranteed by the Parent and its owner, SilkRoadEquity, LLC (“SilkRoad”), a private investment firm, and is secured by all ofthe intellectual property assets of the Law Enforcement division beingtransferred to InterAct911 as part of the Asset Sale.

 

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**NOTE F—PREPAID EXPENSES AND OTHER**

 

Prepaid expensesconsisted of the following as of December 31:

 
| ** **                       | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Insurance and  software licenses |       | $          | 62,330     |       | $          | 53,643 |   |
| Other                            |       | 61,581     |       | 1,200      |       |
|                             |       |       |       |       |       |
| Total                            |       | $          | 123,911    |       | $          | 54,843 |   |

 

**NOTE G—EQUIPMENT AND LEASEHOLDIMPROVEMENTS**

 

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

 
| ** **                                      | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                                       |       | $          | 235,948    |       | $          | 352,740 |   |
| Furniture and  fixtures                         |       | 99,199     |       | 87,972     |       |
| Software                                        |       | 28,624     |       | 72,575     |       |
| Leasehold  improvements                         |       | 39,975     |       | 24,382     |       |
|                                            |       | 403,746    |       | 537,669    |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | (364,503   | )          | (511,992   | )          |
|                                            |       |       |       |       |       |
| Total                                           |       | $          | 39,243     |       | $          | 25,677 |   |

 

**NOTE H—OTHER ASSETS**

 

*Goodwill*

 

Thechanges in the carrying amount of goodwill for the years ended December 31,2009 and 2008, were as follows:

 
| ** **                                               | ** ** | **Law Segment** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|------------|------------|
| ** **                                               | ** ** | ** **      | ** ** | ** ** | ** ** |
| Balance as of  January 1, 2008                      |       | $               | 7,836,986  |       | $          | 7,836,986 |   |
| Additions/subtractions                                   |       | —          |       | —     |       |
|                                                     |       |            |       |       |       |
| Balance as of  December 31, 2008                    |       | $               | 7,836,986  |       | $          | 7,836,986 |   |
| Goodwill  included in gain on disposal of reporting unit |       | (7,836,986      | )          | (7,836,986 | )          |
|                                                     |       |            |       |       |       |
| Balance as of  December 31, 2009                    |       | $               | —     |       | $          | — |   |

 

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*Intangible Assets*

 

Intangible assetsconsisted of the following as of December 31:

 
| ** **                   | ** ** | **2009**                      | ** ** | **2008**                      | ** ** |
|------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|                         |       |                          |       |                          |       |   |   |   |   |   |   |   |   |
| Patents  and patents pending |       | $                             | 287,248    |                          | $          | (56,989 | ) | $ | 230,259 |   | $ | 297,101 |   | $ | (45,289 | ) | $ | 251,812 |   |
|                         |       |                          |       |                          |       |   |   |   |   |   |   |   |   |
| Total                        |       | $                             | 287,248    |                          | $          | (56,989 | ) | $ | 230,259 |   | $ | 297,101 |   | $ | (45,289 | ) | $ | 251,812 |   |

 

Aggregateamortization expense for the year ended December 31, 2009 and 2008, was$11,876 and $12,123, respectively.

 

*Deposits*

 

Deposits consistedof the following as of December 31:

 
| ** **                      | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Property and security  deposits |       | $          | 8,712      |       | $          | 7,812 |   |
|                            |       |       |       |       |       |
| Total                           |       | $          | 8,712      |       | $          | 7,812 |   |

 

Leaseand property deposits are held over the Company’s premises as security forcontractual performance under certain operating leases. At the conclusion ofthese lease arrangements, which is expected to occur over a number of datesthrough August 2014, the lease and property deposits shall be returned tothe Company.

 

*Restricted cash*

 

In 2008 the Companyextended its property lease at its Marlborough, MA location. Pursuant to theagreement BIO-key was to maintain a security deposit in the form of anirrevocable letter of credit in the amount of $40,500. However, BIO-key and thelandlord for the property subsequently agreed to have BIO-key place the fundsin a third  party escrow account, to bereturned at the conclusion of the lease term, in August 2011. Pursuant tothe sale of the Company’s Law Enforcement to InterAct911 in December 2009(see “Note B — Discontinued Operations”), the Company is no longer situated atthis location, and expects to fully assign the obligations of the Marlboroughpremises in early 2010. Accordingly, the balance is recorded as the currentasset, “Restricted cash” as at December 31, 2009.

 

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**NOTE I—ACCRUED LIABILITIES**

 

Accruedliabilities consisted of the following as of December 31:

 
| ** **                                  | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Contract costs  not yet invoiced by vendors |       | $          | —     |       | $          | 105,788 |   |
| Compensation                                |       | 92,860     |       | 48,030     |       |
| Compensated  absences                       |       | 143,387    |       | 130,433    |       |
| Royalties                                   |       | —     |       | 33,402     |       |
| Interest                                    |       | —     |       | 176,083    |       |
| Dividends  payable                          |       | 128,644    |       | 3,435      |       |
| Tax payable                                 |       | 188,000    |       | —     |       |
| Other                                       |       | 155,874    |       | 166,396    |       |
|                                        |       |       |       |       |       |
| Total                                       |       | $          | 708,765    |       | $          | 663,567 |   |

 

**NOTE J—RELATED PARTY**

 

**Consulting Arrangement with Thomas J.Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer from November 2008 to December 2009, theCompany has entered into a number of consulting arrangements with ThomasColatosti. Under the most recent arrangement, which was entered into on January 12,2010, Mr. Colatosti is to provide services to the Company and itssubsidiaries and affiliates for a two year term ending December 31, 2011at a rate of $5,000 per month.

 

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 year ended December 31, 2009, the Company paid Mr. Colatostiapproximately $150,000.

 

On December 28,2009 the Company issued Thomas Colatosti 7% convertible promissory notes with aprincipal balance of $64,878 (see “Note L - Notes Payable, Convertible DebtFinancing / Warrants”).

 

**NOTE K—DEFERRED REVENUE**

 

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

 
| ** **                                                   | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current  Portion**                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | $          | 177,880    |       | $          | 501,353 |   |
| Fully deferred  systems, installation and acceptance revenue |       | 23,116     |       | 176,613    |       |
|                                                         |       | 200,996    |       | 677,966    |       |
| **Long-Term  Portion**                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | 9,391      |       | —     |       |
|                                                         |       |       |       |       |       |
| **Total**                                                    |       | $          | 210,387    |       | $          | 677,966 |   |

 

Maintenancecontracts include provisions for unspecified when-and-if available productupdates and customer telephone support services, and are recognized ratablyover the term of the service period. Fully deferred systems, installation andacceptance revenue relates to projects that have been billed per thecontractual terms, however because of undelivered elements or acceptancecriteria, revenue has not yet been recognized. These amounts are expected to becompleted within the 

 

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next 12 months and areclassified as current 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 been classifiedas a long-term liability.

 

**NOTE L—NOTES PAYABLE, CONVERTIBLE DEBT FINANCING /WARRANTS**

 

*Notes Payable*

 

Effectiveas of July 2, 2009, the Company entered into a Settlement and MutualRelease Agreement (the “Settlement Agreement”) with Longview Special Finance, Inc.and Longview Fund, L.P. (collectively, the “Longview Entities”) in order toresolve all matters relating to the litigation initiated by the LongviewEntities earlier this year, in which they  were seeking $2,886,563 indamages and an unspecified amount of interest and attorney’s fees from theCompany as a result of the Company’s alleged improper failure to redeem theiroutstanding shares of the Company’s Convertible Preferred Stock (collectively,the “Shares”) in accordance with the terms and conditions of such preferredstock.  Pursuant to the Settlement Agreement, without admission of anyliability or fault, the parties agreed to a payment schedule under which theCompany was required to pay a total cash settlement amount of $2,164,922, fiftypercent (50%) of which was paid on July 7, 2009.  The remainingportion of the settlement amount accrued interest at seventeen percent (17%)per annum and was required to be paid in full on or before October 30,2009.  In return, the Longview Entities agreed to a full and completerelease of the Company from all claims that were or could have been alleged inthe lawsuit and agreed to relinquish all of the Shares upon receiving finalpayment of the settlement amount. From October 30, 2009 until November 12,2009, interest on the remaining portion of the settlement amount accrued attwenty percent (20%) per annum.  On November 12, 2009, the Companypaid in full the entire outstanding portion of the settlement amount, togetherwith all accrued and unpaid interest, and satisfied all of its obligations tothe Longview Entities under the Settlement Agreement.

 

On July 7,2009, the Company issued an unsecured promissory note (the “Note”) in theaggregate principal amount of $1,000,000 to the Shaar Fund, Ltd (“Shaar”). The Note accrued interest at eight percent (8%) per annum and was originallydue and payable on November 4, 2009. Pursuant to a Note Amendment andExtension Agreement dated as of November 3, 2009 between the Company andShaar, Shaar extended the due date of the Note to the earlier to occur of (i) thefifth business day after the closing of the Asset Sale (see “Note B —Discountinued Operations”), and (ii) January 31, 2010. On November 12,2009, the Company issued a an unsecured bridge note (the “Bridge Note”) in theaggregate principal amount of $750,000 to Shaar.  The Bridge Note accruedinterest at six percent (6%) per annum and was due and payable on December 15,2009. Both the Note and the Bridge Note were paid in full in accordance withtheir terms.

 

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*ConvertibleDebt Financing/Warrants*

 

Convertible debtfinancing and warrants consisted of the following as of December 31:

 
| ** **                    | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current  Portion**          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2005**                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| FMV of warrants               |       | $          | 47,773     |       | $          | — |   |
| **2009**                      |       |       |       |       |       |
| Convertible  promissory notes |       | 737,957    |       | —     |       |
| Discount                      |       | (659,138   | )          | —     |       |
| FMV of embedded  derivatives  |       | 344,891    |       | —     |       |
| **Total**                     |       | $          | 471,483    | ** ** | $          | — |   |
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Long-Term  Portion**        | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2004**                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| FMV of warrants               |       | $          | —     |       | $          | 291 |   |
| **2005**                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| FMV of warrants               |       | —     |       | 6,666      |       |
| **2006**                      |       |       |       |       |       |
| FMV of warrants               |       | 63,901     |       | 5,360      |       |
| **Total**                     |       | $          | 63,901     |       | $          | 12,317 |   |

 

***Convertible Promissory Notes***

 

On November 12,2009, the Company entered into a Securities Exchange Agreement (the “ExchangeAgreement”), pursuant to which the Company and the holders of the outstandingshares of the Company’s Series A Convertible Preferred Stock, agreed toexchange (a) their shares of Series A Convertible Preferred Stock foran equal number of shares of the Company’s Series D Convertible PreferredStock, and Warrants to purchase up to an aggregate of 5,000,000 shares of theCompany’s Common Stock, at an exercise price of $0.30 per share, and (b) alldividends accrued and unpaid, totaling $737,957, on their shares of Series AConvertible Preferred Stock for Seven Percent (7%) Convertible Promissory Notes(the “Convertible Notes”).

 

TheConvertible Notes may be converted in whole or in part at any time at theoption of the holder into shares of the Company’s Common Stock at a price equalto the lower of (i) the average closing price of the Common Stock asquoted by Bloomberg for the ten (10) trading days prior to the date thatthe notice of conversion is transmitted to the Company, and (ii) $0.30,subject to certain adjustments.

 

The Convertible Notescontain features that are considered embedded derivative financial instruments:Principal’s and Accrued Interest conversion option: All or a portion of theprincipal and all or a portion of the accrued interest of the Convertible Notesmay be converted into common stock at the Holder’s option at any time at lowerof i) the average 10 days trading price prior to conversion, or ii) $0.30 pershare. These features have been bifurcated and recorded on the Company’sbalance sheet at their fair value.

 

The accounting treatmentof the warrants and derivatives requires that the Company record the warrantsand derivatives at their relative fair value and fair value, respectively as ofthe inception date of the agreement. As the warrants were classified as equityinstruments, no further accounting adjustment is required. With respect to thederivatives, which were classified as liabilities, in subsequent periods thederivatives are “marked-to-market” at fair value. Any change in fair value willbe recorded as non-operating, non-cash income or expense at each reportingdate. If the fair value of the derivatives is higher at the subsequent balancesheet date, the Company will record a non-operating, non-cash charge. If thefair value of the derivatives is lower at the subsequent balance sheet date,the Company will record non-operating, non-cash income.

 

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As of December 31,2009, the derivatives were valued at $344,891. Conversion related derivativeswere valued using the Binomial Option Pricing Model with the followingassumptions: dividend yield of 0%; annual volatility of 148%; and risk freeannual interest rate of 0.47% as well as probability analysis related totrading volume restrictions.

 

The initial fair valuesof the warrants and derivatives were recorded as discounts to the ConvertibleNotes and are being amortized to interest expense over the expected term of thedebt, using the effective interest method. At December 31, 2009, theunamortized discount on the Convertible Notes was $659,138.

 

***2004, 2005 and 2006 Warrants***

 

The remaining accountbalance shown represents the fair market value of warrants issued inconjunction with debt offerings undertaken from the 2004 to 2006 fiscal years.The Warrants are classified as liabilities and were valued as of December 31,2009 and 2008, using the Black Scholes Option Pricing model with the followingassumptions:

 
| ** **               | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Dividend  Yield          |       | 0                                      | %          | 0 | % |
| Annual  volatility       |       | 107-156                                | %          | 112-121 | % |
| Risk-free  interest rate |       | 0.20-0.47                              | %          | 0.32-0.78 | % |

 

**NOTE M—SEGMENT INFORMATION**

** **

The Company has determined that its continuingoperations are one discrete segment consisting of Biometric products.

 

Prior to the sale of theLaw Enforcement division in December 2009, Law had been reported as aseparate segment.

 

Geographically, NorthAmerican sales accounted for approximately 96% and 91% of the Company’s totalsales for fiscal years 2009 and 2008, respectively.

 

**NOTE N—COMMITMENTS AND CONTINGENCIES**

 

*Operating Leases*

 

The Company does not own any real estate but conductsoperations from four leased premises. These non-cancelable operating leasesexpire at various dates through 2014. In addition to base rent, the Companypays for property taxes, maintenance, insurance and other occupancy expensesaccording to the terms of the individual leases. The Company also leasesequipment, with a non-cancelable operating lease expiring in 2010.

 

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

 

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| **Year s ending December 31,** |   |    |    |
|----------------------------------------------------|--------|---------|---------|
| 2010                                               |   | $       | 137,831 |   |
| 2011                                               |   | 135,226 |    |
| 2012                                               |   | 136,280 |    |
| 2013                                               |   | 137,370 |    |
| 2014                                               |   | 92,097  |    |
| More than 5  years                                 |   | —  |    |
|                                               |   |    |    |
|                                               |   | $       | 638,804 |   |

 

The minimum rental commitments shown in the tableabove do not include amounts owing under the Marlborough, MA lease, which isexpected to be assigned to InterAct911 as part of the settlement of obligationsunder the sale of the Law Enforcement division (see “Note B — DiscontinuedOperations”). Monthly lease obligations currently paid by BIO-key to thelandlord are reimbursed by InterAct911.

 

Rental expense was approximately $138,000 and $144,000during 2009 and 2008, respectively.

 

*Employment Agreements*

 

The Company has three employment agreements. Theseagreements allow the continuation of the employee’s salary in the event oftermination without cause. The agreements also acknowledge the employee’seligibility to participate in the Company’s bonus and option plans, the termsof which have not yet been established. As of December 31, 2009, theaggregate commitment under these agreements was approximately $190,000.

 

*Legal Proceedings*

 

In the normal course of business, the Company periodically becomes involved in litigation. As of December 31, 2009, 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.

 

Effective as of July 2, 2009, the Company enteredinto a Settlement and Mutual Release Agreement (the “Settlement Agreement”)with Longview Special Finance, Inc. and Longview Fund, L.P. (collectively,the “Longview Entities”) in order to resolve all matters relating to thelitigation initiated by the Longview Entities earlier this year, in whichthey  were seeking $2,886,563 in damages and an unspecified amount ofinterest and attorney’s fees from the Company as a result of the Company’salleged improper failure to redeem their outstanding shares of the Company’sConvertible Preferred Stock (collectively, the “Shares”) in accordance with theterms and conditions of such preferred stock.  Pursuant to the SettlementAgreement, without admission of any liability or fault, the parties agreed to apayment schedule under which the Company was required to pay a total cashsettlement amount of $2,164,922, fifty percent (50%) of which was paid on July 7,2009.  The remaining portion of the settlement amount accrued interest atseventeen percent (17%) per annum and was required to be paid in full on orbefore October 30, 2009.  In return, the Longview Entities agreed toa full and complete release of the Company from all claims that were or couldhave been alleged in the lawsuit and agreed to relinquish all of the Sharesupon receiving final payment of the settlement amount. From October 30,2009 until November 12, 2009, interest on the remaining portion of thesettlement amount accrued at twenty percent (20%) per annum.  On November 12,2009, the Company paid in full the entire outstanding portion of the settlementamount, together with all accrued and unpaid interest, and satisfied all of itsobligations to the Longview Entities under the Settlement Agreement.

 

*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, 2009 and 2008,royalty expense was approximately $82,770 and $53,483, respectively.

 

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*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 customerinstallations and are granted to help ensure customer satisfaction. As of December 31,2009, there was no material requirement for an accrued warranty liabilityreserve.

 

**NOTE O— EQUITY**

 

1.Mezzanine Equity

 

*RedeemablePreferred 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 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 had an OriginalIssue Price of $1.00 per share. The holder had 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 was subject to adjustment if common stockwas issued 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.

 

The mandatory redemptionfeatures of the Series B Convertible Preferred Stock were triggered in January 2009due to the passing of the applicable mandatory redemption dates and the priceof the Company’s common stock, as reported by the OTC Bulletin Board, tradingbelow the applicable thresholds contained in the terms of the Preferred Stock.Absent a waiver from the holders of the Preferred Stock, the Company wastherefore required to redeem its outstanding shares of Preferred Stock, to theextent that the Company was legally permitted to do so, by paying cash to theholders of such shares in accordance with the terms of such Preferred Stock.From January 2009, the Company accrued dividends at the default rate of17%.

 

Effective as of July 2,2009, the Company entered into an Agreement and redeemed 520,612 shares of Series BPreferred Stock for a total cash settlement amount of $390,459, fifty percent(50%) of which was paid on July 7, 2009.  The remaining portion ofthe settlement amount accrued interest at seventeen percent (17%) per annumuntil October 30, 2009, and twenty percent (20%) per annum from October 30,2009 until November 12, 2009, when the Company paid in full the entireoutstanding portion of the settlement amount, together with all accrued and unpaidinterest, and satisfied all of its obligations to the Longview Entities underthe Settlement Agreement.

 

Following theconsummation of the sale of the Company’s Law Enforcement division to InterActon December 8, 2009, the Company redeemed all of the remaining Series BPreferred Stock for a total cash settlement amount of $450,000. Also, inconjunction with the redemption of the Series B Preferred Stock, allaccumulated and unpaid dividends on the Series B Preferred Stock wereconverted into common shares, except for $14,450, which has been recognized asdividends payable as at December 31, 2009.

 

As of December 31,2009 and 2008, 1,000,000 Series B Preferred Stock shares were authorized,0 and 970,612 of which were issued and outstanding, respectively, at a parvalue of $0.0001.

 

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**Series C Convertible PreferredStock**

 

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 had an OriginalIssue Price of $10.00 per share. The holder had 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 was subject to adjustment if common stockwas issued 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.

 

The mandatory redemptionfeatures of the Series C Convertible Preferred Stock were triggered in January 2009due to the passing of the applicable mandatory redemption dates and the priceof the Company’s common stock, as reported by the OTC Bulletin Board, tradingbelow the applicable thresholds contained in the terms of the Preferred Stock.Absent a waiver from the holders of the Preferred Stock, the Company wastherefore required to redeem its outstanding shares of Preferred Stock, to theextent that the Company was legally permitted to do so, by paying cash to theholders of such shares in accordance with the terms of such Preferred Stock.From January 2009, the Company accrued dividends at the default rate of17%.

 

Effective as of July 2,2009, the Company entered into an Agreement and redeemed 236,595 shares of Series CPreferred Stock for a total cash settlement amount of $1,774,463, fifty percent(50%) of which was paid on July 7, 2009.  The remaining portion ofthe settlement amount accrued interest at seventeen percent (17%) per annumuntil October 30, 2009, and twenty percent (20%) per annum from October 30,2009 until November 12, 2009, when the Company paid in full the entireoutstanding portion of the settlement amount, together with all accrued andunpaid interest, and satisfied all of its obligations to the Longview Entitiesunder the Settlement Agreement.

 

Following theconsummation of the sale of the Company’s Law Enforcement division to InterActon December 8, 2009, the Company redeemed all of the remaining Series CPreferred Stock for a total cash settlement amount of $3,554,370. Also, inconjunction with the redemption of the Series C Preferred Stock, allaccumulated and unpaid dividends on the Series C Preferred Stock wereconverted into common shares, except for $110,759, which has been recognized asdividends payable as at December 31, 2009.

 

As of December 31,2009 and 2008, 600,000 Series C Preferred Stock shares were authorized, 0and 592,032 of which were issued and outstanding, respectively, at a par valueof $0.0001.

 

**Series DConvertible Preferred Stock**

 

TheCompany issued 30,557 shares of redeemable Series D Convertible PreferredStock on December 28, 2009, in exchange for 30,557 shares of Series AConvertible Preferred Stock. Each share of Series D Preferred Stock has anOriginal Issue Price of $100.00 per share. The holder has the option to redeemthe shares of Series D Preferred Stock at any time for a number of sharesof the Company’s common stock equal to the Original Issue Price plusaccumulated and unpaid dividends divided by the fixed conversion price of $0.30per share of Common Stock. The conversion price is subject to adjustment ifcommon stock is issued by the Company subsequent to the original issue date ofthe Series D preferred stock, except for other conversions, options,warrants, dividends paid in stock or pursuant to an acquisition by the Company,at a price less than the conversion price. Mandatory conversion of all Series Dshares shall occur on December 31, 2010 by the Company paying cash equalto $100.00 per share with all accrued and unpaid dividends.  In any liquidation of the Company, each shareof preferred stock is entitled to a liquidation preference before anydistribution may be made on the Company’s common stock.

 

As of December 31,2009, 100,000 Series D Preferred Stock shares were authorized, 30,557 ofwhich were issued and outstanding, at a par value of $0.0001 and a liquidationpreference of $100.00 with accumulated dividends in arrears of $1,782, whichhave been accreted to the principal balance of the Series D PreferredStock.

 

The Series DPreferred Stock contains features that are considered embedded derivativefinancial instruments:  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; Semi Annual Dividends Conversion Option:  Holders have the option to convert the Stock’ssemi-annual dividend payment at any time at the fixed conversion price of $0.30per share.  These features have beenbifurcated and 

 

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recorded on the Company’s balance sheet asliabilities, at their fair value.

 

As of December 31,2009, the derivatives were valued at $563,599.

 

Anamount equal to the original value of the derivatives was recorded as adiscount to the Series D Preferred Stock. The discount is being 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 31,2009, the unamortized discount on the Preferred Stock was $426,889.

 

2. Permanent Equity

 

**CommonStock**

 

The Company is authorizedto issue 170,000,000 shares of common stock, $.0001 par value per share, ofwhich 77,713,398 and 67,876,880 were outstanding as of December 31, 2009and 2008, respectively.

 

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, 2009, preferred stockholders convertedaccumulated dividends of $1,385,752 into 9,836,518 shares of the Company’scommon stock. During the year ended December 31, 2008, preferredstockholders converted accumulated dividends of $826,739 into 6,723,678 sharesof the Company’s common stock.

 

**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 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 0 and 30,557 were issuedand outstanding as at December 31, 2009 and 2008, respectively.

 

The mandatory redemptionfeatures of the Series A Convertible Preferred Stock were triggered in January 2009due to the passing of the applicable mandatory redemption dates and the priceof the Company’s common stock, as reported by the OTC Bulletin Board, tradingbelow the applicable thresholds contained in the terms of the Preferred Stock.Absent a waiver from the holders of the Preferred Stock, the Company wastherefore required to redeem its outstanding shares of Preferred Stock, to theextent that the Company was legally permitted to do so, by paying cash to theholders of such shares in accordance with the terms of such Preferred Stock.From January 2009, the Company accrued dividends at the default rate of9%.

 

On November 12,2009, the Company entered into a Securities Exchange Agreement (the “ExchangeAgreement”), pursuant to which the Company and the holders of the outstandingshares of the Company’s Series A Convertible Preferred Stock, agreed toexchange (a) their shares of Series A Convertible Preferred Stock foran equal number of shares of the Company’s Series D Convertible PreferredStock, and Warrants to purchase up to an aggregate of 5,000,000 shares of the Company’sCommon Stock, at an exercise price of $0.30 per share, and (b) alldividends accrued and unpaid, totaling $737,957, on their shares of Series AConvertible Preferred Stock for Seven Percent (7%) Convertible Promissory Notes(the “Convertible Notes”).

 

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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  life  (in years)** | ** ** | **Aggregate  intrinsic  value** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|----------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
|                                                  |       |               |       |                                         |       |                                                    |       |                            |       |
| Outstanding, as  of December 31, 2007            |       | 10,566,375         |       | $                                            | 0.95       |                                                    |       |                            |       |   |
|                                                  |       |               |       |                                         |       |                                                    |       |                            |       |
| Granted                                               |       | —             |       | —                                       |       |                                                    |       |                            |       |
| Exercised                                             |       | —             |       | —                                       |       |                                                    |       |                            |       |
| Expired                                               |       | —             |       | —                                       |       |                                                    |       |                            |       |
| Outstanding, as  of December 31, 2008            |       | 10,566,375         |       | $                                            | 0.95       |                                                    |       |                            |       |   |
|                                                  |       |               |       |                                         |       |                                                    |       |                            |       |
| Granted                                               |       | 13,000,000         |       | 0.30                                         |       |                                                    |       |                            |       |
| Exercised                                             |       | —             |       | —                                       |       |                                                    |       |                            |       |
| Expired                                               |       | (6,790,584         | )          | 1.23                                         |       |                                                    |       |                            |       |
| Outstanding, as  of December 31, 2009            |       | 16,775,791         |       | $                                            | 0.33       |                                                    | 4.09       | ** **                      | **$**      | — | ** ** |
| Vested or  expected to vest at December 31, 2009 |       | 16,775,791         |       | $                                            | 0.33       |                                                    | 4.09       |                            | —     | ** ** |
| Exercisable at  December 31, 2009                |       | 16,775,791         |       | $                                            | 0.33       |                                                    | 4.09       |                            | —     | ** ** |
|                                                       |            |                    |            |                                              |            |                                                         |            |                                 |            |  |  |

 

The warrants outstandingand exercisable at December 31, 2009 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       |                                                    | 15,798,014 |   | 4.28 |   |
|                                        | 0.75       |                                                    | 533,333    |   | 1.61 |   |
|                                        | 1.00       |                                                    | 444,444    |   | 0.44 |   |
|                                        |       | 16,775,791                                              |       |   |   |

 

**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 are reservedfor issuance to employees, officers, directors, and consultants of the Companyat 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.

 

*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 

 

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granted may not exceedten years. Options issued under the Plan vest pursuant to the terms of stockoption agreements with the recipients. In the event of a change in control, asdefined, all options outstanding vest immediately. The 1999 Plan expired 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:

 
| ** **                                                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | ** **    | ** ** | ** **   | ** ** | **Weighted**   | ** ** | ** **    | ** **  |
|-----------------------------------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------|------------|---------------|------------|--------------|------------|----------------|------------|---------------|-------------|
| ** **                                                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | ** **    | ** ** | **Weighted** | ** ** | **average**    | ** ** | ** **    | ** **  |
| ** **                                                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | ** **    | ** ** | **average**  | ** ** | **remaining**  | ** ** | **Aggregate** | ** **  |
| ** **                                                | ** ** | **Number of Options** | ** ** | **exercise**       | ** ** | **life**           | ** ** | **intrinsic**     | ** ** |
| ** **                                                | ** ** | **1996 Plan**              | ** ** | **1999 Plan** | ** ** | **2004 Plan** | ** ** | **Non Plan** | ** ** | **Total**     | ** ** | **price**    | ** ** | **(in years)** | ** ** | **value**     | ** **  |
| Outstanding, as  of December 31, 2007                |       | 80,000                          |       |   805,000     |       | 2,221,415          |       | 3,943,000         |       | 7,049,415     |       | $            | 0.85       |           |       |          |        |   |
|                                                      |       |                            |       |               |       |               |       |              |       |          |       |         |       |           |       |          |        |
| Granted                                                   | ** ** | —                          |       | —             |       | 759,272            |       | —            |       | 759,272       |       | 0.13         |       |           |       |          |        |
| Exercised                                                 | ** ** | —                          |       | —             |       | —             |       | —            |       | —        |       | —       |       |           |       |          |        |
| Forfeited                                                 | ** ** | —                          |       | —             |       | (27,336            | )          | —            |       | (27,336       | )          | 0.63         |       |           |       |          |        |
| Expired                                                   | ** ** | —                          |       | (470,000           | )          | (115,410           | )          | (188,000          | )          | (773,410      | )          | 0.84         |       |           |       |          |        |
| Outstanding,  as of December 31, 2008                |       | 80,000                          |       | 335,000            |       | 2,837,941          |       | 3,755,000         |       | 7,007,941     |       | $            | 0.78       |           |       |          |        |   |
|                                                      |       |                            |       |               |       |               |       |              |       |          |       |         |       |           |       |          |        |
| Granted                                                   |       | —                          |       | 500,000            |       | 1,189,417          |       | 1,329,841         |       | 3,019,258     |       | 0.24         |       |           |       |          |        |
| Exercised                                                 |       | —                          |       | —             |       | —             |       | —            |       | —        |       | —       |       |           |       |          |        |
| Forfeited                                                 |       | (35,000                         | )          | (135,000           | )          | (1,510,677         | )          | (3,455,000        | )          | (5,135,677    | )          | 0.89         |       |           |       |          |        |
| Expired                                                   |       | —                          |       | (200,000           | )          | (443,492           | )          | (300,000          | )          | (943,492      | )          | 0.73         |       |           |       |          |        |
| **Outstanding,  as of December 31, 2009**            | ** ** | **45,000**                      | ** ** | **500,000**        | ** ** | **2,073,189**      | ** ** | **1,329,841**     | ** ** | **3,948,030** | ** ** | **0.24**     | ** ** | **4.33**       | ** ** | **$**         | **234,532** | ** ** |
| **Vested  or expected to vest at December 31, 2009** | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **3,856,790** | ** ** | **0.24**     | ** ** | **4.30**       | ** ** | **$**         | **221,363** | ** ** |
| **Exercisable  at December 31, 2009**                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **3,426,861** | ** ** | **0.26**     | ** ** | **4.14**       | ** ** | **$**         | **160,190** | ** ** |

 

The options outstandingand exercisable at December 31, 2009 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** | ** ** |
| $                                           | 0.07-0.21  |                         | 1,596,272  |                                   | $          | 0.11 |   | 5.63 |   | 1,075,103 |   | $ | 0.11 |   |
|                                        | 0.22-0.40  |                         | 2,229,258  |                                   | 0.30       |   | 3.57 |   | 2,229,258 |   | 0.30 |   |
|                                        | 0.41-0.68  |                         | 47,500     |                                   | 0.48       |   | 0.68 |   | 47,500 |   | 0.48 |   |
|                                        | 0.69-0.94  |                         | 75,000     |                                   | 0.94       |   | 1.84 |   | 75,000 |   | 0.94 |   |
| $                                           | 0.07-0.94  |                         | 3,948,030  |                                   |       |   |   |   | 3,426,861 |   |   |   |
|                                             |            |                              |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

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The aggregate intrinsicvalue in the table above represents the total intrinsic value, based on theCompany’s closing stock price of $0.24 as of December 31, 2009, 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 optionsexercisable as of December 31, 2009 was 1,075,103.

 

The weighted average fairvalue of options granted during the years ended December 31, 2009 and 2008was approximately $0.10 per share. The total intrinsic value of optionsexercised during the years ended December 31, 2009 and 2008 was $0. Thetotal fair value of shares vested during the years ended December 31, 2009and 2008 was $327,382 and $521,831 respectively.

 

As of December 31,2009 future compensation cost related to nonvested stock options isapproximately $24,730 and will be recognized over an estimated weighted averageperiod of approximately 0.9 years.

 

On November 2, 2009,in preparation for the sale of the Law Enforcement Division, the Company:

 

(i)               cancelled all outstanding options toacquire shares of the Company’s common stock, $0.0001 par value per share (“CommonStock”), held by officers, directors and employees of the Company and having anexercise price greater than $0.30 per share granted under the Company’s 2004Stock Incentive Plan and granted the holders of such options new options toacquire shares of Common Stock with an exercise price equal to $0.30 per shareand covering a proportionately reduced number of shares of Common Stockrelative to the existing exercise price, and

 

(ii)            offerred to the holders of alloutstanding options to acquire shares of Common Stock having an exercise pricegreater than $0.30 granted under the Company’s 1999 Stock Option Plan, theCompany’s 1996 Stock Option Plan, or under stock option agreements not subjectto any of the Company’s equity incentive plans, the opportunity to cancel suchoptions and receive in exchange therefor new options to acquire shares ofCommon Stock under the respective plan or under stock option agreements notsubject to any of the Company’s equity incentive plans, in each case with anexercise price equal to $0.30 per share and covering a proportionately reducednumber of shares of Common Stock relative to the existing exercise price.

 

All ofthe outstanding options to acquire shares of Common Stock having an exerciseprice greater than $0.30 per share were fully vested as of November 2,2009 and all new options granted to the holders of those options were fullyvested as of the date of grant.  The options granted to any employee ofthe Company whose employment with the Company terminated in connection with thesale of the Company’s Law Enforcement Division and who became an employee ofthe buyer upon such closing shall be exercisable for up to eighteen (18) monthsfrom and after the date of grant.  The remaining options shall beexercisable for up to three (3) years from and after the date of grant.

 

TheCompany recorded compensation expense during the 2009 period of approximately$138,000 for the modification of the above awards, of which approximately$84,000 related to the Company’s continuing operations, and approximately$54,000 related to the Company’s discontinued Law Enforcement division.

 

**NOTE Q— GAIN ON REDEMPTION OF REDEEMABLE PREFERREDSTOCK**

** **

Pursuant to theSettlement Agreement entered into between the Company and the Longview Entitiesin July 2009, the Company paid a total cash settlement amount of$2,164,922 to the Longview Entities for the redemption of the outstandingshares of the Company’s Convertible Preferred Stock held by the LongviewEntities, and accumulated and unpaid dividends therein. The settlement amountrepresented a discount to the value of the Shares and accumulated and unpaiddividends, resulting in a gain to the Company of $721,640.  The Company increased Additional Paid inCapital by the amount of this gain.

 

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**NOTE R—INCOME TAXES**

** **

The Company has a valuation allowance against the fullamount of its net deferred taxes. The Company currently provides a valuationallowance against deferred taxes when it is more likely than not that someportion, or all of its deferred tax assets will not be realized.

 

The Company reduced its deferred tax assets and theassociated valuation allowance for gross unrecognized tax affected benefits byapproximately $4,000,000. There was no adjustment to accumulated deficit as aresult of these unrecognized tax benefits since there was a full valuationallowance against the related deferred tax assets. If these unrecognized taxbenefits are ultimately recognized, they would have no impact on the effectivetax rate due to 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 2006-2009 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. The Company does not have any accrued interest orpenalties associated with any unrecognized tax benefits, nor was anysignificant interest expense recognized during the years ended December 31,2009 and 2008.

 

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:

 
| ** **                              | ** ** | **2009**    | ** **   | **2008**    | ** ** |
|-----------------------------------------|------------|-------------|--------------|-------------|------------|
| ** **                              | ** ** | ** **  | ** **   | ** **  | ** ** |
| **Current  asset:**                     | ** ** | ** **  | ** **   | ** **  | ** ** |
| Accrued compensation                    |       | $           | 79,000       |        | $          | 172,000 |   |
| Accounts  receivable allowance          |       | 5,000       |         | 32,000      |       |
| **Non-current  asset:**                 | ** ** | ** **  | ** **   | ** **  | ** ** |
| Basis  differences in fixed assets      |       | 29,000      |         | 68,000      |       |
| Basis  differences in intangible assets |       | 22,000      |         | 573,000     |       |
| Accrued interest  and other             |       | —      |         | 79,000      |       |
| Income tax  credits                     |       | 1,939,000   |         | 1,680,000   |       |
| Net operating  loss carryforwards       |       | 12,643,000  |         | 15,350,000  |       |
| Valuation  allowances                   |       | (14,717,000 | )            | (17,954,000 | )          |
|                                    |       |        |         |        |       |
|                                    |       | $           |  — |        | $          | — |   |

 

For year ended December 31,2009, $188,000 has been accrued for state and federal tax liabilities for theAMT tax calculated and netted against the gain on the Law Enforcement Divisionsale.

 

As of December 31,2009 the Company has federal and state net operating loss carryforwards ofapproximately $35,476,000 and $12,020,000, respectively, subject to expirationbetween 2010 and 2028.

 

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

 

A valuation allowanceequal to the full amount of the deferred tax assets has been recorded due tothe uncertainty of realization of the deferred tax assets due to operating losshistory of the Company. The valuation allowance could be reduced or eliminatedbased on future earnings and future estimates of taxable income. Similarly,income tax benefits related to stock options exercised have not been recognizedin the financial statements.

 

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A reconciliationof the effective income tax rate on operations reflected in the Statements ofOperations to the US Federal statutory income tax rate is presented below.

 
| ** **                            | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
|                                  | ** ** |     | ** ** |     | ** ** |
| US  Federal statutory income tax rate |       | 34       | %          | 34       | %          |
| State  taxes, net                     |       | 0        |       | 0        |       |
| Permanent  differences                |       | 24       |       | 229      |       |
| Temporary  differences                |       | (4       | )          | (46      | )          |
| Change  in valuation allowance        |       | (54      | )          | (217     | )          |
|                                  |       |     |       |     |       |
| Effective  tax rate                   |       | 0        | %          | 0        | %          |

 

**NOTES—FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

The Company’s derivativefinancial instruments as at December 31, 2009 and 2008 consisted ofembedded derivatives related to the Convertible Notes Payable as well as the Series B,Series C and Series D Convertible Preferred Stock. These embeddedderivatives include certain conversion features on debt principal and accruedinterest therein, and also preferred principal and accumulated and unpaiddividends therein. The Company also issued warrants to purchase shares of theCompany’s Common stock as part of various debt and preferred equity financings.

 

The accounting treatmentof the warrants and derivatives requires that the Company record the warrantsand derivatives at their relative fair value or fair value, depending onwhether the instrument is initially classified as a liability or equity. As thewarrants issued during 2009 were classified as equity instruments, no furtheraccounting adjustment is required. With respect to the derivatives, andwarrants issued prior to the 2009, which were classified as liabilities, insubsequent periods the derivatives are “marked-to-market” at fair value. Anychange in fair value will be recorded as non-operating, non-cash income orexpense at each reporting date. If the fair value of the derivatives is higherat the subsequent balance sheet date, the Company will record a non-operating,non-cash charge. If the fair value of the derivatives is lower at thesubsequent balance sheet date, the Company will record non-operating, non-cashincome.

 

Derivatives and warrantsclassified as liabilities consisted of the following as of December 31:

 
| ** **                              | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Warrants                                |       | $          | 111,674    |       | $          | 12,317 |   |
| Convertible note  derivatives           |       | $          | 344,891    |       | $          | — |   |
| Redeemable  preferred stock derivatives |       | $          | 563,599    |       | $          | 439 |   |

 

The derivatives were valuedas of December 31, 2009 and 2008, using the Binomial Option Pricing Modelwith the following assumptions:

 
| ** **                  | ** ** | **Year ended  December 31,** | ** ** |
|-----------------------------|------------|----------------------------------------|------------|
| ** **                  | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Interest  or Dividend Yield |       | 7                                      | %          | 15 | % |
| Annual  volatility          |       | 74                                     | %          | 42 | % |
| Risk-free  interest rate    |       | 0.47                                   | %          | 0.92 | % |

 

The assumptions relatingto the valuation of the warrants are listed in Note L.

 

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**NOTE T—SUPPLEMENTARY DISCLOSURES OFCASH FLOW INFORMATION**

 
| ** **                                                                                                                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                              | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                                                                                                                                    |       |                                        |       |   |   |
| **Cash paid for:**                                                                                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest                                                                                                                                                |       | $                                           | 78,681     |   | $ | 66,626 |   |
| **Noncash Financing Activities:**                                                                                                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Issuance  of debt in exchange of discounted Series B redeemable preferred stock                                                                    |       | 390,459                                     |       | — |   |
| Gain  on redemption of Series B redeemable preferred stock                                                                                         |       | 130,153                                     |       | — |   |
| Issuance  of debt in exchange of discounted Series C redeemable preferred stock                                                                    |       | 1,774,463                                   |       | — |   |
| Gain  on redemption of Series C redeemable preferred stock                                                                                         |       | 591,487                                     |       | — |   |
| Issuance  of Series D redeemable preferred stock in exchange for Series A  preferred stock                                                    |       | 3,055,700                                   |       | — |   |
| Issuance  of debt in exchange for cumulative dividends on Series A preferred Stock                                                                 |       | 737,957                                     |       | — |   |
| Issuance  of common stock in exchange for Series A, Series B, and  Series C preferred stock and cumulative dividends in arrears, thereon |       | 1,385,752                                   |       | 826,739 |   |
| Origination  of warrants in conjunction with convertible note financing                                                                                 |       | 373,956                                     |       | — |   |
| Origination  of warrants in conjunction with sale of law enforcement division                                                                           |       | 1,461,044                                   |       | — |   |
| Origination  of embedded derivatives with preferred stock                                                                                               |       | 430,398                                     |       | — |   |
| Origination  of note receivable in exchange for proceeds on the sale of the law  enforcement division                                                   |       | 4,000,000                                   |       | — |   |
|                                                                                                                                                         |            |                                             |            |  |  |  |  |

 

**NOTE U—PROFIT SHARING PLAN**

 

The Company has establisheda savings plan under section 401(k) of the Internal Revenue Code. Allemployees of the Company, after completing one day of service are eligible toenroll in the 401(k) plan. Participating employees may elect to defer aportion of their salary on a pre-tax basis up to the limits as provided by theIRS Code. The Company is not required to match employee contributions but maydo so at its discretion. The Company made no contributions during the two yearsended December 31, 2009.

 

 

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**NOTE V—EARNINGS PER SHARE “EPS”**

 

The Company’s basic EPSis calculated using net income (loss) available to common shareholders and theweighted-average number of shares outstanding during the reporting period.Diluted EPS includes the effect from potential issuance of common stock, suchas stock issuable pursuant to the exercise of stock options and warrants andthe assumed conversion of convertible notes and preferred stock. For the yearsended December 31, 2009 and 2008, diluted per share computations are notpresented since this effect would be antidilutive.

 

The reconciliation of thenumerator of the basic and diluted EPS calculations, due to the inclusion ofpreferred stock dividends, accretion, and gain on redemption, was as followsfor the following fiscal years ended December 31:

 
| ** **                                                                | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Numerator:**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                      |       |       |       |       |       |
| Loss  from continuing operations                                          |       | $          | (2,662,888 | )          | $          | (1,475,831 | ) |
| Convertible  preferred stock dividends, accretion, and gain on redemption |       | (518,749   | )          | (1,890,503 | )          |
| Loss  applicable to common stockholders (basic and diluted EPS)           |       | $          | (3,181,637 | )          | $          | (3,366,334 | ) |

 

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

 
| ** **                   | ** ** | **Years ended December 31,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                         |       |                                        |       |   |   |
| Preferred Stock              |       | 31,708,030                                  |       | 33,155,440 |   |
| Convertible Debt             |       | 20,218                                      |       | — |   |
| Stock Options                |       | 421,081                                     |       | 35,747 |   |
|                         |       |                                        |       |   |   |
| Potentially  dilutive shares |       | 32,149,329                                  |       | 33,191,187 |   |

 

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

 
| ** **    | ** ** | **Years ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Stock options |       | 2,613,758                                   |       | 6,480,669 |   |
| Warrants      |       | 16,775,791                                  |       | 10,566,375 |   |
|          |       |                                        |       |   |   |
| Total         |       | 19,389,549                                  |       | 17,047,044 |   |

 

**NOTE W—RECLASSIFICATIONS**

 

Certain amounts in the2008 financial statements have been reclassified to conform to the 2009presentation. These reclassifications had no effect on the previously reportednet loss or stockholders’ equity (deficit).

 

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

 

The following tablepresents selected unaudited financial information for the eight quarters in theperiod ended December 31, 2009. 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,  2008**    | ** ** | **June 30,  2008** | ** ** | **September 30,    2008** | ** ** | **December 31,    2008** | ** ** | **March 31,  2009** | ** ** | **June 30,  2009** | ** ** | **September 30,    2009** | ** ** | **December 31,**

**2009** | ** ** |
|                                                |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       | $                           | 352,619    |   | $ | 1,221,276 |   | $ | 452,928 |   | $ | 1,352,719 |   | $ | 538,194 |   | $ | 280,685 |   | $ | 524,351 |   | $ | 1,014,052 |   |
| Gross  profit                                       |       | 303,317                     |       | 1,177,485 |   | 354,637 |   | 1,205,945 |   | 401,115 |   | 212,254 |   | 329,565 |   | 910,113 |   |
| Income  (loss) from continuing operations           |       | (937,855                    | )          | (42,487 | ) | (629,976 | ) | 134,487 |   | (789,813 | ) | (890,407 | ) | (794,172 | ) | (188,496 | ) |
| Income  (loss) from discontinued operations         |       | 22,186                      |       | 276,098 |   | 585,008 |   | 777,072 |   | 1,011,862 |   | 1,030,177 |   | 724,761 |   | 105,735 |   |
| Gain  (loss) on disposal of discontinued operations |       | —                      |       | (65,354 | ) | — |   | — |   | — |   | — |   | — |   | 4,483,902 |   |
| Net  income (loss)                                  |       | $                           | (915,669   | ) | $ | 168,257 |   | $ | (44,968 | ) | $ | 911,559 |   | $ | 222,049 |   | $ | 139,770 |   | $ | (69,411 | ) | $ | 4,401,141 |   |
| Basic  and diluted earnings per common share:       |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss  from continuing operations                    |       | $                           | (0.02      | ) | $ | (0.01 | ) | $ | (0.02 | ) | $ | (0.00 | ) | $ | (0.02 | ) | $ | (0.02 | ) | $ | (0.01 | ) | $ | (0.00 | ) |
| Income  (loss) from discontinued operations         |       | 0.00                        |       | 0.00 |   | 0.01 |   | 0.01 |   | 0.02 |   | 0.02 |   | 0.01 |   | 0.00 |   |
| Gain  on disposal of discontinued operations        |       | —                      |       | (0.00 | ) | — |   | — |   | — |   | — |   | — |   | 0.06 |   |
| Net  loss                                           |       | $                           | (0.02      | ) | $ | 0.00 |   | $ | (0.01 | ) | $ | 0.01 |   | $ | 0.00 |   | $ | 0.00 |   | $ | (0.00 | ) | $ | 0.06 |   |
|                                                |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted  average shares outstanding:               |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic  and diluted                                  |       | 61,786,732                  |       | 63,180,281 |   | 64,913,843 |   | 66,720,602 |   | 68,477,547 |   | 71,291,168 |   | 73,521,550 |   | 76,821,746 |   |

 

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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, 2010 | 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,  2010 |
| Michael W.  DePasquale                |   |                                                   |   |                 |
|                                  |   |                                                   |   |                 |
| /s/  CECILIA  WELCH         |   | Chief Financial  Officer, Principal Accounting Officer |   | March 26,  2010 |
| Cecilia Welch                         |   |                                                   |   |                 |
|                                  |   |                                                   |   |                 |
| /s/  THOMAS  J. COLATOSTI   |   | Chairman of the Board  of Directors                    |   | March 26,  2010 |
| Thomas J.  Colatosti                  |   |                                                   |   |                 |
|                                  |   |                                                   |   |                 |
| /s/  JEFFREY  J. MAY        |   | Director                                               |   | March 26,  2010 |
| Jeffrey J. May                        |   |                                                   |   |                 |
|                                  |   |                                                   |   |                 |
| /s/  CHARLES  P. ROMEO      |   | Director                                               |   | March 26,  2010 |
| Charles P. Romeo                      |   |                                                   |   |                 |
|                                  |   |                                                   |   |                 |
| /s/  JOHN  SCHOENHERR       |   | Director                                               |   | March 26,  2010 |
| John Schoenherr                       |   |                                                   |   |                 |

 

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**EXHIBIT INDEX**

 
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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                                                                                                                                                  |
| 3.7 (8)          |       | Certificate of  Designation of the Series D 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)          |       | Employment  Agreement by and between BIO-key International, Inc. and Mira LaCous  dated November 20, 2001                                                                                                                          |
| 10.5(9)          |       | Option to  Purchase 150,000 Shares of Common Stock issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.6(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                                                                        |
| 10.7(9)          |       | Option to  Purchase 580,000 Shares of Common Stock issued to Michael W. DePasquale                                                                                                                                                           |
| 10.8(7)          |       | Option to  Purchase 500,000 Shares of Common Stock issued to Michael W. DePasquale                                                                                                                                                           |
| 10.9(7)          |       | Option to  Purchase 150,000 Shares of Common Stock issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.10(7)         |       | Option to  Purchase 50,000 Shares of Common Stock issued to Thomas J. Colatosti                                                                                                                                                              |
| 10.11(7)         |       | Option to  Purchase 50,000 Shares of Common Stock issued to Jeff May                                                                                                                                                                         |
| 10.12(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                           |
| 10.13(11)        |       | Form of  Warrant issued by BIO-key International, Inc. pursuant to the March Securities  Purchase Agreement                                                                                                                   |
| 10.14(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 |
| 10.15(2)         |       | Form of  Common Stock Purchase Warrant issued by BIO-key International, Inc.  pursuant to the Laurus Securities Purchase Agreement                                                                                                 |
| 10.16(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                                                        |
| 10.17(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      |
| 10.18(2)         |       | Form of  Common Stock Purchase Warrant issued by BIO-key International, Inc.  pursuant to the Shaar Securities Purchase Agreement                                                                                                  |
| 10.19(2)         |       | Registration  Rights Agreement dated as of September 29, 2004 by and between BIO-key  International, Inc., The Shaar Fund, Ltd. and the other Purchasers party  thereto                                                            |
| 10.20(10)        |       | Option to  Purchase 300,000 shares of common stock issued to Kenneth Souza                                                                                                                                                                   |
| 10.21(10)        |       | Employment  Agreement dated as of October 4, 2004 by and between BIO-key  International, Inc. and Kenneth Souza                                                                                                                    |
| 10.22(10)        |       | BIO-key  International, Inc. 2004 Stock Incentive Plan                                                                                                                                                                                  |
| 10.23(10)        |       | Warrant to  purchase 100,000 shares of Common Stock issued to The November Group  Ltd. on July 14, 2004                                                                                                                            |
| 10.24(10)        |       | Warrant to  purchase 230,000 shares of Common Stock issued to Jesup & Lamont  Securities Corp. on March 31, 2004                                                                                                               |
| 10.25(10)        |       | Warrant to  purchase 105,000 shares of Common Stock issued to Douglass Bermingham on March 31,  2004                                                                                                                                    |
| 10.26(10)        |       | Warrant to  purchase 60,000 shares of Common Stock issued to Mason Sexton on March 31,  2004                                                                                                                                            |
| 10.27(10)        |       | Warrant to  purchase 22,000 shares of Common Stock issued to David Moss on March 31,  2004                                                                                                                                              |
| 10.28(10)        |       | Warrant to  purchase 22,000 shares of Common Stock issued to Patrick Gaynes on March 31,  2004                                                                                                                                          |
| 10.29(10)        |       | Warrant to  purchase 5,000 shares of Common Stock issued to Tom DuHamel on March 31,  2004                                                                                                                                              |
| 10.30(11)        |       | Option to  Purchase 155,000 shares of common stock issued to Francis J Cusick                                                                                                                                                                |
| 10.31(11)        |       | Option to  Purchase 50,000 shares of common stock issued to Charles P. Romeo                                                                                                                                                                 |
| 10.32(12)        |       | Securities  Purchase Agreement, dated as of June 8, 2005, by and between the Company  and Laurus Fund, Ltd.                                                                                                                             |

 

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| 10.33(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.                                                                                                                      |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34(12) |   | Registration  Rights Agreement, dated as of June 8, 2005, by and between the Company  and Laurus Fund, Ltd.                                                                                                                                                                                       |
| 10.35(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                                                                                                                                     |
| 10.36(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                                                                |
| 10.37(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                                                                                                         |
| 10.38(20) |   | Escrow  Agreement, dated as of May 31, 2005, by and among the Company, Jesup &  Lamont Securities Corp.                                                                                                                                                                                  |
|      |   | and Thelen, Reid &  Priest LLP.                                                                                                                                                                                                                                                               |
| 10.39(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and  Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.40(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and The  Shaar Fund, Ltd.                                                                                                                                                                                          |
| 10.41(15) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and  Longview Special Finance                                                                                                                                                                                      |
| 10.42(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and  Etienne Des Roys                                                                                                                                                                                              |
| 10.43(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and Eric  Haber                                                                                                                                                                                                    |
| 10.44(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and  Investors Management Corporation                                                                                                                                                                              |
| 10.45(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and The  Tocqueville Fund                                                                                                                                                                                          |
| 10.46(13) |   | Amendment and  Waiver, dated as of August 31, 2005, by and between the Company and The  Tocqueville Amerique Value Fund                                                                                                                                                                           |
| 10.47(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. |
| 10.48(14) |   | Amendment and  Waiver, dated as of January 23, 2006, by and between the Company and  Laurus Master Fund, Ltd.                                                                                                                                                                                     |
| 10.49(14) |   | Registration  Rights Agreement, dated as of January 23, 2006, by and between the  Company and Laurus Master Fund, Ltd.                                                                                                                                                                            |
| 10.50(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                                                                                                                                        |
| 10.51(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                                                                                                                                   |
| 10.52(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                                                                         |
| 10.53(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                                                                 |
| 10.54(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                                                                                                                                    |
| 10.55(14) |   | Amendment No. 1  to Subordinated Secured Promissory Note, dated as of January 23, 2006,  by and between the Company and Aether Systems, Inc.                                                                                                                                            |
| 10.56(17) |   | 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                                                                                                                     |
| 10.57(18) |   | Amendment and  Waiver, dated as of August 10, 2006, by and between the Company and  Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.58(18) |   | Registration  Rights Agreement, dated as of August 10, 2006, by and between the  Company and Laurus Master Fund, Ltd.                                                                                                                                                                             |
| 10.59(18) |   | 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                                             |

 

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| 10.60(18)        |   | 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 |
|------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.61(18)        |   | Securities  Purchase Agreement, dated as of August 10, 2006, by and between the  Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.62(18)        |   | 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.                                                                 |
| 10.63(18)        |   | Registration  Rights Agreement, dated as of August 10, 2006, by and between the  Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.64(18)        |   | Securities  Purchase Agreement, dated as of August 10, 2006, by and between the  Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.65(18)        |   | 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.                                                              |
| 10.66(18)        |   | Registration  Rights Agreement, dated as of August 10, 2006, by and between the  Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.67 (19)       |   | Amendment and  Waiver, dated as of December 29, 2006, by and between the Company and  Laurus Master Fund, Ltd.                                                                                                                                         |
| 10.68 (20)       |   | Amendment and  Waiver, dated as of April 18, 2007, by and between the Company and  Laurus Master Fund, Ltd.                                                                                                                                            |
| 10.69 (21)       |   | Purchase and Sale  Agreement, dated as of May 22, 2007, by and between the Company and ZOLL  Data Systems, Inc                                                                                                                                         |
| 10.70 (27)       |   | Options to  Purchase 50,000 and 65,241 Shares of Common Stock issued to Thomas J.  Colatosti                                                                                                                                                                |
| 10.71 (27)       |   | Options to  Purchase 100,000 and 130,481 Shares of Common Stock issued to Jeff May                                                                                                                                                                          |
| 10.72 (27)       |   | Options to  Purchase 50,000 and 32,620 Shares of Common Stock issued to Charles Romeo                                                                                                                                                                       |
| 10.73 (27)       |   | Options to  Purchase 50,000 and 48,930 Shares of Common Stock issued to John Schoenherr                                                                                                                                                                     |
| 10.74 (24)       |   | Settlement and Mutual  Release Agreement, dated July 28, 2008, by and between the Company and  Dataradio Corporation.                                                                                                                                  |
| 10.75 (27)       |   | Option to  Purchase 500,000 Shares of Common Stock issued to Michael W. DePasquale                                                                                                                                                                          |
| 10.76 (27)       |   | Option to  Purchase 50,000 Shares of Common Stock issued to Thomas J. Colatosti                                                                                                                                                                             |
| 10.77 (27)       |   | Options to  Purchase 50,000 and 25,000 Shares of Common Stock issued to Jeff May                                                                                                                                                                            |
| 10.78 (27)       |   | Option to  Purchase 50,000 Shares of Common Stock issued to Charles Romeo                                                                                                                                                                                   |
| 10.79 (27)       |   | Option to  Purchase 100,000 Shares of Common Stock issued to John Schoenherr                                                                                                                                                                                |
|             |   |                                                                                                                                                                                                                                                        |
| 10.80  (28) |   | Amendment  Agreement, dated April 1, 2009, by and between the Company and Dataradio  Corporation                                                                                                                                                       |
| 10.81 (29)       |   | Settlement and  Mutual Release Agreement, dated July 2, 2009, by and between the Company  and Longview Special Finance, Inc., and Longview Fund LP                                                                                                |
| 10.82 (29)       |   | Promissory Note,  dated July 7, 2009, by and between the Company and The Shaar Fund Ltd                                                                                                                                                                |
| 10.83 (8)        |   | Asset Purchase  Agreement, dated August 13, 2009, by and between the Company and  Interact911 Mobile Systems, Inc.                                                                                                                                |
| 10.84 (8)        |   | Note Amendment  and Extension Agreement, dated as of November 3, 2009, by and between  the Company and The Shaar Fund Ltd                                                                                                                              |
| 10.85 (8)        |   | Securities  Exchange Agreement, dated as of November 12, 2009, by and between the  Company and The Shaar Fund Ltd., and Thomas J. Colatosti                                                                                                            |
| 10.86 (8)        |   | Promissory Note,  dated December 7, 2009, by and between the Company and InterAct911  Mobile Systems, Inc.                                                                                                                                        |
| 10.87 (8)        |   | Warrant to  purchase 8,000,000 shares of Common Stock issue to Silkroad Equity, LLC on December 7,  2009                                                                                                                                               |
| 10.88 (8)        |   | Warrant to  purchase 4,750,000 shares of Common Stock issued to The Shaar Fund Ltd. on December 28,  2009                                                                                                                                              |
| 10.89 (8)        |   | Warrant to  purchase 250,000 shares of Common Stock issued to Thomas J. Colatosti on December 28,  2009                                                                                                                                                |
| 10.90 (8)        |   | Convertible  Note, dated as of December 28, 2009, by and between the Company and The  Shaar Fund Ltd.                                                                                                                                                  |
| 10.91 (8)        |   | Convertible  Note, dated as of December 28, 2009, by and between the Company and  Thomas J. Colatosti                                                                                                                                                  |
| 10.92 (8)        |   | Compensation  Agreement, dated January 12, 2010, by and between the Company and Mr. Colatosti                                                                                                                                                     |
| 10.93 (8)        |   | Employment  Agreement, effective March 25, 2010, by and between the Company and Michael  W. DePasquale                                                                                                                                                      |
| 21.1 (26)        |   | List of  subsidiaries of BIO-key International, Inc.                                                                                                                                                                                                   |
| 23.1 (8)         |   | Consent of CCR  LLP                                                                                                                                                                                                                                         |
| 31.1 (8)         |   | Certification of  the Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                                                                               |
| 31.2 (8)         |   | Certification of  the Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                                                                               |
| 32.1 (8)         |   | Certification of the  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                               |

 

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| 32.2 (8) |   | Certification of  the Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|----------|--------|---------------------------------------------------------------------------------------------------------------|

 

----

(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.

 

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

 

(4)           Filed as anexhibit to the registrant’s registration statement on Form SB-2, FileNo. 333-16451 dated February 14, 1997 and incorporated herein byreference.

 

(5)           Filed as anexhibit to the registrant’s annual report on Form 10-KSB filed withthe Securities and Exchange Commission on April 14, 2000 and incorporatedherein by reference.

 

(6)           Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on November 26, 2001 and incorporatedherein by reference.

 

(7)          Filed as an exhibit to the registrant’s annualreport on Form 10-KSB filed with the Securities and Exchange Commission onMarch 26, 2004 and incorporated herein by reference.

 

(8)           Filed herewith.

 

(9)           Filed as anexhibit to the registrant’s annual report on Form 10-KSB filed withthe Securities and Exchange Commission on March 31, 2003 and incorporatedherein by reference.

 

(10)     Filed as anexhibit to the registrant’s registration statement on Form SB-2, FileNo. 333-120104 dated October 29, 2004 and incorporated herein byreference.

 

(11)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on March 4, 2005 and incorporatedherein by reference.

 

(12)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on June 14, 2005 and incorporatedherein by reference.\

 

(13)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on September 7, 2005 and incorporatedherein by reference.

 

(14)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on January 25, 2006 and incorporatedherein by reference.

 

(15)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on February 9, 2006 and incorporatedherein by reference.

 

(16)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on March 29, 2006 and incorporatedherein by reference.

 

(17)     Filed as anexhibit to the registrant’s annual report on Form 10-KSB filed withthe Securities and Exchange Commission on March 29, 2006 and incorporatedherein by reference.

 

(18)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on August 16, 2006 and incorporatedherein by reference.

 

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(19)    Filed as an exhibit to the registrant’s annualreport on Form 10-KSB filed with the Securities and Exchange Commission onMarch 30, 2007 and incorporated herein by reference.

 

(20)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on April 24, 2007 and incorporatedherein by reference.

 

(21)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on May 25, 2007 and incorporated hereinby reference.

 

(22)     Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on July 18, 2007 and incorporatedherein by reference.

 

(23)    Filed as an exhibit to the registrant’s currentreport on Form 8-K filed with the Securities and Exchange Commission on June 5,2008 and incorporated herein by reference.

 

(24)    Filed as an exhibit to the registrant’s quarterlyreport on Form 10-Q filed with the Securities and Exchange Commission on November 14,2008 and incorporated herein by reference.

 

(25)    Filed as an exhibit to the registrant’s currentreport on Form 8-K filed with the Securities and Exchange Commission on November 20,2008 and incorporated herein by reference.

 

(26)    Previously filed

 

(27)    Filed as an exhibit to the registrant’s annualreport on Form 10-K filed with the Securities and Exchange Commission on March 11,2009 and incorporated herein by reference.

 

(28)    Filed as an exhibit to the registrant’s quarterlyreport on Form 10-Q filed with the Securities and Exchange Commission on August 8,2009 and incorporated herein by reference.

 

(29)    Filed as an exhibit to the registrant’s quarterlyreport on Form 10-Q filed with the Securities and Exchange Commission on November 13,2009 and incorporated herein by reference.

 

79

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