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**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-K**

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

** **

**For the Fiscal Year Ended December 31, 2008**

** **

**CommissionFile Number 1-13463**

 

**BIO-KEYINTERNATIONAL, INC.**

(Exactname 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, NJ07719**

(Addressof Principal Executive Offices) (Zip Code)

 

**(732) 359-1100**

Issuer’stelephone number, including area code.

 

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

 

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

 

**Securities registered pursuant toSection 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 90days.    Yes  x    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            Acceleratedfiler  o            Non-acceleratedfiler  o            Smallerreporting 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 $8,305,169..

 

Asof February 13, 2009, the registrant had 67,876,880 shares of common stockoutstanding.

 

Documents Incorporated by Reference: None

 

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**TABLE OF CONTENTS**

 
|          | PART I                                                                                                         | 1      |
|----------|---------------------------------------------------------------------------------------------------------------------|--------|
|     |                                                                                                                |   |
| Item 1.  | Description of  Business                                                                                            | 1      |
| Item  1A | Risk  Factors                                                                                                       | 11     |
| Item 2   | Description of  Property                                                                                            | 16     |
| Item  3  | Legal  Proceedings                                                                                                  | 16     |
| Item 4   | Submission of  Matters to a Vote of Security Holders                                                                | 16     |
|     |                                                                                                                |   |
|     | PART II                                                                                                        | 17     |
|     |                                                                                                                |   |
| Item 5   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 17     |
| Item 6   | Selected Financial  Data                                                                                            | 19     |
| Item 7   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 19     |
| Item 7A  | Quantitative and  Qualitative Disclosures about Market Risk                                                         | 29     |
| Item 8   | Financial  Statements and Supplementary Data                                                                        | 30     |
| Item 9   | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               | 30     |
| Item 9A  | Controls and Procedures                                                                                             | 30     |
| Item 9B  | Other Information                                                                                                   | 31     |
|     |                                                                                                                |   |
|     | PART III                                                                                                       | 32     |
|     |                                                                                                                |   |
| Item 10  | Directors,  Executive Officers and Corporate Governance                                                             | 32     |
| Item 11  | Executive  Compensation                                                                                             | 35     |
| Item 12  | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 40     |
| Item 13  | Certain  Relationships and Related Transactions, and Director Independence                                          | 42     |
| Item 14  | Principal  Accountant Fees and Services                                                                             | 43     |
| Item  15 | Exhibits                                                                                                            | 44     |
|     | Signatures                                                                                                          | 77     |

 

**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 offactors. 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 anyforward-looking statement, whether as a result of new information, futureevents or otherwise.

 

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**PART I**

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**ITEM 1.**                    DESCRIPTION OFBUSINESS

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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 and software solutions. Biometrictechnology is the science of analyzing specific human characteristics which areunique to each individual in order to identify a specific person from a broaderpopulation. First incorporated as BBGEngineering, the company became SAC Technologies in 1994.  The BIO-key name was introduced in 2002.

 

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

 

We 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 and is the only fingeridentification algorithm that has been certified by the International ComputerSecurity Association (ICSA).

 

Since our inception in 1993,we have spent substantial time and effort in completing the development of whatwe believe is the most discriminating and effective commercially availablefinger-based biometric technology. During the past four years, our primaryfocus has shifted to marketing and selling this technology and completingstrategic acquisitions that can help us leverage our capability to deliveridentification solutions. We have built a direct sales force of professionalswith substantial experience in selling technology solutions to government andcorporate customers.

 

In 2004, BIO-key acquiredPublic Safety Group, Inc. (PSG), a privately held company that is a leaderin wireless solutions for law enforcement and public safety markets. PSG’sprimary technology is 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. Our PacketCluster mobile information software is integrated with50 separate State/NCIC databases, as well as other state, local and federaldatabases. Its open architecture and its published Application ProgrammingInterface (API) make it easy to interface with a wide range of informationsources. PacketCluster products deliver real-time information in seconds,freeing dispatchers to handle more pressing emergencies.

 

In 2007, BIO-key competeda transaction with ZOLL Data Systems, Inc. (“ZOLL”), a subsidiary of ZOLLMedical Corporation, in which ZOLL acquired substantially all of the assetsrelated to the Company’s Fire/EMS Services division.

 

As aresult of these transactions, and as discussed in Note M to theConsolidated Financial Statements included in this report, we have organizedthe Company into two reporting segments: Law Enforcement and Biometrics. During the year ended December 31,2008, 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.

 

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**Markets**

 

***Finger-based Biometric Identification***

 

BIO-keyis a leader in finger-based biometric identification. In partnerships with OEMs,integrators, and solution providers, we provide biometric software solutions toprivate and public sector customers. BIO-key’s patented Vector SegmentTechnology (VST) is the foundation for these solutions. BIO-key’s WEB-key ® is a cost-effective,easy-to-deploy, fingerprint-based, strong authentication system. This uniquesolution allows users to positively identify themselves to any application withthe simple scan of their finger. This capability is a significant improvementin both convenience and security over other alternatives and provides companieswith a cost-effective solution to thwart phishing attacks and comply with governmentregulations and legislation such as FFIEC compliance, HIPAA, HSPD-12, and theElectronic Signatures Act. BIO-key couples these capabilities with deviceinteroperability, system flexibility and scalability. BIO-key enables the useof 40 different fingerprint sensor technologies to enroll and identifyemployees, customers or business partners. BIO-key has formed relationshipswith providers of biometric logon software like IdentiPHI, Softex, JanusAssociates, Sig-Tec and Computer Associates to provide enterprise-readySingleSignOn systems to many large companies in the US and abroad. Through itspartnership with Oracle, we have integrated our technology into the entireFusion Middleware and Identity Management software stack to offer all of Oraclecustomers a scalable biometric authentication solution  Also, BIO-key has integrated VST to a purephysical access solution in NextGenID, which has been deployed across the US atmany leading companies.

 

·                  *Growthpotential*—As the provider ofthe core technology, BIO-key’s greatest growth potential for this market is asa partner with companies that offer applications that address growing concernsparticularly about identity theft and anti-terrorism.

 

For example, BIO-key has implemented programs thatwill enable biometric logical and physical access. These include working withIdentiPHI to provide strong network based authentication on BIO-key technology;and with the Pegasus Program to authenticate users accessing anationwide information-sharing system designed by and for the nation’ssheriffs. These represent the kind of partnership-based opportunities BIO-keymay see in the finger-based biometric market.

 

In parallel, BIO-key is both strengthening securityand improving user and system administrator convenience by integratingbiometric log-in, as well as two-factor authentication, with its lawenforcement suite of solutions.  Thesecapabilities provide BIO-key with the ability to address the latest CJISsecurity requirements providing market leadership in this critical area . Thisis a true differentiator to potential new customers, and creates add-onopportunities with existing customers. Fingerprint identification of First Responders has been identified as away to facilitate disaster recoveries and these integrated projects have beenreceiving funding from the Department of Homeland Security.  By promoting our integration of fingerprintsfor this use, we can capitalize on our vast customer base and drive newrevenue.

 

***LawEnforcement***

 

BIO-key’s InfoServer, MobileCop and PocketCop law enforcement products are a leadingwireless mobile data communications client/server solution, implemented in morethan 750 agencies in 43 states. Providing immediate access to mission-criticaldata and enabling in-field reporting, BIO-key software keeps officers on thestreet, improving their productivity and enhancing officer safety. BIO-keysolutions are able to run across any and all wireless infrastructures andintegrate with virtually all computer-aided dispatch (CAD) and recordsmanagement systems. This makes us a leader in multi-agency cooperation andinteroperability, which are absolutely critical in times of large-scale naturaland terrorist threats.

 

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

 

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

 

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the market segment for MobileCop and PocketCop andrelated add-on products —  expected tototal  $5.5 billion over the next 5 years

 

A key opportunity is the growing awareness of theneed for multi-agency interoperability. In these situations, BIO-key offers:

 

·      BIO-key’s LE products, which can run on any and all wirelessinfrastructures. BIO-key also has had success implementing seamless roamingacross multiple infrastructures for multi-agency consortiums.

 

·      BIO-key’s open architecture.

 

·      BIO-key’s experience in large, complex and multi-agencyimplementations, such as Hamilton County, Ohio Sheriff’s Office andPennsylvania State Police.

 

·      New add-on applications:

 

·                  Data sharing of RMS information —InfoExchange

·                  GPS & AVL Mapping — MobileCopNavigator

·                  Handheld Mobile Solutions for BlackBerriesand PDA’s

·                  Field Reporting — Mobile Office

·                  New ease of useand administration features for hosting multi agencies at lower costs

 

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

 

An additional growth area isthe introduction of BIO-key’s finger-based biometric identification to lawenforcement. In addition to now offering biometric login to our traditional InfoServer product, we have introduced the IdentityMatch fingerprint identification solution, whichlets law enforcement personnel capture fingerprints in the field. UsingBIO-key’s patented Vector Segment Technology, IdentityMatch analyzes andcategorizes fingerprints the same way a fingerprint expert would—only faster.IdentityMatch also enables multiple law enforcement agencies to sharefingerprint data with other agencies. This powerful tool, built on BIO-key’sunderstanding of law enforcement requirements and its fingerprint technology,presents opportunities for the law enforcement business segment in the comingyear.

 

**Products**

 

BIO-key® operates in twomajor segments—biometrics and law enforcement. These segments are describedbelow and a list of products in each line is noted.

 

***Biometrics***

 

The Company’s biometricidentification technology improves both the accuracy and speed of finger-basedbiometrics. The Company’s proprietary biometric technology extracts unique datafrom a fingerprint and uses it to positively identify an individual.  The technology has been built to becompletely scalable to handle databases containing millions of fingerprints.BIO-key achieves the highest levels of discrimination without requiring anyother identifying data—like a userID, smart card, or token.  BIO-key’s core technology supportsinteroperability on over 40 different commercially available readers.  This interoperability is a key differentiatorfor BIO-key in the biometric market. BIO-key has full support for industry standards and recently receivedNational Institute of Standards and Technology (“NIST”) certification on itsability to support HSPD-12 supported INCITS-378 templates.  We believe we have the largest deployment ofISO standard templates in the world with over 300 million created inBangladesh.  Extending our products tosupport standards enables BIO-key to participate in large government projectslike Transportation Workers Identification Card(TWIC), Registered Travelerprojects, PIV initiatives, and FIXS consortium solutions. We believe ourfingerprint identification technology has a broad range of information securityand access control applications, including:

 

·              Securing Internetsites and electronic transactions

 

·              Securing access tological networks and applications

 

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·              Securing access tobuildings and restricted areas

 

·              Providing fast,accurate member identification services

 

·              Securing mobiledevices such as biometric enabled handhelds and PDA’s

 

·              Preventingidentity theft through positive user identification and false alias validation

 

**Biometric Products:**

 

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

 

·                  **Vector Segment Technology SDK (VST)**—BIO-key’sbiometric development kit that provides developers the ability to takeadvantage of a highly accurate, device interoperable algorithm. VST isavailable as a low level SDK for incorporation into any applicationarchitecture to increase security while not sacrificing convenience. VST runson Windows, Linux or Solaris systems.

 

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

 

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

 

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

 

·                  **ID Director**TM—BIO-key’s solution for singlesign on integration with Computer Associates SiteMinder, Oracle’s FusionMiddleware SSO, and other solutions, utilizing the power and security ofWEB-key. This solution provides a simple to implement, custom authenticationscheme for companies looking to enhance authentication. ID Director can easilyadd a level of security and convenience to the transaction level of anyapplication.

 

***Law Enforcement***

 

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

 

·                  **PocketCop®**— PocketCop is a softwaresolution that provides law enforcement personnel with instantaneous access tocriminal, civil, and local database information in a wireless environment.PocketCop is a handheld application that provides access to state and federaldatabases over the wireless network for Windows Mobile, and RIM OS devices.Using a portable wireless handheld device and the PocketCop applicationsoftware, an authorized user can access suspect information such as wantedstatus, warrant status, vehicle registration and driver license status.PocketCop technology has been deployed in numerous police agencies in theUnited States,  including the OklahomaCounty (OK) Sheriff’s Office and the Franklin County (OH) Sheriff’s Office. We expect our PocketCop 

 

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sales to benefit from theincrease in the availability and use of BlackBerry and Windows Mobile smartphonesin public safety.

 

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

 

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

 

ID-Mobile — provides for wireless in the fieldidentification of suspects.  Thisapplication can be used in mobile laptop computers or a convenient handhelddevice. The features and functionality of this application are ideal for lawenforcement patrol, transport vehicles, motorcycle and bike patrols, mountedand foot patrols, as well as water patrols; wherever a versatile handheldbiometric reader would be essential for true suspect identification.

 

ID-Track — ensures the true identification, trackingand management of criminals once they enter the criminal handling continuum.From pre-booking to parolee management ID-Track provides true suspectidentification. In addition to validating true criminal identity it archivesdata for a historical review of enrollments and inmate activity for reportquery (under development).

 

ID-Visit — verifies the identity of visitorsregistered for visitation rights to incarcerated criminals. ID-Visit cangreatly reduce registration time for subsequent visits and ensures compliancewith a facility’s visitor policy.  Ahistory of visitor activity is maintained for historical review and reportquery. This application is also helpful to identify the access of pre-approvedpersonnel such as volunteers, Chaplains, teachers, etc. (under development).

 

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

 

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

 

·                  **Patrol JournalTM -**an automated system to electronicallycapture and record users’ daily activities, such as patrol area assignments.With Patrol Journal, statistical and summary management reports provide anaccurate picture of time spent by field personnel.

 

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

 

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

 

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

 

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sharing and otherapplications.

 

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

 

·                  **InfoExchangeTM  —**provides data from localrecords management system (RMS) and other databases directly to the mobile datauser.  Local RMS systems often containinformation and images (such as mugshots) not available from state and federal databases.

 

·                  **MobileCop® Navigator —**Based on Microsoft MapPoint, MobileCop Navigatorprovides easy-to-use mapping features, such as in-car display of location anddriving directions generated automatically from CAD call information, withoutextensive map creation or maintenance of a full scale GIS mapping system.

 

**Partnerapplications include:**

 

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

 

**Current Business Plan**

 

BIO-key’s currentbusiness plan is to:

 

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

 

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

 

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

 

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

 

**Competition**

 

The markets for BIO-keyproducts and technologies are developing and are characterized by intensecompetition and rapid technological change. No assurance can be given that ourcompetitors will not develop new or enhanced technologies that will offersuperior price, performance, or features, or render BIO-key products ortechnologies obsolete.

 

*Biometrics*

 

In addition to companiesthat provide existing commonplace methods of restricting access to facilitiesand logical access points such as pass cards, PIN numbers, passwords, locks andkeys, there are numerous companies involved in the development, manufacturingand marketing of fingerprint biometrics products to commercial, government, lawenforcement and prison markets. These companies include, but are not limitedto, Cogent, NEC, L-1 Identity Solutions, Sagem-Morpho, and Bioscrypt.

 

The most recent automatedfingerprint identification product sales in the market have been deployed forgovernment and law enforcement applications, typically at more cost thanBIO-key’s products and licensing arrangements. Although most companies thattarget consumer application markets have completed development of theirbiometric products, such technologies have not been widely accepted in thecommercial markets to date. Most companies competing for commercial opportunitiesare in the business of selling scanning devices and tie their algorithm to aspecific device. BIO-key has created a “device independent” algorithm thatprovides flexibility in choosing the correct device and optical or tactilesense to fit the 

 

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application served.

 

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

 

With respect to competingbiometrics technologies, each has its strength and weaknesses and none hasemerged as a market leader:

 

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

 

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

 

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

 

The market for biometrictechnology is evolving. Computer breaches, identity theft, phishing and otherevents in the recent past are driving a large-scale shift to biometricdeployments. In addition, companies such as IBM, Dell, Gateway, MPC, Samsungand HP have all introduced computers with integrated finger scanning devices tocomplement the conventional username/password technique since it is highlysusceptible to hackers and security breaches. BIO-key supports these integrateddevices for broader enterprise level security solutions.

 

*Law Enforcement*

 

The public safety marketcomprises agencies at all government levels, with a range of users, from a fewto many hundreds. BIO-key competitors in the mobile data market includeComputer Aided Dispatch/Records Management companies such as New World, Tiburonand Motorola. Each has comprehensive CAD and/or RMS offerings and has augmentedthose with their own mobile data and field reporting solutions. While thesemobile data solutions may not be as functionally rich as the BIO-keysuite of products, they are sometimes less expensive when bundled with theCAD/RMS offerings. They also provide a complete solution from one vendor.

 

**Marketing and Distribution**

 

BIO-key’s marketing anddistribution efforts comprise the following major initiatives:

 

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

 

·                  BIO-key hasstrategic alliances with technology leaders including Oracle, ComputerAssociates, Hewlett Packard, Dell, Verizon, Sprint/Nextel, AT&T Wireless,and others.

 

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

 

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

 

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

 

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**Addressingthe Market**

 

Following are thespecific marketing/sales programs in place:

 

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

 

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

 

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

 

·                  *StrategicAlliance*— BIO-key’s strategic alliances and reseller agreementswith other vendors play a significant role in our overall sales efforts. In thepast year, BIO-key has initiated and bolstered numerous important and promisinglong-term relationships. Just a few examples include:

 

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

 

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

 

·                  BIO-key is an active member in the CAand Oracle partner programs, delivering authentication and identificationsolutions integrated with their Identity Management platform to all of theircustomers worldwide.

 

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

 

**Licensing**

 

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

 

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

 

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

 

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

 

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

 

·                  *Patient Records and Information Management:*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.

 

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

 

**Intellectual Property Rights**

 

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

 

·                  *Patents*—our biometrics segment uses patented technology andtrade secrets developed or acquired by us.

 

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

 

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

 

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

 

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

 

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OnApril 15, 2008, BIO-key announced that the U.S. Patent andTrademark Office has issued US patent No. 7,359,553 covering BIO-key’simage enhancement and data extraction core algorithm components. The solutionprotected under this recently issued patent provides the capability to quicklyand accurately transform a fingerprint image into a computer image that can beanalyzed to determine the critical data elements

 

OnOctober 15, 2008 BIO-key announced that the U.S. Patent andTrademark Office has issued US patent No. 7,415,605 for the company’s “BiometricIdentification Network Security” method. The solution protected under thisrecently issued patent provides a defense against hackers and system attacks,while leveraging the industry standard Trusted Platform Module (TPM) specification for encryption key management.

 

OnDecember 3, 2008 BIO-key announced that the U.S. Patent andTrademark Office has issued US patent No. 7,454,624 for the company’s “MatchTemplate Protection within a Biometric Security System” method. The solutionprotected under this recently issued patent limits the scope of enrollmenttemplates usage and also eliminates the need for revocation or encryptionprocesses, which can be expensive and time consuming.

 

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

 

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

 

·                  *Copyrights and trade secrets*—We take measures to ensurecopyright and license protection for our software releases prior todistribution. When possible, the software is licensed in an attempt to ensurethat only licensed and activated software functions to its full potential. Wealso take measures to protect the confidentiality of our trade secrets.

 

**Research and Development**

 

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

 

During the fiscal yearsended December 31, 2008 and 2007, BIO-key spent approximately $4,489,000and $4,995,000 respectively, on research, development and engineering. BIO-key’slimited customer base during that time did not directly bear these costs, whichwere principally funded through outside sources of equity and debt financing.

 

**Government Regulations**

 

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

 

**Environmental Regulations**

 

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

 

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**Employees and Consultants**

 

As of February 13,2009, BIO-key currently employed forty-two (42) individuals on a full-timebasis: twenty-three (23) in engineering, customer support, research anddevelopment; eight (8) in finance and administration; and eleven(11) in sales and marketing. BIO-key also uses the services of nine (9) consultants(full and part-time), who provide engineering, finance, and technical services.

 

**ITEM 1A. RISK FACTORS**

 

Set forth below are therisks that we believe are material to our investors. This section containsforward-looking statements. You should refer to the explanation of thequalifications and limitations on forward-looking statements appearing justbefore our Description of Business section above.

 

**Businessand Financial Risks**

 

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

 

Due to, among otherfactors, our history of losses (excluding gains from valuation changes inembedded derivatives) and limited revenue, our independent auditors have includedan explanatory paragraph in their opinion for the year ended December 31,2008 as to the substantial doubt about our ability to continue as a goingconcern. Our financial statements have been prepared in accordance withaccounting principals generally accepted in the United States, whichcontemplate that we will continue to operate as a going concern. Our financialstatements do not contain any adjustments that might result if we are unable tocontinue as a going concern.

 

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

 

As of December 31,2008, we had negative working capital of approximately $4,100,000 and anaccumulated deficit of approximately $54,781,000. Since our inception, we havefocused almost exclusively on developing our core technologies and, until thefourth quarter of 2004 had not generated any significant revenue. In order toincrease revenue, we have developed a direct sales force and anticipate theneed to retain additional sales, marketing and technical support personnel andmay need to incur substantial expenses. We cannot assure you that we willbe able to secure these necessary resources, that a significant market for ourtechnologies will develop or that we will be able to achieve our targetedrevenue.

 

**Our****biometric technology hasyet to gain widespread market acceptance and we do not know how large of amarket will develop for our technology.**

 

Biometric technology hasreceived only limited market acceptance, particularly in the private sector.Our technology represents a novel security solution and we have not yetgenerated significant sales. Although recent security concerns relating toidentification of individuals has increased interest in biometrics generally,it remains an undeveloped, evolving market. Biometric based solutions competewith more traditional security methods including keys, cards, personalidentification numbers and security personnel. Acceptance of biometrics as analternative to such traditional methods depends upon a number of factorsincluding:

 

·      the reliability of biometric solutions

 

·      public perception regarding privacyconcerns

 

·      costs involved in adopting and integratingbiometric solutions

 

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

 

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

 

Our WEB-key ® authentication initiativerepresents a new approach to Internet security which has been adopted on alimited basis by companies which distribute goods, content or softwareapplications over the Internet. The implementation of our WEB-key ® solution requires thedistribution and use of a finger scanning device and integration of databaseand server side software. Although we believe our solutions 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 testingduring development, our software may contain undetected design faults andsoftware errors, or “bugs” that are discovered only after it has been installedand used by a greater number of customers. Any such defect or error in new orexisting software or applications could cause delays in delivering ourtechnology or require design modifications. These could adversely affect ourcompetitive position and cause us to lose potential customers or opportunities.Since our technologies are intended to be utilized to secure physical andelectronic access, the effect of any such bugs or delays will likely have adetrimental impact on us. In addition, given that biometric technologygenerally, and our biometric technology specifically, has yet to gainwidespread acceptance in the market, any delays would likely have a moredetrimental impact on our business than if we were a more established company.

 

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

 

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

 

We market our technologythrough licensing arrangements with:

 

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

 

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

 

As a 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.

 

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

 

Most of our businessinvolves providing products and services under contracts with U.S. federal,state and local government agencies. Obtaining contracts from governmentagencies is challenging, and government contracts often include provisions thatare not standard in private commercial transactions. For example, governmentcontracts may:

 

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

 

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

 

·                  contain onerousprocurement procedures; and

 

·                  be subject tocancellation if government funding becomes unavailable.

 

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

 

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

 

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

 

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

 

A loss of our currentChairman of the Board of Directors or Chief Executive Officer could severelyand negatively impact our operations. Our consulting contract with Thomas J.Colatosti, our Chairman of the Board, and acting Chief Financial Officer,expires in November 2009. Mr Colatosti continues to assist the Company inthe areas of strategic planning and corporate finance. In addition, we have anemployment contract with Michael W. DePasquale, our Chief Executive Officer,through May 2009. Although the contract does not prevent him fromresigning, it does contain confidentiality and non-compete clauses which areintended to prevent him from working for a competitor within one year afterleaving our Company. Our success depends on our ability to attract, train andretain employees with expertise in developing, marketing and selling softwaresolutions. In order to successfully market our technology, we will need toretain additional engineering, technical support and marketing personnel. Themarket for such persons remains highly competitive and our limited financialresources will make it more difficult for us to recruit and retain qualifiedpersons.

 

**We cannot 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 can not assure you thatany additional patents will be issued or that we will have the resources to protectany patent from infringement. Although we believe our technology does notcurrently infringe upon patents held by others, we can not assure you that suchinfringements do not exist or will not exist in the future.

 

**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.**

 

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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.

 

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 and2007.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

We could be subject to fluctuationsin technology spending by existing and potential customers. Accordingly, wewill have to actively manage expenses in a rapidly changing economicenvironment. This could require reducing costs during economic downturns andselectively growing in periods of economic expansion. If we do not properlymanage our resources in response to these conditions, our results of operationscould be negatively impacted.

 

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**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 otherdisposition of any material assets;

 

·                  an acquisitionof a material amount of assets;

 

·                  engaging in amerger, reorganization or consolidation; or

 

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

 

Accordingly, unless 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 31,2008, approximately 67,691,000 shares of our common stock were reserved forissuance upon exercise or conversion of the following securities (at conversionprices applicable as at December 31, 2008):

 

·                  17,589,000shares upon exercise of outstanding stock options and warrants;

 

·                  2,899,000 sharesupon exercise of options available for future grant under our existing optionplans; and

 

·                  47,203,000shares or more upon conversion of our outstanding shares of ConvertiblePreferred Stock and cumulative dividends in arrears.

 

The exercise orconversion of these securities will result in a significant increase in thenumber of outstanding shares and substantially dilute the ownership 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 ourability to raise additional financing may be adversely affected by the influxinto the market of such a substantial number of shares.**

 

Our outstanding shares ofSeries A, B and C Convertible Preferred Stock (collectively, the “PreferredStock”) and cumulative dividends in arrears are convertible into approximately47,203,000 shares of common stock as of December 31, 2008, at a per shareconversion price of $.30. Although many of the shares issuable upon conversionof our Preferred Stock are eligible for public resale under Securities ExchangeCommission Rule 144, we agreed to file a registration statement tocover the public resale of all of these shares. This significant increase inthe number of shares available for public sale may have a negative impact onthe trading price of our shares and substantially dilute the ownershipinterests of our existing shareholders. In the event that our stock tradesbelow $.30 per share, in order to raise additional financing we would likely berequired to issue additional shares of common stock or securities convertibleinto common stock at a purchase or conversion price, as applicable, of lessthan $.30 per share. Any issuance of shares at a purchase price of less than$.30 per share would reduce the conversion price of our Preferred Stock to suchlower price. This would require us to issue additional shares upon conversionof our Preferred Stock and further dilute the ownership interests of ourexisting shareholders. To the extent these factors are viewed negatively by themarket, it may provide an incentive for persons to execute short sales of ourcommon stock that could adversely affect the trading price of our common stock.

 

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

 

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

 

**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.

 

**ITEM 2.**                    DESCRIPTION OFPROPERTY

** **

We do not own any realestate. We conduct operations from leased premises in Marlborough,Massachusetts (14,907 square feet), Eagan, Minnesota (6,822 square feet), Wall,New Jersey (4,179 square feet) and Fulton County, Georgia, (360 square feet).We believe our current facilities are adequate for the foreseeable future.

 

**ITEM 3.**                    LEGALPROCEEDINGS

** **

On February 2,2009, Longview Special Finance, Inc. and Longview Fund, L.P. (the “Plaintiffs”)filed a complaint against the Company in the United States District Court forthe Southern District of New York entitled Longview Special Finance, Inc.and Longview Fund, L.P. v. BIO-key International, Inc., in which thePlaintiffs are seeking $2,915,950 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, on or prior to January 10, 2009, theoutstanding shares of the Company’s Series B Convertible Preferred Stockand Series C Convertible Preferred Stock held by the Plaintiffs.  The Company believes that it has meritoriousdefenses and it intends to defend against these claims vigorously.

 

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

** **

No matters were submittedto a vote of security holders in the fourth quarter of 2008.

 

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** **

**PART II**

** **

**ITEM 5.**              MARKET FORREGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

** **

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

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

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

 

**Holders**

 

As of February 13,2009, the number of stockholders of record of our common stock was 172.

 

**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**

 

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

 

(b) On January 23,2006, the Company issued Convertible Term Notes in the aggregate principalamount of $1,000,000 to certain investors. The Convertible Notes areconvertible into 1,000,000 shares of Shares of Series B ConvertiblePreferred Stock of the Company at an initial fixed conversion of $0.70 pershare for an aggregate amount of 1,428,571 shares. In 

 

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addition the Company issuedwarrants to these certain investors to purchase 500,000 shares of common stockat an initial exercise price of $1.00 These securities were issued in a private placement transaction exemptfrom the registration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

 

(c) On August 10,2006, BIO-key International, Inc. entered into an Amendment and Waiverwith Laurus pursuant to which Laurus allowed the Company to pay principalamounts due and payable under the 2004 Senior Note and the 2005 Senior Note forthe months of August and September 2006 to be paid in shares of the Company’sCommon Stock priced at $0.50 per share, and defer principal amounts due andpayable under the 2004 Senior Note for the months of October, November andDecember 2006 to January 1, 2008, the final maturity date of the 2004Senior Note, and defer the principal amounts due and payable under the 2005Senior Note for the months of October, November and December 2006 to December 1,2008, the final maturity date of the 2005 Senior Note. The Company issued150,000 shares of the Company’s Common Stock to Laurus as consideration forthis payment amendment and deferral. These securities were issued in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

 

(d) On August 10,2006, the Company entered into a Securities Exchange Agreement with The ShaarFund Ltd. and other institutional and accredited investors pursuant towhich these investors agreed to exchange the principal amount outstanding underthe Subordinated Notes, plus accrued and unpaid interest thereon, and certainliquidated damages payments owed by the Company for 592,032 shares of theCompany’s Series C Convertible Preferred Stock at an initial fixedconversion of $0.50 per share. These securities were issued in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

 

(e) On August 10,2006, the Company issued an aggregate of 3,000,000 and 1,000,000 shares ofcommon stock and warrants to purchase 400,000 and 133,333 shares of commonstock at an exercise price of $0.75, to Trellus Partners, L.P. and The ShaarFund Ltd., respectively, for aggregate gross proceeds of approximately$1,500,000 in cash, and $500,000 in declared and unpaid dividends. Thesesecurities were issued in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

 

(f) Effective as of April 18,2007, the Company entered into an Amendment and Waiver (the “April 2007Senior Notes Amendment and Waiver”) with Laurus in connection with the 2004 and2005 Senior Notes then held by Laurus. Underthe April 2007 Secured Notes Amendment and Waiver, the Secured Notesissued by the Company to Laurus on September 29, 2004 and June 7,2005 were amended as follows: the principal amount due and payable under the2004 and 2005 Senior Notes for the months of March, April and May 2007was deferred until the earlier of the closing of a qualified financing transaction,or the final maturity dates of the 2004 and 2005 Senior Notes, which were January 1,2008 and December 1, 2008, respectively (“the Principal Deferral”). Inaddition, the Company agreed to issue 850,000 shares of restricted common stockto Laurus as consideration for: (i) the foregoing Principal Deferral; (ii) thefull satisfaction of all of the Company’s default obligations to Laurus, whichamounted to $622,764, that were incurred by the Company as a result of anyEvent of Default by the Company under the 2004 and 2005 Senior and SubordinatedNote agreements; and (iii) the waiver of all prepayment fees and penaltiesarising from the Company prepaying the obligations under the Notes undercertain circumstances. These securities were issued in a private placementtransaction exempt from the registration requirements of the Securities Actpursuant to Section 4(2) thereof directly by the Company withoutengaging in any advertising or general solicitation of any kind and withoutpayment of underwriting discounts or commissions to any person.

 

**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’s Discussion And Analysis OfFinancial Condition And Results Of Operations, and other parts of thisReport contain forward-looking statements that involve risks and uncertainties.All forward-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’s Discussion And Analysis Of FinancialCondition 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 2008performance and a description of the significant events impacting 2008 andthereafter.

 

RESULTS OF OPERATIONSprovides an analysis of the consolidated and segment results of operations for2008 compared to 2007.

 

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 2008.

 

**OVERVIEW**

 

Our Business

 

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

 

In 2004, BIO-key acquiredPublic Safety Group, Inc. (PSG), a privately held company that is a leaderin wireless solutions for law enforcement and public safety markets. PSG’sprimary technology is PocketCopTM, a handheld solution that provides mobileofficers, such as detectives who are not typically in their vehicles, ahand-held mobile information software solution.

 

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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. Our PacketCluster mobile information software is integrated with50 separate State/NCIC databases, as well as other state, local and federaldatabases. Its open architecture and its published Application ProgrammingInterface (API) make it easy to interface with a wide range of informationsources. PacketCluster products deliver real-time information in seconds,freeing dispatchers to handle more pressing emergencies.

 

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.

 

# **INTRODUCTION**

#  

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

 

Adetailed analysis of both segments can be found below.

 

**RESULTSOF OPERATIONS**

 

**ConsolidatedResults of Operations**

 

**Two Year % trend**

 
| ** **                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| **Revenues**                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Services                                                |       | 56                                          | %          | 70 | % |
| License fees and  other                                 |       | 44                                          | %          | 30 | % |
|                                                    |       | 100                                         | %          | 100 | % |
| **Costs  and other expenses**                           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cost of services                                        |       | 10                                          | %          | 15 | % |
| Cost of license  fees and other                         |       | 3                                           | %          | 3 | % |
|                                                    |       | 13                                          | %          | 18 | % |
| Gross Profit                                            |       | 87                                          | %          | 82 | % |
|                                                    |       |                                        |       |   |   |
| **Operating  expenses**                                 |       |                                        |       |   |   |
| Selling, general  and administrative                    |       | 51                                          | %          | 86 | % |
| Research,  development and engineering                  |       | 35                                          | %          | 50 | % |
|                                                    |       | 86                                          | %          | 136 | % |
| **Operating  income/(loss)**                            |       | 1                                           | %          | -54 | % |
|                                                    |       |                                        |       |   |   |
| **Other  income/(deductions)**                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Total other  income/(deductions)                        |       | 1                                           | %          | -2 | % |
| **Net  Income/(loss) from continuing operations**       |       | 2                                           | %          | -56 | % |
| **Net  Income from discontinued operations**            |       | 0                                           | %          | 4 | % |
| **Gain/(loss)  on disposal of discontinued operations** |       | -1                                          | %          | 41 | % |
| **Net  income/(loss)**                                  |       | 1                                           | %          | -11 | % |

 

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The Company evaluates performanceand allocates resources based on revenues and operating income (loss).Operating income (loss) for each segment includes selling, general andadministrative expenses directly attributable to the segment in addition tothose allocated as a percentage based on the segments’ revenues and otherfactors. The segmentation of operating income as noted above and detailed belowreflects how management evaluates its business.  Assets for the Companyare commingled and are related to all operating segments. Management does notevaluate or identify the operating assets of the segments separately.

 

***Revenuesand Costs of goods sold***

 
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | **2008 - 2007** | ** ** |
|---------------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **                | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| *Revenues*                | * *   | * *   | * *   | * *   | * *   | * *                  | * *   | * * | * * |
| **Law  Enforcement**      | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                   |       | $          | 7,045,222  |       | $          | 6,904,856                 |       | $ | 140,366 |   | 2 | % |
| License &  other |       | 2,451,283  |       | 2,168,344  |       | 282,939                   |       | 13 | % |
|                      |       | 9,496,505  |       | 9,073,200  |       | 423,305                   |       | 5 | % |
| **Biometrics**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                   |       | 191,515    |       | 60,850     |       | 130,665                   |       | 215 | % |
| License &  other |       | 3,188,027  |       | 854,406    |       | 2,333,621                 |       | 273 | % |
|                      |       | 3,379,542  |       | 915,256    |       | 2,464,286                 |       | 269 | % |
|                      |       |       |       |       |       |                      |       |   |   |
| *Total  Revenue*          |       | $          | 12,876,047 |       | $          | 9,988,456                 |       | $ | 2,887,591 |   | 29 | % |
|                      |       |       |       |       |       |                      |       |   |   |
| *Cost of  goods sold*     | * *   | * *   | * *   | * *   | * *   | * *                  | * *   | * * | * * |
| **Law  Enforcement**      | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                   |       | $          | 1,195,602  |       | $          | 1,397,888                 |       | $ | (202,286 | ) | (14 | )% |
| License &  other |       | 200,287    |       | 145,627    |       | 54,660                    |       | 38 | % |
|                      |       | 1,395,889  |       | 1,543,515  |       | (147,626                  | )          | (10 | )% |
| **Biometrics**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                   |       | 70,646     |       | 95,453     |       | (24,807                   | )          | (26 | )% |
| License &  other |       | 268,606    |       | 145,808    |       | 122,798                   |       | 84 | % |
|                      |       | 339,252    |       | 241,261    |       | 97,991                    |       | 41 | % |
|                      |       |       |       |       |       |                      |       |   |   |
| *Total  COGS*             |       | $          | 1,735,141  |       | $          | 1,784,776                 |       | $ | (49,635 | ) | (3 | )% |

 

***Revenues***

 

*LawEnforcement*

 

Forthe year ended December 31, 2008, service revenue increased due to acombination of new license and associated maintenance deals, and the conversionof a long-term project customer into maintenance.  This increase was offset by existing customercancellations.

 

For the year ended December 31, 2008, license andother revenue increased primarily due to product penetration into a number ofnew government agencies in Georgia, Hawaii, and Maryland.

 

*Biometrics*

 

Forthe year ended December 31, 2008, service revenue increased as the Companysuccessfully bundled maintenance agreements to its expanding customer licensebase during the period, as well renewed existing maintenance agreements fromits legacy customers during the period. The percentage of service revenue as aproportion of total Biometric revenue was steady at approximately 6% across thetwo periods reported.

 

Forthe year ended December 31, 2008, license and other revenue increasedprimarily as a result of sales generated from a new OEM customer, and wassupplemented by additional license revenue from existing customers.

 

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***Costsof goods sold***

 

*LawEnforcement*

 

Forthe year ended December 31, 2008, cost of services decreased from the 2007period primarily due to a reduction in payroll costs of approximately $140,000,and the associated allocation of corporate overhead, of approximately $48,000.

 

Forthe year ended December 31, 2008, cost of licenses increased from the 2007period as a result of the Company’s increased use of embedded third-partysoftware, which had the effect of driving up license fees and royalty costs.

 

*Biometrics*

 

Forthe year ended December 31, 2008, cost of services decreased from the 2007period due to lower personnel related expenses. The Company expects these costs will increase in future periods asadditional Biometric customers are added.

 

For the year ended December 31,2008, cost of license and other increased from the 2007 period, due to anincrease in hardware and third party software costs, driven by a largercustomer base. While these costs increased year over year, the proportion oflicense and other costs to license and other revenues decreased to 8% from 17%over the two periods presented, indicating that the Company improved itsmargins in this emerging segment.

 

***Selling, general and administrative***

 
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | **2008 - 2007** | ** ** |
|----------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Law  Enforcement** |       | $          | 5,184,094  |       | $          | 7,142,929                 |       | $ | (1,958,835 | ) | (27 | )% |
| **Biometrics**       |       | 1,369,828  |       | 1,430,934  |       | (61,106                   | )          | (4 | )% |
|                 |       |       |       |       |       |                      |       |   |   |
| **Total**            |       | $          | 6,553,922  |       | $          | 8,573,863                 |       | $ | (2,019,941 | ) | (24 | )% |

 

The overall decline inthe total SG&A costs for the year ended December 31, 2008 as comparedto 2007 was primarily attributable to a reduction in headcount driven by ourcontinued focus on expense management. Payroll costs, which include permanent and temporary staff as well asthe associated benefits, and commissions, were reduced by approximately$730,000, and the associated share-based compensation charges decreased byapproximately $180,000 during 2008.

 

Professional fees droppedby approximately $860,000 throughout the 2008 year due to a number of factors.First, the Company was able to further reduce certain accounting and consultingfees incurred during 2007 relating to reporting and compliance issues theCompany experienced due to the restatement of previously filed financialstatements that occurred in 2007.  Inaddition, there were $426,000 in one-time legal and regulatory costs associatedwith our proposed acquisition of a Canadian company incurred in 2007.

 

During 2008, the Companyextended its property lease at the Marlborough, MA location. The lower squarefootage of floor space rented will save the Company approximately $75,000 permonth, when compared to the previous arrangement. Hence the allocation of facilitiescost across the Law segment was lower.

 

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***Research, development and engineering***

 
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | **2008 - 2007** | ** ** |
|----------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Law  Enforcement** |       | $          | 3,502,451  |       | $          | 3,997,678                 |       | $ | (495,227 | ) | (12 | )% |
| **Biometrics**       |       | 986,341    |       | 997,121    |       | (10,780                   | )          | (1 | )% |
|                 |       |       |       |       |       |                      |       |   |   |
| **Total**            |       | $          | 4,488,792  |       | $          | 4,994,799                 |       | $ | (506,007 | ) | (10 | )% |

 

*LawEnforcement*

 

For the year ended December 31,2008, R & D costs decreased as compared to 2007 due to two mainfactors. Personnel related expenses, including the associated share-basedcompensation charges decreased by approximately $350,000 due to headcountreductions. Another driver of change in facilities charges was due to theCompany extending its property lease at the Marlborough, MA location, asdiscussed above.

 

*Biometrics*

 

For the year ended December 31,2008, R & D costs decreased as compared to 2007, primarily due tolower personnel costs, offset slightly by an increase in consultant expenses.

 

***Other income and expense***

 
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **2008 - 2007** | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **                                     | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Interest income                                |       | $          | 1,339      |       | $          | 3,097                     |       | $ | (1,758 | ) | (57 | )% |
| Interest expense                               |       | (92,520    | )          | (832,457   | )          | 739,937                   |       | (89 | )% |
| Derivative and  warrant fair value adjustments |       | 93,059     |       | 1,016,845  |       | (923,786                  | )          | (91 | )% |
| Investment  income                             |       | 119,348    |       | —     |       | 119,348                   |       | n/a |   |
| Loss on  extinguishment of debt                |       | —     |       | (403,940   | )          | 403,940                   |       | (100 | )% |
| Other income  (expense)                        |       | (34,885    | )          | 12,102     |       | (46,987                   | )          | (388 | )% |
|                                           |       |       |       |       |       |                      |       |   |   |
|                                           |       | $          | 86,341     |       | $          | (204,353                  | )          | $ | 290,694 |   | (142 | )% |

 

Forthe year ended December 31, 2008, the decrease in interest expense wasattributable to repayment of all of the Company’s senior and subordinated debtobligations in May 2007.  Interestexpense includes actual cash paid for interest as well as non-cash interestcharges for the amortization of debt discounts, deferred charges, and deferredrent. The majority of interest expense for 2008 was associated with the NotePayable (Note L).

 

Forthe year ended December 31, 2008, derivative and warrant fair valueadjustments decreased, when compared to the 2007 period, due to changes in thefair market value of embedded derivatives and detachable warrants issued withconvertible debt in 2004 and 2005, as well as additional derivatives recordedas a result of financings in 2006. The fair value of the derivatives willfluctuate based on; our stock price on the valuation date, the debt conversionprice, the volatility of our stock price over a period of time, changes in thevalue of the risk free interest rate, and the time to maturity of theoutstanding debt at different points in time. Stock price is the major driverbehind the movement in the Company’s balances. In dollar terms, our stock pricedecreased less during the 2008 year when compared to the 2007 year, reducingthe extent of the movement in value of the derivatives and warrants, andcreating less substantial non-cash income.

 

As mentioned in Note Q tothe consolidated financial statements,the balance of unamortized debt discounts, deferred financing charges, andderivatives with respect to the 2004 and 2005 financings were extinguished aspart of the May 2007 debt repayment. The changes represented non-cashincome and expense charges to the statement of operations and were 

 

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classified as loss onextinguishment of debt.  There was noextinguishment of debt during 2008.

 

Forthe year ended December 31, 2008, investment income related to therealization of “available-for-sale” securities sold at its market value.

 

**DISCONTINUEDOPERATIONS**

 

On May 22, 2007, wecompleted the sale of our Fire/EMS Services division for $7 million, amountingto a net gain to the Company of approximately $4 million. This business hadpreviously been reported as a separate segment in our financialstatements. For the fiscal years ended 2008 and 2007, $0, and $0.4 millionof operating income, respectively, net of tax, were reflected as discontinuedoperations in the accompanying consolidated statements of operations.  Netsales associated with the discontinued operations were $0, and $1.5 million for2008 and 2007, respectively. See “Note B — Discontinued Operations” forfurther discussion.

 

**LIQUIDITY AND CAPITAL RESOURCES**

** **

***OPERATING ACTIVITIES OVERVIEW***

 

Netcash provided by operations during the year ended December 31, 2008 wasapproximately $129,000. The cash provided by operating activities ofcontinuing operations was primarily due to the following items:

 

·                  Positive cashflows related to a decrease in accounts receivable, offset by a decrease indeferred revenue of approximately $1,440,000, and $810,000, respectively (netinflow of $630,000),

 

·                  Negative cashflows from payments with respect to the note payable, and a decrease in accruedliabilities of approximately$840,000 and $592,000, respectively (total outflow of $1,432,000),

 

·                  Negative cashflows from a reduction in deferred rent by approximately $350,000.

 

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, 2008:

 

·                  The Companyissued notes in 2004, 2005 and 2006 and preferred stock in 2006, all of whichcontained embedded derivatives, and associated warrants. In 2008, the Companyrecognized gains of approximately $93,000 related to the decrease in value ofthe derivatives and associated warrants. The decrease in value is driven mainlyby the decline in value of the underlying BIO-key stock,

 

·                  The Companyrecorded approximately $119,000 as gain on sale of investments in 2008,

 

·                  The Companyrecorded approximately $742,000 of charges in 2008 for the expense ofamortizing intangible assets,

 

·                  The Companyrecorded approximately $415,000 of charges in 2008 for the expense of issuingoptions to employees for services.

 

***INVESTING ACTIVITIES OVERVIEW***

 

Netcash provided by investing activities for the year ended December 31, 2008was approximately $619,000. The cash provided by investing activities forcontinuing operations was primarily driven by deposit returns of approximately$480,000, 

 

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and the proceeds ofapproximately $119,000 from the sale of available-for-sale investments.

 

***FINANCING ACTIVITIES OVERVIEW***

 

Thewere no cash inflows or outflows related to financing activities during 2008.

 

Workingcapital deficit at December 31, 2008 was approximately $4,100,000 ascompared to a deficit of approximately $5,796,000 at December 31, 2007,the improvement of which was driven mainly by the Company’s repayment ofvarious liabilities and recognition of backlog items from deferred revenue.

 

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

 

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

 

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

 

***Liquidity outlook***

 

AtDecember 31, 2008, our total of cash and cash equivalents wasapproximately $1,713,000, as compared to approximately $965,000 at December 31,2007.

 

Asdiscussed above, the Company has financed itself in the past through access tothe capital markets by issuing convertible debt securities, convertiblepreferred stock and common stock. We currently require approximately$900,000 per month to conduct our operations. During 2008, we generated approximately $13,000,000 of revenue. While theCompany expects to increase revenue in 2009, there can be no assurancethat we will achieve that goal.

 

The Company remains obligated under a note payable toone of its subcontractors in the aggregate amount of approximately $1,100,000,which amount is scheduled to be paid by the Company on a monthly basis, withthe final payment due on June 1, 2009. 

 

In addition, as described further in Notes O and X tothe financial statements included in this annual report, the Company iscurrently required to redeem certain of its outstanding shares of preferredstock, to the extent that the Company is legally permitted to do so, by payingcash to the holders of such shares in accordance with the terms of suchpreferred 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 and2007.

 

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.

 

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**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. The office lease agreement signed by theCompany in June 2008 states BIO-key was to maintain a security deposit inthe form of an irrevocable letter of credit in the amount of $40,500. However,BIO-key and the landlord for the property subsequently agreed to have BIO-keyplace the funds in a third-party escrow account, to be returned at theconclusion of the lease term. The escrow is recorded as the non-current asset,restricted cash as at December 31, 2008.

 

**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 assumptions on an ongoing basis.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 softwarelicensing are recognized in accordance with Statement of Position (SOP) No. 97-2,Software Revenue Recognition, as amended by SOP No. 98-9. Accordingly,revenue from software licensing is recognized when all of the followingcriteria are met: persuasive evidence of an arrangement exists, delivery hasoccurred, the fee is fixed or determinable, and collectability is probable.

 

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

 

Multiple-ElementArrangements: For multiple-element arrangements, each element of thearrangement will be analyzed and the Company will allocate a portion of thetotal fee under the arrangement to the elements using vendor specific objectiveevidence of fair value of the element, regardless of any separate prices statedwithin the contract for each element. Vendor specific objective evidence isbased on the price the customer is required to pay when the element is sold separately(i.e., software license fees charged when consulting or other services are notprovided, hourly rates charged for consulting services when sold separatelyfrom a software license). If vendor specific objective evidence of fair valuedoes not exist for any undelivered elements, all revenue is deferred andrecognized ratably over the service period if the undelivered element isservices, or until sufficient objective evidence of fair value exists or allelements 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 

 

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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. Revenues earned but not yetbilled are shown as an asset in Costs and Earnings in Excess of Billings in thebalance sheet. Billings in excess of cost and earnings are reflected as aliability in the balance sheet. Anticipated contract losses are recognized assoon as they become known and are estimable.

 

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

 

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

 

Costs and other expenses: Includesprofessional compensation and other direct contract expenses, as well as costsattributable to the support of client service professional staff, depreciationand amortization costs related to assets used in revenue-generating activities,and other costs attributable to serving the Company’s client base. Professionalcompensation consists of payroll costs and related benefits includingstock-based compensation and bonuses. Other direct contract expenses includecosts directly attributable to client engagements, such as out-of-pocket costsincluding travel and subsistence for client service professional staff, costsof hardware and software and costs of subcontractors. The allocation of leaseand facilities charges for occupied offices are included in costs of service.

 

2.*Derivative and Warrantfinancial instruments*

 

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

 

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

 

3. *Goodwill and Intangible Assets*

 

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards No. 142 (“SFAS 142”),Goodwill and Other Intangible Assets., which requires the Company to testgoodwill for impairment annually or whenever events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable, ratherthan amortize. Accordingly, the Company has not amortized goodwill.

 

Due tothe disposal of the Fire/EMS business in May 2007, the Company allocated agreater proportion of Corporate overhead to its Law and Biometrics segments,which affected the fair value assessment of these two remaining reportingunits. In addition, the Company also repaid the balance of all convertible debtduring the quarter, which increased the net assets of the Company. Accordingly,the Company assessed these events significant enough to trigger the need for aninterim 

 

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assessment as to therecoverability of goodwill. Based on the Company’s assessment, as of June 30,2007, the Company believed no impairment to goodwill existed.

 

Asprovided by SFAS No. 142, the Company has elected to perform the annualassessment of the carrying value of all goodwill as of September 30th of each year using a number of criteria,including the value of the overall enterprise. As of December 31, 2008 and2007, the Company believes that no impairment exists. Future impairment chargesfrom previous or future acquisitions, if any, will be reflected as an operatingexpense in the statement of operations.

 

4. *Research and Development Expenditures*

 

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

 

5.*IncomeTaxes*

 

Theprovision for, or benefit from, income taxes includes deferred taxes resultingfrom the temporary differences in income for financial and tax purposes usingthe liability method. Such temporary differences result primarily from thedifferences in the carrying value of assets and liabilities. Future realizationof deferred income tax assets requires sufficient taxable income within thecarryback, carryforward period available under tax law. The Company evaluates,on a quarterly basis whether, based on all available evidence, if it isprobable that the deferred income tax assets are realizable. Valuationallowances are established when it is more likely than not that the tax benefitof the deferred tax asset will not be realized. The evaluation, as prescribedby Statement of Financial Accounting Standards No. 109, “Accounting forIncome Taxes,” includes the consideration of all available evidence, bothpositive and negative, regarding historical operating results including recentyears with reported losses, the estimated timing of future reversals of existingtaxable temporary differences, estimated future taxable income exclusive ofreversing temporary differences and carryforwards, and potential tax planningstrategies which may be employed to prevent an operating loss or tax creditcarryforward from expiring unused. Because of the Companies historicalperformance and estimated future taxable income a full valuation allowance hasbeen established.

 

6. *Accounting for Stock-Based Compensation*

 

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

 

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**RECENT ACCOUNTING STANDARDS**

 

In September 2006,the FASB issued SFAS No. 157, “*Fair Value Measurements*”(SFAS 157), which is effective for calendar year companies on January 1,2008. This Statement defines fair value, establishes a framework for measuringfair value and expands the related disclosure requirements. Management hasadopted SFAS 157.  The adoption of SFAS157 had no impact on the Company’s financial condition and results ofoperations in 2008.

 

In February 2007, the FASB issued SFAS No. 159,“*The Fair Value Option for Financial Assets andFinancial Liabilities*” (SFAS 159), which is effective for calendaryear companies on January 1, 2008. The statement allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement for certain financial assets and liabilities on acontract-by-contract basis. Subsequent changes in fair value of these financialassets and liabilities would be recognized in earnings when they occur. SFAS159 further establishes certain additional disclosure requirements. Theadoption of SFAS 159 had no impact on the Company’s financial condition andresults of operations in 2008.

 

In December 2007,the SEC issued SAB No. 110.  SAB 110 allows for the continued use ofa “simplified” method, as discussed in SAB No. 107, in developing anestimate of expected term of “plain vanilla” share options in accordance withSFAS 123 (revised 2004).  Originally the SEC staff stated in SAB 107 thatit would not expect a company to use the simplified method for share optiongrants after December 31, 2007.  Accordingly, the SEC staff willcontinue to accept, under certain circumstances, the use of the simplifiedmethod beyond December 31, 2007.  The Company will continue to use ofthe simplified method for determining the value of options granted as allowedby SAB 110.

 

In December 2007,the FASB issued SFAS No. 141(R), “*Business Combinations”*(SFAS No. 141(R)) which establishes principles and requirements for howthe acquirer of a business recognizes and measures in its financial statementsthe identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree.  SFAS No. 141(R) alsoprovides guidance for recognizing and measuring the goodwill acquired in thebusiness combination and determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. The provisions of SFAS No. 141(R) areapplicable to business combinations consummated on or after December 15,2008 with early adoption prohibited. The adoption of SFAS 141(R) will havean impact on the Company’s accounting for business combinations in connectionwith any future acquisitions.

 

In December 2007,the FASB issued SFAS No. 160, “*Noncontrolling Interestsin Consolidated Financial Statements - an amendment of ARB No. 51”* (SFAS No. 160) which establishes accounting and reporting standards forthe noncontrolling interest in a subsidiary for the deconsolidation of asubsidiary.  SFAS No. 160 is effective for financial statementsissued for fiscal years beginning after December 15, 2008, and interimstatements within those fiscal years. The Company does not currently have anynoncontrolling interests.

 

In March 2008, the FASB issued SFAS No. 161, “*Disclosures about Derivative Instruments and Hedging Activities.*”(SFAS No.161) which amends and expands the disclosure requirements related toderivative instruments and hedging activities. The Statement requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of and gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements. The provisions of SFAS 161 are effective forthe fiscal year beginning January 1, 2009. The company will complywith the disclosure requirements of this statement if it utilizes derivativeinstruments or engages in hedging activities upon its effectiveness.

 

In October 2008, theFASB issued Staff Position No. FAS 157-3, *“Determiningthe Fair Value of a Financial Asset When the Market for That Asset is NotActive”* (FSP 157-3). FSP 157-3 clarifies the application of SFAS157, which the Company adopted as of January 1, 2008, in cases where amarket is not active. The adoption of FSP 157-3 had no impact on the Company’sfinancial condition and results of operations in 2008.

 

**ITEM 7A.**           QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

** **

**N/A**

 

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**ITEM8.**              FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

Seefinancial statements appearing at pages 46-76 of this report

 

**ITEM9.**              CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

**ITEM9A.**     CONTROLS ANDPROCEDURES

** **

*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, 2008 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, 2008, our disclosure controls andprocedures were effective in providing reasonable assurance that information weare required to disclose in reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedby the Securities and Exchange Commission rules and forms. Our managementreached this conclusion after identifying our system to capture disclosureitems, our internal process of review for account reconciliations, our documentationof internal controls and our internal process for preparing our annual reporton Form 10-K for the fiscal year ended December 31, 2008 as beingadequate to provide such assurance.

 

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

 

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

 

Underthe supervision and with the participation of our management, including our CEOand CFO, we have conducted an evaluation of the effectiveness of our internalcontrol over financial reporting as of December 31, 2008, based upon theframework in *Internal Control-IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on this evaluation, management has concluded thatour internal control over financial reporting was effective as of December 31,2008.

 

Thisannual report does not include an attestation report of the Company’sregistered public accounting firm regarding internal control over financialreporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to temporary rules of theSecurities and Exchange Commission that permit the company to 

 

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provide only management’sreport in this annual report.

 

*Changesin Internal Control Over Financial Reporting*

 

During the fiscal quarterended December 31, 2008, the Company’s Chief Financial Officer, FrankCusick, left the business, and was replaced by the Company’s Chairman of theBoard, Thomas Colatosti, in an acting capacity.

 

During the fiscal quarterended December 31, 2008, the Company supplemented its review and reportingstructure through the use of outside experts to assist in the determination ofapplicable accounting treatments for certain complex business transactions, inorder to provide adequate disclosure in the Company’s financial statements. Theoutside experts have also assisted with the review and testing of the Company’sinternal control over financial reporting as of December 31, 2008.

 

**ITEM 9B.**           OTHER INFORMATION

** **

None.

 

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**PART III**

** **

**ITEM 10.**             DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

** **

The following sets forthcertain information about each director and executive officer of the Company.

 
| **NAME**                     | ** ** | **AGE** | ** ** | **POSITIONS HELD**                                              |
|------------------------------|------------|---------|------------|-----------------------------------------------------------------|
| Thomas J. Colatosti          |       | 60      |       | Chairman of the Board of Directors and Chief  Financial Officer |
| Michael W. DePasquale        |       | 54      |       | Chief Executive Officer and Director                            |
| Jeffrey J. May (b)      |       | 49      |       | Director                                                        |
| Charles P. Romeo(a) (c) |       | 67      |       | Director                                                        |
| John Schoenherr (b) (c) |       | 56      |       | Director                                                        |
|                         |       |    |       |                                                            |
| Randy Fodero                 |       | 50      |       | Vice President of Sales                                         |
| Kenneth S. Souza             |       | 54      |       | General Manager, Law Enforcement and Chief  Technology Officer  |

 

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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 briefsummary of the business experience of each of the above-named individuals:

 

**THOMAS J.COLATOSTI** has served asa Director of the Company since September 2002, as Chairman of the Boardsince January 3, 2003, and as Chief Financial Officer since November 17,2008. He served as Co-Chief Executive Officer of the Company from July 2005to August 2006. Mr. Colatosti also currently serves as the ChiefExecutive Officer of American Security Ventures, a Lexington,Massachusetts-based consulting firm he founded which specializes in providingstrategic management consulting services to emerging and developing companiesin the homeland security industry.  SinceAugust 18, 2005, Mr. Colatosti has served as a Director and Presidentof Good Harbor Partners Acquisition Corp., a publicly-traded special purposeacquisition company formed to acquire businesses in the securitysectors. From 1997 through June 2002, Mr. Colatosti served asthe Chief Executive Officer of Viisage Technology, Inc., a publicly tradedbiometric technology company. Between 1995 and 1997, Mr. Colatosti served asPresident and Chief Executive Officer of CIS Corporation. Prior to CIS, Mr. Colatostihad a 21 year career with Digital Equipment Corporation. Among his executivepositions he was  Vice President andGeneral Manager of the company’s $1.2 billion Government Systems Division. Mr. Colatostiis considered a security industry authority.

 

**MICHAELW. DEPASQUALE** hasserved as the Chief Executive Officer and a Director of the Company since January 3,2003. He served as Co-Chief Executive Officer of the Company from July 2005to August 2006. Mr. DePasquale brings more than 25 years of executivemanagement, sales and marketing experience to the Company. Prior to joiningBIO-key, Mr. DePasquale served as the President and Chief ExecutiveOfficer of Prism eSolutions, Inc., a Pennsylvania-based provider ofprofessional consulting services and online solutions for ISO-9001/14000certification for customers in manufacturing, healthcare and governmentmarkets, since February 2001. From December 1999 through December 2000,Mr. DePasquale served as Group Vice President for WRC Media, a NewYork-based distributor of supplemental education products and software. From January 1996until December 1999, Mr. DePasquale served as Senior Vice Presidentof Jostens Learning Corp., a California-based provider of multi mediacurriculum. Prior to Jostes, Mr. DePasquale held sales and marketingmanagement positions with McGraw-Hill and Digital Equipment Corporation. Mr. DePasqualeearned a Bachelor of Science degree from the New Jersey Institute ofTechnology.

 

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**JEFFREYJ. MAY **has servedas a Director of the Company since October 29, 2001. Since December 2006,Mr. May has served as the CEO and Director of MagnaLynx, asemiconductor company specializing in high speed chip level communications.Since 1997, Mr. May has served as the President of Gideons PointCapital, a Minnesota-based investment and consulting firm focusing on assistingstart-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 asa director of the Company since February 28, 2005 and from January 29,2003 to April 19, 2004. From April 2004 until February 2005, heserved as Vice President of Sales, Public Safety Division of the Company. From November 2005to November 2007, Mr. Romeo served as the Vice President of Sales andMarketing for UNICOM, a Rhode Island systems integrator. From September 2002until April 2004 Mr. Romeo has served as the President and ChiefExecutive Officer of FreedomBridge Technologies, Inc., a Rhode Island-basedconsulting firm to technology companies in the homeland security industryspecializing in implementing direct and channel selling programs, strategicalliances and partnerships in the law enforcement market. Prior to foundingFreeedomBridge, Mr. Romeo had a 33 year sales and marketing managementcareer with Digital Equipment Corporation, Compaq Computer Corporation andHewlett Packard. During his career, Mr. Romeo served as Vice President ofService Sales for a $500 million business unit, and Director of Public SectorSales, a $275 million division of Hewlett Packard. Mr. Romeo authored *The Sales Manager’s Troubleshooter,* Prentice Hall 1998,which was named as one of the “top 10 must reads” by Sales and MarketingMagazine. Mr. Romeo earned a Bachelor of Science degree in Mathematics andEconomics from the University of Massachusetts and an Executive MBA from BabsonCollege.

 

**JOHNSCHOENHERR** has servedas a Director of the Company since December 30, 2004. Mr. Schoenherrserved as Vice President of Corporate Performance Management for OracleCorporation from 1995 through 2006. Prior to Oracle he served as Senior Vice President of BusinessIntelligence 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.

 

**RANDYFODERO** has served asthe Vice President of Sales since February 1, 2006. From July 2005until February  2006, he was a sales consultant to the Company. Between July 2003and July 2005, Mr. Fodero was the Vice President of Sales andMarketing, and from March 2003 to July 2003 Mr. Fodero was amember of the Company’s sales organization. Mr. Fodero has more than 20years of successful executive and sales management experience. Prior to joiningthe Company, Mr. Fodero served as Director of Global Accounts for VeritasSoftware from February 2002 until January 2003. Between 1999 and February 2002,Mr. Fodero served in executive sales capacities with companies in theenterprise software industry, including Agile Software, and Memco Software, aleading provider of information security software to Fortune 1000 companies,where he was instrumental in increasing sales and enhancing shareholder valuein connection with the sale of Memco to Platinum Technology. From 1990 through1998, Mr. Fodero served as Vice President of Sales of CommVault Systems,where he grew sales from startup to over $36 million and participated in amanagement buyout.

 

**KENNETHS. SOUZA** has served asExecutive Vice President and General Manager, Law Enforcement since October 18,2005. From October 2004 to October 2005 Mr. Souza was ChiefTechnology Officer of the Company. Prior to joining the Company, Mr. Souzawas Vice President of Industry Solutions for EMC Corporation. Prior to joiningEMC, he was Vice President for e-Commerce Enterprise Systems Solutions forCompaq Computer Corporation for four years. His 25-year technology and marketcareer includes serving in a number of executive positions with DigitalEquipment Corporation including Vice President Worldwide Solutions Services andTraining, and Director of Workstations Marketing. In the early 1980’s, Mr. Souzaheld technical sales management positions with Hewlett Packard and Burroughs. Mr. Souzaalso held executive positions with a venture funded MRP software company.

 

**Directors’ Terms of Office**

** **

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

 

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**Audit Committee**

 

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

 

**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, 2008, 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 —one late Form 4 filing with respect to the issuance of a total of 115,241options on April 18, 2008.

 

b)             Jeff May — onelate Form 4 filing with respect to the issuance of a total of 230,481options on April 18, 2008.

 

c)              Charles Romeo — onelate Form 4 filing with respect to the issuance of a total of 82,620options on April 18, 2008.

 

d)             John Schoenherr — onelate Form 4 filing with respect to the issuance of a total of 98,930options on April 18, 2008.

 

**Code of Ethics**

 

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

 

**InternetAddress and SEC Reports**

 

We maintain a websitewith the address www.BIO-key.com. We are not including the informationcontained on our website as a part of, or incorporating it by reference into,this Annual Report on Form 10-K. We make available free of charge throughour website our Annual Reports on Form 10-K (and, where applicable,10-KSB), Quarterly Reports on Form 10-Q (and, where applicable, 10-QSB)and Current Reports on Form 8-K, and amendments to these reports, as soonas reasonably practicable after we electronically file such material with, orfurnish such material to, the SEC. Our SEC filings are also available over theinternet at the SEC’s website www.sec.gov. Members of the public may read andcopy any materials the Company files with the SEC at the SEC’s public referenceroom at 100 F Street, NE, Washington, DC 20549. Information on the operation ofthe public reference room is available by calling the SEC on 1800-SEC-0330.

 

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**ITEM 11.**             EXECUTIVECOMPENSATION

** **

The following table setsforth a summary of the compensation paid to or accrued by our chief executiveofficer (principal executive officer) and the two most highly compensatedexecutive officers other than the principal executive officer, who were servingas executive officers at the end of December 31, 2008, for the fiscalyears ended December 31, 2008 and 2007:

 

**SUMMARYCOMPENSATION TABLE**

 
| **Name**                                  | ** ** | **Fiscal  Year** | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive Plan  Compensation  ($)** | ** ** | **Nonqualified  Deferred  Compensation  Earnings  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|-------------------------------------------|------------|------------------|------------|----------------|------------|---------------|------------|------------------------|------------|-------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------|------------|----------------|------------|
| ** **                                | ** ** | ** **       | ** ** | ** **     | ** ** | ** **    | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                                             | ** ** | ** **                                              | ** ** | ** **                            | ** ** | ** **     | ** ** |
| **Michael  W. DePasquale**                |       | 2008             |       | 250,000        |       | —        |       | —                 |       | 25,122                  | (1)        | —                                                 |       | —                                                  |       | 775                                   |       | 275,897        |       |
| Chief Executive  Officer                  |       | 2007             |       | 250,000        |       | —        |       | —                 |       | 110,545                 | (1)        | —                                                 |       | —                                                  |       | 775                                   |       | 361,320        |       |
|                                      |       |             |       |           |       |          |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| **Randy  Fodero**                         |       | 2008             |       | 170,000        |       | —        |       | —                 |       | 59,046                  | (1)        | 54,916                                                 |       | —                                                  |       | 527                                   |       | 284,489        |       |
| Vice President  Sales                     |       | 2007             |       | 170,000        |       | —        |       | —                 |       | 101,768                 | (1)        | 57,755                                                 |       | —                                                  |       | 527                                   |       | 330,050        |       |
|                                      |       |             |       |           |       |          |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| **Kenneth  S. Souza**                     |       | 2008             |       | 200,000        |       | —        |       | —                 |       | 15,701                  | (1)        | —                                                 |       | —                                                  |       | 620                                   |       | 216,321        |       |
| General Manager,  Law                     |       | 2007             |       | 200,000        |       | —        |       | —                 |       | 112,392                 | (1)        | —                                                 |       | —                                                  |       | 620                                   |       | 313,012        |       |
| Enforcement and  Chief Technology Officer |       |             |       |           |       |          |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |

 

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(1)             The aggregate grantdate fair value of the option awards was estimated using the Black-Scholesoption pricing model, with the assumptions listed in Note A to the Company’sfinancial statements. The amount shown in this column represents thecompensation cost of awards recognized during the year for financial reportingpurposes under FAS 123(R ),without regard to estimated forfeitures related to service-based vestingconditions for option awards.

 

**Narrative Disclosure to SummaryCompensation Table**

 

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

 

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

 

In setting cash compensationlevels, we favor a balance in which base salaries are generally targeted atslightly below the peer average and a bonus opportunity that is targeted atslightly above the average. The committee believes that this higher emphasis onperformance-based cash bonuses places an appropriate linkage between a namedexecutive officer’s pay, his or her individual performance and the achievementof specific business goals by placing a higher proportion of annual cashcompensation at risk, thereby aligning executive opportunity with the interestsof stockholders.

 

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

 

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

 

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***Employment Agreements***

 

On May 25, 2008, theCompany entered into a one-year employment agreement with Michael W. DePasqualeto serve as the Chief Executive Officer of the Company at an annual base salaryof $250,000, subject to adjustment by the Board or Compensation Committee. Inaddition to the Base Salary, a “Performance Bonus” may be awarded to Mr. DePasqualeon the basis of the Company achieving certain corporate and strategicperformance goals, as determined by the Board in its sole discretion.

 

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

 

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

 

***Stock OptionGrants***

 

In the event of anychange in the outstanding shares of our common stock by reason of a stockdividend, stock split, combination of shares, recapitalization, merger,consolidation, transfer of assets, reorganization, conversion or what the boarddeems to be similar circumstances, the number and kind of shares subject tooutstanding 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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**OUTSTANDINGEQUITY AWARDS AT FISCAL YEAR ENDDECEMBER 31, 2008**

 

The following table sets forth for each namedexecutive officer, information regarding outstanding equity awards as at December 31,2008:

 
| ** **            | ** ** | **Option Awards**                                                             | ** ** | **Stock Awards**                                                                | ** ** |
|-----------------------|------------|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| **Name**              | ** ** | **Number of  securities  underlying  unexercised  options  exercisable  (#)** | ** ** | **Number of  securities  underlying  unexercised  options  unexercisable  (#)** | ** ** | **Equity  incentive  plan  awards:  Number of  securities  underlying  unexercised  unearned  options  (#)** | ** ** | **Option  exercise  price  ($)** | ** ** | **Option  expiration  date** | ** ** | **Number  of shares  or units of  stock that  have not  vested  (#)** | ** ** | **Market  value of  shares or  units of  stock that  have not  vested  ($)** | ** ** | **Equity  incentive   plan  awards:  Number  of  unearned   shares or  units or  other  rights that  have not  vested  (#)** | ** ** | **Equity  incentive  plan  awards:  Market or  payout  value of  unearned  shares,  units or  other  rights that  have not  vested  ($)** | ** ** |
|                  |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Michael W. DePasquale |       | 500,000                                                                            |       | —                                                                               |       | — |   | 1.32 |   | 12/11/2010 |   | — |   | — |   | — |   | — |   |
|                  |       | 580,000                                                                            |       | —                                                                               |       | — |   | 0.53 |   | 1/3/2010 |   | — |   | — |   | — |   | — |   |
|                  |       | 400,000                                                                            |       | —                                                                               |       | — |   | 0.75 |   | 3/23/2013 |   | — |   | — |   | — |   | — |   |
|                  |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Randy Fodero          |       | 600,000                                                                            |       | —                                                                               |       | — |   | 0.60 |   | 11/11/2012 |   | — |   | — |   | — |   | — |   |
|                  |       | 100,000                                                                            |       | —                                                                               |       | — |   | 0.75 |   | 3/23/2013 |   | — |   | — |   | — |   | — |   |
|                  |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Kenneth S. Souza      |       | 300,000                                                                            |       | —                                                                               |       | — |   | 1.05 |   | 9/15/2011 |   | — |   | — |   | — |   | — |   |
|                  |       | 250,000                                                                            |       | —                                                                               |       | — |   | 0.75 |   | 3/23/2013 |   | — |   | — |   | — |   | — |   |

 

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

 

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

 

***Termination Arrangements***

 

On May 25, 2008, theCompany entered into a one-year employment agreement with Michael W. DePasqualeto serve as the Chief Executive Officer of the Company. The Company mayterminate the agreement at any time with or without cause. In the event oftermination without cause, Mr. DePasquale shall continue to be paid histhen current base salary for twelve months from the date of such termination.

 

On October 4, 2008,the Company renewed the annual agreement with Kenneth Souza to serve asExecutive Vice President and General Manager, Law Enforcement of the Company.The Company may terminate the agreement at any time with or without cause. Inthe event of termination without cause, Mr. Souza shall continue to bepaid his then current base salary for the greater of six months from the dateof such termination or the number of months remaining until the end of the termof the employment agreement.

 

***Change in Control Provisions***

 

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

 

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

 

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

 

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**DIRECTORCOMPENSATION FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2008**

 

The following table sets forth for each director,information regarding their compensation for the year ended December 31,2008:

 
| **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   |       | —                                                    |       | —                 |       | 8,333                   | (2)        | —                                                 |       | —                                                  |       | —                                |       | 8,333          |       |
| Michael W.  DePasquale | (1)        | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Jeffrey J. May         |       | —                                                    |       | —                 |       | 16,667                  | (2)        | —                                                 |       | —                                                  |       | —                                |       | 16,667         |       |
| Charles P. Romeo       |       | —                                                    |       | —                 |       | 4,746                   | (2)        | —                                                 |       | —                                                  |       | —                                |       | 4,746          |       |
| John Schoenherr        |       | —                                                    |       | —                 |       | 6,539                   | (2)        | —                                                 |       | —                                                  |       | —                                |       | 6,539          |       |

 

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| (1)    |   | Refer to Narrative Disclosure To Summary  Compensation Table for information pertaining to Mr. DePasquale’s  employment agreement.                                                                                                                                                                                                                                                                                                                                 |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| (2)    |   | The aggregate grant date fair value of the option  awards was estimated using the Black-Scholes option pricing model, with the  assumptions listed in Note A to the Company’s financial statements. The  amount shown in this column represents the compensation cost of awards  recognized during the year for financial reporting purposes under FAS 123(R ), without regard to estimated forfeitures  related to service-based vesting conditions for option awards. |

 

**Narrative Disclosure to DirectorCompensation Table**

 

**Directors who are also officers ofthe Company receive no additional compensation for serving on the Board ofDirectors. The Company’s current policy is to issue options to purchase 50,000shares of common stock to each non-employee director on an annual basis. TheChair of the Audit Committee receives options to purchase an additional 50,000shares of common stock on an annual basis. No options were issued during 2007.**

** **

On April 18, 2008,Thomas Colatosti, Jeffrey May, Charles Romeo and John Schoenherr were grantedoptions to purchase 115,241, 230,481, 82,620, and 98,930 shares of commonstock, respectively, at an exercise price of $0.11 per share. Options totaling65,241, 130,481, 32,620, and 48,930, respectively, immediately vested onissuance, with the remaining options to vest in equal increments over twoyears. The options expire on April 18, 2015.

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer in November 2008, the Company has entered into anumber of consulting arrangements with Thomas Colatosti. Under the most recentarrangement, which was entered into on November 17, 2008, Mr. Colatostiis to provide services to the Company and its subsidiaries and affiliates for aone year term ending November 16, 2009 at a rate of $12,500 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 13, 2009, 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                                              |       | 1,595,241                                                         | (2)        | 2.4                              | %          |
| Michael W.  DePasquale                                            |       | 2,000,000                                                         | (3)        | 2.9                              | %          |
| Jeffrey May                                                       |       | 205,481                                                           | (4)        | *                                |       |
| Charles P. Romeo                                                  |       | 432,620                                                           | (5)        | *                                |       |
| John Schoenherr                                                   |       | 98,930                                                            | (6)        | *                                |       |
| Randy Fodero                                                      |       | 700,000                                                           | (7)        | 1.0                              |       |
| Kenneth S. Souza                                                  |       | 550,000                                                           | (8)        | *                                |       |
| Trellus  Management Company, LLC                                  |       |                                                              |       |                             |       |
| 350 Madison  Avenue 9th Floor New York, NY 10017             |       | 7,451,812                                                         |       | 11.0                             | %          |
| All officers and  directors as a group (8) persons           |       | 5,582,272                                                         |       | 8.2                              | %          |

 

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| *      | Less than 1%                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (1)    | The securities  “beneficially owned” by an individual are determined in accordance with the  definition of “beneficial ownership” set forth in the regulations promulgated  under the Securities Exchange Act of 1934 and, accordingly, may include  securities owned by or for, among others, the spouse and/or minor children of  an individual and any other relative who has the same home as such  individual, as well as, other securities as to which the individual has or shares  voting or investment power or which each person has the right to acquire  within 60 days through the exercise of options or otherwise. Beneficial  ownership may be disclaimed as to certain of the securities. This table has  been prepared based on 67,876,880 shares of common stock outstanding as of  February 13,2009. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (2)    | Includes 615,241 shares  issuable upon exercise of options and 875,000 shares issuable upon conversion  of Series A Preferred Stock. Does not include 100,000 shares issuable  upon options subject to vesting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (3)    | Includes 1,980,000  shares issuable upon exercise of options.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (4)    | Consists of 205,481  shares issuable upon exercise of options. Does not include 150,000 shares  issuable upon options subject to vesting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (5)    | Consists of 432,620  shares issuable upon exercise of options. Does not include 100,000 shares  issuable upon options subject to vesting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (6)    | Consists of 98,930  shares issuable upon exercise of options. Does not include 150,000 shares  issuable upon options subject to vesting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (7)    | Consists of shares  issuable upon exercise of options.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (8)    | Consists of shares  issuable upon exercise of options.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

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The following table setsforth, as of December 31, 2008, information with respect to securitiesauthorized for issuance under equity compensation plans.

 

**EQUITYCOMPENSATION PLAN INFORMATION**

 
| ** **                                                  | ** ** | **Number of securities to be issued  upon exercise of outstanding   options, warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of outstanding  options, warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 80,000                                                                                                                                                              |       | $                                                                                                                    | 0.47       |                                                                                                                                                                                                                  | —     |   |
| Equity  compensation plans not approved by security holders |       | 6,927,942                                                                                                                                                           |       | $                                                                                                                    | 0.78       |                                                                                                                                                                                                                  | 2,899,316  |   |
| Total                                                       |       | 7,007,942                                                                                                                                                           |       | $                                                                                                                    | 0.78       |                                                                                                                                                                                                                  | 2,899,316  |   |

 

During 1996, the Board ofDirectors and stockholders of the Company adopted the 1996 Stock Option Plan(the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock arereserved for issuance to employees, officers, directors, and consultants of theCompany at exercise prices which may not be below 100% of fair market value forincentive stock options and 50% for all others. The term of stock optionsgranted may not exceed ten years. Options issued under the Plan vest pursuantto the terms of stock option agreements with the recipients. In the event of achange in control, as defined, all options outstanding vest immediately. The1996 Plan expired in May 2005.

 

As of December 31,2008, there were outstanding options under the 1996 Plan to purchase 80,000shares of common stock, and no shares were available for future grants.

 

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

 

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

 

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

 

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

 

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As of December 31,2008, there were outstanding options under the 1999 Plan to purchase 335,000shares of common stock, and options to purchase an aggregate of 1,374,257shares 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 vest immediately.The 2004 Plan expires in October 2014.

 

As of December 31,2008, there were outstanding options under the 2004 Plan to purchase 2,837,941shares of common stock, and options to purchase an aggregate of 1,162,059shares 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 2008, there were outstanding options underthe non plan to purchase 3,755,000 shares of common stock. The terms of theseoptions are substantially similar to the provisions of the 1999 Plan andoptions issued thereunder.

 

**ITEM 13.**             CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

** **

**Employment Arrangements**

 

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

 

**Consulting Arrangement withThomas J. Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, and as actingChief Financial Officer in November 2008, the Company has entered into anumber of consulting arrangements with Thomas J. Colatosti. Under the mostrecent arrangement, which was entered into on November 17, 2008, Mr. Colatostiis to provide services to the Company and its subsidiaries and affiliates for aone year term ending November 16, 2009 at a rate of $12,500 per month.

 

Under the previousarrangement, which was entered into on July 12, 2007, Mr. Colatosti,provided services to the Company and its subsidiaries and affiliates for theyear ended December 31, 2007 at a rate of $12,000 per month.

 

**DirectorIndependence**

 

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 ACCOUNTANTFEES AND SERVICES

** **

The following table showsfees for professional audit services billed to us by CCR LLP (“CCR”) andDS&B, Ltd. (“DS&B”) for the audit of our annual consolidated financialstatements for the years ended December 31, 2008, and 2007, and feesbilled to us by CCR and DS&B for other services during 2008 and 2007:

 

| ** **          | ** ** | **2008** | ** **  | **2007** | ** ** |
|---------------------|------------|----------|-------------|----------|------------|
| Audit Fees:         |       |     |        |     |       |
| CCR                 |       | $        | 148,400     |     | $          | 177,718 |   |
| DS&B            |       | —   |        | 2,148    |       |
|                |       | 148,400  |        | 179,866  |       |
| Audit-Related  Fees |       |     |        |     |       |
| CCR                 |       | 6,800    |        | —   |       |
|                |       |     |        |     |       |
| Tax Fees:           |       |     |        |     |       |
| CCR                 |       | 51,670   |        | 32,004   |       |
| DS&B            |       | —   |        | 459      |       |
|                |       | 51,670   |        | 32,463   |       |
|                |       |     |        |     |       |
| Total Fees          |       | $        | 206,870,329 |     | $          | 212,329 |   |

 

*AuditFees*consist of fees billed for professional servicesrendered for the audit of our financial statements and review of the interimfinancial statements included in quarterly reports and services that arenormally provided by CCR and DS&B in connection with statutory andregulatory filings or engagements. Audit fees also include fees for servicesprovided in connection with registration of securities, comfort letters, andreview of documents filed with the SEC.

 

*Audit-Related Fees*consist of fees billed for assurance and related services that are reasonablyrelated to the performance of the audit or review of our financial statementsand which are not reported under audit fees. These services relate primarily tomergers and acquisitions due diligence as well as advisory services as itpertains to the Sarbanes-Oxley Act and related rules and regulations;

 

*TaxFees*consist of fees billed for professional services for taxcompliance assistance rendered during the fiscal year.

 

**Audit Committee Pre-ApprovalProcedures**

 

The Audit Committee ofour Board of Directors consists of Jeffrey J. May  and JohnSchoenherr. The Audit Committee approves the engagement of our independentauditors to render audit and non-audit services before they are engaged. All ofthe fees for 2008 and 2007 shown above were pre-approved by the AuditCommittee.

 

The Audit Committeepre-approves all audit and other permitted non-audit services provided by ourindependent auditors. Pre-approval is generally provided for up to one year, isdetailed as to the particular category of services and is subject to a monetarylimit. Our independent auditors and senior management periodically report tothe Audit Committee the extent of services provided by the independent auditorsin accordance with the pre-approval, and the fees for the services performed todate. The Audit Committee may also pre-approve particular services on acase-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 independent registeredpublic accounting firm to cease to be independent within the meaning ofapplicable 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)  Financialstatements filed as part of this Report:

 

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

 

Balance Sheets asat December 31, 2008 and 2007

 

Statements ofOperations—Years ended December 31, 2008 and 2007

 

Statement ofStockholders’ Equity (Deficit)—Years ended December 31, 2008 and 2007

 

Statements of CashFlows—Years ended December 31, 2008 and 2007

 

Notes to FinancialStatements—December 31, 2008 and 2007

 

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

 

**ITEM8—FINANCIAL STATEMENTS**

 

The followingfinancial statements of BIO-key International, Inc. are included herein atthe indicated page numbers:

 
| Report of Independent Registered Public Accounting  Firm, CCR LLP                                  | 45 |
|----------------------------------------------------------------------------------------------------|----|
| Balance Sheets as at December 31, 2008 and 2007                                               | 46 |
| Statements of Operations—Years ended December 31,  2008 and 2007                         | 47 |
| Statement of Stockholders’ Equity (Deficit)—Years  ended December 31, 2008 and 2007 | 48 |
| Statements of Cash Flows—Years ended December 31,  2008 and 2007                         | 49 |
| Notes to the Financial Statements—December 31,  2008 and 2007                            | 50 |

 

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**Report of Independent RegisteredPublic Accounting Firm**

 

The Board of Directorsand StockholdersBIO-key International, Inc.

Marlborough, MA

 

We have audited theaccompanying consolidated balance sheets of BIO-key International, Inc.and Subsidiary as of December 31, 2008 and 2007, and the relatedconsolidated statements of operations, stockholders’ equity (deficit) and cashflows for each of the years in the two-year period ended December 31,2008. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

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

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of BIO-key International, Inc.and Subsidiary as of December 31, 2008 and 2007, and the consolidatedresults of its operations and its cash flows for each of the years in the two-yearperiod ended December 31, 2008, in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern. As disclosed in the consolidated financialstatements, the Company has suffered substantial net losses in recent years,and has an accumulated deficit at December 31, 2008, 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 9, 2009         |   |

 

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**BIO-key International, Inc andSubsidiary**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                      | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                      |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                      |       | $                     | 1,712,912  |   | $ | 964,774 |   |
| Restricted cash                                                                                                                                                                                                                                 |       | —                |       | 153,094 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $82,398 at  December 31, 2008 and $113,771 December 31, 2007                                                                                                          |       | 721,022               |       | 2,129,797 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                                                              |       | 144,551               |       | 233,805 |   |
| Inventory                                                                                                                                                                                                                                       |       | 13,159                |       | 4,879 |   |
| Prepaid expenses                                                                                                                                                                                                                                |       | 96,109                |       | 119,068 |   |
| Total current  assets                                                                                                                                                                                                                           |       | 2,687,753             |       | 3,605,417 |   |
| Equipment and  leasehold improvements, net                                                                                                                                                                                                      |       | 92,238                |       | 177,282 |   |
| Deposits and  other assets                                                                                                                                                                                                                      |       | 7,812                 |       | 487,815 |   |
| Restricted cash                                                                                                                                                                                                                                 |       | 40,500                |       | — |   |
| Intangible  assets—less accumulated amortization                                                                                                                                                                                           |       | 582,701               |       | 1,324,269 |   |
| Goodwill                                                                                                                                                                                                                                        |       | 7,836,986             |       | 7,836,986 |   |
| Total  non-current assets                                                                                                                                                                                                                       |       | 8,560,237             |       | 9,826,352 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                                               |       | $                     | 11,247,990 |   | $ | 13,431,769 |   |
|                                                                                                                                                                                                                                            |       |                  |       |   |   |
| **LIABILITIES**                                                                                                                                                                                                                                 |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                                |       | $                     | 280,994    |   | $ | 1,162,690 |   |
| Accrued  liabilities                                                                                                                                                                                                                            |       | 1,301,889             |       | 3,401,749 |   |
| Notes payable                                                                                                                                                                                                                                   |       | 1,516,651             |       | — |   |
| Deferred rent                                                                                                                                                                                                                                   |       | 6,541                 |       | 367,986 |   |
| Deferred revenue                                                                                                                                                                                                                                |       | 3,684,476             |       | 4,468,748 |   |
| Total current  liabilities                                                                                                                                                                                                                      |       | 6,790,551             |       | 9,401,173 |   |
| Warrants                                                                                                                                                                                                                                        |       | 12,317                |       | 64,520 |   |
| Redeemable  preferred stock derivatives                                                                                                                                                                                                         |       | 439                   |       | 41,295 |   |
| Deferred rent                                                                                                                                                                                                                                   |       | 11,510                |       | — |   |
| Deferred revenue                                                                                                                                                                                                                                |       | 8,382                 |       | 34,518 |   |
| Total  non-current liabilities                                                                                                                                                                                                                  |       | 32,648                |       | 140,333 |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                                                          |       | 6,823,199             |       | 9,541,506 |   |
| ** **                                                                                                                                                                                                                                      |       |                  |       |   |   |
| Commitments and  contingencies                                                                                                                                                                                                                  |       |                  |       |   |   |
|                                                                                                                                                                                                                                            |       |                  |       |   |   |
| Series B  redeemable convertible preferred stock: authorized, 1,000,000 shares  (liquidation preference of $1 per share); issued and outstanding 970,612  shares of $.0001 par value at December 31, 2008 and December 31,  2007 |       | 1,008,224             |       | 881,340 |   |
| Series C  redeemable convertible preferred stock: authorized, 600,000 shares  (liquidation preference of $10 per share); issued and outstanding 592,032  shares of $.0001 par value at December 31, 2008 and December 31,  2007  |       | 6,498,516             |       | 5,776,231 |   |
|                                                                                                                                                                                                                                            |       | 7,506,740             |       | 6,657,571 |   |
| ** **                                                                                                                                                                                                                                      |       |                  |       |   |   |
| **STOCKHOLDERS’ DEFICIT:**                                                                                                                                                                                                                 |       |                  |       |   |   |
| Series A convertible  preferred stock: authorized, 100,000 shares (liquidation preference of $100  per share); issued and outstanding 30,557 shares of $.0001 par value, at  December 31, 2008 and December 31, 2007        |       | 3                     |       | 3 |   |
| Common stock —  authorized, 170,000,000 shares; issued and outstanding; 67,876,880 and  61,153,202 of $.0001 par value at December 31, 2008 and  December 31, 2007, respectively                                                 |       | 6,788                 |       | 6,115 |   |
| Additional  paid-in capital                                                                                                                                                                                                                     |       | 51,692,103            |       | 52,126,595 |   |
| Accumulated  deficit                                                                                                                                                                                                                            |       | (54,780,843           | )          | (54,900,021 | ) |
| **TOTAL  STOCKHOLDERS’ DEFICIT**                                                                                                                                                                                                           |       | (3,081,949            | )          | (2,767,308 | ) |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                                                                                                                           |       | $                     | 11,247,990 |   | $ | 13,431,769 |   |

 

The accompanying notesare an integral part of these statements.

 

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

**STATEMENTSOF OPERATIONS**

 
| ** **                                                                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Revenues**                                                                    | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Services                                                                        |       | $                                           | 7,236,737  |   | $ | 6,965,706 |   |
| License fees and  other                                                         |       | 5,639,310                                   |       | 3,022,750 |   |
|                                                                            |       | 12,876,047                                  |       | 9,988,456 |   |
| **Costs  and other expenses**                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cost of services                                                                |       | 1,266,248                                   |       | 1,493,341 |   |
| Cost of license  fees and other                                                 |       | 468,893                                     |       | 291,435 |   |
|                                                                            |       | 1,735,141                                   |       | 1,784,776 |   |
| Gross Profit                                                                    |       | 11,140,906                                  |       | 8,203,680 |   |
|                                                                            |       |                                        |       |   |   |
| **Operating  expenses**                                                         |       |                                        |       |   |   |
| Selling, general  and administrative                                            |       | 6,553,922                                   |       | 8,573,863 |   |
| Research,  development and engineering                                          |       | 4,488,792                                   |       | 4,994,799 |   |
|                                                                            |       | 11,042,714                                  |       | 13,568,662 |   |
| **Operating  income/(loss)**                                                    |       | 98,192                                      |       | (5,364,982 | ) |
| **Other  income (deductions)**                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest income                                                                 |       | 1,339                                       |       | 3,097 |   |
| Interest expense                                                                |       | (92,520                                     | )          | (832,457 | ) |
| Derivative and  warrant fair value adjustments                                  |       | 93,059                                      |       | 1,016,845 |   |
| Gain on sale of  investments                                                    |       | 119,348                                     |       | — |   |
| Loss on  extinguishment of debt                                                 |       | —                                      |       | (403,940 | ) |
| Other income  (expense)                                                         |       | (34,885                                     | )          | 12,102 |   |
|                                                                            |       | 86,341                                      |       | (204,353 | ) |
| Income/(loss)  from continuing operations                                       |       | 184,533                                     |       | (5,569,335 | ) |
| Income from  discontinued operations                                            |       | —                                      |       | 440,105 |   |
| Gain/(loss) on  disposal of discontinued operations, net of expected tax of $0. |       | (65,354                                     | )          | 4,072,006 |   |
| Net  Income/(loss)                                                              |       | $                                           | 119,179    |   | $ | (1,057,224 | ) |
| ** **                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Loss  applicable to common stockholders**                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Income/(loss)  from continuing operations                                       |       | 184,533                                     |       | (5,569,335 | ) |
| Convertible  preferred stock dividends and accretion                            |       | (1,890,503                                  | )          | (1,891,624 | ) |
| Loss applicable  to common stockholders                                         |       | $                                           | (1,705,970 | ) | $ | (7,460,959 | ) |
| ** **                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Basic  and Diluted Earnings per Common Share:**                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Loss applicable  to common stockholders                                         |       | $                                           | (0.03      | ) | $ | (0.13 | ) |
| Income from  discontinued operations                                            |       | —                                      |       | 0.01 |   |
| Gain/(loss) on  disposal of discontinued operations                             |       | (0.00                                       | )          | 0.07 |   |
| Net loss                                                                        |       | $                                           | (0.03      | ) | $ | (0.05 | ) |
| ** **                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Weighted  Average Shares Outstanding:**                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Basic and  Diluted                                                              |       | 64,159,473                                  |       | 58,692,979 |   |

 

The accompanyingnotes are an integral part of these statements.

 

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

 
| ** **                                                                           | ** ** | **Series B 15%  Convertible  Preferred Stock** | ** ** | **Series C 15%****Convertible  Preferred Stock** | ** **    | **Series A 7%  Convertible  Preferred Stock** | ** **  | **Common Stock** | ** ** | **Additional Contributed** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------------|---------------|--------------------------------------------------------------|-------------|-----------------------|------------|----------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                           | ** ** | **Shares**                                                    | ** ** | **Amount**                                                      | ** **    | **Shares**                                                   | ** **  | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**      | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| **Balance  as of December 31, 2006**                                            | ** ** | **1,000,000**                                                 | ** ** | **$**                                                           | **824,438**   | ** **                                                   | **592,032** | ** **            | **$**      | **5,234,214**              | ** ** | **30,557**      | ** ** | **$**      | **3**      | ** ** | **55,158,814** | ** ** | **$** | **5,516** | ** ** | **$** | **51,093,919** | ** ** | **$** | **(53,842,797** | **)** | **$** | **(2,743,359** | **)** |
| ** **                                                                           | ** ** | ** **                                                    | ** ** | ** **                                                      | ** **    | ** **                                                   | ** **  | ** **            | ** ** | ** **                 | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accretion of  preferred stock discount                                               |       | —                                                        |       | 126,480                                                         |          | —                                                       |        | 449,444               |       | —                     |       | —          |       | —     |       | — |   | (575,924 | ) | — |   | (575,924 | ) |
| Accretion of  preferred stock dividends                                              |       | —                                                        |       | 149,341                                                         |          | —                                                       |        | 903,243               |       | —                     |       | —          |       | —     |       | — |   | (1,052,584 | ) | — |   | (1,052,584 | ) |
| Accretion of  stock issuance costs                                                   |       | —                                                        |       | —                                                          |          | —                                                       |        | 46,248                |       | —                     |       | —          |       | —     |       | — |   | (46,248 | ) | — |   | (46,248 | ) |
| Conversion of  preferred stock and cumulative dividends in arrears into common stock |       | (29,388                                                       | )          | (218,919                                                        | )             | —                                                       |        | (856,918              | )          | —                     |       | —          |       | 4,576,206  |       | 457 |   | 1,119,773 |   | — |   | 1,120,230 |   |
| Conversion of  principal and accrued interest on convertible notes into common stock |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | 1,418,182  |       | 142 |   | 772,623 |   | — |   | 772,765 |   |
| Fair market  adjustment on equity issuance and warrant modification                  |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | —     |       | — |   | 124,999 |   |   |   | 124,999 |   |
| Share-based  compensation                                                            |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | —     |       | — |   | 690,037 |   | — |   | 690,037 |   |
| Net loss                                                                             |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | —     |       | — |   | — |   | (1,057,224 | ) | (1,057,224 | ) |
| ** **                                                                           | ** ** | ** **                                                    | ** ** | ** **                                                      | ** **    | ** **                                                   | ** **  | ** **            | ** ** | ** **                 | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance  as of December 31, 2007**                                            | ** ** | **970,612**                                                   | ** ** | **$**                                                           | **881,340**   | ** **                                                   | **592,032** | ** **            | **$**      | **5,776,231**              | ** ** | **30,557**      | ** ** | **$**      | **3**      | ** ** | **61,153,202** | ** ** | **$** | **6,115** | ** ** | **$** | **52,126,595** | ** ** | **$** | **(54,900,021** | **)** | **$** | **(2,767,308** | **)** |
| ** **                                                                           | ** ** | ** **                                                    | ** ** | ** **                                                      | ** **    | ** **                                                   | ** **  | ** **            | ** ** | ** **                 | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 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 |   | — |   | 826,739 |   |
| Share-based  compensation                                                            |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | —     |       | — |   | 415,350 |   | — |   | 415,350 |   |
| Net income                                                                           |       | —                                                        |       | —                                                          |          | —                                                       |        | —                |       | —                     |       | —          |       | —     |       | — |   | — |   | 119,179 |   | 119,179 |   |
| ** **                                                                           | ** ** | ** **                                                    | ** ** | ** **                                                      | ** **    | ** **                                                   | ** **  | ** **            | ** ** | ** **                 | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance  as of December 31, 2008**                                            | ** ** | **970,612**                                                   | ** ** | **$**                                                           | **1,008,224** | ** **                                                   | **592,032** | ** **            | **$**      | **6,498,516**              | ** ** | **30,557**      | ** ** | **$**      | **3**      | ** ** | **67,876,880** | ** ** | **$** | **6,788** | ** ** | **$** | **51,692,103** | ** ** | **$** | **(54,780,843** | **)** | **$** | **(3,081,949** | **)** |

 

The accompanying notesare an integral part of these statements.

 

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

**STATEMENTSOF CASH FLOWS**

 
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                                                                                  |       |                                        |       |   |   |
| **CASH FLOW FROM OPERATING ACTIVITIES:**                                              |       |                                        |       |   |   |
| Net  Income/(loss)                                                                    |       | $                                           | 119,179    |   | $ | (1,057,224 | ) |
| Less:                                                                                 |       |                                        |       |   |   |
| Income  from discontinued operations                                                  |       | —                                      |       | (440,105 | ) |
| Loss/(gain)  on disposal of discontinued operations                                   |       | 65,354                                      |       | (4,072,006 | ) |
| Income/(loss)  from continuing operations                                             |       | 184,533                                     |       | (5,569,335 | ) |
| **Adjustments to reconcile net loss to cash used  in operating activities:**          |       |                                        |       |   |   |
| Derivative  and warrant fair value adjustments                                        |       | (93,059                                     | )          | (1,016,845 | ) |
| Gain  on sale of investments                                                          |       | (119,348                                    | )          | — |   |
| Loss  on extinguishment of debt                                                       |       | —                                      |       | 403,003 |   |
| Depreciation                                                                          |       | 112,669                                     |       | 252,678 |   |
| Amortization                                                                          |       |                                        |       |   |   |
| Intangible  assets                                                                    |       | 741,568                                     |       | 761,258 |   |
| Deferred  financing costs                                                             |       | —                                      |       | 83,871 |   |
| Discounts  on convertible debt related to warrants and beneficial conversion features |       | —                                      |       | 360,245 |   |
| Allowance  for doubtful receivables                                                   |       | (31,373                                     | )          | (27,856 | ) |
| Deferred  rent                                                                        |       | (349,935                                    | )          | (499,864 | ) |
| Fair  market value adjustment on equity issuance and warrant modification             |       | —                                      |       | 124,999 |   |
| Share-based  compensation                                                             |       | 415,350                                     |       | 657,599 |   |
| **Change in assets and liabilities:**                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Accounts  receivable trade                                                            |       | 1,440,148                                   |       | 748,647 |   |
| Costs  and earnings in excess of billings on uncompleted contracts                    |       | 89,254                                      |       | 920,054 |   |
| Inventory                                                                             |       | (8,280                                      | )          | 6,488 |   |
| Prepaid  expenses and other                                                           |       | 22,959                                      |       | 1,162 |   |
| Accounts  payable                                                                     |       | (33,105                                     | )          | (174,394 | ) |
| Billings  in excess of costs and earnings on uncompleted contracts                    |       | —                                      |       | (11,429 | ) |
| Accrued  liabilities                                                                  |       | (591,680                                    | )          | (500,812 | ) |
| Note  payable                                                                         |       | (840,120                                    | )          | — |   |
| Deferred  revenue                                                                     |       | (810,408                                    | )          | 742,931 |   |
| Net  cash provided/(used) for continuing operations                                   |       | 129,173                                     |       | (2,737,600 | ) |
| Net  cash provided by discontinued operations                                         |       | —                                      |       | 576,383 |   |
| Net  cash provided/(used) for operating activities                                    |       | 129,173                                     |       | (2,161,217 | ) |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                             |       |                                        |       |   |   |
| Capital  expenditures                                                                 |       | (38,156                                     | )          | (49,211 | ) |
| Deposits                                                                              |       | 480,003                                     |       | 312,538 |   |
| Proceeds  from the sale of the Fire/EMS business                                      |       | (65,354                                     | )          | 7,000,000 |   |
| Transfer  of funds from (to) restricted cash                                          |       | 112,594                                     |       | (153,094 | ) |
| Proceeds  from sale of investments                                                    |       | 119,348                                     |       | — |   |
| Proceeds  from sale of assets                                                         |       | 10,530                                      |       | — |   |
| Patent  costs                                                                         |       | —                                      |       | 58,164 |   |
| Net  cash provided by continuing operations                                           |       | 618,965                                     |       | 7,168,397 |   |
| Net  cash used for discontinued operations                                            |       | —                                      |       | (7,615 | ) |
| Net  cash provided by investing activities                                            |       | 618,965                                     |       | 7,160,782 |   |
| **CASH FLOW FROM FINANCING ACTIVITIES:**                                              |       |                                        |       |   |   |
| Repayment  of long term obligations                                                   |       | —                                      |       | (4,661,958 | ) |
| Net  cash used for continuing operations                                              |       | —                                      |       | (4,661,958 | ) |
| Net  cash used for discontinued operations                                            |       | —                                      |       | — |   |
| Net  cash used for financing activities                                               |       | —                                      |       | (4,661,958 | ) |
| **NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                              |       | 748,138                                     |       | 337,607 |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                    |       | 964,774                                     |       | 627,167 |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                          |       | $                                           | 1,712,912  |   | $ | 964,774 |   |

 

The accompanying notesare an integral part of these statements.

 

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

**NOTES TO THE FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

** **

**NOTE A —THE COMPANY AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

*Nature of Business*

 

The Company, founded in 1993, made two strategicacquisitions in 2004. The Company acquired Public Safety Group Inc. (“PSG”)in March, 2004, and the Mobile Government division of Aether Systems, Inc.(“AMG” or “Mobile Government”) in September, 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*

 

We have only recentlybegun to generate significant revenues and have incurred significant losses todate, and at December 31, 2008, we had an accumulated deficit ofapproximately $55 million. In addition, broad commercial acceptance of our technologyis critical to the Company’s success and ability to generate future revenues.

 

If the Company is unableto generate 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. 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 accompanying financial statements have beenprepared in conformity with accounting principles generally accepted in theUnited States, which contemplate continuation of the Company as a goingconcern, and assumes continuity of operations, realization of assets and thesatisfaction of liabilities and commitments in the normal course of business.The matters described in the preceding paragraphs raise substantial doubt aboutthe Company’s ability to continue as a going concern. Recoverability of a majorportion of the recorded asset amounts shown in the accompanying balance sheetis dependent upon the Company’s ability to meet its financing requirements on acontinuing basis, and become profitable in its future operations. Theaccompanying consolidated financial statements do not include any adjustmentsrelating to the recoverability and classification of recorded assets or theamounts and classification of liabilities that might be necessary should theCompany be unable to continue in existence.

 

*Summary of Significant AccountingPolicies*

 

A summary of the significant accounting policiesconsistently applied in the preparation of the accompanying consolidatedfinancial statements follows:

 

1.*Basisof Consolidation*

 

The accompanying consolidated financial statementsinclude the accounts of BIO-key International, Inc. and its wholly ownedsubsidiary (collectively, the Company) and are stated in conformity withaccounting principles generally accepted in the United States, pursuant to the rules andregulations of the Securities and Exchange Commission. Intercompany accountsand transactions have been eliminated in consolidation.

 

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2. *RevenueRecognition*

 

Revenues from software licensing are recognized inaccordance with Statement of Position (SOP) No. 97-2, Software RevenueRecognition, as amended by SOP No. 98-9. Accordingly, revenue fromsoftware licensing is recognized when all of the following criteria are met:persuasive evidence of an arrangement exists, delivery has occurred, the fee isfixed 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 a customer’scontract, 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. Revenues earned but not yetbilled are shown as an asset in Costs and Earnings in Excess of Billings in thebalance sheet. Billings in excess of cost and earnings are reflected as aliability in the balance sheet. Anticipated contract losses are recognized assoon 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.

 

Costs and other expenses: Includesprofessional compensation and other direct contract expenses, as well as costsattributable to the support of client service professional staff, depreciationand amortization costs related to assets used in revenue-generating activities,and other costs attributable to serving the Company’s client base. Professionalcompensation consists of payroll costs and related benefits includingstock-based compensation and bonuses. Other direct contract expenses includecosts directly attributable to client engagements, such as out-of-pocket costsincluding travel and subsistence for client service professional staff, costsof hardware and software and costs of subcontractors. The allocation of leaseand facilities charges for occupied offices are included in costs of service.

 

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3.*Cashand Cash Equivalents*

 

Cash equivalents consist of certificates of depositand all other liquid investments with original maturities of three months orless. The Company maintains its cash balances in a financial institution inNevada. These balances are insured by the Federal Deposit Insurance Corporationup to $250,000.

 

4.*AccountsReceivable*

 

Accounts receivable billed and unbilled are carried atoriginal amount less an estimate made for doubtful receivables based on areview of all outstanding amounts on a monthly basis. Management determines theallowance for doubtful receivables by regularly evaluating individual customerreceivables and considering a customer’s financial condition, credit history,and current economic conditions. Accounts receivable are written off whendeemed uncollectible. Recoveries of accounts receivable previously written offare recorded when received.

 

5. *Accountingfor Acquisitions*

 

Acquisitions areaccounted 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 provided for in amounts sufficient torelate the cost of depreciable assets to operations over the estimated servicelives, principally using straight-line methods. Leasehold improvements areamortized over the shorter of the life of the improvement or the lease term,using the straight-line method. Intangible assets other than patent costs areamortized on the straight-line method over their expected useful lives. Patentcosts are capitalized until patents are awarded. Upon award, such costs areamortized over their respective lives. If a patent is denied, all costs arecharged to operations in that year. Deferred financing fees related to theissuance of long-term obligations are capitalized and amortized to interestexpense over the lives of the related debt using the effective interest ratemethod.

 

The estimated useful lives used to computedepreciation and amortization for financial reporting purposes are as follows:

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

 

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The estimated aggregate amortization expense ofintangible assets for the five years following December 31, 2008 isapproximately as follows:

 
| **Year ending December 31,** | ** ** | **($)** | ** ** |
|---------------------------------------------|------------|---------|------------|
| 2009                                        |       | 342,597 |       |
| 2010                                        |       | 12,315  |       |
| 2011                                        |       | 12,315  |       |
| 2012                                        |       | 12,315  |       |
| 2013                                        |       | 12,315  |       |

 

7. *Derivative and WarrantFinancial Instruments*

 

In connection with the sale of debt or equityinstruments, we may sell options or warrants to purchase our common stock.In certain circumstances, these options or warrants may be classified asderivative liabilities, rather than as equity. Additionally, the debt or equityinstruments 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.

 

The identification of, and accounting for, derivativeinstruments is complex. Our derivative instrument liability is re-valued at theend of each reporting period, with changes in the fair value of the derivativeliability recorded as charges or credits to income, in the period in which thechanges occur. For options, warrants and bifurcated conversion options that areaccounted for as derivative instrument liabilities, we determine the fair valueof these instruments using the Black-Scholes or Binomial option pricing model.That model requires assumptions related to the remaining term of theinstruments and risk-free rates of return, our current common stock price andexpected dividend yield, and the expected volatility of our common stock priceover the life of the option. The identification of, and accounting for,derivative instruments and the assumptions used to value them can significantlyaffect our financial statements.

 

8. *Goodwill andIntangible Assets*

 

Goodwill represents theexcess of costs of an acquired entity over the net of the amounts assigned toassets acquired and liabilities assumed. The Company has adopted Statement ofFinancial Accounting Standards No. 142 (“SFAS 142”), Goodwill and OtherIntangible Assets., which requires the Company to test goodwill for impairmentannually or whenever events or changes in circumstances indicate that thecarrying value of an asset may not be recoverable, rather than amortize.Accordingly, the Company has not amortized goodwill. As provided by SFAS No. 142,the Company has elected to perform the annual assessment of the carrying valueof all goodwill as of September 30th ofeach year using a number of criteria, including the value of the overallenterprise. As of December 31, 2008 and 2007, the Company believes that noimpairment exists. Future impairment charges from previous or futureacquisitions, if any, will be reflected as an operating expense in thestatement of operations.

 

9. *Impairment ofLong-Lived Assets*

 

The Company has adopted SFAS No. 144, Accountingfor the Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 144,long-lived assets subject to depreciation and amortization are reviewed forimpairment whenever events or changes in circumstances indicate the carryingamount of an asset may not be recoverable. The Company’s long-lived assetsconsist primarily of its equipment and leasehold improvements and itsintangible assets. Upon indication of possible impairment, the Companyevaluates the recovery of held-for-use long-lived assets by measuring thecarrying value of the assets against the related estimated undiscounted futurecash flows. When an evaluation indicates that the future undiscounted cashflows are not sufficient to recover the carrying value of the asset, the assetis adjusted to its estimated fair value. The following circumstances would beconsidered important and could lead to an impairment review; significantchanges in the manner of our using the asset, negative industry or economictrends and underperformance relative to projected operating results.

 

10. *AdvertisingExpense*

 

The Company expenses the costs of advertising asincurred. Advertising expenses for the years ended December 31, 2008 and2007, were approximately $131,000 and $144,000, respectively.

 

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11.*Deferred Revenue*

 

Deferred revenue includes customer advances and amountsthat have been billed per the contractual terms but have not been recognized asrevenue. The majority of these amounts are related to maintenance contracts forwhich the revenue is recognized ratably over the applicable term, whichgenerally is 12 months from the date the customer accepts the products.

 

12. *Research andDevelopment Expenditures*

 

Research and development expenses include costsdirectly attributable to the conduct of research and development programsprimarily related to the development of our software products and improving theefficiency and capabilities of our existing software. Such costs includesalaries, payroll taxes, employee benefit costs, materials, supplies,depreciation on research equipment, services provided by outside contractors,and the allocable portions of facility costs, such as rent, utilities,insurance, repairs and maintenance, depreciation and general support services.All costs associated with research and development are expensed as incurred.

 

13. *Earnings PerShare of Common Stock*

 

Earnings per share of common stock-basic is computedby dividing net income applicable to common stockholders by theweighted-average number of common shares outstanding for the period. Earningsper share of common stock-assuming dilution reflects the maximum potentialdilution that could occur if securities or other contracts to issue commonstock were exercised or converted into common stock and would then share in thenet income of the company. See Note V - Earnings Per Share “EPS”, for additional information.

 

14. *Accounting for Stock-Based Compensation*

 

The Company accounts forshare based compensation in accordance with the provisions of SFAS 123R, whichrequires measurement of compensation cost for all stock awards at fair value ondate of grant and recognition of compensation over the service period forawards expected to vest. The majority of our share-based compensationarrangements vest over either a three or four year vesting schedule. TheCompany expenses its share-based compensation under the ratable method, whichtreats each vesting tranche as if it were an individual grant. The fair valueof stock options is determined using the Black-Scholes valuation model, andrequires the input of highly subjective assumptions. These assumptions includeestimating the length of time employees will retain their vested stock optionsbefore exercising them (the “expected option term”), the estimated volatilityof our common stock price over the option’s expected term, the risk-freeinterest rate over the option’s expected term, and the Company’s expectedannual dividend yield. Changes in these subjective assumptions can materiallyaffect the estimate of fair value of stock-based compensation and consequently,the related amount recognized as an expense in the consolidated statements ofoperations. As required under the accounting rules, we review our valuationassumptions at each grant date and, as a result, are likely to change ourvaluation assumptions used to value employee stock-based awards granted infuture periods. The values derived from using the Black-Scholes model arerecognized as expense over the service period, net of estimated forfeitures(the number of individuals that will ultimately not complete their 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 SFAS 123R increased the Company’s loss from continuingoperations by $415,350 and $657,599 with a $0.01 effect per share (basic anddiluted), for the years ended December 31, 2008 and 2007 respectively.

 

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

 
| ** **                             | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2008**                               | ** ** | **2007** | ** ** |
|                                   |       |                                   |       |   |   |
| Cost of services                       |       | $                                      | 16,494     |   | $ | 18,842 |   |
| Selling, general  and administrative   |       | 279,818                                |       | 467,583 |   |
| Research,  development and engineering |       | 119,038                                |       | 171,174 |   |
|                                   |       | $                                      | 415,350    |   | $ | 657,599 |   |

 

*ValuationAssumptions for Stock Options*

 

For the years ended December 31,2008 and 2007, 759,272 and 290,000 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,** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| Risk free  interest rate             |       | 2.95-3.72                              | %          | 4.58-4.68 | % |
| Expected life of  options (in years) |       | 4.5                                    |       | 4.5 |   |
| Expected  dividends                  |       | 0                                      | %          | 0 | % |
| Volatility of  stock price           |       | 87-88                                  | %          | 86-88 | % |

 

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 risk-free rate is based on the U.S. Treasury yield curve ineffect at the time of grant for periods corresponding with the expected life ofthe option.

 

15. *Income Taxes*

 

The provision for, or benefit from, income taxesincludes deferred taxes resulting from the temporary differences in income forfinancial and tax purposes using the liability method. Such temporarydifferences result primarily from the differences in the carrying value ofassets and liabilities. Future realization of deferred income tax assetsrequires sufficient taxable income within the carryback, carryforward periodavailable under tax law. The Company evaluates, on a quarterly basis whether,based on all available evidence, if it is probable that the deferred income taxassets are realizable. Valuation allowances are established when it is morelikely than not that the tax benefit of the deferred tax asset will not berealized. The evaluation, as prescribed by Statement of Financial AccountingStandards No. 109, “Accounting for Income Taxes,” includes theconsideration of all available evidence, both positive and negative, regardinghistorical operating results including recent years with reported losses, theestimated timing of future reversals of existing taxable temporary differences,estimated future taxable income exclusive of reversing temporary differencesand carryforwards, and potential tax planning strategies which may beemployed to prevent an operating loss or tax credit carryforward from expiringunused. Because of the Company’s historical performance and estimated futuretaxable income a full valuation allowance has been established.

 

16. *Use ofEstimates*

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities at the date of the financial statements, the reportedamounts of revenues and expenses during the reporting period, and disclosure ofcontingent assets and liabilities. Actual results could differ from thoseestimates.

 

Estimates and assumptions which, in the opinion ofmanagement are used in accounting for, among other things, long-

 

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

 

17. *ComprehensiveIncome/(Loss)*

 

Comprehensiveincome/(loss) consists of net loss and other gains and losses affectingshareholders’ equity/(deficit) that, under generally accepted accountingprinciples, are excluded from net income/(loss) in accordance with Statement ofFinancial Accounting Standards No. 130, “Reporting Comprehensive Income.”The Company, however, does not have any components of other comprehensiveincome/(loss) as defined by SFAS No. 130 and therefore, for the yearsended December 31, 2008 and 2007, comprehensive income/(loss) isequivalent to the Company’s reported net income/(loss). Accordingly, a separatestatement of comprehensive income/(loss) is not presented.

 

18. *Recent Accounting Pronouncements*

 

In September 2006,the FASB issued SFAS No. 157, “*Fair Value Measurements*”(SFAS 157), which is effective for calendar year companies on January 1,2008. This Statement defines fair value, establishes a framework for measuringfair value and expands the related disclosure requirements. Management hasadopted SFAS 157.  The adoption of SFAS157 had no impact on the Company’s financial condition and results ofoperations in 2008.

 

In February 2007, the FASB issued SFAS No. 159,“*The Fair Value Option for Financial Assets andFinancial Liabilities*” (SFAS 159), which is effective for calendaryear companies on January 1, 2008. The statement allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement for certain financial assets and liabilities on acontract-by-contract basis. Subsequent changes in fair value of these financialassets and liabilities would be recognized in earnings when they occur. SFAS159 further establishes certain additional disclosure requirements. Theadoption of SFAS 159 had no impact on the Company’s financial condition andresults of operations in 2008.

 

In December 2007,the SEC issued SAB No. 110.  SAB 110 allows for the continued use ofa “simplified” method, as discussed in SAB No. 107, in developing anestimate of expected term of “plain vanilla” share options in accordance withSFAS 123 (revised 2004).  Originally the SEC staff stated in SAB 107 thatit would not expect a company to use the simplified method for share optiongrants after December 31, 2007.  Accordingly, the SEC staff willcontinue to accept, under certain circumstances, the use of the simplifiedmethod beyond December 31, 2007.  The Company will continue to use ofthe simplified method for determining the value of options granted as allowedby SAB 110.

 

In December 2007,the FASB issued SFAS No. 141(R), “*Business Combinations”*(SFAS No. 141(R)) which establishes principles and requirements for howthe acquirer of a business recognizes and measures in its financial statementsthe identifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquiree. SFAS No. 141(R) also provides guidancefor recognizing and measuring the goodwill acquired in the business combinationand determines what information to disclose to enable users of the financialstatements to evaluate the nature and financial effects of the businesscombination. The provisions of SFAS No. 141(R) are applicable tobusiness combinations consummated on or after December 15, 2008 with earlyadoption prohibited. The adoption of SFAS 141(R) will have an impact on theCompany’s accounting for business combinations in connection with any futureacquisitions.

 

In December 2007,the FASB issued SFAS No. 160, “*Noncontrolling Interestsin Consolidated Financial Statements - an amendment of ARB No. 51”* (SFAS No. 160) which establishes accounting and reporting standards forthe noncontrolling interest in a subsidiary for the deconsolidation of asubsidiary. SFAS No. 160 is effective for financial statements issuedfor fiscal years beginning after December 15, 2008, and interim statementswithin those fiscal years. The Company does not currently have anynoncontrolling interests.

 

In March 2008, the FASB” issued SFAS No. 161, “*Disclosures about Derivative Instruments and Hedging Activities.*”(SFAS No.161) which amends and expands the disclosure requirements related toderivative instruments and hedging activities. The Statement requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of and gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements. The provisions of SFAS 161 are effective forthe fiscal year beginning January 1, 2009. The company will complywith the disclosure requirements of this statement if it utilizes derivativeinstruments or engages in hedging activities upon its effectiveness.

 

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In October 2008, theFASB issued Staff Position No. FAS 157-3, *“Determiningthe Fair Value of a Financial Asset When the Market for That Asset is NotActive”* (FSP 157-3). FSP 157-3 clarifies the application of SFAS157, which the Company adopted as of January 1, 2008, in cases where amarket is not active. The adoption of FSP 157-3 had no impact on the Company’sfinancial condition and results of operations in 2008.

 

**NOTE B—DISCONTINUED OPERATIONS**

 

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

 

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

 

During the period ended December 31,2007, $250,000 of the escrow balance was released to ZOLL. 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 Fire Segment,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 Company sold its Fire Segment tobetter focus on its core lines of business. The Fire Segment has been reportedas a discontinued operation in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets,”*and all periods presented have been recastaccordingly to reflect these operations as discontinued.

 

Revenues and net income(loss) for the Fire Segment for the years ended December 31, 2008 and 2007were as follows:

 
| ** **         | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------|------------|----------------------------------------|------------|
| ** **         | ** ** | **2008**                               | ** ** | **2007** | ** ** |
|               |       |                                   |       |   |   |
| Revenues           |       | —                                 |       | 1,546,746 |   |
| Net income  (loss) |       | —                                 |       | 440,105 |   |

 

**NOTE C—ACQUISITIONS**

 

*Acquisition of Mobile Government*

 

On September 30, 2004, we acquired certain assetsand assumed certain liabilities of the Mobile Government division of AetherSystems, Inc (Aether). The aggregate purchase price of the acquisition was$12,198,171.

 

In conjunction with the acquisition of the MobileGovernment division, the Company was required to place funds into escrow, whichcomprised of the following as at December 31:

 
| ** **     | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------|------------|------------|------------|------------|------------|
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Escrow balance |       | $          | —     |       | $          | 479,403 |   |
|                |            |            |            |            |            |  |  |

 

The escrow amountsrepresented funds available to Aether in the event the Company defaulted on thesublease 

 

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agreement. The funds were made available for use bythe company on termination of the lease in August 2008.

 

**NOTE D—CONCENTRATION OF RISK**

 

Financial instruments and long-term contracts, which potentiallysubject the Company to risk, primarily consist of receivables and costs andearnings in excess of billings on uncompleted contracts. The Company extendscredit to customers on an unsecured basis in the normal course of business. TheCompany’s policy is to perform an analysis of the recoverability of itsreceivables and costs and earnings in excess of billings on uncompletedcontracts at the end of each reporting period and to establish allowances whereappropriate. The Company analyzes historical bad debts and contract losses,customer concentrations, and customer credit-worthiness when evaluating theadequacy of the allowances.

 

The Company had certain customers whose revenueindividually represented 10% or more of the Company’s total revenue, asfollows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** ** | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Customer A |       | 15                                          | %          | — |   |

 

The Company had concentrations of customers in certainindustry groups which represented 10% or more of the Company’s total revenue,as follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** ** | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Government |       | 74                                          | %          | 91 | % |
| Commercial |       | 26                                          | %          | * |   |

 

----

*              Lessthan 10% of total revenue

 

The Company had certain customers whose accountsreceivable balances individually represented 10% or more of the Company’s totalaccounts receivable, as follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** ** | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Customer B |       | 11                                          | %          | — |   |
| Customer C |       | 23                                          | %          | * |   |
| Customer D |       | —                                      |       | 25 | % |
| Customer E |       | —                                      |       | 12 | % |

 

----

*              Lessthan 10% of total accounts receivable

 

The Company had certain customers whose balance ofcosts and earnings in excess of billings on uncompleted contracts individuallyrepresented 10% or more of the Company’s total costs and earnings in excess ofbillings on uncompleted contracts, as follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** ** | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Customer D |       | 100                                         | %          | 100 | % |

 

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

 

The components of uncompleted contracts consisted ofthe following as of December 31:

 
| ** **                                                         | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost and  earnings incurred on uncompleted contracts               |       | $          | 7,483,122  |       | $          | 7,338,571 |   |
|                                                               |       |       |       |       |       |
| Less billings to  date                                             |       | (7,338,571 | )          | (7,104,766 | )          |
|                                                               |       |       |       |       |       |
|                                                               |       | $          | 144,551    |       | $          | 233,805 |   |
|                                                               |       |       |       |       |       |
| Costs and  earnings in excess of billings on uncompleted contracts |       | $          | 144,551    |       | $          | 233,805 |   |
|                                                               |       |       |       |       |       |
| Billings in  excess of costs and earnings on uncompleted contracts |       | —     |       | —     |       |
|                                                               |       |       |       |       |       |
|                                                               |       | $          | 144,551    |       | $          | 233,805 |   |

 

**NOTE F—PREPAID EXPENSES**

 

Prepaid expenses consisted of the following as of December 31:

 
| ** **                       | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Insurance and  software licenses |       | $          | 92,909     |       | $          | 113,968 |   |
| Other                            |       | 3,200      |       | 5,100      |       |
|                             |       |       |       |       |       |
| Total                            |       | $          | 96,109     |       | $          | 119,068 |   |

 

**NOTE G—EQUIPMENT AND LEASEHOLDIMPROVEMENTS**

 

Equipment and leasehold improvements consisted of thefollowing as of December 31:

 
| ** **                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                                       |       | $          | 555,792    |       | $          | 517,658 |   |
| Furniture and  fixtures                         |       | 148,517    |       | 187,984    |       |
| Software                                        |       | 136,355    |       | 136,355    |       |
| Leasehold  improvements                         |       | 198,889    |       | 198,889    |       |
|                                            |       | 1,039,553  |       | 1,040,886  |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | (947,315   | )          | (863,604   | )          |
|                                            |       |       |       |       |       |
| Total                                           |       | $          | 92,238     |       | $          | 177,282 |   |

 

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**NOTE H—OTHER ASSETS**

 

*Goodwill*

 

The changes in thecarrying amount of goodwill for the years ended December 31, 2008 and2007, were as follows:

 
| ** **                                               | ** ** | **Law Segment** | ** ** | **Fire Segment** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|-----------------------|------------|------------|------------|
| ** **                                               | ** ** | ** **           | ** ** | ** **            | ** ** | ** ** | ** ** |
| Balance as of  January 1, 2007                      |       | $                    | 7,836,986  |                  | $          | 3,552,668  |       | $ | 11,389,654 |   |
| Goodwill  included in gain on disposal of reporting unit |       | —               |       | (3,552,668            | )          | (3,552,668 | )          |
|                                                     |       |                 |       |                  |       |       |       |
| Balance as of  December 31, 2007                    |       | $                    | 7,836,986  |                  | $          | —     |       | $ | 7,836,986 |   |
|                                                     |       |                 |       |                  |       |       |       |
| Additions/subtractions                                   |       | —               |       | —                |       | —     |       |
|                                                     |       |                 |       |                  |       |       |       |
| Balance as of  December 31, 2008                    |       | $                    | 7,836,986  |                  | $          | —     |       | $ | 7,836,986 |   |

 

*Intangible Assets*

 

Intangible assets consisted of the following as of December 31:

 
| ** **                   | ** ** | **2008**                    | ** ** | **2007**                      | ** ** |
|------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
| ** **                   | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Copyrighted  software        |       | $                           | 1,181,429  |                          | $          | (1,122,357 | ) | $ | 59,072 |   | $ | 1,181,429 |   | $ | (886,071 | ) | $ | 295,358 |   |
| Customer  relationships      |       | 617,271                     |       | (524,679                      | )          | 92,592 |   | 617,271 |   | (401,225 | ) | 216,046 |   |
| Trademarks                   |       | 807,872                     |       | (724,673                      | )          | 83,199 |   | 807,872 |   | (563,099 | ) | 244,773 |   |
| Developed  technology        |       | 434,353                     |       | (369,201                      | )          | 65,152 |   | 434,353 |   | (282,330 | ) | 152,023 |   |
| Marketing  agreements        |       | 605,340                     |       | (575,073                      | )          | 30,267 |   | 605,340 |   | (454,005 | ) | 151,335 |   |
| Patents and  patents pending |       | 298,059                     |       | (45,640                       | )          | 252,419 |   | 298,059 |   | (33,325 | ) | 264,734 |   |
|                         |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Total                        |       | $                           | 3,944,324  |                          | $          | (3,361,623 | ) | $ | 582,701 |   | $ | 3,944,324 |   | $ | (2,620,055 | ) | $ | 1,324,269 |   |

 

Aggregate amortizationexpense for the year ended December 31, 2008 and 2007, was $741,568 and$761,258 respectively.

 

#### *Deferred financing costs*

####  

Deferred financing costsare amortized based upon the lives of the respective debt obligations. Due tothe repayment of all convertible debt during the 2007 year, the net book valueof the associated deferred financing costs was written off to Loss onExtinguishment of Debt (see Note Q).

 

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

 

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*Deposits*

 

Deposits consisted of the following as of December 31:

 
| ** **                 | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Lease deposit  with Aether |       | $          | —     |       | $          | 479,403 |   |
| Property  deposits         |       | 7,812      |       | 8,412      |       |
|                       |       |       |       |       |       |
| Total                      |       | $          | 7,812      |       | $          | 487,815 |   |

 

Lease and property depositsare held over the Company’s premises as security for contractual performanceunder certain operating leases. At the conclusion of these lease arrangements,which is expected to occur over a number of dates through August 2009, thelease and property deposits shall be returned to the Company.

 

*Restricted cash*

 

During the 2008 year, theCompany extended its property lease at the Marlborough, MA location. Pursuantto the agreement 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 be returned at the conclusion of the leaseterm, in August 2011. The escrow is recorded as the non-current asset,restricted cash as at December 31, 2008.

 

**NOTE I—ACCRUED LIABILITIES**

 

Accrued liabilities consisted of the following as of December 31:

 
| ** **                                  | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Contract costs  not yet invoiced by vendors |       | $          | 105,788    |       | $          | 2,185,610 |   |
| Compensation                                |       | 136,620    |       | 140,314    |       |
| Compensated  absences                       |       | 383,454    |       | 367,731    |       |
| Royalties                                   |       | 267,400    |       | 371,158    |       |
| Interest                                    |       | 176,083    |       | 176,083    |       |
| Other                                       |       | 232,544    |       | 160,853    |       |
|                                        |       |       |       |       |       |
| Total                                       |       | $          | 1,301,889  |       | $          | 3,401,749 |   |

 

**NOTE J—RELATED PARTY**

 

**Consulting Arrangement with Thomas J.Colatosti**

 

In connection with his appointment to the Board ofDirectors in September 2002, and as acting Chief Financial Officer in November 2008,the Company entered into a number of consulting arrangements with Thomas J.Colatosti. Under the most recent arrangement, which was entered into on November 17,2008, Mr. Colatosti serves as acting Chief Financial Officer at a rate of$12,500 per month from October 15, 2008.

 

Mr. Colatosti has substantial experience in thebiometric industry and in addition to his role as the Chairman of the Board ofDirectors of the Company, provides extensive service to the Company in theareas of strategic planning and corporate finance. During the year ended December 31,2008, the Company paid Mr. Colatosti approximately $37,500.

 

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**NOTE K—DEFERRED REVENUE**

 

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

 
| ** **                                                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current  Portion**                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | $          | 3,195,547  |       | $          | 3,638,988 |   |
| Fully deferred  systems, installation and acceptance revenue |       | 488,929    |       | 829,760    |       |
|                                                         |       | 3,684,476  |       | 4,468,748  |       |
| **Long-Term  Portion**                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | 8,382      |       | 34,518     |       |
|                                                         |       |       |       |       |       |
| **Total**                                                    |       | $          | 3,692,858  |       | $          | 4,503,266 |   |

 

Maintenance contractsinclude provisions for unspecified when-and-if available product updates andcustomer telephone support services, and are recognized ratably over the termof the service period. Fully deferred systems, installation and acceptancerevenue relates to projects that have been billed per the contractual terms,however because of undelivered elements or acceptance criteria, revenue has notyet been recognized. These amounts are expected to be completed within the next12 months and are classified as current liabilities.

 

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

 

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

** **

*Notes Payable*

* *

Note Payable consisted of the following as of December 31:

 
| ** **    | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|---------------|------------|------------|------------|------------|------------|
| ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Notes payable |       | $          | 1,516,651  |       | $          | — |   |
|               |            |            |            |            |            |  |  |

 

On July 28, 2008, the Company entered into aSettlement and Mutual Release Agreement (the “Settlement Agreement”) with avendor in order to resolve all matters relating to invoices totaling approximately$2,350,000 that the Company received in January 2008 for materials thathad been delivered by the vendor, as a subcontractor on a long-term project forwhich the Company had served as the prime contractor.  Pursuant to theSettlement Agreement, the parties agreed to a payment schedule under which theCompany will be required to satisfy this outstanding balance, plus interest atseven percent (7%) per annum on the unpaid portion of the balance, in full onor before June 1, 2009.  In return,the vendor agreed to forbear from exercising any of its rights and remediesagainst the Company with respect to these amounts so long as the Companyremains in compliance with its obligations under the Settlement Agreement.

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*Convertible Debt Financing/Warrants*

* *

Long-term obligations consisted of the following as ofDecember 31:

 
| ** **      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-----------------|------------|------------|------------|------------|------------|
| ** **      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2004**        | ** ** | ** ** | ** ** | ** ** | ** ** |
| FMV of warrants |       | $          | 291        |       | $          | 11,663 |   |
| **2005**        | ** ** | ** ** | ** ** | ** ** | ** ** |
| FMV of warrants |       | 6,666      |       | 34,644     |       |
| **2006**        |       |       |       |       |       |
| FMV of warrants |       | 5,360      |       | 18,213     |       |
|            |       |       |       |       |       |
| **Total**       |       | $          | 12,317     |       | $          | 64,520 |   |

 

***Senior Convertible Term Notes***

*** ***

**2004 and 2005 Senior Notes**

 

On September 29, 2004, we entered into aSecurities Purchase Agreement (the “2004 Senior Purchase Agreement”) withLaurus Master Fund, Ltd. (“Laurus”) to issue secured convertible termnotes in the aggregate principal amount of $5,050,000.  On June 8, 2005, we entered into asecond Securities Purchase Agreement (the “2005 Senior Purchase Agreement”)with Laurus to issue secured convertible term notes in the aggregate principalamount of $2,000,000.

 

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

 

The account balance shownrepresents the fair market value of warrants issued in conjunction with debtofferings undertaken from the 2004 to 2006 fiscal years. The Warrants areclassified as liabilities and were valued as of December 31, 2008 and2007, using the Black Scholes Option Pricing model with the followingassumptions:

 
| ** **               | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| Dividend Yield           |       | 0                                      | %          | 0 | % |
| Annual  volatility       |       | 112-121                                | %          | 84-92 | % |
| Risk-free  interest rate |       | 0.32-0.78                              | %          | 3.0-4.0 | % |

** **

**2004 and2005 Senior Note Derivatives and Discounts**

 

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

 

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

 

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

** **

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

 

Due to the previousdefaults on Senior and Subordinated Notes held by the Company, obligationstotaling $622,765 were accrued in prior periods. Effective April 18, 2007,the Company entered into an agreement with Laurus to satisfy these defaultinterest obligations in full by issuing shares of the Company’s restrictedcommon stock to Laurus. This agreement 

 

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was subject to a conditionthat the Company would consummate a business transaction on or before May 18,2007, or such later date as the parties agreed, which would raise sufficientproceeds to repay all of the Company’s obligations under the 2004 and 2005Senior Notes, as noted above.

 

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

 

**NOTE M—SEGMENT INFORMATION**

** **

TheCompany’s consolidated operations are divided into two segments: Law andBiometric. The Company evaluates performance and allocates resources based onrevenues and operating income (loss). Operating income (loss) for each segmentincludes selling, general and administrative expenses directly attributable tothe segment in addition to those allocated as a percentage based on the segment’sbudgeted revenues. The segmentation of operating income (loss) as noted aboveand detailed below reflects how management evaluates its business.  Assetsfor the Company are commingled and are related to all operating segments.Management does not evaluate or identify the operating assets of the segmentsseparately.

 

Prior to the sale of theFire business in May 2007, Fire had been reported as a separate segment.Prior periods presented have been recast accordingly to reflect theseoperations as discontinued. Geographically, North American sales accounted forapproximately 99% and 100% of the Company’s total sales for fiscal years 2008and 2007, respectively.

 

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

 
| ** **                                          | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                                      | ** ** | **2007** | ** ** |
| ** **                                          | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| **Revenue:**                                        | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Law                                                 |       | $                                                             | 9,496,505  |   | $ | 9,073,200 |   |
| Biometrics                                          |       | 3,379,542                                                     |       | 915,256 |   |
| Consolidated Revenue                                |       | 12,876,047                                                    |       | 9,988,456 |   |
| **Segment  operating income/(loss)**                | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Law                                                 |       | (585,929                                                      | )          | (3,610,922 | ) |
| Biometrics                                          |       | 684,121                                                       |       | (1,754,060 | ) |
| Total Segment  Operating Income/(loss)              |       | 98,192                                                        |       | (5,364,982 | ) |
| **Reconciliation  to net income/(loss)**            | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Interest income                                     |       | 1,339                                                         |       | 3,097 |   |
| Interest expense                                    |       | (92,520                                                       | )          | (832,457 | ) |
| Derivative and  warrant fair value adjustments      |       | 93,059                                                        |       | 1,016,845 |   |
| Investment  income                                  |       | 119,348                                                       |       | — |   |
| Loss on  extinguishment of debt                     |       | —                                                        |       | (403,940 | ) |
| Other  income/(expense)                             |       | (34,885                                                       | )          | 12,102 |   |
| **Net  income/(loss) from continuing operations**   |       | 86,341                                                        |       | (5,569,335 | ) |
| Income from  discontinued operations                |       | —                                                        |       | 440,105 |   |
| Gain/(loss) on  disposal of discontinued operations |       | (65,354                                                       | )          | 4,072,006 |   |
| **Net  income/(loss)**                              |       | $                                                             | 119,179    |   | $ | (1,057,224 | ) |

 

**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, 

 

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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.

 

In connection with the Company’s acquisition of AMG in2004, the Company entered into a sub-lease with Aether, which required monthlylease payments in excess of existing market rates. Rent expense was recorded atthe market rate and charged on a straight-line basis through August 31,2008, the termination date of the lease.

 

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

 
| **Years ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2009                                         |       | $          | 402,091    |   |
| 2010                                         |       | 422,816    |       |
| 2011                                         |       | 320,736    |       |
| 2012                                         |       | 99,615     |       |
| 2013                                         |       | 99,615     |       |
| More than 5  years                           |       | 74,712     |       |
|                                         |       |       |       |
|                                         |       | $          | 1,419,585  |   |

 

Rental expense was approximately $786,000 and $942,000during 2008 and 2007, respectively.

 

*Employment Agreements*

 

The Company has employment agreements with fouremployees. These agreements allow the continuation of the employee’s salary inthe event of termination without cause. The agreements also acknowledge theemployee’s eligibility to participate in the Company’s bonus and option plans,the terms of which have not yet been established. As of December 31, 2008,the aggregate commitment under these agreements was approximately $524,000.

 

*Legal Proceedings*

 

In the normal course of business, the Company periodically becomes involved in litigation. As of December 31, 2008, 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.

 

On February 2, 2009, Longview Special Finance, Inc. and Longview Fund, L.P. (the “Plaintiffs”) filed a complaint against the Company in the United States District Court for the Southern District of New York entitled Longview Special Finance, Inc. and Longview Fund, L.P.v. BIO-key International. Inc., in which the Plaintiffs are seeking $2,915,950 in damages and an unspecified amount of interest and attorney’s fees from the Company as a result of the Company’s alleged improper failure to redeem the outstanding shares of Series B Convertible Preferred Stock and Series C Convertible Preferred Stock held by the Plaintiffs. The Company has not accrued any significant additional liabilities as a result of this matter as the Company believes that it has meritorious defenses and it intends to defend against these claims vigorously. See also Note X to these Financial Statements.

 

*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, 2008 and 2007,royalty expense was approximately $51,000 and $102,000, respectively.

 

*Liquidated Damages*

 

The Company may have to pay liquidated damages tocustomers in certain circumstance, including instances where itssub-contractors do not perform on time. In addition, the Company sometimesindemnifies certain of its customers against damages, if any, they might incuras a result of a claim brought against them related to third party softwareembedded in the Company’s products.

 

The Company’s most significant exposure to liquidatedand other damages is with its largest contract with Hamilton County, Ohio (“Hamilton”).The Hamilton contract limits the Company’s liability for damage to approximately$10,000,000. Management believes the contract was completed within the agreedcontract term, including defined specifications for performance, andaccordingly, payment of damages under the contract is not likely. However, theproject is under warranty until February 2009, and there can be noassurance damages will not be incurred during the remainder of the warrantyperiod. If damages are incurred there can be no assurance that any amountsrequired to be paid will not be material to the financial statements.

 

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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 31,2008, there was no material requirement for an accrued warranty liabilityreserve.

 

**NOTE O— EQUITY**

 

1. Mezzanine Equity

 

*RedeemablePreferred Stock*

 

**Series BConvertible Preferred Stock**

 

The Company issued1,000,000 shares of redeemable Series B Convertible Preferred Stock on February 23,2006, upon the conversion of the 2006 Convertible Notes. Each share of Series Bpreferred stock has an Original Issue Price of $1.00 per share. The holder hasthe option to redeem the shares of Series B preferred stock at any timefor a number of shares of the Company’s common stock equal to the OriginalIssue Price plus accumulated and unpaid dividends divided by the fixedconversion price of $0.30 per share of Common Stock. The conversion price issubject to adjustment if common stock is issued by the Company subsequent tothe original issue date of the Series B preferred stock, except for otherconversions, options, warrants, dividends paid in stock or pursuant to anacquisition by the Company, at a price less than the conversion price.Mandatory conversion of all Series B shares will be automatic if, for the30 trading days prior to January 1, 2009, the average closing bid pricefor one share of common stock is at least $1.10. The shares shall be convertedat the conversion price then in effect. If the average bid price for the 30trading days prior to January 1, 2009 per common share is less than $1.10the Company shall mandatorily redeem all remaining outstanding Series Bpreferred stock by paying cash equal to $1.00 per share with all accrued andunpaid dividends.  The Company may, atits election, redeem any or all of the remaining outstanding Series Bshares in cash at a conversion price equal to $1.20 per share, together withall accrued and unpaid dividends upon giving 30 day notice. Holders of the Series Bpreferred stock are entitled to cumulative, prior and in preference to holdersof common stock dividends equal to 15% per annum of the Original Purchase Pricestill outstanding, payable quarterly commencing April 1, 2006. In anyliquidation of the Company, each share of preferred stock is entitled to aliquidation preference on a pari passu basis with the Series A and Series CPreferred stock before any distribution may be made on the Company’s commonstock. See also Note X to these Financial Statements.

 

As of December 31,2008 and 2007, 1,000,000 preferred stock shares were authorized, 970,612 ofwhich were issued and outstanding, at a par value of $0.0001 and a liquidationpreference of $1.00 with accumulated dividends in arrears of $37,207, whichhave been accreted to the principal balance of the Series B preferredstock.

 

The Preferred Stock contains features that areconsidered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at theHolder’s option at any time at the fixed conversion price of $0.30 per share;Quarterly Dividends Conversion Option: Holders have the option to convert the Stock’s quarterly dividendpayment at a conversion price of the average 10 days closing price prior to thedividend record date.  These featureshave been bifurcated and recorded on the Company’s balance sheet asliabilities, at their fair value.

 

As of December 31, 2008 and 2007, the derivativeswere valued at $111 and $6,005, respectively.

 

An amount equal to theoriginal value of the derivatives was recorded as a discount to the PreferredStock.  The discount is being accreted tothe principal balance of the Preferred Stock, using the effective interestmethod, over the expected term of the term of the Preferred Stock.  At December 31, 2008 and 2007, theunamortized discount on the Preferred Stock was $0 and $126,480, respectively.

 

**Series CConvertible Preferred Stock**

 

The Company issued592,032 shares of redeemable Series C Convertible Preferred Stock on August 10,2006, upon the 

 

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exchange of certain 2004and 2005 Subordinated Notes. Each share of Series C preferred stock has anOriginal Issue Price of $10.00 per share. The holder has the option to redeemthe shares of Series C 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 C 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 Cshares will be automatic if, for the 30 trading days prior to January 1,2009, the average closing bid price for one share of common stock is at least$1.20. The shares shall be converted at the conversion price then in effect. Ifthe average bid price for the 30 trading days prior to January 1, 2009 percommon share is less than $1.20 the Company shall mandatorily redeem allremaining outstanding Series C preferred stock by paying cash equal to$10.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem anyor all of the remaining outstanding Series C shares in cash at aconversion price equal to $12.00 per share, together with all accrued andunpaid dividends upon giving 30 day notice. Holders of the Series Cpreferred stock are entitled to cumulative, prior and in preference to holdersof common stock dividends equal to 15% per annum of the Original Purchase Pricestill outstanding, payable quarterly commencing September 1, 2006. In anyliquidation of the Company, each share of preferred stock is entitled to aliquidation preference on a pari passu basis with the Series A and Series BPreferred stock before any distribution may be made on the Company’s commonstock. See also Note X to these Financial Statements.

 

As of December 31,2008 and 2007, 600,000 preferred stock shares were authorized, 592,032 of whichwere issued and outstanding, at a par value of $0.0001 and a liquidationpreference of $10.00 with accumulated dividends in arrears of $575,728 and $351,601,respectively, which have been accreted to the principal balance of the Series Cpreferred stock.

 

The Preferred Stock contains features that areconsidered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at theHolder’s option at any time at the fixed conversion price of $0.30 per share;Quarterly Dividends Conversion Option: Holders have the option to convert the Stock’s quarterly dividendpayment at a conversion price of the average 10 days closing price prior to thedividend record date.  These featureshave been bifurcated and recorded on the Company’s balance sheet asliabilities, at their fair value.

 

As of December 31, 2008 and 2007 the derivativeswere valued at $328 and $35,290, respectively.

 

An amount equal to theoriginal value of the derivatives was recorded as discount to the PreferredStock.  The discount is being accreted tothe principal balance of the Preferred Stock, using the effective interest method,over the expected term of the term of the Preferred Stock.  At December 31, 2008 and 2007, theunamortized discount on the Preferred Stock was $0 and $449,444, respectively.

 

Together with the abovetransaction, the terms of certain warrants held by the Company’s investmentbankers and their associates were modified. The incremental value of themodification was calculated to be $110,453, and was allocated against theproceeds of the Series C Convertible Preferred Stock as a cost offinancing, and will be accreted to the principal balance of the PreferredStock, using the effective interest method, over the expected term of the termof the Preferred Stock.  At December 31,2008 and 2007, the net amount remaining to be accreted was $0 and $46,249,respectively.

 

2. Permanent Equity

 

**Common Stock**

 

The Company is authorizedto issue 170,000,000 shares of common stock, $.0001 par value per share, ofwhich 67,876,880 and 61,153,202 were outstanding as of December 31, 2008and 2007, 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.

 

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During the yearended December 31, 2008, preferred stockholders converted accumulateddividends of $826,739 into 6,723,678 shares of the Company’s common stock.

 

During the yearended December 31, 2007, preferred stockholders converted principal of$29,388 and accumulated dividends of $1,090,842 into 4,576,206 shares of theCompany’s common stock. In addition accrued default interest of $622,765 on the2004 and 2005 Senior Notes with Laurus was converted into 850,000 shares ofrestricted common stock, and convertible debt principle of $150,000 wasconverted into 568,182 shares of common stock. The Company recorded a non-cashinterest expense of approximately $91,000, which represented the value ofadditional common shares issued to Laurus as consideration for exchangingconvertible debt for equity instead of paying the outstanding principal paymentin cash.

 

**Series AConvertible Preferred Stock**

 

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

 

In March 2004, wedesignated 100,000 shares of preferred stock as Series C ConvertiblePreferred Stock. In connection with the Company’s reincorporation in Delawareon January 1, 2005, each share of Series C Convertible PreferredStock was automatically converted into one share of Series A ConvertiblePreferred Stock (the “Series A Shares”), of which 30,557 were issued andoutstanding as at December 31, 2008 and 2007.

 

The Series A Sharesaccrue a cumulative annual dividend of 7% on the $100 face amount of suchshares payable June 15 and December 15 each year in shares of commonstock. In the event of a liquidation, dissolution or winding up of the Company,the Series A shares have a liquidation preference of $100 per share (plusall accrued and unpaid dividends thereon) prior to any payment or distributionto holders of our common stock. The Series A Shares are convertible intocommon stock at a conversion price of $0.30 per share. The conversion price issubject to proportional adjustment in the event of stock splits, stockdividends or reclassifications. Subject to certain exceptions, in the event weissue additional shares of common stock at a purchase price less than theconversion price of the Series A Shares, the conversion price shall belowered to such lesser price. In the event that the average closing bid priceof our common stock is less than $1.00 per share for thirty (30) consecutivetrading days at any time after November 17, 2008, we will be required toredeem the Series A Shares by payment of $100 per share plus all accruedand unpaid dividends due thereon. See also Note X to these FinancialStatements.

 

We are required to obtainthe consent of the holders of a majority of the Series A Shares in orderto, among other things, issue any shares of preferred stock that are equal toor have a preference over the Series A shares or issue any shares ofpreferred stock, rights, options, warrants, or any other securities convertibleinto common stock of the Company, other than those issued to employees of theCompany in the ordinary course of their employment or to consultants or otherpersons providing services to the Company so long as such issuances do notexceed 500,000 shares of common stock. We are also required to obtain suchconsent in order to, among other things, complete a sale or other dispositionof any material assets, complete an acquisition of a material amount of assets,engage in a merger, reorganization or consolidation, or incur or guaranty anyindebtedness in excess of $50,000.

 

As of December 31,2008 and 2007, cumulative dividends in arrears related to the Series Apreferred stock were approximately $461,417 and $243,953, respectively, whichhave been accreted to the principal balance of the Series A preferredstock.

 

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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       |                                                    | 1.02       | ** **                      | **$**  | — |   |
| Vested or  expected to vest at December 31, 2008 |       | 10,566,375              |       | $                                      | 0.95       |                                                    | 1.02       |                            | — |   |
| Exercisable at  December 31, 2008                |       | 10,566,375              |       | $                                      | 0.95       |                                                    | 1.02       |                            | — |   |
|                                                       |            |                         |            |                                        |            |                                                         |            |                                 |        |  |  |

 

The warrants outstandingand exercisable at December 31, 2008 were in the following exercise priceranges:

 

| ** **                                  | ** ** | **Warrants outstanding and Exercisable** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------|------------|
| **Range of exercise prices** | ** ** | **Number of  warrants**                            | ** ** | **Weighted average  remaining life (in years)** | ** ** |
|                                        |       |                                                    |       |   |   |
| $                                           | 0.30       |                                                    | 2,798,014  |   | 2.11 |   |
|                                        | 0.75       |                                                    | 533,333    |   | 2.61 |   |
|                                        | 0.97       |                                                    | 150,000    |   | 0.53 |   |
|                                        | 1.00       |                                                    | 2,655,552  |   | 0.86 |   |
|                                        | 1.35       |                                                    | 4,429,476  |   | 0.24 |   |
| $                                           | 0.30-1.35  |                                                    | 10,566,375 |   |   |   |

 

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

 

**NOTE P—STOCK-BASED COMPENSATION**

 

*1996Stock Option Plan*

 

During 1996, the Board ofDirectors and stockholders of the Company adopted the 1996 Stock Option Plan(the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock arereserved for issuance to employees, officers, directors, and consultants of theCompany at exercise prices which may not be below 100% of fair market value forincentive stock options and 50% for all others. The term of stock optionsgranted may not exceed ten years. Options issued under the Plan vest 

 

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pursuant to the terms ofstock option agreements with the recipients. In the event of a change incontrol, as defined, all options outstanding vest immediately. The Plan expiredin 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 grantedmay not exceed ten years. Options issued under the Plan vest pursuant to theterms of stock option agreements with the recipients. In the event of a changein control, as defined, all options outstanding vest immediately. The 1999 Planexpires in August 2009.

 

*2004Stock Option Plan*

 

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

 

*Non-PlanStock Options*

 

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

 

*StockOption Activity*

 

Information summarizingoption activity is as follows:

 
| ** **                                                | ** ** | **Number of Options** | ** ** | **Weighted  average  exercise** | ** ** | **Weighted  average  remaining  life** | ** ** | **Aggregate  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** | ** ** | **3.31** | ** ** | **—** |   |
| **Vested  or expected to vest at December 31, 2008** | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                             | ** ** | ** **               | ** ** | **6,850,050** | ** ** | **0.79** | ** ** | **3.24** | ** ** | **—** |   |
| **Exercisable  at December 31, 2008**                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                             | ** ** | ** **               | ** ** | **6,297,071** | ** ** | **0.84** | ** ** | **3.02** | ** ** | **—** |   |
|                                                           |            |                                 |            |                                 |            |                                        |            |                          |            |  |  |  |  |  |  |  |  |  |

 

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The options outstandingand exercisable at December 31, 2008 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** | ** ** |
| $                                           |  0.11-0.21 |                         | 826,272    |                                   | $          | 0.13 |   | 6.31 |   | 299,603 |   | $ | 0.11 |   |
|                                        |  0.22-0.40 |                         | 601,000    |                                   | 0.34       |   | 1.45 |   | 567,330 |   | 0.34 |   |
|                                        |  0.41-0.68 |                         | 1,746,000  |                                   | 0.58       |   | 2.90 |   | 1,595,469 |   | 0.58 |   |
|                                        |  0.69-1.11 |                         | 2,163,169  |                                   | 0.90       |   | 3.66 |   | 2,163,169 |   | 0.90 |   |
|                                        |  1.12-1.62 |                         | 1,671,500  |                                   | 1.30       |   | 2.48 |   | 1,671,500 |   | 1.30 |   |
| $                                           |  0.11-1.62 |                         | 7,007,941  |                                   |       |   |   |   | 6,297,071 |   |   |   |
|                                             |                 |                              |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the table above represents the total intrinsic value, based on theCompany’s closing stock price of $0.05 as of December 31, 2008, 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, 2008 was 0.

 

The weighted average fairvalue of options granted during the years ended December 31, 2008 and 2007was $0.10 and $0.13 per share, respectively. The total intrinsic value ofoptions exercised during the years ended December 31, 2008 and 2007 was$0. The total fair value of shares vested during the years ended December 31,2008 and 2007 was $521,831 and $754,050 respectively.

 

As of December 31,2008 future compensation cost related to nonvested stock options isapproximately $96,415 and will be recognized over an estimated weighted averageperiod of approximately 0.8 years.

 

**NOTE Q— EXTINGUISHMENT OF DEBT**

** **

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

 

In accordance with theEmerging Issues Task Force of the FASB No. 96-19, Debtor’s Accounting forModification or Exchange of Debt Terms (“EITF 96-19”), and AccountingPrinciples Board Opinion No. 26, Early Extinguishment of Debt (“APB 26”),the Company treated the above transaction as an extinguishment of debt, andrecorded a non-operating “loss on extinguishment of debt” of $403,940.

 

**NOTE R—INCOME TAXES**

** **

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

 

As a result of the implementation of FIN No. 48,the Company reduced its deferred tax assets and the associated valuationallowance for gross unrecognized tax affected benefits by approximately$4,100,000. There was no adjustment to accumulated deficit as a result of theseunrecognized tax benefits since there was a full valuation allowance againstthe related deferred tax assets. If these unrecognized tax benefits areultimately recognized, they would have no impact on the effective tax rate dueto the existence of the valuation allowance.

 

The Company has not been audited by the InternalRevenue Service (“IRS”) or any states in connection with income taxes. TheCompany files income tax returns in the U.S. federal jurisdiction and variousstate jurisdictions. The periods from 

 

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2002-2008 remain open to examination by the IRS andstate jurisdictions. The Company believes it is not subject to any tax riskbeyond the preceding discussion. The Company’s policy is to recognize interestand penalties accrued on any unrecognized tax benefits as a component of incometax expense. As of the date of adoption of FIN No. 48, the Company did nothave any accrued interest or penalties associated with any unrecognized taxbenefits, nor was any significant interest expense recognized during the yearsended December 31, 2008 and 2007.

 

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

 
| ** **                              | ** ** | **2008**    | ** ** | **2007**    | ** ** |
|-----------------------------------------|------------|-------------|------------|-------------|------------|
| ** **                              | ** ** | ** **  | ** ** | ** **  | ** ** |
| **Current  asset:**                     | ** ** | ** **  | ** ** | ** **  | ** ** |
| Accrued  compensation                   |       | $           | 172,000    |        | $          | 168,000 |   |
| Accounts  receivable allowance          |       | 32,000      |       | 45,000      |       |
| **Non-current  asset:**                 | ** ** | ** **  | ** ** | ** **  | ** ** |
| Basis  differences in fixed assets      |       | 68,000      |       | (92,000     | )          |
| Basis  differences in intangible assets |       | 573,000     |       | 456,000     |       |
| Accrued interest  and other             |       | 79,000      |       | 70,000      |       |
| Income tax  credits                     |       | 1,680,000   |       | 1,459,000   |       |
| Net operating  loss carryforwards       |       | 15,350,000  |       | 15,548,000  |       |
| Valuation  allowances                   |       | (17,954,000 | )          | (17,654,000 | )          |
|                                    |       |        |       |        |       |
|                                    |       | $           | —     |        | $          | — |   |

 

As of December 31,2008 the Company has federal and state net operating loss carryforwards ofapproximately $42,305,000 and $18,293,000, 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.

 

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.

 
| ** **                            | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| US Federal  statutory income tax rate |       | 34         | %          | (34        | )%         |
| State taxes, net                      |       | 0          |       | 0          |       |
| Permanent  differences                |       | 229        |       | 8          |       |
| Temporary  differences                |       | (46        | )          | 1          |       |
| Change in  valuation allowance        |       | (217       | )          | 25         |       |
|                                  |       |       |       |       |       |
| Effective tax  rate                   |       | 0          | %          | 0          | %          |

 

**NOTES—FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

The Company’s derivativefinancial instruments as at December 31, 2008 and 2007 consisted ofembedded derivatives related to the Series B and Series C ConvertiblePreferred Stock. These embedded derivatives include certain conversion featureson preferred principal and accumulated and unpaid dividends. The Company alsoissued warrants to purchase shares 

 

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of the Company’s Common stock as part of various debtfinancings. The accounting treatment of these derivatives and warrants requiredthe Company to record the instruments as liabilities at their relative fairvalues as of the inception date of the agreement, and at fair value as of eachsubsequent balance sheet date. Any change in fair value is recorded asnon-operating, non-cash income or expense at each reporting date. If the fairvalue of the derivatives or the warrant is higher at the subsequent balancesheet date, the Company will record a non-operating, non-cash charge. If thefair value of the derivatives or warrant is lower at the subsequent balancesheet date, the Company will record non-operating, non-cash income.

 

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

 
| ** **                              | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Warrants                                |       | $          | 12,317     |       | $          | 64,520 |   |
|                                    |       |       |       |       |       |
| Redeemable  preferred stock derivatives |       | $          | 439        |       | $          | 41,295 |   |

 

The derivatives were valuedas of December 31, 2008 and 2007, using the Binomial Option Pricing Modelwith the following assumptions:

 
| ** **               | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| Dividend Yield           |       | 15                                     | %          | 15 | % |
| Annual  volatility       |       | 42                                     | %          | 54 | % |
| Risk-free  interest rate |       | 0.92                                   | %          | 3.3 | % |

 

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

 

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

 
| ** **                                                                                                                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                              | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                                                                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Cash  paid for:**                                                                                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest                                                                                                                                                |       | $                                           | 66,626     |   | $ | 370,090 |   |
| **Noncash  Financing Activities:**                                                                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Conversion of  convertible notes and related obligations, net of discount, and accrued  interest into common stock                                      |       | —                                      |       | 772,765 |   |
| Issuance of  common stock in exchange for Series A, Series B, and Series C  preferred stock and cumulative dividends in arrears, thereon |       | 826,739                                     |       | 1,120,230 |   |
|                                                                                                                                                         |            |                                             |            |  |  |  |  |

 

**NOTE U—PROFIT SHARING PLAN**

 

The Company hasestablished a savings plan under section 401(k) of the InternalRevenue Code. All employees of the Company, after completing one day of serviceare eligible to enroll in the 401(k) plan. Participating employees mayelect to defer a portion of their salary on a pre-tax basis up to the limits asprovided by the IRS Code. The Company is not required to match employeecontributions but may do so at its discretion. The Company made nocontributions during the two years ended December 31, 2008.

 

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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, 2008 and 2007, 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 and accretion was as follows for the following fiscalyears ended December 31:

 
| ** **                                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Numerator:**                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                            |       |       |       |       |       |
| Income/(loss)  from continuing operations                       |       | $          | 184,533    |       | $          | (5,569,335 | ) |
| Convertible  preferred stock dividends and accretion            |       | (1,890,503 | )          | (1,891,624 | )          |
| Loss applicable  to common stockholders (basic and diluted EPS) |       | $          | (1,705,970 | )          | $          | (7,460,959 | ) |

 

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,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                         |       |                                        |       |   |   |
| Preferred Stock              |       | 33,155,440                                  |       | 28,018,775 |   |
| Convertible Debt             |       | —                                      |       | 3,397,957 |   |
| Stock Options                |       | 35,747                                      |       | 10,058 |   |
| Warrants                     |       | —                                      |       | — |   |
|                         |       |                                        |       |   |   |
| Potentially  dilutive shares |       | 33,191,187                                  |       | 31,426,790 |   |

 

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

 
| ** **    | ** ** | **Years ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Stock options |       | 6,480,669                                   |       | 7,012,415 |   |
| Warrants      |       | 10,566,375                                  |       | 10,566,375 |   |
|          |       |                                        |       |   |   |
| Total         |       | 17,047,044                                  |       | 17,578,790 |   |

 

**NOTE W—RECLASSIFICATIONS**

 

Certain amounts in the2007 financial statements have been reclassified to conform to the 2008presentation. These reclassifications had no effect on the previously reportednet loss or stockholders’ equity (deficit).

 

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**NOTE X—EVENTS OCCURRING SUBSEQUENT TODECEMBER 31, 2007**

 

*Redemption of Convertible Preferred Stock*

 

As described in Note O tothese financial statements, the Company’s Series A Convertible PreferredStock, Series B Convertible Preferred Stock and Series C ConvertiblePreferred Stock (collectively, the “Preferred Stock”) contains certainmandatory redemption features.  Thesefeatures were triggered in January 2009 due to the passing of theapplicable mandatory redemption dates and the price of the Company’s commonstock, as reported by the OTC Bulletin Board, trading below the applicablethresholds contained in the terms of the Preferred Stock.  Absent a waiver from the holders of thePreferred Stock, the Company would therefore be required to redeem itsoutstanding shares of Preferred Stock, to the extent that the Company islegally permitted to do so, by paying cash to the holders of such shares inaccordance with the terms of such Preferred Stock.  To date, the Company has received waiversfrom the holders of 64% of the outstanding preferred shares, representing 89%of the outstanding preferred shares other than the shares held by Longview SpecialFinance, Inc. and Longview Fund, L.P.

 

On February 2, 2009,Longview Special Finance, Inc. and Longview Fund, L.P. (the “Plaintiffs”)filed a complaint against the Company in the United States District Court forthe Southern District of New York entitled Longview Special Finance, Inc.and Longview Fund, L.P. v. BIO-key International, Inc., in which thePlaintiffs are seeking $2,915,950 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 the outstanding shares of Series BConvertible Preferred Stock and Series C Convertible Preferred Stock heldby the Plaintiffs.  The Company believesthat it has meritorious defenses and it intends to defend against these claimsvigorously.

 

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**NOTEY—Results by Quarter (Unaudited)**

 

The following tablepresents selected unaudited financial information for the eight quarters in theperiod ended December 31, 2008. 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,  2007**                  | ** ** | **June 30,  2007** | ** ** | **September 30,  2007** | ** ** | **December 31,  2007** | ** ** | **March 31,  2008** | ** ** | **June 30,  2008** | ** ** | **September 30,  2008** | ** ** | **December 31,  2008** | ** ** |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       | $                                         | 2,715,240  |   | $ | 2,462,859 |   | $ | 2,168,091 |   | $ | 2,642,266 |   | $ | 2,540,418 |   | $ | 3,579,953 |   | $ | 2,882,731 |   | $ | 3,872,845 |   |
| Gross profit                                        |       | 2,236,441                                 |       | 1,999,587 |   | 1,706,480 |   | 2,261,172 |   | 2,098,937 |   | 3,158,775 |   | 2,475,488 |   | 3,407,706 |   |
| Income (loss)  from continuing operations           |       | (1,386,864                                | )          | (2,373,202 | ) | (1,190,615 | ) | (618,654 | ) | (915,670 | ) | 233,710 |   | (44,968 | ) | 911,461 |   |
| Income (loss)  from discontinued operations         |       | 474,490                                   |       | (34,385 | ) | — |   | — |   | — |   | — |   | — |   | — |   |
| Gain (loss) on  disposal of discontinued operations |       | —                                    |       | 4,070,859 |   | 1,147 |   | — |   | — |   | (65,454 | ) | — |   | 100 |   |
| Net income (loss)                                   |       | $                                         | (912,374   | ) | $ | 1,663,272 |   | $ | (1,189,468 | ) | $ | (618,654 | ) | $ | (915,670 | ) | $ | 168,256 |   | $ | (44,968 | ) | $ | 911,561 |   |
| Basic and diluted  earnings per common share:       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss from  continuing operations                    |       | $                                         | (0.03      | ) | $ | (0.05 | ) | $ | (0.03 | ) | $ | (0.02 | ) | $ | (0.02 | ) | $ | 0.00 |   | $ | (0.01 | ) | $ | 0.01 |   |
| Income (loss)  from discontinued operations         |       | 0.01                                      |       | 0.00 |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Gain on disposal  of discontinued operations        |       | —                                    |       | 0.07 |   | 0.00 |   | — |   | — |   | (0.00 | ) | — |   | 0.00 |   |
| Net loss                                            |       | $                                         | (0.02      | ) | $ | 0.02 |   | $ | (0.03 | ) | $ | (0.02 | ) | $ | (0.02 | ) | $ | 0.00 |   | $ | (0.01 | ) | $ | 0.01 |   |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding:               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic and diluted                                   |       | 56,634,523                                |       | 58,067,198 |   | 59,413,729 |   | 60,604,914 |   | 61,786,732 |   | 63,180,281 |   | 64,913,843 |   | 66,720,602 |   |

 

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                           | BIO-KEY INTERNATIONAL, INC. |
|---------------------------|----------------------------------|
|                      |                             |   |
| Date: March 11, 2009 | By:                              | /s/  MICHAEL W. DEPASQUALE |
|                      |                             | Michael W. DePasquale |
|                      |                             | CHIEF EXECUTIVE OFFICER |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the Registrant and in the capacities on thedates indicated.

 

| **Signature**                         | ** ** | **Title**                                              | ** ** | **Date**             |
|---------------------------------------|------------|--------------------------------------------------------|------------|----------------------|
|                                  |       |                                                   |       |                 |
| /s/  MICHAEL  W. DEPASQUALE |       | Chief Executive Officer and Director                   |       | March 11,  2009 |
| Michael W.  DePasquale                |       |                                                   |       |                 |
|                                  |       |                                                   |       |                 |
| /s/  THOMAS  J. COLATOSTI   |       | Chairman of the Board of Directors                     |       | March 11,  2009 |
| Thomas J.  Colatosti                  |       | Chief Financial Officer, Principal Accounting  Officer |       |                 |
|                                  |       |                                                   |       |                 |
| /s/  JEFFREY  J. MAY        |       | Director                                               |       | March 11,  2009 |
| Jeffrey J. May                        |       |                                                   |       |                 |
|                                  |       |                                                   |       |                 |
| /s/  CHARLES  P. ROMEO      |       | Director                                               |       | March 11,  2009 |
| Charles P. Romeo                      |       |                                                   |       |                 |
|                                  |       |                                                   |       |                 |
| /s/  JOHN  SCHOENHERR       |       | Director                                               |       | March 11,  2009 |
| John Schoenherr                       |       |                                                   |       |                 |

 

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**EXHIBIT INDEX**

 
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)           |       | Agreement and Plan of Merger dated as of  March 30, 2004 by and among BIO-key International, Inc., BIO-key  Acquisition Corp., Public Safety Group, Inc. (“PSG”) and each of the  shareholders of PSG               |
| 2.2(2)           |       | Asset Purchase Agreement dated as of August 16,  2004 by and among BIO-key International, Inc., Aether  Systems, Inc., Cerulean Technologies, Inc. and SunPro, Inc.                                                 |
| 2.3(3)           |       | Agreement and Plan of Merger dated as of  December 30, 2004 by and among BIO-key International, Inc., a  Delaware corporation, and BIO-key International, Inc., a Minnesota  corporation                                      |
| 3.1(3)           |       | Certificate of Incorporation of BIO-key  International, Inc., a Delaware corporation                                                                                                                                                    |
| 3.2(3)           |       | Certificate of Designation of Series A 7%  Convertible Preferred Stock of BIO-key International, Inc., a Delaware  corporation                                                                                                     |
| 3.3(3)           |       | By-Laws of BIO-key International, Inc., a  Delaware corporation                                                                                                                                                                         |
| 3.4 (19)         |       | Certificate of Amendment of Certificate of  Incorporation of BIO-key International, Inc., a Delaware corporation                                                                                                                        |
| 3.5 (16)         |       | Certificate of Designation of the Series B  Convertible Preferred Stock of the Company                                                                                                                                                  |
| 3.6 (21)         |       | Certificate of Designation of the Series C  Convertible Preferred Stock of the Company                                                                                                                                                  |
| 4.1(4)           |       | Specimen certificates for shares of BIO-key  International, Inc. common stock                                                                                                                                                           |
| 10.1(4)          |       | SAC Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                                                           |
| 10.2(5)          |       | Amendment No. 1 to the SAC  Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                              |
| 10.3(5)          |       | SAC Technologies, Inc. 1999 Stock Option Plan                                                                                                                                                                                           |
| 10.4(6)          |       | Warrant issued to The Shaar Fund Ltd.                                                                                                                                                                                                        |
| 10.5(6)          |       | Security Interest Provisions                                                                                                                                                                                                                 |
| 10.6(6)          |       | Employment Agreement by and between BIO-key  International, Inc. and Mira LaCous dated November 20, 2001                                                                                                                           |
| 10.7(9)          |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.8(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                                                                        |
| 10.9(9)          |       | Option to Purchase 580,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.10(7)         |       | Securities Exchange Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.11(7)         |       | Registration Rights Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.12(7)         |       | Option to Purchase 500,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.13(7)         |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.14(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                              |
| 10.15(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Jeff May                                                                                                                                                                         |
| 10.16(10)        |       | Amendment Agreement dated March 30, 2004 by and  between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                                       |
| 10.17(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                           |
| 10.18(11)        |       | Form of Warrant issued by BIO-key  International, Inc. pursuant to the March Securities Purchase  Agreement                                                                                                                   |
| 10.19(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 |
| 10.20(2)         |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                 |
| 10.21(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                                                         |
| 10.22(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      |
| 10.23(2)         |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Shaar Securities Purchase  Agreement                                                                                                  |
| 10.24(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                                                             |
| 10.25(10)        |       | Option to Purchase 300,000 shares of common stock  issued to Kenneth Souza                                                                                                                                                                   |
| 10.26(10)        |       | Employment Agreement dated as of October 4,  2004 by and between BIO-key International, Inc. and Kenneth Souza                                                                                                                     |

 

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| 10.27(10) |   | BIO-key International, Inc. 2004 Stock  Incentive Plan                                                                                                                                                                                                                                            |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28(10) |   | Warrant to purchase 100,000 shares of Common Stock  issued to The November Group Ltd. on July 14, 2004                                                                                                                                                                                       |
| 10.29(10) |   | Warrant to purchase 230,000 shares of Common Stock  issued to Jesup & Lamont Securities Corp. on March 31, 2004                                                                                                                                                                          |
| 10.30(10) |   | Warrant to purchase 105,000 shares of Common Stock  issued to Douglass Bermingham on March 31, 2004                                                                                                                                                                                               |
| 10.31(10) |   | Warrant to purchase 60,000 shares of Common Stock  issued to Mason Sexton on March 31, 2004                                                                                                                                                                                                       |
| 10.32(10) |   | Warrant to purchase 22,000 shares of Common Stock  issued to David Moss on March 31, 2004                                                                                                                                                                                                         |
| 10.33(10) |   | Warrant to purchase 22,000 shares of Common Stock  issued to Patrick Gaynes on March 31, 2004                                                                                                                                                                                                     |
| 10.34(10) |   | Warrant to purchase 5,000 shares of Common Stock  issued to Tom DuHamel on March 31, 2004                                                                                                                                                                                                         |
| 10.35(11) |   | Option to Purchase 155,000 shares of common stock  issued to Francis J Cusick                                                                                                                                                                                                                          |
| 10.36(11) |   | Option to Purchase 50,000 shares of common stock  issued to Charles P. Romeo                                                                                                                                                                                                                           |
| 10.37(12) |   | Securities Purchase Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.38(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.                                                                                                                       |
| 10.39(12) |   | Registration Rights Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.40(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                                                                                                                                     |
| 10.41(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                                                                |
| 10.42(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                                                                                                          |
| 10.43(20) |   | Escrow Agreement, dated as of May 31, 2005, by  and among the Company, Jesup & Lamont Securities Corp.                                                                                                                                                                                   |
|      |   | and Thelen, Reid & Priest LLP.                                                                                                                                                                                                                                                                |
| 10.44(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                       |
| 10.45(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Shaar Fund, Ltd.                                                                                                                                                                                           |
| 10.46(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Longview Special Finance                                                                                                                                                                                       |
| 10.47(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Etienne Des Roys                                                                                                                                                                                               |
| 10.48(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Eric Haber                                                                                                                                                                                                     |
| 10.49(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Investors Management Corporation                                                                                                                                                                               |
| 10.50(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Fund                                                                                                                                                                                           |
| 10.51(13) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Amerique Value Fund                                                                                                                                                                            |
| 10.52(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. |
| 10.53(14) |   | Amendment and Waiver, dated as of January 23,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.54(14) |   | Registration Rights Agreement, dated as of  January 23, 2006, by and between the Company and Laurus Master Fund,  Ltd.                                                                                                                                                                            |
| 10.55(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                                                                                                                                        |
| 10.56(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                                                                                                                                    |
| 10.57(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                                                                         |
| 10.58(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                                                                 |
| 10.59(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                                                                                                                                    |

 

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| 10.60(14)  |   | Amendment No. 1 to Subordinated Secured  Promissory Note, dated as of January 23, 2006, by and between the  Company and Aether Systems, Inc.                                                                                                |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.61(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                                                                          |
| 10.62(18)  |   | Amendment and Waiver, dated as of August 10,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                           |
| 10.63(18)  |   | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                  |
| 10.64(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 |
| 10.65(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 |
| 10.66(18)  |   | Securities Purchase Agreement, dated as of  August 10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.67(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.                                                                 |
| 10.68(18)  |   | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.69(18)  |   | Securities Purchase Agreement, dated as of  August 10, 2006, by and between the Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.70(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.                                                              |
| 10.71(18)  |   | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.72 (19) |   | Amendment and Waiver, dated as of December 29,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                         |
| 10.73 (20) |   | Amendment and Waiver, dated as of April 18,  2007, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                            |
| 10.74 (21) |   | Purchase and Sale Agreement, dated as of  May 22, 2007, by and between the Company and ZOLL Data Systems, Inc                                                                                                                                         |
| 10.75 (22) |   | Compensation Agreement, dated July 12, 2007, by  and between the Company and Mr. Colatosti                                                                                                                                                       |
| 10.76 (8)  |   | Options to Purchase 50,000 and 65,241 Shares of  Common Stock issued to Thomas J. Colatosti                                                                                                                                                                |
| 10.77 (8)  |   | Options to Purchase 100,000 and 130,481 Shares of  Common Stock issued to Jeff May                                                                                                                                                                         |
| 10.78 (8)  |   | Options to Purchase 50,000 and 32,620 Shares of  Common Stock issued to Charles Romeo                                                                                                                                                                      |
| 10.79 (8)  |   | Options to Purchase 50,000 and 48,930 Shares of  Common Stock issued to John Schoenherr                                                                                                                                                                    |
| 10.80 (23) |   | Employment Agreement, effective as of May 25,  2008, by and between the Company and Michael W. DePasquale.                                                                                                                                            |
| 10.81 (24) |   | Settlement and Mutual  Release Agreement, dated July 28, 2008, by and between the Company and  Dataradio Corporation.                                                                                                                                 |
| 10.82 (24) |   | Office Lease Agreement,  dated July 28, 2008, by and between the Company and Normandy Nickerson  Road, LLC                                                                                                                                            |
| 10.83 (25) |   | Compensation  Agreement, dated as of November 17, 2008, by and between the Company and  Thomas J. Colatosti                                                                                                                                           |
| 10.84 (8)  |   | Option to  Purchase 500,000 Shares of Common Stock issued to Michael W. DePasquale                                                                                                                                                                         |
| 10.85 (8)  |   | Option to  Purchase 50,000 Shares of Common Stock issued to Thomas J. Colatosti                                                                                                                                                                            |
| 10.86 (8)  |   | Options to  Purchase 50,000 and 25,000 Shares of Common Stock issued to Jeff May                                                                                                                                                                           |
| 10.87 (8)  |   | Option to  Purchase 50,000 Shares of Common Stock issued to Charles Romeo                                                                                                                                                                                  |
| 10.88 (8)  |   | Option to  Purchase 100,000 Shares of Common Stock issued to John Schoenherr                                                                                                                                                                               |
| 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                                                                                                                                              |
| 32.2 (8)   |   | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                               |

 

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| (1)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  April 14, 2004 and incorporated herein by reference.    |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                  |
| (2)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  October 5, 2004 and incorporated herein by reference.   |
|   |                                                                                                                                                                                                  |
| (3)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  January 5, 2005 and incorporated herein by reference.   |
|   |                                                                                                                                                                                                  |
| (4)    | Filed as an exhibit to the registrant’s  registration statement on Form SB-2, File No. 333-16451 dated  February 14, 1997 and incorporated herein by reference.              |
|   |                                                                                                                                                                                                  |
| (5)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on April 14, 2000 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (6)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  November 26, 2001 and incorporated herein by reference. |
|   |                                                                                                                                                                                                  |
| (7)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 26, 2004 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (8)    | Filed herewith.                                                                                                                                                                                       |
|   |                                                                                                                                                                                                  |
| (9)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 31, 2003 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (10)   | Filed as an exhibit to the registrant’s  registration statement on Form SB-2, File No. 333-120104 dated  October 29, 2004 and incorporated herein by reference.              |
|   |                                                                                                                                                                                                  |
| (11)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  March 4, 2005 and incorporated herein by reference.     |
|   |                                                                                                                                                                                                  |
| (12)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  June 14, 2005 and incorporated herein by reference.\    |
|   |                                                                                                                                                                                                  |
| (13)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  September 7, 2005 and incorporated herein by reference. |
|   |                                                                                                                                                                                                  |
| (14)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  January 25, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (15)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  February 9, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (16)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  March 29, 2006 and incorporated herein by reference.    |
|   |                                                                                                                                                                                                  |
| (17)   | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 29, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (18)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  August 16, 2006 and incorporated herein by reference.   |
|   |                                                                                                                                                                                                  |
| (19)   | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission                                                                |

 

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|        | on March 30, 2007 and incorporated herein by  reference.                                                                                                                                            |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                     |
| (20)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  April 24, 2007 and incorporated herein by reference.       |
|   |                                                                                                                                                                                                     |
| (21)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  May 25, 2007 and incorporated herein by reference.         |
|   |                                                                                                                                                                                                     |
| (22)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  July 18, 2007 and incorporated herein by reference.        |
|   |                                                                                                                                                                                                     |
| (23)   | Filed as an exhibit to the registrant’s current  report 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  quarterly report 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 current  report on Form 8-K filed with the Securities and Exchange Commission on  November 20, 2008 and incorporated herein by reference.    |
|   |                                                                                                                                                                                                     |
| (26)   | Previously filed                                                                                                                                                                                         |

 

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