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

**WASHINGTON,D.C. 20549**

**FORM 10-KSB**

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

**Forthe Fiscal Year Ended December 31, 2006**

**Commission File Number 1-13463**

**BIO-KEYINTERNATIONAL, INC.**

(Name of small businessissuer in its charter)

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

 

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

(Address of PrincipalExecutive Offices) (Zip Code)

**(732) 359-1100**

Issuer’s telephonenumber, including area code.

Securities registeredpursuant to Section 12(b) of the Act:
| Title of Each Class                        | ** ** | **Name of Exchange on which Registered** |
|--------------------------------------------|------------|------------------------------------------|
| Common Stock,  $0.0001 par value per share |       | None                                     |

 

Securities registered under Section 12(g) ofthe Exchange Act

**None**

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

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

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

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

Yes o   No x

State issuer’s revenues for its most recent fiscalyear: **$15,193,625**

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant based on theclosing sale price of the registrant’ common stock as reported on the OTC BulletinBoard on March 1, 2007 was $11,494,305. The information provided shall inno way be construed as an admission that any person whose holdings are excludedfrom the figure is an affiliate or that any person whose holdings are includedin the figure is not an affiliate, and any such admission is hereby disclaimed.The information provided is solely for the record keeping purposes of theSecurities and Exchange Commission.

As of March 1, 2007, 56,591,104 shares of theregistrant’s common stock were outstanding.

Transitional Small Business Disclosure Formats (checkone):

Yes o   No x

 

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**EXPLANATORY NOTE**

**Restatementof Consolidated Financial Statements**

As previously reported inour Annual Report on Form 10-KSB/A filed with the Securities and ExchangeCommission on June 19, 2006, we have restated our previously reported financialinformation for the years ended December 31, 2003, 2004 and 2005 and ourpreviously reported unaudited financial statements for the first, second andthird quarters of 2003, 2004 and 2005 (the “restatement”).

Our Annual Reports onForm 10-KSB for the years ended 2003 and 2004 and our Quarterly Reports on Form10-QSB for fiscal 2003 through the third quarter of fiscal 2005 have not been revisedto reflect the restatement and the financial statements contained in thosereports should not be relied upon. The restated financial statements for yearsended December 31, 2003, 2004 and 2005 included in our Annual Report onForm 10-KSB/A for the fiscal year ended December 31, 2005 should be reliedupon.

**DOCUMENTSINCORPORATED BY REFERENCE**

None.

**TABLE OF CONTENTS**
|         |   | PART I                                                                                                                 |   |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------|--------|
|    |   |                                                                                                                        |   |
| Item 1. |   | Description of Business                                                                                                     | 1      |
| Item 2  |   | Description of Property                                                                                                     | 20     |
| Item 3  |   | Legal Proceedings                                                                                                           | 21     |
| Item 4  |   | Submission  of Matters to a Vote of Security Holders                                                                        | 21     |
|    |   |                                                                                                                        |   |
|    |   | PART II                                                                                                                |   |
|    |   |                                                                                                                        |   |
| Item 5  |   | Market for  Common Equity and Related Stockholder Matters                                                                   | 22     |
| Item 6  |   | Management’s  Discussion and Analysis or Plan of Operation                                                             | 26     |
| Item 7  |   | Financial Statements                                                                                                        | 44     |
| Item 8  |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                       | 45     |
| Item 8A |   | Controls and  Procedures                                                                                                    | 46     |
| Item 8B |   | Other Information                                                                                                           | 51     |
|    |   |                                                                                                                        |   |
|    |   | PART III                                                                                                               |   |
|    |   |                                                                                                                        |   |
| Item 9  |   | Directors,  Executive Officers, Promoters and Control Persons; Compliance with  Section 16(a) of the Exchange Act | 52     |
| Item 10 |   | Executive  Compensation                                                                                                     | 57     |
| Item 11 |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                            | 62     |
| Item 12 |   | Certain  Relationships and Related Transactions                                                                             | 65     |
| Item 13 |   | Exhibits                                                                                                                    | 65     |
| Item 14 |   | Principal  Accountant Fees and Services                                                                                     | 66     |
|    |   | Signatures                                                                                                                  | 114    |

 

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**PRIVATE SECURITIES LITIGATION REFORM ACT**

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

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**PART I**

**ITEM1.**                    DESCRIPTIONOF BUSINESS

BIO-keyInternational, Inc., a Delaware corporation (the “Company,” “BIO-key,” “we,”or “us), was founded in 1993 to develop and market proprietary biometrictechnology and software solutions. Biometric technology is the science ofanalyzing specific human characteristics which are unique to each individual inorder to identify a specific person from a broader population. First incorporated as BBG Engineering, thecompany became SAC Technologies in 1994. The BIO-key name was introduced in 2002.

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

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

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

Pursuant to theMerger Agreement, at the effective time of the Reincorporation: (i) eachoutstanding share of Common Stock of Old BIO-key, $0.01 par value per share,was automatically converted into one share of Common Stock, $0.0001 par valueper share, of the Company; (ii) each outstanding share of Series C 7%Convertible Preferred Stock of Old BIO-key, $0.01 par value per share, was automaticallyconverted into one share of Series A 7% Convertible Preferred Stock,$0.0001 par value per share, of the Company, with such Series A 7%Convertible Preferred Stock containing substantially identical terms andconditions as the Series C 7% Convertible Preferred Stock of Old BIO-key;(iii) each option to purchase shares of Old BIO-key’s Common Stock grantedby Old BIO-key under any warrant, stock option plan or similar plan of OldBIO-key outstanding immediately before the Reincorporation was, by virtue ofthe Merger Agreement and without any action on the part of the holderthereof, converted into and become an option to purchase, upon the same termsand conditions, the same number of shares of the Company’s Common Stock at anexercise price per share equal to the exercise price per share thereunderimmediately before the Reincorporation; and (iv) each warrant, option orstock option plan of Old BIO-key was assumed by, and continues to be, awarrant, option or plan of the Company. Accordingly, as a result of theReincorporation, the shareholders of Old BIO-key became shareholders of theCompany, and Old BIO-key has been merged out of existence by operation of law.Each certificate representing shares of capital stock of Old BIO-keyoutstanding immediately before the Reincorporation, is deemed from and afterthe Reincorporation for all corporate purposes to represent the same number ofshares of capital stock of the Company.

As a result ofthese mergers, and as discussed in Note M to the Consolidated FinancialStatements included in this report, we have organized the Company into threereporting segments:  Law Enforcement,Fire Safety and Biometrics. During 2006, the Company continued to integrate theproducts, operations and technologies acquired from Public SafetyGroup, Inc. and Aether Systems, Inc.

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**Markets**

***Finger-based BiometricIdentification***

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

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

Forexample, BIO-key has implemented programs that will enable biometric logicaland physical access. These include IdentiPHI to provide strong network basedauthentication on BIO-key technology; and with the Pegasus Program to authenticateusers accessing a nationwide information-sharing system designed by andfor the nation’s sheriffs. These represent the kind of partnership-basedopportunities BIO-key may see in the finger-based biometric market.

Inparallel, BIO-key is both strengthening security and improving user and systemadministrator convenience by integrating biometric log-in, as well astwo-factor authentication, with its law enforcement and fire safety products.This is 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.

***Law Enforcement***

BIO-key’s InfoServer, MobileCop and PocketCop lawenforcement products are a leading wireless mobile data communicationsclient/server solution, implemented in more than 700 agencies in 43 states.Providing immediate access to mission-critical data and enabling in-fieldreporting, BIO-key software keeps officers on the street, improving theirproductivity and enhancing officer safety. BIO-key solutions are able to runacross any and all wireless infrastructures and integrate with virtually allcomputer-aided dispatch (CAD) and records management systems. This makes us aleader in multi-agency cooperation and interoperability, which are absolutelycritical in times of large-scale natural and terrorist threats.

·                  *Growth potential*—BIO-key’s large base of more than 700 lawenforcement agencies continues to be a strength that helps leverage additionalsales from both existing customers and new customers. The 2005 Gartner studyentitled “Forecast: State and Local Government, North America 2005-2008”projects that the Law Enforcement Mobile Data market (hardware and software)will grow at 15% AAGR to $299 million in 2008.

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

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·                  BIO-key’s LE products, which can run on anyand all wireless infrastructures. BIO-key also has had success implementingseamless roaming across multiple infrastructures for multi-agency consortiums.

·                  BIO-key’s open architecture.

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

These capabilities position BIO-key well to work with leading CADvendors, even with vendors that have mobile data solutions but do not have thedepth of interoperability capability that BIO-key offers.

An additional growth area is the introduction of BIO-key’s finger-basedbiometric identification to law enforcement. In addition to now offeringbiometric login to our traditional InfoServer product,we have introduced the ID-Enginefingerprint identification solution, which lets law enforcementpersonnel capture fingerprints in the field. Using BIO-key’s patented VectorSegment Technology, ID-Engine analyzes and categorizes fingerprints the sameway a fingerprint expert would—only faster. ID-Engine also enables multiple lawenforcement agencies to share fingerprint data with other agencies. Thispowerful tool, built on BIO-key’s understanding of law enforcement requirementsand its fingerprint technology, presents opportunities for the law enforcementbusiness segment in the coming year.The 2005 Gartner study entitled “Forecast: State and Local Government, NorthAmerica 2005-2008” projects that the Law Enforcement Biometrics marketwill grow at 15% AAGR to $190 million in 2008.

***Fire Service***

According the United States Fire Administration thenumber of fire calls has decreased over the past  year while the number of medical calls hasincreased. Medical aid calls have nearly tripled since 1980 and there were984,000 Mutual Aid calls in 2004.

In a 2002 study entitled, “A Needs Assessment of theU.S Fire Service,” conducted by the Federal Emergency Management Agency (“FEMA”)and the National Fire Protection Association (“NFPA”), it was reported thatonly three-fifths to four-fifths of fire departments (64% to 77%, by size ofcommunity protected) report they are able to communicate at incident sceneswith their Federal, state, and local partners. Of these, though, only one-thirdreport they are able to communicate with all their partners. This means onlyabout one-fourth of departments overall can communicate with all partners,which results in a serious communication gap in the event of a large scaleincident.

·                  *Growth potential*—BIO-key’s suite of fire/EMS productsare positioned to follow the trends of the fire/EMS service. FireRMSTM meetsHIPAA requirements and with the recent certification of compliance to NEMSIS,fire departments performing EMS functions can manage and report incidents securelyand easily while meeting national standards.

·                  With FireRMSMobileTM allowing EMS workers to collect critical patient data and relay thedata to medical personnel. FireRMS MobileTM also supports the 34% of firedepartments performing inspections. This new mobile approach to fire and EMSdata collection and access offers great potential among both new and existingFireRMSTM customers.

·                  In addition —BIO-key’s Fire/EMS products were designed to easily interface with mostthird-party applications to facilitate the exchange of information. FireRMS,FireRMS Mobile and MobileRescueTM complemented with strategic partner solutionsimprove interoperability at an incident.

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**Products**

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

***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-keyachieves the highest levels of discrimination without requiring any otheridentifying 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 keydifferentiators for BIO-key in the biometric market.  BIO-key has full support for industrystandards and recently received NIST certification on its ability to supportHSPD-12 supported INCITTS-378 templates. Extending our products to support standards enables BIO-key to participatein large government projects like Transportation Workers IdentificationCard(TWIC), Registered Traveler projects, PIV initiatives, and FIXS consortiumsolutions. We believe our fingerprint identification technology has a broadrange of information security and access control applications, including:

·                  SecuringInternet sites and electronic transactions

·                  Securing accessto logical networks and applications

·                  Securing accessto buildings and restricted areas

·                  Providing fast,accurate member identification services

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

·                  Preventingidentity theft through positive user identification and false alias validation

**BiometricProducts:**

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 and 

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also providing a single user interface for multiplefingerprint readers.

·                  **ID Director**TM —BIO-key’s solution forsingle sign 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 authentication schemefor companies looking to enhance authentication. ID Director can easily add alevel of security and convenience to the transaction level of any application.

***Law Enforcement***

·                  **MobileCop®**— A complete wireless query andmessaging application that puts the power of mobile and wireless technology towork for agencies of every size, MobileCop® sets the standard for mobile law enforcement. Providingreal-time retrieval of motor vehicle, warrant and criminal history information,powerful mobile integration capabilities, and an intuitive user interface,MobileCop delivers the most in performance and it’s easy to see why over 700law enforcement agencies around the country have deployed MobileCop for fastand secure access to critical information in the field.

·                  **PocketCop®**— PocketCop is a software solution that provides law enforcement personnelwith instantaneous access to criminal, civil, and local database information ina wireless environment. PocketCop is a handheld application that providesaccess to state and federal databases over the wireless network for WindowsMobile, and RIM OS devices. Using a portable wireless handheld device and thePocketCop application software, an authorized user can access suspectinformation such as wanted status, warrant status, vehicle registration anddriver license status. PocketCop technology has been deployed in numerouspolice agencies in the United States, including the Massachusetts State Police.

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

ID-Track — ensuresthe true identification, tracking and management of criminals once they enterthe criminal handling continuum. From pre-booking to parolee managementID-Track provides true suspect identification. In addition to validating truecriminal identity it archives data for a historical review of enrollments andinmate activity for report query (under development).

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

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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 can bewirelessly 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 sharing and other applications.

·                  **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.

**Partner applications include:**

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

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

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***Fire/EMS Services***

*BIO-keyoffers a suite of products designed for Fire/EMS departments of all sizes toefficiently and securely manage daily operations and critical information.BIO-key’s Fire/EMS Solutions include:*

·                  **FireRMSTM —** aNFIRS 5.0 and NEMSIS 2.2.1 compliant fire/EMS records management systemdesigned to streamline reporting, and dramatically reduce report completiontime for front-line personnel. This enterprise-class solution empowersdepartments to better manage operations, track incidents and effectivelysupport fire prevention initiatives.

·                 **FireRMS MobileTM —****** an extension to the robust FireRMSTMapplication used in the department allowing access to all the FireRMSTM moduleswhile you are in the field. FireRMSTM Mobile uses replication andsynchronization technology allowing you to use FireRMSTM Mobile on-site withoutthe need for a server connection. This mobile application offers real-timeupdates to critical information and eliminates duplication of data entry.

·                  **MobileRescueTM****—**A wireless query and messagingsolution that extends Computer Aided Dispatch (CAD), FireRMSTM and otherin-house data sources to a mobile environment, providing mission-criticalinformation to emergency response personnel. MobileRescue is available withfull incident command — to help manage personnel, resources and incidentlogistics management systems.

·                 **The Collector —** A regional data collection solution thatprovides an easy yet very powerful way to assemble data from a region or state.The Collector imports data from Bio-key’s FireRMSTM program and other NFIRS 5.0compliant software. Data can then be viewed or analyzed allowing users tocompare years, months or geographical areas for similar or dissimilar fireissues.

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

·                  **EMS Interfaces**— EMS interfaces provide amechanism to integrate patient care reports collected in the field. Patientdata is populated in the appropriate fields, eliminating redundant data entry.

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

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

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

·                  **Geographic Data Analysis**— FireViewTM fromthe Omega Group allows Fire and EMS agencies to analyze their deploymentstrategies. FireView integrates FireRMSTM with GIS allowing agencies to easilymap and analyze data. By identifying incident patterns and responseeffectiveness, resources can be more optimally redeployed.

·                  **Personnel Staffing**— TelestaffTM from PDSIautomates and manages complex Fire/EMS agency staffing needs and is integratedwith the FireRMSTM Personnel and Roster modules.

·                  **Incident Command**— AIMSonSceneTM byFieldSoft provides incident management, responder accountability, and tacticalsurvey or preplan browser software solutions. AIMSonScene interfaces withMobile Rescue to support incident management whilst en-route or on-scene.

·                 **Hazard Diagnostics —**Threatscreen by Real Interface istriggered  by  the field  PCR  (patient care report)  is anexposure-diagnostic/identification, data  collection,  and reporting tool used  by  First Responders to quickly assess victims todetermine chemical, biological, or nuclear agent exposure and providesimmediate access to response protocols.

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**CurrentBusiness Plan**

BIO-key’s currentbusiness plan is to:

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

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

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

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

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

**Competition**

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

*Biometrics*

In addition tocompanies that provide existing commonplace methods of restricting access tofacilities and logical access points such as pass cards, PIN numbers,passwords, locks and keys. There are numerous companies involved in thedevelopment, manufacturing and marketing of fingerprint biometrics products tocommercial, government, law enforcement and prison markets. These companiesinclude, but are not limited to, Cogent, NEC, L-1 Identity Solutions,Sagem-Morpho, and Bioscrypt.

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

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

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

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

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

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

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

*Law Enforcement*

The public safetymarket comprises agencies at all government levels, with a range of users, froma few to many hundreds. BIO-key competitors in the mobile data market includeComputer Aided Dispatch/Records Management companies such as 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-key suite ofproducts, they are sometimes less expensive when bundled with the CAD/RMSofferings. They also provide a complete solution from one vendor.

*FireServices*

The fire recordsmanagement market includes a large number of RMS vendors including Firehouse,FDM, 24x7 and ETI. These and other competing companies represent a wide rangeof organizations, from large integration companies, to small garage companies,and offer products similar in scope to BIO-key’s FireRMSTM. Thefunctionality and price of these products also encompass wide ranges offeatures and costs.

**Marketingand Distribution**

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

·                  During the 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’sFireRMSTM received certification of compliance from NEMSIS which will strengthenthe product’s  reputation with EMSagencies. Most EMS agencies will be required to use NEMSIS compliant software.

·                  BIO-key hasstrategic alliances with technology leaders including Oracle, Netegrity,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.

**Addressingthe Market**

Following are thespecific marketing/sales programs in place:

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

BIO-key’s direct salesforce also includes area sales directors for the OEM and Federal Governmentmarkets, each of whom brings not only extensive sales experience but alsoexpertise in emerging biometric technologies. The BIO-key sales force isrounded out by Inside Sales, which is responsible for maintaining andsupporting our existing install base, acting as a front-line support for anyinquiries on our product line, and facilitating activities that make the fieldteam more productive.

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

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

·                  BIO-key ispartnering with AT&T Wireless, the largest wireless carrier in the country,to first responders in a seven-county Tennessee consortium of fire, police andEMS agencies in access to mission critical information using BIO-key’sMobileCOP solution in conjunction with AT&T Wireless’s nationwide* EDGEwireless data network

·                  The Omega Groupcontinues to provide FireView software mapping tools that help review existingdeployment policies and develop new strategies, to complement BIO-key’s rangeof solutions for Fire/EMS agencies.

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

·                  Silex TechnologyAmerica, Inc., which develops fingerprint reader products designed tosupport a variety of secure computing options, utilizes BIO-key’s VST andWEB-key technology.

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

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

**Licensing**

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

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

·                  *Government*—Using BIO-key’s technology,Northup Grumman deployed an application within the Department of 

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Defense to cross-credential visitors and contractorsto certain military bases.

·                  *Education*—Educational Biometric Technologies,Lunch Byte Systems and Identimetrics have incorporated BIO-key technology toenable school children to pay for school lunch programs and checkout librarybooks using 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:*HBOC,one of the largest healthcare patient records and information managementcompanies, has integrated BIO-key technology into their portal and has deployedtheir solution in a pilot for the Baptist Hospital System.

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

**IntellectualProperty Rights**

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

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

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

On August 29 2006, BIO-key announced that the Company’s patent forbiometric identification indexing, a core feature of its VSTTM software, hasbeen granted in Europe. In addition, a WEB-key® authentication security patentfor “Systems and Methods of Secure Biometric Authentication” has been issued inSouth Africa. These patents enhance the worldwide protection of BIO-key’stechnology. The European patent for VST, which provides BIO-key with protectionof its intellectual property in Europe, was issued on March 29, 2006 and coversa similar set of claims for a patent BIO-key was granted in 2005 in the UnitedStates.  BIO-key expects the patent for Secure Biometric Authentication,issued in South Africa on April 26, 2006, to be issued in the United States inthe near future

On October 3, 2006, BIO-key announced that the Company’s patent for abiometric authentication security framework has been granted by the U.S. Patent& Trademark Office. The patent (No. 7,117,356) was issued to BIO-key for abiometric authentication security framework that enhances commercial and civilbiometric use.  BIO-key’s authentication security framework  protectsprivacy and security while also facilitates ease of use of biometricsystems.  The technology that this patent is based on is the foundationfor authentication security as incorporated in BIO-key’s WEB-key® productline.    WEB-key is a mature enterprise authentication solutionthat functions in a wide variety of application environments.  Thesolution supports a variety of implementation alternatives including cardtechnologies for ‘two-factor’ authentication and also supports  ‘single-factor’authentication.  Partners and customersimplementing BIO-key’s WEB-key software to provide convenient and secure useridentity include a number of institutions including the Allscripts HealthcareSolutions, American Association of Medical Colleges, Empresa deTelecomunicaciones de Bogotá (Columbia) and Iomedex Corporation.

On January 11, 2007, BIO-key announced that the U.S.Patent & Trademark Office has issued US patent No. 7,155,040 coveringBIO-key’s unique image processing technology, which is critical for enhancinginformation used in the extraction of biometric minutiae. The issued patentprotects a critical part of an innovative four-phase image enhancement processdeveloped by BIO-key, and represents the third U.S. patent granted to thecompany for its biometric technology.

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Additionally, we have a number of U.S. and foreignpatent applications in process related to this intellectual 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 “Ceurulean”,with the U.S. Patent & Trademark Office. We have also applied fortrademarks for “Cerulean”.

·                  *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.

**Researchand Development**

Our research anddevelopment efforts are concentrated on enhancing the functionality, reliabilityand integration of our current products as well as developing new andinnovative products for the biometrics, law enforcement and fire markets.Although BIO-key believes that its identification technology is one of the mostadvanced and discriminating fingerprint technologies available today, themarkets in which BIO-key compete are characterized by rapid technologicalchange and evolving standards. In order to maintain its position in the market,BIO-key will continue to upgrade and refine its existing technologies. In 2006,BIO-key announced the launch of ID-Engine, our fingerprint identificationsystem. ID-Engine offers a tool for agencies to store and search fingerprintsand the associated demographic data, the ability to compare new prints withthose previously captured as a low-cost AFIS alternative or to be used for awide variety of routine identification transactions not supported by AFIS.ID-EngineTM is currently being tested by a number of customers.

On November 27,2006, BIO-key announced that it has been awarded the Gold Level ComplianceCertification for its FireRMS software application by the National EmergencyMedical Services Information System (NEMSIS). The certification process was developed to help states collect morestandardized elements and eventually submit the data to a national EMSdatabase.  Gold Level Compliance ensures that BIO-key FireRMS softwareconforms to the NEMSIS national EMS dataset. The NHTSA Version 2.2.1 dataelements required for compliance include over 400 data elements which are vitalcomponents needed for the documentation and description of EMS systems andpatient care.

During the fiscalyears ended December 31, 2006 and 2005, BIO-key spent approximately$6,514,000 and $6,846,000 respectively, on research, development andengineering. BIO-key’s limited customer base during that time did not directlybear these costs, which were principally funded through outside sources ofequity and debt financing.

**GovernmentRegulations**

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

**EnvironmentalRegulations**

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

**Employeesand Consultants**

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

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**RISK FACTORS**

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

**Business and Financial Risks**

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

Due to, amongother factors, our history of losses (excluding gains from valuation changes inembedded derivatives) and limited revenue, our independent auditors haveincluded an explanatory paragraph in their opinion for the year endedDecember 31, 2006 as to the substantial doubt about our ability tocontinue as a going concern. Our financial statements have been prepared inaccordance with accounting principals generally accepted in the United States,which contemplate that we will continue to operate as a going concern. Ourfinancial statements do not contain any adjustments that might result if we areunable to continue as a going concern.

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

As ofDecember 31, 2006, we had negative working capital of approximately $8,648,000and an accumulated deficit of approximately $53,843,000. Since our inception,we have focused almost exclusively on developing our core technologies and,until the fourth quarter of 2004 had not generated any significant revenue. Inorder to increase revenue, we have developed a direct sales force andanticipate the need to retain additional sales, marketing and technical supportpersonnel and may need to incur substantial expenses. We cannot assure youthat we will be able to secure these necessary resources, that a significantmarket for our technologies will develop or that we will be able to achieve ourtargeted revenue.

**Wehave previously identified material weaknesses in our internal control overfinancial reporting and have historically failed to maintain an effectivesystem of disclosure controls and procedures. If we are unable to maintain aneffective system of disclosure controls and procedures, we may not be ableto accurately report our financial results or prevent fraud. As a result,current and potential stockholders could lose confidence in our financialreporting; this would harm our business and the trading price of our commonstock.**

During the reviewof the Company’s operating results for the year and quarter ended December 31,2006, our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”)determined that, as of that date, our disclosure controls and procedures wereeffective in providing reasonable assurance that information we are required todisclose in reports we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified by theSecurities and Exchange Commission rules and forms.  Our management reached this conclusion afteridentifying our system to capture disclosure items, our internal process ofreview for account reconciliations, our documentation of internal controls andour internal process for preparing our annual report on Form 10-KSB forthe fiscal year ended December 31, 2006 as being adequate to provide suchassurance.

As previouslydisclosed, reviews of our March 31, 2005, June 30, 2005,September 30, 2005, March 31, 2006, June 30, 2006 andSeptember 30, 2006 quarterly operating results, as well as our 2005 annualoperating results, by our CEO and CFO determined that, as of each such date,our disclosure controls and procedures were not effective to provide reasonableassurance that information we are required to disclose in reports we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified by the Securities and Exchange Commissionrules and forms.

In order to ensure that the Company adequately addressed all previousinternal control issues, the Company initiated follow-up discussions with itsformer auditors to better determine what constituted these material weaknesses.During these discussions, the former auditors and the Company identified thefollowing material weaknesses in the Company’s internal controls: an inadequatesystem to capture disclosure items, an inadequate internal process of reviewfor account reconciliations, an inadequate documentation of internal controlsand an inadequate internal process around drafting of periodic filings with theSecurities and Exchange Commission.

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Effective internalcontrol over financial reporting and disclosure controls and procedures arenecessary for us to provide reliable financial reports and effectively preventfraud and to operate successfully as a public company. We have in the pastdiscovered, as described above, and may in the future discover, areas of ourdisclosure and internal controls that need improvement. As of December 31,2006, we believe we have addressed these issues, ensuring that our internalcontrol over financial reporting and disclosure controls and procedures haveimproved sufficiently for us provide reasonable assurance that the informationwe are required to disclose in reports that we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission rules and forms.If, however, we cannot provide reliable financial reports or prevent fraud, ourreputation and operating results would be harmed.

We cannot becertain that our efforts to remediate previous material weaknesses in our internalcontrol over financial reporting and the ineffectiveness of our disclosurecontrols and procedures will continue to be successful or that we will be ableto maintain adequate controls over our financial processes and reporting in thefuture. We have committed substantial resources, including substantial timefrom our management team’s accounting personnel and from external consultants,to implement and integrate into our organization improved disclosure controlsand additional procedures generally and to improve systems to report financialinformation on a timely basis.

Any failure tomaintain effective controls, or difficulties encountered in theirimplementation or in other effective improvement of our internal and disclosurecontrols could materially harm our operating results or cause us to fail tomeet our reporting obligations. If we are unable to adequately establish orimprove our internal controls over financial reporting, or if we maintain anineffective system of disclosure controls and procedures, our financialstatements may not accurately reflect the financial condition of the Company,and current and potential future investors may not be able to rely upon ourfinancial statements. Additionally, our external auditors may not be able toissue an unqualified opinion on the effectiveness of our internal controls.Ineffective internal and disclosure controls could also cause investors to loseconfidence in our reported financial information, which would likely have asignificant negative effect on the trading price of our securities.

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

Biometrictechnology has received only limited market acceptance, particularly in theprivate sector. Our technology represents a novel security solution and we havenot yet generated significant sales. Although recent security concerns relatingto identification of individuals has increased interest in biometricsgenerally, it remains an undeveloped, evolving market. Biometric basedsolutions compete with more traditional security methods including keys, cards,personal identification numbers and security personnel. Acceptance ofbiometrics as an alternative to such traditional methods depends upon a numberof factors including:

·                  the reliabilityof biometric solutions

·                  publicperception regarding privacy concerns

·                  costs involvedin adopting and integrating biometric solutions

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

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

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

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**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 our technologyor require design modifications. These could adversely affect our competitiveposition and cause us to lose potential customers or opportunities. Since ourtechnologies are intended to be utilized to secure physical and electronicaccess, the effect of any such bugs or delays will likely have a detrimentalimpact on us. In addition, given that biometric technology generally, and ourbiometric technology specifically, has yet to gain widespread acceptance in themarket, any delays would likely have a more detrimental impact on our businessthan if we were a more established company.

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

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

We market ourtechnology through licensing arrangements with:

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

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

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

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

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

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

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

·                  contain onerousprocurement procedures; and

·                  be subject tocancellation if government funding becomes unavailable.

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

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

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The Internet,facility access control and information security markets are subject to rapidtechnological change and intense competition. We compete with both establishedbiometric companies and a significant number of startup enterprises as well asproviders of more traditional methods of access control. Most of 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 chosen markets.In addition, if one or more other biometric technologies such as voice, face,iris, hand geometry or blood vessel recognition are widely adopted, it wouldsignificantly reduce the potential market for our fingerprint identificationtechnology.

**We depend on key employees and members of our managementteam, including our Chairman of the Board and Chief Executive Officer, in orderto achieve our goals. We cannot assure you that we will be able to retain orattract such persons.**

A lossof our current Chairman of the Board of Directors or Chief Executive Officercould severely and negatively impact our operations. Our consulting contractwith Thomas J. Colatosti, our Chairman of the Board, expired on December 31,2006, and has not been renewed. 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 March 28, 2008. Although the contract does not prevent him fromresigning, it does contain confidentiality and non-compete clauses which areintended to prevent him from working for a competitor within one year afterleaving our Company. Our success depends on our ability to attract, train andretain employees with expertise in developing, marketing and selling softwaresolutions. In order to successfully market our technology, we will need toretain additional engineering, technical support and marketing personnel. Themarket for such persons remains highly competitive and our limited financialresources will make it more difficult for us to recruit and retain qualifiedpersons.

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

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

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

Sinceour inception, we have not generated any significant revenue (other thanrevenue from acquired businesses) and have experienced substantial losses,including approximately $7,806,000 during 2006, excluding the impact related toembedded derivative and warrant fair value adjustments, the extinguishment ofdebt, and the amortization of debt discounts and deferred financing costs. InMarch 2004, we completed a private placement equity offering that resultedin approximately $12,000,000 in gross proceeds to the Company and a privateplacement convertible debt offering in September 2004 that resulted inapproximately $10,000,000 in gross proceeds to the Company (a portion of whichwas used to finance the acquisition of Aether Mobile Government). InJune 2005, we raised approximately $5,000,000 in gross proceeds through aprivate placement convertible debt offering, in January 2006 we receivedapproximately $1,000,000 in another 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.

Weneed to obtain additional funding 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) provide working capital. Therefore, we need to obtain additionalfinancing through the issuance of debt or equity securities, or to restructureour financial position through similar transactions to what was consummatedduring 2006. The Company’s Series A

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ConvertiblePreferred Stock may be redeemable in cash by the stockholders during the secondquarter of 2008, if certain stock price performance conditions are not met.This date was deferred from March 3, 2007 to March 3, 2008 by anagreement with the holders of the Series A Shares on March 28, 2007.

Wehave not and cannot assure you that we will ever be able to secure any suchfinancing on terms acceptable to us. If we cannot obtain such financing, we maynot be able to execute our business plan or continue operations.

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

We believe thatour future business prospects depend in part on our ability to maintainand improve our current services and to develop new ones on a timely basis. Ourservices will have to achieve market acceptance, maintain technologicalcompetitiveness and meet an expanding range of customer requirements. As aresult of the complexities inherent in our service offerings, major newwireless data services and service enhancements require long development 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.

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

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

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

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

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

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

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

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

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full. See the “Long TermObligations” footnote to this report for a list of such potential events ofdefault.

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

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

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

·                  pay anydividends;

·                  merge, effect amaterial reorganization, liquidate or dissolve;

·                  materiallychange the scope of our business; or

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

Accordingly,unless we obtain the noteholders’ consent, we may not be able to enterinto certain transactions. In addition, in connection with any potentialsignificant transaction (such as a merger, sale of substantially all ourassets, joint venture, or similar transaction), it is likely that we would haveto pay off such debt obligations and have the applicable security interestsreleased. Although we have the right at any time to prepay our debtobligations, we can only do so upon payment of either 110% or 120% of the thenprincipal balance, plus all other amounts owing under the notes. See the “LongTerm Obligations” footnote of this report. Based on an aggregate principalbalance of $4.8 million at December 31, 2006, a complete prepaymentwould require a cash payment of approximately $5.3 million. Theseprovisions could have the practical effect of increasing the costs of anypotential significant transaction, and restrict our ability to enter into anysuch transaction.

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

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

·                  a sale or otherdisposition of any material assets;

·                  an acquisitionof a material amount of assets;

·                  engaging in amerger, reorganization or consolidation; or

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

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

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**Risks Related To Our Common Stock**

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

As of December 31, 2006, approximately 51,013,900 shares of our commonstock were reserved for issuance upon exercise or conversion of the followingsecurities (at conversion prices applicable as at December 31, 2006):

·                  9,623,900 shares upon conversion ofoutstanding convertible term notes;

·                  18,711,900 shares upon exercise ofoutstanding stock options and warrants;

·                  1,817,800 sharesupon exercise of options available for future grant under our existing optionplans; and

·                  20,860,300shares 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 $.50 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 outstandingSeries A Convertible Preferred Stock and cumulative dividends in arrearsare convertible into 6,165,564 shares of common stock as of December 31, 2006at a per share conversion price of $.50. Although many of the shares issuableupon conversion of our Series A Convertible Preferred Stock are eligiblefor public resale under Securities Exchange Commission Rule 144, we agreedto file a registration statement to cover the public resale of all ofthese shares. This significant increase in the number of shares available forpublic sale may have a negative impact on the trading price of our shares andsubstantially dilute the ownership interests of our existing shareholders. Inthe event that our stock trades below $.50 per share, in order to raiseadditional financing we would likely be required to issue additional shares ofcommon stock or securities convertible into common stock at a purchase orconversion price, as applicable, of less than $.50 per share. Any issuance ofshares at a purchase price of less than $.50 per share would reduce theconversion price of our Series A Convertible Preferred Shares to suchlower price. This would require us to issue additional shares upon conversionof our Series A Shares and further dilute the ownership interests of ourexisting shareholders. To the extent these factors are viewed negatively by themarket, it may provide an incentive for persons to execute short sales of ourcommon stock that could adversely affect the trading price of our common stock.

In January 2006, the Company issued Convertible Term Notes in theaggregate principal amount of $1,000,000 to certain investors. The ConvertibleNotes subsequently converted into 1,000,000 shares of Series B ConvertiblePreferred Stock of the Company, which shares and cumulative dividends areconvertible into shares of the Common Stock of the Company at a fixedconversion of $0.50 per share for an aggregate amount of 2,202,136 shares as atDecember 31, 2006. Although many of the shares issuable upon conversion of ourSeries B Convertible Preferred Stock are eligible for public resale underSecurities Exchange Commission Rule 144, we agreed to file aregistration statement to cover the public resale of all of these shares. This significantincrease in the number of shares available for public sale may have a negativeimpact on the trading price of our shares and substantially dilute theownership interests of our existing shareholders. In the event that our stocktrades below $.50 per share, in order to raise additional financing we wouldlikely be required to issue additional shares of common stock or securitiesconvertible into common stock at a purchase or conversion price, as applicable,of less than $.50 per share. Any issuance of shares at a purchase price of lessthan $.50 per share would reduce the conversion price of our Series BConvertible Preferred Shares to such lower price. This would require us toissue additional shares upon conversion of our Series B Shares and furtherdilute the ownership interests of our existing shareholders. To the extentthese factors are viewed negatively by the market, it may provide an incentivefor persons to execute short sales of our common stock that could adverselyaffect the trading price of our common stock.

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InAugust 2006, certain subordinated terms noted were converted to shares ofSeries C Convertible Preferred Stock of the Company, which shares andcumulative dividends are convertible into shares of the Common Stock of theCompany at an initial fixed conversion of $0.50 per share for an aggregateamount of 12,492,638 shares as at December 31, 2006. Although many of theshares issuable upon conversion of our Series C Convertible PreferredStock are eligible for public resale under Securities Exchange CommissionRule 144, we agreed to file a registration statement to cover thepublic resale of all of these shares. This significant increase in the numberof shares available for public sale may have a negative impact on the tradingprice of our shares and substantially dilute the ownership interests of ourexisting shareholders. In the event that our stock trades below $.50 per share,in order to raise additional financing we would likely be required to issueadditional shares of common stock or securities convertible into common stockat a purchase or conversion price, as applicable, of less than $.50 per share.Any issuance of shares at a purchase price of less than $.50 per share wouldreduce the conversion price of our Series C Convertible Preferred Sharesto such lower price. This would require us to issue additional shares uponconversion of our Series C Shares and further dilute the ownershipinterests of our existing shareholders. To the extent these factors are viewednegatively by the market, it may provide an incentive for persons to executeshort sales of our common stock that could adversely affect the trading priceof our common stock.

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

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

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

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

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

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

**ITEM2.**                    DESCRIPTIONOF PROPERTY

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

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**ITEM3.**                    LEGALPROCEEDINGS

Priorto our acquisition of PSG in March 2004, PSG had been named as a defendantin a civil action initiated in the Superior Court Department in Hampden County,Commonwealth of Massachusetts by The Vince Group, Inc. (“TVG”). The casewas then removed to the United States District Court for the District ofMassachusetts at the request of the parties. The complaint claimed that PSG wasobligated to pay a percentage of certain of its revenues to TVG inconsideration for a strategic business introduction allegedly made by an agentof TVG. PSG denied the allegations and filed an answer in the litigation. OnApril 20, 2006, the action was reported settled to the Court, and on June 20,2006 a Stipulation of Dismissal with Prejudice was filed.

**ITEM4.**                    SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters weresubmitted to a vote of security holders in the fourth quarter of 2006.

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**PART II**

**ITEM5.**                    MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

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

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

 

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

 

The last price ofour common stock as reported on the OTC Bulletin Board on March 1, 2007was $0.28 per share.

**Holders**

As ofMarch 1, 2007, the number of stockholders of record of our common stockwas 191.

**Dividends**

We have not paidany cash dividends on our common stock to date, and have no intention of payingany cash dividends on our common stock in the foreseeable future. The terms ofour outstanding Convertible Preferred Stock preclude us from declaring orpaying a dividend on our common stock unless a dividend is also declared orpaid, as applicable, on our Convertible Preferred Stock. The declaration andpayment of dividends on our common stock is also subject to the discretion ofour Board of Directors and certain limitations imposed under the DelawareGeneral Corporation Law. The timing, amount and form of dividends, if any,will depend on, among other things, our results of operations, financialcondition, cash requirements and other factors deemed relevant by our Board ofDirectors.

**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 andJune 7, 2005. The fixed conversion price under each of the Secured Noteswas reset from $1.35 to $0.85 per share. In addition, the exercise price of allwarrants to purchase Common Stock of the Company held by Laurus was reset to$1.00 per share. The Company issued 150,000 shares of the Company’s CommonStock to Laurus as consideration for this payment deferral. These securitieswere issued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

b)             On January 23,2006, the Company entered into an Amendment and Waiver with The ShaarFund Ltd. and other institutional and accredited investors pursuant towhich these investors allowed the Company to extend the maturity of theSubordinated Notes issued by the Company on September 29, 2004 and onMay 31, 2005. Additionally, the interest rate was fixed at fifteen percent(15%) and all principal amounts are due at the maturity date and shall be paidin shares of Common Stock priced at $0.70 per share if the average closingprice of the Common Stock for the thirty (30) trading days immediatelypreceding the maturity date is greater than $1.10. Interest shall be paid, atthe Company’s election, in cash or shares of Common Stock, with the CommonStock priced at the average closing price of the Common Stock for the ten(10) trading days immediately preceding the repayment date. The currentlyapplicable fixed conversion price was amended to $0.70 per share. In addition,the exercise price of all warrants to purchase Common Stock held by theSubordinated Note Holders that currently have an exercise price greater than$1.00 per share was reset to$1.00 per share. In connection with this financing,we also reduced the conversion price of the Series A Convertible Preferredshares held by the Shaar Fund Ltd. to $0.70 per share.

c)              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 Series B Convertible Preferred Stockof the Company at an initial fixed conversion of $0.70 per share for anaggregate amount of 1,428,571 shares. These securities were issued in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by the Companywithout engaging in any advertising or general solicitation of any kind andwithout payment of underwriting discounts or commissions to any person.

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d)             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 theCompany’s Common Stock priced at $0.50 per share, and defer principal amountsdue and payable under the 2004 Senior Note for the months of October, Novemberand December 2006 to January 1, 2008, the final maturity date of the2004 Senior Note, and defer the principal amounts due and payable under the2005 Senior Note for the months of October, November and December 2006 toDecember 1, 2008, the final maturity date of the 2005 Senior Note. TheCompany issued 150,000 shares of the Company’s Common Stock to Laurus asconsideration for this payment amendment and deferral. These securities wereissued in a private placement transaction exempt from the registration requirementsof the 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.

e)              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 shares of the Company’sSeries C Convertible Preferred Stock at a fixed conversion of $0.50 pershare. These securities were issued in a private placement transaction exemptfrom the registration requirements of the Securities Act pursuant toSection 4(2) thereof directly by the Company without engaging in anyadvertising or general solicitation of any kind and without payment ofunderwriting discounts or commissions to any person. In addition, the exerciseprice of all warrants to purchase Common Stock held by the Subordinated NoteHolders dated as of May 31, 2005 and January 23, 2006 was reset to$0.50 per share. In connection with this financing, we also reduced theconversion price of the Series A and Series B Convertible Preferred sharesto $0.50 per share.

f)                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 to Trellus Partners, L.P. and The Shaar Fund Ltd., respectively, foraggregate gross proceeds of approximately $1,500,000 in cash, and $500,000 byan exchange of rights to declared and unpaid dividends. These securities wereissued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

**ConvertiblePreferred Stock**

Within the limitsand restrictions provided in the Company’s Certificate of Incorporation, theBoard of Directors has the authority, without further action by theshareholders, to issue up to 5,000,000 shares of preferred stock, $.0001 parvalue per share, in one or more series, and to fix, as to any such series, anydividend rate, redemption price, preference on liquidation or dissolution,sinking fund terms, conversion rights, voting rights, and any other preferenceor special rights and qualifications.

**Series AConvertible Preferred Stock.**

InMarch 2004, we designated 100,000 shares of preferred stock asSeries C Convertible Preferred Stock. In connection with the Company’sreincorporation in Delaware, 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 December 31, 2006. The following describes the material provisionsof the Series A Shares which are more fully set forth in the Certificateof Designation on file with the Delaware Secretary of State.

The Series AShares accrue a cumulative annual dividend of 7% on the $100 face amount ofsuch shares payable June 15 and December 15 each year in shares ofcommon stock. In the event of a liquidation, dissolution or winding up of theCompany, the Series A shares have a liquidation preference of $100 pershare (plus all accrued and unpaid dividends thereon) prior to any payment ordistribution to holders of our common stock. The Series A Shares areconvertible into common stock at a conversion price of $.50 per share. Theconversion price is subject to proportional adjustment in the event of stocksplits, stock dividends or reclassifications. Subject to certain exceptions, inthe event we issue additional shares of common stock at a purchase price lessthan the conversion price of the Series A Shares, the conversion priceshall be lowered to such lesser 

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price. In the event thatthe average closing bid price of our common stock is less than $1.00 per sharefor thirty (30) consecutive trading days at any time after March 3, 2008,we will be required to redeem the Series A Shares by payment of $100 pershare plus all accrued and unpaid dividends due thereon. This date was deferredfrom March 3, 2007 to March 3, 2008 by an agreement with the holdersof the Series A Shares on March 28, 2007.

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

**Series BConvertible Preferred Stock.**

InJanuary 2006, the Company designated 1,000,000 shares of preferred stockas Series B Convertible Preferred Stock, all of which are issued andoutstanding as of December 31, 2006. The following describes the materialprovisions of the Series B Convertible Preferred Shares which are morefully set forth in the Certificate of Designation on file with the Delaware Secretaryof State.

The Series BConvertible Preferred Shares accrue a cumulative annual dividend of 15% on the$1 face amount of such shares payable January 1, April 1, July 1and October 1 each year in shares of common stock, or cash at the Company’selection. In the event of a liquidation, dissolution or winding up of theCompany, the Series B Convertible Preferred Shares have a liquidationpreference of $1 per share (plus all accrued and unpaid dividends thereon)prior to any payment or distribution to holders of our common stock. TheSeries B Convertible Preferred Shares are convertible into common stock ata conversion price of $.50 per share. The conversion price is subject toproportional adjustment in the event of stock splits, stock dividends or reclassifications.Subject to certain exceptions, in the event we issue additional shares ofcommon stock at a purchase price less than the conversion price of theSeries B Convertible Preferred Shares, the conversion price shall belowered to such lesser price.

If during thethirty (30) consecutive trading day period occurring prior toJanuary 1, 2009, the average closing bid price for one share of CommonStock, as reported by Bloomberg, L.P. is at least $1.10, all outstandingSeries B shares shall automatically be converted into Common Stock, at thethen effective conversion rate. Upon conversion, all accrued or declared butunpaid dividends on the Series B shares shall be paid in shares of CommonStock. In the event that the average closing bid price of our common stock isless than $1.10 per share for thirty (30) consecutive trading days at anytime after January 1, 2009, we will be required to redeem theSeries B Convertible Preferred Shares by payment of $1 per share plus allaccrued and unpaid dividends due thereon.

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

**Series CConvertible Preferred Stock.**

InAugust 2006, the Company designated 600,000 shares of preferred stock asSeries C Convertible Preferred Stock, 592,032 of which are issued andoutstanding, as of December 31, 2006. The following describes the materialprovisions of the Series C Convertible Preferred Shares, which are morefully set forth in the Certificate of Designation on file with the DelawareSecretary of State.

The Series CConvertible Preferred Shares accrue a cumulative annual dividend of 15% on the$10 face amount of such shares payable December 1, March 1,June 1 and September 1 each year in shares of common stock, or cashat the 

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Company’s election. Inthe event of a liquidation, dissolution or winding up of the Company, theSeries C Convertible Preferred Shares have a liquidation preference of $10per share (plus all accrued and unpaid dividends thereon) prior to any paymentor distribution to holders of our common stock. The Series C ConvertiblePreferred Shares are convertible into common stock at a conversion price of $.50per share. The conversion price is subject to proportional adjustment in theevent of stock splits, stock dividends or reclassifications. Subject to certainexceptions, in the event we issue additional shares of common stock at apurchase price less than the conversion price of the Series C ConvertiblePreferred Shares, the conversion price shall be lowered to such lesser price.

If during thethirty (30) consecutive trading day period occurring prior toJanuary 1, 2009, the average closing bid price for one share of CommonStock, as reported by Bloomberg, L.P. is at least $1.20, all outstandingSeries C shares shall automatically be converted into Common Stock, at thethen effective conversion rate. Upon conversion, all accrued or declared butunpaid dividends on the Series C shares shall be paid in shares of CommonStock. In the event that the average closing bid price of our common stock isless than $1.20 per share for thirty (30) consecutive trading days at anytime after January 1, 2009, we will be required to redeem theSeries C Convertible Preferred Shares by payment of $10.00 per share plusall accrued and unpaid dividends due thereon.

For as long as any of the Series C Convertible Preferred Stock areoutstanding, we are required to obtain the consent of the holders of theSeries C Convertible Preferred Shares in order to, among other things,issue any shares of preferred stock that are equal to or have a preference overthe Series C Convertible Preferred Shares or issue any shares of preferredstock, rights, options, warrants, or any other securities convertible intocommon 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.

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**ITEM6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

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

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

OVERVIEW provides adescription of our business, the major items that affected our business, andhow we analyze our business. It then provides an analysis of our overall 2006performance and a description of the significant events impacting 2006 andthereafter.

RESULTS OF OPERATIONSprovides an analysis of the consolidated and segment results of operations for2006 compared to 2005.

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

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

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

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 2006.

**OVERVIEW**

Our Business

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

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

Since our inception in 1993, we have spent substantial time and effortin completing the development of what we believe is the most discriminating andeffective finger biometric technology available. During the past two years, ourfocus 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 sale force of professionalswith substantial experience in selling technology solutions to government andcorporate customers.

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On March 30, 2004,we acquired all of the outstanding capital stock of Public SafetyGroup, Inc., a privately-held provider of wireless solutions for lawenforcement and public safety markets based in Winter Park, Florida, inexchange for an aggregate of 2,422,108 shares of our common stock, $500,000 incash, and our assumption of $600,000 in aggregate net liabilities of PSG. Theacquisition was completed pursuant to the terms of an agreement and plan ofmerger by and among the Company, BIO-key Acquisition Corp., a wholly-ownedsubsidiary of the Company, PSG and all of the shareholders of PSG. As a resultof this transaction, PSG became a wholly-owned subsidiary of the Company.

On September 30,2004, we completed our acquisition of the Mobile Government Division fromAether Systems Inc. Pursuant to the Asset Purchase Agreement dated as ofAugust 16, 2004 by and among the Company, Aether, CeruleanTechnology, Inc. and SunPro, Inc., the Company paid Aether a purchaseprice of $10,000,000 in cash, subject to post-closing adjustments to reflectchanges in Aether Mobile Government’s working capital and cash flows sinceJune 30, 2004. Post-closing working capital adjustments resulted in anadditional payment by the Company of $341,878 in December 2004. Inconnection with this acquisition, the Company issued a subordinated securedpromissory note to Aether in the face amount of $6,884,588 (the “Aether Note”).The Aether Note evidences a contingent reimbursement obligation of the Companyto Aether and a surety fee payable by the Company to Aether, in each case withrespect to a letter of credit maintained by Aether for the Company’s benefit inconnection with the acquisition. The Company’s obligations under the AetherNote are secured by a security interest granted to Aether in all orsubstantially all of the Company’s assets, subordinate to the security interestdescribed in the “Long-Term Obligations” footnote to this annual report.

The MobileGovernment Division provides wireless data solutions for use by public safetyorganizations, primarily state and local police, fire and rescue and emergencymedical services organizations that enable such organizations to access lawenforcement databases to validate identities and obtain suspect information.Its public safety solutions are integrated into fifty (50) different statedatabases, as well as local and federal databases, and its products deliverreal-time information in seconds, without the need for human dispatchers orother resources.

# INTRODUCTION

During2004 and 2005, the Company integrated the products, operations and technologyacquired from the Public Safety Group in March 2004 and Aether Systems in September2004, in an effort to leverage new business opportunities. In the fourthquarter of 2005, the Company restructured its operations into three businesssegments: Biometrics, Law Enforcement and Fire Safety. Each segment is headedby a General Manager and organized to quickly respond to market needs as wellas to drive down costs to achieve profitability. Management believes that thisinitiative has lead to increased opportunities in 2006 as the General Managersdevelop their organizations. A detailed analysis of each segment can be foundbelow.

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**RESULTSOF OPERATIONS**

**ConsolidatedResults of Operations **

**Two Year % trend**
| ** **                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                            | ** ** | ** **                                  | ** ** | **(As   Restated)** | ** ** |
| **Revenues**                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Services                              |       | 72                                          | %          | 76 | % |
| License fees and other                |       | 28                                          | %          | 24 | % |
|                                  |       | 100                                         | %          | 100 | % |
| **Costs  and other expenses**         | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cost of services                      |       | 17                                          | %          | 20 | % |
| Cost of license fees and other        |       | 5                                           | %          | 7 | % |
|                                  |       | 22                                          | %          | 27 | % |
| Gross Profit                          |       | 78                                          | %          | 73 | % |
|                                  |       |                                        |       |   |   |
| **Operating  expenses**               |       |                                        |       |   |   |
| Selling, general and administrative   |       | 68                                          | %          | 83 | % |
| Research, development and engineering |       | 43                                          | %          | 48 | % |
|                                  |       | 111                                         | %          | 131 | % |
| **Operating  loss**                   |       | (33                                         | )%         | (58 | )% |
|                                  |       |                                        |       |   |   |
| **Other  income (deductions)**        | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Total other income (deductions)       |       | (40                                         | )%         | 32 | % |
| **NET INCOME (LOSS)**                 |       | (73                                         | )%         | (26 | )% |

 

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

The Companyevaluates performance and allocates resources based on revenues and operatingincome (loss). Operating income (loss) for each segment includes selling,general and administrative expenses directly attributable to the segment inaddition to those allocated as a percentage based on the segments’ revenues andother factors. The segmentation of operating income as noted above and detailedbelow reflects how management now evaluates its business.  Assets for theCompany are commingled and are related to all operating segments. Managementdoes not evaluate or identify the operating assets of the segments separately.

28

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| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 - 2005** | ** ** |
|--------------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **               | ** ** | **2006**   | ** ** | **2005**   | ** ** | **$ Chg**            | ** ** | **%  Chg** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| *Revenues*               | * *   | * *   | * *   | * *   | * *   | * *                  | * *   | * * | * * |
| **Law  Enforcement**     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | $          | 8,069,005  |       | $          | 7,886,000                 |       | $ | 183,005 |   | 2 | % |
| License & other |       | 2,357,112  |       | 2,638,938  |       | (281,826                  | )          | (11 | %) |
|                     |       | 10,426,117 |       | 10,524,938 |       | (98,821                   | )          | (1 | %) |
| **Fire  Safety**         | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | 2,801,513  |       | 2,814,616  |       | (13,103                   | )          | 0 | % |
| License & other |       | 1,104,941  |       | 406,470    |       | 698,471                   |       | 172 | % |
|                     |       | 3,906,454  |       | 3,221,086  |       | 685,368                   |       | 21 | % |
|                     |       |       |       |       |       |                      |       |   |   |
| **Biometrics**           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | 79,377     |       | 161,033    |       | (81,656                   | )          | (51 | %) |
| License & other |       | 781,677    |       | 319,038    |       | 462,639                   |       | 145 | % |
|                     |       | 861,054    |       | 480,071    |       | 380,983                   |       | 79 | % |
|                     |       |       |       |       |       |                      |       |   |   |
| *Total Revenue*          |       | $          | 15,193,625 |       | $          | 14,226,095                |       | $ | 967,530 |   | 7 | % |
|                     |       |       |       |       |       |                      |       |   |   |
| *Cost of  goods sold*    | * *   | * *   | * *   | * *   | * *   | * *                  | * *   | * * | * * |
| **Law  Enforcement**     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | $          | 1,629,627  |       | $          | 2,260,845                 |       | $ | (631,218 | ) | (28 | %) |
| License & other |       | 482,794    |       | 679,170    |       | (196,376                  | )          | (29 | %) |
|                     |       | 2,112,421  |       | 2,940,015  |       | (827,594                  | )          | (28 | %) |
| **Fire  Safety**         | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | 950,503    |       | 602,317    |       | 348,186                   |       | 58 | % |
| License & other |       | 81,626     |       | 165,074    |       | (83,448                   | )          | (51 | %) |
|                     |       | 1,032,129  |       | 767,391    |       | 264,738                   |       | 34 | % |
| **Biometrics**           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Service                  |       | 93,693     |       | 42,980     |       | 50,713                    |       | 118 | % |
| License & other |       | 158,463    |       | 93,247     |       | 65,216                    |       | 70 | % |
|                     |       | 252,156    |       | 136,227    |       | 115,929                   |       | 85 | % |
|                     |       |       |       |       |       |                      |       |   |   |
| *Total  COGS*            |       | $          | 3,396,706  |       | $          | 3,843,633                 |       | $ | (446,927 | ) | (12 | %) |

 

***Revenues***

*LawEnforcement*

Service revenuefor the segment for the year ended December 31, 2006 included approximately$1,409,000 from a long-term project that the Company had participated in as asubcontractor.  The amount resulted from a cash payment of approximately$571,000 along with approximately $838,000 of revenue that was previouslydeferred until evidence of full acceptance by the end user was received by theCompany.  That increase was offset by a reduction in revenue from otherlonger-term project work that was present in 2005, as the Company moves to moreof a license-based model.

*FireSafety*

The increase inrevenue for this segment over the prior year was driven by increased licensesales, including a full year of  sales ofthe Fire RMS product that was introduced mid-year 2005. Sales in 2006 alsoincluded increased sales through one of the Company’s channel partners. Managementexpects this increase in market presence to continue, and will continue tofocus resources on this segment.

29

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*Biometrics*

A substantialportion of the revenue for the year ended December 31, 2006, was attributableto a large license order in Q1 2006 from a new customer. However, revenue inthis segment continues to be inconsistent and unpredictable as the market forthe Biometrics’ products continues to develop slowly.

***Costsof goods sold***

*LawEnforcement*

Thedecrease in Service Costs for the 2006 year were attributable to a reduction inpersonnel and related expenses that were needed in connection with several longterm projects that were completed in 2005.

Thecost of License and Other Revenues derived primarily from product sales forwhich we are required to pay a royalty. The decrease in cost is primarilydriven by the sales mix and is solely dependent specifically on what productswere sold.

*FireSafety*

Servicescosts have increased over the prior year primarily from the addition ofdedicated support and implementation staff to support the increasing customerbase in the Fire Safety segment.

Licenseand other costs are attributable primarily to revenues derived from productsales for which we are required to pay a royalty. The decrease in cost is primarilydriven by the sales volume in addition to product mix. These costs are solelydependent specifically on what products were sold.

*Biometrics*

Theincrease in Service costs are the result of an increased allocation of  a customer support person’s time to thesegment to support the larger customer base in 2006.

Licenseand other costs are primarily related to the hardware costs related to sales ofbiometric fingerprint readers. The change in cost of goods sold is directlyattributable to the product mix between types of readers sold and the volume ofreaders sold.

***Selling, general and administrative***

|                      | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 - 2005** | ** ** |
|----------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **           | ** ** | **2006**   | ** ** | **2005**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Law  Enforcement** |       | $          | 4,944,737  |       | $          | 7,471,524                 |       | $ | (2,526,787 | ) | (34 | %) |
| **Fire  Safety**     |       | 3,037,050  |       | 2,802,220  |       | 234,830                   |       | 8 | % |
| **Biometrics**       |       | 2,329,230  |       | 1,550,865  |       | 778,365                   |       | 50 | % |
|                 |       |       |       |       |       |                      |       |   |   |
| **Total**            |       | $          | 10,311,017 |       | $          | 11,824,609                |       | $ | (1,513,592 | ) | (13 | %) |

 

As discussedpreviously, the Company restructured its operations into three business segments:Biometrics, Law Enforcement and Fire Safety in the fourth quarter of2005.  For 2005, SG&A costs were allocated to the segments based onseveral factors including management’s estimates and percentage ofrevenue.  For 2006, sales expenses were a direct cost to the segment, withG&A costs allocated between business segments on fixed percentages whichhad been established by management during the budgeting process.

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The overalldecline in total SG&A costs for the year ended December 31, 2006 ascompared to the 2005 year, is primarily attributable to the continued focus ofmanagement on the cost reduction initiatives which commenced during the fourthquarter of 2005. Significant reductions in selling expenses (includingpersonnel costs and commissions) were partially offset by additional costsrelated to reporting and compliance that the Company has experienced due to therestatements of our previously filed financial statements, and amendments ofour previously filed registration statements.

Management believes the appropriate resources are inplace to support its strategic goals, but also continues to analyze the expensestructure to explore ways in which to further reduce costs, through synergiesand increased system efficiencies.

***Research, development and engineering***

|                      | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 - 2005** | ** ** |
|----------------------|------------|------------|------------|------------|------------|---------------------------|------------|
| ** **           | ** ** | **2006**   | ** ** | **2005**   | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| **Law  Enforcement** |       | $          | 3,812,117  |       | $          | 3,931,265                 |       | $ | (119,148 | ) | (3 | %) |
| **Fire  Safety**     |       | 1,304,874  |       | 1,207,263  |       | 97,611                    |       | 8 | % |
| **Biometrics**       |       | 1,397,362  |       | 1,707,507  |       | (310,145                  | )          | (18 | %) |
|                 |       |       |       |       |       |                      |       |   |   |
| **Total**            |       | $          | 6,514,353  |       | $          | 6,846,035                 |       | $ | (331,682 | ) | (5 | %) |

 

The decrease in total R&D expenses in 2006 as compared to 2005 isprimarily due to lower personnel and related expenses. Managementbelieves the appropriate resources are in place to support its strategic goalsand expenses should remain relatively flat in total dollars.

*LawEnforcement*

R & Dcosts have decreased slightly for the year ended December 31, 2006 as comparedto 2005,  primarily due to staff and coststructure reductions undertaken by management in the fourth quarter of 2005.

*FireSafety*

R &D costs have increased slightly for the year ended December 31, 2006 ascompared to 2005, as the Company added additional resources in this segment tosupport  the increased demand for itsFire segment products

*Biometrics*

R & Dcosts have decreased for the year ended December 31, 2006, as compared to 2005,due to lower personnel costs.  Asthe  Company continues to develop furtherintegration of its Biometric software solutions in other products with inCompany it has required less direct resources in the segment.

31

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***Other income and expense***

|                                                | ** ** | ** ** | ** ** | ** **             | ** ** | **2006 - 2005** | ** ** |
|------------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------|------------|
| ** **                                     | ** ** | **2006**   | ** ** | **2005**               | ** ** | **$ Chg**            | ** ** | **% Chg** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | **(As Restated)** | ** ** | ** **                | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** **             | ** ** | ** **                | ** ** | ** ** | ** ** |
| Interest income                                |       | $          | —     |                   | $          | 35,958                    |       | $ | (35,958 | ) | (100 | %) |
| Interest expense                               |       | (5,730,712 | )          | (4,521,344             | )          | (1,209,368                | )          | 27 | % |
| Derivative and  warrant fair value adjustments |       | 7,542,666  |       | 9,154,951              |       | (1,612,285                | )          | (18 | %) |
| Gain (loss) on  sale of marketable securities  |       | —     |       | (20,000                | )          | 20,000                    |       | (100 | %) |
| Loss on  extinguishment of debt                |       | (7,815,717 | )          | —                 |       | (7,815,717                | )          | n/a |   |
| Other income  (expense)                        |       | (48,637    | )          | (34,767                | )          | (13,870                   | )          | 40 | % |
|                                           |       |       |       |                   |       |                      |       |   |   |
|                                           |       | $          | (6,052,400 | )                      | $          | 4,614,798                 |       | $ | (10,667,198 | ) | (231 | %) |

 

For the year ended December 31, 2006,consolidated interest expense increased approximately $1,209,000 or 27% ascompared to the 2005 year.  Interest expense includes amounts accrued onsenior and subordinated convertible debt, and on the letter of creditarrangement, as well for the amortization of debt discounts, and deferred financingcosts. The increase in interest expense during 2006 was primarily related tothe default interest and the liquidating damages provisions enforced withrespect to the convertible debt and preferred stock instruments. Theseprovisions were triggered due to the Company breaching certain registrationright agreement clauses during the year. The increase in interest expense wasoffset by the exchange of certain debt instruments to preferred stock in August2006.

For the year endedDecember 31, 2006, derivative and warrant fair value adjustments decreased whencompared to the 2005 year, due to changes in the fair market value of embeddedderivatives and detachable warrants issued with convertible debt issued in 2004and 2005, as well as changes in the fair market value of derivatives recordedas a result of financings in 2006. The changes represent non-cash income andexpense charges to the statement of operations. The fair value of thederivatives will fluctuate based on; our stock price on the valuation date, thedebt conversion price, the volatility of our stock price over a period of time,changes in the value of the risk free interest rate, and the time to maturityof the outstanding debt and the time to conversion or redemption of preferredstock at different points in time.

**Asmentioned in Note L and Note Q to the consolidated financial statements, thebalance of the embedded derivatives, warrants, and unamortized discounts withrespect to the 2004 and 2005 financings were extinguished as part of the Januaryand August 2006 debt restructurings. These events precipitated therecording of the above “loss on extinguishment of debt,” during the year endedDecember 31, 2006. There was no such event during the year ended December 31,2005.**

**LIQUIDITY ANDCAPITAL RESOURCES**

***OPERATING ACTIVITIES OVERVIEW***

The net cash used inoperating activities during 2006 was $3,551,455, as compared to $4,513,497 in2005. Some of the major drivers of this change are discussed in more detailbelow. The Company’s income statement includes five non-cash items which madethe most significant contributions to the net cash used in operating activitiesin 2006 and 2005.

·                  The Companyissued notes in 2004 and 2005 and preferred stock in 2006, all of whichcontained embedded derivatives, and associated warrants. In 2006 and 2005, theCompany recognized gains of approximately $7,543,000 and $9,155,000respectively, related to the decrease in value of the derivatives andassociated warrants. The decrease in value is driven mainly by the decline invalue of the underlying BIO-key stock.

·                     The Company recorded approximately$7,816,000 and $0 of charges in 2006 and 2005, respectively, for the non-cashexpense related to the extinguishment of debt as a result of its January andAugust 2006 refinancings.

32

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·                  A debt discountwas identified when the 2004 and 2005 notes were initially recorded to reflectthe fair market value of the embedded derivatives and warrants associated withthe debt. The discount is amortized using the effective interest method intoearnings over the life of the related debt. In 2006 and 2005, the companyrecorded non-cash interest expense related to the amortization of the debtdiscount of approximately $2,774,000 and $2,098,000 respectively.

·                     The companyrecorded approximately $864,000 and $1,324,000 of charges in 2006 and 2005,respectively, for the non-cash expense of amortizing intangible assets.

·                  The Companyrecorded approximately $727,000 and $664,000 of charges in 2006 and 2005,respectively, for the non-cash expense of issuing options and warrants to nonemployees for services.

For the years endedDecember 31, 2006 and 2005, the Company reported positive cash flowsrelated to a decrease in costs and earnings in excess of billings onuncompleted contracts of approximately $3,106,000 and $2,469,000, respectively.Costs and earnings in excess of billings on uncompleted contracts representservices which have been performed on long term contracts but have not beeninvoiced at year end due to milestones contained within the contracts. During2006 and 2005, the Company was able to bill the customers due to the fact themilestones had been reached. A corresponding increase of approximately$1,336,000 and decrease of approximately 345,000 in accounts receivable wasexperienced during 2006 and 2005 respectively, which indicated the majority ofamounts transferred from the costs and earnings in excess of billings onuncompleted contracts during the period were collected by the Company.

The Company alsoexperienced a positive cash flow from an increase of approximately $613,000 and$1,192,000 in deferred revenue from 2006 and 2005 respectively, due tocustomers who had purchased and paid for maintenance agreements which thecompany had to earn typically over a one year period.

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

***FINANCING ACTIVITIES OVERVIEW***

***Financing Activities***

**2005Senior and Subordinate Term Notes**

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

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

We entered into aSecurities Purchase Agreement, effective as of May 31, 2005, (the “SubordinatedPurchase Agreement”) with existing shareholders of the Company and otheraccredited investors (collectively, the “Subordinated Investors”). Under theSubordinated Purchase Agreement, the Company issued Convertible Term Notes (the“Subordinated Convertible Notes”) in the aggregate principal amount of$2,794,723, respectively convertible into Common Stock of the Company incertain circumstances at $0.70 per share, and issued warrants (the “SubordinatedWarrants”) to purchase an aggregate of 828,066 shares of the Common Stock at aper share exercise price of $1.00. The aggregate consideration received by theCompany, net of all fees and expenses, for such Subordinated Convertible Notesand Subordinated Warrants 

33

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was approximately $2,411,000. The proceeds from thistransaction were used for working capital purposes. The SubordinatedConvertible Notes were issued at a purchase price equal to $900 for each $1,000of principal amount of the Note.

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

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

**2005Amendment and Waivers**

The Company entered intoan Amendment and Waiver with Laurus, dated as of August 31, 2005, pursuantto which the Company was permitted to defer the payment of the monthlyprincipal amounts due and payable for the months of September, October,November and December 2005 under both (a) the SecuredConvertible Term Note in the original principal amount of $5,000,000 issued bythe Company to Laurus on September 29,2004 (the “September 2004 Note”),and (b) the Secured Convertible Term Note in the original principal amountof $2,000,000 issued by the Company to Laurus on June 8, 2005 (the “June 2005Note”), such aggregate deferred principal amounts being equal to $625,000 and$187,500, respectively. The deferred principal amount under theSeptember 2004 Note is now due on September 29, 2007, the maturitydate of that note, and will be paid at the same time the final payments duewith respect to that note upon maturity. The deferred principal amount underthe June 2005 Note is now due on June 7, 2008, the maturity date ofthat note, and will be paid at the same time the final payments due withrespect to that note upon maturity. The Company will remain obligated to payall monthly interest amounts under these notes as they are currently due.

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

**2006Amendment and Waiver**

The Companyentered into an Amendment No. 1 to its Subordinated Secured PromissoryNote, dated as of January 23, 2006, with Aether Systems, Inc.Pursuant to the Aether Note Amendment, the Subordinated Secured Promissory Noteissued by the Company to Aether on September 30, 2004 in the aggregatemaximum principal amount of $6,884,588 was amended to increase such aggregatemaximum principal amount to $7,884,588. The Aether Note evidences a contingentreimbursement obligation of the Company to Aether and a surety fee payable bythe Company to Aether, in each case with respect to a letter of creditmaintained by Aether for the Company’s benefit in connection with the Company’sacquisition of the Mobile Government Division of Aether on September 30,2004. The Company’s obligations under the Aether Note remain secured by asecurity interest granted to Aether in all or substantially all of the Company’sassets subordinated to the security interest of Laurus pursuant to the 2004 and2005 Senior Notes.

The Companyentered into a Securities Purchase Agreement, effective as of January 23,2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview SpecialFinance. Under the Securities Purchase Agreement, the Company issued to thePurchasers Convertible Term Notes in the aggregate principal amount of$1,000,000. The Convertible Notes converted into shares of the Series BPreferred Stock of the Company, which shares are convertible into shares of theCommon Stock of the Company at an initial fixed conversion price of $0.70 pershare.

Effective as ofJanuary 23, 2006, BIO-key International, Inc. entered into anAmendment and Waiver with Laurus Master Fund Ltd. in connection with theSecured Convertible Notes currently held by Laurus. Under the Secured Notes 

34

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Amendment and Waiver, theSecured Notes issued by the Company to Laurus on September 29, 2004 in theaggregate principal amount of $5,000,000 and on June 7, 2008 in theaggregate principal amount of $2,000,000 were amended as follows: (i) thematurity date of the September 2004 Note was extended to January 1,2008; (ii) the maturity date of the June 2005 Note was extended toDecember 1, 2008, and (iii) the fixed conversion price under each ofthe Secured Notes was reset from $1.35 to $0.85 per share. In addition, theexercise price of all warrants to purchase Common Stock of the Company held byLaurus was reset to $1.00 per share.

Effective as ofJanuary 23, 2006, the Company also entered into an Amendment and Waiverwith certain holders of its Subordinated Convertible Promissory Notes. Underthe Subordinated Notes Amendment and Waiver, the Subordinated Notes issued bythe Company on September 29, 2004 in the aggregate principal amount of$5,288,221 and on May 31, 2005 in the aggregate principal amount of$3,244,723 were amended as follows: (i) the maturity dates were extendedfrom September 29, 2007 and May 31, 2008, respectively, toJanuary 1, 2009; (ii) the interest rate was fixed at fifteen percent(15%); (iii) all principal amounts are due at the maturity date and shallbe paid in shares of Common Stock priced at $0.70 per share if the averageclosing price of the Common Stock for the thirty (30) trading daysimmediately preceding the maturity date is greater than $1.10;(iv) interest shall be paid, at the Company’s election, in cash or sharesof Common Stock, with the Common Stock priced at the average closing price ofthe Common Stock for the ten (10) trading days immediately preceding therepayment date; and (v) the currently applicable fixed conversion price wasamended to $0.70 per share. In addition, the exercise price of all warrants topurchase Common Stock held by the Subordinated Note Holders that currently havean exercise price greater than $1.00 per share was reset to $1.00 per share. Inconnection with this financing, we also reduced the conversion price of theSeries A Convertible Preferred shares held by the Shaar Fund Ltd. to$0.70 per share.

Effective as ofAugust 10, 2006, the Company also entered into an Amendment and Waiverwith Laurus in connection with the holder of its Secured Convertible Notescurrently held by Laurus. Under the Amendment and Waiver, theSeptember 2004 Note and June 2005 Note were amended as follows:(i) the principal amounts due and payable under the 2004 Note and the 2005Note for the months of August and September 2006, respectively, shall bepaid in shares of the Company’s Common Stock priced at $0.50 per share; and(ii) the principal amount due and payable under the 2004 Note for themonths of October, November and December 2006 is deferred untilJanuary 1, 2008, the final maturity date of the 2004 Note, and theprincipal amount due and payable under the 2005 Note for the months of October,November and December 2006 is deferred until December 1, 2008, thefinal maturity date of the 2005 Note. Pursuant to this Amendment and Waiver,the Company issued 150,000 shares of its common stock to Laurus asconsideration for the principal payment deferral. In connection with thisfinancing, the Company reduced the conversion price under each of theSeptember 2004 Note and June 2005 Note to $0.50 per share.

Effective as ofAugust 10, 2006, the Company also entered into a Securities ExchangeAgreement with certain holders of its Subordinated Convertible PromissoryNotes. Under the Securities Exchange Agreement, certain Subordinated Notesissued by the Company on September 29, 2004 in the aggregate principalamount of $5,288,221 and on May 31, 2005 in the aggregate principal amountof $3,244,723 were amended as follows: (i) the aggregate principal amountoutstanding under the Notes, plus accrued and unpaid interest, and liquidateddamages were exchanged for shares of Series C Convertible Preferred Stock;and (ii) in addition, the exercise price of all warrants held bySubordinated Note Holders dated May 31, 2005 and January 23, 2006, topurchase Common Stock of the Company was reset to $0.50 per share. Inconnection with this financing, the Company also reduced the conversion priceof the Series A and Series B Convertible Preferred shares to $0.50per share.

The Companyentered into (i) a Securities Purchase Agreement (the “Trellus SecuritiesPurchase Agreement”), dated as of August 10, 2006, with Trellus Partners,L.P. (“Trellus”) and (ii) a Securities Purchase Agreement (the “ShaarSecurities Purchase Agreement”), dated as of August 10, 2006, with Shaar.Under the Trellus Securities Purchase Agreement, the Company (i) issuedand sold 3,000,000 shares of its Common Stock (the “Trellus Shares”) toTrellus, at a purchase price of $0.50 per share, for an aggregate purchaseprice of $1,500,000 and (ii) issued a warrant to Trellus (the “TrellusWarrant”) to purchase up to an aggregate of 400,000 shares of the Company’sCommon Stock at an exercise price of $0.75 per share.

Under the ShaarSecurities Purchase Agreement, the Company agreed to (i) issue and sell1,000,000 shares of its Common Stock (the “Shaar Shares”) to Shaar, at apurchase price of $0.50 per share, for an aggregate purchase price of $500,000to be paid by exchanging Shaar’s rights in an aggregate amount of $500,000 byan exchange of rights to declared and unpaid dividends on the Shares ofSeries A Convertible Preferred Stock currently held by Shaar; and(ii) issue a warrant to Shaar (the “Shaar Warrant”) to purchase up to anaggregate of 133,333 shares of the Company’s Common Stock at an exercise priceof $0.75 per share.

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***Liquidity outlook***

At December 31,2006, our total of cash and cash equivalents was approximately $627,000. Thetotal was approximately $1,423,000 at December 31, 2005. We have financedourselves through access to the capital markets by issuing debt securities,convertible preferred stock and common stock.

We currentlyrequire approximately $1,700,000 per month, excluding debt related payments, toconduct our operations. During the fourth quarter of 2006, we generatedapproximately $4,012,000 of revenue and expect it to increase quarterly in2007. During the first quarter of 2007, the Company incurred approximately$400,000 in legal and accounting fees with respect to the unsuccessful takeoverbid for a Canadian organization (refer Note X – Events occurring subsequent toDecember 31, 2006 for more information). The amount is expected to be paid overthe first six months of 2007.

During 2006, theCompany incurred significant expenses in order to complete several SB-2registration statements related to various financing transactions.  While the Company does not expect these coststo continue into 2007, there will be additional costs incurred in order for theCompany to comply with Section 404 of the Sarbanes-Oxley Act of 2002.

In August 2006,the Company agreed with certain 2004 and 2005 Subordinated Investors toexchange the principal amounts outstanding under their 2004 and 2005Subordinated Notes, plus accrued and unpaid interest thereon, and certainliquidated damages, for shares of the Company’s Series C ConvertiblePreferred Stock. The exchange enabled the Company to reduce its debtdependence, and short-term repayment obligations significantly.

We need to obtain additional funding to(i) conduct the sales, marketing and technical support necessary toexecute our plan to substantially grow operations, increase revenue and serve asignificant customer base; and (ii) provide working capital. Therefore, weneed to obtain additional financing through the issuance of debt or equitysecurities, or to restructure our financial position through similartransactions to what was consummated during 2006. The Company’s Series AConvertible Preferred Stock may be redeemable in cash by the stockholdersduring the second quarter of 2008, if certain stock price performanceconditions are not met. This date was deferred from March 3, 2007 toMarch 3, 2008 by an agreement with the holders of the Series A shareson March 28, 2007.

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

**CONTRACTUALOBLIGATIONS**

We have various contractual obligations impacting ourliquidity. The following represents some of our contractual obligations as ofDecember 31, 2006:
| ** **                                     | ** ** | **Total** | ** ** | **2007**  | ** ** | **2008**  | ** ** | **2009** | ** ** | **2010** | ** ** |
|------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|----------|------------|----------|------------|
| Non-cancelable  operating leases               |       | $         | 2,198,121  |      | $          | 1,285,970 |       | $        | 874,605    |     | $          | 36,089 |   | $ | 1,457 |   |
| Senior secured  convertible term notes         |       | 4,797,895 |       | 3,048,421 |       | 1,749,474 |       | —   |       | —   |       |
| Subordinated  unsecured convertible term notes |       | 17,188    |       | 17,188    |       | —    |       | —   |       | —   |       |
|                                           |       |      |       |      |       |      |       |     |       |     |       |
| Total                                          |       | $         | 7,013,204  |      | $          | 4,351,579 |       | $        | 2,624,079  |     | $          | 36,089 |   | $ | 1,457 |   |

 

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

36

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operating leasesexpire a various dates through 2010. In addition to base rent, the Company paysfor property taxes, maintenance, insurance and other occupancy expensesaccording to the terms of the individual leases.

**RESTATEMENT**

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

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

·                  *Revenue Recognition*

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

·                  *Accounting for Convertible Financing Arrangements*

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

·                  Theprincipal conversion option

·                  Themonthly payments conversion option

·                  Theinterest rate adjustment provisions.

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

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

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

·                  *Valuations of Embedded Derivatives*

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

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·                  *Additional Derivative (Default Provision)*

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

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

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

The errors in our previously reported financialinformation, and the failure to prevent them or detect them in our financialreporting process, were largely attributable to weak internal controls, aninadequate staff of competent accounting personnel with an appropriate level ofknowledge of GAAP and to errors in the valuations of the previously identifiedembedded derivatives.

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

The followingtables summarize the impact of all of these adjustments on previously reportedrevenue and assets, liabilities, and stockholders’ equity (deficit) for theyear ended December 31, 2005.
| ** **                  | ** ** | **Impact of Adjustments on Revenue  For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                                                                           | ** ** |
| **As  previously reported** |       | $                                                                                                                  | 14,226,095 |   |
| Revenue  recognition        |       | —                                                                                                             |       |
| **As restated**             |       | $                                                                                                                  | 14,226,095 |   |

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

 

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

 

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The followingtable presents the effect of the restatement adjustments on the ConsolidatedStatement of Cash Flows for the year ended December 31, 2005.

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

 

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**CRITICAL ACCOUNTING POLICIES**

1.                                       *Basis of Consolidation*

The accompanyingconsolidated financial statements include the accounts of BIO-keyInternational, Inc. and its wholly owned subsidiary (collectively, theCompany) and are stated in conformity with accounting principles generallyaccepted in the United States, pursuant to the rules and regulations ofthe Securities and Exchange Commission. Intercompany accounts and transactionshave been eliminated in consolidation.

2.                                       *Revenue Recognition*

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

TheCompany intends to enter into arrangements with end users for items which mayinclude software license fees, and services or various combinations thereof. Foreach arrangement, revenues will be recognized when evidence of an agreement hasbeen documented, the fees are fixed or determinable, collection of fees isprobable, delivery of the product has occurred and no other significantobligations remain.

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

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

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

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

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

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3.                                       *Accounting for Acquisitions*

Acquisitionsare accounted for under the purchase method of accounting, which resulted inrecording significant goodwill and other intangible asset balances. Thepurchase prices are allocated to assets acquired and liabilities assumed attheir estimated fair values on the date of the acquisitions, as determined bymanagement, and by appraisals with respect to identifiable intangible assets.Accounting for acquisitions involves significant judgments and estimates regardingfair values of acquired intangible assets, which are based on projections offuture revenues and cash flows, assumptions regarding discount factors, royaltyrates, tax rates, amortization methodologies and related useful lives.Developed technology (software), copyrighted software, marketing agreements,customer relationships and trademarks are valued using the income approach.

4.                                       *Marketable Debt Securities*

TheCompany accounts for marketable securities pursuant to Statement of FinancialAccounting Standards No. 115—”Accounting for Certain Investments in Debtand Equity Securities” (“SFAS 115”). SFAS 115 requires classificationof debt and equity securities in three categories: trading securities,available-for-sale securities and held-to-maturity securities. Debt and equitysecurities classified as trading securities are carried at fair value withunrealized gains or losses included in income. Debt and equity securitiesdesignated as available-for-sale, whose fair values are readily determinable, arecarried at fair value with unrealized gains or losses included as a componentof accumulated other comprehensive income, net of applicable taxes. Debtsecurities that are expected to be held-to-maturity are carried at amortizedcost. In January 2005 the Company sold these investments and did not holdany Marketable Debt Securities as of December 31, 2006.

5.                                       *Derivative and Warrant financial instruments*

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

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

6.                                       *Goodwill and Intangible Assets*

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards No. 142 (“SFAS 142”),Goodwill and Other Intangible Assets., which requires the Company to testgoodwill for impairment annually or whenever events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable, ratherthan amortize. Accordingly, the Company has not amortized goodwill. As providedby SFAS No. 142, the Company has elected to perform the annual assessmentof the carrying value of all goodwill as of September 30th of each year using a number of criteria,including the value of the overall enterprise. As of December 31, 2006,the Company believes that no material impairment exists. Future impairmentcharges from previous or future acquisitions, if any, will be reflected as anoperating expense in the statement of operations.

7.                                       *Deferred Revenue*

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

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8.                                       *Research and Development Expenditures*

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

9.                                       *Earnings Per Share of Common Stock*

Earningsper share of common stock-basic is computed by dividing Net Income applicable tocommon stockholders by the weighted-average number of common shares outstandingfor the period. Earnings per share of common stock-assuming dilution reflectsthe maximum potential dilution that could occur if securities or othercontracts to issue common stock were exercised or converted into common stockand would then share in the net income of the company. See Note V - EarningsPer Share “EPS,” for additional information.

10.                                 *Income Taxes*

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

11.                                 *Accounting for Stock-Based Compensation*

As ofJanuary 1, 2006, the Company adopted SFAS 123R using the modified prospectivemethod, which requires measurement of compensation cost for all stock awards atfair value on date of grant and recognition of compensation over the serviceperiod for awards expected to vest. Accordingly, financial statement amountsfor the prior periods presented in this Form 10-KSB have not been restated toreflect the fair value method of expensing share-based compensation. Under thisapplication, we are required to record compensation cost for all share-basedpayments granted after the date of adoption based on the grant date fair valueestimated in accordance with the provisions of SFAS 123R and for the unvestedportion of all share-based payments previously granted that remain outstandingwhich were based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS 123. 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, whichis consistent with our valuation techniques previously utilized for options infootnote disclosures required under SFAS 123, as amended by SFAS 148, 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 requisite service period, net of estimatedforfeitures (the number of individuals that will ultimately not complete theirvesting requirements). The estimation of stock awards that will ultimately vestrequires significant judgment. We consider many factors when estimatingexpected forfeitures, including 

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types of awards, employeeclass, and historical experience. Actual results, and future changes inestimates, may differ substantially from our current estimates.

12.                                 *Use of Estimates*

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

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

**RECENTACCOUNTING STANDARDS**

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

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements,” which is effective for calendar year companies onJanuary 1, 2008. The Statement defines fair value, establishes a frameworkfor measuring fair value in accordance with Generally Accepted AccountingPrinciples, and expands disclosures about fair value measurements. TheStatement codifies the definition of fair value as the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date. The standardclarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing the asset or liability and establishesa fair value hierarchy that prioritizes the information used to develop thoseassumptions. The Company is currently assessing the potential impacts ofimplementing this standard.

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N(SAB 108), “Financial Statements — Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements,” which is effective for calendar year companies as ofDecember 31, 2006. SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thefinancial statements are materially misstated. Under this guidance, companiesshould take into account both the effect of a misstatement on the current yearbalance sheet as well as the impact upon the current year income statement inassessing the materiality of a current year misstatement. Once a current yearmisstatement has been quantified, the guidance in SAB Topic 1M, “FinancialStatements — Materiality,” (SAB 99) should be applied todetermine whether the misstatement is material. The implementation ofSAB 108 did not have a material impact on the Company’s financial statements.

In June 2006, theFASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes—An Interpretation of FASB StatementNo. 109*,*”**which prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 will be effective for the Company’s first interim period beginningJanuary 1 2007. The implementation of FIN 48 is not expected to have a materialimpact on the Company’s financial statements.

**ITEM7.**                    FINANCIALSTATEMENTS

Seefinancial statements appearing at pages 69-115 of this report

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**ITEM8.       CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

On July 24, 2006,the Audit Committee of the Board of Directors of the Company dismissedDS&B, Ltd. (“DS&B”) as the Company’s independent registered publicaccounting firm.  The reports issued by DS&B on their audit of theCompany’s financial statements for each of the past two fiscal years did notcontain an adverse opinion or disclaimer of opinion, nor were they qualified ormodified as to uncertainty, audit scope or accounting principles, except asfollows: 

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

(ii)           DS&Binformed the Audit Committee by letter dated May 16, 2006 that theywithdrew their audit report included in the Company’s Annual Report on Form10-KSB for the year ended December 31, 2005 related to the Company’s financialstatements for the years ended December 31, 2004 and December 31,2005 and that they would be unable to complete their review of the Company’sQuarterly Report on Form 10-QSB for the quarter ended March 31,2006.  Subsequently, however, DS&B included its audit report to theCompany’s Annual Report on Form 10-KSB/A for the year ended December 31, 2005filed with the Securities and Exchange Commission on June 19, 2006 andcompleted its review of the Company’s Quarterly Report on Form 10-QSB/Afor the quarter ended March 31, 2006 filed with the Securities and ExchangeCommission on July 18, 2006.

During theCompany’s two most recent fiscal years and through the date hereof, there wereno disagreements with DS&B on any matter of accounting principle orpractice, financial statement disclosure, or auditing scope or procedure which,if not resolved to DS&B’s satisfaction, would have caused them to makereference to the subject matter in connection with their report of theCompany’s financial statements for such years; and there were no reportableevents as defined in Item 304(a)(1)(iv) of Regulation S-B except for:

(i)            Asfirst noted in Item 3 in our 10-QSB filed on May 16, 2005, the Audit Committeewas in receipt of a letter dated April 18, 2005 from DS&B which identifiedseveral material weaknesses in the Company’s internal control over financialreporting and

(ii)           Asnoted above and in our Form 8-K filed on May 18, 2006, the Audit Committeereceived a letter dated May 16, 2006 from DS&B that they withdrew theiraudit report included in the Company’s Annual Report on Form 10-KSB for theyear ended December 31, 2005.

The Audit Committee held discussions with DS&Bregarding each such event and the Company authorized DS&B to respond fullyto any inquiries of Carlin, Charron & Rosen LLP concerning the subjectmatter of each such event. The Company requested DS&B to provide a letterto the Securities and Exchange Commission stating whether it agreed with theforegoing disclosures. The letter was sent by DS&B dated August 9, 2006.

On July 24, 2006, the Company engaged Carlin, Charron& Rosen LLP (“CCR”) to serve as the Company’s independent registered publicaccounting firm for the fiscal year ended December 31, 2006.  TheCompany’s engagement of CCR was approved by the Audit Committee of theCompany’s Board of Directors.

During the fiscal years ended December 31, 2005 andDecember 31, 2004, and through the date hereof, the Company did not consultwith CCR with respect to the application of accounting principles to aspecified transaction, either completed or proposed, or the type of auditopinion that might be rendered on the Company’s consolidated financialstatements, or any other matters or reportable events as set forth in Items304(a)(2)(i) and (ii) of Regulation S-K.

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**ITEM8A.**           CONTROLSAND PROCEDURES

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

An evaluation ofthe effectiveness of the Company’s “disclosure controls and procedures” (assuch term is defined in Rules 13(a)-15(e) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) as of December 31, 2006was carried out by the Company under the supervision and with the participationof the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).

As previouslydescribed in our Quarterly Reports on Form 10-QSB for the periods ended March31, 2005, June 30, 2005, September 30, 2005, March 31, 2006, June 30, 2006, andSeptember 30, 2006, and in our Annual Report on Form 10-KSB/A for the yearended December 31, 2005, we noted that our former independent auditors,DS&B, Ltd., in a letter to the Audit Committee of the Company’s Board ofDirectors dated April 18, 2005, had identified certain material weaknesses inthe Company’s internal control systems.  These weaknesses were discoveredby the former auditors during their audit of the Company’s financial statementsfor the year ended December 31, 2004.

In order to ensurethat the Company was adequately addressing all existing internal controlissues, the Company initiated follow-up discussions with its former auditors tobetter determine what constituted these material weaknesses.  During thesediscussions, the Company and its former auditors identified the followingweaknesses in the Company’s internal controls, each of which the Company determinedfirst occurred during the fourth quarter of 2004:

·               Inadequatesystem to capture disclosure items

The Company did not have the requisite accounting skills in certaintechnical areas, such as accounting for convertible debt financing arrangementsand associated derivatives, revenue recognition or equity transactions. This was a significant factor leading to restatements of the Company’sfinancial statements included in its periodic reports filed with the Securitiesand Exchange Commission, as further discussed below.

·               Inadequateinternal process of review for account reconciliations

The Company did not have a formal, documented financial close processwhich included a high-level detailed review of account reconciliations. Furthermore, manual journal entries were not controlled through thegeneral ledger system, leading to poor segregation between the preparation,review, approval and recording of transactions.  This was a significantfactor leading to late filing of our periodic reports and restatements of ourprior financial statements, as further discussed below.

·               Inadequatedocumentation of internal controls

The Company did not have narratives, cycle descriptions or flowchartsof its internal control system, making it difficult to identify key controls ona preventive or investigative level.

·               Inadequateinternal process around drafting of periodic filings with the Securities andExchange Commission

The two acquisitions made by the Company during 2004 increased thelevel of complexity in our business by combining several different software andgeneral ledger packages, orchestrating complex financing transactions, andrecording significant revenues for the business.  The Company did not havea formal, approved financial statement checklist to give its officers adequatecomfort over the level of, and specific disclosures required under, applicableaccounting standards for its periodic Securities and Exchange Commissionfilings.  This was a significant factor leading to late filings andrestatements of prior filings, as further discussed below.

Throughout thefiscal periods spanning the quarters ended December 31, 2005 to December 31,2006, we have implemented changes that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.  These measures include the following:

·               Inadequatesystem to capture disclosure items

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·               In November 2005,the Company retained the services of a consulting firm that specializes inhandling complex accounting issues to assist with its SB-2 registrationstatements and the responses to the SEC Staff’s comments related to thoseregistration statements and its periodic filings;

·               In December 2005,the Company hired a Manager of Accounting Operations with four years of publicaccounting experience;

·               In March 2006, theCompany hired a Manager of Reporting who is a Certified Public Accountant witheighteen years of experience;

·               In June 2006, theCompany replaced the Manager of Finance with a Manager of OrderAdministration.  This individual has sixteen years of experience includingsignificant experience with publicly held companies in the area of orderadministration, including revenue recognized in accordance with accountingprinciples generally accepted in the United States;

·                  InJuly 2006, the Company replaced its Corporate Controller with an individual,who is a certified public accountant, with over twenty years of financeexperience, specializing in operational improvements in small businesses;

·                  InJuly 2006, the Company obtained the services of a consultant to assist with allCompany compliance activities with the SEC;

·                  InSeptember 2006, the Company appointed an Assistant Controller, currently stilla consultant, to assist with enhancing the process around the month-end closecycle; and

·                  InOctober 2006, the Company upgraded its software system enabling it to automatethe recognition of revenue with respect to delivered services or maintenance onits customer contracts.

·               Inadequateinternal process of review for account reconciliations

·               In November 2005,the Company instituted a more formal general ledger close process.Reconciliations for all balance sheet accounts are now prepared by the Company’saccounting staff and then reviewed and signed off by either the Manager ofAccounting Operations or the Corporate Controller prior to the preparation ofthe financial statements;

·                 In November 2005,the Company instituted a process of enhanced review of journal entries andaccount reconciliations, to provide reasonable assurance of complete andaccurate transactions;

·                 In December 2005,the Company instituted weekly revenue meetings, a quarterly certification anddisclosure process, and customer account reviews of revenue files to understandand document our customer arrangements;

·                 In December 2005,the Company instituted a process of manual reconciliation of customer invoicesto related purchase orders and shipping documentation;

·                 In December 2005,the Company instituted a process of manual reconciliation of cash paymentsapplied to customer accounts with invoices and purchase orders;

·                 In February 2006,the Company began the use of outside accounting and financial consultants toassist in the preparation, review and reconciliation of our accounts andfinancial statements;

·                  InJune 2006, the Company instituted a formal secondary review and sign off by theCFO of all cash, debt and equity reconciliations, as well as the accountingtreatment of all significant revenue and business transactions; and

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·                  InJuly 2006, the Company instituted a process whereby all license and servicerevenue transactions are reviewed and signed off by the Manager of OrderAdministration.

·              Inadequatedocumentation of internal controls

·                 The Company iscurrently in the process of identifying, analyzing and documenting the internalcontrols that it believes are critical to ensuring the accuracy of thetransactions that are being recorded in the Company’s accounting system. Someof the areas that are currently documented include the revenue, disbursement,payroll, and equity cycles.

·               Inadequateinternal process around drafting of periodic filings with the Securities andExchange Commission

·               In preparing thisReport, the Company utilized a more formal disclosure checklist to ensureaccuracy.

·                  Aspart of the drafting of this Report, the Company’s Audit Committee increasedits oversight of the disclosure and reporting processes;

·                  InJuly 2006, the Company obtained the services of an outside financial consultantto assist with all Company compliance activities with the SEC; and

·                  BySeptember 30, 2006, our periodic filings with the SEC were made timely.

In addition, wewill continue to design and implement additional policies and procedures thatthe Company may deem necessary.

***Late Filings***

We did not fileour Annual Report on Form 10-KSB for the year ended December 31,2004, and our Quarterly Reports on Form 10-QSB for the periods ended June 30,2005, September 30, 2005, March 31, 2006 or June 30, 2006 on a timely basis(all such reports, however, were filed within the applicable time periodspermitted under Exchange Act Rule 12b-25), because we experienced significantdelays in completing our consolidated financial statements for the year endedDecember 31, 2004 and our condensed consolidated financial statements forthese quarters. Such delays were primarily a result of:

·               The need to performsignificant substantive procedures to compensate for the material weaknesses inour internal control over financial reporting;

·               The additional timerequired for us to complete our expanded financial statement close proceduresin a number of areas, including revenue recognition, derivatives valuation, andaccrual of invoices; and

·               The additional timerequired to perform a substantive review of the majority of our contracts andother financial records.

***Restatements***

As previouslydisclosed by the Company in its prior periodic reports and registrationstatements filed with the Securities and Exchange Commission, including ourAnnual Report on From 10-KSB/A for the year ended December 31, 2005, wedetermined on two separate occasions, in January 2006 and May 2006, that arestatement of our previously reported financial information was required andthat our previously reported financial information should no longer be reliedupon.  Accordingly, during the past year, have restated our previouslyreported financial information for the years ended December 31, 2003, 2004and 2005 and our previously reported unaudited financial statements for thefirst, second and third quarters of 2003, 2004 and 2005 (the “restatement”). The restatement covered a number of separate matters, each of which isdescribed below.

·               *Revenue Recognition*

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

·              *Accounting for Convertible Financing Arrangements*

The Company reviewed the initial accounting for the 7% ConvertibleNotes issued in 2003, the Senior and Subordinated Convertible Term Notes issuedin 2004 and the Senior and Subordinated Convertible Term Notes issued in 2005.During the review the company identified that EITF 00-19 should be applied toevaluate whether any embedded derivative instruments qualify as equityinstruments or as liabilities. As such certain embedded derivatives wereidentified that met the conditions set forth under paragraph 12 of SFASNo. 133. These embedded derivative instruments have been evaluated usingEITF 00-19 paragraphs 12 to 32 and determined that these instruments would notbe classified as components of stockholders equity. The instruments have beendeemed liabilities, and as such will be subject to SFAS 133 and should berecorded at fair value. Features that have been evaluated and determined torequire such treatment include:

·                     The principalconversion option,

·                     The monthlypayments conversion option, and

·                     The interestrate adjustment provisions.

Additionally, it was identified that certain other components of therelated financings were also incorrectly accounted for. This includes thewarrants issued with the above financing and the costs incurred by Company inobtaining the above financings. The correction of prior errors affected thesubsequent accounting for debt conversions to equity as well as theamortization of related discounts and deferred finance charges associated withthe above financings.

·               *Accounting for Warrants Related to the Companies 2004Debt Financing*

Based on certain registration rights provisions it was determined thatthe warrants issued as part of the Company’s 2004 debt financing would requirecontinued classification as a liability and revalued every quarter. The Companypreviously classified the warrants as equity upon the registration rightsagreement becoming effective during the fourth quarter of 2004.

·              *Valuations of Embedded Derivatives*

The initial valuation methodology overstated the value of theconversion option derivatives. The company’s review of the valuations of theembedded derivatives determined that the valuation of the principal conversionoption and the monthly payments conversion option shared certain componentsthat resulted in a double counting of the embedded derivative valuation. Assuch the company has adjusted its valuations of these embedded derivatives.

·               *Additional Derivative (Default Provision)*

The company also reviewed the default provisions set forth in the debtinstruments and determined that an additional embedded derivative existed thatrequired bifurcation from the host contract and would need to be revalued on aquarterly basis.

The Company alsoreviewed the earnout calculations performed in the prior year for the PSGacquisition and identified an error in the calculation. As a result the Companyhas restated the prior year’s impact relating to this error. AtDecember 31, 2004 the Company had accrued $43,635 for the earnoutprovision. The corrected calculation resulted in no accrual being required, andas such the related accrual and goodwill balances have been reduced by $43,635.

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

The errors in ourpreviously reported financial information, and the failure to prevent them ordetect them in our financial reporting process, were largely attributable tothe material weaknesses in our internal controls described above, an inadequatestaff of competent accounting personnel with an appropriate level of knowledgeof GAAP and to errors in the valuations of the previously identified embeddedderivatives.

### **Evaluationof Disclosure Controls and Procedures as of December 31, 2006**

During the reviewof the Company’s operating results for the year and quarter ended December 31,2006, our CEO and CFO determined that, as of that date, our disclosure controlsand procedures were effective in providing reasonable assurance thatinformation we are required to disclose in reports we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified by the Securities and Exchange Commission rules andforms.  Our management reached thisconclusion after identifying our system to capture disclosure items, ourinternal process of review for account reconciliations, our documentation ofinternal controls and our internal process for preparing our annual report onForm 10-KSB for the fiscal year ended December 31, 2006 as beingadequate to provide such assurance.

Effective internalcontrol over financial reporting and disclosure controls and procedures arenecessary for us to provide reliable financial reports and effectively preventfraud and to operate successfully as a public company. We have in the pastdiscovered, as described above, and may in the future discover, areas of ourdisclosure and internal controls that need improvement. As of December 31,2006, we believe we have addressed these issues, ensuring that our internalcontrol over financial reporting and disclosure controls and procedures haveimproved sufficiently for us provide reasonable assurance that the informationwe are required to disclose in reports that we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission rules and forms.If, however, we cannot provide reliable financial reports or prevent fraud, ourreputation and operating results would be harmed.

We cannot becertain that our efforts to remediate previous material weaknesses in ourinternal control over financial reporting and the ineffectiveness of ourdisclosure controls and procedures will continue to be successful or that wewill be able to maintain adequate controls over our financial processes andreporting in the future. We have committed substantial resources, includingsubstantial time from our management team’s accounting personnel and fromexternal consultants, to implement and integrate into our organization improveddisclosure controls and additional procedures generally and to improve systemsto report financial information on a timely basis.

Any failure tomaintain effective controls, or difficulties encountered in their implementationor in other effective improvement of our internal and disclosure controls couldmaterially harm our operating results or cause us to fail to meet our reportingobligations. If we are unable to adequately establish or improve our internalcontrols over financial reporting, or if we maintain an ineffective system ofdisclosure controls and procedures, our financial statements may not accuratelyreflect the financial condition of the Company, and current and potentialfuture investors may not be able to rely upon our financial statements.Additionally, our external auditors may not be able to issue an unqualifiedopinion on the effectiveness of our internal controls. Ineffective internal anddisclosure controls could also cause investors to lose confidence in ourreported financial information, which would likely have a significant negativeeffect on the trading price of our securities.

Moreover, becauseof the inherent limitations in all control systems, no evaluation of controls,even where we conclude the controls are operating effectively, can provideabsolute assurance that all control issues, including instances of fraud, ifany, have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and breakdowns can occur because ofsimple error or mistake. Additionally, controls can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the controls. The design of any system of controls alsois based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Over time, our controlsystems, as we develop them, may become inadequate because of changes inconditions, or the degree of compliance with the policies 

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or procedures maydeteriorate. Because of the inherent limitations in a cost-effective controlsystem, misstatements due to error or fraud may occur and not be detected andcould be material to our financial statements.

The certifications of our principal executive officerand principal financial officer required in accordance with Rule 13a-14(a) under theExchange Act and Section 302 of the Sarbanes-Oxley Act of 2002 areattached as exhibits to this Annual Report on Form 10-KSB. The disclosuresset forth in this Item 8A contain information concerning theevaluation of our disclosure controls and procedures, and changes in internalcontrol over financial reporting, referred to in paragraph 4 of thecertifications. Those certifications should be read in conjunction with thisItem 8A for a more complete understanding of the matters covered by thecertifications.

**ITEM8B.**           OTHERINFORMATION

Not applicable.

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**PART III**

**ITEM9.**                    DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITHSECTION 16(a) OF THE EXCHANGE ACT

The following sets forthcertain information about each director and executive officer of the Company.
| **NAME**              | ** ** | **AGE** | ** ** | **POSITIONS HELD**                                             |
|-----------------------|------------|---------|------------|----------------------------------------------------------------|
| Thomas J. Colatosti   |       | 59      |       | Chairman of the Board of Directors                             |
| Michael W. DePasquale |       | 52      |       | Chief Executive Officer and Director                           |
| Jeffrey J. May (b)    |       | 47      |       | Director                                                       |
| Charles P. Romeo(a)   |       | 65      |       | Director                                                       |
| John Schoenherr (b)   |       | 54      |       | Director                                                       |
|                  |       |    |       |                                                           |
| Francis J. Cusick     |       | 52      |       | Chief Financial Officer                                        |
| Randy Fodero          |       | 48      |       | Vice President of Sales                                        |
| Kenneth S. Souza      |       | 52      |       | General Manager, Law Enforcement and Chief  Technology Officer |

 

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

(b)            AuditCommittee Member

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 and as Chairman of the Boardsince January 3, 2003. He served as Co-Chief Executive Officer of the Companyfrom July 2005 to August 2006. Mr. Colatosti also currently serves as the ChiefExecutive Officer of American Security Ventures, a Lexington, Massachusettsbased consulting firm he founded which specializes in providing strategicmanagement consulting services to emerging and developing companies in thehomeland security industry. From 1997 through June 2002, Mr. Colatosti servedas the Chief Executive Officer of Viisage Technology, Inc., a publicly tradedbiometric technology company focusing on biometric face-recognition technologyand delivering highly secure identification documents and systems. Between 1995and 1997, Mr. Colatosti served as President and Chief Executive Officer of CISCorporation, a higher education industry leader that designed and implementedintegrated and flexible systems solutions to manage entire universityadministrative operations. Prior to CIS, Mr. Colatosti had a 21 year careerwith Digital Equipment Corporation. His most recent responsibility was VicePresident and General Manager, Northeast Area, where he was responsible for abusiness unit with annual revenues of more than $1.2 billion and 3,000 people.Mr. Colatosti is an active industry security spokesperson testifying beforeCongressional Committees and advising the White House and other Federalsecurity agencies on homeland security issues. Since August 18, 2005, Mr.Colatosti has served as a Director and Chief Financial Officer of Good HarborPartners Acquisition Corp., a publicly-traded blank check company formedto acquire businesses in the security sectors. Mr. Colatosti earned aBachelor of Science degree in Management and Finance as well as a Mastersdegree in Business Administration from Suffolk University.

**MICHAELW. DEPASQUALE** hasserved as the Chief Executive Officer and a Director of the Company sinceJanuary 3, 2003. He served as Co-Chief Executive Officer of the Company fromJuly 2005 to August 2006. Mr. DePasquale brings more than 20 years of executivemanagement, sales and marketing experience to the Company. Prior to joining theCompany, Mr. DePasquale served as the President and Chief Executive Officer ofPrism eSolutions, Inc., a Pennsylvania based provider of professionalconsulting services and online solutions for ISO-9001/14000 certification forcustomers in manufacturing, healthcare and government markets, since February2001. From December 1999 through December 2000, Mr. DePasquale served as GroupVice President for WRC Media, a New York based distributor of supplementaleducation products and software. From January 1996 until December 1999, Mr.DePasquale served as Senior Vice President of Jostens Learning Corp., aCalifornia based provider of multi media curriculum. Prior to Jostes, Mr. DePasqualeheld sales and marketing management positions with McGraw-Hill and DigitalEquipment Corporation. Mr. DePasquale earned a Bachelor of Science degreefrom the New Jersey Institute of Technology.

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**JEFFREYJ. MAY** has served as aDirector of the Company since October 29, 2001. Since December 2006, Mr. Mayhas served as the CEO of MagnaLynx, a semiconductor manufacturer specializingin high speed chip to chip communication. Since 1997, Mr. May has served as thePresident of Gideons Point Capital, a Tonka Bay Minnesota based financialconsulting firm and angel investor focusing on assisting and investing instart-up technology companies. In 1983, Mr. May co-found Advantek,Inc., a manufacturer of equipment and materials which facilitate the automatichandling of semi-conductors and other electrical components which was sold in1993. Mr. May continued to serve as a director and Vice-President of Operationsof Advantek until 1997, at which time it had over 600 employees and sales inexcess of $100 million. Mr. May earned a Bachelor of Science degree inElectrical Engineering from the University of Minnesota in 1983.

**CHARLESP. ROMEO** has served asa director of the Company since February 28, 2005 and from January 29, 2003 toApril 19, 2004. From April 2004 until February 2005, he served as VicePresident of Sales, Public Safety Division of the Company. Mr Romeo iscurrently the Vice President of Sales and Marketing for UNICOM, a Rhode Islandsystems integrator. From September 2002 until April 2004 Mr. Romeo has servedas the President and Chief Executive Officer of FreedomBridge Technologies,Inc., a Rhode Island based consulting firm to technology companies in thehomeland security industry specializing in implementing direct and channelselling programs, strategic alliances and partnerships in the law enforcementmarket. Prior to founding FreeedomBridge, Mr. Romeo had a 33 year sales andmarketing management career with Digital Equipment Corporation, Compaq ComputerCorporation and Hewlett Packard. During his career, Mr. Romeo served asVice President of Service Sales for a $500 million business unit, and Directorof Public Sector Sales, a $275 million division of Hewlett Packard. Mr. Romeoauthored *The Sales Manager’s Troubleshooter,*Prentice Hall 1998, which was named as one of the “top 10 must reads” by Salesand Marketing Magazine. Mr. Romeo earned a Bachelor of Science degree inMathematics and Economics from the University of Massachusetts and an ExecutiveMBA from Babson College.

**JOHNSCHOENHERR** has servedas a Director of the Company since December 30, 2004. Mr. Schoenherr served asVice President of Corporate Performance Management for Oracle Corporationfrom  1995 through 2006.  Prior to Oracle he served as Senior VicePresident of Business Intelligence and Analytics at Information Resources,Inc.   Mr. Schoenherr has over 25 yearsof experience in the area of business intelligence and strategic planning.  His career includes a number of product developmentand management positions.

**FRANCISJ. CUSICK** has served asthe Chief Financial of the Company since February 28, 2005. Mr. Cusick joinedthe Company as the Corporate Controller in September 2004. Mr. Cusick served asan independent business consultant to public and private companies in a varietyof strategic and financial executive roles from March 2002 until September2004. From January 2001 through February 2002, Mr. Cusick was Chief FinancialOfficer for SANgate Systems, a multi-national provider of storagehardware and software. Prior to SANgate Systems, Mr. Cusick held seniorfinancial management positions at Equipe Communications Corp., ParametricTechnology Corp., Cascade Communications Corp. and Synernetics Inc.

**RANDYFODERO** has served asthe Vice President of Sales since February 1, 2006. From July 22, 2005 untilFebruary 1, 2006, he was a sales consultant to the Company. Between July 18,2003 and July 22, 2005, Mr. Fodero was the Vice President of Sales andMarketing of the Company. Mr. Fodero joined the Company as a member of thesales organization in March 2003. Mr. Fodero brings more than 20 years ofsuccessful executive and sales management experience to the Company. Prior tojoining the Company, Mr. Fodero served as director of Global Accounts forVeritas Software from February 2002 until January 2003. Between 1999 andFebruary 2002, Mr. Fodero served in executive sales capacities with bothcompanies in the enterprise software industry, including Agile Software. From1998 to 1999, Mr. Fodero served as Regional Vice President of Sales for MemcoSoftware, a leading provider of information security software to Fortune 1000companies, where he was instrumental in increasing sales and enhancingshareholder value in connection with the sale of Memco to Platinum Technology.From 1990 through 1998, Mr. Fodero served as Vice President of Sales ofAT&T CommVault Systems, where he grew sales from startup to over $36million and participated in a management buyout.

**KENNETHS. SOUZA** has served asExecutive Vice President and General Manager, Law Enforcement since October 18,2005. From October 4, 2004 to October 17, 2005 Mr. Souza was Chief TechnologyOfficer of the Company. Prior to joining the Company, Mr. Souza was VicePresident of Industry Solutions for EMC Corporation. Prior to joining EMC, hewas Vice President for e-Commerce Enterprise Systems Solutions for CompaqComputer Corporation for 4 years. His 25-year technology and market careerincludes serving in a number of executive positions with Digital EquipmentCorporation including Vice President Worldwide Solutions Services and Training,and Director of Workstations Marketing. In the early 1980’s, Mr. Souza heldtechnical sales management positions with Hewlett Packard and Burroughs. Mr.Souza also held executive positions with a venture funded MRP software company.

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**Directors’ Terms of Office**

Mr.May was initially elected to serve as a director in 2001, and was re-elected in2004. Mr. Colatosti was initially elected to serve as a director in 2002, andwas re-elected in 2004. Mr. DePasquale was initially elected as a director in2003, and was re-elected in 2004. Mr. Schoenherr was initially elected as adirector in 2004. Mr. Romeo was initially elected as a director in 2005. Eachsuch director was elected to serve until the Company’s next annual meeting oruntil his successor is duly elected and qualified in accordance with theBy-laws of the Company.

**IndependentDirectors**

The Board applies thedefinition of independent director as set forth in NASDAQ Stock Market Rule4200 (a)(15). In accordance with this guidance, the Board considers Mr. May andMr. Schoenherr to be independent.

**Committees of the Board**

**Audit Committee**

The AuditCommittee is comprised of John Schoenherr and Jeffrey J. May, who may notqualify as “audit committee financial experts” under the applicablerules adopted by the Securities and Exchange Commission. However, theBoard believes that each Audit Committee member has sufficient knowledge infinancial and auditing matters to serve on the Audit Committee. Additionally,the Audit Committee has the ability on its own to retain independentaccountants or consultants whenever it deems appropriate.

TheBoard of Directors has determined that each member of the Audit Committeequalifies as independent director, as required by the Audit Committee Charter.In addition, the members of the audit committee satisfy the independencerequirements of Rule 10A-3 under the Securities Exchange Act of 1934, asamended, as well as NASDAQ Stock Market Rule 4200 (a)(15).

The primaryfunction of our audit committee is to assist the Board of Directors infulfilling its responsibilities for oversight of:

·                  the integrity ofour financial statements;

·                  our compliancewith legal and regulatory requirements;

·                  the independentregistered public accounting firm’s qualifications and independence; and

·                  theperformance of our internal audit function and our independent registeredpublic accounting firm.

Specificresponsibilities of our audit committee include:

·                  appointing,retaining, evaluating, terminating, approving the compensation of, and assessingthe independence of our independent registered public accounting firm;

·                  overseeing thework of our independent registered public accounting firm, including throughthe receipt and consideration of certain reports from the independentregistered public accounting firm;

·                  reviewing anddiscussing with management and the independent registered public accountingfirm our annual and quarterly financial statements and related disclosures;

·                  monitoring ourinternal control over financial reporting, our disclosure controls andprocedures and our Code of Business Conduct and Ethics;

·                  discussing ourrisk management policies;

·                  establishingpolicies regarding hiring employees or former employees of our independentregistered public accounting firm;

·                  establishingprocedures for the receipt and retention of accounting related complaints andconcerns;

·                  meetingindependently with our independent registered public accounting firm andmanagement; and

·                  preparingthe audit committee report required by SEC rules and regulations (which isincluded below).

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

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

Management isresponsible for our financial reporting process, including its system ofinternal control over financial reporting, and for the preparation ofconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America. Our independent registeredpublic accounting firm is responsible for auditing those financial statementsand expressing an opinion on the conformity of the company’s audited financialstatements in accordance with accounting principles generally accepted in theUnited States of America. The audit committee’s responsibility is to monitorand review these processes.

The auditcommittee has reviewed and discussed with the independent registered publicaccounting firm and management the plan and results of the auditing engagementand the audited financial statements for the fiscal year endedDecember 31, 2006. The audit committee discussed with the independentregistered public accounting firm the matters required to be discussed byStatement on Auditing Standards No. 61, “Communication With AuditCommittees.” Statement on Auditing Standards No. 61 requires ourindependent registered public accounting firm to discuss with the auditcommittee, among other things, the following:

·                  methods toaccount for significant unusual transactions;

·                  the effect ofsignificant accounting policies in controversial or emerging areas for whichthere is a lack of authoritative guidance or consensus;

·                  the process usedby management in formulating particularly sensitive accounting estimates andthe basis for the auditors’ conclusions regarding the reasonableness of thoseestimates; and

·                  disagreementswith management over the application of accounting principles, the basis formanagement’s accounting estimates and the disclosures in the financialstatements.

In addition, theaudit committee has received from the independent registered public accountingfirm the written disclosures required by Independence Standards BoardNo. 1, “Independence Discussions With Audit Committees”, and discussedwith the independent registered public accounting firm its independence fromthe Company and its management. Independence Standards Board StandardNo. 1 requires auditors annually to disclose in writing all relationshipsthat in the auditor’s professional opinion may reasonably be thought to bear onindependence, confirm their perceived independence, and engage in a discussionof independence. The audit committee considered whether the provision ofnon-audit services by the independent registered public accounting firm iscompatible with maintaining the independent registered public accounting firm’sindependence and concluded that it is compatible at this time.

The auditcommittee has also reported to the board of directors its activities,conclusions and recommendations. Specifically, in reliance on the reviews anddiscussions referred to above, the audit committee recommended to the board ofdirectors that the audited financial statements be included in our AnnualReport on Form 10-KSB for the year ended December 31, 2006, forfiling with the SEC. The Audit Committee has also approved the appointment ofCarlin, Charron & Rosen, LLP as the Company’s independent registered publicaccounting firm for the fiscal year ending December 31, 2007.

Respectfully submitted,

**AUDITCOMMITTEE**

Jeffrey J. May (Chairman)

John Schoenherr

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**Directors Compensation**

Directors who are alsoofficers of the Company receive no additional compensation for serving on theBoard of Directors, other than reimbursement of reasonable expenses incurred inattending meetings. The Company’s 1996 stock incentive plan provides for thegrant of options to purchase 50,000 shares of common stock to each non-employeedirector upon first being elected or appointed to the Board of Directors. TheCompany’s current policy is to issue options to purchase 50,000 shares ofcommon stock to each non-employee director on an annual basis. No options wereissued during 2006.

**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 toSection 16(a) of the Exchange Act. Based solely on its review of thecopies of such forms received by it, or written representations from suchpersons that no other reports were required for such persons, the Companybelieves that during the fiscal year ended December 31, 2006, allSection 16(a) filing requirements applicable to the Company’sofficers, directors and ten percent (10%) stockholders were satisfied in atimely fashion.

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**ITEM10.**             EXECUTIVECOMPENSATION

The following table setsforth a summary of the compensation paid to or accrued by our co-chiefexecutive officers (principal executive officers) and the two most highlycompensated executive officers other than the principal executive officers, whowere serving as executive officers at the end of December 31, 2006, forthe fiscal year ended December 31, 2006:

**SUMMARYCOMPENSATION TABLE**
| **Name**                                  | ** ** | **Fiscal  Year** | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive Plan  Compensation  ($)** | ** ** | **Nonqualified  Deferred  Compensation  Earnings  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|-------------------------------------------|------------|------------------|------------|---------------------|------------|--------------------|------------|------------------------|------------|-------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------|------------|----------------|------------|
| **Michael  W. DePasquale (1)**       |       | 2006             |       | 250,000             |       | —             |       | —                 |       | 85,892                  | (6)        | —                                                 |       | —                                                  |       | —                                |       | 335,892        |       |
| Co-Chief Executive  Officer               |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| ** **                                | ** ** | ** **       | ** ** | ** **          | ** ** | ** **         | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                                             | ** ** | ** **                                              | ** ** | ** **                            | ** ** | ** **     | ** ** |
| **Thomas  J. Colatosti (2)**              |       | 2006             |       | 174,000             |       | —             |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | 174,000        |       |
| Co-Chief  Executive Officer               |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| ** **                                | ** ** | ** **       | ** ** | ** **          | ** ** | ** **         | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                                             | ** ** | ** **                                              | ** ** | ** **                            | ** ** | ** **     | ** ** |
| **Randy  Fodero (3)**                     |       | 2006             |       | 256,803             | (4)        | —             |       | —                 |       | 95,633                  | (6)        | —                                                 |       | —                                                  |       | —                                |       | 352,436        |       |
| Vice President  Sales                     |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| ** **                                | ** ** | ** **       | ** ** | ** **          | ** ** | ** **         | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                                             | ** ** | ** **                                              | ** ** | ** **                            | ** ** | ** **     | ** ** |
| **Kenneth  S. Souza (5)**                 |       | 2006             |       | 200,000             |       | 10,000             |       | —                 |       | 114,943                 | (6)        | —                                                 |       | —                                                  |       | —                                |       | 324,943        |       |
| General Manager,  Law                     |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |
| Enforcement and Chief  Technology Officer |       |             |       |                |       |               |       |                   |       |                    |       |                                                   |       |                                                    |       |                                  |       |           |       |

 

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

(2)             Mr. Colatostiserved as Co-Chief Executive Officer from July 2005 to August 2006.

(3)             Mr. Foderobecame Vice President of Sales on February 1, 2006. He was a sales consultantto the Company from July 22, 2005 until February 1, 2006. BetweenJuly 18, 2003 and July 22, 2005, Mr. Fodero was the Senior VicePresident of Sales and Marketing of the Company.

(4)             Includes$85,870 of commission income.

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

(6)             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**

***Employment Agreements***

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

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

**THOMAS J. COLATOSTI.**Inconnection with his appointment to the Board of Directors inSeptember 2002, the Company entered into a number of consulting arrangementswith Thomas J. Colatosti. Under the most recent arrangement, which was enteredinto on February 7, 2006, Mr. Colatosti provided services to theCompany and its subsidiaries and affiliates for the year endedDecember 31, 2006 at a rate of $14,500 per month. This agreement expiredon December 31, 2006 and has not been renewed.

**KENNETH S. SOUZA.**  Inconnection with his appointment as Senior Vice President and Chief TechnologyOfficer of the Company on October 4, 2004, we entered into a one yearemployment agreement with Kenneth S. Souza. The employment agreement providesfor an annual base salary of $200,000 and a performance bonus in the amount ofup to $76,000 payable upon achievement of certain performance criteria. Unlessnotice of non-renewal is provided to Mr. Souza at least two months priorto the end of the term, the employment agreement automatically renews forsuccessive one year terms. This agreement also contains a number of terminationand change of control provisions as described in “Termination and Change inControl Arrangements” in this Item.

***Stock Option Grant***

On March 23, 2006, Michael DePasquale, Randy Fodero,and Kenneth Souza were granted options to purchase 400,000, 100,000, and250,000 shares of common stock respectively, at an exercise price of $0.75 pershare. These options expire on March 23, 2016. The options vest in equalincrements over two years, as described in “Outstanding Equity Awards at FiscalYear End” in this Item.

In the event of any change in the outstanding sharesof our common stock by reason of a stock dividend, stock split, combination ofshares, recapitalization, merger, consolidation, transfer of assets,reorganization, conversion or what the board deems to be similar circumstances,the number and kind of shares subject to this option and the exercise price ofsuch option shall be appropriately adjusted in a manner to be determined in thesole discretion of the board. Furthermore, these option agreements contain achange of control provision as described in “Termination and Change in ControlArrangements” in this Item.

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**OUTSTANDINGEQUITY AWARDS AT FISCAL YEAR ENDDECEMBER 31, 2006**

The following table sets forth for each namedexecutive officer, information regarding outstanding equity awards as atDecember 31, 2006:
| ** **             | ** ** | **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                                                                              | (1)        |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Thomas J.  Colatosti   |       | 200,000                                                                            |       | —                                                                               |       | — |   | 0.31 |   | 8/28/2009 |   | — |   | — |   | — |   | — |   |
|                   |       | 150,000                                                                            |       | —                                                                               |       |   |   | 0.31 |   | 8/28/2009 |   |   |   |   |   |   |   |   |   |
|                   |       | 50,000                                                                             |       | —                                                                               |       |   |   | 1.32 |   | 12/11/2010 |   |   |   |   |   |   |   |   |   |
|                   |       | 150,000                                                                            |       | —                                                                               |       |   |   | 1.32 |   | 12/11/2010 |   |   |   |   |   |   |   |   |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Randy Fodero           |       | 333,333                                                                            |       | 266,667                                                                              | (2)        | — |   | 0.60 |   | 11/11/2012 |   | — |   | — |   | — |   | — |   |
|                   |       | —                                                                             |       | 100,000                                                                              | (3)        |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |
|                   |       |                                                                               |       |                                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Kenneth S. Souza       |       | 200,000                                                                            |       | 100,000                                                                              | (4)        | — |   | 1.05 |   | 9/15/2011 |   | — |   | — |   | — |   | — |   |
|                   |       | —                                                                             |       | 250,000                                                                              | (5)        |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |

 

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(1)             The options vestequally in two annual installments commencing March 23, 2007; 200,000 vested onMarch 23, 2007 and 200,000 will vest on March 23, 2008.

(2)             200,000 of theoptions vested upon grant and the remaining options vest equally thereafter inthree annual installments commencing November 11, 2006; 133,333 vested onNovember 11, 2006, 133,333 will vest on November 11, 2007 and 133,334 will veston November 11, 2008.

(3)             The options vestequally in two annual installments commencing March 23, 2007; 50,000 vested onMarch 23, 2007 and 50,000 will vest on March 23, 2008.

(4)             The options vestequally in three annual installments commencing October 4, 2005;  100,000 vested on October 4, 2005; 100,000 vestedon October 4, 2006 and 100,000 will vest on October 4, 2007.

(5)             The options vestequally in two annual installments commencing March 23, 2007; 125,000 vested onMarch 23, 2007 and 125,000 will vest on March 23, 2008.

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**Terminationand Change in Control Arrangements**

The following are the material terms of eachagreement, contract, plan or arrangement that provide for payments to one ormore of our named executive officers at, following or pursuant to theirresignation, retirement or termination, or in connection with a change incontrol of the Company.

***TerminationArrangements***

**MICHAEL W. DEPASQUALE employmentagreement.**  On March 28, 2006, the Companyentered into a two-year employment agreement with Michael W. DePasquale toserve as the Chief Executive Officer of the Company.

The Company may terminate the agreement at any timewith or without cause. In the event of termination without cause,Mr. DePasquale shall continue to be paid his then current base salary forsix months from the date of such termination.

**KENNETH S. SOUZA employmentagreement.**  On October 4, 2006, the Companyrenewed the annual agreement with Kenneth Souza to serve as Executive VicePresident and General Manager, Law Enforcement of the Company.

The Company may terminate the agreement at any timewith or without cause. In the event of termination without cause,Mr. Souza shall continue to be paid his then current base salary for thegreater of six months from the date of such termination or the number of monthsremaining until the end of the term of the employment agreement.

***Change in Control Provisions***

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

In the event of a “ChangeIn Control” each Plan provides for the immediate vesting of all options issuedthereunder. The 1999 Plan provides for the Company to deliver written notice toeach optionee under the 1999 Plan fifteen (15) days prior to theoccurrence of a Change In Control during which all options issued under the1999 Plan may be exercised. Thereafter, all options issued under the 1999 Planwhich are neither assumed or substituted in connection with such transaction,automatically expire unless otherwise determined by the Board. The 1996 Planprovides for all options to remain exercisable for the remainder of theirrespective terms and permits the Company to make a cash payment to any or alloptionees equal to the difference between the exercise price of any or all suchoptions and the fair market value of the Company’s common stock immediatelyprior to the Change In Control. The 2004 Plan enables the Board to provide thatall outstanding options be assumed, or equivalent options be substituted by theacquiring or succeeding corporation upon the occurrence of a “ReorganizationEvent” as defined. If such Reorganization Event also constitutes a Change inControl, then such assumed or substituted options shall be immediatelyexercisable in full. If the acquiring or succeeding corporation does not agreeto assume, or substitute for such options, then the Board, upon written noticeto the Participants, may provide that all unexercised options becomeexercisable in full as of a specified time prior to the Reorganization Event andterminate prior to the consummation of the Reorganization Event. Alternatively,if under the terms and conditions of the Reorganization Event, holders ofcommon stock will receive a cash payment for their shares, then the Board mayprovide that all Participants receive a cash payment equal to the differencebetween the Acquisition Price and the Option Price multiplied by the number ofoptions 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, 2006**

The following table sets forth for each director,information regarding their compensation for the year ended December 31, 2006:
| **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 (1)   |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Michael W.  DePasquale (1) |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Jeffrey J. May             |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Charles P. Romeo           |       | —                                                    |       | —                 |       | 112,978                 | (2)        | —                                                 |       | —                                                  |       | —                                |       | 112,978        |       |
| John Schoenherr            |       | —                                                    |       | —                 |       | 20,053                  | (2)        | —                                                 |       | —                                                  |       | —                                |       | 20,053         |       |

 

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(1)             Refernarrative disclosure to summary compensation table for information pertainingto employment agreements.

(2)             Theaggregate grant date fair value of the option awards was estimated using theBlack-Scholes option pricing model, with the assumptions listed in Note A tothe Company’s financial statements. The amount shown in this column representsthe compensation cost of awards recognized during the year for financialreporting purposes under FAS 123(R ),without regard to estimated forfeitures related to service-based vestingconditions for option awards.

We reimburse each of our non-employee directors fortheir reasonable expenses incurred in connection with attending meetings of theboard of directors and related committees.

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

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

The following table setsforth, as of March 1, 2007, 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                                           |       | 1,080,000                                                         | (2)        | 1.9                              | %          |
|                                                          |       |                                                              |       |                             |       |
| Michael W. DePasquale                                         |       | 1,300,000                                                         | (3)        | 2.3                              | %          |
|                                                          |       |                                                              |       |                             |       |
| Francis J. Cusick                                             |       | 208,331                                                           | (4)        | *                                |       |
| Jeffrey May                                                   |       | 250,000                                                           | (5)        | *                                |       |
| Charles P. Romeo                                              |       | 325,000                                                           | (6)        | *                                |       |
| John Schoenherr                                               |       | 50,000                                                            | (7)        | *                                |       |
| Randy Fodero                                                  |       | 383,333                                                           | (8)        | *                                |       |
| Kenneth S. Souza                                              |       | 325,000                                                           | (9)        | *                                |       |
| Kingdon Capital Management,  LLC                              |       | 2,696,112                                                         |       | 4.8                              | %          |
| 152 West 57 th Street 50 th Floor New York, NY 10019          |       |                                                              |       |                             |       |
| Trellus  Management Company, LLC                              |       | 8,922,239                                                         |       | 15.8                             | %          |
| 350 Madison  Avenue 9th Floor New York, NY 10017         |       |                                                              |       |                             |       |
| All officers and directors  as a group (8) persons       |       | 3,921,664                                                         |       | 6.9                              | %          |

 

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*                    Lessthan 1%

(1)             Thesecurities “beneficially owned” by an individual are determined in accordancewith the definition of “beneficial ownership” set forth in the regulationspromulgated under the Securities Exchange Act of 1934 and, accordingly, mayinclude securities owned by or for, among others, the spouse and/or minorchildren of an individual and any other relative who has the same home as suchindividual, as well as, other securities as to which the individual has orshares voting or investment power or which each person has the right to acquirewithin 60 days through the exercise of options or otherwise. Beneficialownership may be disclaimed as to certain of the securities. This table hasbeen prepared based on 56,591,104 shares of common stock outstanding as of March 1,2007.

(2)             Includes550,000 shares assumable upon exercise of options and 525,000 shares issuableupon conversion of series A preferred stock.

(3)             Includes1,280,000 shares issuable upon exercise of options. Does not include 200,000shares issuable upon exercise of options subject to vesting.

(4)             Includes208,331 shares issuable upon exercise of options. Does not include 141,669shares issuable upon exercise of options subject to vesting.

(5)             Consistsof shares issuable upon exercise of options.

(6)             Includes325,000 shares issuable upon exercise of options. Does not include 75,000shares issuable upon exercise of options subject to vesting.

(7)             Consistsof shares issuable upon exercise of options.

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(8)             Includes383,333 shares issuable upon exercise of options. Does not include 316,667shares issuable upon exercise of options subject to vesting.

(9)             Includes325,000 shares issuable upon exercise of options. Does not include 225,000shares issuable upon exercise of options subject to vesting.

The following table setsforth, as of December 31, 2006, 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     |       | 125,000                                                                                                                                                       |       | $                                                                                                                    | 0.47       |                                                                                                                                                                                                                  | —     |   |
| Equity  compensation plans not approved by security holders |       | 8,009,419                                                                                                                                                     |       | $                                                                                                                    | 0.86       |                                                                                                                                                                                                                  | 1,817,838  |   |
| Total                                                       |       | 8,134,419                                                                                                                                                     |       | $                                                                                                                    | 0.85       |                                                                                                                                                                                                                  | 1,817,838  |   |

 

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 terminated in May 2005.

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

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

The 1999 Plan providesfor the issuance of options to purchase up to 2,000,000 shares of common stockto officers, employees, directors and consultants of the Company at exerciseprices not less than 85% of the last sale price of the Company’s common stockas reported on the OTC Bulletin Board on the date of grant. Options have termsof not more than 10 years from the date of grant, are subject to vestingas determined by the Plan Administrator and are not transferable without thepermission of the Company except by will or the laws of descent and distributionor 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 Planprovides for the immediate vesting of all options in the event of a “Change InControl” of the Company. In the event of a Change In Control, the Company isrequired to deliver written notice to each optionee under the 1999 Plan fifteen(15) days prior to the occurrence of a Change in Control, during whichtime all options issued under 1999 Plan may be exercised. Thereafter, alloptions issued under the 1999 Plan which are neither assumed or substituted inconnection with such transaction, automatically expire, unless otherwisedetermined by the Board. Under the 1999 Plan, a “Change In Control” is definedto include (i) a sale or transfer of substantially all of the Company’sassets; (ii) the dissolution or liquidation of the Company; (iii) amerger or consolidation to which the Company is a party and after which theprior shareholders of the Company hold less than 50% of the combined votingpower of the surviving corporation’s outstanding securities; (iv) theincumbent directors cease to constitute at least a majority of the Board ofDirectors; or (v) a change in

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control of the Companywhich would otherwise be reportable under Section 13 or 15(d) of theExchange Act. The 1999 Plan terminates in August 2009.

As of December 31,2006, there were outstanding options under the 1996 Plan to purchase 125,000shares of common stock, and no shares were available for future grants.

As of December 31,2006, there were outstanding options under the 1999 Plan to purchase 995,000shares of common stock, and options to purchase an aggregate of 714,257 shareswere available for future grants.

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

As of December 31,2006, there were outstanding options under the 2004 Plan to purchase 2,896,419shares of common stock, and options to purchase an aggregate of 1,103,581shares 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 2006, there were outstanding options underthe non plan to purchase 4,118,000 shares of common stock. The terms of theseoptions are substantially similar to the provisions of the 1999 Plan andoptions issued thereunder.

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**ITEM12.**             CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

**Employment Arrangements**

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

**Options Granted to Executive Officersand Directors**

During 2006 and 2005, theCompany issued options to purchase an aggregate of 900,000 and 1,155,000shares, respectively of common stock to its officers and directors. The optionswere issued at exercise prices equal to the last sales price of the Company’scommon stock as reported on the OTC Bulletin Board on the date of grant, have aterm of seven years, and vest over a two to three year period.

**Consulting Arrangement withThomas J. Colatosti**

In connection with hisappointment to the Board of Directors in September 2002, the Companyentered into a number of consulting arrangements with Thomas J. Colatosti.Under the most recent arrangement, which was entered into on February 7,2006, Mr. Colatosti provided services to the Company and its subsidiariesand affiliates for the year ended December 31, 2006 at a rate of $14,500per month.

**Equity raisingwith Trellus Partners, LP (“Trellus”)**

Trellus may bedeemed to be a “related person” under Item 404 of Regulation S-B by virtue ofits ownership of more than five percent of the Company’s outstanding commonstock. As further discussed in this Report, including in the “Management’sDiscussion and Analysis or Plan of Operation” section,  pursuant to the August 10, 2006 SecuritiesPurchase Agreement with Trellus, the Company issued and sold 3,000,000 shares of its Common Stock to Trellus, at apurchase price of $0.50 per share, for an aggregate purchase price of$1,500,000.

**ITEM13.**             EXHIBITS

(a)   The following documents arefiled as part of this Report. Portions of Item 13 are submitted asseparate sections of this Report:

(1)          Financial statementsfiled as part of this Report:

****Reports of Independent RegisteredPublic Accounting Firm****

Balance Sheet atDecember 31, 2006

Statements ofOperations—Years ended December 31, 2006 and 2005

Statement of Stockholders’Equity (Deficit)—Years ended December 31, 2006 and 2005

Statements of CashFlows—Years ended December 31, 2006 and 2005

Notes to FinancialStatements—December 31, 2006 and 2005

(2)          The exhibits listed inthe Exhibits Index immediately preceding such exhibits are filed aspart of this Report

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**ITEM14.**             PRINCIPALACCOUNTANT FEES AND SERVICES

The followingtable shows fees for professional audit services billed to us by Carlin,Charron & Rosen, LLP (“CCR”)  andDS&B, Ltd. (“DS&B”) for the audit of our annual consolidated financialstatements for the years ended December 31, 2006 and December 31,2005, and fees billed to us by CCR and DS&B for other services during 2006and 2005:
|             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| Audit Fees: |       |     |       |     |       |
| CCR         |       | $        | 165,948    |     | $          | — |   |
| DS&B    |       | 99,770   |       | 478,786  |       |
|        |       | 265,718  |       | 478,786  |       |
| Tax Fees:   |       |     |       |     |       |
| CCR         |       | —   |       | —   |       |
| DS&B    |       | 33,823   |       | 25,428   |       |
|        |       | 33,823   |       | 25,428   |       |
|        |       |     |       |     |       |
| Total Fees  |       | $        | 299,541    |     | $          | 504,214 |   |

 

*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, Ltd. 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,

*TaxFees*consists of fees billed for professional services fortax compliance assistance rendered during the fiscal year.

**AuditCommittee Pre-Approval Procedures**

The AuditCommittee of our Board of Directors consists of John Schoenherr andJeffrey J. May. Our entire Board of Directors approves the engagement ofour independent auditors to render audit and non-audit services before they areengaged. All of the fees for 2006 and 2005 shown above were pre-approved by theAudit Committee.

The AuditCommittee pre-approves all audit and other permitted non-audit servicesprovided by our independent auditors. Pre-approval is generally provided for upto one year, is detailed as to the particular category of services and issubject to a monetary limit. Our independent auditors and senior managementperiodically report to the Audit Committee the extent of services provided bythe independent auditors in accordance with the pre-approval, and the fees forthe services performed to date. The Audit Committee may also pre-approveparticular services on a case-by-case basis.

Our auditcommittee will not approve engagements of our independent registered publicaccounting firm to perform non-audit services for us if doing so will cause ourindependent registered public accounting firm to cease to be independent withinthe meaning of applicable SEC rules. In other circumstances, our auditcommittee considers, among other things, whether our independent registeredpublic accounting firm is able to provide the required services in a more orless effective and efficient manner than other available service providers.

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**ITEM7—FINANCIAL STATEMENTS**

The following financial statements of BIO-keyInternational, Inc. are included herein at the indicatedpage numbers:
| Report of Independent  Registered Public Accounting Firm, Carlin, Charron, & Rosen, LLP        |   | 70     |
|----------------------------------------------------------------------------------------------------|--------|--------|
| Report of  Independent Registered Public Accounting Firm, DS&B, Ltd                            |   | 71     |
| Balance Sheet at  December 31, 2006                                                           |   | 72     |
| Statements of  Operations—Years ended December 31, 2006 and 2005                         |   | 73     |
| Statement of  Stockholders’ Equity (Deficit)—Years ended December 31, 2006 and 2005 |   | 74     |
| Statements of  Cash Flows—Years ended December 31, 2006 and 2005                         |   | 76     |
| Notes to the  Financial Statements—December 31, 2006 and 2005                            |   | 77-115 |

 

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersBIO-key International, Inc.

Marlborough, MA

We have audited theaccompanying consolidated balance sheet of BIO-key International, Inc. andSubsidiary as of December 31, 2006, and the related statements ofoperations, stockholders’ equity (deficit) and cash flows for the year thenended. 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 audit.

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

In our opinion, the 2006consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of BIO-key International, Inc.and Subsidiary as of December 31, 2006, and the consolidated results ofits operations and its cash flows for the year then ended, in conformity withaccounting principles generally 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, 2006, which raise substantialdoubt about the Company’s ability to continue as a going concern. Management’splans regarding these matters are disclosed in Note A. The consolidated financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.
| /s/ Carlin, Charron, & Rosen, LLP. |   |
|----------------------------------------|--------|
|                                   |
| Westborough, Massachusetts             |
| March 29, 2007                         |

 

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**Report ofIndependent Registered Public Accounting Firm**

Board of Directors andStockholdersBIO-key International, Inc.

We have audited theaccompanying consolidated statements of operations, stockholders’ equity(deficit) and cash flows of BIO-key International, Inc. and Subsidiary forthe year ended December 31, 2005. The consolidated financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on the consolidated financial statements based on our audit.

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

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

In our opinion, the 2005consolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated results of operations and cash flows ofBIO-key International, Inc. and Subsidiary for the year endedDecember 31, 2005, in conformity with accounting principles generallyaccepted in the United States of America.

The accompanyingfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America, whichcontemplate continuation of the Company as a going concern. However, as discussedin note A to the financial statements, the Company has only recently begun togenerate significant revenues, has suffered recurring losses from operationsand has a working capital deficit. These aforementioned issues, among others,raise substantial doubt about the Company’s ability to continue as a goingconcern. The financial statements do not include any adjustments that mightresult from this uncertainty. Management’s plans in regard to these matters arealso discussed in Note A.
| /s/  DS&B, Ltd.   |   |
|-----------------------|--------|
|                  |   |
|                  |   |
| Minneapolis Minnesota |
| June 14, 2006         |

 

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**BIO-keyInternational, Inc and Subsidiary****CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2006**              | ** ** |
| **ASSETS:**                                                                                                                                                                                 |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                  |       | $                     | 627,167    |   |
| Receivables                                                                                                                                                                                 |       |                  |       |
| Billed, less  allowance for doubtful receivables of $177,750                                                                                                                                |       | 3,147,211             |       |
| Unbilled                                                                                                                                                                                    |       | 8,709                 |       |
| Costs and earnings in  excess of billings on uncompleted contracts                                                                                                                          |       | 1,215,045             |       |
| Inventory                                                                                                                                                                                   |       | 17,122                |       |
| Prepaid expenses                                                                                                                                                                            |       | 148,002               |       |
| Total current  assets                                                                                                                                                                       |       | 5,163,256             |       |
| Equipment and leasehold  improvements, net                                                                                                                                                  |       | 428,726               |       |
| Deposits                                                                                                                                                                                    |       | 800,353               |       |
| Intangible assets—less  accumulated amortization                                                                                                                                       |       | 2,510,746             |       |
| Deferred financing  costs, net                                                                                                                                                              |       | 171,806               |       |
| Goodwill                                                                                                                                                                                    |       | 11,389,654            |       |
| Total  non-current assets                                                                                                                                                                   |       | 15,301,285            |       |
| **TOTAL ASSETS**                                                                                                                                                                            |       | $                     | 20,464,541 |   |
| **LIABILITIES:**                                                                                                                                                                            |       |                  |       |
| Current maturities of  long-term obligations and related obligations, net of discount                                                                                                       |       | $                     | 2,389,792  |   |
| Accounts payable                                                                                                                                                                            |       | 1,215,429             |       |
| Billings in excess of  costs and earnings on uncompleted contracts                                                                                                                          |       | 78,343                |       |
| Accrued liabilities                                                                                                                                                                         |       | 4,686,877             |       |
| Deferred rent                                                                                                                                                                               |       | 499,864               |       |
| Deferred revenue                                                                                                                                                                            |       | 4,941,428             |       |
| Total current  liabilities                                                                                                                                                                  |       | 13,811,733            |       |
| Warrants and long-term  obligations                                                                                                                                                         |       | 2,467,417             |       |
| Redeemable preferred  stock derivatives                                                                                                                                                     |       | 402,096               |       |
| Deferred rent                                                                                                                                                                               |       | 367,986               |       |
| Deferred revenue                                                                                                                                                                            |       | 100,017               |       |
| Total  non-current liabilities                                                                                                                                                              |       | 3,337,516             |       |
| **TOTAL LIABILITIES**                                                                                                                                                                       |       | 17,149,249            |       |
| ** **                                                                                                                                                                                  | ** ** | ** **            | ** ** |
| Commitments and  contingencies                                                                                                                                                              |       |                  |       |
|                                                                                                                                                                                        |       |                  |       |
| Series B redeemable  convertible preferred stock: authorized, 1,000,000 shares (liquidation  preference of $1 per share); issued and outstanding 1,000,000 shares of $.0001  par value, net |       | 824,438               |       |
| Series C redeemable  convertible preferred stock: authorized, 600,000 shares (liquidation  preference of $10 per share); issued and outstanding 592,032 shares of $.0001  par value, net    |       | 5,234,214             |       |
|                                                                                                                                                                                        |       | 6,058,652             |       |
|                                                                                                                                                                                        |       |                  |       |
| **STOCKHOLDERS’  EQUITY/(DEFICIT):**                                                                                                                                                   |       |                  |       |
| Series A convertible  preferred stock: authorized, 100,000 shares (liquidation preference of $100  per share); issued and outstanding 30,557 shares of $.0001 par value, net      |       | 3                     |       |
| Common stock —  authorized, 170,000,000 shares; issued and outstanding; 55,158,814 of $.0001  par value                                                                                |       | 5,516                 |       |
| Additional paid-in  capital                                                                                                                                                                 |       | 51,093,919            |       |
| Accumulated deficit                                                                                                                                                                         |       | (53,842,798           | )          |
| **TOTAL STOCKHOLDERS’  EQUITY/(DEFICIT)**                                                                                                                                              |       | (2,743,360            | )          |
| **TOTAL LIABILITIES AND STOCKHOLDERS’  EQUITY/(DEFICIT)**                                                                                                                              |       | $                     | 20,464,541 |   |

 

The accompanying notesare an integral part of these statements.

70

 

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**BIO-keyInternational, Inc. and SubsidiarySTATEMENTS OF OPERATIONS**
| ** **                                           | ** ** | **Years ended December 31,** | ** **  |
|------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                           | ** ** | **2006**                                    | ** **  | **2005** | ** ** |
| ** **                                           | ** ** | ** **                                  | ** **  | **(As Restated)** | ** ** |
| **Revenues**                                         | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Services                                             |       | $                                           | 10,949,895  |   | $ | 10,861,649 |   |
| License fees and  other                              |       | 4,243,730                                   |        | 3,364,446 |   |
|                                                 |       | 15,193,625                                  |        | 14,226,095 |   |
| **Costs and other expenses**                         | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Cost of services                                     |       | 2,673,823                                   |        | 2,906,142 |   |
| Cost of license  fees and other                      |       | 722,883                                     |        | 937,491 |   |
|                                                 |       | 3,396,706                                   |        | 3,843,633 |   |
| Gross Profit                                         |       | 11,796,919                                  |        | 10,382,462 |   |
|                                                 |       |                                        |        |   |   |
| **Operating expenses**                               |       |                                        |        |   |   |
| Selling, general  and administrative                 |       | 10,311,017                                  |        | 11,824,609 |   |
| Research,  development and engineering               |       | 6,514,353                                   |        | 6,846,035 |   |
|                                                 |       | 16,825,370                                  |        | 18,670,644 |   |
| **Operating loss**                                   |       | (5,028,451                                  | )           | (8,288,182 | ) |
| **Other income (deductions)**                        | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Interest income                                      |       | —                                      |        | 35,958 |   |
| Interest expense                                     |       | (5,730,712                                  | )           | (4,521,344 | ) |
| Derivative and  warrant fair value adjustments       |       | 7,542,666                                   |        | 9,154,951 |   |
| Loss on sale of  marketable securities               |       | —                                      |        | (20,000 | ) |
| Loss on  extinguishment of debt                      |       | (7,815,717                                  | )           | — |   |
| Other income  (expense)                              |       | (48,637                                     | )           | (34,767 | ) |
| Total other  income (deductions)                     |       | (6,052,400                                  | )           | 4,614,798 |   |
| **NET LOSS**                                         |       | $                                           | (11,080,851 | ) | $ | (3,673,384 | ) |
| ** **                                           | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| **Basic Loss to Common  Shareholders:**              | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Net loss                                             |       | $                                           | (11,080,851 | ) | $ | (3,673,384 | ) |
| Convertible  preferred stock dividends and accretion |       | (1,042,069                                  | )           | (313,517 | ) |
| Net loss  attributable to common shareholders        |       | $                                           | (12,122,920 | ) | $ | (3,986,901 | ) |
| ** **                                           | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| **Loss Per Share:**                                  | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Basic                                                |       | $                                           | (0.24       | ) | $ | (0.09 | ) |
| Diluted                                              |       | $                                           | (0.24       | ) | $ | (0.12 | ) |
| ** **                                           | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| **Weighted Average Shares  Outstanding:**            | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Basic                                                |       | 50,232,961                                  |        | 44,787,807 |   |
| Diluted                                              |       | 50,232,961                                  |        | 52,046,303 |   |

 

Theaccompanying notes are an integral part of these statements.

71

 

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**BIO-key International, Inc. andSubsidiary****STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)**
| ** **                                                                                                                            | ** ** | **Series A 7%** | ** ** | **Series C 7%** | ** ** | **Series B 15%** | ** ** | **Series C 15%** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|----------------------------|------------|----------------------------|------------|-----------------------|------------|-----------------|------------|-----------------|------------|------------|------------|------------|------------|
| ** **                                                                                                                            | ** ** | **Convertible**           | ** ** | **Convertible**           | ** ** | **Convertible**            | ** ** | **Convertible**            | ** ** | ** **            | ** ** | ** **      | ** ** | **Additional**  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Preferred Stock**  | ** ** | **Preferred Stock**  | ** ** | **Preferred Stock**   | ** ** | **Preferred Stock**   | ** ** | **Common Stock** | ** ** | **Contributed** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Shares**                | ** ** | **Amount**                | ** ** | **Shares**                 | ** ** | **Amount**                 | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **Shares**      | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| **Balance as of December 31,  2004 (As Restated)**                                                                               | ** ** | **—**                | ** ** | **$**                     | **—** | ** **                 | **62,182** | ** **                 | **$**      | **623**               | ** ** | **—**      | ** ** | **$**           | **—** | ** ** | **—** | ** ** | **$**      | **—** | ** ** | **40,680,692** | ** ** | **$** | **406,808** | ** ** | **$** | **45,098,731** | ** ** | **$** | **(38,956,507** | **)** | **$** | **6,549,655** | ** ** |
| Conversion of  series C preferred stock to series A preferred stock                                                         |       | 62,182                    |       | 6                         |       | (62,182                    | )          | (623                       | )          | —                |       | —          |       | —          |       | —     |       | —     |       | — |   | 617 |   | — |   | — |   |
| Adjust par values to  $0.0001                                                                                                         |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | —     |       | (402,739 | ) | 402,739 |   | — |   | — |   |
| Costs incurred in  conjunction with issuance of debt                                                                                  |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | —     |       | — |   | (56,642 | ) | — |   | (56,642 | ) |
| Issuance of shares in  exchange for debt payment delay                                                                                |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 875,871    |       | 88 |   | 788,196 |   | — |   | 788,284 |   |
| Conversion of  debentures, bridge notes, convertible notes, accrued interest and related  discounts and derivatives into common stock |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 1,575,135  |       | 158 |   | 1,179,341 |   | — |   | 1,179,499 |   |
| Conversion of  series A preferred stock and cumulative dividends in arrears into common  stock                                   |       | (17,625                   | )          | (2                        | )          | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 2,512,426  |       | 251 |   | 121,569 |   | (132,056 | ) | (10,238 | ) |
| Exercise of options and  warrants into common stock                                                                                   |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 662,465    |       | 66 |   | 558,722 |   | — |   | 558,788 |   |
| Issuance of warrants in  conjunction with convertible notes offering                                                                  |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | —     |       | — |   | 234,150 |   | — |   | 234,150 |   |
| Options and warrants  issued for services and other                                                                                   |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | —     |       | — |   | 593,893 |   | — |   | 593,893 |   |
| Net loss                                                                                                                              |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | —     |       | — |   | — |   | (3,673,384 | ) | (3,673,384 | ) |
| **Balance as of December 31,  2005 (As Restated)**                                                                               | ** ** | **44,557**                | ** ** | **$**                     | **4**      | ** **                 | **—** | ** **                 | **$**      | **——**      | ** ** | **—**      | ** ** | **$**           | **—** | ** ** | **—** | ** ** | **$**      | **—** | ** ** | **46,306,589** | ** ** | **$** | **4,632** | ** ** | **$** | **48,921,316** | ** ** | **$** | **(42,761,947** | **)** | **$** | **6,164,005** | ** ** |
| ** **                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Exchange of convertible  debt for preferred stock                                                                                     |       | —                    |       | —                    |       | —                     |       | —                     |       | 1,000,000             |       | 1,000,000       |       | 592,032         |       | 5,920,320  |       | —     |       | — |   | — |   | — |   | — |   |
| Discount on preferred  stock                                                                                                          |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | (360,467        | )          | —          |       | (1,073,537 | )          | —     |       | — |   | — |   | — |   | — |   |
| Accretion of preferred  stock discount                                                                                                |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | 107,508         |       | —          |       | 174,648    |       | —     |       | — |   | (282,156 | ) | — |   | (282,156 | ) |
| Accretion of preferred  stock dividends                                                                                               |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | 130,000         |       | —          |       | 356,370    |       | —     |       | — |   | (486,370 | ) | — |   | (486,370 | ) |
| Dividends declared on  preferred stock                                                                                                |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | (52,603         | )          | —          |       | (51,093    | )          | —     |       | — |   | (606,968 | ) | — |   | (606,968 | ) |
| Stock issuance costs                                                                                                                  |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | (110,453   | )          | —     |       | — |   | 110,453 |   | — |   | 110,453 |   |
| Accretion of stock  issuance costs                                                                                                    |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | 17,959     |       | —     |       | — |   | (17,959 | ) | — |   | (17,959 | ) |
| Conversion of  series A preferred stock and cumulative dividends in arrears into common  stock                                   |       | (14,000                   | )          | (1                        | )          | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 2,801,343  |       | 280 |   | 117,072 |   | — |   | 117,351 |   |
| Conversion of  convertible notes, accrued interest and related discounts and derivatives  into common stock                           |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 1,724,632  |       | 172 |   | 414,791 |   | — |   | 414,963 |   |
| Issuance of common stock  and warrants                                                                                                |       | —                    |       | —                    |       | —                     |       | —                     |       | —                |       | —          |       | —          |       | —     |       | 4,000,000  |       | 400 |   | 1,999,600 |   | — |   | 2,000,000 |   |

 

72

 

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| Issuance of shares in  exchange for debt payment delay |       | —     |       | —     |       | —     |       | —     |       | —     |       | —        |       | —     |        | —     |        | 300,000    |       | 30            |       | 188,970        |       | —      |       | 189,000     |       |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|---------------|------------|------------|-------------|------------|-------------|------------|------------|---------------|------------|----------------|------------|-------------|------------|-------------|------------|
| Exercise of warrants  into common stock                |       | —     |       | —     |       | —     |       | —     |       | —     |       | —        |       | —     |        | —     |        | 26,250     |       | 2             |       | 8,398          |       | —      |       | 8,400       |       |
| Share-based compensation                               |       | —     |       | —     |       | —     |       | —     |       | —     |       | —        |       | —     |        | —     |        | —     |       | —        |       | 726,772        |       | —      |       | 726,772     |       |
| Net loss                                               |       | —     |       | —     |       | —     |       | —     |       | —     |       | —        |       | —     |        | —     |        | —     |       | —        |       | —         |       | (11,080,851 | )          | (11,080,851 | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** **    | ** ** | ** **     | ** ** | ** **  | ** ** | ** **  | ** ** |
| **Balance as of December 31, 2006**               | ** ** | **30,557** | ** ** | **$**      | **3**      | ** ** | **—** | ** ** | **$**      | **—** | ** ** | **1,000,000** | ** ** | **$**      | **824,438** | ** ** | **592,032** | ** ** | **$**      | **5,234,214** | ** ** | **55,158,814** | ** ** | **$**       | **5,516**  | ** **  | **$**      | **51,093,919** | ** ** | **$** | **(53,842,798** | **)** | **$** | **(2,743,360** | **)** |
|                                                        |            |            |            |            |            |            |            |            |            |            |            |               |            |            |             |            |             |            |            |               |            |                |            |             |            |             |            |  |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of these statements.

73

 

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**BIO-key International, Inc. andSubsidiary****STATEMENTS OF CASH FLOWS**
| ** **                                                                       | ** ** | **Years ended December 31,** | ** **  |
|----------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                                                       | ** ** | **2006**                                    | ** **  | **2005** | ** ** |
| ** **                                                                       | ** ** | ** **                                  | ** **  | **(As Restated)** | ** ** |
|                                                                             |       |                                        |        |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                        | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Net Loss                                                                         |       | $                                           | (11,080,851 | ) | $ | (3,673,384 | ) |
| **Adjustments  to reconcile net loss to net cash used in operating activities:** | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Derivative and  warrant fair value adjustments                                   |       | (7,542,666                                  | )           | (9,154,951 | ) |
| Loss on  extinguishment of debt                                                  |       | 7,815,717                                   |        | — |   |
| Depreciation                                                                     |       | 275,453                                     |        | 244,450 |   |
| Amortization                                                                     |       |                                        |        |   |   |
| Intangible  assets                                                               |       | 863,520                                     |        | 1,323,601 |   |
| Deferred  financing costs                                                        |       | 227,348                                     |        | 186,279 |   |
| Discounts on  convertible debt related to warrants and embedded derivatives      |       | 2,774,177                                   |        | 2,097,973 |   |
| Allowance for  doubtful receivables                                              |       | 17,750                                      |        | 48,148 |   |
| Loss on sale of  marketable debt securities                                      |       | —                                      |        | 20,000 |   |
| Deferred rent                                                                    |       | (443,603                                    | )           | (393,677 | ) |
| Share-based  compensation                                                        |       | 726,772                                     |        | — |   |
| Options and  warrants issued for services and other                              |       | —                                      |        | 664,043 |   |
| **Change  in assets and liabilities:**                                           | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Accounts  receivable trade                                                       |       | (1,336,357                                  | )           | 345,050 |   |
| Costs and  earnings in excess of billings on uncompleted contracts               |       | 3,106,347                                   |        | 2,468,770 |   |
| Inventories                                                                      |       | (8,362                                      | )           | 20,839 |   |
| Prepaid expenses  and other                                                      |       | (11,002                                     | )           | (65,227 | ) |
| Accounts payable                                                                 |       | 381,821                                     |        | (549,036 | ) |
| Billings in  excess of costs and earnings on uncompleted contracts               |       | 45,958                                      |        | (317,737 | ) |
| Accrued  liabilities                                                             |       | 23,099                                      |        | 1,029,404 |   |
| Deferred revenue                                                                 |       | 613,424                                     |        | 1,191,958 |   |
| Net cash used in  operating activities                                           |       | (3,551,455                                  | )           | (4,513,497 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                       | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Capital  expenditures                                                            |       | (155,912                                    | )           | (148,616 | ) |
| Proceeds from  sale of marketable debt securities                                |       | —                                      |        | 980,000 |   |
| Deposits                                                                         |       | 1,028,207                                   |        | 1,009,471 |   |
| Patents and  patents pending                                                     |       | (72,443                                     | )           | (65,786 | ) |
| Other                                                                            |       | —                                      |        | 50,000 |   |
| Net cash  provided by investing activities                                       |       | 799,852                                     |        | 1,825,069 |   |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                        | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Net advance from  (to) stockholders                                              |       | —                                      |        | (12,753 | ) |
| Issuance of  convertible bridge notes                                            |       | —                                      |        | 250,000 |   |
| Repayment of  convertible bridge notes                                           |       | —                                      |        | (250,000 | ) |
| Issuance of long-term  obligations                                               |       | 988,000                                     |        | 4,822,250 |   |
| Repayment of  long term obligations                                              |       | (353,037                                    | )           | (1,908,212 | ) |
| Financing costs                                                                  |       | (131,552                                    | )           | (248,406 | ) |
| Sale of common  stock                                                            |       | 1,500,000                                   |        | — |   |
| Exercise of  warrants                                                            |       | 8,400                                       |        | 558,788 |   |
| Preferred stock  dividends paid                                                  |       | (55,868                                     | )           |   |   |
| Payment of  offering costs                                                       |       | —                                      |        | (56,642 | ) |
| Net cash  provided by financing activities                                       |       | 1,955,943                                   |        | 3,155,025 |   |
| **NET INCREASE (DECREASE) IN CASH**                                              |       | (795,660                                    | )           | 466,597 |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF YEAR**                                |       | 1,422,827                                   |        | 956,230 |   |
| **CASH AND CASH EQUIVALENTS, END OF YEAR**                                       |       | $                                           | 627,167     |   | $ | 1,422,827 |   |

 

The accompanying notesare an integral part of these statements.

74

 

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**BIO-keyInternational, Inc. and SubsidiaryNOTES TO THE FINANCIAL STATEMENTSDecember 31, 2006 and 2005**

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

*Changein Name of Company and State of Incorporation*

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

*Natureof Business*

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

*Basisof Presentation*

Broad commercial acceptanceof the Company’s technology is critical to the Company’s success and ability togenerate revenues. As a result of two acquisitions, the Company’s onlysignificant revenues to date began in the fourth quarter of 2004. The Companyrecorded approximately $15,194,000 in revenues, and incurred $11,081,000 oflosses in 2006. As of December 31, 2006, there was a working capitaldeficit of approximately $8,648,000.

The Company issuednotes in the amount of approximately $1,000,000, exchanged its subordinateddebt to preferred stock, and raised $2,000,000 in new equity, of which$1,500,000 was paid in cash, during 2006. The Company is also currentlyconsidering various alternatives to improve its operating results. No assurancecan be given that the Company’s operating results will improve as a result ofthis additional funding, if available, or that such funding would not bedilutive to existing stockholders.

The accompanyingfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States, which contemplatecontinuation of the Company as a going concern. The matters described in thepreceding paragraphs raise substantial doubt about the Company’s ability tocontinue as a going concern. Recoverability of a major portion of the recordedasset amounts shown in the accompanying balance sheet is dependent upon theCompany’s ability to obtain additional funding, meet its funding requirementson a continuing basis, and succeed in its future operations. The accompanyingfinancial statements do not include any adjustments that might be necessaryshould the Company be unable to continue in existence.

*Summaryof Significant Accounting Policies*

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

1.             *Basis of Consolidation*

The accompanyingconsolidated financial statements include the accounts of BIO-keyInternational, Inc. and its wholly owned subsidiary (collectively, theCompany) and are stated in conformity with accounting principles generallyaccepted in the United States, pursuant to the rules and regulations ofthe Securities and Exchange Commission. Intercompany accounts and transactionshave been eliminated in consolidation.

75

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2.             *Revenue Recognition*

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

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

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

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

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

Service Revenues:Revenues from services are comprised of maintenance and consulting and implementationservices. Maintenance revenues include providing for unspecified when-and-ifavailable product updates and customer telephone support services, and arerecognized ratably over the term of the service period. Consulting services aregenerally sold on a time-and-materials basis and include a range of servicesincluding installation of software and assisting in the design of interfaces toallow the software to operate in customized environments. Services aregenerally separable from other elements under the arrangement since performanceof the services are not essential to the functionality of any other element ofthe transaction and are described in the contract such that the total price ofthe arrangement would be expected to vary as the result of the inclusion orexclusion of the services. Revenues from services are generally recognized asthe services are performed.

The Companyprovides customers, free of charge or at a minimal cost, testing kits whichpotential licensing customers may use to test compatibility/acceptance ofthe Company’s technology with the customer’s intended applications.

3.             *Cash and Cash Equivalents*

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

4.             *Accounts Receivable*

Accountsreceivable billed and unbilled are carried at original amount less an estimatemade for doubtful receivables

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based on a review of alloutstanding amounts on a monthly basis. Management determines the allowance fordoubtful receivables by regularly evaluating individual customer receivablesand considering a customer’s financial condition, credit history, and currenteconomic conditions. Accounts receivable are written off when deemeduncollectible. Recoveries of accounts receivable previously written off arerecorded when received.

5.             *Accounting for Acquisitions*

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

6.             *Depreciation and Amortization*

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

The estimateduseful lives used to compute depreciation and amortization for financialreporting 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            |     |

 

The estimatedaggregate amortization expense of intangible assets for the five yearsfollowing December 31, 2006 is approximately as follows:
| Year ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2007                                    |       | $          | 863,520    |   |
| 2008                                    |       | $          | 863,520    |   |
| 2009                                    |       | $          | 431,179    |   |
| 2010                                    |       | $          | 792        |   |
| 2011                                    |       | $          | 792        |   |

 

7.             *Marketable Debt Securities*

TheCompany accounts for marketable securities pursuant to Statement of FinancialAccounting Standards No. 115—

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“Accounting forCertain Investments in Debt and Equity Securities” (“SFAS 115”).SFAS 115 requires classification of debt and equity securities in threecategories: trading securities, available-for-sale securities andheld-to-maturity securities. Debt and equity securities classified as tradingsecurities are carried at fair value with unrealized gains or losses included inincome. Debt and equity securities designated as available-for-sale, whose fairvalues are readily determinable, are carried at fair value with unrealizedgains or losses included as a component of accumulated other comprehensiveincome, net of applicable taxes. Debt securities that are expected to beheld-to-maturity are carried at amortized cost. In January 2005 theCompany sold their investments and did not hold any Marketable Debt Securitiesas of December 31, 2006.

8.             *Derivative and Warrant Financial Instruments*

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

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

9.             *Goodwill and Intangible Assets*

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards No. 142 (“SFAS 142”),Goodwill and Other Intangible Assets., which requires the Company to testgoodwill for impairment annually or whenever events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable, ratherthan amortize. Accordingly, the Company has not amortized goodwill. As providedby SFAS No. 142, the Company has elected to perform the annual assessmentof the carrying value of all goodwill as of September 30th of each year using a number of criteria,including the value of the overall enterprise. As of December 31, 2006,the Company believes that no material impairment exists. Future impairmentcharges from previous or future acquisitions, if any, will be reflected as anoperating expense in the statement of operations.

10.           *Impairment of Long-Lived Assets*

The Company hasadopted SFAS No. 144, Accounting for the Impairment or Disposal ofLong-Lived Assets. In accordance with SFAS No. 144, long-lived assetssubject to depreciation and amortization are reviewed for impairment wheneverevents or changes in circumstances indicate the carrying amount of an assetmay not be recoverable. The Company’s long-lived assets consist primarilyof its equipment and leasehold improvements and its intangible assets. Uponindication of possible impairment, the Company evaluates the recovery of held-for-uselong-lived assets by measuring the carrying value of the assets against therelated estimated undiscounted future cash flows. When an evaluation indicatesthat the future undiscounted cash flows are not sufficient to recover thecarrying value of the asset, the asset is adjusted to its estimated fair value.The following circumstances would be considered important and could lead to animpairment review; significant changes in the manner of our using the asset,negative industry or economic trends and underperformance relative to projectedoperating results.

11.           *Advertising Expense*

The Companyexpenses the costs of advertising as incurred. Advertising expenses for theyears ended December 31, 2006 and 2005, were approximately $216,000 and$108,000, respectively.

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12.*           Deferred Revenue*

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

13.           *Research and Development Expenditures*

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

14.           *Earnings Per Share Common Stock*

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

15.           *Accounting for Stock-Based Compensation*

*Effectof Adoption of SFAS 123R, Share-Based Payment*

Prior toJanuary 1, 2006, the Company’s employee stock compensation plans wereaccounted for in accordance with Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and relatedinterpretations. Under this method, no compensation expense was recognized aslong as the exercise price equaled or exceeded the market price of theunderlying stock on the date of the grant. The Company elected thedisclosure-only alternative permitted under SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation — Transition and Disclosure” (SFAS 148”), forfixed stock-based awards to employees.

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

As ofJanuary 1, 2006, the Company adopted SFAS 123R using the modifiedprospective method, which requires measurement of compensation cost for allstock awards at fair value on date of grant and recognition of compensationover the service period for awards expected to vest. Accordingly, financialstatement amounts for the prior periods presented in this Form 10-KSB have notbeen restated to reflect the fair value method of expensing share-basedcompensation. Under this application, we are required to record compensationcost for all share-based payments granted after the date of adoption based onthe grant date fair value estimated in accordance with the provisions of SFAS123R and for the unvested portion of all share-based payments previouslygranted that remain outstanding which were based on the grant date fair valueestimated in accordance with the original provisions of SFAS 123. The majorityof our share-based compensation arrangements vest over either a three or fouryear vesting schedule. The Company expenses its share-based compensation underthe ratable method, which treats each vesting tranche as if it were anindividual grant. The fair value of stock options is determined using theBlack-Scholes valuation model, which is consistent with our valuationtechniques previously utilized for options in footnote disclosures requiredunder SFAS 123, as amended by SFAS 148, and requires the input of highlysubjective assumptions. These assumptions include estimating the length of timeemployees will retain their vested stock options before

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exercising them (the “expectedoption term”), the estimated volatility of our common stock price over theoption’s expected term, the risk-free interest rate over the option’s expectedterm, and the Company’s expected annual dividend yield. Changes in thesesubjective assumptions can materially affect the estimate of fair value ofstock-based compensation and consequently, the related amount recognized as anexpense in the consolidated statements of operations. As required under theaccounting rules, we review our valuation assumptions at each grant date and,as a result, are likely to change our valuation assumptions used to valueemployee stock-based awards granted in future periods. The values derived fromusing the Black-Scholes model are recognized as expense over the requisiteservice period, net of estimated forfeitures (the number of individuals thatwill ultimately not complete their vesting requirements). The estimation ofstock awards that will ultimately vest requires significant judgment. We considermany factors when estimating expected forfeitures, including types of awards,employee class, and historical experience. Actual results, and future changesin estimates, may differ substantially from our current estimates.

The compensationexpense recognized in connection with the adoption of SFAS 123R increased theCompany’s net loss by $726,772 with a $0.01 effect per share (basic anddiluted), for the year ended December 31, 2006. There was no impact on cashflows from operations, investment, or financing in connections with theadoptions of SFAS 123R. As the Company uses the full valuation allowance withrespect to deferred taxes, the adoption of SFAS 123R had no impact on deferredtaxes.

The followingtable presents share-based compensation expenses for continuing operationsincluded in the Company’s consolidated statements of operations:
|                                        | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2006**                               | ** ** |
|                                   |       |                                   |       |
| Cost of services                       |       | $                                      | 63,100     |   |
| Selling, general  and administrative   |       | 486,250                                |       |
| Research,  development and engineering |       | 177,422                                |       |
|                                   |       | $                                      | 726,772    |   |

 

*Proforma Compensation Disclosure*

If compensationexpense for the stock options granted had been determined based on the fairvalue at the grant dates consistent with the method of SFAS No. 123, theCompany’s proforma net loss available to common shareholders and proforma lossavailable to common shareholders per share would have been as follows:
|                                                                             | ** ** | **Year ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                               | ** ** |
| ** **                                                                  | ** ** | **(As Restated)**                 | ** ** |
| Net loss  available to common shareholders                                  |       | (3,986,901                             | )          |
| Stock-based  compensation expense if the fair value method had been adopted |       | (1,496,086                             | )          |
| Pro forma net  loss available to common shareholders                        |       | (5,482,987                             | )          |
| Basic loss per  common shares                                               |       | (0.09                                  | )          |
| Basic loss per  common shares - pro forma                                   |       | (0.12                                  | )          |
| Diluted loss per  common shares                                             |       | (0.12                                  | )          |
| Diluted loss per common  shares - pro forma                                 |       | (0.14                                  | )          |

 

In determining theproforma compensation cost of the options granted, the fair value of each grantwas estimated on the date of grant using the Black-Scholes option pricingmodel. The assumptions used to determine the fair value of each grant includedthe following:
|                                      | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|--------------------------------------|------------|-----------|------------|-----------|------------|
| Risk free  interest rate             |       | 4.53-5.08 | %          | 3.95-4.51 | %          |
| Expected life of  options (in years) |       | 4.0-7.0   |       | 6.5-7.0   |       |
| Expected  dividends                  |       | —    |       | —    |       |
| Volatility of stock  price           |       | 92-129    | %          | 132-134   | %          |

 

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The stockvolatility for each grant is determined based on the review of the experienceof the weighted average of historical daily price changes of the Company’scommon stock over the expected option term. The expected life represents theweighted average period of time that options granted are expected to beoutstanding giving consideration to vesting schedules and our historicalexercise patterns; and the risk-free rate is based on the U.S. Treasury yieldcurve in effect at the time of grant for periods corresponding with theexpected life of the option.

16.           *Income Taxes*

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

17.           *Use of Estimates*

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

Estimates andassumptions which, in the opinion of management are used in accounting for,among other things, long-term contracts, allowances for uncollectiblereceivables, recoverability of goodwill and other long-lived assets,depreciation and amortization, valuation of deferred income taxes, convertiblenotes and related discounts, embedded derivates, preferred stock, share-basedcompensation, and warrants outstanding.

18.*          Comprehensive Loss*

Comprehensive lossconsists of net loss and other gains and losses affecting shareholders’equity/(deficit) that, under generally accepted accounting principles, areexcluded from net loss in accordance with Statement of Financial AccountingStandards No. 130, “Reporting Comprehensive Income.” The Company, however, doesnot have any components of other comprehensive loss as defined by SFAS No. 130and therefore, for the years ended December 31, 2006 and 2005, comprehensiveloss is equivalent to the Company’s reported net loss. Accordingly, a separatestatement of comprehensive loss is not presented.

19.           *Recent Accounting Pronouncements*

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

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements,” which is effective for calendar year companies onJanuary 1, 2008. The Statement defines fair value, establishes a frameworkfor measuring fair value in accordance with Generally Accepted AccountingPrinciples, and expands disclosures about fair value measurements. The

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Statement codifies thedefinition of fair value as the price that would be received to sell an assetor paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. The standard clarifies the principle thatfair value should be based on the assumptions market participants would usewhen pricing the asset or liability and establishes a fair value hierarchy thatprioritizes the information used to develop those assumptions. The Company iscurrently assessing the potential impacts of implementing this standard.

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N(SAB 108), “Financial Statements — Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements,” which is effective for calendar year companies as ofDecember 31, 2006. SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thefinancial statements are materially misstated. Under this guidance, companiesshould take into account both the effect of a misstatement on the current yearbalance sheet as well as the impact upon the current year income statement inassessing the materiality of a current year misstatement. Once a current yearmisstatement has been quantified, the guidance in SAB Topic 1M, “FinancialStatements — Materiality,” (SAB 99) should be applied todetermine whether the misstatement is material. The implementation ofSAB 108 did not have a material impact on the Company’s financialstatements.

In June 2006, theFASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes—An Interpretation of FASB StatementNo. 109*,*”**which prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 will be effective for the Company’s first interim period beginningJanuary 1 2007. The implementation of FIN 48 is not expected to have a materialimpact on the Company’s financial statements.

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**NOTEB—RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS**

RESTATEMENT

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

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

·                  *Revenue Recognition*

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

·                  *Accounting for Convertible Financing Arrangements*

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

·                  Theprincipal conversion option,

·                  Themonthly payments conversion option,

·                  Theinterest rate adjustment provisions.

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

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

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

·      *Valuations of EmbeddedDerivatives*

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

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·      *Additional Derivative(Default Provision)*

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

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

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

The errors in our previously reported financialinformation, and the failure to prevent them or detect them in our financialreporting process, were largely attributable to weak internal controls, aninadequate staff of competent accounting personnel with an appropriate level ofknowledge of GAAP and to errors in the valuations of the previously identifiedembedded derivatives.

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

The followingtables summarize the impact of all of these adjustments on previously reportedrevenue and assets, liabilities, and stockholders’ equity (deficit) for theyear ended December 31, 2005.
| ** **                  | ** ** | **Impact of Adjustments on Revenue  For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                                                                           | ** ** |
| **As  previously reported** |       | $                                                                                                                  | 14,226,095 |   |
| Revenue  recognition        |       | —                                                                                                             |       |
| **As restated**             |       | $                                                                                                                  | 14,226,095 |   |

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

 

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The followingtable presents the effect of the restatement adjustments on the consolidatedStatement of Operations for the year ended December 31, 2005.

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

 

85

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The followingtable presents the effect of the restatement adjustments on the ConsolidatedStatement of Cash Flows for the year ended December 31, 2005.

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

 

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**NOTE C—ACQUISITIONS**

*Acquisitionof Public Safety Group, Inc.*

On March 30,2004, we acquired all of the outstanding capital stock of Public SafetyGroup, Inc. (PSG), a privately-held leader in wireless solutions for lawenforcement and public safety markets based in Winter Park, Florida, inexchange for an aggregate of 2,416,108 shares of our common stock issued to theformer shareholders of PSG, 6,000 shares of our common stock issued to HarwardInvestments, Inc. (“Harward”), $500,000 in cash, and our assumption of$600,000 in aggregate net liabilities of PSG, for an aggregate purchase priceof $4,108,941. In connection with this acquisition, three former employees ofPSG, who were also shareholders of PSG, entered into two-year employmentagreements with the Company to serve within the Public Safety Division.

The 2,416,108 sharesissued to the PSG shareholders (the Merger Shares) are subject to the provisionscontained in the Merger Agreement and a related escrow agreement, which providefor periodic releases of the shares from escrow on a schedule determinedby the revenues achieved by the Public Safety Division. The owners of suchescrowed shares, however, continue to enjoy all the rights and privilegesattributable to the shares, including, without limitation, the right to voteand receive dividends. The principal terms of the escrow arrangement are asfollows:

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

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

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

As at December 31, 2006,1,835,453 Merger Shares have been released from escrow under the MergerAgreement.

*Acquisitionof Mobile Government*

OnSeptember 30, 2004, we acquired certain assets and assumed certainliabilities of the Mobile Government division of Aether Systems, Inc (Aether).The aggregate purchase price of the acquisition was $12,198,171.

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

Also, inconjunction with the acquisition of the Mobile Government division, the Companywas required to place funds into escrow, which comprised of the following as atDecember 31, 2006:

·                  Thereis approximately $750,000 in escrow which is available to Aether in the eventthe Company defaults on the letter of credit, or sublease agreements. The fundswill not be available for use by the company until the termination of the leasein August 2008.

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*LiquidatedDamages*

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

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

*Warranty Reserve*

In some instances theCompany may make commitments to provide additional products or services tocustomers beyond those obligations specified in the contract or those providedin standard maintenance agreements or ordinary upgrades. These commitmentsusually arise in complex customer installations and are granted to help ensurecustomer satisfaction. As of December 31, 2006, there was no materialrequirement for an accrued warranty liability reserve.

**NOTE D—CONCENTRATION OF RISK**

Financial instruments andlong-term contracts, which potentially subject the Company to risk, primarilyconsist of receivables and costs and earnings in excess of billings onuncompleted contracts. The Company extends credit to customers on an unsecuredbasis in the normal course of business. The Company’s policy is to perform ananalysis of the recoverability of its receivables and costs and earnings inexcess of billings on uncompleted contracts at the end of each reporting periodand to establish allowances where appropriate. The Company analyzes historicalbad debts and contract losses, customer concentrations, and customercredit-worthiness when evaluating the adequacy of the allowances.

As of December 31,2006, two customers accounted for approximately 24% of the Company’soutstanding accounts receivable balance. As of December 31, 2006 onecustomer accounted for approximately 92% of the balance in the account costsand earnings in excess of billings on uncompleted contracts. No single customeraccounted for more than 10% of revenue for any period presented.

Approximately 90% and 79%of our total revenues for the years ended December 31, 2006, and 2005,respectively,  and approximately 90% ofthe balance in our outstanding accounts receivable as at December 31, 2006, wasderived from governmental entities, sourced from either our direct salesefforts, or through our network of resellers.

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

The components ofuncompleted contracts consisted of the following as of December 31, 2006:
|                                                                    | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** |
| Cost and  earnings incurred on uncompleted contracts               |       | $          | 10,032,680 |   |
|                                                               |       |       |       |
| Less billings to  date                                             |       | (8,895,978 | )          |
|                                                               |       |       |       |
|                                                               |       | $          | 1,136,702  |   |
|                                                               |       |       |       |
| Costs and  earnings in excess of billings on uncompleted contracts |       | $          | 1,215,045  |   |
|                                                               |       |       |       |
| Billings in  excess of costs and earnings on uncompleted contracts |       | (78,343    | )          |
|                                                               |       |       |       |
|                                                               |       | $          | 1,136,702  |   |

 

**NOTE F—PREPAID EXPENSES**

Prepaid expensesconsisted of the following as of December 31, 2006:
|                                  | ** ** | **2006**   | ** ** |
|----------------------------------|------------|------------|------------|
| ** **                       | ** ** | ** ** | ** ** |
| Insurance and  software licenses |       | $          | 79,693     |   |
|                             |       |       |       |
| Other                            |       | 68,309     |       |
|                             |       |       |       |
| Total                            |       | $          | 148,002    |   |

 

**NOTE G—EQUIPMENT AND LEASEHOLD IMPROVEMENTS**

Equipment andleasehold improvements consisted of the following as of December 31, 2006:
|                                                 | ** ** | **2006**   | ** ** |
|-------------------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** |
| Equipment                                       |       | $          | 566,593    |   |
| Furniture and  fixtures                         |       | 187,984    |       |
| Software                                        |       | 116,011    |       |
| Leasehold  improvements                         |       | 198,889    |       |
|                                            |       | 1,069,477  |       |
|                                            |       |       |       |
| Less accumulated  depreciation and amortization |       | (640,751   | )          |
|                                            |       |       |       |
| Total                                           |       | $          | 428,726    |   |

 

89

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**NOTE H—OTHER ASSETS**

*Goodwill*

TheCompany’s goodwill resulted from the acquisition of Public SafetyGroup, Inc. and certain assets and assumed liabilities of the MobileGovernment Division of Aether Systems, Inc. in 2004. As provided by SFASNo. 142, the Company has elected to perform the annual assessment of thecarrying value of all goodwill as of September 30 of each year using anumber of criteria, including the value of the overall enterprise. As ofSeptember 30, 2006, the Company believes no material impairment exists. Futureimpairment charges from existing operations or other acquisitions, if any, willbe reflected as an operating expense in the statement of operations. As ofDecember 31, 2006 goodwill totaled $11,389,654.

*Intangible Assets*

Intangible assetsconsisted of the following as of December 31, 2006:
|                              | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|------------------------------|------------|-----------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** **                    | ** ** |
| Copyrighted  software        |       | $                           | 1,181,429  |                          | $          | (649,786                      | )          | $ | 531,643 |   |
| Customer  relationships      |       | 1,009,000                   |       | (454,050                      | )          | 554,950                       |       |
| Trademarks                   |       | 807,872                     |       | (401,524                      | )          | 406,348                       |       |
| Developed  technology        |       | 710,000                     |       | (319,500                      | )          | 390,500                       |       |
| Marketing  agreements        |       | 605,340                     |       | (332,937                      | )          | 272,403                       |       |
| Patents and  patents pending |       | 356,222                     |       | (1,320                        | )          | 354,902                       |       |
|                         |       |                        |       |                          |       |                          |       |
| Total                        |       | $                           | 4,669,863  |                          | $          | (2,159,117                    | )          | $ | 2,510,746 |   |

 

Aggregate amortization expense for the year endedDecember 31, 2006 and 2005, was $863,520 and $863,256 respectively.

#### *Deferredfinancing costs*

Debt issuancecosts are amortized based upon the lives of the respective debt obligations.The gross carrying amount of deferred loan costs at December 31, 2006 was$335,828, and accumulated amortization was $164,022. Amortization of deferredfinancing costs is included in interest expense and was $227,348 and $186,279for 2006 and 2005, respectively.

*Deferred Offering Costs*

The Company engaged theservices of an investment banking firm in connection with the issuance of theCompany’s debt securities in 2004 and 2005. The Company issued the firmwarrants to purchase the Company’s common stock on three separate occasions,the fair market value of which was amortized over the life of the associateddebt. During 2005, approximately $266,000 was charged to non-cash interestexpense. As the associated debt was extinguished in January 2006, the balanceof the warrants was written off at that time.

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*Deposits*

Deposits consistedof the following as of December 31, 2006:
|                            | ** ** | **2006**   | ** ** |
|----------------------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** |
| Lease deposit  with Aether |       | $          | 748,605    |   |
| Property  deposits         |       | 8,411      |       |
| Other                      |       | 43,337     |       |
|                       |       |       |       |
| Total                      |       | $          | 800,353    |   |

 

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

Otherdeposits represent bonds with respect to certain competitive bids undertaken bythe Company from time to time in the normal course of business. These moniesare expected to be returned to the Company during the first quarter of 2007.

**NOTE I—ACCRUED LIABILITIES**

Accruedliabilities consisted of the following as of December 31, 2006:
|                                             | ** ** | **2006**   | ** ** |
|---------------------------------------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** |
| Contract costs  not yet invoiced by vendors |       | $          | 2,301,425  |   |
| Compensation                                |       | 675,927    |       |
| Royalties                                   |       | 288,146    |       |
| Interest                                    |       | 1,006,942  |       |
| Other                                       |       | 414,437    |       |
|                                        |       |       |       |
| Total                                       |       | $          | 4,686,877  |   |

 

**NOTE J—RELATED PARTY**

**Consulting Arrangement with Thomas J.Colatosti**

In connection with hisappointment to the Board of Directors in September 2002, the Companyentered into a number of consulting arrangements with Thomas J. Colatosti.Under the most recent arrangement, which was entered into on November 1, 2004,and extended on February 7, 2006, Mr. Colatosti, provided services tothe Company and its subsidiaries and affiliates for the years endedDecember 31, 2006 and 2005, at a rate of $14,500 per month.

Mr. Colatosti hassubstantial experience in the biometric industry and in addition to his role asthe Chairman of the Board of Directors of the Company, provides extensiveservice to the Company in the areas of strategic planning and corporatefinance. During the years ended December 31, 2006 and 2005, approximately$174,000 and $102,000 were paid, respectively. Mr. Colatosti agreed towaive his fees for five months during 2005. As at December 31, 2006, theCompany owed Mr. Colatosti $14,500.

In March 2004,Mr. Colatosti entered into a three year consulting arrangement with theShaar Fund Ltd., a principal creditor and long-term shareholder of the Company.Under the terms of the arrangement, The Shaar Fund transferred $375,000principal amount of our secured convertible notes due October 1, 2005 toMr. Colatosti. On April 28, 2004 the

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Company issued 3,750shares of the Company’s Series A 7% convertible preferred stock toMr. Colatosti in conversion of the $375,000 secured convertible note.

**NOTE K—DEFERRED REVENUE**

Thecomponents of Deferred Revenue are as follows as of December 31, 2006:
|                                                              | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** |
| **Current  Portion**                                         | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | $          | 4,192,480  |   |
| Fully deferred  systems, installation and acceptance revenue |       | 748,948    |       |
|                                                         |       | 4,941,428  |       |
| **Long-Term  Portion**                                       | ** ** | ** ** | ** ** |
| Maintenance  contracts                                       |       | 100,017    |       |
|                                                         |       |       |       |
| **Total**                                                    |       | $          | 5,041,445  |   |

 

Maintenancecontracts include provisions for unspecified when-and-if available productupdates and customer telephone support services, and are recognized ratablyover the term of the service period. Fully deferred systems, installation andacceptance revenue relates to projects that have been billed per thecontractual terms, however because of undelivered elements or acceptancecriteria, revenue has not yet been recognized. These amounts are expected to becompleted within the next 12 months and are classified as current liabilities.

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

**NOTE L—LONG-TERM OBLIGATIONS**

Long-termobligations consisted of the following as of December 31, 2006:
|                                        | ** ** | **2006**   | ** ** |
|----------------------------------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** |
| **2004**                               | ** ** | ** ** | ** ** |
| Convertible term notes                 |       | $          | 3,011,957  |   |
| Discount                               |       | (389,719   | )          |
| FMV of embedded derivatives            |       | 164,240    |       |
| FMV of warrants                        |       | 179,319    |       |
| **2005**                               | ** ** | ** ** | ** ** |
| Convertible term notes                 |       | 1,800,000  |       |
| Discount                               |       | (396,851   | )          |
| FMV of embedded derivatives            |       | 190,834    |       |
| FMV of warrants                        |       | 203,286    |       |
| **2006**                               |       |       |       |
| FMV of warrants                        |       | 94,143     |       |
|                                   |       | 4,857,209  |       |
|                                   |       |       |       |
| Less current portion (net of discount) |       | 2,389,792  |       |
|                                   |       |       |       |
| **Total**                              |       | $          | 2,467,417  |   |

 

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***Senior Convertible Term Notes***

**2004 and 2005 Senior Notes**

On September 29,2004, we entered into a Securities Purchase Agreement (the “2004 SeniorPurchase Agreement”) with Laurus Master Fund, Ltd. (“Laurus”). Under the2004 Senior Purchase Agreement, the Company issued secured convertible termnotes (the “2004 Senior Note”) in the aggregate principal amount of $5,050,000,convertible into common stock of the Company at an initial conversion price of$1.35 per share, and issued warrants (the “2004 Senior Warrants”) to purchasean aggregate of 1,122,222 shares of our common stock at an initial exerciseprice of $1.55 per share. The proceeds from this transaction were used in partto finance the Company’s acquisition of Aether Mobile Government.

On June 8, 2005, weentered into a Securities Purchase Agreement (the “2005 Senior PurchaseAgreement”) with Laurus. Under the 2005 Senior Purchase Agreement, the Companyissued a secured convertible term note (the “2005 Senior Note”) in theaggregate principal amount of $2,000,000, convertible into common stock of theCompany in certain circumstances at an initial conversion price of $1.35 pershare, and issued a warrant (the “2005 Senior Warrant”) to purchase anaggregate of 444,444 shares of our common stock at an initial exercise price of$1.55 per share. The proceeds from this transaction have been used for theCompany’s general working capital purposes.

The Company’s obligationsunder the 2004 and 2005 Senior Purchase Agreements, the 2004 and 2005 SeniorNotes and the 2004 and 2005 Senior Warrants are secured by a security interestin all or substantially all of the Company’s assets.

Under the terms ofthe 2004 and 2005 Senior Notes, we are required to make monthly payments of accruedinterest and principal. The 2004 and 2005 Senior Notes bear interest at aninitial rate equal to the prime rate plus two percent (2%), subject to a sixpercent (6%) floor. The interest rate on the 2005 Senior Note is subject toreduction on a month-by-month basis if the following conditions are met: If(a) we register the common stock underlying the 2004 and 2005 Senior Notesand 2004 and 2005 Senior Warrants on a registration statement declaredeffective by the Securities and Exchange Commission and (b) our commonstock is trading at a 25% or greater premium to the note conversion price, thenthe interest rate will be adjusted downward by 2.0% for each incremental 25%increase over the note conversion price. Alternatively, if (x) we have notregistered such common stock under an effective registration statement, but(y) our common stock is trading at a 25% or greater premium to the noteconversion price, then the interest rate will be adjusted downward by 1.0% foreach incremental 25% increase over the note conversion price. In no event shallthe interest rate be less than 0%. The effective interest rate as ofDecember 31, 2006 was 12.77%, and as of December 31, 2005 the effectiveinterest rates ranged between 73.2% and 76.9%.

For cash paymentsmade on the 2004 and 2005 Senior Notes (e.g., any amounts due that are notconverted into common stock), we are required to pay an amount equal to 102% ofthe amount of principal or interest due. In addition, we can prepay the note atany time upon payment of an amount equal to 110% of the then outstandingprincipal balance, plus accrued and unpaid interest.

Laurus has theoption at any time to convert any or all of the outstanding principal andaccrued and unpaid interest on the 2004 and 2005 Senior Notes into shares ofour common stock at a conversion price of $0.50 per share, as reduced pursuantto subsequent transactions which are described further below. In addition, foreach monthly payment under the note, Laurus will be obligated to convert aportion of the monthly payment into common stock at the applicable conversionprice, so long as:

·                  theaverage closing price of our common stock (for the five trading daysimmediately preceding the payment date) is greater than $0.55 per share (whichrepresents 110% of the note conversion price, based on the conversion price of$0.50),

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

·                  theshares of common stock underlying the notes are registered under an effectiveregistration statement with the Securities and Exchange Commission.

The terms of the2004 and 2005 Senior Notes and 2004 and 2005 Senior Warrants prohibitconversion of the notes or exercise of the warrants to the extent thatconversion of the notes and exercise of the warrants would result in any holderthereof, together with its affiliates, beneficially owning in excess of 4.99%of our outstanding shares of common stock. A

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holder may waive the4.99% limitation upon 75 days’ prior written notice to us. Also, thislimitation does not preclude the holder from converting or exercising the notesor warrants and selling shares underlying the notes or warrants in stages overtime where each stage does not cause the holder and its affiliates tobeneficially own shares in excess of the limitation amount.

As security forour obligations to Laurus, we, along with our wholly-owned subsidiary PublicSafety Group, Inc. (“PSG”), have granted to Laurus a blanket securityinterest in all of our assets, and we have entered into a stock pledge withLaurus for the capital stock in PSG. If an event of default occurs under the2004 or 2005 Senior Notes or the other related investment agreements, 120% ofthe unpaid principal balance on the 2004 and 2005 Senior Notes, plus accruedinterest and fees, shall become immediately due and Laurus shall be entitled topayment of a default interest rate of 1.5% per month on all amounts due underthe 2004 and 2005 Senior Notes. Such events of default include the following:

·                  afailure to pay interest and principal payments under the 2004 or 2005 SeniorNotes within three days of when due;

·                  abreach by us of any material covenant or term or condition of the 2004 or 2005Senior Notes or in any of the investment agreements, if not cured within30 days of such breach;

·                  abreach by us of any material representation or warranty made in the 2004 or2005 Senior Notes or in any of the investment agreements;

·                  ifwe make an assignment for the benefit of our creditors, or a receiver ortrustee is appointed for us, or any form of bankruptcy or insolvency proceedingis instituted by us, or any involuntary proceeding is instituted against us ifnot vacated within 60 days;

·                  thefiling of any money judgment or similar final process against us for more than$50,000, which remains unvacated, unbonded or unstayed for a period of30 days;

·                  ifour common stock is suspended for five consecutive days or for five days duringany ten consecutive days from a principal market or pursuant to a Securitiesand Exchange Commission stop order; and

·                  afailure by us to timely deliver shares of common stock when due uponconversions of the 2004 or 2005 Senior Notes.

Upon an event of default,Laurus will be entitled to specified remedies, including remedies under theUniform Commercial Code.

We agreed to registerwith the Securities and Exchange Commission (the “SEC”) for resale the sharesof common stock that are issuable upon conversion of the 2004 and 2005 SeniorNotes and upon exercise of the 2004 and 2005 Senior Warrants. Under theregistration rights agreement, the registration statement for the 2005 SeniorNotes and 2005 Senior Warrants was to be declared effective not later thanSeptember 6, 2005. As the registration statement was not declaredeffective until July 24, 2006, the Company accrued liquidated damages of 2% permonth of the original principal amount of the 2005 Senior Notes in accordancewith the agreement. Laurus subsequently agreed to waive such liquidated damagesin an Amendment and Waiver agreement dated August 10, 2006, and mentionedbelow, which amounted to approximately $385,000.

Laurus has agreed,pursuant to the Senior Purchase Agreements, that neither it nor any of itsaffiliates and investment partners will (and will not cause any other person orentity, directly or indirectly, to) engage in “short sales” of our common stockfor as long as any 2004 or 2005 Senior Notes held by it remain outstanding. “Shortsales” are contracts for the sale of shares of stock that the seller does notown, or certificates which are not within the seller’s control, so as to beavailable for delivery at the time when, under applicable rules, delivery mustbe made.

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**2004 and2005 Senior Notes Amendment and Waivers**

Effective as ofAugust 31, 2005, the Company entered into an Amendment and Waiveragreement with Laurus, pursuant to which the Company was permitted to defer thepayment of the monthly principal amounts due and payable for the months of September,October, November and December 2005 under both (a) the 2004 SeniorNote, and (b) the 2005 Senior Note, such aggregate deferred principalamounts being equal to $625,000 and $187,500, respectively. The deferredprincipal amount under the 2004 Senior Note was then due on September 29,2007, the final maturity date of the 2004 Senior Note. The deferred principalamount under the 2005 Senior Note was then due on June 7, 2008, the finalmaturity date of the 2005 Senior Note. The Company remained obligated to payall monthly interest amounts under these notes as they were currently due.

Pursuant to thisAmendment and Waiver, the Company issued an aggregate of 612,166 shares of itsCommon Stock to Laurus as consideration for this principal payment deferral.The Company entered into a Registration Rights Agreement dated as ofAugust 31, 2005 pursuant to which the Company has agreed to file aregistration statement with the SEC covering the resale of these shares ofCommon Stock. The resale registration statement of which this prospectus is apart was initially filed with the SEC on September 11, 2006, and becameeffective on December 19, 2006.

Effective as ofJanuary 23, 2006, the Company entered into an Amendment and Waiver (the “January2006 Senior Notes Amendment and Waiver”) with Laurus in connection with the2004 and 2005 Senior Notes then held by Laurus. Under the January 2006 SeniorNotes Amendment and Waiver, the 2004 and 2005 Senior Notes issued by theCompany to Laurus were amended as follows: (i) the maturity date of the2004 Senior Note was extended to January 1, 2008, (ii) the maturitydate of the 2005 Senior Note was extended to December 1, 2008, and(iii) the fixed conversion price under each of the Senior Notes was resetfrom $1.35 to $0.85 per share. In addition, the exercise price of all warrantsto purchase Common Stock of the Company held by Laurus was reset to $1.00 pershare.

Pursuant to theJanuary 2006 Senior Notes Amendment and Waiver, the Company issued 150,000shares of its Common Stock to Laurus as consideration for the principal paymentdeferral. In connection with the issuance of these shares, Laurus agreed towaive the provisions of the 2004 and 2005 Senior Notes regarding any adjustmentof the fixed conversion price that would otherwise be triggered as a result ofthe issuance of these shares and certain other securities which have aconversion price of $0.70 per share.

Effective as ofAugust 10, 2006, the Company entered into a further Amendment and Waiver(the “August 2006 Senior Notes Amendment and Waiver”) with Laurus in connectionwith the 2004 and 2005 Senior Notes. Under the August 2006 Senior NotesAmendment and Waiver, the 2004 and 2005 Senior Notes were amended as follows:(i) the principal amounts due and payable under the 2004 and 2005 SeniorNotes for the months of August and September 2006, shall be paid in sharesof the Company’s Common Stock priced at $0.50 per share; and (ii) theprincipal amount due and payable under the 2004 Senior Note for the months ofOctober, November and December 2006 is deferred until January 1,2008, the final maturity date of the 2004 Senior Note, and the principal amountdue and payable under the 2005 Senior Note for the months of October, Novemberand December 2006 is deferred until December 1, 2008, the finalmaturity date of the 2005 Senior Note.

Pursuant to theAugust 2006 Senior Notes Amendment and Waiver, the Company issued 150,000shares of its common stock to Laurus as consideration for the principal paymentdeferral. In connection with this financing, the Company also reduced theconversion price of the Series A and Series B Convertible Preferredshares to $0.50 per share.

***Subordinated Term Notes***

**2004 and 2005 Notes**

On September 29,2004, we entered into a Securities Purchase Agreement (the “2004 SubordinatedPurchase Agreement”) with The Shaar Fund, Ltd. (“Shaar”) and otherexisting shareholders of the Company and accredited investors (collectively,the “2004 Subordinated Investors”) for $4,950,000. Under the 2004 SubordinatedPurchase Agreement, the Company issued unsecured convertible term notes (the “2004Subordinated Notes”) in the aggregate principal amount of $4,950,000,convertible into common stock of the Company in certain circumstances at aninitial conversion price of $1.35 per share, and issued warrants (the “2004Subordinated Warrants”) to purchase an aggregate of 1,099,997 shares of ourcommon stock at an initial exercise price of $1.55 per share. The proceeds fromthis transaction were used in part to finance a portion of the AetherAcquisition and for working capital purposes.

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On May 31, 2005,we entered into a Securities Purchase Agreement, (the “2005 SubordinatedPurchase Agreement”) with Shaar, Longview Fund, L.P. (“Longview”) and otherexisting shareholders of the Company and accredited investors (collectively,the “2005 Subordinated Investors”). Under the 2005 Subordinated PurchaseAgreement, the Company issued convertible Term Notes (the “2005 SubordinatedNotes”) in the aggregate principal amount of $2,794,723, convertible intocommon stock of the Company in certain circumstances at an initial conversionprice of $1.35 per share, and issued warrants (the “2005 Subordinated Warrants”)to purchase an aggregate of 828,066 shares of the Common Stock at an initialper share exercise price of $1.50. The proceeds from this transaction were usedfor working capital purposes.

On July 8, 2005,certain 2005 Subordinated Investors purchased additional 2005 SubordinatedNotes in the aggregate principal amount of $450,000 and received additional2005 Subordinated Warrants to purchase an aggregate of 133,333 shares of CommonStock at an initial per share exercise price of $1.50. The proceeds from thistransaction were used for working capital purposes.

Under the terms ofthe 2004 and 2005 Subordinated Notes, we are required to make monthly paymentsof accrued interest and principal. The 2004 and 2005 Subordinated Notes bearinterest at an initial rate equal to the prime rate plus seven and one-halfpercent (7.5%), subject to an eleven percent (11%) floor. The effectiveinterest rate as of December 31, 2006 was 15.25%, and as of December 31,2005 the effective interest rates ranged between 104.9% and 136.0%.

We may prepay the 2004and 2005 Subordinated Notes at any time upon payment of an amount equal to 110%and 120% respectively, of the then outstanding principal balance, plus accruedand unpaid interest. Upon any such prepayment, the 2004 and 2005 Senior Notesmust also be prepaid. The 2004 and 2005 Subordinated Investors have the optionat any time to convert any or all of the outstanding principal and accrued andunpaid interest on the 2004 and 2005 Subordinated Notes into shares of ourcommon stock at a conversion price of $0.50 per share.

The terms of the 2004 and2005 Subordinated Notes and 2004 and 2005 Subordinated Warrants prohibitconversion of the notes or exercise of the warrants to the extent thatconversion of the notes and exercise of the warrants would result in any holderthereof, together with its affiliates, beneficially owning in excess of 4.99%of our outstanding shares of common stock. A holder may waive the 4.99%limitation upon 75 days’ prior written notice to us. Also, this limitationdoes not preclude the holder from converting or exercising the note or warrantand selling shares underlying the note or warrant in stages over time whereeach stage does not cause the holder and its affiliates to beneficially ownshares in excess of the limitation amount.

If an event of defaultoccurs under the 2004 or 2005 Subordinated Notes or the other relatedinvestment agreements, the unpaid principal balance on the 2004 and 2005Subordinated Notes, plus accrued interest, shall, at the noteholder’s option,become immediately due and the 2004 and 2005 Subordinated Investors shall beentitled to payment of additional default interest at the rate of 2.0% perannum on all amounts due under the 2004 and 2005 Subordinated Notes. Suchevents of default include the following:

·              A failure to pay interestand principal payments under the 2004 or 2005 Subordinated Notes within threedays of when due;

·              A breach by us ofany covenant, term or condition in any material respect of the 2004 or 2005Subordinated Notes or in any of the investment agreements, if not cured within30 days of such breach;

·              Any representationor warranty made in the 2004 or 2005 Subordinated Notes or in any of theinvestment agreements being false or misleading in any material respect;

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

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

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

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·              A failure by us totimely deliver shares of common stock when due upon conversions of the 2004 or2005 Subordinated Convertible Notes; and

·              A change in ourcontrolling ownership.

Upon an event of default,the rights and remedies of the 2004 and 2005 Subordinated Investors will besubordinate to those of the Senior Investors pursuant to Subordination andIntercreditor Agreement dated as of September 30, 2004 by and amongLaurus, as Collateral Agent, Shaar, as Purchaser Agent, AetherSystems, Inc., PSG and the Company.

We have registered withthe Securities and Exchange Commission for resale the shares of common stockthat are issuable upon conversion of the 2004 and 2005 Subordinated Notes andupon exercise of the 2004 and 2005 Subordinated Warrants. Under theregistration rights agreement, the registration statement for the 2005Subordinated Notes and 2005 Subordinated Warrants was to be declared effectivenot later than September 6, 2005. As the registration statement was notdeclared effective until July 24, 2006, the Company accrued liquidated damagesof 2% per month of the original principal amount of the 2005 Subordinated Notesin accordance with the agreement. The 2005 Subordinated Investors subsequentlyagreed to waive a portion of such liquidated damages in a Securities Exchangeagreement dated August 10, 2006, and mentioned below, which amounted toapproximately $321,500.

Each 2004 and 2005Subordinated Investor has agreed, pursuant to the 2004 and 2005 SubordinatedPurchase Agreements, that neither it nor any of its affiliates and investmentpartners will (and will not cause any other person or entity, directly orindirectly, to) engage in “short sales” of our common stock for as long as any2004 or 2005 Subordinated Notes held by it remain outstanding.

**2004 and2005 Subordinated Notes Amendment and Waivers**

Effective August31, 2005, the Company entered into an Amendment and Waiver (the “August 2005Amendment and Waiver”), with certain 2004 Subordinated Investors, pursuant towhich the Company was permitted to defer the payment of the monthly principalamounts due and payable for the months of September, October, November andDecember 2005 under the 2004 Subordinated Notes, such aggregate deferredprincipal amount being equal to $350,004. The deferred principal amount undereach 2004 Subordinated Note was then due on September 29, 2007, the finalmaturity date of each such note. The Company remained obligated to pay allmonthly interest amounts under these notes as they were currently due.

Pursuant to theseAmendment and Waivers, the Company issued an aggregate of 263,705 shares of itsCommon Stock to the Subordinated Investors as consideration for this principalpayment deferral. The Company entered into the Registration Rights Agreementwith each of the Subordinated Investors, pursuant to which the Company hasagreed to file a registration statement with the SEC covering the resaleof these shares of Common Stock. The resale registration statement of which thisprospectus is a part was initially filed with the SEC on September 11,2006, and became effective on December 19, 2006.

Effective as ofJanuary 23, 2006, the Company entered into an Amendment and Waiver (the “January2006 Subordinated Notes Amendment and Waiver”) with certain 2004 and 2005Subordinated Investors. Under the January 2006 Subordinated Notes Amendment andWaiver, the 2004 and 2005 Subordinated Notes were amended as follows:(i) the maturity dates were extended from September 29, 2007 and May 31,2008, respectively, to January 1, 2009; (ii) the interest rate wasfixed at fifteen percent (15%); (iii) all principal amounts are due at thematurity date and shall be paid in shares of Common Stock priced at $0.70 pershare if the average closing price of the Common Stock for the thirty(30) trading days immediately preceding the maturity date is greater than$1.10; (iv) interest shall be paid, at the Company’s election, in cash orshares of Common Stock, with the Common Stock priced at the average closingprice of the Common Stock for the ten (10) trading days immediatelypreceding the repayment date; and (v) the currently applicable fixedconversion price was amended to $0.70 per share. In addition, the exerciseprice of all warrants to purchase Common Stock held by the 2004 and 2005Subordinated Note Holders that had an exercise price greater than $1.00 pershare was reset to $1.00 per share.

***SubordinatedDebt and Preferred Stock Financing Transactions***

On January 23, 2006, we entered into a Securities Purchase Agreement,with Shaar, Longview and Longview Special Finance, Inc (“Longview Special”),  (the “2006 Securities Purchase Agreement”).Under the 2006 Securities Purchase Agreement, the Company issued unsecuredconvertible term notes (the “2006 Convertible Notes”) in the aggregateprincipal

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amount of $1,000,000,interest at 15% per annum, convertible into Series B Preferred Stock of theCompany at a conversion rate of $1.00 per share. The proceeds from thistransaction were used for general working capital purposes.

In connection withthe Purchasers’ purchase of the Notes, the Company also issued warrants to thePurchasers (the “Warrants”) to purchase up to an aggregate of 500,000 shares ofthe Company’s Common Stock (subject to adjustment as set forth therein) at aninitial exercise price of $1.00 per share.

The Warrants wereclassified as liabilities and were valued at $94,143 as of December 31,2006, using the Black Scholes Option Pricing model with the followingassumptions: dividend yield of 0%; annual volatility of 86% and risk-freeinterest rate of 4.7%.

OnFebruary 22, 2006, the 2006 Subordinated Notes converted by their termsinto shares of the Company’s Series B Preferred Stock, which shares areconvertible into shares of the Company’s Common Stock at an initial fixedconversion price of $0.70 per share.

On August 10,2006, the Company entered into a Securities Exchange Agreement (the “2006Securities Exchange Agreement”) with certain 2004 and 2005 SubordinatedInvestors. Under the 2006 Securities Exchange Agreement, the 2004 and 2005Subordinated Notes were exchanged for shares of the Company’s Series CConvertible Preferred Stock (the “Series C Shares”), which shares areinitially convertible into Common Stock at $0.50 per share, having an aggregatevalue equal to the principal amount outstanding under the 2004 and 2005Subordinated Notes, plus accrued and unpaid interest thereon, and certainliquidated damages payments owed by the Company to the 2004 and 2005Subordinated Note Holders. In connection with the transaction, the Company alsoreduced the conversion price of the Series A and Series B ConvertiblePreferred shares to $0.50 per share. The Company entered into a RegistrationRights Agreement dated as of August 10, 2006 (the “Exchange RegistrationRights Agreement”) with the 2004 and 2005 Subordinated Note Holders, pursuantto which the Company has agreed to file a registration statement with theCommission covering the resale of the shares of Common Stock underlying theSeries C Shares. The resale registration statement of which thisprospectus is a part was initially filed with the SEC on September 11,2006, and became effective on December 19, 2006.

***2004 and 2005Senior and Subordinated Note Derivatives***

The 2004 and 2005Senior and Subordinated Notes (the “Notes”) contain features that areconsidered embedded derivative financial instruments: Principal’s conversionoption: The Notes are convertible at the Holder’s option at any time at thefixed conversion price of $0.50 per share; Monthly Payments Conversion Option:Holders have the option to convert the Notes’ monthly payment at a $0.50 pershare conversion price if the common stock price is higher than 110% of theconversion price ($0.55), as long as the amount converted is not higher than25% of trading volume for the last 22 trading days. If the Notes’ monthlypayments are not converted, the payments will be paid in cash at 102% of suchamount; Interest Rate Adjustment provision (Senior Notes only): For every 25%increase in common stock value above $0.50 per share, the interest will bereduced by 2%. The interest rate may never be reduced below 0%; Defaultprovision: In the event of default under the terms set forth above, the Holderswill be entitled to specified remedies, including remedies under the UniformCommercial Code. These features have been bifurcated and recorded on theCompany’s balance sheet at their fair value.

The accountingtreatment of the derivatives and warrants requires that the Company record thederivatives and the warrants at their relative fair value as of the inceptiondate of the agreement, and at fair value as of each subsequent balance sheetdate. Any change in fair value will be recorded as non-operating, non-cashincome or expense at each reporting date. If the fair value of the derivativesand warrants is higher at the subsequent balance sheet date, the Company willrecord a non-operating, non-cash charge. If the fair value of the derivativesand warrants is lower at the subsequent balance sheet date, the Company willrecord non-operating, non-cash income.

As of December 31, 2006, the derivatives were valued at $355,074.Conversion related derivatives were valued using the Binomial Option PricingModel with the following assumptions: dividend yield of 0%; annual volatilityof 68% to 72%; and risk free annual interest rate of 4.8% to 5.0% as well asprobability analysis related to trading volume restrictions. The remainingderivatives were valued using other binomial models and measuring the impact ofthe derivative on the expected interest payment amount over the life of theNote. The Warrants issued with the 2004 and 2005 debt financings classified asliabilities were valued at $382,605 as of December 31, 2006, using theBlack Scholes Option Pricing model with the following assumptions: dividendyield of 0%; annual volatility of 78% to 81% and risk-free interest rate of4.7% to 4.8%.

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The initialrelative fair values of both the derivatives and the warrants were recorded asdiscounts to the Notes and are being amortized to interest expense over theexpected term of the debt, using the effective interest method. At December 31,2006, the unamortized discount on the Notes was $786,570.

**AetherNote Amendment**

The Companyentered into an Amendment No. 1 to Subordinated Secured Promissory Note,dated as of January 23, 2006 (the “Aether Note Amendment”), with AetherSystems, Inc. (“Aether”). Pursuant to the Aether Note Amendment, theSubordinated Secured Promissory Note issued by the Company to Aether onSeptember 30, 2004 in the aggregate maximum principal amount of $6,884,588(the “Aether Note”), was amended to increase such aggregate maximum principalamount to $7,884,588. The Aether Note evidences a contingent reimbursementobligation of the Company to Aether and a surety fee payable by the Company toAether, in each case with respect to a letter of credit maintained by Aetherfor the Company’s benefit in connection with the Company’s acquisition of theMobile Government Division of Aether on September 30, 2004. The Company’sobligations under the Aether Note remain secured by a security interest grantedto Aether in all or substantially all of the Company’s assets subordinated tothe security interest of Laurus pursuant to the 2004 and 2005 Senior Notes.  Should the Company default on the letter ofcredit, or sublease agreements, Aether may draw down on the escrow amounts itcurrently holds on behalf of the Company. The letter of credit expired onDecember 31, 2006 and has not been renewed by Aether.

**Defaulton 2004 and 2005 Notes**

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

During the yearended December 31, 2006, the Company failed to make such payments or issue suchregistered shares to the 2004 and 2005 subordinated debt holders. The failureto make the required monthly payments caused the subordinated debt to default,and in accordance with the provisions set forth in the subordinated convertiblenote agreements, the interest rate on the subordinated notes was increased byan additional 2.0% per annum.

In connection withthe exchange of subordinated debt for Series C Convertible Preferred Stockpursuant to the 2006 Securities Exchange Agreement, as described above, thethen current interest liability of the note holders was exchanged forSeries C Convertible Preferred Stock.

During the yearended December 31, 2006, the Company made the required payments to the 2004 and2005 senior debt holder, Laurus. However, due to the non-payment ofsubordinated interest described above, the Company incurred, in accordance withthe cross-default provisions of the senior debt agreements, an additional 1.5%per month default interest penalty relating to the senior debt. Total accrueddefault interest payable as at December 31, 2006 was $622,764 as related to the2004 and 2005 senior notes.

Effective December29, 2006, the Company entered into an agreement with Laurus, to convert thedefault interest payable by the Company to Laurus of $622,764 into 1,000,000shares of common stock. This agreement was made subject to the Company raisingat least $2,000,000 in gross proceeds from the issuance of new equitysecurities before March 29, 2007. As the conversion agreement is contingent ona future event, the default interest remained as a liability as at December 31,2006. See Note X.

Total accrued interest for all convertible debt as of December 31, 2006amounted to $671,040.

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**NOTE M—SEGMENT INFORMATION**

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

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

Geographically North American sales accounted forapproximately 100% of the Company’s total sales for fiscal years 2006 and 2005.

Summarized financialinformation concerning our reportable segments is shown in the following table:
|                                                | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                     | ** ** | **2006**                                                      | ** **  | **2005** | ** ** |
| ** **                                     | ** ** | ** **                                                    | ** **  | **As Restated** | ** ** |
| **Revenue:**                                   | ** ** | ** **                                                    | ** **  | ** ** | ** ** |
| Law                                            |       | $                                                             | 10,426,117  |   | $ | 10,524,938 |   |
| Fire                                           |       | 3,906,454                                                     |        | 3,221,086 |   |
| Biometrics                                     |       | 861,054                                                       |        | 480,071 |   |
| Consolidated Revenue                           |       | 15,193,625                                                    |        | 14,226,095 |   |
| **Segment  operating income**                  | ** ** | ** **                                                    | ** **  | ** ** | ** ** |
| Law                                            |       | (443,156                                                      | )           | (3,817,866 | ) |
| Fire                                           |       | (1,467,600                                                    | )           | (1,555,788 | ) |
| Biometrics                                     |       | (3,117,695                                                    | )           | (2,914,528 | ) |
| Total Segment Operating Income (Loss)          |       | (5,028,451                                                    | )           | (8,288,182 | ) |
| **Reconciliation  to net loss**                | ** ** | ** **                                                    | ** **  | ** ** | ** ** |
| Interest expense                               |       | (5,730,712                                                    | )           | (4,521,344 | ) |
| Interest income                                |       | —                                                        |        | 35,958 |   |
| Derivative and  warrant fair value adjustments |       | 7,542,666                                                     |        | 9,154,951 |   |
| Loss on  extinguishment of debt                |       | (7,815,717                                                    | )           | — |   |
| Other expense                                  |       | (48,637                                                       | )           | (54,767 | ) |
| **Net  loss**                                  |       | $                                                             | (11,080,851 | ) | $ | (3,673,384 | ) |

 

**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 2009. In addition to base rent, the Companypays for property taxes, maintenance, insurance and other occupancy expensesaccording to the terms of the individual leases. The Company also leasesequipment, with a non-cancelable operating lease expiring in 2010.

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

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Minimumrental commitments of non-cancelable operating leases are approximately asfollows:
| Year s ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------|------------|
| 2007                                           |       | $          | 1,285,970  |   |
| 2008                                           |       | 874,605    |       |
| 2009                                           |       | 36,089     |       |
| 2010                                           |       | 1,457      |       |
|                                           |       |       |       |
|                                           |       | $          | 2,198,121  |   |

 

Rental expense was approximately $853,000 and $753,000during 2006 and 2005, respectively.

*Employment Agreements*

The Company has employment agreements with threeemployees. These agreements allow the continuation of the employee’s salary inthe event of termination without cause. The agreements also acknowledge theemployee’s eligibility to participate in the Company’s bonus and option plans,the terms of which have not yet been established. As of December 31, 2006,the aggregate commitment under these agreements was approximately $545,000.

*Legal Proceeding*

Priorto our acquisition of PSG in March 2004, PSG had been named as a defendantin a civil action initiated in the Superior Court Department in Hampden County,Commonwealth of Massachusetts by The Vince Group, Inc. (“TVG”). The casewas then removed to the United States District Court for the District ofMassachusetts at the request of the parties. The complaint claimed that PSG wasobligated to pay a percentage of certain of its revenues to TVG inconsideration for a strategic business introduction allegedly made by an agentof TVG. PSG denied the allegations and filed an answer in the litigation. On April20, 2006, the action was reported settled to the Court, and on June 20, 2006 aStipulation of Dismissal with Prejudice was filed.

*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 and acceptedby the customer. For the years ended December 31, 2006 and 2005, royaltyexpense was approximately $83,000 and $178,000, respectively.

**NOTE O— EQUITY**

1.Mezzanine Equity

*Redeemable Preferred Stock*

**Series B Convertible Preferred Stock**

The Company issued 1,000,000 shares of redeemableSeries B Convertible Preferred Stock on February 23, 2006, upon theconversion of the 2006 Convertible Notes. Each share of Series B preferredstock has an Original Issue Price of $1.00 per share. The holder has the optionto redeem the shares of Series B preferred stock at any time for a numberof shares of the Company’s common stock equal to the Original Issue Price plusaccumulated and unpaid dividends divided by the fixed conversion price of $0.50per 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 B 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 allSeries B shares will be automatic if, for the 30 trading days prior toJanuary 1, 2009, the average closing bid price for one share of common stockis at least $1.10. The shares shall be converted at the conversion price thenin effect. If the average bid price for the 30 trading days prior toJanuary 1, 2009 per common share is less than

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$1.10 the Companyshall mandatorily redeem all remaining outstanding Series B preferredstock by paying cash equal to $1.00 per share with all accrued and unpaiddividends.  The Company may, at itselection, redeem any or all of the remaining outstanding Series B sharesin cash at a conversion price equal to $1.20 per share, together with allaccrued and unpaid dividends upon giving 30 day notice. Holders of theSeries B preferred stock are entitled to cumulative, prior and inpreference to holders of common stock dividends equal to 15% per annum of theOriginal Purchase Price still outstanding, payable quarterly commencingApril 1, 2006. In any liquidation of the Company, each share of preferredstock is entitled to a liquidation preference in pari passu with theSeries A and Series C Preferred stock before any distribution may be madeon the Company’s common stock.

Duringthe year ended December 31, 2006, $52,603 of dividends ($0.053 per share) weredeclared payable to the holders of Series B Convertible Preferred Stock, ofwhich $28,932 was paid in cash during the period. As of December 31, 2006,1,000,000 preferred stock shares are authorized, issued and outstanding, at apar value of $0.0001 and a liquidation preference of $1.00 with accumulateddividends in arrears of $77,397, which have been accreted to the principalbalance of the Series B preferred stock.

The Preferred Stockcontains features that are considered embedded derivative financialinstruments:  Preferred Stock’sconversion option:  The Preferred Stockis convertible at the Holder’s option at any time at the fixed conversion priceof $0.50 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’squarterly dividend payment at a conversion price of the average 10 days closingprice prior to the dividend record date. These features have been bifurcated and recorded on the Company’sbalance sheet as liabilities, at their fair value.

As of December 31, 2006,the derivatives were valued at $58,103. Conversion related derivatives were valued using the Binomial OptionPricing Model with the following assumptions: dividend yield of 15%; annualvolatility of 34%; and risk free annual interest rate of 4.8% as well asprobability analysis related to trading volume restrictions.

Anamount equal to the original value of the derivatives was recorded as adiscount to the Preferred Stock.  Thediscount is being accreted to the principal balance of the Preferred Stock,using the effective interest method, over the expected term of the term of thePreferred Stock.  At December 31, 2006,the unamortized discount on the Preferred Stock was $252,959.

**Series CConvertible Preferred Stock**

TheCompany issued 592,032 shares of redeemable Series C Convertible PreferredStock on August 10, 2006, upon the exchange of certain 2004 and 2005Subordinated Notes. Each share of Series C preferred stock has an OriginalIssue Price of $10.00 per share. The holder has the option to redeem the sharesof Series C preferred stock at any time for a number of shares of theCompany’s common stock equal to the Original Issue Price plus accumulated andunpaid dividends divided by the fixed conversion price of $0.50 per share ofCommon Stock. The conversion price is subject to adjustment if common stock isissued by the Company subsequent to the original issue date of theSeries C preferred stock, except for other conversions, options, warrants,dividends paid in stock or pursuant to an acquisition by the Company, at aprice 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 in pari passu with the Series A and Series BPreferred stock before any distribution may be made on the Company’s commonstock.

Duringthe year ended December 31, 2006, $51,093 of dividends ($0.086 per share) weredeclared payable to the holders of Series C Convertible Preferred Stock, ofwhich $26,936 was paid in cash during the period. As of December 31, 2006,600,000 preferred stock shares are authorized, 592,032 of which are issued andoutstanding, at a par value of $0.0001 and a liquidation preference of $10.00with accumulated dividends in arrears of $305,277, which have been accreted tothe principal balance of the Series C preferred stock.

The Preferred Stockcontains features that are considered embedded derivative financialinstruments:  Preferred Stock’s

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conversion option: The Preferred Stock is convertible at the Holder’s option at any time atthe fixed conversion price of $0.50 per share; Quarterly Dividends ConversionOption:  Holders have the option toconvert the Stock’s quarterly dividend payment at a conversion price of theaverage 10 days closing price prior to the dividend record date.  These features have been bifurcated andrecorded on the Company’s balance sheet as liabilities, at their fair value.

As of December 31, 2006the derivatives were valued at $343,993. Conversion related derivatives were valued using the Binomial OptionPricing Model with the following assumptions: dividend yield of 15%; annualvolatility of 34%; and risk free annual interest rate of 4.8% as well asprobability analysis related to trading volume restrictions.

Anamount of $1,073,537 equal to the original value of the derivatives wasrecorded as discount to the Preferred Stock. The discount is being accreted to the principal balance of the PreferredStock, using the effective interest method, over the expected term of the termof the Preferred Stock.  At December 31,2006, the unamortized discount on the Preferred Stock was $898,889.

Togetherwith the above transaction, the terms of certain warrants held by the Company’sinvestment bankers and their associates were modified. The incremental value ofthe modification was calculated to be $110,453, and was allocated against theproceeds of the Series C Convertible Preferred Stock as a cost of financing,and will be accreted to the principal balance of the Preferred Stock, using theeffective interest method, over the expected term of the term of the PreferredStock.  At December 31, 2006, the netamount remaining to be accreted was $92,494.

2. Permanent Equity

**CommonStock**

The Company isauthorized to issue 170,000,000 shares of common stock, $.0001 par value pershare, of which 55,158,814 were outstanding as of December 31, 2006.

Holders of commonstock have equal rights to receive dividends when, as and if declared by theBoard of Directors, out of funds legally available therefor. Holders of commonstock have one vote for each share held of record and do not have cumulativevoting rights.

Holders of commonstock are entitled, upon liquidation of the Company, to share ratably in thenet assets available for distribution, subject to the rights, if any, ofholders of any preferred stock then outstanding. Shares of common stock are notredeemable and have no preemptive or similar rights. All outstanding shares ofcommon stock are fully paid and nonassessable.

Pursuant to theAugust 10, 2006 Securities Purchase Agreement with Trellus Partners, L.P, (“Trellus”)the Company  issued and sold 3,000,000shares of its Common Stock to Trellus, at a purchase price of $0.50 per share,for an aggregate purchase price of $1,500,000. The proceeds from thistransaction were used for general working capital purposes.

Pursuant to theAugust 10, 2006 Securities Purchase Agreement with Shaar, the Company issuedand sold 1,000,000 shares of its Common Stock to Shaar, at a purchase price of$0.50 per share, for an aggregate purchase price of $500,000, which was paid byexchanging Shaar’s rights in an aggregate amount of $500,000 in accrued andunpaid dividends on the shares of Series A Convertible Preferred Stock thenheld by Shaar.

**Series AConvertible Preferred Stock**

Within the limits and restrictions provided in the Company’s Certificateof Incorporation, the Board of Directors has the authority, without furtheraction by the shareholders, to issue up to 5,000,000 shares of preferred stock,$.0001 par value per share, in one or more series, and to fix, as to any suchseries, any dividend rate, redemption price, preference on liquidation ordissolution, sinking fund terms, conversion rights, voting rights, and anyother preference or special rights and qualifications.

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InMarch 2004, we designated 100,000 shares of preferred stock as Series CConvertible Preferred Stock. In connection with the Company’s reincorporationin Delaware on January 1, 2005, each share of Series C ConvertiblePreferred Stock was automatically converted into one share of Series AConvertible Preferred Stock (the “Series A Shares”), of which 30,557 wereissued and outstanding December 31, 2006. The following describes the materialprovisions of the Series A Shares which are more fully set forth in theCertificate of Designation on file with the Delaware Secretary of State.

The Series AShares accrue a cumulative annual dividend of 7% on the $100 face amount ofsuch shares payable June 15 and December 15 each year in shares ofcommon stock. In the event of a liquidation, dissolution or winding up of theCompany, the Series A shares have a liquidation preference of $100 pershare (plus all accrued and unpaid dividends thereon) prior to any payment ordistribution to holders of our common stock. The Series A Shares areconvertible into common stock at a conversion price of $0.50 per share. Theconversion price is subject to proportional adjustment in the event of stocksplits, stock dividends or reclassifications. Subject to certain exceptions, inthe event we issue additional shares of common stock at a purchase price lessthan the conversion price of the Series A Shares, the conversion priceshall be lowered to such lesser price. In the event that the average closingbid price of our common stock is less than $1.00 per share for thirty(30) consecutive trading days at any time after March 3, 2008, wewill be required to redeem the Series A Shares by payment of $100 pershare plus all accrued and unpaid dividends due thereon. See Note X.

We are required toobtain the consent of the holders of a majority of the Series A Shares inorder to, among other things, issue any shares of preferred stock that areequal to or have a preference over the Series A shares or issue any sharesof preferred 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.

During the yearended December 31, 2006, $606,968 of dividends ($17.070 per share) was declaredpayable to the holders of Series A Convertible Preferred Stock. $500,000 of theamount payable to Shaar was used to pay the purchase price of the 1,000,000shares of Common Stock, as mentioned above.

In addition, theholders of Series A Convertible Preferred Stock converted 14,000 shares and$294,425 in accrued and unpaid dividends into 2,801,343 shares of the Company’scommon stock, during the year.

As ofDecember 31, 2006, cumulative dividends in arrears related to the Series Apreferred stock were approximately $27,083, which have been accreted to theprincipal balance of the Series A preferred stock.

3. Warrants

The Company has issuedwarrants to certain creditors, investors, investment bankers and consultants. Asummary of warrant activity is as follows:
| ** **                                               | ** ** | **Outstanding** | ** ** | **Initial   Price per  share** | ** **   | **Expiration  date** | ** ** | **Exercisable at  December 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|------------------------------------------|--------------|----------------------|------------|--------------------------------------------|------------|
|                                                     |       |            |       |                                     |         |                 |       |                                       |       |
| **Balance,  December 31, 2005**                     |       | 13,188,280      |       |                                     |         |                 |       | 13,163,280                                 |       |
|                                                     |       |            |       |                                     |         |                 |       |                                       |       |
| Issued in  connection with purchase of convertible notes |       | 500,000         |       | $                                        | 1.00         |                 | 2011       |                                       | 500,000    |   |
| Issued in  connection with purchase of common stock      |       | 533,333         |       | $                                        | 0.75         |                 | 2011       |                                       | 533,333    |   |
| Exercised                                                |       | (26,250         | )          | $                                        | 0.32         |                 | —     |                                       | (26,250    | ) |
| Expired or  cancelled                                    |       | (3,628,988      | )          | $                                        | 0.38 - $1.00 |                 | —     |                                       | (3,628,988 | ) |
| Vested during  the year                                  |       | —          |       | $                                        | 0.97         |                 | —     |                                       | 25,000     |   |
| ** **                                               | ** ** | ** **      | ** ** | ** **                               | ** **   | ** **           | ** ** | ** **                                 | ** ** |
| **Balance, December 31, 2006**                      |       | 10,566,375      |       |                                     |         |                 |       | 10,566,375                                 |       |

 

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The estimated fair value of the warrants grantedduring 2006 and 2005 was $423,287 and $1,467,302, respectively. The fair valueof warrants is estimated as of the grant date using the Black-Scholes pricingmodel utilizing the following assumptions: dividend yield of 0%; annual volatilityof 72% to 99%; and risk free annual interest rate of 4.3% to 4.5% for 2006, anddividend yield of 0%; annual volatility of 121% to 123%%; and risk free annualinterest rate of 3.7% to 4.0% for 2005, respectively.

**NOTE P—STOCK-BASED COMPENSATION**

*1996Stock Option Plan*

During 1996, theBoard of Directors and stockholders of the Company adopted the 1996 StockOption Plan (the 1996 Plan). Under the 1996 Plan, 750,000 shares of commonstock are reserved for issuance to employees, officers, directors, and consultantsof the Company at exercise prices which may not be below 100% of fair marketvalue for incentive stock options and 50% for all others. The term of stockoptions granted may not exceed ten years. Options issued under the Plan vestpursuant to the terms of stock option agreements with the recipients. In theevent of a change in control, as defined, all options outstanding vestimmediately. The Plan expired in May 2005.

*1999Stock Option Plan*

During 1999, theBoard of Directors of the Company adopted the 1999 Stock Option Plan (the 1999Plan). The 1999 Plan was not presented to stockholders for approval and thusincentive stock options are not available under the plan. Under the 1999 Plan,2,000,000 shares of common stock are reserved for issuance to employees,officers, directors, and consultants of the Company at exercise prices whichmay not be below 85% of fair market value. The term of nonstatutory stockoptions granted may not exceed ten years. Options issued under the Plan vestpursuant to the terms of stock option agreements with the recipients. In theevent of a change in control, as defined, all options outstanding vestimmediately. The 1999 Plan terminates in August 2009.

*2004Stock Option Plan*

OnOctober 12, 2004, the Board of Directors of the Company approved the 2004Stock Option Plan (the 2004 Plan). The 2004 Plan has not yet been presented tostockholders for approval and thus incentive stock options are not availableunder this plan. Under the terms of this plan, 4,000,000 shares of common stockare reserved for issuance to employees, officers, directors, and consultants ofthe Company at exercise prices which may not be below 85% of fair market value.The term of stock options granted may not exceed ten years. Options issuedunder the Plan vest pursuant to the terms of stock option agreements with therecipients. In the event of a change in control, as defined, all optionsoutstanding vest immediately. The Plan terminates in October 2014.

*Non-PlanStock Options*

Periodically, theCompany has granted options outside of the 1996, 1999, and 2004 Plans tovarious employees and consultants. In the event of change in control, asdefined, certain of the non-plan options outstanding vest immediately.

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*StockOption Activity*

Information summarizing optionactivity is as follows:
| ** **                                           | ** ** | **Number of Options** | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **1996 Plan**              | ** ** | **1999 Plan** | ** ** | **2004 Plan** | ** ** | **Non Plan** | ** ** | **Total** | ** ** | **Weighted  average  exercise   price** | ** ** | **Weighted  average  remaining  contractual  term  (in years)** | ** ** | **Aggregate  intrinsic  value** | ** ** |
| Outstanding, as  of December 31, 2005           |       | 150,000                         |       | 1,062,125          |       | 2,052,860          |       | 3,082,850         |       | 6,347,835 |   | $ | 0.92 |   | 4.52 |   | $ |   |   |
|                                                 |       |                            |       |               |       |               |       |              |       |   |   |   |   |   |   |   |   |
| Granted                                              |       | —                          |       | 135,000            |       | 1,197,669          |       | 1,050,000         |       | 2,382,669 |   | 0.67 |   |   |   |   |   |
| Exercised                                            |       | —                          |       | —             |       | —             |       | —            |       | — |   | — |   |   |   |   |   |
| Expired or  cancelled                                |       | (25,000                         | )          | (202,125           | )          | (354,110           | )          | (14,850           | )          | (596,085 | ) | 0.79 |   |   |   |   |   |
| **Outstanding,  as of December 31, 2006**       | ** ** | **125,000**                     | ** ** | **995,000**        | ** ** | **2,896,419**      | ** ** | **4,118,000**     | ** ** | **8,134,419** | ** ** | **0.85** | ** ** | **4.64** | ** ** | **24,000** | ** ** |
| **Vested  or expected to vest at December 31, 2006** | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **7,401,830** | ** ** | **0.87** | ** ** | **4.49** | ** ** | **24,000** | ** ** |
| **Exercisable at December 31,  2006**                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **5,373,743** | ** ** | **0.90** | ** ** | **3.92** | ** ** | **24,000** | ** ** |
|                                                      |            |                                 |            |                    |            |                    |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

The options outstandingand exercisable at December 31, 2006 were in the following exercise priceranges:
|                                             | ** ** | **Options Outstanding** | ** ** | **Options Vested**                | ** ** |
|---------------------------------------------|------------|------------------------------|------------|----------------------------------------|------------|
| **Range of exercise prices** | ** ** | **Number of  shares**   | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted  average  remaining life  (in years)** | ** ** | **Number  exercisable** | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted  average  remaining life  (in years)** | ** ** |
| $0.19                                       |       |                         | 60,000     |                                   | $          | 0.19 |   | 1.65 |   | 60,000 |   | $ | 0.19 |   | 1.65 |   |
| .29-.40                                     |       |                         | 912,000    |                                   | 0.33       |   | 2.98 |   | 815,000 |   | 0.33 |   | 2.55 |   |
| .46-.69                                     |       |                         | 2,712,000  |                                   | 0.58       |   | 4.60 |   | 1,506,663 |   | 0.54 |   | 3.32 |   |
|  .75-1.11                              |       |                         | 2,655,919  |                                   | 0.93       |   | 5.49 |   | 1,490,918 |   | 1.05 |   | 5.04 |   |
| 1.17-1.62                                   |       |                         | 1,746,500  |                                   | 1.30       |   | 4.46 |   | 1,453,162 |   | 1.30 |   | 4.36 |   |
| 6.42                                        |       |                         | 48,000     |                                   | 6.42       |   | 1.12 |   | 48,000 |   | 6.42 |   | 1.12 |   |
|  $0.19-6.42                            |       |                         | 8,134,419  |                                   |       |   |   |   | 5,373,743 |   |   |   |   |   |
|                                             |            |                              |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |

 

The weightedaverage remaining contractual life of options exercisable at December 31, 2006was 3.92 years.

The aggregateintrinsic value in the table above represents the total intrinsic value, basedon the Company’s closing stock price of $0.33 as of December 31, 2006, 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, 2006 was 640,000.

The weightedaverage fair value of options, as determined under SFAS No. 123R and SFAS123, granted during the year ended December 31, 2006 and December 31, 2005 was$0.52 and $0.85 per share, respectively.

The totalintrinsic value of options exercised during the year ended December 31, 2006and December 31, 2005 was $0 and $136,688, respectively.

As ofDecember 31, 2006 future compensation cost related to nonvested stock optionsis approximately $660,430 and will be recognized over an estimated weightedaverage period of approximately 3.0 years.

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**NOTE Q— EXTINGUISHMENT OF DEBT**

To address certainliquidity issues, on January 23, 2006, the Company issued convertibledebt, common stock and warrants in consideration for certain modifications ofits outstanding 2004 and 2005 Senior Notes, as explained in Note L. Inaddition, the Company also entered into the 2006 Securities Purchase Agreement,with Shaar., Longview,  and LongviewSpecial, also as explained in Note L.

Furthermore, on August10, 2006, the Company exchanged convertible debt for preferred stock, andissued common stock and warrants in consideration for certain modifications ofits outstanding 2004 and 2005 Senior Notes, also as explained in Note L.

In accordance withthe Emerging Issues Task Force of the FASB No. 96-19, Debtor’sAccounting for Modification or Exchange of Debt Terms (“EITF 96-19”), theCompany treated the above transactions as extinguishments of debt, and recordeda non-operating “loss on extinguishment of debt” of $2,322,016 for the January2006 transaction and $5,493,701 for the August 2006 transaction.

**NOTE R—INCOMETAXES**

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

Significant components ofdeferred taxes are as follows at December 31:
|                                         | ** ** | **2006**    | ** ** |
|-----------------------------------------|------------|-------------|------------|
| ** **                              | ** ** | ** **  | ** ** |
| **Current  asset:**                     | ** ** | ** **  | ** ** |
| Accrued  compensation                   |       | $           | 254,000    |   |
| Accounts receivable  allowance          |       | 70,000      |       |
| **Non-current  asset:**                 | ** ** | ** **  | ** ** |
| Basis  differences in fixed assets      |       | (60,000     | )          |
| Basis  differences in intangible assets |       | 198,000     |       |
| Accrued interest  and other             |       | 396,000     |       |
| Income tax  credits                     |       | 1,149,000   |       |
| Net operating  loss carryforwards       |       | 18,251,000  |       |
| Valuation  allowances                   |       | (20,258,000 | )          |
|                                    |       | $           | —     |   |

 

As of December 31, 2006 the Company has federaland state net operating loss carryforwards of approximately $50,914,000 and $17,819,000,respectively, subject to expiration between 2011 and 2026.

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

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

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A reconciliation of theeffective income tax rate on operations reflected in the Statements ofOperations to the US Federal statutory income tax rate is presented below.
|                                                           | ** ** | **2006**   | ** ** | **2005**             | ** ** |
|-----------------------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                                                | ** ** | ** ** | ** ** | **As Restated** | ** ** |
| US Federal  statutory income tax rate                     |       | 34.0       | %          | 34.0                 | %          |
|                                                      |       |       |       |                 |       |
| Federal income  tax provision (benefit) at statutory rate |       | $          | (3,767,000 | )                    | $          | (1,249,000 | ) |
| Extinguishment  of debt                                   |       | 2,658,000  |       | —               |       |
| Derivative and  warrant valuation adjustments             |       | (2,565,000 | )          | (3,113,000           | )          |
| Other                                                     |       | 881,000    |       | (1,273,000           | )          |
| Change in  valuation allowance                            |       | 2,793,000  |       | 5,635,000            |       |
|                                                      |       |       |       |                 |       |
| Provision (benefit)  for income taxes                     |       | $          | —     |                 | $          | — |   |
| Effective rate on  operations                             |       | 0.0        | %          | 0.0                  | %          |

 

**NOTES—FAIR VALUES OF FINANCIAL INSTRUMENTS**

The Company’s derivativefinancial instruments as at December 31, 2006 consisted of embedded derivativesrelated to the 2004 and 2005 Senior Notes and the Series B and Series CConvertible Preferred Stock. These embedded derivatives include certainconversion features and variable interest features. The Company also issuedwarrants to purchase shares of the Company’s Common stock as part of variousdebt financings. The accounting treatment of derivatives and the warrantsrequires that the Company record the derivatives and the warrants as aliability at their relative fair values as of the inception date of theagreement, and at fair value as of each subsequent balance sheet date. Anychange in fair value will be recorded as non-operating, non-cash income orexpense at each reporting date. If the fair value of the derivatives or thewarrant is higher at the subsequent balance sheet date, the Company will recorda non-operating, non-cash charge. If the fair value of the derivatives orwarrant is lower at the subsequent balance sheet date, the Company will recordnon-operating, non-cash income.

As of December 31, 2006, the derivatives and warrants classifiedas liabilities were valued at $757,170 and $476,748 respectively. Conversionrelated derivatives were valued using the Binomial Option Pricing Model withthe following assumptions: dividend yield of 0% or 15%; annual volatility of 34%to 72%; and risk free annual interest rate of 4.8% to 5.0% as well asprobability analysis related to trading volume restrictions. The remainingderivatives were valued using other binomial models and measuring the impact ofthe derivative on the expected interest payment amount over the life of theinstrument. The Warrants issued with the 2004, 2005 and 2006 debt financingsclassified as liabilities were valued at $476,748 as of December 31, 2006,using the Black Scholes Option Pricing model with the following assumptions:dividend yield of 0%; annual volatility of 78% to 86% and risk-free interestrate of 4.7% to 4.8%.

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**NOTE T—SUPPLEMENTARY DISCLOSURES OFCASH FLOW INFORMATION**
| ** **                                                                                                                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                               | ** ** | ** **                                  | ** ** | **(As Restated)** | ** ** |
| **Cash  paid for:**                                                                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest                                                                                                                                 |       | 1,369,723                                   |       | 1,267,713 |   |
| **Noncash  Financing Activities:**                                                                                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Conversion of convertible notes and related  obligations, net of discount, and accrued interest into common stock                        |       | 894,123                                     |       | 890,003 |   |
| Issuance of Series B redeemable preferred stock  in exchange for debt, and related obligations                                      |       | 988,000                                     |       | — |   |
| Issuance of Series C redeemable preferred stock  in exchange for debt, and related obligations                                      |       | 5,920,320                                   |       | — |   |
| Issuance of common stock in conjunction with  financing                                                                                  |       | 189,000                                     |       | 788,284 |   |
| Modification of warrants in conjunction with  financing                                                                                  |       | 110,453                                     |       | — |   |
| Issuance of common stock in exchange for  Series A, and Series C preferred stock and cumulative dividends in  arrears, thereon |       | 2,193,665                                   |       | 121,819 |   |
| Origination of warrants in conjunction with debt financing                                                                               |       | 308,376                                     |       | 1,467,303 |   |
| Origination of warrants in conjunction with equity  financing                                                                            |       | 103,229                                     |       | — |   |
| Cashless exercise of options and warrants                                                                                                |       | —                                      |       | 164,075 |   |
| Goodwill allocation adjustment                                                                                                           |       | —                                      |       | 633,959 |   |
| Origination of embedded derivatives and debt discounts  with debt financing                                                              |       | 679,624                                     |       | 2,722,023 |   |
| Origination of  embedded derivatives with preferred stock                                                                                |       | 1,434,004                                   |       | — |   |

 

**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, 2006.

109

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**NOTE V—EARNINGS PER SHARE “EPS”**

The Company’s basic EPSis calculated using net income (loss) and the weighted-average number of sharesoutstanding during the reporting period. Diluted EPS includes the effect frompotential issuance of common stock, such as stock issuable pursuant to theexercise of stock options and warrants and the assumed conversion of convertiblenotes and preferred stock. For the year ended December 31, 2006, the dilutedper share computation is not presented since this effect would be antidilutive.

The reconciliation of thenumerators and denominators of the basic and diluted EPS calculations was asfollows for the following fiscal years ended December 31:
| ** **                                                    | ** ** | **2006**    | ** ** | **2005**             | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                                                    | ** ** | ** **  | ** ** | **As Restated** | ** ** |
| ** **                                                    | ** ** | ** **  | ** ** | ** **           | ** ** |
| **Numerator:**                                                | ** ** | ** **  | ** ** | ** **           | ** ** |
| Net income (loss)                                             |       | (11,080,851 | )          | (3,673,384           | )          |
|                                                          |       |        |       |                 |       |
| Convertible preferred stock dividends and accretion           |       | (1,042,069  | )          | (313,517             | )          |
| Income (loss) available to common stockholders  (basic EPS)   |       | (12,122,920 | )          | (3,986,901           | )          |
|                                                          |       |        |       |                 |       |
| Adjustment for interest expense and debt conversion  features |       | —      |       | (2,036,945           | )          |
| Loss as adjusted (diluted EPS)                                |       | (12,122,920 | )          | (6,023,846           | )          |
|                                                          |       |        |       |                 |       |
| **Denominator:**                                              | ** ** | ** **  | ** ** | ** **           | ** ** |
| Weighted-average shares used to compute basic EPS             |       | 50,232,961  |       | 44,787,807           |       |
| Effect of dilutive securities:                                |       |        |       |                 |       |
| Convertible notes                                             |       | —      |       | 7,258,496            |       |
| Weighted-average shares used to compute diluted EPS           |       | 50,232,961  |       | 52,046,303           |       |
|                                                          |       |        |       |                 |       |
| **Earnings  per share**                                       | ** ** | ** **  | ** ** | ** **           | ** ** |
| Basic                                                         |       | $           | (0.24      | )                    | $          | (0.09 | ) |
| Diluted                                                       |       | $           | (0.24      | )                    | $          | (0.12 | ) |

 

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,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
|                         |       |                                        |       |   |   |
| Preferred Stock              |       | 11,971,430                                  |       | 5,971,755 |   |
| Convertible Debt             |       | 12,228,852                                  |       | — |   |
| Stock Options                |       | 443,784                                     |       | 1,456,349 |   |
| Warrants                     |       | 151,416                                     |       | 188,009 |   |
|                         |       |                                        |       |   |   |
| Potentially dilutive  shares |       | 24,795,482                                  |       | 7,616,113 |   |

 

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,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Stock options |       | 6,506,419                                   |       | 4,024,544 |   |
| Warrants      |       | 7,779,472                                   |       | 8,565,442 |   |
|          |       |                                        |       |   |   |
| Total         |       | 14,285,891                                  |       | 12,589,986 |   |

 

110

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**NOTE W—RECLASSIFICATIONS**

Certain amounts in the2005 financial statements have been reclassified to conform to the 2006presentation. These reclassifications had no effect on the previously reportednet loss or stockholders’ equity (deficit).

**NOTE X—EVENTS OCCURRING SUBSEQUENT TODECEMBER 31, 2006**

a) LaurusAmendment

Effective as ofDecember 29, 2006, BIO-key entered into an amendment agreement (the “Amendment”)with Laurus with respect to the 2004 and 2005 Senior Notes (the “Notes”) issuedby the Company to Laurus.  Under the Amendment, the Company and Laurusagreed to amend the Notes to provide that, as to the principal amount and all interestand fees thereon due and payable under the Notes for the month of January 2007(collectively, the “January Payment”), a portion of such January Payment,consisting solely of principal amount thereof, will be paid in 568,182 sharesof the Company’s common stock, $0.0001 par value per share (“Common Stock”),and the balance of such January Notes Payment, consisting of all remainingprincipal amount thereof and all interest and fees thereon in the aggregateamount of $152,311, will be paid in cash.

Subject to certainother terms and conditions under the Amendment, including the Company’scompletion of its previously announced financing transaction, the Company andLaurus also agreed subject to the Company raising at least $2,000,000 in grossproceeds from the issuance of new equity securities before March 29, 2007,to amend each of the 2004 and 2005 Senior Notes so as to terminate all rightsand obligations of either party to convert all or any portion of the remainingprincipal amount of the Notes, together with any interest and fees due thereon,into shares of Common Stock.  The total outstanding principal amount ofthe Notes as of December 31, 2006 was approximately $4,800,000, of whichapproximately $3,000,000 is currently scheduled to mature in full on January 1,2008 and approximately $1,800,000 is currently scheduled to mature in full onDecember 1, 2008.

In addition, theCompany agreed to issue 1,000,000 shares of Common Stock to Laurus pursuant tothe Amendment in exchange for the full satisfaction of certain accrued interestobligations owed to Laurus under the Notes, as discussed in Note L, subject tothe Company raising at least $2,000,000 in gross proceeds from the issuance ofnew equity securities before March 29, 2007. 

As the Company didnot raise the requisite proceeds by this date, the 2004 and 2005 SeniorNoteholders did not terminate their conversion rights and obligations, and theaccrued interest liability has not been exchanged for shares of the Company’sCommon Stock.

b)ComnetiX Offer

On January 19,2007, BIO-key commenced a formal tender offer to acquire all of the issued andoutstanding common shares of ComnetiX, Inc. (“ComnetiX”) (TSX: CXI) for US$1.29 per share. ComnetiX is a leading provider of biometricidentification and authentication technologies. In connection with the tenderoffer, BIO-key also intended to proceed with a financing with NorthernFinancial Corporation, a Canadian merchant bank and shareholder of ComnetiX,the proceeds of which would have been used for working capital purposes in thecombined BIO-key and ComnetiX business.  The financing was expected toclose during the first quarter of 2007.

On February 9,2007, the Company announced that its formal take-over bid for all of the outstandingcommon shares of ComnetiX had been withdrawn in accordance with BIO-key’s rightunder its Offer to Purchase.  The Company, after considering its options,decided not to raise its original stock offer of US $1.29 per share forComnetiX in response to ComnetiX shareholders approval of L-1 IdentitySolutions, Inc.’s (“L-1”) revised cash bid of $1.17 pr share.

c) Unasserted Claims

On January 30, 2007, duringthe tender offer process discussed above, ComnetiX notified the Company that itmay commence legal proceedings should BIO-key fail to immediatelywithdraw its tender offer and that ComnetiX holds BIO-key responsible for anyand all costs and fees incurred by ComnetiX (including legal fees) and any andall damages suffered by

111

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ComnetiX as aresult of BIO-key’s breach of the May 2006 “standstill” agreement, which statedthat BIO-key agreed in writing, among other things, not to acquire ComnetiX’sshares, or make an offer to acquire ComnetiX’s shares, for a period of one year.. ComnetiX also reserved the right to seek punitive and exemplary damagesagainst BIO-key.

On February 2,2007, the Company announced it had received a letter from L-1’s US counseladvising that it intended to hold BIO-key liable to L-1 on the grounds thatBIO-key’s actions constituted a tortuous interference with L-1’s proposedtransaction with ComnetiX.

Subsequent to the withdrawal of its takeover bid for ComnetiX, theCompany received a waiver from ComnetiX and L-1 stating that neither companywould be pursuing any actions or claims against the Company in relation to theCompany’s tender offer for ComnetiX.

d) Redemption of Series AConvertible Preferred Stock

As at December 31,2006, the Certificate of Designation of the Company’s Series A Convertible Preferred Stock contained a redemption clause whichstated that if in the event the average closing bid price of our commonstock is less than $1.00 per share for thirty (30) consecutive tradingdays at any time after March 3, 2007, we will be required to redeem theSeries A Convertible Preferred Stock (“Series A Shares”) by payment of$100 per share plus all accrued and unpaid dividends due thereon.

On March 28, 2007, theCompany entered into an agreement with the holders of the Series A Shares, suchthat they agreed to defer the date of any such mandatory redemption for oneyear.

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

The followingtable presents selected unaudited financial information for the eight quartersin the period ended December 31, 2006. 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.

The amounts presented for the four quarters in the period ended December31, 2005, have been restated from those previously reported on Form 10-QSBfor the applicable periods, in our 2005 annual report on Form 10-KSB,as amended.  The restatement adjustmentsare attributable to the same matters that are discussed in depth in Note B,Restatement of Previously Issued Financial Statements, and we refer you to thatdiscussion.
| ** **                                         | ** ** | ** **              | ** ** | ** **            | ** ** | ** **             | ** ** | ** **            | ** ** | ** **          | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
| ** **                                         | ** ** | ** **              | ** ** | ** **            | ** ** | ** **             | ** ** | ** **            | ** ** | **Year Ended** | ** ** |
| ** **                                         | ** ** | **Quarters Ended** | ** ** | **December 31,** | ** ** |
| ** **                                         | ** ** | **March 31,**      | ** ** | **June 30,**     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **2006**            | ** ** |
|                                               |       |                    |       |                  |       |                   |       |                  |       |                |       |
| Revenue                                            |       | $                       | 3,149,191  |                  | $          | 3,832,771              |       | $                     | 4,200,098  |                | $          | 4,011,565 |   | $ | 15,193,625 |   |
| Gross profit                                       |       | 2,378,229               |       | 2,995,429             |       | 3,450,087              |       | 2,973,174             |       | 11,796,919          |       |
| Net income /  (loss)                               |       | (3,796,280              | )          | (1,072,985            | )          | (6,232,732             | )          | 21,146                |       | (11,080,851         | )          |
| Net income /  (loss) per share - basic   |       | $                       | (0.08      | )                     | $          | (0.02                  | )          | $                     | (0.13      | )                   | $          | (0.01 | ) | $ | (0.24 | ) |
| Net income / (loss) per  share - diluted |       | $                       | (0.08      | )                     | $          | (0.02                  | )          | $                     | (0.13      | )                   | $          | (0.01 | ) | $ | (0.24 | ) |

 

112

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| ** **                                         | ** ** | ** **              | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | **Year Ended**    | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                         | ** ** | **Quarters Ended** | ** ** | **December 31,**  | ** ** |
| ** **                                         | ** ** | **March 31,**      | ** ** | **June 30,**      | ** ** | **September 30,** | ** ** | **December 31,**  | ** ** | **2005**               | ** ** |
| ** **                                         | ** ** | **(As Restated)**  | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** |
| Revenue                                            |       | $                       | 3,939,591  |                   | $          | 3,685,552              |       | $                      | 3,232,471  |                   | $          | 3,368,481 |   | $ | 14,226,095 |   |
| Gross profit                                       |       | 2,776,169               |       | 2,446,040              |       | 2,602,995              |       | 2,557,258              |       | 10,382,462             |       |
| Net income /  (loss)                               |       | 602,504                 |       | (1,526,172             | )          | (447,347               | )          | (2,302,369             | )          | (3,673,384             | )          |
| Net income /  (loss) per share - basic   |       | $                       | 0.01       |                   | $          | (0.04                  | )          | $                      | (0.01      | )                      | $          | (0.05 | ) | $ | (0.09 | ) |
| Net income / (loss) per  share - diluted |       | $                       | (0.03      | )                      | $          | (0.04                  | )          | $                      | (0.02      | )                      | $          | (0.05 | ) | $ | (0.12 | ) |

 

113

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**SIGNATURES**

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                      |   | BIO-KEY INTERNATIONAL, INC. |
|----------------------|--------|----------------------------------|
|                 |   |                             |   |   |
| Date: March 29, 2007 |   | By:                              |   | /s/  MICHAEL W. DEPASQUALE |   |
|                 |   |                             |   | Michael W. DePasquale |
|                 |   |                             |   | CHIEF EXECUTIVE OFFICER |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities on the datesindicated.
| Signature                             | ** ** | **Title**                                              | ** ** | **Date**       |
|---------------------------------------|------------|--------------------------------------------------------|------------|----------------|
|                                  |       |                                                   |       |           |
| /s/  MICHAEL  W. DEPASQUALE |       | Chief Executive Officer and Director                   |       | March 29, 2007 |
| Michael W.  DePasquale                |       |                                                   |       |           |
|                                  |       |                                                   |       |           |
| /s/  FRANCIS  J. CUSICK     |       | Chief Financial Officer, Principal Accounting  Officer |       | March 29, 2007 |
| Francis J.  Cusick                    |       |                                                   |       |           |
|                                  |       |                                                   |       |           |
| /s/  THOMAS  J. COLATOSTI   |       | Chairman of the Board of Directors                     |       | March 29, 2007 |
| Thomas J.  Colatosti                  |       |                                                   |       |           |
|                                  |       |                                                   |       |           |
| /s/  JEFFREY  J. MAY        |       | Director                                               |       | March 29, 2007 |
| Jeffrey J. May                        |       |                                                   |       |           |
|                                  |       |                                                   |       |           |
| /s/  CHARLES  P. ROMEO      |       | Director                                               |       | March 29, 2007 |
| Charles P. Romeo                      |       |                                                   |       |           |
|                                  |       |                                                   |       |           |
| /s/  JOHN  SCHOENHERR       |       | Director                                               |       | March 29, 2007 |
| John Schoenherr                       |       |                                                   |       |           |

 

114

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**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)           |       | Agreement and Plan of Merger dated as of  March 30, 2004 by and among BIO-key International, Inc., BIO-key  Acquisition Corp., Public Safety Group, Inc. (“PSG”) and each of the  shareholders of PSG               |
| 2.2(2)           |       | Asset Purchase Agreement dated as of August 16,  2004 by and among BIO-key International, Inc., Aether  Systems, Inc., Cerulean Technologies, Inc. and SunPro, Inc.                                                 |
| 2.3(3)           |       | Agreement and Plan of Merger dated as of  December 30, 2004 by and among BIO-key International, Inc., a  Delaware corporation, and BIO-key International, Inc., a Minnesota  corporation                                      |
| 3.1(3)           |       | Certificate of Incorporation of BIO-key  International, Inc., a Delaware corporation                                                                                                                                                    |
| 3.2(3)           |       | Certificate of Designation of Series A 7%  Convertible Preferred Stock of BIO-key International, Inc., a Delaware  corporation                                                                                                     |
| 3.3(3)           |       | By-Laws of BIO-key International, Inc., a  Delaware corporation                                                                                                                                                                         |
| 3.4 (19)         |       | Certificate of Amendment of Certificate of  Incorporation of BIO-key International, Inc., a Delaware corporation                                                                                                                        |
| 3.5 (16)         |       | Certificate of Designation of the Series B  Convertible Preferred Stock of the Company                                                                                                                                                  |
| 3.6 (21)         |       | Certificate of Designation of the Series C  Convertible Preferred Stock of the Company                                                                                                                                                  |
| 4.1(4)           |       | Specimen certificates for shares of BIO-key  International, Inc. common stock                                                                                                                                                           |
| 10.1(4)          |       | SAC Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                                                           |
| 10.2(5)          |       | Amendment No. 1 to the SAC  Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                              |
| 10.3(5)          |       | SAC Technologies, Inc. 1999 Stock Option Plan                                                                                                                                                                                           |
| 10.4(6)          |       | Warrant issued to The Shaar Fund Ltd.                                                                                                                                                                                                        |
| 10.5(6)          |       | Security Interest Provisions                                                                                                                                                                                                                 |
| 10.6(6)          |       | Employment Agreement by and between BIO-key  International, Inc. and Mira LaCous dated November 20, 2001                                                                                                                           |
| 10.7(6)          |       | Option to Purchase 140,000 Shares of Common Stock  issued to Mira LaCous                                                                                                                                                                     |
| 10.8(9)          |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.9(9)          |       | Non-Qualified Stock Option Agreement under the  registrant’s 1999 Stock Incentive Plan to Purchase 200,000 Shares of Common  Stock issued to Thomas J. Colatosti                                                                        |
| 10.10(9)         |       | Employment Agreement by and between BIO-key  International, Inc. and Michael W. DePasquale dated January 3, 2003                                                                                                                   |
| 10.11(9)         |       | Option to Purchase 580,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.12(9)         |       | Note Purchase Agreement dated January 27, 2003                                                                                                                                                                                          |
| 10.13(9)         |       | Secured Convertible Promissory due June 30,  2004                                                                                                                                                                                       |
| 10.14(9)         |       | Option to Purchase 200,000 Shares of Common Stock  issued to Charles P. Romeo                                                                                                                                                                |
| 10.15(7)         |       | Amendment No. 1 to Note Purchase Agreement  dated October 31, 2003 by and between BIO-key International, Inc.  and The Shaar Fund Ltd.                                                                                        |
| 10.16(7)         |       | Securities Exchange Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.17(7)         |       | Registration Rights Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.18(7)         |       | Secured Convertible Promissory Note due  October 31, 2005 in the principal amount of up to $2,125,000                                                                                                                                   |
| 10.19(7)         |       | Secured Convertible Promissory Note due  October 31, 2005 in the principal amount of up to $375,000                                                                                                                                     |
| 10.20(7)         |       | Option to Purchase 500,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.21(7)         |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.22(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                              |
| 10.23(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Jeff May                                                                                                                                                                         |
| 10.24(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Charles Romeo                                                                                                                                                                    |
| 10.25(7)         |       | Option to Purchase 300,000 Shares of Common Stock  issued to Randy Fodero                                                                                                                                                                    |
| 10.26(10)        |       | Amendment Agreement dated March 30, 2004 by and  between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                                       |
| 10.27(11)        |       | Securities Purchase Agreement dated as of  March 31, 2004 (the “March Securities Purchase Agreement”) by and  among BIO-key International, Inc. and each of the Purchasers named  therein                           |
| 10.28(11)        |       | Form of Warrant issued by BIO-key  International, Inc. pursuant to the March Securities Purchase  Agreement                                                                                                                   |
| 10.29(2)         |       | Securities Purchase Agreement dated as of  September 29, 2004 (the “Laurus Securities Purchase Agreement”) by and  between BIO-key International, Inc., Laurus Master Fund, Ltd. and the  other Purchasers party thereto |
| 10.30(2)         |       | Form of Secured Convertible Term Note issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                 |

 

115

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| 10.31(2)  |   | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                                                           |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.32(2)  |   | Master Security Agreement dated as of September 29,  2004 by and between BIO-key International, Inc., Public Safety  Group, Inc. and Laurus Master Fund, Ltd., as Collateral Agent                                                                                      |
| 10.33(2)  |   | Subsidiary Guaranty dated as of September 29,  2004 made by Public Safety Group, Inc. in favor of Laurus Master Fund,  Ltd. and the other Purchasers party thereto                                                                                                           |
| 10.34(2)  |   | Stock Pledge Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc. and  Laurus Master Fund, Ltd. and the other Purchasers party thereto                                                                                                       |
| 10.35(2)  |   | Registration Rights Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc.,  Laurus Master Fund, Ltd. and the other Purchasers party thereto                                                                                                   |
| 10.36(2)  |   | Securities Purchase Agreement dated as of  September 29, 2004 (the “Shaar Securities Purchase Agreement”) by and  between BIO-key International, Inc., The Shaar Fund, Ltd. and the other  Purchasers party thereto                                                |
| 10.37(2)  |   | Form of Convertible Term Note issued by BIO-key  International, Inc. pursuant to the Shaar Securities Purchase Agreement                                                                                                                                                     |
| 10.38(2)  |   | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Shaar Securities Purchase  Agreement                                                                                                                                            |
| 10.39(2)  |   | Registration Rights Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc., The  Shaar Fund, Ltd. and the other Purchasers party thereto                                                                                                       |
| 10.40(2)  |   | Intercreditor Agreement dated as of  September 30, 2004 by and among Laurus Master Fund, Ltd., individually  and as Collateral Agent, Aether Systems, Inc., Public Safety  Group, Inc. and BIO-key International, Inc.                                             |
| 10.41(2)  |   | Subordination and Intercreditor Agreement dated as  of September 30, 2004 by and among Laurus Master Fund, Ltd., as  Collateral Agent, The Shaar Fund, Ltd., as Purchaser Agent, Aether  Systems, Inc., Public Safety Group, Inc. and BIO-key  International, Inc. |
| 10.42(2)  |   | Subordinated Secured Promissory Note dated  September 30, 2004 issued by BIO-key International, Inc. and Public  Safety Group, Inc. in favor of Aether Systems, Inc.                                                                                               |
| 10.45(12) |   | Option to Purchase 300,000 shares of common stock  issued to Kenneth Souza                                                                                                                                                                                                             |
| 10.46(12) |   | Employment Agreement dated as of October 4,  2004 by and between BIO-key International, Inc. and Kenneth Souza                                                                                                                                                               |
| 10.47(12) |   | Option to Purchase 50,000 shares of common stock  issued to Richard Gaddy                                                                                                                                                                                                              |
| 10.48(12) |   | BIO-key International, Inc. 2004 Stock  Incentive Plan                                                                                                                                                                                                                            |
| 10.49(12) |   | Warrant to purchase 10,000 shares of Common Stock  issued to Krieger & Prager LLP on November 26, 2001                                                                                                                                                                   |
| 10.50(12) |   | Warrant to purchase 100,000 shares of Common Stock  issued to The November Group Ltd. on July 14, 2004                                                                                                                                                                       |
| 10.51(12) |   | Warrant to purchase 230,000 shares of Common Stock  issued to Jesup & Lamont Securities Corp. on March 31, 2004                                                                                                                                                          |
| 10.52(12) |   | Warrant to purchase 105,000 shares of Common Stock  issued to Douglass Bermingham on March 31, 2004                                                                                                                                                                               |
| 10.53(12) |   | Warrant to purchase 60,000 shares of Common Stock  issued to Mason Sexton on March 31, 2004                                                                                                                                                                                       |
| 10.54(12) |   | Warrant to purchase 22,000 shares of Common Stock  issued to David Moss on March 31, 2004                                                                                                                                                                                         |
| 10.55(12) |   | Warrant to purchase 22,000 shares of Common Stock  issued to Patrick Gaynes on March 31, 2004                                                                                                                                                                                     |
| 10.56(12) |   | Warrant to purchase 5,000 shares of Common Stock  issued to Tom DuHamel on March 31, 2004                                                                                                                                                                                         |
| 10.57(13) |   | Option to Purchase 155,000 shares of common stock  issued to Francis J Cusick                                                                                                                                                                                                          |
| 10.58(13) |   | Option to Purchase 50,000 shares of common stock  issued to Charles P. Romeo                                                                                                                                                                                                           |
| 10.59(14) |   | Securities Purchase Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                        |
| 10.60(14) |   | Common Stock Purchase Warrant issued pursuant to the  Securities Purchase Agreement, dated as of June 8, 2005, by and between  the Company and the Laurus Master Fund, Ltd.                                                                                                       |
| 10.61(14) |   | Secured Convertible Term Note issued pursuant to the  Securities Purchase Agreement, dated as of June 8, 2005, by and between  the Company and Laurus Master Fund, Ltd.                                                                                                           |
| 10.62(14) |   | Registration Rights Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                        |
| 10.63(14) |   | Securities Purchase Agreement, effective as of  May 31, 2005, by and among the Company, The Shaar Fund, Ltd. and the  other pursuant that are a party thereto                                                                                                                     |
| 10.64(14) |   | Form of Common Stock Purchase warrant issued  pursuant to the Securities Purchase Agreement, effective as of May 31,  2005, by and among the Company, The Shaar Fund, Ltd. and the other purchasers  that are a party thereto                                                |
| 10.65(14) |   | Form of Convertible Term Note issued pursuant  to the Securities Purchase Agreement, effective as of May 31, 2005, by  and among the Company, The Shaar Fund, Ltd. and the other purchasers that are  a party thereto                                                        |
| 10.66(14) |   | Registration Rights Agreement, effective as of  May 31, 2005, by and among the Company, The Shaar Fund, Ltd.,  Jesup & Lamont and the other purchasers that are a party thereto                                                                                          |
| 10.67(22) |   | Escrow Agreement, dated as of May 31, 2005, by and among  the Company, Jesup & Lamont Securities Corp.                                                                                                                                                                             |

 

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|           |   | and Thelen, Reid & Priest LLP.                                                                                                                                                                                                                                                                     |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.68(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                       |
| 10.69(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Shaar Fund, Ltd.                                                                                                                                                                                           |
| 10.70(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Longview Special Finance                                                                                                                                                                                       |
| 10.71(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Etienne Des Roys                                                                                                                                                                                               |
| 10.72(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Eric Haber                                                                                                                                                                                                     |
| 10.73(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Investors Management Corporation                                                                                                                                                                               |
| 10.74(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Fund                                                                                                                                                                                           |
| 10.75(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Amerique Value Fund                                                                                                                                                                            |
| 10.76(15) |   | Registration Rights Agreement, dated as of  August 31, 2005, by and among the Company, Laurus Master Fund, Ltd., The  Shaar Fund, Ltd., Longview Special Finance, Etienne Des Roys, Eric Haber,  Investors Management Corporation, The Tocqueville Fund and The Tocqueville  Amerique Value Fund. |
| 10.77(16) |   | Amendment and Waiver, dated as of January 23,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.78(16) |   | Registration Rights Agreement, dated as of  January 23, 2006, by and between the Company and Laurus Master Fund,  Ltd.                                                                                                                                                                            |
| 10.79(16) |   | Amendment and Waiver, dated as of January 23,  2006, by and among the Company and the holders of Subordinated Convertible  Promissory Notes of the Company                                                                                                                                        |
| 10.80(16) |   | Securities Purchase Agreement, dated as of  January 23, 2006, by and among the Company, The Shaar Fund Ltd.,  Longview Fund, L.P. and Longview Special Finance                                                                                                                                    |
| 10.81(16) |   | Form of Convertible Term Note issued pursuant  to the Securities Purchase Agreement, dated as of January 23, 2006, by  and among the Company, The Shaar Fund Ltd., Longview Fund, L.P. and Longview  Special Finance                                                                         |
| 10.82(16) |   | Form of Common Stock Purchase Warrant issued  pursuant to the Securities Purchase Agreement, dated as of January 23,  2006, by and among the Company, The Shaar Fund Ltd., Longview Fund, L.P. and  Longview Special Finance                                                                 |
| 10.83(16) |   | Registration Rights Agreement, dated as of  January 23, 2006 by and among the Company, The Shaar Fund, Ltd.,  Longview Fund, L.P. and Longview Special Finance                                                                                                                                    |
| 10.84(16) |   | Amendment No. 1 to Subordinated Secured  Promissory Note, dated as of January 23, 2006, by and between the  Company and Aether Systems, Inc.                                                                                                                                            |
| 10.85(17) |   | Compensation Agreement by and between the Company  and Thomas J. Colatosti dated February 7, 2006                                                                                                                                                                                                 |
| 10.86(18) |   | Employment Agreement by and between the Company and  Michael DePasquale dated March 28, 2006                                                                                                                                                                                                      |
| 10.87(20) |   | 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                                                                                                                      |
| 10.88(21) |   | Amendment and Waiver, dated as of August 10, 2006,  by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                            |
| 10.89(21) |   | Registration Rights Agreement, dated as of August  10, 2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                   |
| 10.90(21) |   | 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                                                  |
| 10.91(21) |   | 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                                                  |
| 10.92(21) |   | Securities Purchase Agreement, dated as of August  10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                                                                     |
| 10.93(21) |   | 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.                                                                                                                       |
| 10.94(21) |   | Registration Rights Agreement, dated as of August  10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                                                                     |
| 10.95(21) |   | Securities Purchase Agreement, dated as of August 10,  2006, by and between the Company and The Shaar Fund Ltd.                                                                                                                                                                                        |

 

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| 10.96(21) |   | 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. |
|-----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.97(21) |   | Registration Rights Agreement, dated as of August  10, 2006, by and between the Company and The Shaar Fund Ltd.                                                                     |
| 10.98 (8) |   | Sublease Agreement, dated as of September 20,  2004, by and between the Company and Aether Systems, Inc.                                                                       |
| 10.99 (8) |   | Amendment and Waiver, dated as of December 29, 2006,  by and between the Company and Laurus Master Fund, Ltd.                                                                       |
| 21.1(22)  |   | List of subsidiaries of BIO-key  International, Inc.                                                                                                                           |
| 23.1(8)   |   | Consent of Carlin, Charron & Rosen, LLP.                                                                                                                                        |
| 23.2(8)   |   | Consent of DS&B, Ltd.                                                                                                                                                           |
| 31.1(8)   |   | Certificate of CEO of Registrant required under  Rule 13a-14(a) under the Securities Exchange Act of 1934, as  amended                                                    |
| 31.2(8)   |   | Certificate of CFO of Registrant required under  Rule 13a-14(a) under the Securities Exchange Act of 1934, as  amended                                                    |
| 32.1(8)   |   | Certificate of CEO of Registrant required under  18 U.S.C. Section 1350, as amended                                                                                       |
| 32.2(8)   |   | Certificate of CFO of Registrant required under  18 U.S.C. Section 1350, as amended                                                                                       |

 

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(1)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on April 14, 2004 and incorporated herein byreference.

(2)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on October 5, 2004 and incorporated herein byreference.

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

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

(5)           Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on April 14, 2000 and incorporated herein byreference.

(6)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on November 26, 2001 and incorporated herein byreference.

(7)           Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 26, 2004 and incorporated herein byreference.

(8)           Filed herewith.

(9)           Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 31, 2003 and incorporated herein byreference.

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

(11)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on April 5, 2004 and incorporated herein byreference.

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

(13)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on March 4, 2005 and incorporated herein byreference.

(14)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on June 14, 2005 and incorporated herein byreference.

118

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(15)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on September 7, 2005 and incorporated herein byreference.

(16)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on January 25, 2006 and incorporated herein byreference.

(17)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on February 9, 2006 and incorporated herein byreference.

(18)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on March 29, 2006 and incorporated herein byreference.

(19)         Filed as an exhibit to the registrant’sproxy statement filed with the Securities and Exchange Commission onJanuary 18, 2006 and incorporated herein by reference.

(20)         Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 29, 2006 and incorporated herein byreference.

(21)         Filedas an exhibit to the registrant’s current report on Form 8-K filedwith the Securities and Exchange Commission on August 16, 2006 and incorporatedherein by reference.

(22)         Previously filed

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