-----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, SrLhdZGygx/QSE/NDpeSTWq+Z7gk44C29nPAHKUFh3uoe+oC5uN6bPi7bMTfe51T dufsbjEzKqMqby+3sjAk/w== 0000914190-98-000126.txt : 19980327 0000914190-98-000126.hdr.sgml : 19980327 ACCESSION NUMBER: 0000914190-98-000126 CONFORMED SUBMISSION TYPE: 10KSB40 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980326 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: SEC FILE NUMBER: 000-11447 FILM NUMBER: 98573911 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 FISCAL YEAR ENDING 12/31/97 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, 1997 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: $5,977,464. The aggregate market value of the voting stock (Common Stock) held by non-affiliates was approximately $6,529,018 based upon the closing sale price of the Issuer's Common Stock on March 13, 1998. As of March 13, 1998, 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, 1997 (the "1997 Annual Report"). Portions of the Company's definitive Proxy Statement for its Annual Meeting of Shareholders to be held on June 2, 1998 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 also manufactures and sells 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 16,384,000 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 additional end-user systems that are designed to provide advanced information security utilizing digital signatures and encryption. These systems 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 Electronic 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 or updated. The storage capacities of the Company's portable memory devices range from 1,024 bits (150 alphanumeric characters) to 16,384,000 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. Integrated System Solutions For the past two years, Datakey has been developing new products that provide advanced security solutions to the problems of organizations, worldwide. The first release of these token-based information security systems was introduced in September 1997 and additional versions are expected to be introduced in the first half of 1998. The launch and success of such products is dependent on further successful development efforts and market acceptance, along with other risks. See "Forward Looking Statements." SignaSURE CIP. 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 (Cryptographic Interface Provider) is designed to solve this problem, allowing the Internet to be used safely for electronic commerce. SignaSURE CIP allows 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 and for applications that incorporate Microsoft's CryptoAPI. These products offer "load, plug and play" convenience for strong information security. SignaSURE CIP 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 companion reader/writer that plugs into a computer's serial port, PCMCIA port or floppy disk drive, and software which is loaded into the workstation and interfaces to the application program. The Company introduced, in September 1997, a version of SignaSURE CIP that utilizes the standard PKCS #11 (Cryptoki) Interface and plans to release in early 1998 a version that utilizes Microsoft's CryptoAPI. 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 designed 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 user-developers who utilize SignaSURE DTK to integrate just what is needed for their application. The Company began selling 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 CAD-created 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 operating systems, is compatible with all CAD programs and file formats, and moves design and drafting to a paperless environment. A new SignaSURE version of EDM with a more "windows like" look and feel is scheduled for release in the second quarter of 1998. 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 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 non-repudiation. 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 quarter of 1998. 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 - ----------- --------------------------- ----------- ---------- ----------- ---------- -------------
Year 2000 The Company's products are designed on an operating system which uses four digits in designating the year. As a result, these products can distinguish the year 2000 from the year 1900; therefore, the year 2000 will not cause problems. Research and Development During 1997, 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 information security products, which were initially 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. The initial development effort for the Company's information security products was completed in 1997 but the Company must continue to improve its present information security products in order to remain competitive. In 1997, 1996 and 1995, research and development expenses were $3,186,000, $2,263,000 and $704,000, respectively. The Company expects that research and development expenses in 1998 will be about 45% less than in 1997. 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 purchased microprocessors for its advanced information security products (the SignaSURE line of products) from a single supplier in 1997. This supplier also provided a proprietary card and key (token) operating system which will be discontinued after the current supply of microprocessors is depleted. The Company has also developed its own proprietary card operating system which is "masked" into a new microprocessor. The new microprocessor is being purchased from a different single supplier, will be placed into smart cards and smart keys and introduced to the marketplace when the current supply of microprocessors is depleted. Due to the unique nature of these cryptographic microprocessors, there are currently a limited number of alternative sources of supply and, due to different operating systems and other characteristics, one supplier's microprocessors are not easily interchanged with another. Should the newly arranged source of supply become inadequate or inferior to other offerings in the future, the Company will be required to incur a significant cost and possibly experience a gap in supply to switch to a new supplier. 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 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 electronic 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, sales to OEM customers increased 23% to $7,219,000, in 1996 they decreased 9% to $6,559,000, and in 1997 they decreased 11% to $5,868,000. The Company believes that commercial OEM sales may decrease again in 1998. New end-user products being developed for the information security marketplace were introduced in 1997 and, based upon current expectations, are expected to result in material revenue during the second half of 1998. As with any new product line, revenue will depend on customer acceptance, the extent of which is difficult to assess at this time. Market of OEM Products. To date, most applications in the commercial and government 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 1997, 1996 and 1995, OEM sales to domestic customers, and the corresponding percentage of total revenue, were approximately $4,068,000 (68%), $4,653,000 (71%) and $5,312,000 (74%), 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 1997, 1996 and 1995, OEM sales to international customers, and the corresponding percentage of total revenue, were approximately $1,800,000 (30%), $1,906,000 (29%) and $1,907,000 (26%), 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 "Risks and Uncertainties" in the Management's Discussion and Analysis contained in the Company's 1997 Annual Report, portions of which are included in Exhibit 13.1 of this Report. Backlog As of March 9, 1998, the Company had an order backlog, totaling approximately $3,047,000, including approximately $404,000 with scheduled shipment dates in 1999, compared to $4,127,000 a year ago, $1,187,000 of which were scheduled for shipment in 1998. 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 Electronic Products. The Company's primary competition for its electronic products sold to OEMs 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. 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 updated, 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. Integrated System Solutions. Datakey currently offers token-based (smart card, smart key) information security systems which are primarily utilized in encryption for electronic mail privacy, private and secure file transfer 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 continuing a significant product development effort to expand the applications and ease-of-use of its products and systems. See "Products--Integrated System Solutions." 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, company intranets and on 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, some of which are released and some of which are 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. The initial reception to the Company's products in the marketplace, beginning in late 1997, has been encouraging and sales of evaluation units and units for pilot programs have been progressing very well. There are no assurances, however, that the existing and future products will, in the long term, be accepted in the marketplace. 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 55 full-time employees, 14 of whom are involved in manufacturing, 5 in materials handling, 3 in quality assurance, 14 in engineering, 11 in marketing/sales and 8 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. Forward Looking Statements Certain statements made in this Form 10-KSB, which are summarized here, are forward-looking statements that involve risk and uncertainties, and actual results may be materially different. Factors that could cause actual results to differ include, but are not limited to those identified: - -- The expectation that Datakey in the first half of 1998 will introduce additional versions of its token-based information security systems, a new version of SignaSURE CIP, and a new version of SignaSURE EDM is subject to the risk of unanticipated problems or delays in development and depends upon market acceptance and demand, as well as other general market conditions and competitive conditions within this market, including the introduction of products by competitors. - -- The expectation that Datakey will begin to sell SignaSURE ESS in the second quarter of 1998 depends upon successful development efforts and meeting the currently scheduled timetable for such development. - -- The expectation that the Company will continue to improve its manufacturing processes, leading to more efficient production, depends on the Company's ability to monitor such processes and to add capital equipment to its manufacturing operations. - -- The expectation that the Company will expand sales in international markets depends on the acceptance of its products in such markets, the quality and performance of the Company's products as compared to competitive products, the effectiveness of relatively new marketing and sales personnel, and other general market and competitive conditions within such markets. 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, and the balance for present and future office space. All of this space is rented under a lease which extends through June 1999. The Company also utilizes approximately 2,400 square feet in a nearby office under a sublease that expires in May 1999. The annual rent expense for the space currently occupied is $156,000, 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 1997. 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 1997 and 1996. On March 13, 1998, the Company had approximately 1,100 shareholders, including approximately 800 beneficial owners. The Company has never paid dividends and does not plan to in the foreseeable future. Sale Prices High Low 1997 1st Quarter................................. $4 7/8 $2 1/4 2nd Quarter................................. $4 7/8 $1 7/8 3rd Quarter................................. $4 1/4 $3 4th Quarter................................. $4 1/4 $3 1/8 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 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 1997 Annual Report, a portion of which is included herewith in Exhibit 13.1 to this Report. ITEM 7. FINANCIAL STATEMENTS The following financial statements of the Company are included immediately following the signature page of this Report on the pages indicated: Page Independent Auditor's Report F-1 Consolidated Balance Sheets as of December 31, 1997 and 1996 F-2 Consolidated Statements of Operations for Years Ended December 31, 1997, 1996 and 1995 F-4 Consolidated Statements of Stockholders' Equity for Years Ended December 31, 1997, 1996 and 1995 F-5 Consolidated Statements of Cash Flows for Years Ended December 31, 1997, 1996 and 1995 F-7 Notes to Consolidated Financial Statements F-9 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 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 1998 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 1998 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 1998 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 1998 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 financial statements 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, 1997. 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 26, 1998 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 26, 1998 Carl P. Boecher Director (Principal Executive Officer) /s/ Alan G. Shuler Vice President and Chief March 26, 1998 Alan G. Shuler Financial Officer (Principal Financial and Accounting Officer) /s/ Thomas R. King Director and Secretary March 26, 1998 Thomas R. King /s/ Terrence W. Glarner Director March 26, 1998 Terrence W. Glarner /s/ Gary R. Holland Chairman of the Board of March 26, 1998 Gary R. Holland Directors /s/ Eugene W. Courtney Director March 26, 1998 Eugene W. Courtney /s/ John H. Underwood Director March 26, 1998 John H. Underwood INDEPENDENT AUDITOR'S REPORT To the Stockholders Datakey, Inc. Burnsville, Minnesota We have audited the accompanying consolidated balance sheets of Datakey, Inc. and Subsidiary as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /S/ McGladrey & Pullen, LLP McGLADREY & PULLEN, LLP Minneapolis, Minnesota February 3, 1998 DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996
ASSETS (Note 9) 1997 1996 ---------- ---------- Current Assets Cash and cash equivalents $1,305,392 $ 140,030 Investment in held-to-maturity securities (Note 2) -- 5,993,228 Trade receivables, less allowance for doubtful accounts of $30,000 in 1997 and $45,000 in 1996 (Note 7) 634,267 634,538 Inventories (Note 3) 1,082,737 1,128,907 Prepaid expenses and other 53,360 46,962 ---------- ---------- Total current assets 3,075,756 7,943,665 ---------- ---------- Other Assets Deferred taxes (Note 4) -- 325,000 Licenses and patents, less amortization--1997 $181,801; 1996 $105,531 (Note 8) 1,104,302 228,986 ---------- ---------- 1,104,302 553,986 ---------- ---------- Equipment and Leasehold Improvements, at cost Production tooling 1,215,012 1,179,021 Equipment 2,956,269 2,561,659 Furniture and fixtures 298,771 267,482 Leasehold improvements 281,956 234,452 ---------- ---------- 4,752,008 4,242,614 Less accumulated depreciation 3,278,760 2,840,909 ---------- ---------- 1,473,248 1,401,705 ---------- ---------- $5,653,306 $9,899,356 ========== ==========
See Notes to Consolidated Financial Statements.
LIABILITIES AND STOCKHOLDERS' EQUITY 1997 1996 ----------- ----------- Current Liabilities Accounts payable $ 184,103 $ 559,280 Accrued expenses: Compensation 410,055 538,664 Other 91,774 108,885 License obligation (Note 8) 439,000 -- ----------- ----------- Total current liabilities 1,124,932 1,206,829 ----------- ----------- Commitments and Contingencies (Notes 5, 8, and 9) 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 2,887,235 shares in 1997 and 2,882,069 shares in 1996 144,361 144,103 Additional paid-in capital 4,089,283 4,070,815 Retained earnings (deficit) (80,270) 4,102,609 ----------- ----------- 4,528,374 8,692,527 ----------- ----------- $ 5,653,306 $ 9,899,356 =========== ===========
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 Net sales (Note 7) $ 5,977,464 $ 6,558,025 $ 7,219,308 ------------ ------------ ------------ Costs and expenses: Cost of goods sold 4,389,367 4,282,062 4,821,516 Research and development 3,185,894 2,262,920 703,816 Marketing and sales 1,716,343 1,311,663 1,123,781 General and administrative 713,308 1,156,270 669,954 ------------ ------------ ------------ Total costs and expenses 10,004,912 9,012,915 7,319,067 ------------ ------------ ------------ Operating loss (4,027,448) (2,454,890) (99,759) Interest income 169,569 360,558 381,385 ------------ ------------ ------------ Income (loss) before income taxes (3,857,879) (2,094,332) 281,626 Income tax expense (benefit) (Note 4) 325,000 (388,000) 106,000 ------------ ------------ ------------ Net income (loss) $ (4,182,879) $ (1,706,332) $ 175,626 ============ ============ ============ Basic and diluted income (loss) per share $ (1.45) $ (0.60) $ 0.06 ============ ============ ============
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1997, 1996, and 1995
Additional Retained Convertible Preferred Stock Common Stock Paid-In Earnings Shares Amount Shares Amount Capital (Deficit) Total ------- --------- --------- --------- ----------- ----------- ------------ Balance, December 31, 1994 150,000 $ 375,000 2,829,570 $ 141,479 $ 3,865,631 $ 5,633,315 $ 10,015,425 Issuance of common stock under stock options (Note 6) -- -- 5,666 283 20,256 -- 20,539 Net income -- -- -- -- -- 175,626 175,626 ------- --------- --------- --------- ----------- ----------- ------------ Balance, December 31, 1995 150,000 375,000 2,835,236 141,762 3,885,887 5,808,941 10,211,590 Issuance of common stock under stock options (Note 6) -- -- 46,833 2,341 184,928 -- 187,269 Net loss -- -- -- -- -- (1,706,332) (1,706,332) ------- --------- --------- --------- ----------- ----------- ------------ Balance, December 31, 1996 150,000 375,000 2,882,069 144,103 4,070,815 4,102,609 8,692,527 Issuance of common stock under stock options (Note 6) -- -- 5,166 258 18,468 -- 18,726 Net loss -- -- -- -- -- (4,182,879) (4,182,879) ------- --------- --------- --------- ----------- ----------- ------------ Balance, December 31, 1997 150,000 $ 375,000 2,887,235 $ 144,361 $ 4,089,283 $ (80,270) $ 4,528,374 ======= ========= ========= ========= =========== =========== ============
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ----------- ----------- ----------- Cash Flows From Operating Activities Net income (loss) $(4,182,879) $(1,706,332) $ 175,626 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 515,593 475,475 461,378 Amortization 127,723 134,041 133,253 Change in accrued interest on investment securities 163,287 16,962 (44,399) Deferred taxes 325,000 (374,000) 114,000 Changes in assets and liabilities: Trade receivables 271 420,537 135,818 Inventories 46,170 94,031 126,047 Accounts payable (375,177) 49,597 (249,193) Other (152,118) 400,734 85,049 ----------- ----------- ----------- Net cash provided by (used in) operating activities (3,532,130) (488,955) 937,579 ----------- ----------- ----------- Cash Flows From Investing Activities Purchase of equipment (587,136) (351,795) (262,892) Purchase of held-to-maturity securities -- (5,829,941) (6,073,735) Proceeds from maturity of held-to-maturity securities 5,829,941 6,073,735 5,974,726 License and patent costs (234,789) (163,513) (55,526) ----------- ----------- ----------- Net cash provided by (used in) investing activities 5,008,016 (271,514) (417,427) ----------- ----------- -----------
(Continued) DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years Ended December 31, 1997, 1996, and 1995
1997 1996 1995 ----------- ----------- ----------- Cash Flows From Financing Activities Net proceeds from issuance of common stock 18,726 187,269 20,539 Payment on license obligation (329,250) -- -- Payments on noncompete obligation -- -- (82,500) ----------- ----------- ----------- Net cash provided by (used in) financing activities (310,524) 187,269 (61,961) ----------- ----------- ----------- Increase (decrease) in cash and cash equivalents 1,165,362 (573,200) 458,191 Cash and Cash Equivalents Beginning 140,030 713,230 255,039 ----------- ----------- ----------- Ending $ 1,305,392 $ 140,030 $ 713,230 =========== =========== =========== Supplemental Disclosures of Cash Flow Information Net cash refunds of income taxes $ -- $ 75,112 $ 63,038 =========== =========== =========== Supplemental Schedule of Noncash Investing and Financing Activity License obligation to licensor (Note 8) $ 768,250 $ -- $ -- =========== =========== ===========
See 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. Fair value of financial instruments: The Company's financial instruments consist of cash and cash equivalents 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. Licenses and patents: Licenses and patents are stated at cost. Patents 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 agreements are amortized to cost of goods sold as the products incorporating the licensed units are sold (Note 8). The Company periodically reviews the utilization of its licenses, patents, and long-lived assets for impairment. To date, management has determined that no impairment in the value of these assets has occurred. 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. 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. Advertising: Expenditures for advertising costs are expensed as incurred. Earnings (loss) per share: The Financial Accounting Standards Board has issued Statement No. 128, Earnings Per Share, which supersedes APB Opinion No. 15. Statement No. 128 requires the presentation of earnings per share by all entities that have common stock or potential common stock, such as options, warrants, and convertible securities, outstanding that trade in a public market. Those entities that have only common stock outstanding are required to present basic earnings per share amounts. Basic per share amounts are computed by dividing net income (loss) (the numerator) by the weighted-average number of common shares outstanding (the denominator). All other entities are required to present basic and diluted per share amounts. Diluted per share amounts assume the conversion, exercise, or issuance of all potential common stock instruments unless the effect is to reduce the loss or increase the income per common share from continuing operations. The Company initially applied Statement No. 128 for the year ended December 31, 1997, and, as required by the statement, has restated all per share information for the prior years to conform to the statement. Note 1. Nature of Business and Significant Accounting Policies (Continued) Following is information about the computation of the earnings per share data for the years ended December 31, 1997, 1996, and 1995: Numerator Denominator Net Income (Loss) Per Share Year ended December 31, 1997: Basic and diluted loss per share, loss available to common stockholders $(4,182,879) 2,886,924 $ (1.45) ============ ========= ========= Year ended December 31, 1996: Basic and diluted loss per share, loss available to common stockholders $(1,706,332) 2,861,498 $ (0.60) ============ ========= ========= Year ended December 31, 1995: Basic income per share, income available to common stockholders $ 175,626 2,829,885 $ 0.06 ========= Effect of dilutive securities: Convertible preferred stock -- 150,000 Stock options -- 65,289 ------------ --------- Dilutive income per share, income available to common stockholders plus assumed exercise of options $ 175,626 3,045,174 $ 0.06 ============ ========= ========= The Company had outstanding options to purchase 701,333 and 517,167 shares of common stock at an average price of $3.84 and $4.37 per share during the years ended December 31, 1997 and 1996, respectively. The Company also has 150,000 shares of convertible preferred stock outstanding. Those options and the preferred stock were not included in the computation of diluted loss per share in 1997 and 1996 as they would be antidilutive. Of the 452,334 options outstanding at December 31, 1995, a total of 125,000 options to purchase common stock at an average price of $5.60 per share were not included in the computation of diluted income per share because the exercise price of those options exceeded the average market price of the common shares 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: Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value U. S. government securities $5,993,228 $ 465 $ 6,445 $5,987,248 All securities matured in 1997. Note 3. Inventories Inventories consist of the following components as of December 31, 1997 and 1996: 1997 1996 ---------- ---------- Raw materials $ 766,955 $ 754,629 Work in process 63,007 87,453 Finished goods 252,775 286,825 ---------- ---------- $1,082,737 $1,128,907 ========== ========== Note 4. Income Taxes The income tax expense (benefit) consists of the following: December 31 1997 1996 1995 --------- --------- --------- Currently payable (refundable): Federal $ -- $ (15,000) $ (9,000) State -- 1,000 1,000 Deferred 325,000 (374,000) 114,000 --------- --------- --------- $ 325,000 $(388,000) $ 106,000 ========= ========= ========= 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:
December 31 1997 1996 1995 ----------- ----------- ----------- Computed "expected" federal tax expense (benefit) at statutory rates $(1,350,000) $ (733,000) $ 99,000 Effect of graduated tax rates -- 21,000 (3,000) Effect of net operating loss carryforward, with no current benefit 1,350,000 338,000 -- State income taxes, net of federal benefit -- 1,000 1,000 Change in valuation allowance 325,000 -- -- Other -- (15,000) 9,000 ----------- ----------- ----------- Actual tax expense (benefit) $ 325,000 $ (388,000) $ 106,000 =========== =========== ===========
Note 4. Income Taxes (Continued) Net deferred tax assets (liabilities) consist of the following components as of December 31, 1997 and 1996: 1997 1996 ----------- ----------- Deferred tax assets: Allowance for doubtful accounts $ 11,000 $ 16,000 Inventory 239,000 86,000 Warranty reserve 18,000 18,000 Compensation and benefits 89,000 134,000 Net operating loss carryforward 1,940,000 698,000 Research and development tax credit 68,000 -- ----------- ----------- Total gross deferred tax assets 2,365,000 952,000 Valuation allowance (2,206,000) (455,000) ----------- ----------- Net deferred tax assets 159,000 497,000 Deferred tax liability: Depreciation (159,000) (172,000) ----------- ----------- Net deferred tax asset $ -- $ 325,000 =========== =========== Realization of deferred tax assets is dependent upon the generation of sufficient future taxable income. At December 31, 1996, the Company had established a valuation allowance against a portion of the net deferred tax assets in recognition of the risk that part of the loss carryforward may not be realized. During 1997, management determined that sufficient uncertainty exists regarding the realizability of the deferred tax assets, and accordingly, the Company increased the valuation allowance to entirely reserve the net deferred tax asset of the Company. At December 31, 1997, the Company's net operating loss carryforward is approximately $5,390,000 and expires as follows: 2011 $ 1,850,000 2012 3,540,000 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 1997, 1996, and 1995 consistent with the provisions of SFAS No. 123, the Company's net income (loss) and basic and diluted income (loss) per share would have changed to the pro forma amounts indicated below: Years Ended December 31 1997 1996 1995 Net income (loss), as reported $ (4,182,879) $ (1,706,332) $ 175,626 Net income (loss), pro forma (4,391,620) (1,844,604) 112,348 Basic and diluted income (loss), per share, as reported (1.45) (0.60) 0.06 Basic and diluted income (loss), per share, pro forma (1.52) (0.64) 0.04 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 1997, 1996, and 1995: Years Ended December 31 1997 1996 1995 Expected dividend yield -- -- -- Expected stock price volatility 53.26% 48.39% 32.76% Risk-free interest rate 6.17% 5.87% 6.71% Expected life of options 3.6 years 3 years 3 years Weighted-average fair value of options granted during the year $ 1.39 $ 1.29 $ 1.15 The pro forma effect on net loss or net income in 1997, 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. Note 6. Stock Options (Continued) Additional information relating to all outstanding options as of December 31, 1997, 1996, and 1995 is as follows:
1997 1996 1995 ------------------ ------------------ ------------------- Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ------- ------- ------- ------- ------- -------- Options outstanding at beginning of year 517,167 $ 4.37 452,334 $ 4.16 179,000 $ 5.17 Options exercised (5,166) 3.62 (46,833) 4.00 (5,666) 3.63 Options expired (80,668) 4.81 (27,334) 3.73 (33,000) 4.66 Options granted 270,000 3.12 139,000 4.80 312,000 3.62 ------- ------- ------- ------- ------- -------- Options outstanding at end of year 701,333 $ 3.84 517,167 $ 4.37 452,334 $ 4.16 ======= ======= ======= ======= ======= ========
The following table summarizes information about stock options outstanding at December 31, 1997:
Options Outstanding Options Exercisable -------------------------- ---------------------------- Weighted- Average Number Remaining Weighted- Number Weighted- Range of Outstanding Contractual Average Exercisable Average Exercise at December 31, Life Exercise at December 31, Exercise Prices 1997 (Years) Price 1997 Price - ------------- --------------- ----------- --------- --------------- --------- $2.25 - $3.38 187,500 9.5 $ 2.77 35,000 $ 2.88 $3.50 - $5.00 383,833 8.5 3.69 214,333 3.65 $5.38 - $8.00 130,000 5.5 5.84 130,000 5.84 - ------------- --------------- ----------- --------- --------------- --------- $2.25 - $8.00 701,333 8.2 $ 3.84 379,333 $ 4.33 ============= =============== =========== ========= =============== =========
Note 7. Major Customers and International Sales Major customers: Net sales for 1997, 1996, and 1995 include sales to the following major customers:
Amount of Net Sales Trade Receivables Balance ------------------------------------ ----------------------- 1997 1996 1995 1997 1996 ---------- ---------- ---------- ---------- ---------- U.S. government agencies $1,198,000 $ 889,000 $ 993,000 $ 70,000 $ 103,000 Customer A 616,000 1,161,000 2,158,000 1,000 104,000 Customer B -- 376,000 563,000 -- -- Customer C 638,000 471,000 530,000 95,000 14,000 ---------- ---------- ---------- ---------- ---------- $2,452,000 $2,897,000 $4,244,000 $ 166,000 $ 221,000 ========== ========== ========== ========== ==========
International sales: Export sales to international customers for 1997, 1996, and 1995 were $1,800,000, $1,906,000, and $1,907,000, respectively. Note 8. Commitments and Contingencies License agreement: In December 1996, the Company entered into a license agreement with a software company to allow the Company to bundle the licensed products into certain of the Company's products. Under the agreement, payments to the software company for the licensed products are based upon the number of units sold and the nature of the software bundled. In addition, the Company agreed to purchase a minimum quantity of software units over a specified period of time. The value of the minimum purchase is included in the initial license agreement. At December 31, 1996, the Company had paid $109,750 as the first payment for the license agreement, with an additional $768,250 to be paid in seven quarterly installments pending the successful delivery of a beta version of the licensed product from the software company in 1997. Upon delivery of the product in 1997, the Company recorded an additional liability of $768,250 and a corresponding asset for prepaid license fees. Subsequently, the software company announced that certain of the licensed software would be available at no cost to the general public. As a result of this announcement, the Company has suspended payments, with $439,000 remaining under the original agreement, and the Company is seeking to renegotiate the agreement to reduce or eliminate the remaining liability. Upon completion of any contract amendment, the prepaid license fee and corresponding liability would be adjusted to reflect the new agreement. Leases: The Company leases its office and warehouse facilities under noncancelable operating leases which expire in May and June 1999. Minimum annual cash commitments under this lease are approximately $156,000 and $75,000 for 1998 and 1999, respectively. Total rent expense under these leases totaled $136,000 in 1997 and $97,000 in 1996 and 1995. Note 9. Subsequent Event In January 1998, the Company obtained a $1,000,000 line of credit from a bank which bears interest at 1.25 percent above the prime rate and is secured by substantially all assets of the Company. The line of credit expires in May 1998 and is subject to annual renewal. DATAKEY, INC. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-KSB For the Fiscal Year Ended December 31, 1997 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 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)* 10.2 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)* 10.3 Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.5 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.4 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) 10.5 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) 10.6 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) 10.7 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)* 10.8 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)* 10.9 Amendment dated February 11, 1997 to Consulting Agreement between Gary R. Holland and the Company dated November 1, 1995 (Incorporated by reference to Exhibit 10.18 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.10 Employment Agreement between Carl P. Boecher and the Company dated January 1, 1997 (Incorporated by reference to Exhibit 10.19 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.11 Separation Agreement and Release between John H. Underwood and the Company dated January 1, 1997 (Incorporated by reference to Exhibit 10.20 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.12 1997 Management Incentive Plan, as amended March 10, 1997 (Incorporated by reference to Exhibit 10 to Form 10-QSB for fiscal quarter ended June 28, 1997)* 10.13 Lease Amendment No. 5 dated December 17, 1996 to Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987 (Incorporated by reference to Exhibit 10.22 to Form 10-KSB for fiscal year ended December 31, 1996) 10.14 Employment Agreement between Michael L. Sorensen and the Company dated April 16, 1997* 10.15 1997 Stock Option Plan* 10.16 Forms of Incentive and Nonqualified Stock Option Agreements under 1997 Stock Option Plan* 13.1 Portions of 1997 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 Auditors' 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) * Designates a management contract or compensatory plan or arrangement. EX-10.14 2 MICHAEL SORENSEN EMPLOYMENT AGREEMENT EMPLOYMENT AGREEMENT This Employment Agreement made and entered into effective as of the 16th day of April 1997, by and between Datakey, Inc., a Minnesota corporation (the "Company" or "Datakey") and Michael L. Sorensen ("Executive"). RECITALS Michael L. Sorensen became the Vice President of Operations as of the date hereof. The Company and the Executive are desirous that the Executive serves the Company in this capacity under the following terms and conditions. AGREEMENT 1. Employment a. Datakey agrees to continue to employ Executive on a full-time basis as the Vice President of Operations of Datakey. 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 an officer 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 April 16, 1997 and terminating on April 15, 1998, unless extended as set forth in Subsection 2b below. b. This Agreement will be renewed automatically after April 15, 1998 for additional one-year periods unless either party gives the other party written notice 30 days before April 15, 1998 or 30 days before the end of any one-year period thereafter of his or its intention to terminate the Agreement. 3. Base Monthly Compensation As compensation for his services to Datakey, Executive shall be paid a monthly salary of $7,500, payable in accordance with Datakey's periodic payment periods. 4. Bonus Executive shall be eligible to participate in both the Annual Incentive Plan (AIP) and the Long-Term Incentive Plan or any other approved bonus plan. 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. b. Automobile Allowance. During the term of this Agreement, Datakey will pay Executive $400 per month to be applied toward his automobile expenses. c. Miscellaneous. During the term of this Agreement, Executive will be eligible to receive the other benefits described in the attached Exhibit A, subject to such changes as Datakey may adopt from time to time for salaried employees generally. 6. Termination a. Notwithstanding Section 2 above, the Employment Term or any extension thereof shall terminate upon the happening of any of the following events: (i) Mutual written agreement between the Board of Directors of Datakey and Executive to terminate his employment; (ii) Executive's death; (iii) Executive's disability defined as physically or mentally unable to perform as Vice President of Engineering for a period of six consecutive months; or (iv) For cause (as defined below) upon written notice from the Board of Directors specifying the nature of the cause. b. For purposes of this Agreement, "cause" shall include commission of any felony, misdemeanor, any act of fraud or dishonesty in connection with the affairs of Datakey. 7. Payment Upon Termination of Employment for Cause or Voluntary Resignation If Executive is terminated for cause or voluntarily resigns, 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 or 30 days from the date the notice of resignation is given. Executive shall be entitled to no additional compensation past the date of a notice of termination for cause or after 30 days from the notice of resignation. 8. Payment Upon Termination of Employment Without Cause a. If during the term of this Agreement Executive is terminated without cause, and without cause shall include death, disability or mutual agreement, Executive shall not be entitled to receive his agreed compensation for the balance of the term of this Agreement but shall instead receive a severance payment equal to his base monthly compensation payable for six months in accordance with Datakey's payment periods beginning on the 10th day of the first month following the last month of his employment term. b. Base compensation shall be deemed to be no less than $7,500.00 per month. c. 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. d. The Company will continue to provide medical and health coverage, under its plans as they currently exist or may hereafter be amended, at Company subsidized rates during the six-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. Payment Upon Termination of Agreement by the Company on April 15, 1998 or at the End of Any One-Year Extension a. If the Company decides to terminate the Employment Agreement on April 15, 1998 or as of the end of any one-year extension, Executive shall receive his base monthly compensation for six (6) months beginning on the 10th of the first month following the last month of the Employment Term in accordance with Datakey's payment periods. b. The payments provided for under this Section 9 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 continue to provide medical and health coverage, under its plans as they currently exist or may hereafter be amended, at Company subsidized rates during the six-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. 10. Termination of Employment or Resignation Within Six Months of a Change in Control a. If Employee's employment is terminated within six months of a Change of Control, or if Employee resigns within six months of a Change of Control because of a diminution of either position responsibilities or remuneration, notwithstanding such termination or resignation, Employee shall receive his base monthly compensation for a period of six months. The severance payments shall be made in six monthly installments beginning on the 10th day of the first month following Employee's termination or resignation in accordance with the Company's payroll periods. b. A Change in Control shall be deemed to have occurred if: (a) any person or entity becomes the beneficial owner of thirty-five percent (35%) or more of the Company's outstanding securities other than any institution, individual, individuals acting in concert, or entity owning thirty-five percent (35%) or more of the Company's outstanding securities as of the date of this Agreement; (b) the consummation of a merger or consolidation of the Company into or with any other corporation; (c) the consummation of a plan of complete liquidation of the Company; or (d) the consummation of the sale of substantially all of the Company's assets. c. The payments provided for under this Section 10 shall, in the event of Employee's death, continue and be payable to his wife if she survives or, if not, to his estate. 11. 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 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. 12. Inventions Any invention, discovery, improvement, or idea, whether patentable or copyrightable or not, and whether or not shown or described in writing or reduced to practice ("Invention") shall be promptly and fully disclosed by Executive to the Company, and the Company will hold in trust for its sole right and benefit, any Invention that Executive, during the period of employment, and for one year thereafter, make, conceive, or reduce to practice or cause to be made, conceived, or reduced to practice, either alone or in conjunction with others, that: a. Relates to any subject matter pertaining to Executive's employment with the Company; b. Relates to or is directly or indirectly connected with the Company's business, products, projects, or Confidential Information; or c. Involves the use of any time, material, or facility of the Company's. Executive hereby assigns to the Company all of his right, title, and interest in and to all such Inventions and, upon the Company's request, shall execute, verify, and deliver to the Company such documents including, without limitation, assignments and applications for Letters Patent, and shall perform such other acts, including, without limitation, appearing as a witness in any action brought in connection with this Employment Agreement that is necessary to enable the Company to obtain the sole right, title, and benefit to all such Inventions. 13. Specific Performance Executive acknowledges that a breach of this Employment Agreement would cause Datakey irreparable injury and damage which could not be remedied or 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. 14. Noncompetition a. For a period of six months from and after the end of the Employment Term or any extension thereof or after termination of employment, 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), and 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 14 anywhere in the United States. Therefore, Executive agrees that the covenants contained in this Section 14 shall apply to all portions of, and throughout, the United States. c. Executive acknowledges that if he fails to fulfill his obligations under this Section 14, the damages to Datakey would be very difficult to determine. Therefore, in addition to any other rights or remedies available to Datakey at law, in equity, or by statute, Executive hereby consents to the specific enforcement of the provisions of this Section 14 by Datakey through an injunction or restraining order issued by the appropriate court. d. To the extent any provision of this Section 14 shall be invalid or unenforceable, it shall be considered deleted herefrom and the remainder of such provision and this Section 14 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 14 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 14 be given the construction which renders its provisions valid and enforceable to the maximum extent (not exceeding its expressed terms) possible under applicable laws. 15. 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. By Carl P. Boecher, President Michael L. Sorensen, Executive EXHIBIT A TO EMPLOYMENT AGREEMENT DATED APRIL 16, 1997 EXECUTIVE BENEFITS - -- Group health, dental, life and disability insurance, 401K plan, 125 plan and other benefits as provided to all employees - -- Supplemental life insurance in the amount of $200,000 paid 100% by the Company - -- Supplemental long-term disability insurance paying $4,000 per month paid 90% by the Company - -- Auto allowance of $400 per month - -- Four weeks of annual vacation, unused vacation cannot be carried over - -- Sick leave as needed, up to 90 days at the discretion of the CEO EX-10.15 3 1997 STOCK OPTION PLAN DATAKEY, INC. 1997 STOCK OPTION PLAN SECTION 1. DEFINITIONS As used herein, the following terms shall have the meanings indicated below: (a) "Committee" shall mean a Committee of two or more directors who shall be appointed by and serve at the pleasure of the Board. As long as the Company's securities are registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended, then, to the extent necessary for compliance with Rule 16b-3, or any successor provision, each of the members of the Committee shall be a "Non-Employee Director." For purposes of this Section 1(a) "Non-Employee Director" shall have the same meaning as set forth in Rule 16b-3, or any successor provision, as then in effect, of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended. (b) The "Company" shall mean Datakey, Inc., a Minnesota corporation. (c) "Fair Market Value" shall mean (i) if such stock is reported by the Nasdaq National Market or Nasdaq SmallCap Market or is listed upon an established stock exchange or exchanges, the reported closing price of such stock by the Nasdaq National Market or Nasdaq SmallCap Market or on such stock exchange or exchanges on the date the option is granted or, if no sale of such stock shall have occurred on that date, on the next preceding day on which there was a sale of stock; (ii) if such stock is not so reported by the Nasdaq National Market or Nasdaq SmallCap Market or listed upon an established stock exchange, the average of the closing "bid" and "asked" prices quoted by the National Quotation Bureau, Inc. (or any comparable reporting service) on the date the option is granted, or if there are no quoted "bid" and "asked" prices on such date, on the next preceding date for which there are such quotes; or (iii) if such stock is not publicly traded as of the date the option is granted, the per share value as determined by the Board, or the Committee, in its sole discretion by applying principles of valuation with respect to all such options. (d) The "Internal Revenue Code" is the Internal Revenue Code of 1986, as amended from time to time. (e) "Non-Employee Director" shall mean members of the Board who are not employees of the Company or any subsidiary. (f) "Option Stock" shall mean Common Stock of the Company (subject to adjustment as described in Section 13) reserved for options pursuant to this Plan. (g) The "Optionee" means an employee of the Company or any Subsidiary to whom an incentive stock option has been granted pursuant to Section 9; a consultant or advisor to or director (including a Non-Employee Director), employee or officer of the Company or any Subsidiary to whom a nonqualified stock option has been granted pursuant to Section 10; or a Non-Employee Director to whom a nonqualified stock option has been granted pursuant to Section 11. (h) "Parent" shall mean any corporation which owns, directly or indirectly in an unbroken chain, fifty percent (50%) or more of the total voting power of the Company's outstanding stock. (i) The "Plan" means the Datakey, Inc. 1997 Stock Option Plan, as amended hereafter from time to time, including the form of Option Agreements as they may be modified by the Board from time to time. (j) A "Subsidiary" shall mean any corporation of which fifty percent (50%) or more of the total voting power of outstanding stock is owned, directly or indirectly in an unbroken chain, by the Company. SECTION 2. PURPOSE The purpose of the Plan is to promote the success of the Company and its Subsidiaries by facilitating the retention of competent personnel and by furnishing incentive to officers, directors, employees, consultants, and advisors upon whose efforts the success of the Company and its Subsidiaries will depend to a large degree. It is the intention of the Company to carry out the Plan through the granting of stock options which will qualify as "incentive stock options" under the provisions of Section 422 of the Internal Revenue Code, or any successor provision, pursuant to Section 9 of this Plan, and through the granting of "nonqualified stock options" pursuant to Sections 10 and 11 of this Plan. Adoption of this Plan shall be and is expressly subject to the condition of approval by the shareholders of the Company within twelve (12) months before or after the adoption of the Plan by the Board of Directors. Any incentive stock options granted after adoption of the Plan by the Board of Directors shall be treated as nonqualified stock options if shareholder approval is not obtained within such twelve-month period. SECTION 3. EFFECTIVE DATE OF PLAN The Plan shall be effective as of the date of adoption by the Board of Directors, subject to approval by the shareholders of the Company as required in Section 2. SECTION 4. ADMINISTRATION The Plan shall be administered by the Board of Directors of the Company (hereinafter referred to as the "Board") or by a Committee which may be appointed by the Board from time to time (collectively referred to as the "Administrator"). The Administrator shall have all of the powers vested in it under the provisions of the Plan, including but not limited to exclusive authority (where applicable and within the limitations described herein) to determine, in its sole discretion, whether an incentive stock option or nonqualified stock option shall be granted, the individuals to whom, and the time or times at which, options shall be granted, the number of shares subject to each option and the option price and terms and conditions of each option. The Administrator shall have full power and authority to administer and interpret the Plan, to make and amend rules, regulations and guidelines for administering the Plan, to prescribe the form and conditions of the respective stock option agreements (which may vary from Optionee to Optionee) evidencing each option and to make all other determinations necessary or advisable for the administration of the Plan. The Administrator's interpretation of the Plan, and all actions taken and determinations made by the Administrator pursuant to the power vested in it hereunder, shall be conclusive and binding on all parties concerned. No member of the Board or the Committee shall be liable for any action taken or determination made in good faith in connection with the administration of the Plan. In the event the Board appoints a Committee as provided hereunder, any action of the Committee with respect to the administration of the Plan shall be taken pursuant to a majority vote of the Committee members or pursuant to the written resolution of all Committee members. SECTION 5. PARTICIPANTS The Administrator shall from time to time, at its discretion and without approval of the shareholders, designate those employees, officers, directors (including Non-Employee Directors), consultants, and advisors of the Company or of any Subsidiary to whom nonqualified stock options shall be granted under this Plan; provided, however, that consultants or advisors shall not be eligible to receive stock options hereunder unless such consultant or advisor renders bona fide services to the Company or Subsidiary and such services are not in connection with the offer or sale of securities in a capital raising transaction; and, provided further, that Non-Employee Directors will be granted options pursuant to Section 11 hereof without further action by the Administrator. The Administrator shall, from time to time, at its discretion and without approval of the shareholders, designate those employees of the Company or any Subsidiary to whom incentive stock options shall be granted under this Plan. The Administrator may grant additional incentive stock options or nonqualified stock options under this Plan to some or all participants then holding options or may grant options solely or partially to new participants. In designating participants, the Administrator shall also determine the number of shares to be optioned to each such participant. The Board may from time to time designate individuals as being ineligible to participate in the Plan. SECTION 6. STOCK The Stock to be optioned under this Plan shall consist of authorized but unissued shares of Option Stock. Five Hundred Thousand (500,000) shares of Option Stock shall be reserved and available for options under the Plan; provided, however, that the total number of shares of Option Stock reserved for options under this Plan shall be subject to adjustment as provided in Section 13 of the Plan. In the event that any outstanding option under the Plan for any reason expires or is terminated prior to the exercise thereof, the shares of Option Stock allocable to the unexercised portion of such option shall continue to be reserved for options under the Plan and may be optioned hereunder. SECTION 7. DURATION OF PLAN Incentive stock options may be granted pursuant to the Plan from time to time during a period of ten (10) years from the effective date as defined in Section 3. Nonqualified stock options may be granted pursuant to the Plan from time to time after the effective date of the Plan and until the Plan is discontinued or terminated by the Board. Any incentive stock option granted during such ten-year period and any nonqualified stock option granted prior to the termination of the Plan by the Board shall remain in full force and effect until the expiration of the option as specified in the written stock option agreement and shall remain subject to the terms and conditions of this Plan. SECTION 8. PAYMENT Optionees may pay for shares upon exercise of options granted pursuant to this Plan with cash, personal check, certified check or, if approved by the Administrator in its sole discretion, Common Stock of the Company valued at such Stock's then Fair Market Value, or such other form of payment as may be authorized by the Administrator. The Administrator may, in its sole discretion, limit the forms of payment available to the Optionee and may exercise such discretion any time prior to the termination of the option granted to the Optionee or upon any exercise of the option by the Optionee. With respect to payment in the form of Common Stock of the Company, the Administrator may require advance approval or adopt such rules as it deems necessary to assure compliance with Rule 16b-3, or any successor provision, as then in effect, of the General Rules and Regulations under the Securities Exchange Act of 1934, if applicable. SECTION 9. TERMS AND CONDITIONS OF INCENTIVE STOCK OPTIONS Each incentive stock option granted pursuant to this Section 9 shall be evidenced by a written stock option agreement (the "Option Agreement"). The Option Agreement shall be in such form as may be approved from time to time by the Administrator and may vary from Optionee to Optionee; provided, however, that each Optionee and each Option Agreement shall comply with and be subject to the following terms and conditions: (a) Number of Shares and Option Price. The Option Agreement shall state the total number of shares covered by the incentive stock option. To the extent required to qualify the Option as an incentive stock option under Section 422 of the Internal Revenue Code, or any successor provision, the option price per share shall not be less than one hundred percent (100%) of the Fair Market Value of the Common Stock per share on the date the Administrator grants the option; provided, however, that if an Optionee owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or of its Parent or any Subsidiary, the option price per share of an incentive stock option granted to such Optionee shall not be less than one hundred ten percent (110%) of the Fair Market Value of the Common Stock per share on the date of the grant of the option. The Administrator shall have full authority and discretion in establishing the option price and shall be fully protected in so doing. (b) Term and Exercisability of Incentive Stock Option. The term during which any incentive stock option granted under the Plan may be exercised shall be established in each case by the Administrator. To the extent required to qualify the Option as an incentive stock option under Section 422 of the Internal Revenue Code, or any successor provision, in no event shall any incentive stock option be exercisable during a term of more than ten (10) years after the date on which it is granted; provided, however, that if an Optionee owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or of its parent or any Subsidiary, the incentive stock option granted to such Optionee shall be exercisable during a term of not more than five (5) years after the date on which it is granted. The Option Agreement shall state when the incentive stock option becomes exercisable and shall also state the maximum term during which the option may be exercised. In the event an incentive stock option is exercisable immediately, the manner of exercise of the option in the event it is not exercised in full immediately shall be specified in the Option Agreement. The Administrator may accelerate the exercisability of any incentive stock option granted hereunder which is not immediately exercisable as of the date of grant. (c) Other Provisions. The Option Agreement authorized under this Section 9 shall contain such other provisions as the Administrator shall deem advisable. Any such Option Agreement shall contain such limitations and restrictions upon the exercise of the option as shall be necessary to ensure that such option will be considered an "incentive stock option" as defined in Section 422 of the Internal Revenue Code or to conform to any change therein. SECTION 10. TERMS AND CONDITIONS OF NONQUALIFIED STOCK OPTIONS Each nonqualified stock option granted pursuant to this Section 10 shall be evidenced by a written Option Agreement. The Option Agreement shall be in such form as may be approved from time to time by the Administrator and may vary from Optionee to Optionee; provided, however, that each Optionee and each Option Agreement shall comply with and be subject to the following terms and conditions: (a) Number of Shares and Option Price. The Option Agreement shall state the total number of shares covered by the nonqualified stock option. Unless otherwise determined by the Administrator, the option price per share shall be one hundred percent (100%) of the Fair Market Value of the Common Stock per share on the date the Administrator grants the option. (b) Term and Exercisability of Nonqualified Stock Option. The term during which any nonqualified stock option granted under the Plan may be exercised shall be established in each case by the Administrator. The Option Agreement shall state when the nonqualified stock option becomes exercisable and shall also state the maximum term during which the option may be exercised. In the event a nonqualified stock option is exercisable immediately, the manner of exercise of the option in the event it is not exercised in full immediately shall be specified in the stock option agreement. The Administrator may accelerate the exercisability of any nonqualified stock option granted hereunder which is not immediately exercisable as of the date of grant. (c) Withholding. The Company or its Subsidiary shall be entitled to withhold and deduct from future wages of the Optionee all legally required amounts necessary to satisfy any and all withholding and employment-related taxes attributable to the Optionee's exercise of a nonqualified stock option. In the event the Optionee is required under the Option Agreement to pay the Company, or make arrangements satisfactory to the Company respecting payment of, such withholding and employment-related taxes, the Administrator may, in its discretion and pursuant to such rules as it may adopt, permit the Optionee to satisfy such obligation, in whole or in part, by electing to have the Company withhold shares of Common Stock otherwise issuable to the Optionee as a result of the option's exercise equal to the amount required to be withheld for tax purposes. Any stock elected to be withheld shall be valued at its Fair Market Value, as of the date the amount of tax to be withheld is determined under applicable tax law. The Optionee's election to have shares withheld for this purpose shall be made on or before the date the option is exercised or, if later, the date that the amount of tax to be withheld is determined under applicable tax law. Such election shall be approved by the Administrator and otherwise comply with such rules as the Administrator may adopt to assure compliance with Rule 16b-3, or any successor provision, as then in effect, of the General Rules and Regulations under the Securities Exchange Act of 1934, if applicable. (d) Other Provisions. The Option Agreement authorized under this Section 10 shall contain such other provisions as the Administrator shall deem advisable. SECTION 11. GRANTING OF OPTIONS TO NON-EMPLOYEE DIRECTORS (a) Upon Joining Board. Each Non-Employee Director of the Company whose initial election or appointment to the Board of Directors occurs on or after the date this Plan is approved by the Company's shareholders 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. (b) Upon Re-election to Board. Each Non-Employee Director who, on and after the date this Plan is approved by the Company's shareholders, 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 11 in any one fiscal year. All options granted pursuant to this Section 11 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, including Section 13 of the Plan, 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 11 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. SECTION 12. TRANSFER OF OPTION No incentive stock option shall be transferable, in whole or in part, by the Optionee other than by will or by the laws of descent and distribution and, during the Optionee's lifetime, the option may be exercised only by the Optionee. If the Optionee shall attempt any transfer of any incentive stock option granted under the Plan during the Optionee's lifetime, such transfer shall be void and the incentive stock option, to the extent not fully exercised, shall terminate. The Administrator may, in its sole discretion, permit the Optionee to transfer any or all nonqualified stock options to any member of the Optionee's "immediate family" as such term is defined in Rule 16a-1(e) promulgated under the Securities Exchange Act of 1934, or any successor provision, or to one or more trusts whose beneficiaries are members of such Optionee's "immediate family" or partnerships in which such family members are the only partners; provided, however, that the Optionee receives no consideration for the transfer and such transferred nonqualified stock option shall continue to be subject to the same terms and conditions as were applicable to such nonqualified stock option immediately prior to its transfer. SECTION 13. RECAPITALIZATION, SALE, MERGER, EXCHANGE OR LIQUIDATION In the event of an increase or decrease in the number of shares of Common Stock resulting from a subdivision or consolidation of shares or the payment of a stock dividend or any other increase or decrease in the number of shares of Common Stock effected without receipt of consideration by the Company, the number of shares of Option Stock reserved under Section 6 hereof and the number of shares of Option Stock covered by each outstanding option and the price per share thereof shall be adjusted by the Board to reflect such change. Additional shares which may be credited pursuant to such adjustment shall be subject to the same restrictions as are applicable to the shares with respect to which the adjustment relates. Unless otherwise provided in the stock option agreement, in the event of (i) an acquisition of the Company by a corporation, partnership, trust or other entity not controlled by the Company through (A) the sale of substantially all of the Company's assets and the consequent discontinuance of its business or (B) through a merger, consolidation, exchange, reorganization, reclassification, extraordinary dividend, divestiture or liquidation of the Company, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least 80% of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation (collectively referred to as a "transaction"), or (ii) a change of control such that (A) any individual, partnership, trust or other entity becomes after the effective date of the Plan the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of 30% or more of the combined voting power of the Company's outstanding securities ordinarily having the right to vote at elections of directors of the Company, or (B) individuals who constitute the Board of Directors of the Company on the effective date of the Plan cease for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to the effective date of the Plan whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least a majority of the directors comprising the Board of Directors of the Company on the effective date of the Plan (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director, without objection to such nomination) shall be, for purposes of this clause (B) considered as though such person were a member of the Board of Directors of the Company on the effective date of the Plan (collectively referred to as a "change of control"), all outstanding options shall become immediately exercisable, whether or not such options had become exercisable prior to the transaction or change of control; provided, however, that if the acquiring party seeks to have the transaction accounted for on a "pooling of interests" basis and, in the opinion of the Company's independent certified public accountants, accelerating the exercisability of such options would preclude a pooling of interests under generally accepted accounting principles, the exercisability of such options shall not accelerate. In addition to the foregoing, in the event of such a transaction or change of control, the Board may provide for one or more of the following: (a) the complete termination of this Plan and cancellation of outstanding options not exercised prior to a date specified by the Board (which date shall give Optionees a reasonable period of time in which to exercise the options prior to the effectiveness of such transaction); (b) that Optionees holding outstanding incentive or nonqualified options shall receive, with respect to each share of Option Stock subject to such options, as of the effective date of any such transaction, cash in an amount equal to the excess of the Fair Market Value of such Option Stock on the date immediately preceding the effective date of such transaction over the option price per share of such options; provided that the Board may, in lieu of such cash payment, distribute to such Optionees shares of stock of the Company or shares of stock of any corporation succeeding the Company by reason of such transaction, such shares having a value equal to the cash payment herein; or (c) the continuance of the Plan with respect to the exercise of options which were outstanding as of the date of adoption by the Board of such plan for such transaction and provide to Optionees holding such options the right to exercise their respective options as to an equivalent number of shares of stock of the corporation succeeding the Company by reason of such transaction. The Board may restrict the rights of or the applicability of this Section 13 to the extent necessary to comply with Section 16(b) of the Securities Exchange Act of 1934, the Internal Revenue Code or any other applicable law or regulation. The grant of an option pursuant to the Plan shall not limit in any way the right or power of the Company to make adjustments, reclassifications, reorganizations or changes of its capital or business structure or to merge, exchange or consolidate or to dissolve, liquidate, sell or transfer all or any part of its business or assets. SECTION 14. SECURITIES LAW COMPLIANCE No shares of Common Stock shall be issued pursuant to the Plan unless and until there has been compliance, in the opinion of Company's counsel, with all applicable legal requirements, including without limitation, those relating to securities laws and stock exchange listing requirements. As a condition to the issuance of Option Stock to Optionee, the Administrator may require Optionee to (i) represent that the shares of Option Stock are being acquired for investment and not resale and to make such other representations as the Administrator shall deem necessary or appropriate to qualify the issuance of the shares as exempt from the Securities Act of 1933 and any other applicable securities laws, and (ii) represent that Optionee shall not dispose of the shares of Option Stock in violation of the Securities Act of 1933 or any other applicable securities laws. As a further condition to the grant of any incentive or nonqualified stock option or the issuance of Option Stock to Optionee, Optionee agrees to the following: (a) In the event the Company advises Optionee that it plans an underwritten public offering of its Common Stock in compliance with the Securities Act of 1933, as amended, and the underwriter(s) seek to impose restrictions under which certain shareholders may not sell or contract to sell or grant any option to buy or otherwise dispose of part or all of their stock purchase rights of the underlying Common Stock, Optionee will not, for a period not to exceed 180 days from the prospectus, sell or contract to sell or grant an option to buy or otherwise dispose of any incentive or nonqualified stock option granted to Optionee pursuant to the Plan or any of the underlying shares of Common Stock without the prior written consent of the underwriter(s) or its representative(s). (b) In the event the Company makes any public offering of its securities and determines in its sole discretion that it is necessary to reduce the number of issued but unexercised stock purchase rights so as to comply with any states securities or Blue Sky law limitations with respect thereto, the Board of Directors of the Company shall have the right (i) to accelerate the exercisability of any incentive or nonqualified stock option and the date on which such option must be exercised, provided that the Company gives Optionee prior written notice of such acceleration, and (ii) to cancel any options or portions thereof which Optionee does not exercise prior to or contemporaneously with such public offering. (c) In the event of a transaction (as defined in Section 13 of the Plan) which is treated as a "pooling of interests" under generally accepted accounting principles, Optionee will comply with Rule 145 of the Securities Act of 1933 and any other restrictions imposed under other applicable legal or accounting principles if Optionee is an "affiliate" (as defined in such applicable legal and accounting principles) at the time of the transaction, and Optionee will execute any documents necessary to ensure compliance with such rules. The Company reserves the right to place a legend on any stock certificate issued upon exercise of an option granted pursuant to the Plan to assure compliance with this Section 14. SECTION 15. RIGHTS AS A SHAREHOLDER An Optionee (or the Optionee's successor or successors) shall have no rights as a shareholder with respect to any shares covered by an option until the date of the issuance of a stock certificate evidencing such shares. No adjustment shall be made for dividends (ordinary or extraordinary, whether in cash, securities or other property), distributions or other rights for which the record date is prior to the date such stock certificate is actually issued (except as otherwise provided in Section 13 of the Plan). SECTION 16. AMENDMENT OF THE PLAN The Board may from time to time, insofar as permitted by law, suspend or discontinue the Plan or revise or amend it in any respect; provided, however, that no such revision or amendment, except as is authorized in Section 13, shall impair the terms and conditions of any option which is outstanding on the date of such revision or amendment to the material detriment of the Optionee without the consent of the Optionee. Notwithstanding the foregoing, no such revision or amendment shall (i) materially increase the number of shares subject to the Plan except as provided in Section 13 hereof, (ii) change the designation of the class of employees eligible to receive options, (iii) decrease the price at which options may be granted, or (iv) materially increase the benefits accruing to Optionees under the Plan without the approval of the shareholders of the Company if such approval is required for compliance with the requirements of any applicable law or regulation. Furthermore, the Plan may not, without the approval of the shareholders, be amended in any manner that will cause incentive stock options to fail to meet the requirements of Section 422 of the Internal Revenue Code. SECTION 17. NO OBLIGATION TO EXERCISE OPTION The granting of an option shall impose no obligation upon the Optionee to exercise such option. Further, the granting of an option hereunder shall not impose upon the Company or any Subsidiary any obligation to retain the Optionee in its employ for any period. EX-10.16 4 FORMS OF INCENTIVE AND NONQ STOCK OPTION AGMTS DATAKEY, INC. INCENTIVE STOCK OPTION AGREEMENT THIS AGREEMENT, made effective as of this _____ day of _______________, 199___, by and between DATAKEY, INC., a Minnesota corporation (the "Company"), and __________________ ("Optionee"). W I T N E S S E T H: WHEREAS, Optionee on the date hereof is a key employee of the Company or one of its Subsidiaries; and WHEREAS, the Company wishes to grant an incentive stock option to Optionee to purchase shares of the Company's Common Stock pursuant to the Company's 1997 Stock Option Plan (the "Plan"); and WHEREAS, the Administrator of the Plan has authorized the grant of an incentive stock option to Optionee and has determined that, as of the effective date of this Agreement, the fair market value of the Company's Common Stock is $_______ per share; NOW, THEREFORE, in consideration of the premises and of the mutual covenants herein contained, the parties hereto agree as follows: 1. Grant of Option. The Company hereby grants to Optionee on the date set forth above (the "Date of Grant"), the right and option (the "Option") to purchase all or portions of an aggregate of _____________________ (______) shares of Common Stock at a per share price of $________ on the terms and conditions set forth herein, subject to adjustment pursuant to Section 13 of the Plan. Except as otherwise provided in Paragraph 2(c), this Option is intended to be an incentive stock option within the meaning of Section 422, or any successor provision, of the Internal Revenue Code of 1986, as amended (the "Code"), and the regulations thereunder. 2. Duration and Exercisability. a. The term during which this Option may be exercised shall terminate at the close of business on ________, 20___, except as otherwise provided in Paragraphs 2(b) through 2(e) below. This Option shall become exercisable according to the following schedule: Vesting Date Percentage/Number of Shares Once the Option becomes exercisable to the extent of one hundred percent (100%) of the aggregate number of shares specified in Paragraph 1, Optionee may continue to exercise this Option under the terms and conditions of this Agreement until the termination of the Option as provided herein. If Optionee does not purchase upon an exercise of this Option the full number of shares which Optionee is then entitled to purchase, Optionee may purchase upon any subsequent exercise prior to this Option's termination such previously unpurchased shares in addition to those Optionee is otherwise entitled to purchase. b. Termination of Employment (other than Change of Control, Disability or Death). If Optionee's employment with the Company or any Subsidiary is terminated for any reason other than because of a "transaction" or "change of control" as described in Paragraph 2(c) or because of disability or death, this Option shall completely terminate on the earlier of (i) the close of business on the three-month anniversary date of such termination of employment, and (ii) the expiration date of this Option stated in Paragraph 2 above. In such period following the termination of Optionee's employment, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding such termination of employment but had not previously been exercised. To the extent this Option was not exercisable upon such termination of employment or if Optionee does not exercise the Option within the time specified in this Paragraph 2(b), all rights of Optionee under this Option shall be forfeited. c. Change of Control. If (i) Optionee's employment with the Company or any Subsidiary is terminated because of a "transaction" or "change of control transaction" (as those terms are defined in Section 13 of the Plan), (ii) such transaction is treated as a "pooling of interests" under generally accepted accounting principles, and (iii) Optionee is an "affiliate" of the Company or Subsidiary under applicable legal and accounting principles, this Option shall completely terminate on the later of (A) the close of business on the three-month anniversary date of such termination of employment or (B) the close of business on the date that is 60 days after the date on which affiliates are no longer restricted from selling, transferring or otherwise disposing of the shares of stock received in the change of control transaction. In such period following the termination of Optionee's employment because of a "transaction" or "change of control", this Option shall become immediately exercisable unless the acceleration of the exercisability of this Option has been prevented as provided in Section 13 of the Plan, in which case, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding such termination of employment, but had not previously been exercised. To the extent this Option was not exercisable upon such termination of employment, or if Optionee does not exercise the Option within the time specified in this Paragraph 2(c), all rights of Optionee under this Option shall be forfeited. If Optionee exercises this Option on a date that is after the three-month anniversary of the termination of Optionee's employment or on a date that is more than ten years (or five years, if applicable) after the Date of Grant, this Option shall not be treated as an incentive stock option within the meaning of Code Section 422. d. Disability. If Optionee ceases to be an employee of the Company or any Subsidiary due to disability (as such term is defined in Code Section 22(e)(3), or any successor provision), this Option shall completely terminate on the earlier of (i) the close of business on the twelve-month anniversary date of such termination of employment, and (ii) the expiration date under this Option stated in Paragraph 2(a) above. In such period following such termination of employment, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding the date of Optionee's termination of employment. If Optionee does not exercise the Option within the time specified in this Paragraph 2(d), all rights of Optionee under this Option shall be forfeited. e. Death. In the event of Optionee's death, this Option shall terminate on the earlier of (i) the close of business on the twelve-month anniversary date of the date of Optionee's death, and (ii) the expiration date of this Option stated in Paragraph 2(a) above. In such period following Optionee's death, this Option shall be exercisable by the person or persons to whom Optionee's rights under this Option shall have passed by Optionee's will or by the laws of descent and distribution only to the extent the Option was exercisable on the vesting date immediately preceding the date of Optionee's death. If such person or persons do not exercise this Option within the time specified in this Paragraph 2(e), all rights under this Option shall be forfeited. 3. Manner of Exercise. a. General. The Option may be exercised only by Optionee (or other proper party in the event of death or incapacity), subject to the conditions of the Plan and subject to such other administrative rules as the Administrator may deem advisable, by delivering within the Option Period written notice of exercise to the Company at its principal office. The notice shall state the number of shares as to which the Option is being exercised and shall be accompanied by payment in full of the Option price for all shares designated in the notice. The exercise of the Option shall be deemed effective upon receipt of such notice by the Company and upon payment that complies with the terms of the Plan and this Agreement. The Option may be exercised with respect to any number or all of the shares as to which it can then be exercised and, if partially exercised, may be so exercised as to the unexercised shares any number of times during the Option period as provided herein. b. Form of Payment. Payment of the Option price by Optionee shall be in the form of cash, personal check, certified check or previously acquired shares of Common Stock of the Company, or any combination thereof. Any stock so tendered as part of such payment shall be valued at its Fair Market Value as provided in the Plan. For purposes of this Agreement, "previously acquired shares of Common Stock" shall include shares of Common Stock that are already owned by Optionee at the time of exercise. c. Stock Transfer Records. As soon as practicable after the effective exercise of all or any part of the Option, Optionee shall be recorded on the stock transfer books of the Company as the owner of the shares purchased, and the Company shall deliver to Optionee one or more duly issued stock certificates evidencing such ownership. All requisite original issue or transfer documentary stamp taxes shall be paid by the Company. 4. Miscellaneous. a. Employment; Rights as Shareholder. This Agreement shall not confer on Optionee any right with respect to continuance of employment by the Company or any of its Subsidiaries, nor will it interfere in any way with the right of the Company to terminate such employment. Optionee shall have no rights as a shareholder with respect to shares subject to this Option until such shares have been issued to Optionee upon exercise of this Option. No adjustment shall be made for dividends (ordinary or extraordinary, whether in cash, securities or other property), distributions or other rights for which the record date is prior to the date such shares are issued, except as provided in Section 13 of the Plan. b. Securities Law Compliance. The exercise of all or any parts of this Option shall only be effective at such time as counsel to the Company shall have determined that the issuance and delivery of Common Stock pursuant to such exercise will not violate any state or federal securities or other laws. Optionee may be required by the Company, as a condition of the effectiveness of any exercise of this Option, to agree in writing that all Common Stock to be acquired pursuant to such exercise shall be held, until such time that such Common Stock is registered and freely tradable under applicable state and federal securities laws, for Optionee's own account without a view to any further distribution thereof, that the certificates for such shares shall bear an appropriate legend to that effect and that such shares will not be transferred or disposed of except in compliance with applicable state and federal securities laws. c. Mergers, Recapitalizations, Stock Splits, Etc. Pursuant and subject to Section 13 of the Plan, certain changes in the number or character of the Common Stock of the Company (through sale, merger, consolidation, exchange, reorganization, divestiture (including a spin-off), liquidation, recapitalization, stock split, stock dividend or otherwise) shall result in an adjustment, reduction or enlargement, as appropriate, in Optionee's rights with respect to any unexercised portion of the Option (i.e., Optionee shall have such "anti-dilution" rights under the Option with respect to such events, but shall not have "preemptive" rights). d. Withholding Taxes on Disqualifying Disposition. In the event of a disqualifying disposition of the shares acquired through the exercise of this Option, Optionee hereby agrees to inform the Company of such disposition. Upon notice of a disqualifying disposition, the Company may take such action as it deems appropriate to insure that, if necessary to comply with all applicable federal or state income tax laws or regulations, all applicable federal and state payroll, income or other taxes are withheld from any amounts payable by the Company to Optionee. If the Company is unable to withhold such federal and state taxes, for whatever reason, Optionee hereby agrees to pay to the Company an amount equal to the amount the Company would otherwise be required to withhold under federal or state law. Optionee may, subject to the approval and discretion of the Administrator or such administrative rules it may deem advisable, elect to have all or a portion of such tax withholding obligations satisfied by delivering shares of the Company's Common Stock having a fair market value equal to such obligations. e. Nontransferability. During the lifetime of Optionee, the accrued Option shall be exercisable only by Optionee or by the Optionee's guardian or other legal representative, and shall not be assignable or transferable by Optionee, in whole or in part, other than by will or by the laws of descent and distribution. f. 1997 Stock Option Plan. The Option evidenced by this Agreement is granted pursuant to the Plan, a copy of which Plan has been made available to Optionee and is hereby incorporated into this Agreement. This Agreement is subject to and in all respects limited and conditioned as provided in the Plan. The Plan governs this Option and, in the event of any questions as to the construction of this Agreement or in the event of a conflict between the Plan and this Agreement, the Plan shall govern, except as the Plan otherwise provides. g. Lockup Period Limitation. Optionee agrees that in the event the Company advises Optionee that it plans an underwritten public offering of its Common Stock in compliance with the Securities Act of 1933, as amended, and that the underwriter(s) seek to impose restrictions under which certain shareholders may not sell or contract to sell or grant any option to buy or otherwise dispose of part or all of their stock purchase rights of the underlying Common Stock, Optionee hereby agrees that for a period not to exceed 180 days from the date of the prospectus, Optionee will not sell or contract to sell or grant an option to buy or otherwise dispose of this option or any of the underlying shares of Common Stock without the prior written consent of the underwriter(s) or its representative(s). h. Blue Sky Limitation. Notwithstanding anything in this Agreement to the contrary, in the event the Company makes any public offering of its securities and determines in its sole discretion that it is necessary to reduce the number of issued but unexercised stock purchase rights so as to comply with any state securities or Blue Sky law limitations with respect thereto, the Board of Directors of the Company shall have the right (i) to accelerate the exercisability of this Option and the date on which this Option must be exercised, provided that the Company gives Optionee 15 days' prior written notice of such acceleration, and (ii) to cancel any portion of this Option or any other option granted to Optionee pursuant to the Plan which is not exercised prior to or contemporaneously with such public offering. Notice shall be deemed given when delivered personally or when deposited in the United States mail, first class postage prepaid and addressed to Optionee at the address of Optionee on file with the Company. i. Accounting Compliance. Optionee agrees that, in the event a "change of control transaction" (as defined in Paragraph 2(c) above) is treated as a "pooling of interests" under generally accepted accounting principles and Optionee is an "affiliate" of the Company or any Subsidiary (as defined in applicable legal and accounting principles) at the time of such change of control transaction, Optionee will comply with all requirements of Rule 145 of the Securities Act of 1933, as amended, and the requirements of such other legal or accounting principles, and will execute any documents necessary to ensure such compliance. j. Stock Legend. If applicable, the Company may put an appropriate legend on the certificates for any shares of Common Stock purchased by Optionee (or, in the case of death, Optionee's successors) to reflect the restrictions of Paragraphs 4(b), 4(g), 4(h) and 4(i) of this Agreement. k. Scope of Agreement. This Agreement shall bind and inure to the benefit of the Company and its successors and assigns and Optionee and any successor or successors of Optionee permitted by Paragraph 4(e) above. l. Arbitration. Any dispute arising out of or relating to this Agreement or the alleged breach of it, or the making of this Agreement, including claims of fraud in the inducement, shall be discussed between the disputing parties in a good faith effort to arrive at a mutual settlement of any such controversy. If, notwithstanding, such dispute cannot be resolved, such dispute shall be settled by binding arbitration. Judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The arbitrator shall be a retired state or federal judge or an attorney who has practiced securities or business litigation for at least ten years. If the parties cannot agree on an arbitrator within 20 days, any party may request that the chief judge of the District Court for Hennepin County, Minnesota, select an arbitrator. Arbitration will be conducted pursuant to the provisions of this Agreement, and the commercial arbitration rules of the American Arbitration Association, unless such rules are inconsistent with the provisions of this Agreement. Limited civil discovery shall be permitted for the production of documents and taking of depositions. Unresolved discovery disputes may be brought to the attention of the arbitrator who may dispose of such dispute. The arbitrator shall have the authority to award any remedy or relief that a court of this state could order or grant; provided, however, that punitive or exemplary damages shall not be awarded. The arbitrator may award to the prevailing party, if any, as determined by the arbitrator, all of its costs and fees, including the arbitrator's fees, administrative fees, travel expenses, out-of-pocket expenses and reasonable attorneys' fees. Unless otherwise agreed by the parties, the place of any arbitration proceedings shall be Hennepin County, Minnesota. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed on the day and year first above written. DATAKEY, INC. By:__________________________________________ Its: COMPANY _____________________________________________ OPTIONEE DATAKEY, INC. NONQUALIFIED STOCK OPTION AGREEMENT THIS AGREEMENT, made effective as of this _____ day of ______________, 199__, by and between DATAKEY, INC., a Minnesota corporation (the "Company"), and _____________________________ ("Optionee"). W I T N E S S E T H: WHEREAS, Optionee on the date hereof is a key employee, officer, director, consultant or advisor of the Company or one of its Subsidiaries; and WHEREAS, the Company wishes to grant a nonqualified stock option to Optionee to purchase shares of the Company's Common Stock pursuant to the Company's 1997 Stock Option Plan (the "Plan"); and WHEREAS, the Administrator has authorized the grant of a nonqualified stock option to Optionee and has determined that, as of the effective date of this Agreement, the fair market value of the Company's Common Stock is $ per share; NOW, THEREFORE, in consideration of the premises and of the mutual covenants herein contained, the parties hereto agree as follows: 1. Grant of Option. The Company hereby grants to Optionee on the date set forth above (the "Date of Grant"), the right and option (the "Option") to purchase all or portions of an aggregate of ____________ (____) shares of Common Stock at a per share price of $______ on the terms and conditions set forth herein, subject to adjustment pursuant to Section 13 of the Plan. This Option is a nonqualified stock option and will not be treated as an incentive stock option, as defined under Section 422, or any successor provision, of the Internal Revenue Code of 1986, as amended (the "Code"), and the regulations thereunder. 2. Duration and Exercisability. a. The term during which this Option may be exercised shall terminate on _______________, 20__, except as otherwise provided in Paragraphs 2(b) through 2(e) below. This Option shall become exercisable according to the following schedule: Vesting Date Percentage/Number of Shares Once the Option becomes exercisable to the extent of one hundred percent (100%) of the aggregate number of shares specified in Paragraph 1, Optionee may continue to exercise this Option under the terms and conditions of this Agreement until the termination of the Option as provided herein. If Optionee does not purchase upon an exercise of this Option the full number of shares which Optionee is then entitled to purchase, Optionee may purchase upon any subsequent exercise prior to this Option's termination such previously unpurchased shares in addition to those Optionee is otherwise entitled to purchase. b. Termination of Relationship (other than Change of Control, Disability or Death). If Optionee ceases to be an employee, director, consultant or an advisor of the Company or any Subsidiary for any reason other than because of a "transaction" or "change of control transaction" as described in Paragraph 2(c) or because of disability or death, this Option shall completely terminate on the earlier of (i) the close of business on the three-month anniversary date of the termination of all such relationships, and (ii) the expiration date of this Option stated in Paragraph 2(a) above. In such period following such termination, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding the date on which all of Optionee's relationships with the Company or Subsidiary have terminated, but had not previously been exercised. To the extent this Option was not exercisable upon the termination of such relationship, or if Optionee does not exercise the Option within the time specified in this Paragraph 2(b), all rights of Optionee under this Option shall be forfeited. c. Change of Control. If (i) Optionee ceases to be an employee, director, consultant or advisor of the Company or any Subsidiary because of a "transaction" or "change of control transaction" (as those terms are defined in Section 13 of the Plan), (ii) such transaction is treated as a "pooling of interests" under generally accepted accounting principles, and (iii) Optionee is an "affiliate" of the Company or Subsidiary under applicable legal and accounting principles, this Option shall completely terminate on the later of (A) the close of business on the three-month anniversary date of the termination of all such relationships with the Company or any Subsidiary, and (B) the close of business on the date that is 60 days after the date on which affiliates are no longer restricted from selling, transferring or otherwise disposing of the shares of stock received in the change of control transaction. In such period following such termination, this Option shall become immediately exercisable unless the acceleration of the exercisability of this Option has been prevented as provided in Section 13 of the Plan, in which case, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding such termination of Optionee's relationships with the Company or Subsidiary, but had not previously been exercised. To the extent this Option was not exercisable upon such termination of such relationships, or if Optionee does not exercise the Option within the time specified in this Paragraph 2(c), all rights of Optionee under this Option shall be forfeited. d. Disability. If Optionee ceases to be an employee, director, consultant or advisor of the Company or any Subsidiary because of disability (as such term is defined in Code Section 22(e)(3), or any successor provision), this Option shall completely terminate on the earlier of (i) the close of business on the twelve-month anniversary date of the termination of all such relationships with the Company or any Subsidiary, and (ii) the expiration date under this Option stated in Paragraph 2(a) above. In such period following such termination, this Option shall be exercisable only to the extent the Option was exercisable on the vesting date immediately preceding the termination of all of Optionee's relationships. If Optionee does not exercise the Option within the time specified in this Paragraph 2(d), all rights of Optionee under this Option shall be forfeited. e. Death. In the event of Optionee's death, this Option shall terminate on the earlier of (i) the close of business on the twelve-month anniversary date of the date of Optionee's death, and (ii) the expiration date of this Option stated in Paragraph 2(a) above. In such period following Optionee's death, this Option may be exercised by the person or persons to whom Optionee's rights under this Option shall have passed by Optionee's will or by the laws of descent and distribution only to the extent the Option was exercisable on the vesting date immediately preceding the date of Optionee's death. If such person or persons fail to exercise this Option within the time specified in this Paragraph 2(e), all rights under this Option shall be forfeited. 3. Manner of Exercise. a. General. The Option may be exercised only by Optionee (or other proper party in the event of death or incapacity), subject to the conditions of the Plan and subject to such other administrative rules as the Administrator may deem advisable, by delivering within the option period written notice of exercise to the Company at its principal office. The notice shall state the number of shares as to which the Option is being exercised and shall be accompanied by payment in full of the option price for all shares designated in the notice. The exercise of the Option shall be deemed effective upon receipt of such notice by the Company and upon payment that complies with the terms of the Plan and this Agreement. The Option may be exercised with respect to any number or all of the shares as to which it can then be exercised and, if partially exercised, may be exercised as to the unexercised shares any number of times during the option period as provided herein. b. Form of Payment. Payment of the option price by Optionee shall be in the form of cash, personal check, certified check or previously acquired shares of Common Stock of the Company, or any combination thereof. Any stock so tendered as part of such payment shall be valued at its Fair Market Value as provided in the Plan. For purposes of this Agreement, "previously acquired shares of Common Stock" shall include shares of Common Stock that are already owned by Optionee at the time of exercise. c. Stock Transfer Records. As soon as practicable after the effective exercise of all or any part of the Option, Optionee shall be recorded on the stock transfer books of the Company as the owner of the shares purchased, and the Company shall deliver to Optionee one or more duly issued stock certificates evidencing such ownership. All requisite original issue or transfer documentary stamp taxes shall be paid by the Company. 4. Miscellaneous. a. Rights as Shareholder. This Agreement shall not confer on Optionee any right with respect to the continuance of any relationship with the Company or any of its Subsidiaries, nor will it interfere in any way with the right of the Company to terminate any such relationship. Optionee shall have no rights as a shareholder with respect to shares subject to this Option until such shares have been issued to Optionee upon exercise of this Option. No adjustment shall be made for dividends (ordinary or extraordinary, whether in cash, securities or other property), distributions or other rights for which the record date is prior to the date such shares are issued, except as provided in Section 13 of the Plan. b. Securities Law Compliance. The exercise of all or any parts of this Option shall only be effective at such time as counsel to the Company shall have determined that the issuance and delivery of Common Stock pursuant to such exercise will not violate any state or federal securities or other laws. Optionee may be required by the Company, as a condition of the effectiveness of any exercise of this Option, to agree in writing that all Common Stock to be acquired pursuant to such exercise shall be held, until such time that such Common Stock is registered and freely tradable under applicable state and federal securities laws, for Optionee's own account without a view to any further distribution thereof and that such shares will be not transferred or disposed of except in compliance with applicable state and federal securities laws. c. Mergers, Recapitalizations, Stock Splits, Etc. Pursuant and subject to Section 13 of the Plan, certain changes in the number or character of the Common Stock of the Company (through sale, merger, consolidation, exchange, reorganization, divestiture (including a spin-off), liquidation, recapitalization, stock split, stock dividend or otherwise) shall result in an adjustment, reduction or enlargement, as appropriate, in Optionee's rights with respect to any unexercised portion of the Option (i.e., Optionee shall have such "anti-dilution" rights under the Option with respect to such events, but shall not have "preemptive" rights). d. Withholding Taxes. In order to permit the Company to comply with all applicable federal or state income tax laws or regulations, the Company may take such action as it deems appropriate to insure that, if necessary, all applicable federal or state payroll, income or other taxes are withheld from any amounts payable by the Company to Optionee. If the Company is unable to withhold such federal and state taxes, for whatever reason, Optionee hereby agrees to pay to the Company an amount equal to the amount the Company would otherwise be required to withhold under federal or state law. Optionee may, subject to the approval and discretion of the Administrator or such administrative rules it may deem advisable, elect to have all or a portion of such tax withholding obligations satisfied by delivering shares of the Company's Common Stock having a fair market value equal to such obligations. e. Nontransferability. During the lifetime of Optionee, the accrued Option shall be exercisable only by Optionee or by the Optionee's guardian or other legal representative, and shall not be assignable or transferable by Optionee, in whole or in part, other than by will or by the laws of descent and distribution. f. 1997 Stock Option Plan. The Option evidenced by this Agreement is granted pursuant to the Plan, a copy of which Plan has been made available to Optionee and is hereby incorporated into this Agreement. This Agreement is subject to and in all respects limited and conditioned as provided in the Plan. The Plan governs this Option and, in the event of any questions as to the construction of this Agreement or in the event of a conflict between the Plan and this Agreement, the Plan shall govern, except as the Plan otherwise provides. g. Lockup Period Limitation. Optionee agrees that in the event the Company advises Optionee that it plans an underwritten public offering of its Common Stock in compliance with the Securities Act of 1933, as amended, and that the underwriter(s) seek to impose restrictions under which certain shareholders may not sell or contract to sell or grant any option to buy or otherwise dispose of part or all of their stock purchase rights of the underlying Common Stock, Optionee hereby agrees that for a period not to exceed 180 days from the date of prospectus, Optionee will not sell or contract to sell or grant an option to buy or otherwise dispose of this option or any of the underlying shares of Common Stock without the prior written consent of the underwriter(s) or its representative(s). h. Blue Sky Limitation. Notwithstanding anything in this Agreement to the contrary, in the event the Company makes any public offering of its securities and determines in its sole discretion that it is necessary to reduce the number of issued but unexercised stock purchase rights so as to comply with any state securities or Blue Sky law limitations with respect thereto, the Board of Directors of the Company shall have the right (i) to accelerate the exercisability of this Option and the date on which this Option must be exercised, provided that the Company gives Optionee 15 days' prior written notice of such acceleration, and (ii) to cancel any portion of this Option or any other option granted to Optionee pursuant to the Plan which is not exercised prior to or contemporaneously with such public offering. Notice shall be deemed given when delivered personally or when deposited in the United States mail, first class postage prepaid and addressed to Optionee at the address of Optionee on file with the Company. i. Accounting Compliance. Optionee agrees that, in the event a "change of control transaction" (as defined in Paragraph 2(c) above) is treated as a "pooling of interests" under generally accepted accounting principles and Optionee is an "affiliate" of the Company or any Subsidiary (as defined in applicable legal and accounting principles) at the time of such change of control transaction, Optionee will comply with all requirements of Rule 145 of the Securities Act of 1933, as amended, and the requirements of such other legal or accounting principles, and will execute any documents necessary to ensure such compliance. j. Stock Legend. If applicable, the Company may put an appropriate legend on the certificates for any shares of Common Stock purchased by Optionee (or, in the case of death, Optionee's successors) to reflect the restrictions of Paragraphs 4(b), 4(h), 4(i) and 4(j) of this Agreement. k. Scope of Agreement. This Agreement shall bind and inure to the benefit of the Company and its successors and assigns and Optionee and any successor or successors of Optionee permitted by Paragraph 4(e) above. l. Arbitration. Any dispute arising out of or relating to this Agreement or the alleged breach of it, or the making of this Agreement, including claims of fraud in the inducement, shall be discussed between the disputing parties in a good faith effort to arrive at a mutual settlement of any such controversy. If, notwithstanding, such dispute cannot be resolved, such dispute shall be settled by binding arbitration. Judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The arbitrator shall be a retired state or federal judge or an attorney who has practiced securities or business litigation for at least ten years. If the parties cannot agree on an arbitrator within 20 days, any party may request that the chief judge of the District Court for Hennepin County, Minnesota, select an arbitrator. Arbitration will be conducted pursuant to the provisions of this Agreement, and the commercial arbitration rules of the American Arbitration Association, unless such rules are inconsistent with the provisions of this Agreement. Limited civil discovery shall be permitted for the production of documents and taking of depositions. Unresolved discovery disputes may be brought to the attention of the arbitrator who may dispose of such dispute. The arbitrator shall have the authority to award any remedy or relief that a court of this state could order or grant; provided, however, that punitive or exemplary damages shall not be awarded. The arbitrator may award to the prevailing party, if any, as determined by the arbitrator, all of its costs and fees, including the arbitrator's fees, administrative fees, travel expenses, out-of-pocket expenses and reasonable attorneys' fees. Unless otherwise agreed by the parties, the place of any arbitration proceedings shall be Hennepin County, Minnesota. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed on the day and year first above written. DATAKEY, INC. By:__________________________________________ Its: COMPANY _____________________________________________ OPTIONEE EX-13.1 5 MD&A FROM ANNUAL REPORT MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION & 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, 1997 1996 1995 -------- --------- -------- Revenue........................ 100% 100% 100% Cost and Expenses Cost of goods sold............. 73% 65% 67% Research and development....... 53 35 10 Marketing and sales............ 29 20 15 General and administrative..... 12 18 9 -------- --------- -------- Total cost and expenses..... 167 138 101 Interest income................ 2 6 5 Income (loss) before income taxes.......................... (65) (32) 4 Income taxes (benefit)......... 5 (6) 2 -------- --------- -------- Net income (loss).............. (70) (26) 2 -------- --------- -------- Comparison of 1997 with 1996 Total Revenue: Total revenue was $5,977,000 in 1997, a decrease of 9 percent from $6,558,000 in 1996. The revenue decrease is primarily due to customer requested delays in major electronic products customer shipments during the second half of 1997 resulting from delays, cancellation, or non-renewal of orders from their customers. The Company anticipates that sales of electronic products will continue to decrease in 1998. Its future growth will depend primarily on the market acceptance of new end-user products introduced to the information security marketplace. Gross margins: The gross profit margin decreased to 27 percent in 1997 from 35 percent in 1996 primarily as a result of lower revenue, product costs associated with zero charge evaluation units to customers, and increases in reserves for inventory obsolescence. Research and development: Research and development expenses increased 41 percent to $3,186,000 in 1997 from $2,263,000 in 1996 due to the Company's significant increase in product development activities for token-based information security systems. Marketing and sales, General and administrative: Marketing and sales expense in 1997 increased 31 percent to $1,716,000 from $1,312,000 in 1996 due to a planned increase in product promotion expense to achieve market introduction of the new token-based information security systems. General and administrative expenses decreased 38 percent to $713,000 in 1997 from $1,156,000 in 1996 primarily due to an accrual in 1996 for severance pay and benefits due the Company's former chief executive officer. Interest income: Interest income decreased 53 percent to $170,000 in 1997 from $361,000 in 1996 due to a decline in the Company's investment in interest bearing investments. Income tax expense (benefit): The Company recorded an income tax expense of $325,000 in 1997 as compared to an income tax benefit of $388,000 in 1996. As a result of the net operating loss carryover in excess of $5,000,000 at December 31, 1997, the Company determined that the realization of the future tax benefit of the operating losses for tax purposes was uncertain and, accordingly, the deferred tax asset of $325,000 recorded at December 31, 1996, was entirely reserved and charged to expense in 1997. 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. The revenue decrease was 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 was 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 was $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. Liquidity and Capital Resources The Company had a reduction of $4,828,000 in cash and held-to-maturity marketable debt securities in 1997 compared to a reduction of $834,000 in 1996. The 1997 reduction in cash and marketable debt securities resulted primarily from significant expenditures, totaling $4,902,000, in research and development and marketing expenses principally related to the Company's new product development activities. Inventory decreased $46,000 to $1,083,000 as of December 31, 1997, compared to $1,129,000 as of December 31, 1996. Accrued compensation expense decreased by $129,000 primarily due to the payment of severance pay and benefits due the Company's former chief executive officer. The Company invested $822,000 in the purchase of equipment and maintenance of licenses and patents in 1997, compared to $515,000 in 1996. The 1997 increase is primarily attributable to prepaid license fees related to licensed software that will be bundled with the Company's information security systems and purchase of automated equipment to improve factory efficiency. Cash, cash equivalents, and investment in held-to-maturity marketable debt securities as of December 31, 1997, totaled $1,305,000 as compared to $6,133,000 as of December 31, 1996. See "Outlook". Datakey's balance sheet reflects $1,951,000 in working capital and a current assets to current liabilities ratio of 2.7 to 1 as of December 31, 1997. Outlook Certain statements in the following Outlook section and in other parts of this Annual Report are forward looking and are based upon current expectations. These statements are forward looking and actual results may differ materially due to risks and uncertainties, including those set forth below. Revenue: Shipment delays experienced in the second half of 1997 are expected to continue through the first half of 1998 and likely will result in a reduction in electronic products revenue for the year as compared to 1997. New end-user products being introduced to the information security marketplace are expected to result in significant revenue during the second half of 1998. If this revenue meets the Company's present expectations, the total revenue from the new products could exceed the revenue from the electronic products group. Gross margins: A gradual improvement in gross profit margins during 1998 is expected through selective price increases, effective material purchasing, an increase in revenue without an attendant increase in factory overhead and improvements in manufacturing efficiency. Research and development: The Company will continue to fund new product development activities in 1998 but at about 45 percent less than in 1997. Marketing and sales, General and administrative: Marketing and sales expenses are expected to increase about 40 percent in 1998 to support new product introductions and the expected increase in revenue, but will be about the same percent of revenue provided revenue from new product sales materializes as expected. General and administrative expenses in 1998 are expected to increase slightly from the 1997 level. Interest income (expense): Interest income is expected to decline materially in early 1998 as the Company intends to use cash and cash equivalents to fund continuing product development and marketing activities to support the Company's entry into advanced information security products. Beginning in the second or third quarter the Company expects to borrow money and begin incurring interest expense under the recently arranged bank line of credit. Income tax expense (benefit): As a result of a net operating loss carry-forward, the Company does not expect to record an income tax benefit or expense during 1998. Expected first half loss: The Company expects to report a loss in the first half of 1998 but may return to profitability by the end of 1998 if revenue from the new product line materializes as expected. Liquidity and capital resources: The Company plans to continue new product development in 1998 at a lower level than in 1997 and marketing activities will continue at an increased level during 1998. The Company expects to spend $4,000,000 to $4,500,000 on these activities. Inventory levels are expected to increase slightly in 1998 to support advanced information security products as well as electronic products. 1998 investments in equipment and maintenance of licenses and patents are expected to return to a level of $500,000 to $550,000. The Company believes its working capital and cash equivalent investments together with its bank line of credit are sufficient to fund its planned operations and continued development and promotional activities during 1998, provided that the revenue from new products materialize as expected. The bank line is scheduled to expire in May 1998, but the Company expects to be able to renew it for another year. The Board of Directors believes the prudent course of action is for the Company to seek additional debt or equity financing, and the Company is currently discussing financing options with several local broker-dealers. Risks and Uncertainties Rapid technological change: Datakey's information security end-user products such as SignaSURE CIP and SignaSURE ESS will integrate hardware tokens with software that provides 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 CIP and ESS. Although the Company believes that the decision to fund these new products is correct, there are no assurances that investments already made and additional investments planned for 1998 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 with significantly greater resources 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 consists of 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: Corporate utilization of the Internet and internal intranets dictate a need for information security, but 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. Financing: There is no assurance that the Company's current negotiations with broker-dealers will lead to a financing on acceptable terms. Should there be a delay in new orders or if new product revenue does not materialize to the extent currently projected, the inability to obtain acceptable financing could jeopardize the Company's ability to maintain its current business operations. Other Matters The Company has begun its analysis of the impact, if any, from the changeover of various computer systems during the year 2000. Based upon its internal analysis and results of questions posed to major software and service suppliers, the Company feels that year 2000 will have no significant financial or operational impact. EX-23.1 6 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements on Forms S-8 No. 33-14144, No. 33-47068, No. 33-67280, No. 333-11405, No. 33-80894, and No. 333-43937 of our report dated February 3, 1998, 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, 1997. /s/ McGLADREY & PULLEN, LLP Minneapolis, Minnesota March 25, 1998 EX-27 7 FDS FOR FISCAL YEAR ENDED 12/31/97
5 1 U.S. Dollars YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 1 1,305,392 0 664,267 30,000 1,082,737 3,075,756 4,752,008 3,278,760 5,653,306 1,124,932 0 0 375,000 144,361 4,009,013 5,653,306 5,977,464 5,977,464 4,389,367 4,389,367 5,615,545 0 (169,569) (3,857,879) 325,000 (4,182,879) 0 0 0 (4,182,879) (1.45) (1.45)
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