10KSB40

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, 2000

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:  (952) 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: $7,407,000, which represents $3,608,000 for continuing operations and $3,799,000 for discontinued operations.

The aggregate market value of the voting stock (Common Stock) held by non-affiliates was approximately $19,233,000  based upon the closing sale price of the Issuer’s Common Stock on March 20, 2001.

As of March 20, 2001, there were 9,885,239 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, 2000 (the “2000 Annual Report”).  Portions of the Company’s definitive Proxy Statement for its Annual Meeting of Shareholders to be held on May 31, 2001 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. was incorporated under the laws of the State of Minnesota in 1976 under the name “The Systems Group, Inc.”  In 1980, we changed our name to Datakey, Inc.  Datakey operates two business segments.  Our Information Security Solutions (ISS) business segment provides products and systems for information security markets that enable user authentication, secure data exchange and information validation.  Our Electronic Products (EP) business segment 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 rugged environments.  As is explained further in this report, we intend to divest EP in 2001 and that segment is, therefore, reflected as discontinued operations in the financial statements contained in this report.

          From 1976 to 1995, Datakey was primarily a supplier of electronic memory keys and custom tokens used for data storage in a variety of small niche applications.  This business segment is known today as Electronic Products.  EP’s first portable memory products, consisting of an electronic key and support electronics, were introduced in 1981 for applications requiring convenient storage, transportation and management of information.  EP’s current products utilize semiconductor technology to provide a storage device more versatile and rugged than conventional portable information products.  EP’s current product line of portable memory devices and associated interface products provide up to 16,384,000 bits of data storage which are used as OEM devices in a wide range of applications including communications security, computer security, facility security, vending and process control.  EP has recently developed a line of Cashless Vending and Access Control products which we first introduced to market in 2000.  On February 22, 2001, we announced that we intend to strategically focus our business on opportunities for the ISS business, and plan to divest our EP business.  We have already begun to significantly cut back EP operations.  We also eliminated 11 positions in the EP business segment.

          In 1996, Datakey made a strategic decision to utilize its public key cryptographic smart card and reader technology founded in 1991 to provide information systems that allow secure use of intranets, extranets and the Internet for business-to-business electronic commerce—a market with explosive growth potential.  In September 1997 we introduced a family of end-user systems under the SignaSURE® trademark using smart cards or smart keys that provide advanced information security utilizing public key digital signatures and encryption.  These systems incorporate both hardware and software to provide a higher level of security available from software only solutions.

          Datakey is located at 407 West Travelers Trail in Burnsville, Minnesota, a suburb of Minneapolis.  We also maintain regional sales offices in the metropolitan areas of New York City, Washington, D.C. and Frankfurt, Germany that support the information security business.

Product and Service Description

EP business segment  (DISCONTINUED OPERATIONS):

Portable Memory Devices.   Portable memory devices are electronic devices which store information.  They have a plastic exterior, are in the forms of keys, cards, or custom shaped tokens and encapsulate semiconductor memory.

Access Devices.  Access devices are elements into which a portable memory device is inserted to provide the interconnection between the portable memory device and the electronic interface circuitry or the host processor-based equipment.

Interface Modules and Subsystems.  The interface is the electronics control module between the access device and a customer’s processor-based equipment.  This module is used with our 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

          ISS business segment (CONTINUING OPERATIONS):

For the past five years, Datakey has been developing “token-based” (smart card and other smart token) products that provide advanced information security solutions for the problems of organizations, worldwide.  The first of a family of products known by the SignaSUREâ trademark was introduced in September 1997 and additional versions have been released on a regular basis. In addition to the current versions, we expect to launch new versions of SignaSURE in 2001 and beyond.

             SignaSURE Product Components:

Smart card-based Operating System and Security Application Software.  Datakey developed its own smart card operating system (OS) specifically designed for information security.  It manages all security functions performed in the smart card.  The OS, known as DKCCOS (Datakey chip card operating system), including public key security application software, was first released in 1998 as the OS for our SignaSURE Model 320 smart card.  The Model 320 was the first PKI smart card in the world to use 1024 bit keys, to generate public key pairs on the card, the first with 8K Bytes of storage for data and programs, and the first PKI card with an extensible operating system.  In 1999, Datakey released its Model 330 smart card which increased key length to 2048 bits, increased storage to 32K Bytes, added applications for processing DES and Elliptic Curve algorithm applications, and passed FIPS 140-1 level 2 certification—a requirement to operate in the government market and a desirable for financial service customers.  This card is a technology leader in the industry.

Smart card readers.  Although Datakey initially designed and manufactured its own reader, today’s readers are primarily purchased components.

Client based security interface software.  Datakey software, resident on the desktop or laptop, is the interface between the smart card and security application program.  It allows private and secret key functions previously performed in the software application to be done much more securely in the smart card. The first version, named SignaSURE CIP 1.0, was introduced in 1997. The current CIP 4.x version is recognized as the leader in technology and stability today .  It features a multi-threaded application interface and can operate with multiple applications in a single session.  It supports PC/SC compatible readers, both PKCS #11 and Microsoft CAPI standard cryptographic interfaces and Windows 2000 security features.

SignaSURE Product Family:

SignaSURE CIP (Cryptographic Interface Provider).  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 public networks with connections, such as extranets and the Internet, outside of the organization.  Datakey’s SignaSURE CIP allows enterprise users 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 add-ons to Cryptoki (PKCS-11) standard information security interface applications and for applications that incorporate Microsoft’s CryptoAPI (CAPI).  It offers “load, plug and play” convenience for strong information security.  SignaSURE CIP includes three elements:

•         A user-unique smart card or smart key “token” that holds critical information and performs the cryptographic functions necessary for information security

•         A companion reader/writer that plugs into a computer’s serial port, PCMCIA port, USB port or floppy disk drive

•         Software that is loaded once into the workstation and interfaces to the application program.

SignaSURE DTK (Developers Tool Kit). SignaSURE DTK is a turnkey package to allow software developers to integrate Datakey hardware tokens and a public key Infrastructure (PKI) 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 several configurations ranging from a token with a reader/writer and integration software, to the full PKI 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.  Datakey began selling SignaSURE DTK in 1997.

SignaSURE SCC (Security Control Center).  Smart cards need to be “initialized and personalized” with unique user and enterprise data before they are issued.  In addition, many enterprises want to hold a copy of the keys used for encryption so they can recover encrypted data in an emergency.  SignaSURE SCC provides these features and provides an audit trail for these actions.

          The following chart shows Datakey’s SignaSURE products:

		SignaSURE Product
Attribute		CIP	DTK	SCC
Customer	Organizational End-User	X		X
	Software Developer		X
System Type	Integrated Solution			X
	Add-on Subsystem	X
	Component		X
Application	Information Security	X		X
	Token Integration	X	X
Hardware	Datakey Smart Token	X	X
	Datakey Reader/Writer	X	X
Software	Security Solution
	Token Interface	X	X

          OEM Private Label Products.  Datakey also provides its SignaSURE family of information security products to OEM’s under their own private label.

          OEM Technology Licensing.  In addition to selling products, Datakey licenses its Smart Card Operating System and interface software to OEM’s for incorporation into their products.  Current licensees include Rainbow Technologies (iKey 2000, iKey 2032), and Certicom (SC 500).  Licenses are sold on a per seat basis with revenue recognized at time of delivery to the customer, provided that Datakey has no significant cost or obligation beyond the original authorization to the silicon supplier.

Manufacturing

          The Company’s in-house manufacturing capabilities include microelectronic assembly, plastic injection molding, automated surface mount assembly, and general electronic assembly.  During 2001, while the EP business segment is being divested, we intend to continue to manufacture the EP product line on a limited basis, but we are beginning a transition to outsource the manufacture of the ISS product line so that upon discontinuation of EP the manufacturing of the ISS products will continue without interruption.

Sources of Supply

          The Company purchases a microprocessor, with its proprietary operating system masked into the chip, from a single source supplier.  The Company is currently qualifying a second supplier of the microprocessor to reduce the dependency on one supplier.

          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 present source of supply become inadequate or inferior to other offerings in the future or should its second supplier be inadequate, 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 memory devices.  The components for the Company’s products are, in general, available from multiple suppliers.  Many 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

          Sales to one of the Company’s ISS customers totaled approximately $1,437,000, or 19% of total sales during the year ended December 31, 2000.

Marketing

          General.  While there appears to be a broad range of applications and potential customers for portable memory devices, 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 1998, sales to EP customers decreased to $5,241,000, and in 1999 and 2000 they decreased to $4,550,000 and 3,799,000, respectively

          ISS products for the information security marketplace were introduced in 1997 and resulted in revenue of $629,000 during 1998, $1,316,000 during 1999 and $3,608,000 during 2000.  In 2001, the Company expects revenue from these products to increase significantly as additional pilot programs are commenced, certain customers convert into production mode and the Company signs additional licensing agreements.  As with any new product line, revenue will depend on customer acceptance, the extent of which is difficult to assess at this time, as well as other general business and economic conditions.

          Marketing Strategy.  The marketing of our information security products employs five key strategies:

      •   Seek recognition as a major player in the public key token-based information security market.  We participate in industry trade shows with exhibits and product demonstrations.  Our Technical Services personnel write white papers and articles for technical trade magazines and other periodicals.  We hold regular press conferences at conferences and trade shows that are intended to publicize our products and organization.  Direct mail is used as a follow-up method for trade shows so we keep our name and products in front of customers and prospects.  Our sales and marketing staff are members of key trade associations and participate in meetings with product and technology presentations.  Our products are tested by independent testing laboratories hosted by media publications and the results published. We also maintain a significant web presence that describes Datakey and our products.

      •   Develop products in concert with customer needs.  Before development is started, the product description is discussed with our current customer base and prospects to determine its future acceptability in the marketplace.  We also host customer feedback sessions to better determine their needs and our product enhancements.

      •   Emphasize Datakey’s advanced technology, service and support discriminators.  Our customer presentations, product literature and proposal responses are designed to highlight those functions and features that distinguish Datakey from our competitors.  Our technology white papers, useful for those prospects in the early stages of product selection, also emphasize those capabilities unique to our products.  We also use satisfied customers and their testimonials as references for new prospects.

      •   Partner with PKI suppliers and larger system integrators as additional delivery channels.

      •   Offer Datakey technology through licenses to non-competitive security solution providers

          Pricing Strategy.  Datakey token-based information security products are priced competitively with software information security products providing our customers with high security at little additional price.  As we expand our product line with additional software application modules that work with our smart cards and keys, we expect to improve our gross margins over time.  As we become better known in the information security marketplace, we intend to charge our customers for pre-sales consultation which today is offered free.  We offer service subscriptions and upgrades that represent a substantial profit potential to Datakey.

          Promotion Strategy.  Datakey uses a variety of promotional vehicles to reach new customers.  A summary of our promotional strategy follows:

1. Sales Literature – Datakey generates a variety of product and corporate literature pieces, each written for an intended audience. Our literature is distributed at events, sent as follow up to product information requests, sent to interested investors and posted on our web site.

2. Direct Mail – Datakey implements direct mail programs around events throughout the year as well as focused mailings to our target markets.

3. Trade Shows and Seminars  - Industry events are an effective way for Datakey to generate sales leads.  Information security and target market trade shows, as well as joint seminars with our technology partners provide our sales force with highly qualified leads.

4. Public Relations – Datakey relies on professional public relations firms with experience in the networking and information security markets to work with the press and industry analysts to build brand awareness for Datakey products.

5. Web Site – the Datakey web site is becoming a strong vehicle for quickly disseminating product information to prospects as well as a lead generation tool by utilizing various methods to capture information about our web visitors.

          Worldwide Distribution Strategy.  Datakey uses a combination of a direct sales force and indirect sales channels to distribute its ISS products.  Our direct sales force currently consists of four sales professionals covering the North American market, a European office that sells direct and manages our European reseller channel, and a channel sales manager that establishes worldwide product representation through resellers and distributors specializing in information security technologies, and manages our strategic partner relationships.  We are in the process of hiring additional sales personnel for North America and the Asia/Pacific markets.

Sales in North America are generally conducted through direct sales representatives.  The Company has a number of distributors in Europe, Australia and New Zealand and plans to add more international distributors as appropriate to serve those markets.  In 2000 and 1999, sales to domestic customers and the corresponding percentage of total revenue, were approximately $5,814,000 (78%) and $4,236,000 (72%), respectively.  Sales to international customers, and the corresponding percentage of total revenue, were approximately $1,593,000 (22%) and $1,630,000 (28%), respectively.

Backlog

          As of March 2, 2001, the Company had an order backlog totaling approximately $2,042,000.  Although the orders generally 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 electronic products sold to original equipment manufacturers has been 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 database, may also compete with centralized database systems.  Many of the manufacturers of these portable information devices and systems are large, well-established companies.

          Information Security Solutions.  Datakey currently offers token-based (smart card, smart key) information security solutions which are primarily utilized in encryption for electronic mail privacy, private and secure file transfer and digital signatures for electronic document authentication. The Company is continuing a significant product development effort to expand the applications and ease-of-use of its products and systems.  See “Products—Information Security 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.  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.

          The technology involved in information security systems is 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.

Research and Development

          In 2000 and 1999, research and development expenses in continuing operations were $2,003,000 and $1,632,000, respectively.  The Company expects that research and development expenses in 2001 will increase by about 40% as the Company plans to hire 6 new engineers in the software development and technical support areas.

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.  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

          As of March 15, 2001, the Company employs 53 full-time employees, 12 of whom are involved in manufacturing, three in materials handling, one in quality assurance, 15 in engineering, 13 in marketing/sales and 9 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 expectations that in 2001 Datakey will release new versions of SignaSURE CIP are subject to the risk of unanticipated problems or delays in development and depend 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 revenues from ISS products will increase significantly depends on the ability of the Company’s sales force to commence additional pilot programs with new customers, the success of current and future pilot programs and the resulting customer interest in converting to production mode, as well as the Company’s success in securing additional licensing agreements.

ITEM 2.      DESCRIPTION OF PROPERTY

          The Company’s corporate offices and manufacturing facility, located at 407 West Travelers Trail, Burnsville, Minnesota, consists of approximately 25,000 square feet including approximately 16,000 square feet that is currently occupied by the EP business segment that is being discontinued.  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 2004.  The annualized rent expense for the space currently occupied is $170,000, plus a portion of the operating expenses and real estate taxes.

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 2000.

PART II

ITEM 5.      MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

          The Company’s common stock is currently traded on the Nasdaq SmallCap Market under the symbol DKEY.  Prior to May 11, 1999, it was traded on the Nasdaq National Market.  The high and low sale prices for the common stock by quarter as reported by Nasdaq are set forth in the following table for 2000 and 1999.

          On March 15, 2001, the Company had approximately 4,500 shareholders, including approximately 4,200 beneficial owners.  The Company has never paid dividends on its common stock and does not plan to in the foreseeable future.

	Sale Prices
	High	Low
2000
1st Quarter	$18	$3 9/32
2nd Quarter	$9 1/2	$2 11/16
3rd Quarter	$10 1/4	$4 3/4
4th Quarter	$8 1/2	$2
1999
1st Quarter	$5 5/8	$2
2nd Quarter	$4 3/8	$2 1/8
3rd Quarter	$3 1/2	$1 9/32
4th Quarter	$3 7/8	$1

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 2000 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 as part of Exhibit 13.1 to this Report:

Independent Auditor’s Report
Balance Sheets as of December 31, 2000 and 1999
Statements of Operations for Years Ended December 31,  2000 and 1999
Statements of Stockholders’ Equity for Years Ended December 31, 2000 and 1999
Statements of Cash Flows for Years Ended December 31, 2000 and 1999
Notes to Financial Statements

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 2001 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 2001 Annual Meeting of Shareholders under the caption “Section 16(a) Beneficial Ownership Compliance.”

ITEM 10.    EXECUTIVE COMPENSATION

          The information required by Item 10 is incorporated by reference to the Company’s proxy statement for its 2001 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 2001 Annual Meeting of Shareholders under the caption “Security Ownership of Management and Certain Beneficial Owners.”

ITEM 12.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

                    The information required by Item 11 is incorporated by reference to the Company’s proxy statement for its 2001 Annual Meeting of Shareholders under the caption “Certain Relationships and Related Transactions.”

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

          Datakey filed no reports on Form 8-K during the fourth quarter of 2000, but it did file a Form 8-K dated February 20, 2001 announcing (i) completion of a $4,800,000 private placement financing; (ii) its strategic focus on ISS and divestiture of EP and (iii) fourth quarter and year 2000 financial results.

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 29, 2001	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 29, 2001
Carl P. Boecher	Director (Principal Executive
	Officer)
/s/ Alan G. Shuler	Vice President and Chief	March 29, 2001
Alan G. Shuler	Financial Officer (Principal
	Financial and Accounting Officer)
/s/ Thomas R. King	Director and Secretary	March 29, 2001
Thomas R. King
/s/ Terrence W. Glarner	Director	March 29, 2001
Terrence W. Glarner
/s/ Gary R. Holland	Chairman of the Board of	March 29, 2001
Gary R. Holland	Directors
/s/ Eugene W. Courtney	Director	March 29, 2001
Eugene W. Courtney

DATAKEY, INC.

EXHIBIT INDEX TO ANNUAL REPORT
ON FORM 10-KSB
For the Fiscal Year Ended December 31, 2000

Exhibit No.	Description
3.1	Restated Articles of Incorporation, as amended
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	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)
10.5	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)
10.6	Employment Agreement between Carl P. Boecher and the Company dated January 1, 1999 (Incorporated by reference to Exhibit 10.1 to Form 10-QSB for fiscal quarter ended April 3, 1999)*
10.7	Employment Agreement between Alan G. Shuler and the Company dated January 1, 1999 (Incorporated by reference to Exhibit 10.2 to Form 10-QSB for fiscal quarter ended April 3, 1999)*
10.8	Employment Agreement between Michael L. Sorensen and the Company dated January 1, 1999 (Incorporated by reference to Exhibit 10.3 to Form 10-QSB for fiscal quarter ended April 3, 1999)*
10.9	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)*
10.10	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)
10.11	1997 Stock Option Plan (Incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended December 31, 1997)*
10.12	Forms of Incentive and Nonqualified Stock Option Agreements under 1997 Stock Option Plan (Incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended December 31, 1997)*
10.13	Lease Extension and Expansion Agreement between the Company and Kraus-Anderson, Incorporated dated April 19, 1999 (Incorporated by reference to Exhibit 10.14 to Form 10-KSB for fiscal year ended December 31, 1999)
10.14	Employment Agreement between Timothy Russell and the Company dated August 16, 1999 (Incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended December 31, 1999)*
10.15	Employment Agreement between Colleen M. Kulhanek and the Company dated April 1, 2000 (Incorporated by reference to Exhibit 10.1 to Form 10-QSB for fiscal quarter ended April 1, 2000)*
10.16	Management Incentive Bonus Plan for 2000 (Incorporated by reference to Exhibit 10.2 to Form 10-QSB for fiscal quarter ended April 1, 2000)*
10.17	2001 Executive Incentive Plan*
10.18	Loan Agreement dated January 23, 2001 between the Company and Ray Lipkin and Unsecured Promissory Note dated January 26, 2001 in the amount of $500,000
13.1	Portions of 2000 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	Consent of Independent Accountant
24.1	Power of attorney for Carl P. Boecher, Alan G. Shuler, Thomas R. King, Terrence W. Glarner, Gary R. Holland, Eugene W. Courtney (included on the signature page of this Form 10-KSB)

* Designates a management contract or compensatory plan or arrangement.

EX-3.1

EXHIBIT 3.1

CERTIFICATE OF
RESTATED ARTICLES OF INCORPORATION OF
DATAKEY, INC.

We the undersigned William P. Flies and Thomas R. King, respectively the president and secretary of Datakey, Inc., a corporation subject to the provisions of the Minnesota Business Corporations Act, do hereby certify that, pursuant to action taken by the directors of the Corporation at a regularly scheduled meeting thereof and a majority vote of the outstanding shares of the Corporation present in person or by proxy at an annual meeting thereof, the Corporation effective as of May 24, 1982 elected to become governed by Minnesota Statutes Ch. 302A and, in addition, approved and adopted the following Restated Articles of Incorporation to supercede and take place of the existing Articles of Incorporation.

ARTICLE I

The name of the Corporation is Datakey, Inc.

ARTICLE II

The registered office of this Corporation is located at 12281 Nicollet Avenue South, Burnsville, Minnesota, 55337.

ARTICLE III

3.01   The aggregate number of shares of stock which this Corporation shall have the authority to issue is 5,000,000.  All common stock issued by the Corporation shall have a par value of $.05 per share.

3.02.  The board of directors may from time to time establish by resolution different classes or series of shares and may fix the rights and preferences of said shares in any class or series.

3.03.  No shareholder of the Corporation shall have any preemptive rights.

3.04.  No shareholder shall be entitled to any cumulative voting rights.

3.05.  The shareholders shall take action by the affirmative vote of the holders of a majority of the voting power of all voting shares outstanding, except where a larger proportion is required by law, these articles or a shareholder control agreement.

ARTICLE IV

The name and address of the original incorporator of this Corporation is: William P. Flies, 12808 Woodview Lane, Burnsville, Minnesota, 55337.

ARTICLE V

The names and addresses of the present board of directors are:

William P. Flies	Richard A. Walter
12281 Nicollet Avenue	10101 E. Bren Road
Burnsville, MN  55337	Minnetonka, MN  55343
Thomas R. King	Timothy P. Stepanek
600 Midwest Plaza Bldg.	1730 Midwest Plaza Bldg.
Minneapolis, MN  55402	Minneapolis, MN  55402

IN WITNESS WHEREOF, we have hereunto set our hands this 24th day of May, 1982.

/s/ William P. Flies

William P. Flies, President

/s/ Thomas R. King

Thomas R. King, Secretary

STATE OF MINNESOTA	)
	) ss.
COUNTY OF HENNEPIN	)

William P. Flies and Thomas R. King, being duly sworn on oath, depose and say that they are, respectively, the president and secretary of Datakey, Inc., the corporation named in the foregoing certificate; that said certificate contains a true statement of the action of the shareholders and board of directors of said corporation; that said certificate is executed on behalf of said corporation by its express authority; and that they further acknowledge the same to be their free act and deed and the free act, and deed of said corporation.

/s/ William Flies

/s/ Thomas R. King

Subscribed and sworn to before me this 24th day of May, 1982.

/s/ Elizabeth A. Forehand

Notary Public - Minnesota

Hennepin County

My commission expires 3-13-87

OFFICERS’ CERTIFICATE OF
DATAKEY, INC.

We, the undersigned, John H. Underwood and Thomas R. King, the respective President and Secretary of Datakey, Inc., a corporation subject to the provisions of Minnesota Statutes, Chapter 302A, do hereby certify that the Minutes of Action Without Meeting of the Board of Directors of the corporation dated December 23, 1985, a copy of which is attached hereto and incorporated herein by reference, in which the Board of Directors authorized the issuance of Preferred Stock, were unanimously adopted and approved by such Board of Directors.

IN WITNESS WHEREOF, we have subscribed our names this 23rd day of December, 1985.

/s/ John H. Underwood

John H. Underwood

President

/s/ Thomas R. King

Thomas R. King

Secretary

STATE OF MINNESOTA	)
	) ss.
COUNTY OF HENNEPIN	)

On this 23rd day of December, 1985, before a Notary Public within and for said County, personally appeared John H. Underwood and Thomas R. King, to me personally known, being by me duly sworn, and did say that they are the President and Secretary, respectively, of the corporation named above and that the said instrument was signed on behalf of the corporation and the persons who signed said instrument acknowledged it to be the free act and deed of said corporation.

/s/ Diane M. Dossetto

Notary Public - Minnesota

Ramsey County

My commission expires 7-10-90

MINUTES OF ACTION WITHOUT MEETING
OF THE BOARD OF DIRECTORS OF
DATAKEY, INC.

The undersigned, being all of the members of the Board of Directors of Datakey, Inc., hereby adopt, by action without meeting, the following resolutions to be effective as of December 23, 1985, to-wit:

RESOLVED:  That the Preferred Stock authorizing resolutions, which resolutions are attached hereto as Exhibit A and which resolutions establish a class of Convertible Preferred Stock be and they hereby are adopted.

FURTHER RESOLVED:  That the officers of the corporation be, and they hereby are, authorized and directed to take whatever action is necessary to effect the foregoing resolutions.

/s/ John H. Underwood

John H. Underwood

/s/ William P. Flies

William P. Flies

/s/ Timothy A. Stepanek

Timothy A. Stepanek

/s/ Thomas R. King

Thomas R. King

EXHIBIT A

MINUTES OF ACTION
WITHOUT MEETING OF THE
BOARD OF DIRECTORS OF DATAKEY, INC.

The undersigned, being all of the members of the Board of Directors of Datakey, Inc., hereby adopt, by action without meeting, the following resolution to be effective as of December 23, 1985, to-wit:

WHEREAS, the Articles of Incorporation of Datakey, Inc., a Minnesota corporation, authorize the corporation to issue an aggregate of 5,000,000 shares of capital stock and empower the corporation’s Board of Directors to establish from time to time by resolution different classes or series of shares and to fix the rights and preferences of said shares in any class or series; and

WHEREAS, there currently are outstanding 2,979,750 shares of Common Stock, the remaining 2,020,250 authorized shares of capital stock being undesignated; and

WHEREAS, the corporation’s Board of Directors deems it to be in the best interests of the corporation and its shareholders to establish a second class of capital stock, Convertible Preferred Stock, having certain rights and preferences;

NOW, THEREFORE, BE IT RESOLVED, that the 5,000,000 shares of capital stock authorized by the Articles of Incorporation of this corporation be, and they hereby are, designated as belonging to the following classes having the relative rights and preferences set forth below:

Section 1.     Shares and Classes Authorized.

Of the 5,000,000 shares which the corporation is authorized to issue, 4,000,000 shares shall be designated Common Stock, par value $.05, 400,000 shares shall be designated Convertible Preferred Stock and 600,000 shares shall be undesignated capital stock.

Section 2.     Right and Preferences of Convertible Preferred Stock.

The rights and preferences of the 400,000 shares of Convertible Preferred Stock shall be as set forth in Exhibit 1 which is attached hereto and made a part hereof.

/s/ William P. Flies

William P. Flies

/s/ John H. Underwood

John H. Underwood

/s/ Timothy A. Stepanek

Timothy A. Stepanek

/s/ Thomas R. King

Thomas R. King

EXHIBIT 1

CERTIFICATE OF RIGHTS AND PREFERENCES
OF
CONVERTIBLE PREFERRED STOCK
OF
DATAKEY, INC.

(A).    Classification of Undesignated Shares.

Of the 1,000,000 undesignated shares which the corporation is authorized to issue under its Articles of Incorporation, 400,000 of such shares shall all be classified as shares of Convertible Preferred Stock of the corporation (the “Preferred Stock”).  Such shares of Preferred Stock, together with the 4,000,000 authorized shares of Common Stock of the corporation (the “Common Stock”) and the balance of the undesignated shares of the corporation, are sometimes hereinafter collectively referred to as the “capital stock”.

(B).    Voting Privileges.

(a)      General.  Each holder of Preferred Stock shall have that number of votes on all matters submitted to the stockholders that is equal to the number of shares of Common Stock into which such holder’s shares of Preferred Stock are then convertible, as hereinafter provided.  Except as otherwise provided in subparagraph (b) below, and except as otherwise required by agreement or law, the shares of capital stock of the corporation shall vote as a single class on all matters submitted to the stockholders.

(b)      Without the affirmative vote of the holders (acting together as a class) of at least a majority (with respect to (1) below) or at least 90% (with respect to (2) below) of the shares of Preferred Stock at the time outstanding, the corporation shall not:

(1)	authorize or issue any shares of stock having a priority over Preferred Stock or ranking on a parity therewith as to the payment or distribution of assets upon the liquidation or dissolution, voluntary or involuntary, of the corporation; or
(2)	amend the Articles of Incorporation of the corporation so as to alter any existing provision relating to Preferred Stock.

(c)      No Cumulative Voting.  No holder of shares of capital stock shall have any cumulative voting rights.

(C).    No Preemptive Rights.

          No holder of shares of any class of capital stock shall be entitled as such, as a matter of right, to subscribe for, purchase or receive any part of any new or additional issue of stock of any class whatsoever, or of securities convertible into or exchangeable for any stock of any class whatsoever, whether now or hereafter authorized and whether issued for cash or other consideration or by way of dividend.

(D).    Cash Dividends.

Any dividend declared must be payable with respect to all outstanding shares of capital stock of the corporation.  In the event any dividend is declared with respect to the capital stock, each holder of Preferred Stock shall be paid such cash dividend on the basis of the number of shares of Common Stock into which such holder’s shares of Preferred Stock are then convertible, as hereinafter provided.

(E).    Other Terms of the Preferred Stock.

(a)      Liquidation Preference.  In the event of either an involuntary or a voluntary liquidation or dissolution of the corporation, the holders of shares of Preferred Stock shall be entitled to receive out of the assets of the corporation an amount equal to $2.50 per share.  In the event of either an involuntary or voluntary liquidation or dissolution of the corporation, payment shall be made to the holders of the Preferred Stock in the amounts herein fixed before any payment shall be made or any assets distributed to the holders of the Common Stock or any other class of shares of the corporation ranking junior to the Preferred Stock with respect to payment of dividends or upon dissolution or liquidation of the corporation.  If upon any such liquidation or dissolution of the corporation the assets available for distribution ‘shall be insufficient to pay the holders of all outstanding shares of Preferred Stock the full amounts to which they respectively shall be entitled, the holders of such shares shall share pro rata in any such distribution.

The merger or consolidation of the corporation into or with another corporation or the merger or consolidation of any other corporation into or with the corporation (in which consolidation or merger the stockholders of the corporation receive distribution of cash or securities or other property as a result of such consolidation or merger), or the sale, transfer or other disposition of all or substantially all of the assets of the corporation, shall be deemed, for purposes of determining the amounts to be received by the holders of the Preferred Stock in such merger, consolidation, sale, transfer or other disposition, to be a liquidation or dissolution of the corporation for purposes of this subparagraph (a) if the holders of a majority of the outstanding shares of Preferred Stock so elect by giving written notice thereof to the corporation at least two days before the effective date of such event.  If no such notice is given, the provisions of subparagraph (c)(7) hereof shall apply.

Nothing hereinabove set forth shall affect in any way the right of each holder of shares of Preferred Stock to convert such shares at any time and from time to time in accordance with subparagraph (c) below.

(b)      Redemptions.  Redemptions of shares of Preferred Stock by the corporation without the consent of the holders thereof are not permitted.  Mandatory redemptions of shares of Preferred Stock by the corporation are not required.

          (c)      Conversion Right; Mandatory Conversion .  At the option of the holders thereof, the shares of Preferred Stock shall be convertible, at the office of the corporation (or at such other office or offices, if any, as the Board of Directors may designate), into fully paid and nonassessable shares (calculated as to each conversion to the nearest 1/100th of a share) of Common Stock of the corporation, at the conversion price, determined as hereinafter provided, in effect at the time of conversion, each share of the Preferred Stock being taken at $2.50 for the purpose of such conversion.  The price at which shares of Common Stock shall be delivered upon conversion (herein called the “conversion price”) shall be initially $2.50 per share of Common Stock (i.e., at an initial conversion rate of one share of Common Stock for each share of Preferred Stock), provided, however, that such initial conversion price shall be subject to adjustment from time to time in certain instances as hereinafter provided.  The following provisions shall govern such right of conversion:

(1)	In order to convert shares of Preferred Stock into shares of Common Stock of the corporation, the holder thereof shall surrender at any office hereinabove mentioned the certificate or certificates therefor, duly endorsed to the corporation or in blank, and give written notice to the corporation at such office that such holder elects to convert such shares.  Shares of Preferred Stock shall be deemed to have been converted immediately prior to the close of business on the day of the surrender of such shares for conversion as herein provided, and the person entitled to receive the shares of Common Stock of the corporation issuable upon such conversion shall be treated for all purposes as the record holder of such shares of Common Stock at such time.  As promptly as practicable on or after the conversion date, the corporation shall issue and deliver or cause to be issued and delivered at such office a certificate or certificates for the number of shares of Common Stock of the corporation issuable upon such conversion.
(2)	The conversion price shall be subject to adjustment from time to time as hereinafter provided.  Upon each adjustment of the conversion price each holder of shares of Preferred Stock shall thereafter be entitled to receive the number of shares of Common Stock of the corporation obtained by multiplying the conversion price in effect immediately prior to such adjustment by the number of shares issuable pursuant to conversion immediately prior to such adjustment and dividing the product thereof by the conversion price resulting from such adjustment.
(3)	Except for the issuance of Conversion Stock and Warrant Stock (as those terms are defined in the Preferred Stock Purchase Agreement dated December 16, 1985 among the corporation and the Purchasers named therein) (a) if and whenever on or prior to June 30, 1987 the corporation shall issue or sell any shares of its Common Stock for a consideration per share less than the conversion price in effect immediately prior to the time of such issue or sale, then forthwith upon such issue or sale the conversion price shall be reduced to such lesser price, and (b) if and whenever after June 30, 1987 the corporation shall issue or sell any shares of its Common Stock for a consideration per share less than the conversion price in effect immediately prior to the time of such issue or sale, and/or the corporation shall issue or sell any shares of Common Stock for a consideration per share less than the market price on the date of such issue or sale, then forthwith upon such issue or sale the conversion price shall be reduced to the price (calculated to the nearest cent) determined by dividing (1) an amount equal to the sum of (aa) the number of shares of Common Stock outstanding immediately prior to such issue or sale multiplied by the then existing conversion price, and (bb) the consideration, if any, received by the corporation upon such issue or sale, by (2) an amount equal to the sum of (aa) the number of shares of Common Stock outstanding immediately prior to such issue or sale and (bb) the number of shares of Common Stock thus issued or sold.

For the purposes of this subparagraph (3), the following provisions (i) to (vii), inclusive, shall also be applicable:

(i)	In case at any time the corporation shall grant (whether directly or by assumption in a merger or otherwise) any rights to subscribe for or to purchase, or any options for the purchase of, (a) Common Stock or (b) any obligations or any shares of stock of the corporation which are convertible into, or exchangeable for, Common Stock (any of such obligations or shares of stock being hereinafter called “Convertible Securities”) whether or not such rights or options or the right to convert or exchange any such Convertible Securities are immediately exercisable, and the price per share for which Common Stock is issuable upon the exercise of such rights or options or upon conversion or exchange of such Convertible Securities (determined by dividing (x) the total amount, if any, received or receivable by the corporation as consideration for the granting of such rights or options, plus the minimum aggregate amount of additional consideration payable to the, corporation upon the exercise of such rights or options, plus, in the case of such Convertible Securities, the minimum aggregate amount of additional consideration, if any, payable upon the issue of such Convertible Securities and upon the conversion or exchange thereof, by (y) the total maximum number of shares of Common Stock issuable upon the exercise of such rights or options or upon the conversion or exchange of all such Convertible Securities issuable upon the exercise of such rights or options) shall be less than the conversion price in effect immediately prior to the time of the granting of such rights or options, then the total maximum number of shares of Common Stock issuable upon the exercise of such rights or options or upon conversion or exchange of the total maximum amount of such Convertible Securities issuable upon the exercise of such rights or options shall (as of the date of granting of such rights or options) be deemed to have been issued for such price per share.  Except as provided in subparagraph (6) below, no further adjustments of the conversion price shall be made upon the actual issue of such Common Stock or of such Convertible Securities upon exercise of such rights or options or upon the actual issue of such Common Stock upon conversion or exchange of such Convertible Securities.
(ii)	In case the corporation shall issue or sell (whether directly or by assumption in a merger or otherwise) any Convertible Securities, whether or not the rights to exchange or convert thereunder are immediately exercisable, and the price per share for which Common Stock is issuable upon such conversion or exchange (determined by dividing (x) the total amount received or receivable by the corporation as consideration for the issue or sale of such Convertible Securities, plus the minimum aggregate amount of additional consideration, if any, payable to the corporation upon the conversion or exchange thereof, by (y) the total maximum number of shares of Common Stock issuable upon the conversion or exchange of all such Convertible Securities) shall be less than the conversion price in effect immediately prior to the time of such issue or sale, then the total maximum number of shares of Common Stock issuable upon conversion or exchange of all such Convertible Securities shall (as of the date of the issue or sale of such Convertible Securities) be deemed to be outstanding and to have been issued for such price per share, provided that (a) except as provided in subparagraph (6) below, no further adjustments of the conversion price shall be made upon the actual issue of such Common Stock upon conversion or exchange of such Convertible Securities, and (b) if any such issue or sale of such Convertible Securities is made upon exercise of any rights to subscribe for or to purchase or any option to purchase any such Convertible Securities for which adjustments of the conversion price have been or are to be made pursuant to other provisions of this subparagraph (3), no further adjustment of the conversion price shall be made by reason of such issue or sale.
(iii)	In case the corporation shall, after June 30, 1987, declare a dividend or make any other distribution upon any capital stock of the corporation payable in Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities, any Common Stock or Convertible Securities, or any such rights or options, as the case may be, issuable in payment of such dividend or distribution shall be deemed to have been issued or sold without consideration.
(iv)	In case any shares of Common Stock or Convertible Securities or any rights or options to purchase any such Common Stock or Convertible Securities shall be issued or sold for cash, the consideration received therefor shall be deemed to be the amount received by the corporation therefor, without deducting therefrom any expenses incurred or any underwriting commissions or concessions paid or allowed by the corporation in connection therewith.  In case any shares of Common Stock or Convertible Securities or any rights or options to purchase any such Common Stock or Convertible Securities shall be issued or sold for a consideration other than cash, the amount of the consideration other than cash received by the corporation shall be deemed to be the fair value of such consideration as determined by the Board of Directors of the corporation, without deducting therefrom any expenses incurred or any underwriting commissions or concessions paid or allowed by the corporation in connection therewith.  In case any shares of Common Stock or Convertible Securities or any rights or options to purchase such Common Stock or Convertible Securities shall be issued in connection with any merger or consolidation in which the corporation is the surviving corporation, the amount of consideration therefor shall be deemed to be the fair value as determined by the Board of Directors of the corporation of such portion of the assets and business of the non-surviving corporation or corporations as such Board shall determine to be attributable to such Common Stock, Convertible Securities, rights or options, as the case may be.  In the event of any consolidation or merger of the corporation in which the corporation is not the surviving corporation or in the event of any sale of all or substantially all of the assets of the corporation for stock or other securities of any other corporation, the corporation shall be deemed to have issued a number of shares of its Common Stock for stock or securities of the other corporation computed on the basis of the actual exchange ratio on which the transaction was predicated and for a consideration equal to the fair market value on the date of such transaction of such stock or securities of the other corporation, and if any such calculation results in adjustment of the conversion price, the determination of the number of shares of Common Stock issuable upon conversion immediately prior to such merger, conversion or sale, for purposes of subparagraph (7) below, shall be made after giving effect to such adjustment of the conversion price.
(v)	In case the corporation shall take a record of the holders of its Common Stock for the purpose of entitling them (a) to receive a dividend or other distribution payable in Common Stock or in Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities, or (b) to subscribe for or purchase Common Stock or Convertible Securities, then the date of such record shall be deemed to be the date of the issue or sale of the shares of Common Stock deemed to have been issued or sold upon the declaration of such dividend or the making of such other distribution or the date of the granting of such rights of subscription or purchase, as the case may be.
(vi)	The number of shares of Common Stock outstanding at any given time shall not include shares owned or held by or for the account of the corporation, and the disposition of any such shares shall be considered an issue or sale of Common Stock for the purpose of this subparagraph (3).
(vii)	“Market price” shall mean the average of the high and low prices of the Common Stock sales on all exchanges on which the Common Stock may at the time be listed, or, if there shall have been no sales on any such exchange on any such day, the average of the bid and asked prices at the end of such day, or, if the Common Stock shall not be so listed, the average of the bid and asked prices at the end of the day in the over-the-counter market, in each case averaged over a period of 20 consecutive business days prior to the date as of which “market price” is being determined.  If at any time the Common Stock is not listed on any exchange or quoted in the over-the-counter market, the “market price” shall be deemed to be the higher of (i) the book value thereof as determined by any firm of independent public accountants of recognized standing selected by the Board of Directors of the corporation as of the last day of any month ending within 60 days preceding the date as of which the determination is to be made, or (ii) the fair value thereof determined in good faith by the Board of Directors of the corporation as of a date which is within 15 days of the date as of which the determination is to be made.

(4)	In case the corporation shall declare a dividend or make a distribution upon the Common Stock payable otherwise than out of earnings or earned surplus (including dividends or distributions in Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities), then thereafter each holder of shares of Preferred Stock upon the conversion thereof will be entitled to receive the number of shares of Common Stock into which such shares of Preferred Stock have been converted, and, in addition and without payment therefor, the cash, stock or other securities and other property which such holder would have received by way of dividends (otherwise than out of such earnings or surplus) if continuously since such holder became the record holder of such shares of Preferred Stock such holder (i) had been the record holder of the number of shares of Common Stock then received, and (ii) had retained all dividends or distributions in stock or securities (including Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities) payable in respect of such Common Stock or in respect of any stock or securities paid as dividends or distributions and originating directly or indirectly from such Common Stock.  For the purposes of the foregoing a dividend or distribution other than in cash shall be considered payable out of earnings or earned surplus only to the extent that such earnings or surplus are charged an amount equal to the fair value of such dividend or distribution as determined by the Board of Directors of the corporation.
(5)	In case the corporation shall at any time subdivide its outstanding shares of Common Stock into a greater number of shares, the conversion price in effect immediately prior to such subdivision shall be proportionately reduced, and conversely, in case the outstanding shares of Common Stock of the corporation shall be combined into a smaller number of shares, the conversion price in effect immediately prior to such combination shall be proportionately increased.
(6)	If (i) the purchase price provided for in any right or option referred to in clause (i) of subparagraph (3), or (ii) the additional consideration, if any, payable upon the conversion or exchange of Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3), or (iii) the rate at which any Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3) are convertible into or exchangeable for Common Stock, shall change at any time (other than under or by reason of provisions designed to protect against dilution), the conversion price then in effect hereunder shall forthwith be increased or decreased to such conversion price as would have obtained had the adjustments made upon the issuance of such rights, options or Convertible Securities been made upon the basis of (a) the issuance of the number of shares of Common Stock theretofore actually delivered upon the exercise of such options or rights or upon the conversion or exchange of such Convertible Securities, and the total consideration received therefor, and (b) the issuance at the time of such change of any such options, rights, or Convertible Securities then still outstanding for the consideration, if any, received by the corporation therefor and to be received on the basis of such changed price; and on the expiration of any such option or right or the termination of any such right to convert or exchange such Convertible Securities, the conversion price then in effect hereunder shall forthwith be increased to such conversion price as would have obtained had the adjustments made upon the issuance of such rights or options or Convertible Securities been made upon the basis of the issuance o the shares of Common Stock theretofore actually delivered (and the total consideration received therefor) upon the exercise of such rights or options or upon the conversion or exchange of such Convertible Securities.  If the purchase price provided for in any right or option referred to in clause (i) of subparagraph (3), or the rate at which any Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3) are convertible into or exchangeable for Common Stock, shall decrease at any time under or by reason of provisions with respect thereto designed to protect against dilution, then in case of the delivery of Common Stock upon the exercise of any such right or option or upon conversion or exchange of any such Convertible Security, the conversion price then in effect hereunder shall forthwith be decreased to such conversion price as would have obtained had the adjustments made upon the issuance of such right, option or Convertible Security been made upon the basis of the issuance of (and the total consideration received for) the shares of Common Stock delivered as aforesaid.
(7)	If any capital reorganization or reclassification of the capital stock of the corporation, or consolidation or merger of the corporation with another corporation, or the sale of all or substantially all of its assets to another corporation shall be effected in such a way that holders of Common Stock shall be entitled to receive stock, securities or assets with respect to or in exchange for Common Stock, then, as a condition of such reorganization, reclassification, consolidation, merger or sale, and subject to subparagraph (a) above, lawful and adequate provision shall be made whereby the holders of Preferred Stock shall thereafter have the right to receive upon the basis and upon the terms and conditions specified herein and in lieu of the shares of the Common Stock of the corporation immediately theretofore receivable upon the conversion of Preferred Stock, such shares of stock, securities or assets as may be issued or payable with respect to or in exchange for a number of outstanding shares of such Common Stock equal to the number of shares of such stock immediately theretofore receivable upon the conversion of Preferred Stock had such reorganization, reclassification, consolidation, merger or sale not taken place, plus all dividends unpaid and accumulated or accrued thereon to the date of such reorganization, reclassification, consolidation, merger or sale, and in any such case appropriate provision shall be made with respect to the rights and interests of the holders of Preferred Stock to the end that the provisions hereof (including without limitation provisions for adjustments of the conversion price and of the number of shares receivable upon the conversion of Preferred Stock) shall thereafter be applicable, as nearly as may be in relation to any shares of stock, securities or assets thereafter receivable upon the conversion of Preferred Stock.  The corporation shall not effect any such consolidation, merger or sale, unless prior to the consummation thereof the successor corporation (if other than the corporation) resulting from such consolidation or merger or the corporation purchasing such assets shall assume by written instrument executed and mailed to the holders of Preferred Stock, at the last addresses of such holders appearing on the books of the corporation, the obligation to deliver to such holder such shares of stock, securities or assets as, in accordance with the foregoing provisions, such holder may be entitled to receive.
(8)	Upon any adjustment of the conversion price, then and in each case the corporation shall give written notice thereof, by first-class mail, postage prepaid, addressed to the holders of Preferred Stock, at the addresses of such holders as shown on the books of the corporation, which notice shall state the conversion price resulting from such adjustment and the increase or decrease, if any, in the number of shares receivable at such price upon the conversion of Preferred Stock, setting forth in reasonable detail the method of calculation and the facts upon which such calculation is based.
(9)	In case at any time:

(i)	the corporation shall declare any cash dividend on its Common Stock at a rate in excess of the rate of the last cash dividend theretofore paid;
(ii)	the corporation shall pay any dividend payable in stock upon its Common Stock or make any distribution (other than regular cash dividends) to the holders of its Common Stock;
(iii)	the corporation shall offer for subscription pro rata to the holders of its Common Stock any additional shares of stock of any class or other rights;
(iv)	there shall be any capital reorganization, or reclassification of the capital stock of the corporation, or consolidation or merger of the corporation with, or sales of all or substantially all of its assets to, another corporation; or
(v)	there shall be a voluntary or involuntary dissolution, liquidation or winding up of the corporation;

then, in any one or more of said cases, the corporation shall give written notice, by first-class mail, postage prepaid, addressed to the holders of Preferred Stock at the addresses of such holders as shown on the books of the corporation, of the date on which (a) the books of the corporation shall close or a record shall be taken for such dividend, distribution or subscription rights, or (b) such reorganization, reclassification, consolidation, merger, sale, dissolution, liquidation or winding up shall take place, as the case may be.  Such notice shall also specify the date as of which the holders of Common Stock of record shall participate in such dividend, distribution or subscription rights, or shall be entitled to exchange their Common Stock for securities or other property deliverable upon such reorganization, reclassification, consolidation, merger, sale, dissolution, liquidation, or winding up, as the case may be.  Such written notice shall be given at least 20 days prior to the action in question and not less than 20 days prior to the record date or the date on which the corporation’s transfer books are closed in respect thereto.

(10)	If any event occurs as to which in the opinion of the Board of Directors of the corporation the other provisions of this paragraph (c) are not strictly applicable or if strictly applicable would not fairly protect the rights of the holders of Preferred Stock in accordance with the essential intent and principles of such provisions, then the Board of Directors shall make an adjustment in the application of such provisions, in accordance with such essential intent and principles, so as to protect such rights as aforesaid.
(11)	As used in this paragraph (c) the term “Common Stock” shall mean and include the corporation’s presently authorized Common Stock and shall also include any capital stock of any class of the corporation hereafter authorized which shall not be limited to a fixed sum or percentage in respect of the rights of the holders thereof to participate in dividends or in the distribution of assets upon the voluntary or involuntary liquidation, dissolution or winding up of the corporation; provided that the shares receivable pursuant to conversion of shares of Preferred Stock shall include shares designated as Common Stock of the corporation as of the date of issuance of such shares of Preferred Stock, or, in case of any reclassification of the outstanding shares thereof, the stock, securities or assets provided for in subparagraph (7) above.
(12)	No fractional shares of Common Stock shall be issued upon conversion, but, instead of any fraction of a share which would otherwise be issuable, the corporation shall pay a cash adjustment in respect of such fraction in an amount equal to the same fraction of the market price per share of Common Stock, determined pursuant to subparagraph (3)(vii) above, as of the close of business on the day of conversion.

Mandatory Conversion.  Preferred Stock shall automatically be converted into shares of Common Stock of the corporation, without any act by the corporation or the holders of Preferred Stock, concurrently with the closing of the first public offering by the corporation of shares of Common Stock of the corporation registered under the Securities Act of 1933, as amended, in which (1) the offering is underwritten on a firm commitment basis by an underwriter, or a group of underwriters represented by an underwriter or underwriters, and (2) the aggregate public offering price of the securities sold for cash by the corporation in the offering, net of expenses payable by the corporation in connection with such offering, is at least $5,000,000, and (3) the public offering price per share of Common Stock is at least $5 (as adjusted from time to time to reflect stock splits, dividends, recapitalizations, combinations or the like).  As used herein, the term “closing” shall mean the delivery by the corporation to the underwriters of certificates representing the shares of Common Stock of the corporation offered to the public against delivery to the corporation by such underwriters of payment therefor.  The term “firm commitment basis” with respect to the underwriting of such public offering shall mean a commitment pursuant to a written underwriting agreement under which the nature of the underwriters’ commitment is such that all securities will be purchased by such underwriters if any securities are purchased by such underwriters.  Each holder of a share of Preferred Stock so converted shall be entitled to receive the full number of shares of Common Stock into which such share of Preferred Stock held by such holder could be converted if such holder had exercised its conversion right at the time of closing of such public offering.  Upon such conversion, each holder of a share of Preferred Stock shall immediately surrender such share in exchange for appropriate stock certificates representing a share or shares of Common Stock of the corporation.

ARTICLES OF AMENDMENT OF ARTICLES OF INCORPORATION

OF
DATAKEY, INC.

Pursuant to the provisions of Minnesota Statutes, Section 302A.135, the following Amendment of Section 3.01 of the Articles of Incorporation of Datakey, Inc. was adopted at a meeting of the shareholders of the corporation duly convened and held on the 6^th day of May, 1986, by a vote of 84% of the voting power of all shares entitled to vote:

“3.01  The aggregate number of shares of stock which this corporation shall have authority to issue is 12,500,000 shares, consisting of 10,000,000 shares of Common Stock, par value $.05, 400,000 shares of Preferred Stock and 2,100,000 undesignated shares.”

I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation.

/s/ John H. Underwood

John H. Underwood, President

STATE OF MINNESOTA	)
	) ss.
COUNTY OF Dakota	)

The foregoing instrument was acknowledged before me this 25th day of June, 1986, by John H. Underwood, President of Datakey, Inc., a Minnesota corporation, on behalf of the corporation.

/s/ Bette F. Feahr

Notary Public - Minnesota

Dakota County

My commission expires 8-20-91

(Notarial Seal)

ARTICLES OF AMENDMENT OF ARTICLES OF INCORPORAT10N
OF
DATAKEY, INC.

Pursuant to the provisions of Minnesota Statutes, Section 302A.135, the following Amendment of the Articles of Incorporation of Datakey, Inc., adding Article VI, was adopted at a meeting of the shareholders of the corporation duly convened and held on the May 12, 1987, by a majority vote of the voting power of all shares entitled to vote:

“ARTICLE VI - LIMITATION OF DIRECTOR LIABILITY

6.1)    To the fullest extent permitted by the Minnesota Business Corporation Act as the same exists or may hereafter be amended, a director of this corporation shall not be personally liable to the corporation or its shareholders for monetary damages for breach of fiduciary duty as a director.”

I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation.

/s/ John H. Underwood

John H. Underwood, President

STATE OF MINNESOTA	)
	) ss.
COUNTY OF DAKOTA	)

The foregoing instrument was acknowledged before me this 27 day of May, 1987, by John H. Underwood, President of Datakey, Inc., a Minnesota corporation, on behalf of the corporation.

/s/ Bette F. Feahr

Notary Public - Minnesota

Dakota County

My commission expires 8-20-91

(Notarial Seal)

Notice of Change of Registered Office
by
DATAKEY, INC.

Pursuant to Minnesota Statutes, Section 302A.123, the undersigned hereby certifies that the Board of Directors of the above named Minnesota Corporation has resolved to change the corporation’s registered office or agent:

FROM:	Datakey, Inc.
	12281 Nicollet Avenue South
	Burnsville, MN  55337
TO:	Datakey, Inc.
	407 West Travelers Trail
	Burnsville, MN  55337-2554

The new address may not be a post office box.  It must be a street address, pursuant to Minnesota Statutes, Section 302A.011, Subd. 3.

The effective date of the change will be the 1st day of July, 1987 or the day of filing of this certificate with the Secretary of State, whichever is later.

I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation.

/s/ George H. M. Rountree

George H. M. Rountree

Vice President Finance

July 11, 1988

STATE OF MINNESOTA	)
	) ss.
COUNTY OF Dakota	)

The foregoing instrument was acknowledged before me on this 11th day of July, 1988.

/s/ Bette F. Feahr

Notary Public - Minnesota

Dakota County

My commission expires 8-20-91

State of Minnesota
Department of State

Filed: August 10, 1988

STATEMENT OF DESIGNATION OF SHARES
OF
DATAKEY, INC.

The undersigned hereby certifies that the resolutions set forth on Exhibit A attached hereto were duly adopted by the Board of Directors of Datakey, Inc. on May 11, 1998.

I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation.

May 14, 1998

DATAKEY, INC.

/s/ Alan G. Shuler

Alan G. Shuler

Vice President and Chief Financial Officer

EXHIBIT A

DESIGNATION OF SERIES A CONVERTIBLE CUMULATIVE PREFERRED STOCK

WHEREAS, pursuant to the Articles of Incorporation of this corporation, the Board of Directors has authority to establish, from the 2,100,000 undesignated shares of capital stock, one or more classes or series of shares, to designate each such class or series, and to fix the relative rights and preferences of each such class or series; and

WHEREAS, the Board of Directors deem it advisable to designate shares of Series A Convertible Cumulative Preferred Stock;

NOW, THEREFORE, RESOLVED, that of the 2,100,000 undesignated shares currently authorized, 150,000 shares are hereby designated as shares of Series A Convertible Cumulative Preferred Stock, which shares shall have the terms as set forth on Exhibit A hereto.

EXHIBIT A

RIGHTS, PREFERENCES AND RESTRICTIONS OF PREFERRED STOCK

The rights, preferences, restrictions and other matters relating to the Series A Convertible Cumulative Preferred Stock (the “Series A Preferred Stock”) are as follows:

1.       Dividend Provisions.  Upon issuance, dividends shall accrue on each share of outstanding Series A Preferred Stock at an annual rate equal to $1.264 per share per annum (8% of the Original Issue Price, as defined herein).  Such dividends shall be cumulative and shall be payable upon any conversion of the Series A Preferred Stock pursuant to Section 3 hereof.  Such dividends shall only be paid out of legally available funds of the Company.  Such dividends shall be payable by the Company, in its sole discretion, all in cash or all by the issuance of a number of shares of the Company’s unrestricted, freely tradable common stock equal to the dividends owing on the Series A Preferred Stock; provided, however, that prior to the payment of any such dividend by the issuance of shares of the Company’s common stock, the Company shall deliver to the Investors an opinion of its counsel stating that all such shares have been validly registered, and that they are duly authorized, validly issued and nonassessable.  For the purposes hereof, the number of shares of the Company’s common stock issuable in lieu of any cash dividend payment shall equal the total dividend payment then due divided by the per share price of such stock.  The per share price of the Company’s common stock shall be determined based on the average closing bid price of such stock quoted on The Nasdaq Stock Market for the ten consecutive trading days prior to the payment of such dividends.  Dividends on shares of the Series A Preferred Stock shall accrue beginning on the date of issuance of the shares of Series A Preferred Stock, shall compound on an annual basis and shall be payable upon conversion of the Series A Preferred Stock (a “Payment Date”).  All accrued and unpaid dividends on the Series A Preferred Stock must be paid before any dividends may be declared or paid on any other junior series of preferred or common stock issued by the Company.

2.       Liquidation Preference.

(a)      In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary, the holders of the previously issued Convertible Preferred Stock (the “Convertible Preferred Stock”) and the Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets of the Company to the holders of common stock by reason of their ownership thereof, an amount per share equal to $2.50 for the Convertible Preferred Stock, and for the Series A Preferred Stock the sum of (i) $15.80, as adjusted pursuant to Section 4(c) hereof (the “Original Issue Price”), and (ii) an amount equal to cumulative unpaid dividends on such shares (respectively, a “Liquidation Amount”).  If upon the occurrence of such an event, the assets and funds thus distributed among the holders of the Convertible Preferred Stock and the Series A Preferred Stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then, the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the Convertible Preferred Stock and the Series A Preferred Stock in proportion to the amount of such stock owned by each such holder multiplied by the appropriate Liquidation Amount.

(b)      Upon the completion of the distribution required by subparagraph (a) of this Section 2, if assets remain in the Company, the remaining assets of the Company shall be distributed ratably among the holders of the Company’s common stock and the Series A Preferred Stock in proportion to the number of shares of common stock held by each (assuming full conversion of all shares of Series A Preferred Stock).

(c)      (i)       For purposes of this Section 2, a liquidation, dissolution or winding up of the Company shall be deemed to be occasioned by, or to include, (A) the acquisition of the Company by another entity by means of any transaction or series of related transactions (including any reorganization, merger or consolidation but excluding any merger effected exclusively for the purpose of changing the domicile of the Company); or (B) a sale of all or substantially all of the assets of the Company, unless the Company’s shareholders as constituted immediately prior to such acquisition or sale will, immediately after such acquisition or sale (by virtue of securities issued as consideration for the Company’s acquisition or sale or otherwise) hold at least 50% of the voting power of the surviving or acquiring entity.

(ii)      In any of such events, if the consideration received by the Company is other than cash, its value will be deemed its fair market value.

(iii)     In the event the requirements of this Section 2 are not complied with, the Company shall forthwith either:

(A)     cause such closing to be postponed until such time as the requirements of this Section 2 have been complied with, or

(B)     cancel such transaction, in which event the rights, preferences and privileges of the holders of the Convertible Preferred Stock and the Series A Preferred Stock shall revert to and be the same as such rights, preferences and privileges existing immediately prior to the date of the first notice referred to in subsection 2(c)(iv) hereof.

(iv)     The Company shall give each holder of record of Convertible Preferred Stock and the Series A Preferred Stock written notice of such impending transaction not later than 20 days prior to the shareholders’ meeting called to approve such transaction, or 20 days prior to the closing of such transaction, whichever is earlier, and shall also notify such holders in writing of the final approval of such transaction; provided, however, that the holder of any shares of then outstanding Convertible Preferred Stock or Series A Preferred Stock shall have the right during such 20–day period to convert such shares pursuant to Section 3 hereof. The first of such notices shall describe the material terms and conditions of the impending transaction and the provisions of this Section 2, and the Company shall thereafter give such holders prompt notice of any material changes. The transaction shall in no event take place sooner than 20 days after the Company has given the first notice provided for herein or sooner than ten days after the Company has given notice of any material changes provided for herein; provided, however, that such periods may be shortened upon the written consent of the holders of the Convertible Preferred Stock and the Series A Preferred Stock that are entitled to such notice rights or similar notice rights and that represent at least a majority of the voting power of all then outstanding shares of each of the classes of preferred stock, voting separately as a class.

3.       Conversion.

(a)      Conversion Right.  At the option of the holder thereof, each share of Series A Preferred Stock shall be convertible at any time during the period commencing on the day on which the Series A Preferred Stock is issued and expiring on May 15, 2000 (the date which is the second anniversary of the date of issuance of the Series A Preferred Stock); provided, however, that such expiration date shall be extended for a number of days equal to the number of days beyond the 90th day following the date of issuance of the Series A Preferred Stock that the Registration Statement (as such term is defined in the Registration Rights Agreement, of even date herewith, entered into by and between the Company and the Investors set forth on Schedule A thereto) is not effective (such date, including any extension thereof pursuant to the foregoing proviso, being herein referred to as the “Second Anniversary”).  The Series A Preferred Stock shall be convertible at the office of the Company or any transfer agent for such stock into such number of fully paid and nonassessable shares of the Company’s common stock as is determined by dividing the Original Issue Price, subject to adjustment as provided in Section 4, by the Conversion Price applicable to such shares, determined as hereafter provided, in effect on the date the certificates representing such shares are surrendered for conversion (the “Conversion Date”).  The Conversion Price shall be equal to the average closing bid price of one share of the Company’s common stock as quoted by the Nasdaq SmallCap Market, the Nasdaq National Market or the principal exchange upon which shares of the Company’s common stock may be listed, or, if the Company’s common stock shall not then be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market or listed on a national securities exchange, but shall otherwise be traded in the over–the–counter market, on such over–the–counter market for the ten–day period ending on the day prior to the Conversion Date (the “Trading Period”) multiplied by .8 (the “Conversion Price”); provided, however, that in no event shall the Conversion Price exceed $5.00 per share or be less than $2.75 (the “Maximum Price” and “Minimum Price,” respectively) per share; and provided, further, that appropriate adjustments shall be made in determining the average closing bid price if a recapitalization or other event affecting the Company’s common stock shall occur during the Trading Period.

(b)      Dividend Payment. Should the Company, pursuant to Section 1 hereof, not elect to pay all outstanding, cumulative, accrued and unpaid dividends on the Series A Preferred Stock in shares of its common stock, the Company shall pay, in immediately available funds, to the holder of any shares of Series A Preferred Stock being converted, within two days, all such dividends on the date that it receives notice of such holder’s intent to convert such shares pursuant to (d) below.  Separately, should the Company elect to pay all outstanding, cumulative, accrued and unpaid dividends on the Series A Preferred Stock in shares of its common stock, it shall, within two business days of receiving a holder’s notice of intent to convert, deliver certificates representing such shares to the holder of the Series A Preferred Stock.

(c)      Automatic Conversion. Any shares of Series A Preferred Stock remaining outstanding on the Second Anniversary shall be automatically converted pursuant to the conversion terms of Section 3(a) above.  The Conversion Date with respect to such automatic conversion shall be the Second Anniversary.  In any event, the Company shall, within two business days after automatic conversion of the Series A Preferred Stock, issue and deliver a certificate or certificates for the number of shares of the Company’s common stock to which each former holder of Series A Preferred Stock is entitled.  Notwithstanding the foregoing, no automatic conversion of the Series A Preferred Stock shall occur pursuant to this Section unless (i) all shares of the Company’s common stock underlying the shares of Series A Preferred Stock may be sold pursuant to an effective registration statement under the Securities Act of 1933, as amended, (ii) the Company’s common stock is listed and trading on The Nasdaq Stock Market, and (iii) the Company has reserved and available for issuance a number of shares of its common stock sufficient to cover conversion of all outstanding shares of Series A Preferred Stock.

(d)      Mechanics of Conversion.  Before any holder of Series A Preferred Stock shall be entitled to convert the same into shares of the Company’s common stock, he, she or it  shall surrender the certificate or certificates therefor, duly endorsed, at the office of the Company or of any transfer agent for the Series A Preferred Stock, and shall give written notice, via facsimile, to the Company, at its principal corporate office, of the election to convert the same and shall state therein the name or names in which the certificate or certificates for shares of the Company’s common stock are to be issued.  The Company shall, immediately thereafter (and in any event no more than two business days thereafter), issue and deliver to such holder of Series A Preferred Stock at the address shown on the Company’s records or at such other address as such party may designate by written notice to the Company, or to the nominee or nominees of such holder, a certificate or certificates for the number of shares of the Company’s common stock to which such holder shall be entitled pursuant to Section 3(a) and a certificate representing shares of Series A Preferred Stock not so converted by the holder.  Such conversion shall be deemed to have been made immediately prior to the close of business on the Conversion Date, and the person or persons entitled to receive the shares of the Company’s common stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of the Company’s common stock as of such date.

(e)      Mechanics of Automatic Conversion .  On the Conversion Date with respect to the automatic conversion pursuant to subsection 3(c) above, the certificates representing shares of Series A Preferred Stock shall immediately represent that number of shares of the Company’s common stock into which such shares are convertible.  Holders of Series A Preferred Stock shall deliver their certificates, duly endorsed in blank, to the principal office of the Company, together with a notice setting out the name or names (with addresses) and denominations in which the certificates representing such shares of common stock issuable upon conversion are to be issued and including instructions for delivery thereof.  The person entitled to receive the shares of the Company’s common stock issuable upon such conversion shall be treated for all purposes as the record holder of such shares of common stock at and on the Conversion Date, and the rights of such person as a holder of shares of Series A Preferred Stock shall cease and terminate at and on the Conversion Date, in any case without regard to any failure by such holder to deliver the certificates or the notice required by this subsection 3(e).  On the Conversion Date with respect to automatic conversion, the Company shall pay all outstanding, cumulative, accrued and unpaid dividends, either by the issuance of shares of its common stock or in cash, pursuant to the provisions set forth in (a) above; provided, however, that should the Company elect to pay such dividends by the issuance of additional shares of its common stock, the person entitled to receive such shares of the Company’s common stock issuable upon such conversion shall be treated for all purposes as the record holder of such additional shares on the Conversion Date

(f)       No Impairment.  The Company will not, by amendment of its Articles of Incorporation or through any reorganization, recapitalization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Company, but will at all times in good faith assist in the carrying out of all the provisions of this Section 3 and in the taking of all such action as may be necessary or appropriate in order to protect the conversion rights of the holders of the Series A Preferred Stock against impairment.

(g)      No Fractional Shares.        No fractional shares shall be issued upon the conversion of any share or shares of the Series A Preferred Stock, and the number of shares of the Company’s common stock to be issued shall be rounded to the nearest whole share.  Whether or not fractional shares are issuable upon such conversion shall be determined on the basis of the total number of shares of Series A Preferred Stock the holder is at the time converting into shares of the Company’s common stock and the number of shares of such common stock issuable upon such aggregate conversion.

(h)      Notices of Record Date.  In the event of any taking by the Company of a record of the holders of any class of securities for the purpose of determining the holders thereof who are entitled to receive any dividend or other distribution, any right to subscribe for, purchase or otherwise acquire any shares of stock of any class or any other securities or property, or to receive any other right, the Company shall mail to each holder of Series A Preferred Stock, at least 20 days prior to the date specified therein, a notice specifying the date on which any such record is to be taken for the purpose of such dividend, distribution or right, and the amount and character of such dividend, distribution or right.

                    (i)       Reservation of Stock Issuable Upon Conversion.  The Company shall at all times reserve and keep available out of its authorized but unissued shares of common stock, solely for the purpose of effecting the conversion of the shares of the Series A Preferred Stock, such number of its shares of its common stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Series A Preferred Stock; and if at any time the number of authorized but unissued shares of the Company’s common stock shall not be sufficient to effect the conversion of all then outstanding shares of the Series A Preferred Stock, in addition to such other remedies as shall be available to the holder of such Series A Preferred Stock, the Company will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of common stock to such number of shares as shall be sufficient for such purposes, including engaging in best efforts to obtain the requisite shareholder approval of any necessary amendment to the Company’s Articles of Incorporation.

(j)       Notices.  Any notice required by the provisions of this Section 3 to be given to the holders of shares of Series A Preferred Stock shall be deemed given if deposited in the United States mail, postage prepaid, and addressed to each holder of record at his, her or its address appearing on the books of the Company.

4.       Anti-Dilution Provisions.

The Original Issue Price shall be subject to adjustment from time to time upon the happening of any of the following events:  (a) In the event the Company shall issue or sell any shares of its common stock (except as provided in paragraph (e) hereof) for a consideration per share less than the greater of (A) $5.00, or (B) 80% of the Market Price (as defined below) on the date of such issue or sale, then the Original Issue Price shall be increased to such greater price (calculated to the nearest cent) as shall be determined by multiplying the Original Issue Price by a fraction, the numerator of which shall be the number of shares of the Company’s common stock outstanding immediately after the issuance or sale of such additional shares, and the denominator of which shall be the sum of (i) the number of shares of the Company’s common stock outstanding immediately prior to the issuance or sale of such additional shares, and (ii) the number of shares of the Company’s common stock which the aggregate consideration received for the issuance or sale of such additional shares would purchase at the greater of $5.00, or if such shares of the Company’s common stock shall have been issued for a consideration per share less than 80% of the Market Price on the date of issuance or sale, the current Market Price.  For purposes of this paragraph, all shares of the Company’s common stock issuable upon exercise of outstanding options and warrants shall be deemed to be outstanding.

(b)      For the purposes of paragraph 4(a) above, the following subparagraphs (i) to (vii), inclusive, shall be applicable:

(i)        If at any time the Company shall issue or sell any rights to subscribe for, or any rights or options to purchase, shares of its common stock or any stock or other securities convertible into or exchangeable for such common stock (such convertible or exchangeable stock or securities being hereinafter called “Convertible Securities”), whether or not such rights or options or the right to convert or exchange any such Convertible Securities shall be immediately exercisable, and the price per share for which shares of the Company’s common stock shall be issuable upon the exercise of such rights or options or upon conversion or exchange of such Convertible Securities (determined by dividing (1) the total amount, if any, received or receivable by the Company as consideration for the granting of such rights or options, plus the minimum aggregate amount of additional consideration payable to the Company upon the exercise of such rights or options, plus, in the case of any such rights or options which shall relate to Convertible Securities, the minimum aggregate amount of additional consideration, if any, payable upon the issue or sale of such Convertible Securities and upon the conversion or exchange thereof, by (2) the total number of shares of the Company’s common stock issuable upon the exercise of such rights or options or upon the conversion or exchange of all such Convertible Securities issuable upon the exercise of such rights or options) shall be less than the greater of (x) the $5.00, or (y) 80% of the Market Price at the time of such issue or sale, then the total number of shares of the Company’s common stock issuable upon the exercise of such rights or options or upon conversion or exchange of the total amount of such Convertible Securities issuable upon the exercise of such rights or options shall (as of the date of granting of such rights or options) be deemed to be outstanding and to have been issued for such price per share, and except as provided in paragraph 4(d), no further adjustments of the Original Issue Price shall be made upon the actual issue of such shares of common stock or of such Convertible Securities, upon the exercise of such rights or options or upon the actual issue of such common stock upon conversion or exchange of such Convertible Securities.

(ii)      If at any time the Company shall issue or sell any Convertible Securities, whether or not the rights to exchange or convert thereunder shall be immediately exercisable, and the price per share for which shares of the Company’s common stock shall be issuable upon such conversion or exchange (determined by dividing (1) the total amount received or receivable by the Company as consideration for the issue or sale of such Convertible Securities, plus the minimum aggregate amount of additional consideration, if any, payable to the Company upon the conversion or exchange thereof, by (2) the total number of shares of the Company’s common stock issuable upon the conversion or exchange of all such Convertible Securities) shall be less than the greater of (x) $5.00, or (y) 80% of the Market Price at the time of such issue or sale, then the total number of shares of the Company’s common stock issuable upon conversion or exchange of all such Convertible Securities shall (as of the date of the issue or sale of such Convertible Securities) be deemed to be outstanding and to have been issued for such price per share, and, except as provided in paragraph 4(d), no further adjustments of the Original Issue Price shall be made upon the actual issue of such shares of common stock upon conversion or exchange of such Convertible Securities.  In addition, if any issue or sale of such Convertible Securities shall be made upon exercise of any rights to subscribe for or to purchase or any option to purchase any such Convertible Securities for which adjustments of the Original Issue Price shall have been or shall be made pursuant to other provisions of this paragraph 4(b)(ii), no further adjustment of the Original Issue Price shall be made by reason of such issue or sale.

(iii)     If at any time the Company shall declare and pay a dividend or make any other distribution upon the shares of its common stock payable in such stock or Convertible Securities, any such stock or Convertible Securities, as the case may be, issuable in payment of such dividend or distribution shall be deemed to have been issued or sold without consideration.

(iv)     If at any time any shares of the Company’s common stock or Convertible Securities or any rights or options to purchase shares of any such stock or Convertible Securities shall be issued or sold for cash, the consideration received therefor shall be deemed to be the amount received by the Company therefor, without deduction therefrom of any expenses incurred or any underwriting commissions or concessions or discounts paid or allowed by the Company in connection therewith.  In case any shares of the Company’s common stock or Convertible Securities or any rights or options to purchase any such common stock or Convertible Securities shall be issued or sold for a consideration other than cash, the amount of the consideration other than cash received by the Company shall be deemed to be the fair value of such consideration as determined by the Company’s Board of Directors, without deduction therefrom of any expenses incurred or any underwriting commissions or concessions or discounts paid or allowed by the Company in connection therewith.  In case any shares of the Company’s common stock or Convertible Securities or any rights or options to purchase any such common stock or Convertible Securities shall be issued in connection with any merger of another corporation into the Company, the amount of consideration therefor shall be deemed to be the fair value of the net assets of such merged corporation as determined by the Company’s Board of Directors after deducting therefrom all cash and other consideration (if any) paid by the Company in connection with such merger.

(v)      If at any time the Company shall take a record of the holders of its common stock for the purpose of entitling them (1) to receive a dividend or other distribution payable in shares of the Company’s common stock or in Convertible Securities, or (2) to subscribe for or purchase shares of the Company’s common stock or Convertible Securities, then such record date shall be deemed to be  the date of the issue or sale of the shares of the Company’s common stock deemed to have been issued or sold upon the declaration of such dividend or the making of such other distribution or the date of the granting of such right of subscription or purchase, as the case may be.

(vi)     The number of shares of the Company’s common stock outstanding at any given time shall not include shares owned or held by or for the account of the Company, provided that such shares are neither issued, sold or otherwise distributed by the Company.

(vii)    For purposes hereof, the “Market Price” shall mean the average closing bid price of the Company’s common stock on the Nasdaq SmallCap Market, the Nasdaq National Market or the principal exchange upon which shares of the Company’s common stock may be listed, or, if the Company’s common stock shall not then be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market or listed on a national securities exchange, but shall otherwise be traded in the over-the-counter market, on such over-the-counter market, in each case for the ten day period immediately preceding any determination of such “Market Price” (subject to appropriate adjustments which shall be made in determining the average closing bid price if a recapitalization or other event affecting the Company’s common stock shall occur during such 10-day period).  If at any time shares of the Company’s common stock shall not be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market, listed on a national securities exchange, or otherwise traded in the over–the-counter market, the “Market Price” of a share of the Company’s common stock shall be deemed to be the higher of (x) the book value thereof (as determined by any firm of independent public accountants of nationally recognized standing selected by the Company’s Board of Directors) as of the last day of any month ending within 60 days preceding the date of determination, or (y) the fair value thereof (as determined in good faith by the Company’s Board of Directors) as of a date which shall be within 15 days of the date of determination.

(c)      In case at any time the Company shall subdivide its outstanding shares of common stock into a greater number of shares, the Original Issue Price in effect immediately prior to such subdivision, the Maximum Price and the Minimum Price shall be proportionately reduced, and the Company shall subdivide the Series A Preferred Stock in the same proportion.  In case at any time the outstanding shares of the Company’s common stock shall be combined into a smaller number of shares, the Original Issue Price in effect immediately prior to such combination, the Maximum Price and the Minimum Price shall be proportionately increased, and the Company shall combine the Series A Preferred Stock in the same proportion.  Any adjustment under this paragraph 4(c) shall become effective at the close of business on the date the subdivision or combination shall become effective.  The Company will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of Series A Preferred Stock to such number of shares as shall be sufficient for any such purposes, including engaging in best efforts to obtain the requisite shareholder approval of any necessary amendment to the Company’s Articles of Incorporation.

(d)      If the purchase or exercise price provided for in any right or option referred to in paragraph 4(b)(i), or the rate at which any Convertible Securities referred to in paragraph 4(b)(i) or (ii) shall be convertible into or exchangeable for shares of the Company’s common stock, shall change or a different purchase or exercise price or rate shall become effective at any time or from time to time (including any change resulting from termination of such right, option or convertible security), then, upon such change becoming effective, the Original Issue Price then in effect hereunder shall forthwith be increased or decreased to such Original Issue Price as would have been obtained had the adjustments made upon the granting or issuance of such rights or options or Convertible Securities been made upon the basis of (A) the issuance of the number of shares of the Company’s common stock theretofore actually delivered upon the exercise of such options or rights or upon the conversion or exchange of such Convertible Securities, and (B) the granting or issuance at the time of such change of any such options, rights or Convertible Securities then still outstanding for the consideration, if any, received by the Company therefor and to be received on the basis of such changed price.

(e)      The Company shall not be required to make any adjustment to the Original Issue Price in the case of:

(i)        the granting, after the date hereof, by the Company of stock options under the Company’s 1997 Stock Option Plan, so long as the shares of the Company’s common stock underlying such options are covered by the 800,000 shares currently reserved for issuance under such plan as of the date hereof, assuming approval by the Company’s shareholders of the 300,000 share increase at the Company’s 1998 Annual Meeting of Shareholders;

(ii)      the issuance of shares of the Company’s common stock, pursuant to the exercise of the options referred to in paragraph 4(e)(i) above or the exercise of any other options or warrants outstanding as of the date hereof; or

(iii)     the issuance of shares of the Series A Preferred Stock hereunder or of shares of the Company’s common stock upon the conversion of any shares of the Series A Preferred Stock or upon the exercise of the Warrant or the Warrant issued to Miller, Johnson & Kuehn, Incorporated on the same date as the Preferred Stock Purchase Agreement to which this certificate of Designation is an Exhibit.

5.       Voting Rights. The holder of each share of Series A Preferred Stock shall have the right to the number of votes on all matters submitted to the Company’s shareholders that shall be equal to the number of shares of the Company’s common stock into which such holder’s shares of Series A Preferred Stock shall then be convertible (assuming a conversion as of the record date set for the vote).

6.       Status of Converted Stock.  In the event any shares of Series A Preferred Stock shall be converted pursuant to Section 3 hereof, the shares of Series A Preferred Stock so converted shall be canceled and shall not be issuable by the Company.  The Articles of Incorporation of the Company shall be appropriately amended to effect the corresponding reduction in the Company’s authorized capital stock.

7.       Notice of Adjustment.  The Company shall provide all holders of shares of Series A Preferred Stock five business days prior written notice of any adjustments in the Original Issue Price, the Maximum Price, the Minimum Price or any other adjustments made pursuant to the provisions hereof.

Filed with
State of Minnesota
May 14, 1998

STATEMENT OF DESIGNATION
OF ADDITIONAL SHARES
OF
DATAKEY, INC.

The undersigned hereby certifies that the resolutions set forth below were duly adopted by the Board of Directors of Datakey, Inc., a Minnesota corporation, on January 25, 2000:

WHEREAS, pursuant to the Articles of Incorporation of this corporation, the Board of Directors has authority to establish, from the 1,950,000 undesignated shares of capital stock, one or more classes or series of shares and to fix the relative rights and preferences of each such class of or series; and

WHEREAS, the Board of Directors deems it advisable to designate additional common shares;

NOW, THEREFORE, RESOLVED, that, of the 1,950,000 undesignated shares, currently authorized, 1,000,000 shares are designated as additional common shares.

I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation.

Dated:  February 10, 2000

/s/ Carl P. Boecher

Carl P. Boecher, President and

Chief Executive Officer of Datakey, Inc.

Filed with
State of Minnesota
Feb. 11, 2000

ARTICLES OF AMENDMENT
OF
ARTICLES OF INCORPORATION
OF
DATAKEY, INC.

Pursuant to the provisions of Minnesota Statutes, Section 302A.135, the amendment to the Articles of Incorporation of Datakey, Inc., amending and restating Article 3.01 in its entirety, as set forth below, was duly adopted by the shareholders of the corporation on May 31, 2000:

“3.01  The aggregate number of shares of stock which this corporation shall have authority to issue is 30,000,000 shares, consisting of 20,000,000 shares of common stock, par value $.05, 400,000 shares of convertible preferred stock, which shall have the rights and preferences as set forth on a Certificate of Rights and Preferences filed with the Minnesota Secretary of State on December 24, 1985, and 9,600,000 undesignated shares.”

The undersigned swears that the foregoing is true and accurate and that the undersigned has the authority to sign this document on behalf of the corporation.

Dated:   May 31, 2000

/s/ Carl P. Boecher

Carl P. Boecher, President and Chief Executive Officer

Filed with
State of Minnesota
June 19, 2000

EX-10.17

EXHIBIT 10.17

Datakey 2001 Executive Incentive Plan

The 2001 Datakey Executive Incentive Plan is designed to pay for performance to revenue growth and profitability objectives set forth at the beginning of the year as defined in the Board approved 2001 Financial Plan.  This plan provides for quarterly payments of cash and Datakey stock options issued at the closing price of the last day of the quarter and vesting in six months.  The 2001 Datakey Executive Incentive Plan applies to the following executives, and others if approved by the Board of Directors:

•   President & CEO

•   Vice President/General Manager ISS

•   Vice President & CFO

•   Vice President of Corporate Marketing

In the event of a change in control, bonus amounts will be computed and paid throughout the year as if the approved business plan revenue and profitability goals have been met.

Cash Incentive
Each executive is assigned a target annual incentive cash payment as determined by the Board of Directors.

Payment of the cash incentive is based on achievement of revenue growth 2001 quarter over same quarter in 2000 and achievement of the planned profit/loss in conjunction with the following table, with the amounts as set forth by the Board of Directors:

	Q1	Q2	Q3	Q4
2000 ISS revenue	$459,000	$940,000	$843,000	$1,368,000
Planned 2001 ISS revenue
Planned ISS revenue growth
% planned revenue growth
Actual ISS revenue
Actual ISS revenue growth
% = actual revenue growth/planned revenue growth (F)
Meets profit plan? (0=no, .5=yes) (PP)
ISS profitable? (0=no, .5=yes) (PR)
% earned

Payment amount determination begins with the calculation of actual 2001 ISS revenue growth (Quarterly increase year-to-year) and its percentage (F) of revenue growth as specified in the 2001 plan.  (F) is further modified by consideration for meeting profit/loss planned for the quarter (PP) and quarter profitability (PR), all of which are taken after bonus payments have been applied, and according to the following formula:

•         F = Actual revenue growth/planned revenue growth

•         % earned = F x (1+PP+PR)/2  where PP is .5 if profit/loss in the plan is met and PR are .5 if the quarter is profitable.

•         Quarter payment = % earned x target annual incentive payment/4

Stock Option Incentive
Each executive is assigned a target stock option incentive payment as determined by the Board of Directors.

Calculations for F, % earned, and Quarter payment are the same as for the cash incentive above.

EX-10.18

EXHIBIT 10.18

Datakey, Inc.
407 West Travelers Trail
Burnsville, MN  55337

Mr. Ray Lipkin

Dear Mr. Lipkin:

Datakey and you have recently arrived at an understanding under which you have agreed to loan Datakey up to $1,000,000.  This letter is intended to formalize this understanding as follows:

1.       The maximum aggregate of any loans you will make to Datakey under this Agreement will be $1,000,000.  The minimum loan amount will be $250,000.

2.       The funding of a particular loan may be effected by letter or fax, signed by Datakey’s CEO or CFO, requesting a transfer of funds to a depository of Datakey’s choosing.  The transfer of funds will be conditional upon your receipt of a promissory note as described in Paragraph 4 below.

3.       No new funds may be borrowed after March 31, 2001, whether or not all of the $1,000,000 has been borrowed as of such date.

4.       Each loan will be evidenced by a separate promissory note in the form attached to this letter.  The promissory note will be payable on demand six months after any transfer of funds to Datakey has been completed, as set forth in Paragraph 2 above.  The promissory note may be repaid at any time, but any repayment must be made in full, including accrued interest to the date of repayment.

5.       Interest will accrue at the annual rate of 12% for the first three months during which any promissory note remains outstanding.  If a promissory note remains unpaid for more than three months, interest will accrue at an annual rate of 15% until the promissory note is paid in full.

6.       Any loan made pursuant to this letter Agreement will be unsecured.

7.       Each promissory note will contain customary default provisions.  All reasonable collection costs will be assumed and paid for by Datakey.

8.       You may have been provided and/or you may in the future be provided with material non-public information relating to Datakey.  You should be aware that the receipt of material non-public information may restrict your ability to trade in Datakey stock.

Accompanying this letter is our written request to you to transfer $500,000 to the depository described therein.  We are also enclosing Datakey’s Promissory Note which incorporates those terms set forth above.  The Promissory Note is dated January 25, 2001, the anticipated date of the transfer.  Should the transfer not be effected on January 25, we would ask that you destroy the Promissory Note and we will messenger a new Promissory Note dated as of the date of the funds transfer.

If the foregoing is acceptable, please sign two copies of this letter and forward a signed copy to me.

Very truly yours,

/s/ Alan G. Shuler
                                                                       Alan G. Shuler, Vice President and CFO

I have read the above letter and am agreeable to the terms set forth therein.

/s/ Raymond A. Lipkin
                                                                       Ray Lipkin

UNSECURED PROMISSORY NOTE

$500,000 January 26, 2001

FOR VALUE RECEIVED, Datakey, Inc. (“Maker”) promises to pay to Ray Lipkin, and his heirs, assigns and successors (“Payee”), at such place as may be designated by Payee from time to time, the principal sum of Five Hundred Thousand Dollars ($500,000), together with interest accruing at an annual rate of twelve percent (12%) for the three months ending April 25, 2001 and at an annual rate of fifteen percent (15%) thereafter until this Promissory Note (“Note”) is paid in full.  The entire principal balance and any unpaid accrued interest due on this Note shall be paid in full on or before July 25, 2001.

Maker may prepay all or any portion of the outstanding balance of this Note at any time and from time to time without premium or penalty.

The occurrence of any one or more the following events constitutes an Event of Default under this Note:

(a)Maker fails to pay this Note when due;

(b)Maker (i) is unable to pay Maker’s debts as they mature or admits in writing Maker’s inability to pay Maker’s debts as they mature; (ii) makes a general assignment for the benefit of creditors; (iii) is adjudicated involuntarily bankrupt or voluntarily files a petition for bankruptcy; (iv) applies for the appointment of a receiver or a trustee for any of its property or assets or permits the appointment of a receiver or trustee who is not discharged within a period of thirty (30) days after such appointment; or (v) has entered against it an order in a foreclosure, execution and levy, or similar proceeding involving a substantial part of Maker’s assets; or

(c)Substantially all of Maker’s assets or a controlling equity interest in Maker is sold in a transaction or a number of related transactions.

Upon the occurrence of an Event of Default hereunder, at the option of the Payee, Payee may (i) declare the entire outstanding balance of this Note immediately due and payable; and (ii) exercise any of its other rights and remedies under applicable law.  No act, omission or delay on the part of the Payee to exercise any of Payee’s rights is a waiver of any of Payee’s rights, unless such waiver is expressly made in a writing signed by Payee.  Maker agrees to pay all costs of collection, including reasonable attorneys’ fees, in the event that this Note is not paid when due, whether or not a lawsuit is commenced.  Presentment and demand for payment, notice of dishonor, protest and notice of protest are hereby waived.

IN WITNESS WHEREOF, this Note has been duly executed by the undersigned, intending to be legally bound, on the day and year first above written.

DATAKEY, INC.
By	/s/ Alan Shuler
	Alan Shuler, Vice President and CFO

EX-13.1

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 from continuing operations for each of the past two years.  Inflation has not been a significant factor in Datakey’s operations to date.

	Percentage of Total Revenue
Year Ended December 31,	2000	1999
Revenue	100%	100%
Cost and Expenses
Cost of goods sold	53	52
Research and development	56	124
Marketing and sales	61	108
General and administrative	16	36
Total cost and expenses	186	320
Interest income	4	0
Loss before income taxes	(82)	(220)
Income taxes	-	-
Net loss	(82)%	(220)%

Comparison of 2000 with 1999

Continuing Operations

Total revenue:  Total revenue was $3,608,000 in 2000 compared to $1,316,000 in 1999.  The substantial increase in revenue is due to increasing acceptance of our information security solutions’ products and increases in technology license fees.  Because of the discontinuance of the EP operation, total revenue includes only sales and licensing of Information Security Solutions products.

Gross margins:  The gross profit margin decreased to 47 percent in 2000 from 48 percent in 1999 primarily because the Company began amortizing a prepaid license fee to cost of sales in 2000.  This amortization was $220,000 or 6 percent of sales in 2000.

Research and development:  Research and development (R&D) expense increased by 23 percent to $2,003,000 in 2000 from $1,632,000 in 1999.  R&D expense increased during 2000 as the Company invested in significant upgrades and enhancements to its information security products.

Marketing and sales, General and administrative:  Marketing and sales expense increased 56 percent to $2,216,000 in 2000 from $1,418,000 in 1999.  The increase in 2000 marketing and sales expense resulted from additions to the sales staff, including a new European office, increased commissions due to higher revenue and continuing promotional activities to promote the Company’s information security products.
General and administrative expenses increased 23 percent to $582,000 in 2000 from $472,000 in 1999 primarily as a result of increases in legal, audit and employment related expenses to support the growth in the ISS business segment.

Interest income:  Interest income increased to $170,000 in 2000 from $3,000 in 1999, as the Company invested a portion of the proceeds of a $4 million private placement completed in February 2000 in an interest bearing account.

Income tax expense:  As a result of the net cumulative operating losses of approximately $14,800,000 at December 31, 2000, and $10,000,000 at December 31, 1999 the Company recorded no income tax expense in either year.

Net loss.  Net loss in 2000 was $2,953,000 compared to $2,891,000 in 1999, primarily due to the significant 2000 increase in marketing, sales and R&D expenditures which exceeded the contribution from increased revenues in the ISS business segment.

Discontinued Operations

The Company announced in February 2001 that it is phasing down or divesting its Electronic Products (EP) business segment.  Accordingly, the operating loss of $565,000 during 2000 as well as an estimated loss upon disposal of the segment of $1,281,000 are reflected as losses from discontinued operations compared to a loss from discontinued operations of $18,000 in 1999.  The increased loss from discontinued operations in 2000 was primarily due to a reduction in revenue to $3,799,000 from $4,550,000 in 1999.

Comparison of 1999 with 1998

Continuing Operations

Total revenue:  Total revenue was $1,316,000 in 1999 compared to $629,000 in 1998.  The substantial increase in revenue was due to increasing acceptance of the Company’s information security products and technology.

Gross margins:  The gross profit margin increased to 48 percent in 1999 from 28 percent in 1998, due primarily to an increase in revenue during 1999.

Research and development:  Research and development (R&D) expense increased by 32 percent to $1,632,000 in 1999 from $1,232,000 in 1998.  R&D expense increased during 1999 as the Company invested in significant upgrades and enhancements to its information security products.

Marketing and sales, General and administrative:  Marketing and sales expense increased 1 percent to $1,418,000 in 1999 from $1,406,000 in 1998.  The increase in 1999 expense resulted from increases in advertising and promotional activities to promote the Company’s information security products.
General and administrative expenses increased 4 percent to $472,000 in 1999 from $453,000 in 1998 primarily as a result of increases in office rental and real estate tax.

Interest income:  Interest income decreased to $3,000 in 1999 from $58,000 in 1998 due to a decline in the Company’s interest bearing cash equivalent accounts.

Income tax expense:  As a result of the net cumulative operating losses of approximately $10,000,000 at December 31, 1999, and $8,000,000 at December 31, 1998, the Company recorded no income tax expense in either year.

Net loss.  Net loss in 1999 was $2,909,000 compared to $2,860,000 in 1998 primarily due to the significant 1999 increase in R&D expenditures in the ISS business segment that exceeded the contribution from additional revenue.

Discontinued Operations

Loss in the EP business segment, now reflected as discontinued operations, was $18,000 in 1999 compared to income of $573,000 in 1998.  The loss in 1999 was primarily due to a reduction in revenue to $4,550,000 in 1999 from $5,241,000 in 1998.

Liquidity and Capital Resources

The Company had an increase of $1,188,000 in cash and cash equivalents in 2000 compared to a reduction of $509,000 in cash and cash equivalents in 1999.  The 2000 increase is due to proceeds from the sale of common stock during the year of $5,439,000, offset by the net loss of $4,799,000.  The net loss was due, in part, to significant expenditures totaling $4,219,000 in research and development and marketing which were related to the Company’s information security products.  The Company invested $630,000 in the purchase of equipment and maintenance of licenses and patents in 2000 compared to $271,000 in 1999.  Cash and cash equivalents as of December 31, 2000, were $1,533,000 as compared to $345,000 as of December 31, 1999.  In the first quarter of 2001, the Company completed the private placement of common stock and warrants in a private placement transaction which generated net proceeds of approximately $4,500,000.

Datakey’s balance sheet reflected $3,478,000 in working capital and a current assets to current liabilities ratio of 3.8 to 1 as of December 31, 2000.

In 2001, the Company plans to increase expenditures for new product development, marketing activities and inventory levels to support anticipated revenue growth.  Based on its current plan, which assumes significantly increased revenues from the sale of information security products and technology licensing arrangements, the Company believes its working capital together with its bank line of credit, which the Company plans to extend for another year, and proceeds from the recent sale of securities will be sufficient to fund its planned operations and product development and promotional activities in 2001.  In the event that the revenues for the Company’s products and licenses are significantly less than projected, the Company’s ability to extend its current bank credit line may be jeopardized and the Company’s ability to maintain its current business operations would be materially and adversely affected.

Outlook & Risks

Certain statements in this Annual Report are forward looking, are based upon current expectations and actual results may differ materially due to certain risks and uncertainties, including those set forth below.

Revenue:    Revenue is expected to increase significantly in 2001 as more pilot programs move into a deployment phase, additional pilot programs are commenced and additional licensing agreements are arranged.  Revenue increases depend on customer acceptance, competition, and the effectiveness of the Company’s marketing and sales organization.  There is no assurance that the Company will achieve its revenue plan.

Gross margins:  A gradual improvement in gross profit margins during 2001 is expected through effective material purchasing and an anticipated increase in revenue from information security products and license fees.  Such an increase in gross margin depends on achievement of the expected purchasing prices, realization of the revenue increases, and a continuation of improvement in manufacturing processes.

Research and development:  The Company intends to increase funding for new product development activities in 2001 by about 40 percent compared to 2000 to accelerate the pace at which new products and product enhancements are released into the marketplace.  The ability to increase such funding depends in significant part on the Company’s ability to meet its 2001 revenue plan.

Marketing and sales, General and administrative:  Marketing and sales expenses are expected to increase about 70 percent in 2001 to support new product introductions, increase the number of sales and marketing personnel dedicated to the Company’s information security products and licenses and to support the expected increase in revenue. General and administrative expenses in 2001 are expected to increase about 50 percent from the 2000 level to support the growth in the level of activity and because certain fixed G&A expenses that were previously allocated, in part, to the EP business segment will be fully absorbed in 2001 by continuing operations.

Given the level of expected increases in expenses, the Company’s ability to approach or attain profitability by the end of 2001 will depend on the Company’s attainment of its revenue objectives for 2001.

Expected loss:  The Company’s goal is to reach quarterly profitability by the second half of 2001 but expects to report a loss for the year.  The Company’s ability to attain profitability in the second half of 2001 and thereafter will depend primarily on its ability to significantly increase the revenue from its information security products and from technology licensing.  Based upon the level of sales of information security products and license fees to date, there has not been sufficient market acceptance to be assured that revenue will increase significantly or that the Company will ever attain profitability.

INDEPENDENT AUDITOR’S REPORT

To the Stockholders
Datakey, Inc.
Burnsville, Minnesota

We have audited the accompanying balance sheets of Datakey, Inc. as of December 31, 2000 and 1999, and the related statements of operations, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the 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 financial statements referred to above present fairly, in all material respects, the financial position of Datakey, Inc. as of December 31, 2000 and 1999, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles.

/s/ McGladrey & Pullen LLP

Minneapolis, Minnesota
February 2, 2001, except for Note 3
as to which the date is February 26, 2001

DATAKEY, INC.

BALANCE SHEETS
December 31, 2000 and 1999

ASSETS (Note 3)	2000	1999
Current Assets
Cash and cash equivalents	$1,532,558	$344,922
Trade receivables, less allowance for doubtful accounts of $26,000 (Note7)	989,020	1,474,480
Inventories (Note 2)	513,846	1,328,991
Prepaid expenses and other	113,176	29,981
Net assets of discontinued operations (Note 10)	1,561,999	-
Total current assets	4,710,599	3,178,374
Other Assets
Licenses and patents, less amortization of $698,517 in 2000 and $364,832 in 1999 (Note 8)	498,961	668,036
Equipment and Leasehold Improvements, at cost
Production tooling	1,162,750	1,306,260
Equipment	2,690,894	2,768,214
Furniture and fixtures	322,095	317,103
Leasehold improvements	278,371	278,371
	4,454,110	4,669,948
Less accumulated depreciation	4,227,882	3,917,996
	226,228	751,952
	$5,435,788	$4,598,362

See Notes to Financial Statements.

LIABILITIES AND STOCKHOLDERS' EQUITY	2000	1999
Current Liabilities
Accounts payable	$386,613	$803,887
Accrued expenses:
Compensation	226,803	197,335
Other	74,031	70,166
Deferred revenue	63,797	26,978
Net liabilities from discontinued operations (Note 10)	480,875	-
Total current liabilities	1,232,119	1,098,366
Commitments and Contingencies (Notes 3, 5, 8 and 10)
Stockholders' Equity (Notes 5, 6 and 11)
Convertible preferred stock, voting, liquidation 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 20,000,000 shares; issued and outstanding 8,269,173 shares in 2000 and 6,322,285 shares in 1999	413,459	316,114
Additional paid-in capital	13,906,744	8,501,543
Accumulated deficit	(10,491,534)	(5,692,661)
	4,203,669	3,499,996
	$5,435,788	$4,598,362

DATAKEY, INC.

STATEMENTS OF OPERATIONS
Years Ended December 31, 2000 and 1999

	2000	1999
Net sales (Note 7)	$3,608,480	$1,315,622
Costs and expenses:
Cost of goods sold	1,904,221	688,268
Research and development	2,003,455	1,631,984
Marketing and sales	2,216,282	1,417,970
General and administrative	582,238	471,557
Total costs and expenses	6,706,196	4,209,779
Operating loss	(3,097,716)	(2,894,157)
Interest income	169,909	11,340
Interest expense	(25,000)	(8,442)
Loss from continuing operations before income taxes	(2,952,807)	(2,891,259)
Income tax expense (Note 4)	-	-
Net loss from continuing operations	(2,952,807)	(2,891,259)
Discontinued operations (Note 10)
Loss from operations of discontinued segment	(565,066)	(17,880)
Loss on disposal of discontinued segment	(1,281,000)	-
Loss from discontinued operations	(1,846,066)	(17,880)
Net loss	$(4,798,873)	$(2,909,139)
Net loss from continuing operations attributable to common stockholders:
Net loss from continuing operations	$(2,952,807)	$(2,891,259)
Preferred stock dividends (Note 5)	-	(81,568)
Net loss from continuing operations attributable to common stockholders	$(2,952,807)	$(2,972,827)
Loss per share:
Basic and diluted loss from continuing operations	$(0.37)	$(0.80)
Basic and diluted loss from discontinued operations	(0.23)	-
Basic and diluted loss per common share	$(0.60)	$(0.80)
Weighted-average common shares:
Basic and diluted	7,977,281	3,730,499

See Notes to Financial Statements.

DATAKEY, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2000 and 1999

			Series A Cumulative Preferred Stock				Additional Paid-In Capital
	Convertible Preferred Stock				Common Stock			Accumulated Deficit
	Shares	Amount	Shares	Amount	Shares	Amount			Total
Balance, December 31, 1998	150,000	$375,000	83,957	$1,326,519	3,045,704	$152,285	$4,793,665	$(2,842,958)	$3,804,511
Conversion of Series A preferred stock, including accrued dividends, to common stock (Note 5)	-	-	(83,957)	(1,326,519)	997,555	49,878	1,284,228	(7,587)	-
Issuance of common stock (net of offering expenses of $309,394)	-	-	-	-	2,279,026	113,951	2,423,239	-	2,537,190
Preferred stock dividends (Note 5)	-	-	-	-	-	-	-	(73,981)	(73,981)
Preferred stock dividends forgiven (Note 5)	-	-	-	-	-	-	-	141,004	141,004
Compensation expense from stock options	-	-	-	-	-	-	411	-	411
Net loss	-	-	-	-	-	-	-	(2,909,139)	(2,909,139)
Balance, December 31, 1999	150,000	375,000	-	-	6,322,285	316,114	8,501,543	(5,692,661)	3,499,996
Issuance of common stock (net of offering expenses of $409,745)	-	-	-	-	1,946,888	97,345	5,341,229	-	5,438,574
Compensation expense from stock options	-	-	-	-	-	-	63,972	-	63,972
Net loss	-	-	-	-	-	-	-	(4,798,873)	(4,798,873)
Balance, December 31, 2000	150,000	$375,000	-	$-	8,269,173	$413,459	$13,906,744	$(10,491,534)	$4,203,669

See Notes to Financial Statements.

STATEMENTS OF CASH FLOWS
Years Ended December 31, 2000 and 1999

	2000	1999
Cash Flows From Operating Activities
Net loss	$(4,798,873)	$(2,909,139)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation	353,881	440,820
Amortization	543,580	135,309
Loss on disposal of discontinued segment	1,281,000	-
Loss on disposal of equipment	10,051	33,854
Noncash compensation	63,972	411
Changes in assets and liabilities:
Trade receivables	(12,821)	(614,844)
Inventories	(1,112,343)	(321,043)
Accounts payable	(59,734)	368,014
Deferred revenue	36,819	26,978
Other	73,473	64,884
Net cash used in operating activities	(3,620,995)	(2,774,756)
Cash Flows From Investing Activities
Purchases of equipment	(182,626)	(177,475)
Proceeds on sale of equipment	-	35,000
License and patent costs	(447,317)	(128,864)
Net cash used in investing activities	(629,943)	(271,339)
Cash Flows From Financing Activities
Net proceeds from issuance of common stock	5,438,574	2,537,190
Increase (decrease) in cash and cash equivalents	1,187,636	(508,905)
Cash and Cash Equivalents
Beginning	344,922	853,827
Ending	$1,532,558	$344,922
Supplemental Disclosure of Noncash items
Cash paid for interest	$25,000	$8,442
Supplemental Schedule of Noncash Investing and Financing Activities
Preferred stock dividend converted to common stock	$-	$7,587
Preferred stock dividends forgiven (Note 5)	-	141,004

See Notes to Financial Statements.

NOTES TO FINANCIAL STATEMENTS

Note 1.        Nature of Business and Significant Accounting Policies

Nature of business:Datakey, Inc. provides products and systems directed to the information security market, which enables user identification and authentication, secure data exchange, and information validation. The Company also provides electronic 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 has a wholly owned subsidiary which is inactive.

A summary of significant accounting policies follows:

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 in 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.

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 have been estimated to be five years. The costs of the license agreements are amortized to cost of goods sold as the products incorporating the licensed units are sold or over the life of the agreement.

Accounting for long-lived assets:The Company periodically reviews the utilization of its licenses, patents, and other long-lived assets for impairment. To date, management has determined that no impairment in the value of these assets has occurred.

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	3–7
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 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 an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss or tax credit carry-forwards, 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 revenue from products and systems sold by the information security business segment is recognized upon shipment to the customer as the Company has no future obligation for support, upgrades, or other services. If the customer purchases an extended maintenance contract, revenue from the contract is deferred and recognized over the term of the contract.

The revenue from products sold by the electronic products business segment is recognized upon shipment.

In December 1999, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 (SAB No. 101), “Revenue Recognition in Financial Statements”. SAB No. 101 summarizes some of the staff’s interpretations of the application of generally accepted accounting principles related to revenue recognition. The Company adopted SAB No. 101 during the year ended December 31, 2000. The adoption of SAB No. 101 did not have a significant affect on the financial statements.

Shipping and handling charges to customers are included in net sales. Shipping and handling costs incurred by the Company are included in cost of goods sold.

Research and development:  Research and development costs are charged to expense as incurred.

Advertising:  Expenditures for advertising costs are expensed as incurred. Advertising and product promotion expense was approximately $213,000 and $104,000 during 2000 and 1999, respectively.

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 value.

Loss per share:The Company computes basic and diluted net loss per share based upon the weighted-average number of common shares outstanding during each year. In 1999, preferred stock dividends (Note 5) are included in the net loss attributable to common stockholders in calculating basic and diluted loss per share. Potential common shares, such as options, warrants, and convertible preferred stock (as discussed in Note 6), were not included in the computation of diluted loss per common share as their effect is anti-dilutive.

Due to the losses in 2000 and 1999, basic and diluted loss per share were the same for each of these years.

Note 2.        Inventories

Inventories consist of the following components as of December 31, 2000 and 1999:

	2000	1999
Raw materials	$459,729	$1,225,307
Work in process	71,314	173,385
Finished goods	398,510	378,452
Inventory obsolescence reserve	(415,707)	(448,153)
	$513,846	$1,328,991

Note 3.        Financing Agreements

The Company has available a $1,000,000 line of credit from a bank which bears interest at the prime rate plus 1.25 percent (10.25 percent at December 31, 2000) and is secured by substantially all assets of the Company. The line of credit expires in May 2001 and is subject to annual renewal. There were no balances outstanding as of December 31, 2000 or 1999.

The Company also has a standby letter of credit with a bank up to $500,000 in favor of one of its vendors. In connection with this letter of credit, the Company has assigned $250,000 held in an account at the bank. The letter of credit expires January 2002. There were no draws against the letter of credit as of December 31, 2000.

In January 2001 the Company entered into a line of credit with a shareholder. The Company may borrow up to $1,000,000 through March 31, 2001. Advances are unsecured and bear interest at 12% for the first three months during which any individual advance remains outstanding. After three months interest accrues at 15 percent until the advance is paid off. As of February 2, 2001, $500,000 was outstanding under this agreement. This advance was repaid in full February 26, 2001.

Note 4.        Income Taxes

There has been no tax expense recorded due to losses in both 2000 and 1999.

The income tax benefit is different from that which would be computed by applying the U.S. federal income tax rate (35 percent) to pretax loss as follows:

	December 31
	2000	1999
Computed "expected" federal tax benefit at statutory rates	$(1,680,000)	$(1,018,000)
Effect of net operating loss with no current benefit	1,680,000	1,018,000
Actual tax expense	$-	$-

Deferred taxes consist of the following components as of December 31, 2000 and 1999:

	2000	1999
Deferred tax assets:
Allowance for doubtful accounts	$9,000	$9,000
Inventory	270,000	244,000
Warranty reserve	10,000	11,000
Compensation and benefits	35,000	26,000
Net operating loss carryforward	5,279,000	3,700,000
Reserve for discontinued operations	461,000	-
Research and development tax credit	279,000	239,000
Contributions carryforward	15,000	15,000
Total gross deferred tax assets	6,358,000	4,244,000
Valuation allowance	(6,314,000)	(4,200,000)
Net deferred tax assets	44,000	44,000
Deferred tax liability:
Depreciation	(44,000)	(44,000)
Net deferred taxes	$-	$-

Realization of deferred tax assets is dependent upon the generation of sufficient future taxable income. Management has determined that sufficient uncertainty exists regarding the realizability of the net deferred tax assets and, accordingly, has provided a valuation allowance against such net deferred tax assets of the Company.

At December 31, 2000, the Company’s net operating loss and tax credit carry-forwards expire as follows:

	Operating Loss Carry-forward	Research and Development Tax Credit Carry-forward
2011	$1,850,000	$-
2012	3,540,000	113,000
2018	2,560,000	59,000
2019	2,450,000	67,000
2020	4,386,000	40,000
	$14,786,000	$279,000

The use of the federal net operating losses may be limited under the provisions of the Internal Revenue Code, Section 382, which relates to a 50 percent change in control over a three-year period. Further changes of control may result in additional limitations of the remaining carry-forward. Utilization of the carry-forwards is dependent upon the Company attaining profitable operations in the future.

Note 5.        Stockholders’ Equity

Convertible preferred stock:The preferred stock is convertible at the rate of one share of common stock for each share of preferred stock, subject to certain anti-dilution 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, voting rights, have a liquidation preference of $2.50 per share, and share in dividends paid on common stock.

Series A convertible cumulative preferred stock:  In May 1998, the Company completed a $1.58 million convertible preferred stock offering. The holders of the Series A convertible preferred stock were entitled to receive dividends at the rate of 8 percent annually, which were payable at the option of the Company in cash or shares of the Company’s common stock. Accumulated dividends of $7,587 were paid in 1999 by issuance of 2,457 shares of common stock. Dividends of $141,004 were forgiven by two stockholders in exchange for the right to convert their Series A convertible preferred stock into common stock at $1.25 per common share. All outstanding shares of the Series A convertible cumulative preferred stock were converted into 995,098 shares of common stock during 1999.

Undesignated stock:  The Company has 9,600,000 shares of undesignated capital stock.

Note 6.        Stock Options and Warrants

Stock options:  The Company has reserved 1,100,000 common shares for issuance under qualified and nonqualified stock options for its key employees and directors. The Company has also reserved 100,000 common shares for issuance under nonqualified options to various distributors, dealers, and consultants. Option prices are generally at 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 10 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. In 2000 and 1999, compensation cost of $63,972 and $411 was recognized for the stock options. Had compensation cost for the Company’s stock options been determined based on the fair value at the grant date for awards in 2000 and 1999, consistent with the provisions of SFAS No. 123, the Company’s net loss attributable to common stockholders and basic and diluted loss per share would have changed to the pro forma amounts indicated below:

	Years Ended December 31
	2000	1999
Net loss attributable to common stockholders, as reported	$(4,798,873)	$(2,990,707)
Net loss attributable to common stockholders, pro forma	(5,268,742)	(3,305,195)
Basic and diluted loss per share, as reported	(0.60)	(0.80)
Basic and diluted loss per share, pro forma	(0.66)	(0.89)

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 2000 and 1999:

	Years Ended December 31
	2000	1999
Expected dividend yield	-	-
Expected stock price volatility	101.36%	75.53%
Risk-free interest rate	6.40%	5.63%
Expected life of options	4.88 years	4.83 years
Weighted-average fair value of options granted during the year	$3.95	$1.42

The pro forma effect on net loss attributable to common stockholders in 2000 and 1999 is not representative of the pro forma effect in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995.

Additional information relating to all outstanding options as of December 31, 2000 and 1999, is as follows:

	2000		1999
		Weighted- Average Exercise Price		Weighted- Average Exercise Price
	Shares		Shares
Options outstanding at beginning of year	1,011,581	$3.24	952,333	$3.97
Options exercised	(136,126)	3.42	(8,000)	3.63
Options forfeited	(128,666)	3.55	(243,500)	4.61
Options granted	312,634	5.48	310,748	2.10
Options outstanding at end of year	1,059,423	$3.84	1,011,581	$3.24

The following table summarizes information about stock options outstanding at December 31, 2000:

		Options Outstanding		Options Exercisable
Range of Exercise Prices	Number Outstanding at December 31, 2000	Weighted- Average Remaining Contractual Life (Years)	Weighted- Average Exercise Price	Number Exercisable at December 31, 2000	Weighted- Average Exercise Price
$0.01	8,397	9.71	$0.01	4,697	$0.01
$1.50 - $2.25	214,500	8.42	1.79	81,502	1.84
$2.50 - $3.625	402,626	6.50	3.12	180,501	3.25
$3.81 - $5.25	235,500	8.27	4.53	94,400	4.75
$5.38 - $7.56	113,400	7.21	5.98	40,233	5.86
$8.00 - $8.38	85,000	9.28	8.10	7,000	8.00
$0.01 - $8.38	1,059,423	7.61	$3.84	408,333	$3.62

Employee stock purchase plan:Under its 1998 employee stock purchase plan, which became effective for the plan year beginning January 1, 1999, the Company is authorized to issue up to 100,000 shares of common stock to its full-time employees, nearly all of whom are eligible to participate. Employees can choose each year to have up to 10 percent of their earnings withheld to purchase the Company’s stock at a price that is 85 percent of the lower of its beginning-of-year or end-of-year fair market value. During 2000 6,710 shares were issued under the plan. No shares were issued under the plan in 1999.

Warrants:The Company has issued warrants to purchase shares of common stock at prices between $1.25 and $6.60 per share. All warrants are currently exercisable. The following tables summarize information about warrants outstanding at December 31, 2000:

	2000		1999
	Shares	Weighted- Average Exercise Price	Shares	Weighted- Average Exercise Price
Warrants outstanding at beginning of year	1,505,617	$1.59	290,710	$4.94
Warrants exercised	(1,004,052)	1.34	-	-
Warrants forfeited	-	-	(699,658)	3.16
Warrants granted	880,000	5.05	1,914,565	1.65
Warrants outstanding at end of year	1,381,565	$3.97	1,505,617	$1.59

Warrants outstanding at December 31, 2000 expire as follows:

2003	83,675
2004	10,000
2005	880,000
2008	37,890
2009	370,000
	1,381,565

Note 7.        Major Customers and International Sales

Major customer: Sales to U.S. government agencies for 2000 and 1999 were approximately $244,000 and $608,000 in 2000 and 1999, respectively. Accounts receivable from U.S. government agencies were approximately $70,000 and $158,000 at December 31, 2000 and 1999, respectively. In addition, sales to one customer were approximately $1,437,000, or 19 percent of total sales during the year ended December 31, 2000. Accounts receivable from this customer were approximately $564,000 at December 31, 2000. There were no major customers in 1999.

International sales:Export sales to international customers for 2000 and 1999 were approximately $1,593,000 and $1,630,000, respectively. Accounts receivable from international customers were approximately $277,000 and $388,000 at December 31, 2000 and 1999, respectively. Sales to customers in Great Britain accounted for approximately 12 percent of sales in 2000. There were no individual countries accounting for more than 10 percent of total sales in 1999.

Note 8.        Commitments and Contingencies

License agreement:  The Company has entered into various license agreements to allow the Company to bundle licensed products into certain of the Company’s products. Under the agreements, payments are based upon the number of units sold and the nature of the item bundled. In these agreements, 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.

Lease:The Company leases its office and warehouse facilities under a non-cancelable operating lease, which expires in June 2004. In addition certain items of equipment are leased under non-cancelable operating leases through June 2004.

Future lease commitments are as follows:

2001	$243,000
2002	249,000
2003	237,000
2004	107,000
	$836,000

Rent expense totaled approximately $240,000 and $189,000 in 2000 and 1999, respectively.

Employee benefits:The Company has a discretionary defined contribution profit sharing plan in effect for its employees. Contributions to the plan were $36,000 and $24,000 in 2000 and 1999, respectively.

The Company maintains a voluntary 401(k) plan in effect for its employees. The Company offers a match of 25 percent of the employees’ contributions, up to six percent. The Company’s match was approximately $36,000 and $25,000 in 2000 and 1999, respectively.

Note 9.        Operating Segments

The Company has two reportable segments: Electronic Products (EP) and ISS Information Security Solutions (ISS). The Electronic Products segment produces and markets proprietary memory keys, cards, and other custom-shaped tokens that serve as a convenient way to carry electronic information. The ISS Information Security Solutions segment produces and markets products for the information security market, which enable user identification and authentication, secure data exchange, and information validation.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. There are no inter-segment transactions. The Company evaluates performance based on operating earnings of the respective segments.

	December 31, 2000
	EP	ISS	Unallocated	Total
Revenue	$3,799,000	$3,608,000	$-	$7,407,000
Depreciation and amortization	314,000	583,000	-	897,000
Segment profit (loss)	(565,000)	(3,141,000)	140,000	(3,566,000)

	December 31, 1999
	EP	ISS	Unallocated	Total
Revenue	$4,550,000	$1,316,000	-	$5,866,000
Depreciation and amortization	411,000	165,000	-	576,000
Segment profit (loss)	(18,000)	(2,894,000)	3,000	(2,909,000)

See Note 10 for discontinued operations disclosure for the EP segment.

Note 10.      Discontinued Operations

In February 2001 the Company’s Board of Directors approved management’s plan to discontinue the operations of the EP segment. The plan anticipates the phase down of operations through December 31, 2001, although it is possible the operations could be sold if a purchaser is found. Some deliveries for orders received prior to December 31, 2001 are expected to take place through June 30, 2002. The financial statements have been prepared as if the operation will be phased down.

The estimated loss on the phase down of the EP segment includes the write-off of inventory, patents and equipment anticipated to remain at the date of closedown and expenses associated with the phase down, net of estimated operating income through that date. The phase down of the segment is being accounted for as discontinued operations and, accordingly, its net assets have been segregated from continuing operations in the accompanying balance sheets and the results of its operations have been excluded from continuing operations for all periods presented. Net assets and liabilities of the EP segment at December 31, 2000 are summarized as follows:

Trade receivables	$498,281
Inventories	1,927,488
Equipment and leasehold improvements	344,418
Patents	72,812
Reserve for discontinued operations	(1,281,000)
Net assets from discontinued operations	$1,561,999
Accounts payable	$357,540
Accrued expenses:
Compensation	90,165
Other	33,170
Net liabilities from discontinued operations	$480,875

The EP segment had total revenues of $3,798,687 and $4,550,413 in 2000 and 1999, respectively.

Note 11.      Subsequent Events

In February 2001 the Company completed a $4,800,000 private placement of 1,600,000 shares of common stock with net proceeds of approximately $4,500,000. In connection with the transaction, the Company issued 1,680,268 warrants to purchase common stock with exercise prices between $3.02 and $3.44 per share.

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT ACCOUNT

We hereby consent to the incorporation by reference of our report, dated February 2, 2001 (February 26, 2001 as to note 3) with respect to the financial statements of Datakey, Inc. (the “Company”) included in this Form 10-KSB into the Company’s previously filed Registration Statements on Form S-8 No. 33-14144, No. 33-47068, No. 33-67280, No. 333-11405, No. 33-80894, No. 333-43937, No. 333-83999 and 333-39556 and on Form S-3 No. 333-56711, No. 333-84007, No. 333-91779, No. 333-90969, No. 333-94087 and No. 333-33332.

Minneapolis, Minnesota
March 29, 2001