-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MZGQVLIGRMehGZohmBA98LMphrVOywnB7PoOVNwE86PiaYlvoJbfJuouvMxt5TMQ 0KjlaITXyP+guh3zxVWCXw== 0000914190-97-000150.txt : 19970329 0000914190-97-000150.hdr.sgml : 19970329 ACCESSION NUMBER: 0000914190-97-000150 CONFORMED SUBMISSION TYPE: 10KSB40 PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970328 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: DATAKEY INC CENTRAL INDEX KEY: 0000704914 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS ELECTRICAL MACHINERY, EQUIPMENT & SUPPLIES [3690] IRS NUMBER: 411291472 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10KSB40 SEC ACT: 1934 Act SEC FILE NUMBER: 000-11447 FILM NUMBER: 97567225 BUSINESS ADDRESS: STREET 1: 407 W TRAVELERS TRAIL CITY: BURNSVILLE STATE: MN ZIP: 55337 BUSINESS PHONE: 6128906850 MAIL ADDRESS: STREET 1: 407 WEST TRAVELERS TRAIL CITY: BURNSVILLE STATE: MN ZIP: 55337 10KSB40 1 FORM 10-KSB FOR YEAR ENDED 12/31/96 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB ANNUAL REPORT ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1996 Commission file No. 0-11447 DATAKEY, INC. (Name of small business issuer in its charter) MINNESOTA 41-1291472 (State of incorporation or organization) (I.R.S. Employer Identification No.) 407 West Travelers Trail, Burnsville, Minnesota 55337 (Address of principal executive offices) Issuer's telephone number, including area code: (612) 890-6850 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.05 per share (Title of Class) Check whether the Issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Issuer was required to file such reports) and (2) has been subject to such filing requirements for the last 90 days. YES X NO ____ Check if there is no disclosure of delinquent filers pursuant to Item 405 of Regulation S-B contained herein and no disclosure will be contained, to the best of Issuer's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ X ] Issuer's revenues for its most recent fiscal year: $6,558,025. The aggregate market value of the voting stock (Common Stock) held by non-affiliates was approximately $5,278,000 based upon the closing sale price of the Issuer's Common Stock on March 20, 1997. As of March 20, 1997, there were 2,887,235 shares of the Issuer's Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part II of this Annual Report on Form 10-KSB incorporates by reference information (to the extent specific sections are referred to herein) from the Issuer's Annual Report to Shareholders for the year ended December 31, 1996 (the "1996 Annual Report"). Portions of the Company's definitive Proxy Statement for its Annual Meeting of Shareholders to be held on June 4, 1997 are incorporated by reference pursuant to Rule 12b-23 into Items 9, 10 and 11 of Part III. Transitional Small Business Disclosure Format (check one) YES ___ NO X PART I ITEM 1. DESCRIPTION OF BUSINESS General Datakey, Inc. (the "Company") was incorporated under the laws of the State of Minnesota in 1976 under the name "The Systems Group, Inc." In 1980, the Company changed its name to Datakey, Inc. The Company provides product, subsystem and system solutions to record, store and transmit electronic information. Datakey is also developing products and systems directed to the information security market which will enable user identification and authentication, secure data exchange and information validation. It also provides OEM products, consisting of proprietary memory keys, cards and other custom-shaped tokens that serve as a convenient way to carry electronic information and are packaged to survive in portable environments. The Company's first portable information system, consisting of an electronic key and support electronics, was introduced in 1981 for applications requiring convenient storage, transportation and management of information. The Company's current system utilizes semiconductor technology to provide a storage device more versatile than conventional portable information products such as keys, badges and magnetic stripe cards. The Company's current product line of portable data carriers and associated interface products provide up to 2,048,000 bits of data storage which are used in a wide range of applications including communications security, computer security, facility security, vending and process control. Each of the Company's personal portable information systems consists of one or more portable data carriers, access devices and, for certain models, interface modules containing microprocessors. These components, together with the user's processor-based equipment, function as an integrated system allowing instantaneous processing of personalized data carried within a portable data carrier. Through the incorporation of advanced semiconductor memory technology, the Company's portable data carrier is able to store and carry substantial amounts of information. When the portable data carrier is used in conjunction with the other components of the Company's system, information can be selectively altered, added to or erased, as required, to effectively and reliably manage or control a particular activity or transaction. The Company has introduced an end-user system level product which is designed to provide electronic signatures on computer aided drafting (CAD) drawings, and is developing additional end-user systems that are designed to provide advanced information security utilizing digital signatures and encryption. These systems will incorporate hardware and software to provide a higher level of security than is obtainable with current software only solutions. Current Products and Products Under Development OEM Products Portable Data Carrier Devices. Portable data carriers are electronic memory devices which store information. They have a plastic exterior, are in the forms of keys, cards, or custom shaped tokens and encapsulate semiconductor memory. Certain devices have been designed to store information which may be retrieved, altered, erased or updated; while other devices have been designed to store one-time programmable information which may be retrieved but not altered 2 or updated. The storage capacities of the Company's portable memory devices range from 1,000 bits (150 alphanumeric characters) to 2,048,000 bits. The portable data carriers are priced generally between $2 and $100 per unit, depending on capacities and quantities purchased. Access Device. The access device is the element into which a portable data carrier is inserted to provide the interconnection between the portable data carrier and the electronic interface circuitry or the host processor-based equipment. It is through this physical interconnection that the data contained in the portable data carrier's memory is transmitted to the electronic interface or to the host interface. Several models of the access device have been developed to handle the Company's different portable data carriers. The access devices are priced generally between $15 and $120 per unit, depending on models and quantities purchased. Interface. The interface is the electronics control module between the access device and a customer's processor-based equipment. This module is used with the Company's serial communication key and contains all the necessary electronics to control information within the key and to coordinate the information requests of the host equipment. This communication process is managed by the system's firmware, which is a software program existing within the interface. For some applications, this firmware structures, secures and verifies the information within the portable device, and may allow separate groups or files of data to reside in a single portable device and be secure from access except by equipment authorized to manage a particular group or file of data. The interface is priced between $70 and $120 per unit, depending on models and quantities purchased. End-User Systems (Advanced Information Security Products) For the past year, Datakey has been developing new products that provide advanced security solutions to the problems of organizations, worldwide. All of Datakey's new products, some of which Datakey expects to begin to introduce by mid-1997, incorporate hardware tokens such as the key-shaped tokens that the Company has been known for in the past. The launch and success of such products is dependent on further successful development efforts and market acceptance, along with other risks. See "Outlook and Risks." SignaSURE CIP and SignaSURE CSP. Password-based software programs that implement public-key cryptography technology for information security offer easier operation and improved data integrity over older symmetric cryptography software. Password-based security, however, is insufficient for private networks with connections outside of the corporation. The Company's SignaSURE CIP (Cryptoki Interface Provider) and SignaSURE CSP (Cryptographic Service Provider) are designed to solve this problem, allowing the Internet to be used safely for electronic commerce. Both SignaSURE CIP and SignaSURE CSP will allow users and value-added resellers to upgrade their software-only systems to token-based information security and gain the benefit of secure Internet operation. Token-based information security implements a two-level security scheme--something that is owned (a hardware token) and something that is known (a password to activate the token) for a much stronger level of security than password-based software solutions. SignaSURE CIP provides token upgrades for Cryptoki or PKCS-11 standard information security interface applications. SignaSURE CSP provides the same capability for applications that incorporate Microsoft's CryptoAPI. Both products offer "load, plug and play" convenience for strong information security. SignaSURE CIP and SignaSURE CSP products include a user-unique smart card or smart key that holds the critical information to perform the cryptographic functions necessary for information privacy and data integrity, a 3 companion reader/writer that plugs into a computer's serial port, and software which is loaded into the workstation and interfaces to the application program. The Company expects to begin to sell the SignaSURE CIP and SignaSURE CSP in mid-1997. SignaSURE DTK. As public-key information security grows due to the technology's adoption by well-known software companies such as Microsoft and Netscape, smaller software developers are also implementing public-key information security into their specialized applications. Because no easy method was available for smaller application developers to implement a token-based public key infrastructure, the Company developed its SignaSURE DTK (Developers Tool Kit) so that developers could easily and cost-effectively launch their applications with the much stronger, token-based information security. SignaSURE DTK is a turnkey package that the Company is designing to allow software developers to integrate Datakey hardware tokens and a public-key infrastructure into their applications. DTK includes up to three main components: hardware cryptographic tokens, interface and integration software and security infrastructure products. DTK is available in four configurations ranging from just a token with a reader/writer and integration software, to the full public-key infrastructure configuration that issues and manages hardware tokens and digital certificates. This product flexibility allows userdevelopers who utilize SignaSURE DTK to integrate just what is needed for their application. The Company expects to begin to sell the SignaSURE DTK in mid-1997. SignaSURE EDM. Design and drafting was revolutionized several decades ago with the introduction of computer aided-design (CAD) software. However, engineers still must print their CADcreated designs, approve the documents with hand-written signatures, and archive these hand-signed originals to maintain change control and ensure design traceability. The Company's SignaSURE EDM (Electronic Document Manager), which Datakey began to sell in late 1996, provides a way to sign an electronic document to ensure its authenticity, thus eliminating the need for hand-signed originals and all of the storage and archiving requirements for paper-based engineering drawings and documents. SignaSURE EDM adds digital signatures to CAD and other documents to ensure document authenticity, configuration control and conformance to ISO 9000 document management requirements. SignaSURE EDM provides for copying, distributing and archiving of electronically generated documents with a level of authenticity formerly obtainable only with hand-signed paper documents. It answers questions of document authorship, integrity and culpability quickly, easily and unambiguously. With SignaSURE EDM, documents in electronic form can be transmitted over local area networks, intranets and the Internet with their authenticity assured. SignaSURE EDM includes a smart card or smart key that generates the user's digital signature, a companion reader/writer that plugs into a computer's serial port, and a software program which is loaded into the workstation. SignaSURE EDM operates on all Windows(TM) operating systems, is compatible with all CAD programs and file formats, and moves design and drafting to a paperless environment. SignaSURE ESS. Many of today's organizations have made the transition from large mainframe systems to more flexible, but much less secure, client-server networks and intranets. Client-server networks and intranets allow digital information to reside on networks, rather than at the desktop so authorized users can access the same information. Authorized users can include company employees, suppliers and customers who can be connected to the network, or located remotely from the enterprise. With the advent of the Internet, information transmission over any distance can be accomplished quickly and cost effectively, but not securely. Datakey believes its SignaSURE ESS (Enterprise Security Suite) offers a solution to manage a network, intranet and Internet 4 computing structure to allow authorized users ready access to information, but deny it to the unauthorized. Information can then be transmitted securely and stored safely on both private and public networks without privacy and data integrity concerns. SignaSURE ESS is an integrated end-to-end data security system that the Company believes will assure secure network access, confidential information exchange, integrity of data and transaction nonrepudiation. Secure, personalized smart tokens are employed within a public key infrastructure to provide a higher level of information security than is provided by software-only solutions. Security functions are integrated into applications like Microsoft Office(TM), thereby providing seamless security operation to the user. SignaSURE ESS will operate over the Internet, and wide and local area networks enabling secure information exchange for all users, whether local or remote to the enterprise. SignaSURE ESS includes a user-personalized smart card or smart key hardware token and companion reader/writer for workstation or laptop that perform the functions necessary for information privacy and data integrity. It also incorporates client software that manages secure information and interfaces to applications, and server-based, enterprise infrastructure hardware and software that initialize SignaSURE ESS and continually ensures all users are authorized. The Company expects to begin selling SignaSURE ESS in the second half of 1997. The following chart shows the Company's SignaSURE products:
=================================================================================================================================== SignaSURE Product - ----------------------------------------------------------------------------------------------------------------------------------- Attribute CIP CSP DTK EDM ESS - ----------------------------------------------------------------------------------------------------------------------------------- Customer Organizational End-User x x x Engineer/Architect End-User x Software Developer x - ----------------------------------------------------------------------------------------------------------------------------------- System Type Integrated Solution x x Add-on Subsystem x x Component x - ----------------------------------------------------------------------------------------------------------------------------------- Application Information Security x x x Paperless Automation x Token Integration x x x - ----------------------------------------------------------------------------------------------------------------------------------- Hardware Datakey Smart Token x x x x x Datakey Reader/Writer x x x x x - ----------------------------------------------------------------------------------------------------------------------------------- Software Security Solution x x Token Interface x x x ===================================================================================================================================
Research and Development During 1996, the Company continued the development of portable data carriers to expand its line of standard products as well as newly designed custom products. The Company also substantially increased its development of token-based information security products. As the need for computer security products continues to grow, the Company has been expending significant effort into development of token-based computer information security systems. The Company's SignaSURE line of 5 information security products, which are expected to be released for sale during 1997, are designed to provide encryption and digital signatures required for electronically generated documents on computer networks. The technology involved in information systems in undergoing rapid expansion and advancement which could result in the development of new products and systems which may make the Company's present information security products obsolete. As a result, the Company must continue to improve its present information security products in order to remain competitive. In 1996, 1995 and 1994, research and development expenses were $2,263,000, $704,000 and $771,000, respectively. The Company expects that research and development expenses in 1997 will be significantly higher than in 1996. Manufacturing The Company's in-house manufacturing capabilities include microelectronic assembly, plastic injection molding, automated surface mount assembly, and general electronic assembly. The Company also utilizes independent subcontractors from time to time to perform certain manufacturing functions. The Company provides a 90-day warranty on domestic sales, a 180-day warranty on sales to its international distributors to cover the longer shelf life of the Company's products, and a 180-day warranty on sales to the government. In an effort to more efficiently produce products, to reduce product costs, and to increase its manufacturing flexibility, the Company intends to continue to improve certain manufacturing processes and add capital equipment to its manufacturing operations. While the Company believes that these steps will provide a greater level of control over, and flexibility in, its manufacturing processes, there are no assurances that the Company's ability to produce products and to meet required delivery schedules will be sufficiently improved to meet the demands created by increased sales and more complex manufacturing processes. Sources of Supply The Company purchases microprocessors for its advanced information security products (the SignaSURE line of products) from a single supplier. This supplier also provides a proprietary card and key (token) operating system which will be discontinued after the current supply of microprocessors is depleted. The Company believes the current supply is sufficient to meet the expected need in 1997. Upon depletion of this supply, however, the Company will be required to purchase new microprocessors from this sole source or an alternative source and provide its own smart token operating system. The Company has a significant development effort underway to produce its own proprietary smart token operating system and expects it to be available by the time the current microprocessor supply is exhausted. Negotiations and evaluations are also underway to qualify and procure new microprocessors from the same source or an alternative source. Although the Company has a schedule and plan in place to avoid any gap in supply of the microprocessors and operating system, there are no assurances that the current supply will not be exhausted earlier than expected, that the new operating system will be available on time and operate as intended or that new microprocessors will be available when needed and operate satisfactorily. The Company has several qualified sources from which to purchase printed circuit boards and electronic components for most of its standard portable data carriers. The components for the Company's products are, in general, available from multiple suppliers. Some of the plastic components are 6 molded on the Company's in-house molding equipment or suppliers' molding equipment using Company-owned tooling. The Company purchases integrated circuits primarily through nationwide multivendor distributors. If, for any reason, the Company would have to cancel or reduce a particular integrated circuit order, it might thereafter have to pay a higher price for the integrated circuits. Since general economic conditions have an effect on the supply and cost of integrated circuits, there is no guarantee that the Company will be able to obtain adequate quantities of integrated circuits to meet all of its production needs during periods of short supply. Significant Customer The Company sells its OEM products to a number of commercial original equipment manufacturers (OEMs) and other customers, including governmental entities. At this time, the Company is not dependent on any one customer or few customers, the loss of which would have a material adverse effect on its business. Marketing General. While there appears to be a broad range of applications and potential customers for portable data carriers, no single application group has evidenced strong, long-term growth potential. The diversity of potential applications has made it difficult for the Company to focus its limited marketing resources. In 1995, commercial sales to OEM customers increased 33% to $6,205,000 and in 1996 they decreased 9% to $5,669,000. The Company believes that commercial OEM sales may decrease again in 1997. New end-user products being developed for the information security marketplace are planned for sales introduction by mid-1997 and, based upon current expectations, are expected to result in material revenue during the second half of 1997. As with any new product line, revenue will depend on customer acceptance, the extent of which is difficult to assess at this time. Commercial Market of OEM Products. To date, most applications in the commercial market have used the Data Key for electronic security and equipment control applications. The Company is seeking to develop other long-term business in this market. The Company markets its products to both domestic and international customers using the following channels. Domestic. The Company markets its portable information products domestically through a combination of direct and indirect sales personnel. In addition, it utilizes advertising, trade shows and direct mail to reach its buying audience. In 1996, 1995 and 1994, sales to domestic customers, and the corresponding percentage of total revenue, were approximately $3,763,000 (57%), $4,319,000 (60%) and $2,953,000 (50%), respectively. International. The Company presently markets its portable information products internationally through an independent sales agent in the United Kingdom and agents and/or distributors in Columbia, Australia, Belgium, the Netherlands and Germany. The Company has customers in other countries who are handled on a direct basis from the Company's headquarters in the United States. The Company intends to expand into other international market areas in the future. In 1996, 1995 and 1994, sales to international customers, and the corresponding percentage of total revenue, were approximately $1,906,000 (29%), $1,907,000 (26%) and $1,716,000 (29%), respectively. 7 Government Market. The Company markets its products to government agencies through its direct sales and marketing personnel. The Company's primary activity in this segment has been in the marketing of its portable data and access devices to government agencies for use in various secure information systems and in the development of custom designed portable data devices for other government programs. In 1996, 1995 and 1994, sales to government agencies and government subcontractors, and the corresponding percentage of total revenue, were approximately $889,000 (14%), $993,000 (14%) and $1,146,000 (20%), respectively. End-User Products Datakey plans to market and sell its advanced information security products (the initial offerings in its end-user systems line) through a combination of direct sales and marketing personnel, dealers, distributors, value added resellers and system integrators/developers. The direct sales and marketing personnel will concentrate primarily on relationships with large security-conscious organizations either through direct or indirect contact, establishing alliances with system integrators/developers and setting up dealer/distributor relationships for its products. The future revenue of Datakey end-user systems is dependent on the success of a new and untested marketing and direct sales organization. Also, see "Issues and Uncertainties" in the Management's Discussion and Analysis contained in the Company's 1996 Annual Report, portions of which are included in Exhibit 13.1 of this Report. Backlog As of March 7, 1997, the Company had an order backlog, totaling approximately $4,127,000, including approximately $1,187,000 with scheduled shipment dates in 1998, compared to $2,813,000 a year ago, all of which were scheduled for shipment in 1996. Although the orders contain scheduled shipment dates, they may be accelerated, delayed or canceled at the customer's request. The Company does not believe that the current backlog is necessarily indicative of future backlog levels. Competition OEM Products. The Company's primary competition for its OEM products is presently, and is expected to remain, conventional portable information systems, such as keys and cards, and more advanced portable information systems including those in the familiar credit card format, such as "smart cards," Personal Computer Memory Card Industry Association (PCMCIA) cards, magnetic stripe cards, bar-code cards and laser technology cards. The Company's products, when used as a portable data base, may also compete with centralized data base systems. Many of the manufacturers of these portable information devices and systems are large, well-established companies. A number of European and Japanese firms continue to develop and refine the smart card technologies. Some of these companies have established branch offices in the United States to explore the United States market. To date, the smart card has been used primarily in Europe, where it has been implemented in prepaid telephone systems. In the United States, smart cards are currently being used mainly in field trial environments. Although the Company does not have complete information about the status of these trials, the Company believes that, in time, the smart card will be successfully developed and could become a competitor, especially in those markets which have a history of using a card or a preference for card-type devices. Memory cards, such as PCMCIA standard cards, are functionally equivalent to the Company's portable data carriers in that they utilize semiconductor memory in card-shaped devices made of plastic. 8 Memory cards generally have larger memory capacities than the devices currently offered by the Company and historically incorporated volatile, battery-backed memory elements. More recently, nonvolatile (principally "Flash Memory") memory elements which do not require battery backup have become more prominent. They are used in such applications as laser printer fonts, instrumentation, electronic lettering machines and fax/modems, and are also used as replacements or "add ons" to diskettes and hard drives for data storage in certain desktop, notebook and smaller portable computers. Magnetic stripe cards are relatively inexpensive and are used extensively in the access control industry and in the banking and credit card industries. These markets are not priority markets for the Company's portable information devices. Magnetic stripe cards are not conveniently updatable, have limited storage capacity and generally have a useful life of one or two years. As a result, the Company believes its products are technologically superior and may be more cost-effective for applications requiring more complex technologies. Another technology utilizes a strip of reflective material which is laminated into a card. Information is inscribed on this material through use of a laser beam. Since these cards can contain several million bits of information, the Company believes that this technology will be a competitor in portable information markets where very large information storage capacities are required and instantaneous management of information is not essential. The Company's ability to compete in the portable information market will depend primarily on its ability to demonstrate superior product performance at cost-effective prices and on the enhanced features of its system which make it more effective than competing systems. End-User Systems. Datakey currently offers token-based (smart card, smart key) information security products which are primarily utilized in encryption for electronic mail and other electronic document privacy and digital signatures for electronic document authentication. The Company also sells a digital signature based product, known as SignaSURE EDM, which enables users to electronically sign computer-aided drafting (CAD) documents. The Company is presently undertaking a significant product development effort to expand the applications and ease-of-use of its products and systems. See "Products--End-User Systems." Competition in the information security business is varied with companies offering hardware solutions, software solutions and combinations of hardware and software solutions. As awareness for security on the Internet and company intranets and other local area networks has increased over the past few years, many companies have introduced software and/or hardware based products to provide security. These products range from software-based password only systems to firewalls, which may be very sophisticated. Other applications are using hand held hardware devices, commonly referred to as tokens, to provide access to networks and, in some cases, use encryption and digital signatures to further secure networks. The Company's advanced information security products currently in development are based upon a smart card or smart key and utilize encryption and digital signatures. They also include extensive software to make the system user-friendly and seamless with common desktop software packages. The Company feels this will provide a unique combination of advanced security features at a reasonable selling price. There are several companies operating in this highly competitive and rapidly changing marketplace, however, and many of such companies have strong name recognition and vast financial resources. The Company believes it can compete on the basis of its unique design and ease of use. There are no assurances, however, that the products will be readily accepted in the marketplace when they become available. 9 Patents and Trademarks The Company has been granted several patents by the United States Patent and Trademark Office relative to the Data Key, its key interface and its overall portable information device technology. The Company has sought and will, when appropriate, continue to seek patent protection in several foreign countries. The federal registration of the Datakey trademark was approved in 1985. The Company also has patents in application or in the filing process. In an industry characterized by rapid technological change, the Company believes that the knowledge, experience and creativity of its employees will prove to be more important than patent protection. Employees The Company presently employs 50 full-time employees, 18 of whom are involved in manufacturing, 4 in materials handling, 2 in quality assurance, 11 in engineering, 8 in marketing/sales and 7 in general and administrative areas. In addition, the Company uses contract labor during peak production times and for major projects. The Company's employees are not subject to a collective bargaining agreement, and the Company believes that its employee relations are good. Outlook and Risks As provided for under the Private Securities Litigation Reform Act of 1995, the Company wishes to caution investors that the following important factors, among others, in some cases have affected and in the future could affect the Company's actual results of operations and cause such results to differ materially from those anticipated in forward-looking statements made in this document and in the Company's 1996 Annual Report by or on behalf of the Company: Uncertainty of Market Acceptance of New Products. The Company is currently developing new data security products, some of which it expects to introduce by mid-1997. While Datakey performs market research and beta testing to determine the viability of its new products, actual user acceptance will ultimately dictate the success of the marketing and sales efforts of new products such as SignaSURE EDM and ESS. Although the Company believes that the decision to fund these new products is correct, there are no assurances that the investments already made and additional investments planned for 1997 will result in a financial return. New Product Development and Product Delivery. Substantial additional development work is required for the introduction of the Company's planned new information security products. The Company expects extensive software development and staffing expenses to contribute to an overall research and development expense figure for 1997 in excess of that for 1996 and substantially in excess of previous years. No assurance can be given that the Company's timetable for these development plans will be achieved or that development efforts will be successful. Delays in the release of new products will cause operational inefficiencies, increased development costs and reduced revenues. Dependence on Key Personnel. The Company is highly dependent on a limited number of key management and technical personnel, including Carl P. Boecher who has been President and Chief Executive Officer since December 1996 and was Vice President of Marketing and Sales from January 1995 to December 1996, Alan G. Shuler who has been the Vice President and Chief Financial Officer since June 1992 and Jim Foley, who joined the Company in January 1997 as Vice President of Engineering. The loss of key personnel, especially while working to add a new product line, could have an adverse effect on the Company's business, financial condition and results of operations. 10 Fluctuations in Operating Results. Due to the Company's historical dependence on sales to OEM customers who, themselves, must successfully sell products containing components produced by Datakey, the Company has experienced year to year fluctuations in its revenue. During the past three years, Datakey has marketed secure microprocessor-based tokens in the smart card format and its patented key shaped format, along with a file based software package for encrypting and digitally signing electronic documents in the emerging information data security market. The information data security market is a rapidly developing and changing market, but to date the Company has not achieved a high sales level on its current product offerings. In addition, the Company plans to spend substantially more for research and development of such new products. Therefore, the Company believes that its results of operations may fluctuate as a result of the new product mix and the timing of releases of new products and product upgrades. As a result of its product development expenditures, the Company expects to have significant losses in 1997. Competition - General. Both the Company's OEM Products business, consisting of portable memory-based systems, subsystems and custom-designed components for security-driven markets, and the information data security (end-user) market are highly competitive. The information data security market is rapidly developing. There can be no assurance that the Company will be able to effectively compete within such markets, and that others will not enter these markets. Competition in the sale of information data security products occurs principally on the basis of price and functionality. Many of the manufacturers of portable information devices and systems are large, well-established companies. Datakey's information security end-user products such as SignaSURE EDM(TM) and SignaSURE ESS(TM) will integrate hardware tokens with software that provide a much higher level of security than software implementations alone. There is a possibility that software-only solutions may overcome this deficiency in the future. Price Competition. While Datakey believes that its strategy of providing token-based product solutions at a price that is competitive with software-only products is attainable, there are no assurances that competitive pressures will not force the Company to accept reduced margins to compete in the future. Large companies have recognized the need for information security and could enter this market as competitors with much greater financial resources. A portion of its new end-user products' cost is royalties and license fees which would need to be re-negotiated to maintain acceptable margins. Integrated information security products. Although the Company's new products will operate seamlessly with popular application programs, new application programs that integrate information security into their product could erode the future market for these Datakey products. Marketing and sales. The future revenue of Datakey products is dependent on the success of a new and untested marketing and direct sales organization. Need for information security. Although corporate utilization of the Internet and internal intranets dictate a need for information security, there are no assurances that other, more secure information transmission media may not become available in the future that would preclude the need for the type of information security provided by the Company's products. ITEM 2. DESCRIPTION OF PROPERTY The Company's corporate offices and manufacturing facility, located at 407 West Travelers Trail, Burnsville, Minnesota, consists of 18,488 square feet. Approximately one-half of the space is used for manufacturing and warehousing, 11 and the balance for present and future office space. All of this space is rented under a lease which extends through June 1999. The annual rent expense for the space currently occupied is $97,000, plus a portion of the operating expenses and real estate taxes. The Company believes its space is sufficient for its needs in the foreseeable future, and it believes its property is adequately insured. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings pending to which the Company is a party or of which any of its property is the subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year 1996. PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the NASDAQ National Market System under the symbol DKEY. The high and low sale prices for the common stock by quarter as reported by NASDAQ are set forth in the following table for 1996 and 1995. On March 17, 1997, the Company had approximately 1,350 shareholders, including approximately 1,000 beneficial owners. The Company has never paid dividends and does not plan to in the foreseeable future. Sale Prices High Low 1996 1st Quarter.................................... $5 7/8 $3 3/4 2nd Quarter.................................... $8 3/4 $3 7/8 3rd Quarter.................................... $7 3/4 $4 1/4 4th Quarter.................................... $5 3/8 $3 1995 1st Quarter.................................... $4 $2 7/8 2nd Quarter.................................... $4 1/8 $3 1/2 3rd Quarter.................................... $4 1/4 $2 1/2 4th Quarter.................................... $8 3/4 $3 3/8 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The information required by Item 6 is incorporated by reference from the Company's 1996 Annual Report, portions of which are included herewith in Exhibit 13.1 to this Report. 12 ITEM 7. FINANCIAL STATEMENTS The information required by Item 7 is incorporated by reference from the Company's 1996 Annual Report, portions of which are included herewith in Exhibit 13.1 to this Report. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 13 PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT The information required by Item 9 regarding the Company's directors and executive officers is incorporated by reference to the Company's proxy statement for its 1997 Annual Meeting of Shareholders under the captions "Determination of Number and Election of Directors" and "Executive Officers of the Company." The Company's proxy statement will be filed pursuant to Rule 14a-3 within 120 days after the close of the fiscal year for which this report is filed. The information relating to compliance with Section 16(a) of the Exchange Act is incorporated by reference to the Company's proxy statement for its 1997 Annual Meeting of Shareholders under the caption "Compliance With Section 16(a) of the Exchange Act." ITEM 10. EXECUTIVE COMPENSATION The information required by Item 10 is incorporated by reference to the Company's proxy statement for its 1997 Annual Meeting of Shareholders under the caption "Executive Compensation." ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 11 is incorporated by reference to the Company's proxy statement for its 1997 Annual Meeting of Shareholders under the caption "Security Ownership of Management and Certain Beneficial Owners." ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are included in this report: See "Exhibit Index" immediately following the signature page of this Form 10-KSB. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1996. 14 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Issuer has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 28, 1997 DATAKEY, INC. BY: /s/ Carl P. Boecher Carl P. Boecher Chief Executive Officer and Director (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company, in the capacities, and on the dates, indicated: POWER OF ATTORNEY Each person whose signature appears below constitutes and appoints Carl P. Boecher and Alan G. Shuler as his true and lawful attorneys-in-fact and agents, each acting alone, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-KSB and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming said attorneys-in-fact and agents, acting alone, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof. SIGNATURES TITLES DATE /s/ Carl P. Boecher Chief Executive Officer and March 28, 1997 Carl P. Boecher Director (Principal Executive Officer) /s/ Alan G. Shuler Vice President and Chief March 28, 1997 Alan G. Shuler Financial Officer (Principal Financial and Accounting Officer) /s/ Thomas R. King Director and Secretary March 28, 1997 Thomas R. King /s/ Terrence W. Glarner Director March 28, 1997 Terrence W. Glarner /s/ Gary R. Holland Chairman of the Board of March 28, 1997 Gary R. Holland Directors /s/ Eugene W. Courtney Director March 28, 1997 Eugene W. Courtney /s/ John H. Underwood Director March 28, 1997 John H. Underwood 15 DATAKEY, INC. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-KSB For the Fiscal Year Ended December 31, 1996 Exhibit No. Description 3.1 Restated Articles of Incorporation, as amended (Incorporated by reference to Exhibit 3.1 to Form 10-K for fiscal year ended December 31, 1987) 3.2 Bylaws, as Amended (Incorporated by reference to Exhibit 3.2 to Form 10-K for fiscal year ended December 31, 1988) 10.1 Agreement between National Security Agency and the Company dated September 30, 1986, as amended on October 16, 1986 (Incorporated by reference to Exhibit 10.5 to Form 10-K for fiscal year ended December 31, 1986) 10.2 Amendments dated May 8, 1987, May 29, 1987, June 30, 1987 and February 17, 1988 to Agreement between National Security Agency and the Company dated September 30, 1986 (Incorporated by reference to Exhibit 10.6 to Form 10-K for fiscal year ended December 31, 1987) 10.3 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)** 10.4 Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.5 to Form 10-K for fiscal year ended December 31, 1991)** 10.5 Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey, Inc. Stock Option Plan** 10.6 License Agreement between CTS Corporation and the Company dated March 9, 1988 (Incorporated by reference to Exhibit 10.8 to Form 10-K for fiscal year ended December 31, 1987) 10.7 Agreement between Maryland Procurement Office and the Company dated September 24, 1988 as amended on September 26, 1988, November 7, 1988, November 9, 1988 and December 19, 1988 (Incorporated by reference to Exhibit 10.9 to Form 10- K for fiscal year ended December 31, 1988) 10.8 Agreement between Maryland Procurement Office and the Company dated October 2, 1989 as amended on November 8, 1989 (Incorporated by reference to Exhibit 10.10 to Form 10-K for fiscal year ended December 31, 1989) 10.9 Agreement between Maryland Procurement Office and the Company dated September 28, 1990 as amended on October 29, 1990, February 22, 1991 and May 15, 1991 (Incorporated by reference to Exhibit 10.10 to Form 10-K for fiscal year ended December 31, 1991) 10.10 Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987, as amended on February 10, 1988, December 23, 1988, February 13, 1992 and April 1, 1992 (Incorporated by reference to Exhibit 10.12 to Form 10-K for fiscal year ended December 31, 1991) 16 10.11 Agreement between National Institute of Standards & Technology Acquisition of Assistance Division and the Company dated June 2, 1992, as amended on June 3, 1992 (Incorporated by reference to Exhibit 10.12 to Form 10-KSB for fiscal year ended December 31, 1992)* 10.12 Agreement between Maryland Procurement Office and the Company dated July 29, 1992,* as amended on October 13, 1992 (Incorporated by reference to Exhibit 10.13 to Form 10-KSB for fiscal year ended December 31, 1992) 10.13 Agreement between Maryland Procurement Office and the Company dated November 16, 1993 (Incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended December 31, 1993)* 10.14 Manufacturing Agreement between Duncan Industries and the Company dated August 27, 1993 (Incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended December 31, 1993) 10.15 Employment Agreement between Alan G. Shuler and the Company dated January 1, 1995 (Incorporated by reference to Exhibit 10 to Form 10-QSB for fiscal year ended July 1, 1995) 10.16 Employment Agreement between James P. Foley and the Company dated January 1, 1996 (Incorporated by reference to Exhibit 10.18 to Form 10-KSB for fiscal year ended December 31, 1995)** 10.17 Consulting Agreement between Gary R. Holland and the Company dated November 1, 1995 (Incorporated by reference to Exhibit 10.19 to Form 10-KSB for fiscal year ended December 31, 1995)** 10.18 Amendment dated February 11, 1997 to Consulting Agreement between Gary R. Holland and the Company dated November 1, 1995** 10.19 Employment Agreement between Carl P. Boecher and the Company dated January 1, 1997** 10.20 Separation Agreement and Release between John H. Underwood and the Company dated January 1, 1997** 10.21 Management Incentive Plan dated February 27, 1997** 10.22 Lease Amendment No. 5 dated December 17, 1996 to Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987 13.1 Portions of 1996 Annual Report 21.1 Subsidiaries of the Company (Incorporated by reference to Exhibit 21.1 to Form 10-KSB for fiscal year ended December 31, 1994) 23.1 Independent Auditor's Consent 24.1 Power of attorney for Carl P. Boecher, Alan G. Shuler, Thomas R. King, Terrence W. Glarner, Gary R. Holland, Eugene W. Courtney and John H. Underwood (included on the signature page of this Form 10-KSB) 27 Financial Data Schedule (filed with electronic version only) * Confidential treatment has been granted for certain portion of this exhibit. ** Designates a management contract or compensatory plan or arrangement. 17 EX-10.5 2 AMENDMENTS TO STOCK OPTION PLAN AMENDMENTS TO THE DATAKEY, INC. 1987 STOCK OPTION PLAN ADOPTED BY BOARD OF DIRECTORS ON JULY 1, 1995: 1. A new sentence shall be added at the end of subsection (e) of Section 1 Definitions to read as follows: "For purposes of Section 19, the "Optionee" is a Non-Employee Director to whom a nonqualified option has been granted." 2. A new subsection (h) shall be added to Section 1 Definitions to read as follows: "(h) 'Non-Employee Directors' shall mean members of the Board who are not employees of the Company or any Subsidiary." 3. Section 17 Amendment of the Plan shall be amended to add a new sentence at the end of such Section 17 as follows: "In addition to and notwithstanding the foregoing, the provisions of Section 19 shall not be amended more than once every six months, other than to comport with changes in the Internal Revenue Code, the Employee Retirement Income Security Act, or the rules thereunder." 4. A new Section 19 Granting of Options to Non-Employee Directors shall be added to read as follows: "SECTION 19. GRANTING OF OPTIONS TO NON-EMPLOYEE DIRECTORS (a) Upon Joining Board. Each Non-Employee Director of the Company who, on or after July 1, 1995, the date of approval of this Section 19 by the Board, is initially elected as a director, shall, as of the date of such election, automatically be granted an option to purchase 15,000 shares of the Common Stock at an option price per share equal to 100% of the fair market value of the Common Stock on such date. Options granted pursuant to this subsection (a) shall be immediately exercisable to the extent of 3,000 shares subject to such option and to the extent of an additional 3,000 shares on each of the first, second, third and fourth anniversaries of the date of grant; provided, however, that options granted before approval by the Company's shareholders of an amendment to the Company's 1987 Stock Option Plan adding this Section 19 to the Plan shall not be exercisable before such approval. 1 (b) Upon Re-election to Board. Each Non-Employee Director who, on and after July 1, 1995, the date of approval of this Section 19 by the Board, is re-elected as a director of the Company or whose term of office continues after a meeting of shareholders at which directors are elected shall, as of the date of such re-election or shareholder meeting, automatically be granted an option to purchase 2,500 shares of the Common Stock at an option price per share equal to 100% of the fair market value of the Common Stock on the date of such re-election or shareholder meeting. Options granted pursuant to this subsection (b) shall be immediately exercisable in full. (c) General. No director shall receive more than one option pursuant to subsection (b) of this Section 19 in any one fiscal year. All options granted pursuant to this Section 19 shall be designated as nonqualified options and shall be subject to the same terms and provisions as are then in effect with respect to granting of nonqualified options to officers and employees of the Company except that the option shall expire on the earlier of (i) three months after the Optionee ceases to be a director (except by death) and (ii) ten (10) years after the date of grant. Notwithstanding the foregoing, in the event of the death of a Non-Employee Director, any option granted to such Non-Employee Director pursuant to this Section 19 may be exercised at any time within six months of the death of such Non-Employee Director or on the date on which the option, by its terms expires, whichever is earlier." ADOPTED BY BOARD OF DIRECTORS ON MARCH 19, 1996: Increase of Shares Reserved Under 1987 Stock Option Plan RESOLVED, that, subject to shareholder approval which shall be requested at the Annual Meeting, the number of shares reserved for issuance pursuant to the Company's 1987 Stock Option Plan be and hereby is increased from 550,000 to 800,000 shares. AMENDMENTS APPROVED BY SHAREHOLDERS ON JUNE 5, 1996 2 EX-10.18 3 HOLLAND CONSULTING AGREEMENT AMENDMENT TO AGREEMENT WHEREAS, Datakey, Inc. (the "Company") and Gary R. Holland ("Holland") entered into an Agreement dated November 1, 1995 (the "Agreement"), pursuant to which Holland was to provide consulting services to the Company until October 31, 1996; WHEREAS, Holland has provided such services to Datakey in an exemplary manner; and WHEREAS, the Company and Holland wish to extend the term of the Agreement until December 31, 1997. IT IS THEREFORE AGREED THAT the term of the Agreement shall be extended until December 31, 1997. Except to the extent affected by this extension, all other terms of the Agreement remain in full force and effect. Dated: February 11, 1997 DATAKEY, INC. By /s/ Carl P. Boecher Carl P. Boecher, President and Chief Executive Officer /s/ Gary R. Holland Gary R. Holland EX-10.19 4 BOECHER EMPLOYMENT AGREEMENT EMPLOYMENT AGREEMENT This Employment Agreement (the "Agreement") made and entered into effective as of the 1st day of January 1997, by and between Datakey, Inc., a Minnesota corporation (the "Company" or "Datakey") and Carl P. Boecher ("Executive"). RECITALS Carl P. Boecher joined the Company in January 1995 as Vice President of Sales and Marketing. He was appointed President and Chief Executive Officer on December 1, 1996. The parties desire to memorialize their relationship in the following Agreement. AGREEMENT 1. Employment a. Datakey agrees to continue to employ Executive on a full-time basis as the President and Chief Executive Officer ("CEO") of Datakey pursuant to the terms and conditions hereof. b. Executive agrees that he will, at all times, faithfully, industriously, and, to the best of his abilities, experience and talents, continue to perform all the duties and responsibilities that may be required of him as President and CEO of Datakey. 2. Term of Employment a. Subject to the terms and conditions hereof, Executive shall be employed for a term ("Employment Term") commencing on January 1, 1997, and terminating on January 1, 1998, unless extended as set forth in Subsection 2b below. b. This Agreement will be renewed automatically after January 1, 1998, for additional one-year periods unless either party gives the other party written notice 30 days before January 1, 1998 or 30 days before the end of any one-year period thereafter of his or its intention to terminate the Agreement. 3. Base Compensation As compensation for his services to Datakey, Executive shall be paid an initial monthly salary of $10,000, payable in accordance with Datakey's payment periods. Executive's base compensation will be reviewed on an annual basis throughout the term of this Agreement. - 1 - 4. Incentive Compensation Executive will be paid a target bonus of 30% of his base salary which will be dependent on attainment of performance targets set by the Company's Compensation Committee by February 15, 1997. In addition, Executive will be eligible to participate in any long-term incentive plan approved by Datakey's Board of Directors. 5. Other Benefits a. Vacation. Executive will receive four weeks of vacation for every twelve months of employment. Unused vacation may not be carried over from one year to the next. Datakey will pay Executive for any earned and unused vacation upon termination. b. Automobile Allowance. During the term of this Agreement, Datakey will pay Executive $500 per month to be applied toward his automobile expenses. c. Stock Options. Executive has been granted the following incentive stock options: (i) 50,000 shares at an exercise price of $3.50 per share and (ii) 25,000 shares at an exercise price of $3.00 per share. Both options have been or will be memorialized in Stock Option Agreements and will contain standard terms and conditions, including vesting. d. Miscellaneous. During the term of this Agreement, Executive will receive such other benefits which are provided by Datakey to other officers as a group. 6. Termination Notwithstanding Section 2 above, the Employment Term or any extension thereof shall terminate upon the happening of any of the following events: a. Mutual written agreement between the Board of Directors of Datakey and Executive to terminate his employment. b. Executive's death. c. Executive's disability defined as physically or mentally unable to perform as CEO with or without reasonable accommodation for a period of six consecutive months, or d. For cause (as defined below) upon written notice from the Board of Directors specifying the nature of the cause. For purposes of this Agreement, "cause" shall include commission of any felony, gross misdemeanor, or any act of fraud or dishonesty in connection with the affairs of Datakey. - 2 - e. By either party with or without cause upon thirty days written notice to the other. 7. Payment Upon Termination of Employment For Cause If Executive is terminated for cause as defined in Section 6 above, Executive shall not be eligible to receive any severance benefits. The date of termination under this Section 7 shall be on the day the notice of termination for cause is given and Executive shall be entitled to no additional compensation past the date of such notice. 8. Payment Upon Termination of Employment Without Cause or Termination Upon Failure to Renew Agreement a. If Executive is terminated without cause or terminated for failure of Datakey to renew Agreement, Executive shall receive a severance payment equal to his base compensation payable for twelve months in accordance with Datakey's payment periods beginning on the 10th day of the first month following the last month of employment. b. The payments provided for under this Section 8 shall, in the event of Executive's death, continue and shall be payable to his wife if she survives or, if not, to his estate. c. The Company will also expend up to $6,000 to be applied only to outplacement counseling of Executive's choice. Payments will be made directly to the outplacement counselor. d. The Company will continue to provide to Executive and his covered dependents access to medical and health coverage under its plans as they currently exist or may hereafter be amended at company subsidized rates during the twelve-month severance pay period. Thereafter, Executive and his covered dependents will be entitled to elect to continue coverage under COBRA to the extent it is available. Coverage by the Company or under COBRA will end on the earlier of Executive's obtaining new employment which gives him the ability to provide medical and health insurance coverage for himself and his family through his new employer, or the failure to pay any premium when due. 9. Nondisclosure Except by written permission from Datakey, Executive shall never disclose or use any trade secrets, sales projections, formulations, customer lists or information, product specifications or information, credit information, production know-how, research and development plans or other information not generally known to the public ("Confidential Information") acquired or learned by Executive during the course, and on account, of his employment, whether or not developed by Executive, except as such disclosure or use may be required by - 3 - his duties to Datakey, and then only in strict accordance with his obligations of service and loyalty thereto. Upon termination of employment, Executive agrees to deliver to Datakey all Confidential Information. 10. Noncompetition a. For a period of one (1) year after the end of the Employment Term or any extension thereof or after termination of employment for any reason, Executive will not, directly or indirectly, alone or in any capacity with another legal entity: (i) engage in any activity that competes in any respect with Datakey, (ii) contact or in any way interfere or attempt to interfere with the relationship of Datakey with any current or potential customers of Datakey, or (iii) employ or attempt to employ any employee of Datakey (other than a former employee thereof after such employee has terminated employment with the Datakey); b. Executive acknowledges that Datakey markets products throughout the United States and that Datakey would be harmed if Executive conducted any of the activities described in this Section 10 anywhere in the United States. Therefore, Executive agrees that the covenants contained in this Section 10 shall apply to all portions of, and throughout, the United States; and c. To the extent any provision of this Section 10 shall be invalid or unenforceable, it shall be considered deleted herefrom and the remainder of such provision and this Section 10 shall be unaffected and shall continue in full force and effect. In furtherance to and not in limitation of the foregoing, should the duration or geographical extent of, or business activities covered by, any provision of this Section 10 be in excess of that which is valid and enforceable under applicable law, then such provision shall be construed to cover only that duration, extent or activities which are validly and enforceably covered. Executive acknowledges the uncertainty of the law in this respect and expressly stipulates that this Section 10 be given the construction which renders its provisions valid and enforceable to the maximum extent (not exceeding its expressed terms) possible under applicable laws. d. Executive and Datakey acknowledge that the noncompetition provision of this Section 10 is enforceable against Executive under Minnesota law only if it is supported by independent consideration because Executive is entering into this noncompetition agreement after having already accepted employment with Datakey. Executive specifically acknowledges and agrees that Datakey is providing him adequate independent consideration for this noncompetition provision by way of this Agreement, including but not limited to the term of employment (Section 2), increased base compensation (Section 3), increased incentive compensation (Section 4), and one-year severance upon termination (Section 8). 11. Specific Performance Executive acknowledges that a breach of this Employment Agreement would cause Datakey irreparable injury and damage which could not be remedied or - 4 - adequately compensated by damages at law; therefore, Executive expressly agrees that Datakey shall be entitled, in addition to any other remedies legally available, to injunctive and/or other equitable relief to prevent a breach of this Employment Agreement. 12. Miscellaneous a. Waiver by Datakey of a breach of any provision of this Agreement by Executive shall not operate or be construed as a waiver of any subsequent breach by Executive. b. This Agreement shall be binding upon and inure to the benefit of Datakey, its successors and assigns, and as to Executive, his heirs, personal representatives, estate, legatees and assigns. c. This Agreement constitutes the entire agreement between the parties hereto with respect to the subject matter hereof and supersedes all prior agreements whether written or oral relating hereto. d. This Agreement shall be governed by and construed under the laws of the State of Minnesota. IN WITNESS WHEREOF, the parties have hereto executed this Employment Agreement effective as of the day and year first above written. DATAKEY, INC. /s/ Gary R. Holland By: Gary Holland, Chairman of the Board /s/ Carl P. Boecher Carl P. Boecher, Executive - 5 - EX-10.20 5 UNDERWOOD SEPARATION AGREEMENT SEPARATION AGREEMENT AND RELEASE This Separation Agreement and Release (the "Agreement") is entered into by and between Datakey, Inc. (the "Company") and John H. Underwood ("Employee") effective as of January 1, 1997. RECITALS John H. Underwood has been an officer, director and employee of the Company since 1983. In December 1996, Employee resigned as the Chief Executive Officer of the Company and continued as an employee of the Company through December 31, 1996. In consideration of his covenants hereunder and his release of claims set forth hereunder, the Company has made provisions for certain payments and other benefits to be paid to Employee. AGREEMENT NOW THEREFORE, the parties agree as follows: 1. Company. Company, as used herein, means Datakey, Inc., its successors and assigns, its subsidiaries, and its present and former directors, officers, shareholders, employees, and agents, whether in their individual or official capacities. 2. Employee. Employee, as used herein, means John H. Underwood and anyone who has or obtains legal rights or claims through him. 3. Resignation. On or about December 1, 1996, Employee resigned as the Chief Executive Officer of the Company. He continued as a non-officer employee of the Company until December 31, 1996, at which time he resigned as an employee. Employee will continue as a director of the Company at his discretion until the next annual meeting of the Company's shareholders or until his successor has been elected. 4. Agreement Not to Compete. (a) Restrictive Covenant. Employee agrees that until December 31, 1998, he shall not, directly or indirectly, engage in competition with the Company in any manner or capacity (e.g., as an advisor, principal, agent, partner, officer, directors, stockholder, employee, member of any association, or otherwise) in any phase of the business which the Company is currently conducting or as part of its business plan intends to conduct. (b) Equitable Remedies. The monthly severance payments to be made to Employee through December of 1998 as set forth in Section 5(a) - 1 - below are in part in consideration for Employee's agreement not to compete. If Employee violates his agreement not to compete, the Company shall have the right to terminate his monthly payment and seek injunctive relief prohibiting Employee from competing against the Company. (c) Geographic Extent of Covenant. The obligations of Employee not to compete shall apply to the entire United States. (d) Indirect Competition. Employee further agrees that through December, 1998, he will not, directly or indirectly, assist or encourage any other person in carrying out, directly or indirectly, any activity that would be prohibited by the above provisions of Section 4(a) if such activity were carried out by Employee, either directly or indirectly; and in particular Employee agrees that he will not, directly or indirectly, induce any employee of the Company to carry out, directly or indirectly, any such activity. (e) Non-Solicitation. Employee further agrees that through December 31, 1998, he will not solicit or encourage employees of the Company to terminate their employment with the Company or contact or in any way interfere or attempt to interfere with the Company's relationship with any current or potential customers of Datakey. (f) Construction of Agreement Not to Compete. To the extent any provision of this Section 4 shall be invalid or unenforceable, it shall be considered deleted herefrom and the remainder of such provision and this Section 4 shall be unaffected and shall continue in full force and effect. In furtherance to and not in limitation of the foregoing, should the duration or geographical extent of, or business activities covered by, any provision of this Section 4 be in excess of that which is valid and enforceable under applicable law, then such provision shall be construed to cover only that duration, extent or activities which are validly and enforceably covered. Employee acknowledges the uncertainty of the law in this respect and expressly stipulates that this Section 4 be given the construction which renders its provisions valid and enforceable to the maximum extent (not exceeding its expressed terms) possible under applicable laws. 5. Benefits. (a) Through December 31, 1998, Employee shall continue to receive on a monthly basis, in accordance with Datakey's current payroll practices, an amount of severance equal to his monthly base salary in effect on December 31, 1996. (b) The Company will continue to provide to Employee access to medical and health coverage, under its plans as they currently exist or may hereafter be amended, at Company subsidized rates during the twenty-four month severance pay period. Thereafter, Employee and his covered dependents will be entitled to elect to continue coverage under - 2 - COBRA to the extent it is available. Coverage by the Company or under COBRA will end on the earlier of Employee's obtaining new employment which gives him the ability to provide medical and health insurance coverage for himself and his family through his new employer, or the failure to pay any premium when due. (c) The Company will expend up to $6,000 to be applied only to actual outplacement counseling of Employee's choice. (d) Unpaid vacation benefits, if any, will be paid to Employee on or about January 15, 1997. (b) Effective as of January 1, 1997 Employee's vested account balance under the Company's 401(k) Plan and Trust shall be distributed to Employee or at his direction, pursuant to the terms of the 401(k) Plan and Employee's election thereunder. 6. Stock Options. Employee has been granted the following stock options: (i) 25,000 shares at an exercise price of $3.625 per share which expires on April 30, 2005 and which is vested at 16,600 shares; and (ii) 75,000 shares at an exercise price of $5.75 per share which expires on January 12, 2002 and which is fully vested. After the termination of Employee's employment on December 31, 1996, Employee will have until February 28, 1999, to exercise his two stock options. 7. Release of Employment Claims. Employee hereby releases and forever discharges the Company of and from any and all actions or causes of action, suits, debts, claims, complaints, contracts (expressed or implied), controversies, agreements, promises, damages, claims for attorneys' fees, judgments, costs, disbursements, severance, compensation, vacation pay and other benefits (except as specifically provided for in this Agreement), known or unknown, in law or equity, Employee ever had, now has, or shall have as of the date of this Agreement relating in any manner to Employee's employment with and/or resignation as an officer, director or employee of the Company, including, but not limited to, any alleged violation of any federal, state, or local law, regulation or ordinance prohibiting discrimination or other unlawful activity on the basis of race, color, creed, marital status, sex, age, religion, national origin, sexual orientation, sexual harassment, disability, or any other basis (whether arising under Title VII of the Civil Rights Act, 42 U.S.C. ss. 2000e et seq., the Age Discrimination in Employment Act, 29 U.S.C. ss. 621 et seq., the Americans With Disabilities Act, 42 U.S.C. ss. 12101 et seq., the Minnesota Human Rights act, Minn. Stat. ss. 363.01 et seq., or elsewhere), or any alleged obligation created by statute or by common law contract or tort theory. Employee releases and discharges Company not only from any and all claims that he could make on his own behalf, but also those that may or could be brought by any other person or organization on his behalf. Employee affirms that as a current or former employee he has not caused or permitted to be filed any charge, complaint, or action against Company and agrees that he will not cause or permit to be filed any charge, complaint, or action and that he will not participate with any other party in the filing of any charge, complaint or action on the basis of his employee status. - 3 - 8. Notification of Rights Pursuant to the Federal Age Discrimination in Employment Act (29 U.S.C. ss.ss. 621-634) and Minnesota Human Rights Act (Minn. Stat. Ch. 363). Employee agrees that he is hereby notified that the federal Age Discrimination in Employment Act provides that he is entitled to wait 21 days to sign this Agreement. The 21-day period shall begin the day following the day on which Employee receives the Agreement. Employee acknowledges that the purpose of the 21-day period is to provide Employee adequate time to consider whether the terms of this Agreement are acceptable to him. Employee is also hereby notified of his right to rescind his release of claims arising under the Federal Age Discrimination in Employment Act within 7 calendar days of his signing of this Agreement. Employee is further notified of his right to rescind his release of claims arising under the Minnesota Human Rights Act within 15 calendar days of his signing of this Agreement. In order to be effective, Employee's rescission must be in writing and delivered by hand or mail to Gary Holland, Datakey, Inc., 407 West Travelers Trail, Burnsville, MN 55337-2554. If delivered by mail, the rescission must be postmarked within the required period, properly addressed to Gary Holland as set forth above, and sent by certified mail, return receipt requested. Employee understands that if he rescinds his release of claims as provided for in this paragraph, Employee will not receive, and will have to return to Company, all benefits and payments provided for in this Agreement. 9. Confidentiality. The parties agree specifically that the contents and terms of this Agreement shall remain confidential except as required by applicable law or regulation (including of the Securities and Exchange Commission or of the Nasdaq National Market). However, Employee shall be entitled to discuss the matters contained herein with his legal and financial advisors and his immediate family, provided they also agree to keep this Agreement confidential. Provided further that Company shall be entitled to discuss the matters contained herein with its legal and financial advisers and its management employees on a need to know basis. 10. Non-Disparagement. Each party agrees not to disparage in any manner the other party. Any such disparagement will be grounds for rescission of this Agreement. 11. Corporate Information. Employee agrees that he will not remove any proprietary corporate information from the Company's offices, including the office he occupied. The determination of what information is proprietary will be in the discretion of the Company. Subject to the foregoing, corporate information shall include, but not be limited to, sales plans, customer information, employee information, business correspondence and any other information which is related to Datakey, Inc. or its subsidiaries or their businesses. All personal property of the Employee, property which is not owned by or is not proprietary or confidential to the Company, will be returned to Employee. 12. Assignment. The obligations of Employee under this Agreement may not be assigned by Employee. However, in the event of Employee's mental or physical disability, incapacitation or death, all remaining payments shall continue to be made to Employee's spouse, or in the event of the death of the - 4 - Employee's spouse, the payments will be made to Employee's estate. The Company's rights and obligations under this Agreement will inure to the benefit and be binding upon the Company's successors and assignees. 13. Severability. If a court rules that any part of this Agreement is not enforceable, that part may be modified by the court to make it enforceable. The parties expressly agree that the restrictions contained in Section 4 are reasonable and should be enforced to the maximum extent and scope possible. 14. Governing Law. Any disputes arising under this Agreement shall be governed by the laws of the State of Minnesota. 15. Acknowledgment of Reading and Understanding; Consultation with Counsel; Period to Consider Agreement. Employee, by signing this Agreement, acknowledges and agrees that he has carefully read and understood all provisions of this Agreement and that he has entered into this Agreement knowingly and voluntarily. Employee further acknowledges that he has consulted with counsel before signing this Agreement. Employee also acknowledges that Company informed him that he has 21 days from the receipt of this Agreement to consider whether its terms are acceptable to him and that he has had the benefit of the 21-day period. Employee acknowledges and agrees that he has not relied on any representations or statements by Company, whether oral or written, other than the express statements of this Agreement, in executing this Agreement. 16. Full Agreement. This Agreement contains the full agreement of the parties and may not be modified, altered, or changed in any way except by written agreement signed by both parties. Except as expressly stated in this Agreement, the parties agree that this Agreement supersedes and terminates any and all oral and written prior agreements and understandings between the parties. DATAKEY, INC. Dated: January 27, 1997 By /s/ Gary R. Holland Gary Holland Chairman of the Board of Directors Dated: February 27, 1997 /s/ John H. Underwood John H. Underwood - 5 - EX-10.21 6 MANAGEMENT INCENTIVE PLAN LTIP NOTES AND ASSUMPTIONS February 27, 1997 Amended March 10, 1997 The RONAEBIT calculation during the two year period is determined using operating income after deducting the short-term bonus accrual expense. Since the stock options will be granted at the fair market value on the date of grant with a fixed number of options and fixed term, there is no compensation expense to be recorded during the operating periods. The only accounting transactions that will take place during the two year period are the footnote disclosure for FAS123 and the common stock equivalent calculation that is taken into account in determining primary and fully diluted shares for EPS calculations. Each manager will be granted three sets of options equal to the one times LTIP financial performance. If the performance qualifies for a 1 times payout the first set of options will vest, if the performance qualifies for 2 times payout the second set will vest, and if it qualifies for 3 times payout the third set of options will vest. In the event none of the performance criteria are met all the options will vest at the end of 5 years. Since the number of shares and the price must be determined at the time the option is granted in order for compensation expense to be avoided there is no provision for interpolation of the shares. In other words, if the base number of shares is 5,000 then the individual gets early vesting of 5,000, 10,000 or 15,000 shares and no intervals in between. If the minimum level is not reached, all 15,000 shares will vest at the end of five years. To accommodate the same result as interpolation of shares the vesting schedule will reflect the financial performance level. For example, at a performance level of .25 in the enclosed LTIP table (50% revenue growth and 15% RONAEBIT or 25% revenue growth and 25% RONAEBIT) the number of shares in this example will be as follows: (At .50 the first set is vested in 3.50 years and at .75 level the first set is vested at 2.75 years). 5,000 shares vested in 4.25 years first set 5,000 shares vested in 5.00 years second set 5,000 shares vested in 5.00 years third set ------ 15,000 Total At performance level of 1 the number of shares is as follows: 5,000 shares vested in 2.00 years first set 5,000 shares vested in 5.00 years second set 5,000 shares vested in 5.00 years third set ------ 15,000 Total At performance level of 2 the number of shares is as follows: 5,000 shares vested in 2.00 years first set 5,000 shares vested in 2.00 years second set 5,000 shares vested in 5.00 years third set ------ 15,000 Total At performance level of 3 the number of shares is as follows: 5,000 shares vested in 2.00 years first set 5,000 shares vested in 2.00 years second set 5,000 shares vested in 2.00 years third set ------ 15,000 Total To determine the vesting if performance falls in between 1, 2 and 3 the number of years vesting is determined by using the following vesting schedule for the fractional performance and adding that to the shares with full performance: .25 4.25 years .50 3.50 years .75 2.75 years At a performance level of 2.25, for example, the vesting is as follows: 5,000 shares vested in 2.00 years first set 5,000 shares vested in 2.00 years second set 5,000 shares vested in 4.25 years third set ------ 15,000 Total Part 1: Annual Incentive Plan (AIP) 1. The AIP is applicable to the Management Team and other key contributors except sales (who have a separate plan). 2. The AIP rewards corporate revenue growth and reduced operating losses before tax. (See table below) 3. Participation level (target bonus percentage) is based on the individual's planned contribution to these metrics. 4. The Individual Performance Coefficient is a numerical rating of 0.5 - 1.0 recommended by the President and approved by the Compensation Committee on the individual's actual contribution to the measurement metrics. 5. Plan formula is: Base compensation x financial performance coefficient x target bonus percentage x individual performance coefficient. 6. Pre-tax operating loss for calculation purposes is defined as the loss before incentive payout.
Financial Performance Coefficient Table PRETAX OPERATING LOSS REVENUE greater than 110% plan plan to 75% plan to less than 110% plan to plan 75% plan 50%plan 50% plan less than 90% plan 0 0 0 0 0 90% plan to 0 .25 .5 .75 1 100% plan 100% plan to 0 .5 1 1.2 1.4 120% plan 120 % plan to 0 .75 1.2 1.5 1.8 140% plan greater than 0 1 1.4 1.8 2.2 140% plan
This table may not be interpolated for incentive payout calculation. Part 2: Long Term Incentive Plan (LTIP) 1. The LTIP is applicable to Management team and other recommended key contributors including sales, and is reissued on an annual basis. 2. The LTIP is based on corporate revenue growth and RONAEBIT. RONAEBIT is defined as: Earnings before interest and taxes/average net assets employed and is calculated for the second year of the period. 3. The individual's target participation units are based on his/her contribution to these metrics. 4. Metrics are defined for a two (2) year period. 5. LTIP payout, made after completion of the two year plan period, will be in the form of Datakey non-qualified stock options. Option quantity for each participant will be defined at the beginning of the two year plan period. Option price will be determined by the average price of Datakey stock for the 15 day period immediately prior to the January 1 beginning of each two year plan period. 6. LTI Plan awards will be made based on the following formula: Individual target participation units x LTI performance factor (from table below) 7. RONAEBIT is calculated after all incentives are paid. LTI Performance Factor Table Revenue Growth for 2 Year Period less than 125% or RONAEBIT 25% 25% 50% 75% 100% greater less than 15% 0 0 0 0 0 0 15% 0 0 0.25 0.5 .75 1 25% 0 0.25 0.5 1 1.5 2 35% or greater 0 .5 0.75 1.5 2.25 3 This table may be interpolated for incentive payout calculation. EX-10.22 7 KRAUS-ANDERSON LEASE AMENDMENT NO. 5 LEASE AMENDMENT NO. 5 THIS LEASE AMENDMENT No. 5, made and entered into this 17th day of December, 1996, by and between Kraus-Anderson(R) Incorporated, a Minnesota Corporation, (hereinafter referred to as "Landlord") and Datakey, Inc., a Minnesota Corporation (hereinafter referred to as "Tenant"); WITNESSETH THAT: WHEREAS, Landlord is leasing to Tenant and Tenant is leasing from Landlord certain premises commonly known as 401-409 West Travelers Trail, Burnsville, Minnesota and located in the, Gateway Business Park, (the "Leased Premises") pursuant to written Lease Agreement dated June 3, 1987, as amended February 10, 1988, December 23, 1988, February 13, 1992 and April 1, 1992 and (collectively referred to as the "Lease"); WHEREAS, the parties hereto now desire to amend certain provisions of the Lease; NOW THEREFORE, in consideration of mutual agreements contained herein, it is hereby agreed to amend the Lease as follows: 1. ARTICLE 1. PREMISES AND TERM: The term of this lease is hereby extended for an additional two years commencing July 1, 1997 through June 30, 1999, (the "Extension Term"). 2. ARTICLE 3. BASE RENT AND SECURITY DEPOSIT: The annual base rent, Article 3, Section 1 during the Extension Term shall be as follows: Annual Base Rent for July 1, 1997 through June 30, 1998 shall be One Hundred Twenty Eight Thousand Four Hundred Ninety One Dollars and 60/100 ($128,491.56) payable in monthly installments of Ten Thousand Seven Hundred Seven and 63/100 ($10,707.63). Annual Base Rent for July 1, 1998 through June 30, 1999 shall be One Hundred Thirty Four Thousand Thirty Eight and 96/100 Dollars ($134,038.96) payable in monthly installments of Eleven Thousand One Hundred Sixty Nine and 83/100 ($11,169.83). 3. Except as herein specifically modified and amended, the Lease shall remain in full force and effect and unaltered hereby. IN WITNESS WHEREOF the parties hereto have caused this Lease Amendment to be executed the day and year first above written. KRAUS-ANDERSON, INCORPORATED DATAKEY, INC. By: /s/ Burton F. Dahlberg By: /s/ Alan Shuler Its: President Its: Vice President Landlord Tenant EX-13.1 8 PORTIONS OF ANNUAL REPORT MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations The table below summarizes changes in selected operating indicators, showing certain income, cost and expense items as a percentage of total revenue for each of the past three years. Inflation has not been a significant factor in Datakey's operations to date. Percentage of Total Revenue Year Ended December 31, 1996 1995 1994 --------- ------- --------- Revenue........................ 100% 100% 100% Cost and Expenses Cost of goods sold............. 65% 67% 70% Research and development....... 35 10 13 Marketing and sales............ 20 15 17 General and administrative..... 18 9 10 --------- -------- -------- Total cost and expenses..... 138 101 110 Interest income................ 6 5 5 --------- -------- -------- Income (loss) before income taxes.......................... (32) 4 (5) Income taxes (benefit)......... (6) 2 (2) --------- -------- -------- Net income (loss).............. (26) 2 (3) ========= ======== ======== Comparison of 1996 with 1995 Total Revenue: Total revenue was $6,558,000 in 1996, a decrease of 9 percent from $7,219,000 in 1995. Commercial sales were $5,669,000 or 86 percent of revenue with government sales representing $889,000 or 14 percent of revenue. The revenue decrease is primarily due to customer requested delays in commercial OEM product shipments during the second half of 1996 resulting from delays in shipments to their customers. Gross margins: The gross profit margin increased to 35 percent in 1996 from 33 percent in 1995 in spite of a reduction in revenue which normally reduces the margin percentage. The improved margin percentage is primarily due to increases in product selling prices in excess of the increases in material and manufacturing costs. Research and development: Research and development expenses increased 221 percent to $2,263,000 in 1996 from $704,000 in 1995 due to the Company's significant increase in product development activities for new end-user products. Marketing and sales, General and administrative: Marketing and sales expense in 1996 increased 17 percent to $1,312,000 from $1,124,000 in 1995 due to an increase in product promotion expense for newly developed and in-development end-user products. General and administrative expenses increased 73 percent to $1,156,000 in 1996 from $670,000 in 1995 primarily due to an accrual for severance pay and benefits due the Company's former chief executive officer. Interest income: Interest income decreased 6 percent to $361,000 in 1996 from $381,000 in 1995 due to a decline in the Company's investment in interest bearing investments. Income tax expense (benefit): Income tax benefit for 1996 is $388,000 as compared to an income tax expense of $106,000 in 1995. The benefit is related to the 1996 loss before taxes of $2,094,000 for which the Company recorded a deferred tax asset of $325,000, and 1995 expense is related to the $282,000 income before taxes. Comparison of 1995 with 1994 Total Revenue: Total revenue was $7,219,000 in 1995, an increase of 23 percent from $5,874,000 in 1994. The increase was principally due to a substantial increase in commercial revenue offset, in part, by a decline in government revenue. Commercial sales increased 33 percent to $6,205,000 in 1995 from $4,669,000 in 1994. Commercial sales as a percentage of total revenue was 86 percent in 1995 versus 79 percent in 1994. The increase in commercial sales was attributed to increased business with existing customers as well as sales, generally small initially, to several new customers. The decline in government revenue resulted from a discontinuation of US Government purchases of keys for the secure telephone program. Gross margins: The gross profit margin on net sales increased to 33 percent in 1995 from 29 percent in 1994. This increase in gross profit percentage was achieved primarily by improvements in manufacturing productivity and the increase in revenue over which the fixed factory overhead is absorbed. Research and development: Research and development expenses decreased 9 percent to $704,000 from $771,000 in 1994 and also decreased as a percentage of revenue to 10 percent in 1995 from 13 percent in 1994. The decrease in 1995 was primarily related to a reduction in travel and project supplies expense. Marketing and sales, General and administrative: Marketing and sales expense increased 16 percent to $1,124,000 in 1995 from $971,000 in 1994. The 1995 increase was principally due to commissions payable on the higher level of revenue and an increase in travel and promotional expenses. Marketing and sales expense declined as a percentage of revenue to 15 percent in 1995 from 17 percent in 1994. General and administrative expenses increased 14 percent to $670,000 in 1995 from $590,000 in 1994. This increase was related to increased data processing support costs for a more complex computer system as well as general increases in a variety of administrative costs necessary to support the growth in the Company. General and administrative expenses as a percentage of revenue declined to 9 percent in 1995 from 10 percent in 1994. Interest income: Interest income increased 34 percent to $381,000 in 1995 from $285,000 in 1994. The increase was due to an increased market interest rate for the Company's interest bearing investments as well as an increase in the average balance of these investments. Liquidity and Capital Resources The Company's operating activities used $489,000 of cash in 1996 and provided $938,000 of cash in 1995. The Company had a reduction of $834,000 in cash and held-to-maturity marketable debt securities in 1996 compared to an increase of $601,000 in 1995. The 1996 reduction in cash and marketable debt securities was primarily the result of a significant increase, totaling $1,747,000, in research and development and marketing expenses which was principally related to the Company's new product development activities. Trade receivables as of December 31, 1996, were $635,000 compared to $1,055,000 as of December 31, 1995. The reduction in trade receivables is due to a lower level of shipments in the fourth quarter of 1996 as compared to the fourth quarter of 1995. Inventory decreased $94,000 to $1,129,000 as of December 31, 1996, compared to $1,223,000 as of December 31, 1995. The lower 1996 inventory level reflects a reduction in the expected level of revenue during the fourth quarter of 1996 as well as improvements in inventory management. Accrued compensation expense increased by $349,000 primarily due to the accrual of severance pay and benefits due the Company's former chief executive officer. The Company invested $515,000 in the purchase of equipment and maintenance of licenses and patents in 1996 compared to $318,000 in 1995. The 1996 increase is primarily attributable to prepaid license fees related to licensed client and server software that will be bundled with the Company's information security systems. Cash, cash equivalents, and investment in held-to-maturity marketable debt securities as of December 31, 1996, were $6,133,000 as compared to $6,967,000 as of December 31, 1995. Datakey's balance continues to reflect a strong financial position with $6,737,000 in working capital and a current assets to current liabilities ratio of 6.6 to 1 as of December 31, 1996. Outlook The statements in this outlook section are based upon current expectations. These statements are forward looking and actual results may differ materially due to the risks, issues and uncertainties set forth below. Revenue: Customer requested shipment delays experienced in the fourth quarter of 1996 are, based upon customer communications to us, expected to continue through the first one or two quarters of 1997 and will result in a reduction in OEM products revenue for the year as compared to 1996. New end-user products being developed for the information security marketplace are planned for sales introduction by mid-1997 and, based upon current expectations, are expected to result in material revenue during the second half of 1997. As with any new product line, revenue will depend on customer acceptance, the extent of which is difficult to assess at this time. If this revenue meets the Company's present expectations the total revenue in 1997 will exceed the 1996 level. Gross margins: A gradual improvement in gross profit margins during 1997 is expected through selective price increases, effective material purchasing and improvements in manufacturing efficiency. Research and development: The Company will continue to fund new product development activities at a higher level in 1997 than in 1996, and may also exceed the 1996 percentage of revenue unless revenue from these new products in the second half of 1997 is substantial. Marketing and sales, General and administrative: Marketing and sales expenses are expected to increase by 30 to 40 percent in 1997 to support new product introductions and the expected increase in revenue, but will be about the same percent of revenue as in 1996 provided the revenue from new product sales materializes as expected. General and administrative expenses in 1997 are expected to increase only slightly from the 1996 level, exclusive of the 1996 severance pay accrual. Interest income: Interest income is expected to decline in 1997 as the pany intends to use the proceeds from maturing investments to fund continuing product development and marketing activities to support the Company's planned introduction of advanced information security products. Income tax benefit: The Company has recorded an income tax benefit and a corresponding deferred tax asset of $325,000 as of December 31, 1996 related to the estimated future tax benefit of the Company's net operating loss carryforward. Management believes it is more likely than not that the Company will realize income in the future from its existing OEM products business, as well as income from its new advanced information security products business that will allow the Company to utilize a portion of the net operating loss carryforward to reduce future taxable income. However, the net deferred tax asset could be increased or reduced in the future if management's estimates of taxable income during the carryforward period change. Expected loss: For the reasons explained above the Company expects to report a loss in 1997. Although the Company expects to have new end-user products available for sale in the second half of 1997, the marketability of these products will not be known until at least late 1997. The extent of the Company's loss will depend directly on product availability and market acceptance. Liquidity and capital resources: The Company plans to continue new product development and marketing activities during 1997 and expects to spend $4.5 to $5 million on these activities. Inventory levels are expected to increase in 1997 to support advanced information security products that are planned to be available for sale in the second half of the year. 1997 investments in equipment and maintenance of licenses and patents in 1997 are expected to be about 2 to 3 times the 1996 level of $515,000 primarily related to prepaid license fees for client and server software to be bundled with the Company's information security products. This spending will be funded by a reduction in the Company's marketable debt securities. The Company's working capital and investments are sufficient to fund its planned operations and continued development and promotional activities in 1997. Issues and Uncertainties: While management is optimistic about the companies long-term prospects, the following issues and uncertainties, as well as those discussed in the outlook section, should be considered in evaluating its growth outlook. Rapid technological change. Datakey's information security end-user products such as SignaSURE EDMTM and SignaSURE ESSTM will integrate hardware tokens with software that provide a much higher level of security than software implementations alone. There is a possibility that software-only solutions may overcome this deficiency in the future. Customer Acceptance. While Datakey performs market research and beta testing to determine the viability of its new products, actual user acceptance will ultimately dictate the success of the marketing and sales efforts of new products such as SignaSURE EDM and ESS. Although the company believes that the decision to fund these new products is correct, there are no assurances that the investments already made and additional investments planned for 1997 will result in a financial return. Product delivery schedules. Delays in the release of new products will cause operational inefficiencies, increased development costs and reduced revenues. Price competition. While Datakey believes that its strategy of providing token-based product solutions at a price that is competitive with software-only products is attainable, there are no assurances that competitive pressures will not force the company to accept reduced margins to compete in the future. Large companies have recognized the need for information security and could enter this market as competitors with much greater financial resources. A portion of the new end-user products' cost is royalties and license fees which would need to be re-negotiated in order to maintain acceptable profit margins. Integrated information security products. Although the Company's new products will operate seamlessly with popular application programs, new application programs that integrate information security into their product could erode the future market for these Datakey products. Marketing and sales. The future revenue of Datakey end-user systems is dependent on the success of a new and untested marketing and direct sales organization. Need for information security. Although corporate utilization of the Internet and internal intranets dictate a need for information security, there are no assurances that other, more secure information transmission media may not become available in the future that would preclude the need for the type of information security provided by the Company's products. INDEPENDENT AUDITOR'S REPORT To the Stockholders Datakey, Inc. We have audited the accompanying consolidated balance sheets of Datakey, Inc. and Subsidiary as of December 31, 1996 and 1995, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Datakey, Inc. and Subsidiary as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. McGLADREY & PULLEN, LLP /s/ McGladrey & Pullen, LLP Minneapolis, Minnesota February 5, 1997 DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, 1996 and 1995 ASSETS 1996 1995 - -------------------------------------------------------------------------------------------------------------------- Current Assets Cash and cash equivalents $ 140,030 $ 713,230 Investment in held-to-maturity securities (Note 2) 5,993,228 6,253,984 Trade receivables, less allowance for doubtful accounts of $45,000 in 1996 and $34,300 in 1995 (Note 7) 634,538 1,055,075 Inventories (Note 3) 1,128,907 1,222,938 Deferred taxes (Note 4) - 109,000 Prepaid expenses and other 46,962 52,177 Refundable income taxes - 46,642 ------------------------------------- Total current assets 7,943,665 9,453,046 ------------------------------------- Other Assets Deferred taxes (Note 4) 325,000 - Licenses and patents, less amortization--1996 $105,531; 1995 $118,702 (Note 8) 228,986 158,264 Noncompete agreement, less amortization--1995 $123,750 - 41,250 ------------------------------------- 553,986 199,514 ------------------------------------- Equipment and Leasehold Improvements, at cost Production tooling 1,179,021 1,109,524 Equipment 2,561,659 2,358,938 Furniture and fixtures 267,482 211,822 Leasehold improvements 234,452 211,761 ------------------------------------- 4,242,614 3,892,045 Less accumulated depreciation 2,840,909 2,366,660 ------------------------------------- 1,401,705 1,525,385 ------------------------------------- $ 9,899,356 $ 11,177,945 =====================================
See Notes to Consolidated Financial Statements. LIABILITIES AND STOCKHOLDERS' EQUITY 1996 1995 - -------------------------------------------------------------------------------------------------------------------- Current Liabilities Accounts payable $ 559,280 $ 509,683 Accrued expenses: Compensation (Note 9) 538,664 189,980 Other 108,885 108,692 ------------------------------------- Total current liabilities 1,206,829 808,355 ------------------------------------- Deferred Taxes (Note 4) - 158,000 ------------------------------------- Commitments (Notes 5 and 8) Stockholders' Equity (Notes 5 and 6) Convertible preferred stock, voting, stated value $2.50 per share; authorized 400,000 shares; issued and outstanding 150,000 shares 375,000 375,000 Common stock, par value $0.05 per share; authorized 10,000,000 shares; issued and outstanding 2,882,069 shares in 1996 and 2,835,236 shares in 1995 144,103 141,762 Additional paid-in capital 4,070,815 3,885,887 Retained earnings 4,102,609 5,808,941 ------------------------------------- 8,692,527 10,211,590 ------------------------------------- $ 9,899,356 $ 11,177,945 =====================================
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1996, 1995, and 1994 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------- Net sales (Note 7) $ 6,558,025 $ 7,219,308 $ 5,873,508 --------------------------------------------------------- Costs and expenses: Cost of goods sold 4,282,062 4,821,516 4,111,131 Research and development 2,262,920 703,816 771,230 Marketing and sales 1,311,663 1,123,781 970,782 General and administrative 1,156,270 669,954 590,078 --------------------------------------------------------- Total costs and expenses 9,012,915 7,319,067 6,443,221 --------------------------------------------------------- Operating loss (2,454,890) (99,759) (569,713) Interest income 360,558 381,385 284,693 --------------------------------------------------------- Income (loss) before income taxes (2,094,332) 281,626 (285,020) Income tax expense (benefit) (Note 4) (388,000) 106,000 (112,000) --------------------------------------------------------- Net income (loss) $ (1,706,332) $ 175,626 $ (173,020) ========================================================= Net income (loss) per common share $ (.60) $ .06 $ (.06) Weighted average number of common shares and common equivalent shares outstanding 2,861,498 3,006,352 2,829,236
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1996, 1995, and 1994
Convertible Preferred Stock Common Stock ------------------------------------------------------ Shares Amount Shares Amount - -------------------------------------------------------------------------------------------------- Balance, December 31, 1993 150,500 $ 376,250 2,829,070 $ 141,454 Conversion of preferred stock (500) (1,250) 500 25 Net loss - - - - ---------------------------- --------------------------- Balance, December 31, 1994 150,000 375,000 2,829,570 141,479 Issuance of common stock under stock options (Note 6) - - 5,666 283 Net income - - - - ---------------------------- --------------------------- Balance, December 31, 1995 150,000 375,000 2,835,236 141,762 Issuance of common stock under stock options (Note 6) - - 46,833 2,341 Net loss - - - - ---------------------------- --------------------------- Balance, December 31, 1996 150,000 $ 375,000 2,882,069 $ 144,103 ============================ ===========================
See Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (continued)
Additional Paid-In Retained Capital Earnings Total - ------------------------------------------------------------------------------------------ Balance, December 31, 1993 $3,864,406 $ 5,806,335 $ 10,188,445 Conversion of preferred stock 1,225 - - Net loss - (173,020) (173,020) -------------------------------------------------- Balance, December 31, 1994 3,865,631 5,633,315 10,015,425 Issuance of common stock under stock options (Note 6) 20,256 - 20,539 Net income - 175,626 175,626 -------------------------------------------------- Balance, December 31, 1995 3,885,887 5,808,941 10,211,590 Issuance of common stock under stock options (Note 6) 184,928 - 187,269 Net loss - (1,706,332) (1,706,332) -------------------------------------------------- Balance, December 31, 1996 $4,070,815 $ 4,102,609 $ 8,692,527 ==================================================
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1996, 1995, and 1994 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------- Cash Flows From Operating Activities Net income (loss) $ (1,706,332) $ 175,626 $ (173,020) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 475,475 461,378 402,394 Amortization 134,041 133,253 82,549 Change in accrued interest on investment securities 16,962 (44,399) (96,689) Deferred taxes (374,000) 114,000 18,500 Changes in assets and liabilities: Trade receivables 420,537 135,818 133,964 Inventories 94,031 126,047 (639,068) Accounts payable 49,597 (249,193) 63,488 Other 400,734 85,049 (107,972) --------------------------------------------------------- Net cash provided by (used in) operating activities (488,955) 937,579 (315,854) --------------------------------------------------------- Cash Flows From Investing Activities Purchase of equipment (351,795) (262,892) (574,752) Purchase of held-to-maturity securities (5,829,941) (6,073,735) (8,313,568) Proceeds from maturity of held-to-maturity securities 6,073,735 5,974,726 6,806,795 License and patent costs (163,513) (55,526) (92,882) --------------------------------------------------------- Net cash provided by (used in) investing activities (271,514) (417,427) (2,174,407) --------------------------------------------------------- (Continued)
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years Ended December 31, 1996, 1995, and 1994 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------- Cash Flows From Financing Activities Net proceeds from issuance of common stock 187,269 20,539 - Payments on non-compete obligation - (82,500) (82,500) --------------------------------------------------------- Net cash provided by (used in) financing activities 187,269 (61,961) (82,500) --------------------------------------------------------- Increase (decrease) in cash and cash equivalents (573,200) 458,191 (2,572,761) Cash and Cash Equivalents Beginning 713,230 255,039 2,827,800 --------------------------------------------------------- Ending $ 140,030 $ 713,230 $ 255,039 ========================================================= Supplemental Disclosures of Cash Flow Information Net cash refunds of income taxes $ 75,112 $ 63,038 $ 136,603 ========================================================= Supplementary Schedule of Noncash Investing and Financing Activities Obligation recorded under non-compete agreement $ - $ - $ 165,000 =========================================================
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Business and Significant Accounting Policies Nature of business: Datakey, Inc. is an international supplier of electronic products and services. The Company designs, manufactures, and markets products, subsystems, and systems solutions to record, store, and transmit electronic information. The Company is developing products and systems directed to the information security market which will enable user identification and authentication, secure data exchange, and information validation. The Company also provides OEM products, consisting of proprietary memory keys, cards, and other custom-shaped tokens, that serve as a convenient way to carry electronic information and are packaged to survive in portable environments. The Company's practice is to grant credit on an unsecured basis to customers who meet certain financial criteria. A summary of significant accounting policies follows: Principles of consolidation: The consolidated financial statements include the accounts of Datakey, Inc. and its wholly-owned subsidiary. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and cash equivalents: For purposes of reporting the statements of cash flows, the Company includes all cash accounts and all highly liquid debt instruments purchased with an original maturity of three months or less as cash and cash equivalents on the accompanying consolidated balance sheets. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. Investment in debt securities: The Company has investments in debt securities consisting of obligations of the U. S. government with maturities of 12 months or less. Since the Company intends to hold the debt securities to their maturities, the investment in debt securities has been classified as held-to-maturity and is recorded at amortized cost. Fair value of financial instruments: The Company's financial instruments consist of cash and cash equivalents, marketable securities, and short-term trade receivables and payables for which current carrying amounts approximate fair market value. Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market. Note 1. Nature of Business and Significant Accounting Policies (Continued) Depreciation: Depreciation of equipment and leasehold improvements is computed on the straight-line and accelerated methods over the following estimated useful lives: Years - ------------------------------------------------------------------------------- Production tooling 2-5 Equipment 5-7 Furniture and fixtures 7 Leasehold improvements Life of lease Warranty costs: The Company provides for estimated normal warranty costs at the time of product sales to the customers and for other costs associated with specific items at the time their existence and amounts are determinable. Income taxes: Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss or tax credit carryforwards, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the amounts of assets and liabilities recorded for income tax and financial reporting purposes. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Licenses and patents: Licenses and patents are stated at cost and are being amortized using the straight-line method over their economic useful lives which has been estimated to be five years. The cost of the license agreement discussed in Note 8 will be amortized to cost of goods sold as the products incorporating the licensed units are sold. Noncompete agreement: During 1994, the Company's former president entered into a noncompete agreement with the Company payable over a one-year period. The agreement not to compete was for a period of two years and was amortized over that term using the straight-line method. Revenue recognition: The Company records sales revenue upon shipment to the customer. Research and development: Research and development costs are charged to expense as incurred. Net income (loss) per common share: In 1995, net income per common share and common equivalent share was based on the weighted-average number of common shares outstanding during the year, adjusted for the conversion of the preferred shares into common shares, and the use of the treasury stock method to include the effect of the exercise of all stock options having exercise prices less than the average market price of common stock. In 1996 and 1994, the net loss per common share was based on the weighted-average number of common shares outstanding. There was no material difference between primary and fully diluted net income per share in 1995. Note 2. Investment in Held-to-Maturity Securities The following is a summary of the Company's investment in held-to-maturity securities as of December 31, 1996 and 1995:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value - ------------------------------------------ --------------- --------------- --------------- --------------- U. S. government securities: 1996 $5,993,228 $ 465 $ 6,445 $5,987,248 1995 6,253,984 8,713 743 6,261,954
All securities are due within one year and all investment earnings represent interest income on the above securities and previously held debt securities. Note 3. Inventories Inventories consist of the following components as of December 31, 1996 and 1995: 1996 1995 - --------------------------------- -------------- ------------------ Raw materials $ 754,629 $ 822,035 Work in process 87,453 127,567 Finished goods 286,825 273,336 ------------ ------------ $ 1,128,907 $ 1,222,938 ============ ============ Note 4. Income Taxes The income tax expense (benefit), consists of the following: 1996 1995 1994 - ------------------------------------- ------------- ----------- ----------- Currently payable (refundable): Federal $ (15,000) $ (9,000) $(131,500) State 1,000 1,000 1,000 Deferred (374,000) 114,000 18,500 ------------- ----------- ----------- $ (388,000) $ 106,000 $(112,000) ============= =========== =========== Note 4. Income Taxes (Continued) The income tax expense (benefit) is different from that which would be computed by applying the U. S. federal income tax rate (35 percent) to pretax income (loss) as follows:
1996 1995 1994 - ------------------------------------------------- ---------- ---------- ----------- Computed "expected" federal tax expense (benefit) at statutory rates $ (733,000) $ 99,000 $ (100,000) Effect of graduated tax rates 21,000 (3,000) 3,000 Effect of net operating loss carryforward, with no current benefit 338,000 - - State income taxes, net of federal benefit 1,000 1,000 1,000 Nontaxable municipal bond interest income - - (11,000) Other (15,000) 9,000 (5,000) ----------- ---------- ----------- Actual tax expense (benefit) $ (388,000) $ 106,000 $ (112,000) ----------- ---------- -----------
Net deferred tax assets (liabilities) consist of the following components as of December 31, 1996 and 1995: 1996 1995 -------- -------- Deferred tax assets: Allowance for doubtful accounts $ 16,000 $ 12,000 Inventory 86,000 59,000 Warranty reserve 18,000 13,000 Compensation and benefits 134,000 13,000 Net operating loss carryforward 698,000 - Other - 12,000 -------- -------- Total gross deferred tax assets 952,000 109,000 Valuation allowance (455,000) - -------- -------- Net deferred tax assets 497,000 109,000 Deferred tax liability: Depreciation (172,000) (158,000) -------- -------- Net deferred tax asset (liability) $ 325,000 $ (49,000) ======== ======== Realization of deferred tax assets associated with the net operating loss carryforward is dependent upon the generation of sufficient future taxable income prior to the expiration of the loss carryforwards. Management has established a valuation allowance against a portion of the deferred tax asset in recognition of the risk that part of the loss carryforward may not be realized. Although realization is not assured for the remaining deferred tax assets, management believes it is more likely than not that they will be realized through future taxable income. However, the net deferred tax asset could be increased or reduced in the future if management's estimates of taxable income during the carryforward period change. Note 4. Income Taxes (Continued) At December 31, 1996, the Company's net operating loss is approximately $1,850,000 and expires in the year 2011. Note 5. Preferred Stock The preferred shares are convertible at the rate of one share of common stock for each share of preferred stock, subject to certain antidilution adjustments. Conversion is mandatory in the event of certain future public offerings of corporate stock. The holders of the preferred stock have certain piggyback and demand registration rights, have a liquidation preference of $2.50 per share, and share in dividends paid on common stock. Note 6. Stock Options The Company has reserved 800,000 common shares for issuance under qualified and nonqualified stock options for its key employees and directors. The Company has also reserved 50,000 common shares for issuance under nonqualified options to various distributors, dealers, and consultants. Option prices are the fair market value of the stock at the time the option was granted. Options become exercisable as determined at the date of grant by a committee of the Board of Directors. Options expire ten years after the date of grant unless an earlier expiration date is set at the time of grant. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. Accordingly, no compensation cost has been recognized for the stock option plans. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards in 1996 and 1995 consistent with the provisions of SFAS No. 123, the Company's net income (loss) and net income (loss) per share would have changed to the pro forma amounts indicated below: 1996 1995 - ----------------------------------------------- ------------- --------------- Net income (loss), as reported $ (1,706,332) $ 175,626 Net income (loss), pro forma (1,844,604) 112,348 Net income (loss), per share, as reported (0.60) .06 Net income (loss), per share, pro forma (0.64) .04 The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1996 and 1995: 1996 1995 - ----------------------------------------------- -------------- -------------- Expected dividend yield - - Expected stock price volatility 48.39% 32.76% Risk-free interest rate 5.87% 6.71% Expected life of options 3 years 3 years Note 6. Stock Options (Continued) The pro forma effect on net loss or net income in 1996 and 1995 is not representative of the pro forma effect in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995. Additional information relating to all outstanding options as of December 31, 1996, 1995, and 1994 is as follows:
1996 1995 1994 ------------------------ ----------------------- ----------- Weighted- Weighted- Average Average Exercise Exercise Shares Price Shares Price Shares - ---------------------------- ----------- ---------- ------------- ---------- ----------- Options outstanding at beginning of year 452,334 $ 4.16 179,000 $ 5.17 304,000 Options exercised (46,833) 4.00 (5,666) 3.63 - Options expired (27,334) 3.73 (33,000) 4.66 (145,000) Options granted 139,000 4.80 312,000 3.62 20,000 -------- --------- --------- --------- ----------- Options outstanding at end of year 517,167 $ 4.37 452,334 $ 4.16 179,000 ======== ========= ========= ========= =========== Weighted-average fair value of options, granted during the year $ 1.29 $ 1.15
The following table summarizes information about stock options outstanding at December 31, 1996:
Options Outstanding Options Exercisable ---------------------------- --------------------------- Weighted- Average Number Remaining Weighted- Number Weighted- Range of Outstanding Contractual Average Exercisable Average Exercise at Life Exercise at Exercise Prices December 31, (Years) Price December 31, Price 1996 1996 - -------------- ------------- -------------- -------------- ------------- ------------- ------------- $3.00 - $4.44 322,167 8.8 $ 3.62 156,337 $ 3.58 $5.00 - $5.75 180,000 6.8 5.45 90,000 5.63 $7.25 - $8.00 15,000 10.0 7.50 12,500 7.40 - -------------- ---------- ------------- ------------ -------- --------- $3.00 - $8.00 517,167 8.2 $ 4.37 258,837 $ 4.48 - -------------- ========== ============= ============ ======== =========
Note 7. Major Customers and International Sales Major customers: Net sales for 1996, 1995, and 1994 include sales to the following major customers.
Amount of Net Sales Trade Receivables Balance ------------------------------------- ------------------------ 1996 1995 1994 1996 1995 - ------------------------------ ---------- ----------- ----------- ---------- ---------- U.S. government agencies $ 889,000 $ 993,000 $ 1,146,000 $ 103,000 $ 192,000 Customer A 1,161,000 2,158,000 781,000 104,000 94,000 Customer B 376,000 563,000 627,000 - - Customer C 471,000 530,000 603,000 14,000 98,000 ---------- ----------- ----------- ---------- ---------- $ 2,897,000 $ 4,244,000 $ 3,157,000 $ 221,000 $ 384,000 ========== =========== =========== ========== ==========
International sales: Export sales to international customers for 1996, 1995, and 1994 were $1,906,000, $1,907,000, and $1,716,000, respectively. Note 8. Commitments Lease: The Company leases its office and warehouse facilities under a noncancelable operating lease which expires June 1999. Total rent expense for 1996, 1995, and 1994 was $97,000. Minimum annual cash commitments under this lease are approximately $124,000, $131,000, and $67,000 for 1997, 1998, and 1999, respectively. License agreement: As of December 31, 1996, the Company had paid $110,000 as the first payment for a license agreement for the use of certain products. Upon the successful delivery of a beta version of the product by April 1997, the Company will be required to make additional nonrefundable quarterly payments totaling $768,000 through October 1998. Note 9. Fourth Quarter 1996 Operating Results The Company recorded a pretax loss of $1,356,000 in the 1996 fourth quarter compared to pretax losses totaling $738,000 in the first three quarters of 1996. The fourth quarter 1996 loss is due in part to lower than expected revenues which were primarily due to reduced sales to the Company's OEM customers. The Company also continued to increase its level of spending on research and development and marketing for its new information security products and systems. Fourth quarter expenditures for research and development and marketing totaled $1,213,000 compared to $2,361,000 for the first three quarters of 1996. In addition, the Company accrued a $332,000 charge in the fourth quarter of 1996 relating to severance costs to be paid to the Company's former president and chief executive officer who resigned in December 1996. EX-23.1 9 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement on Forms S-8 No.33-14144, No. 33-47068, No. 33-67280, No. 333-11405, and No. 33-80894 of our report dated February 5, 1997, with respect to the financial statements of Datakey, Inc., which appear in Item 7 of the annual report on Form 10-KSB for the year ended December 31, 1996. /s/ McGladrey & Pullen, LLP McGLADREY & PULLEN, LLP Minneapolis, Minnesota March 28, 1997 EX-27 10 ARTICLE 5 FDS FOR YEAR ENDED 12/31/96
5 1 U. S. Dollars YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 1 140,030 5,993,228 679,538 45,000 1,128,907 7,943,665 4,242,614 2,840,909 9,899,356 1,206,829 0 0 375,000 144,103 8,173,424 9,899,356 6,558,025 6,558,025 4,282,062 4,282,062 4,730,853 0 0 (2,094,332) (388,000) (1,706,332) 0 0 0 (1,706,332) (.60) (.60)
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