form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the quarterly period ended September 30, 2007

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the transition period from ________________ to ________________

Commission file number: 0-12965

NESTOR, INC.

(Exact name of registrant as specified in its charter)

Delaware		13-3163744
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

42 Oriental Street; Providence, RI		02908
(Address of principal executive offices)		(Zip Code)

401-274-5658

(Registrant’s telephone number, including area code)

[None]

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes:x

No: ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer: ¨

Accelerated filer: ¨

Non-accelerated filer: x

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

Yes:¨

No: x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class		Outstanding at October 31, 2007
[Common Stock, $.01 par value per share]		28,954,219 shares

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INDEX

NESTOR, INC.

FORM 10Q

For the Quarterly Period Ended September 30, 2007

INDEX

		Page Number

Part I	FINANCIAL INFORMATION

Item 1	Financial Statements:

	Condensed Consolidated Balance Sheets	3
	September 30, 2007 (Unaudited ) and December 31, 2006

	Condensed Consolidated Statements of Operations (Unaudited)	4
	Quarter and Nine months ended September 30, 2007 and 2006

	Condensed Consolidated Statements of Cash Flows (Unaudited)	5
	Nine months ended September 30, 2007 and 2006

	Notes to Condensed Consolidated Financial Statements	6


Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16


Item 3	Quantitative and Qualitative Disclosure of Market Risk	28


Item 4	Controls and Procedures	28


Part II	OTHER INFORMATION

Item 1	Legal Proceedings	29

Item 1A	Risk Factors	30

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	42

Item 3	Defaults Upon Senior Securities	42

Item 4	Submission of Matters to a Vote of Security Holders	42

Item 5	Other Information	42

Item 6	Exhibit Index	43

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INDEX

NESTOR, INC.

Condensed Consolidated Balance Sheets

In Thousands, Except Share And Per Share Information

	September 30, 2007			December 31, 2006
	(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents	$	5,216		$	2,952
Marketable securities		---			58
Accounts receivable, net		2,806			2,343
Inventory, net		920			1,950
Other current assets		225			197
Total current assets		9,167			7,500
Noncurrent assets
Capitalized system costs, net		10,183			8,185
Property and equipment, net		529			789
Goodwill		5,581			5,581
Patent development costs, net		129			125
Other long term assets		2,011			2,331
Total Assets	$	27,600		$	24,511

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	1,017		$	1,325
Accrued liabilities		1,400			1,493
Accrued employee compensation		409			351
Deferred revenue		1,375			712
Asset retirement obligation		313			186
Total current liabilities		4,514			4,067
Noncurrent Liabilities:
Senior convertible notes payable, net of discount		1,519			920
Senior secured convertible notes payable, net of discount		10,987			8,563
Variable rate senior notes payable		1,500			---
Derivative financial instruments – debt and warrants		2,804			4,971
Long term asset retirement obligation		897			488
Total liabilities		22,221			19,009

Commitments and contingencies		---			---

Stockholders’ Equity:
Preferred stock, $1.00 par value, authorized 10,000,000 shares;
issued and outstanding: Series B – 180,000 shares at
September 30, 2007 and December 31, 2006		180			180
Common stock, $0.01 par value, authorized 50,000,000
shares issued and outstanding: 28,954,219 shares at
September 30, 2007 and 20,386,816 shares at December 31, 2006		290			204
Additional paid-in capital		78,824			73,597
Accumulated deficit		(73,915	)		(68,479	)
Total stockholders’ equity		5,379			5,502
Total Liabilities and Stockholders’ Equity	$	27,600		$	24,511

*The Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.*

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INDEX

NESTOR, INC.

Condensed Consolidated Statements of Operations

In Thousands, Except Share And Per Share Information

(Unaudited)

	Quarter Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Revenues:
Lease and service fees	$	3,329		$	1,979		$	8,771		$	5,733
Product royalties		20			3			20			4

Total revenue		3,349			1,982			8,791			5,737

Cost of sales:
Lease and service fees		1,943			1,659			5,164			4,715
Product royalties		---			---			---			---

Total cost of sales		1,943			1,659			5,164			4,715


Gross profit:
Lease and service fees		1,386			320			3,607			1,018
Product royalties		20			3			20			4

Total gross profit		1,406			323			3,627			1,022


Operating expenses:
Engineering and operations		926			861			3,019			3,162
Research and development		99			365			318			1,137
Selling and marketing		181			549			552			1,598
General and administrative		812			1,316			2,524			4,044

Total operating expenses		2,018			3,091			6,413			9,941

Loss from operations		(612	)		(2,768	)		(2,786	)		(8,919	)

Derivative instrument income (expense)		338			7,145			2,204			10,112
Debt discount expense		(1,008	)		(1,167	)		(3,024	)		(4,681	)
Other (expense) income, net		(685	)		(562	)		(1,830	)		(1,360	)

Net income (loss)	$	(1,967	)	$	2,648		$	(5,436	)	$	(4,848	)


Income (loss) per share:

Income (loss) per share, basic and diluted	$	(0.07	)	$	0.13		$	(0.24	)	$	(0.24	)

Shares used in computing loss per share:
Basic		26,542,888			20,378,648			22,480,692			20,241,421
Diluted		26,542,888			20,385,970			22,480,692			20,241,421

*The Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.*

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INDEX

NESTOR, INC.

Condensed Consolidated Statements of Cash Flows

In Thousands, Except Share And Per Share Information

(Unaudited)

	Nine Months Ended September 30,
	2007			2006
				(As Restated)
Cash flows from operating activities:
Net income (loss)	$	(5,436	)	$	(4,848	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		2,458			2,165
Asset impairment charge		---			175
Write off of deferred financing fees		405			406
Stock based compensation		439			1,940
Derivative instrument (income) expense		(2,204	)		(10,112	)
Debt discount expense		3,024			4,681
Provision for doubtful accounts		11			63
Provision for inventory reserve		180			83
Increase (decrease) in cash arising from
changes in assets and liabilities:
Accounts receivable		(473	)		316
Inventory		851			(533	)
Other assets		5			230
Accounts payable and accrued expenses		193			119
Deferred revenue		663			319

Net cash provided by/(used) in operating activities		116			(4,996	)

Cash flows from investing activities:
Sale of (investment in) marketable securities		60			---
Investment in capitalized systems		(4,118	)		(3,538	)
Purchase of property and equipment		(58	)		(172	)
Investment in patent development costs		(24	)		(7	)

Net cash used in investing activities		(4,140	)		(3,717	)

Cash flows from financing activities:
Repayment of notes payable		---			(10,850	)
Proceeds from notes payable, net		1,415			26,397
Cash restricted by notes payable		---			(3,859	)
Proceeds from private stock placement, net		4,873			4,822
Proceeds from issuance of common stock, net		---			3

Net cash provided by financing activities		6,288			16,513

Net change in cash and cash equivalents		2,264			7,800
Cash and cash equivalents – beginning of period		2,952			1,224

Cash and cash equivalents – end of period	$	5,216		$	9,024

Supplemental cash flows information:
Interest paid	$	1,461		$	891

Income taxes paid	$	---		$	---

*The Unaudited Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.*

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INDEX

Nestor, Inc.

Notes to Condensed Consolidated Financial Statements

In Thousands, Except Share And Per Share Information

(Unaudited)

Note 1

–

Nature of Operations:

A.	Organization

Nestor, Inc., a Delaware corporation (“We, “Us” or the “Company”) was organized on March 21, 1983 to maintain and further develop certain patent rights and know-how acquired from its predecessor, Nestor Associates, a limited partnership. Two wholly-owned subsidiaries, Nestor Traffic Systems, Inc. (“NTS”) and Nestor Interactive, Inc. (“Interactive”), were formed effective January 1, 1997. Effective November 7, 1998, Nestor, Inc. ceased further investment in the Interactive subsidiary. CrossingGuard, Inc., a wholly owned subsidiary of NTS, was formed July 18, 2003 in connection with a financing and is now inactive. Nearly all of our operations are conducted by our wholly owned subsidiary, Nestor Traffic Systems, Inc. (“NTS”). The condensed consolidated financials statements include the accounts of Nestor, Inc. and NTS. All intercompany transactions and balances have been eliminated. Our main offices are located in Providence, RI and Los Angeles, CA.

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and in Canada. We provide:

CrossingGuard®, a fully video-based automated red light enforcement system

PoliScan^Speed™,a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system; and

ViDAR™, a new video-based speed detection and imaging system that complements our other systems or stands alone as a speed enforcement system.

CrossingGuard® uses our patented image processing technology to predict and record the occurrence of a red light violation and manages the process of issuing and processing a citation. PoliScan^Speed™ uses LiDAR, a technology developed by Vitronic GmbH. Although the Company is no longer the exclusive North America distributor of Vitronic PoliScan^Speed™, we remain a distributor and continue to market and support this highly effective speed system. ViDAR™ uses non-detectable, passive video detection and average speed over distance calculations to detect and record evidence of speeding vehicles. ViDAR™ enforces multiple, simultaneous violations bi-directionally.

In addition to our automated traffic enforcement systems, we offer state of the art back office solutions for the processing and management of citation issuance, prosecution and collection. Our new i-Citation software application assists customers with all event tasks. i-Citation provides customers with the ability to review the complete evidence package online. i-Citation provides police and other officials with convenient and quick access to all event information. i-Citation also provides ready access over the web to violation information such as location and date/time; and disposition status of an event. Our suite of traffic safety solutions in combination with our advanced back-office software make customer-friendly, fully integrated and turnkey services available.

B.	Liquidity and management’s plans

On July 23, 2007, the Company entered into a Securities Purchase Agreement with certain accredited investors, including affiliates of the Company (the “Purchasers”) to sell 8,532,403 shares of the Company’s common stock, par value $0.01 per share at a purchase price per share of $0.5802 (the “Purchase Price”) for an aggregate purchase price of $4,950,500 in a private placement pursuant to Regulation D under the Securities Act of 1933 (the “Transaction”). The Transaction was closed on July 27, 2007.

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INDEX

As a predicate to the Transaction, the Company entered into separate agreements (“Waivers”) with holders of more that 75% of the outstanding principal amount of the Company’s Senior Secured Convertible Notes bearing interest at the rate of 7.0% (subject to adjustment) (the “7% Notes”) and holders of more than 66⅔% of holders of the Company’s 5% Senior Convertible Notes (the “5% Notes”) pursuant to which such holders (constituting holders of a sufficient amount of the 7% Notes and 5% Notes respectively) have waived the anti-dilution provisions associated with their respective Notes that would have been triggered by the transaction. Had the Waivers not been entered into, the Company would have been subject to a substantial downward adjustment to the conversion price of the outstanding principal of the 7% Notes and the 5% Notes. Waivers did not affect certain Warrants related to the 7% Notes, which were adjusted in accordance with their original terms. As a result of the Transaction, Warrants to purchase 2,032,205 shares with an exercise price of $4.35 and 198,264 shares with an exercise price of $3.60 were modified to 2,611,750 warrants with an exercise price of $3.38 and 252,496 warrants with an exercise price of $2.82, respectively.

In connection with the Transaction, we entered into a registration rights agreement with the Purchasers, pursuant to which we agreed to file a Registration Statement on Form S-3 registering for resale the shares purchased in the Transaction. The Registration Statement must be filed not later than 30 business days after the earlier of (a) the date the Company files its Annual Report on Form 10-K for the fiscal year ending December 31, 2007 or (b) the last day on which the Company could timely file such Annual Report on Form 10-K in accordance with SEC rules, with penalties imposed on the Company if such filing deadline is not met, or if the registration statement is not declared effective by the SEC within 60 days of filing (or 90 days if subject to SEC review) in an amount equal to 0.0493% of the Purchase Price of each share held by the Purchaser for each day of any such failure.

On March 30, 2007, the Company entered into a Note Purchase Agreement, which became effective on April 1, 2007, pursuant to which accredited investors including affiliates of the Company agreed to purchase $1,500 of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units. See Note 4 for further details.

We have incurred significant losses to date and at September 30, 2007, we have an accumulated deficit of $73,915. However, the Company has reduced its losses in the nine months of 2007 and has reported positive modified EBITDA in the second and third quarters of 2007. Management believes that the financing obtained in 2007 mentioned above and our liquidity at September 30, 2007 will enable us to continue with the development and delivery of our products and sustain operations through the next twelve months. There can be no assurance, however, that our operations will be sustained or be profitable in the future, that our product development and marketing efforts will be successful, or that if we have to raise additional funds to expand and sustain our operations, such funds will be available on terms acceptable to us, if at all.

Note 2

–

Basis of Presentation:

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial results have been included. Operating results for the quarter and nine months ending September 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. There were no material unusual charges or credits to operations during the recently completed fiscal quarter.

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The balance sheet at December 31, 2006 is derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the audited consolidated financial statements and footnotes thereto included in our annual report on Form 10-K, as amended, for the year ended December 31, 2006.

Certain prior year balances have been reclassified to conform to the current year presentation. The reclassifications had no net effect on the net loss previously reported.

Cash equivalents – The Company considers all highly liquid debt instruments purchased with an original maturity of 90 days or less to be cash equivalents.

Inventory – inventory is valued at the lower of cost or market, with cost determined on a first-in, first-out basis, and consists primarily of component equipment considered to be finished goods and which are expected to be installed as roadside capitalized systems or speed enforcement units.

Capitalized system costs – material, labor and contractor costs incurred to build and install our equipment are capitalized and depreciated over a minimum of 3 years or the initial term of our contracts. The Company's CrossingGuard red light enforcement business requires us to install our technology in the communities that we serve. To do this, the Company deploys internal and external resources to design, help install, and configure its software and equipment in those communities (i.e. build out). Internal build out costs are defined as directly related payroll, fringe, and travel related expenses. Those build out costs are capitalizable as part of the cost of the system deployed under contract in a community we serve and depreciated over a minimum of 3 years or the initial term of the contracts. The Company accumulates the amount of those internal build out costs incurred on a quarterly basis and capitalizes them. Internal build out costs capitalized in the third quarter of 2007 and 2006 were approximately $107 and $336, respectfully, and $349 and $336 for the nine months ending September 30, 2007 and 2006, respectively.

Other long term assets – are primarily debt financing costs associated with our debt agreements and are being amortized over the life of the debt.

Goodwill – Goodwill represents the excess of cost over the fair value of net assets acquired. Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Goodwill is reviewed for impairment using the Company’s quoted stock price as a measurement of the Company’s fair value of assets, including goodwill, and liabilities. Any resulting goodwill impairment will be charged to operations.

Deferred revenue – certain customer contracts allow us to bill and/or collect payment prior to the performance of services, resulting in deferred revenue.

Derivative Instruments – In connection with the sale of debt or equity instruments, the Company may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.

The identification of, and accounting for, derivative instruments is complex. Derivative instruments are re-valued at the end of each reporting period, with changes in fair value of the derivatives recorded as charges or credits to income in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instruments, we determine the fair value of these instruments using the Black-Sholes option pricing model, binomial stock price probability trees, or other valuation techniques, sometimes with the assistance of a certified valuation expert. These models require assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price based on not only the history of our stock price but also the experience of other entities considered comparable to us. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.

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Loss per share – loss per share is computed using the weighted average number of shares of stock outstanding during the period. Diluted per share computations, which would include shares from the effect of common stock equivalents and other dilutive securities are not presented for the third quarter of 2007 and nine month periods of 2007 and 2006, since their effect would be antidilutive.

Note 3

–

Stock Based Compensation:

The Company accounts for share-based compensation in accordance with the provisions of SFAS 123R, which requires the measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The majority of our share-based compensation arrangements vest over either a four or five year graded vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant.

The following table presents share-based compensation expenses for continuing operations included in the Company’s unaudited condensed consolidated statements of operations:

	Quarter Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Cost of sales	$	5	$	5	$	15	$	22
Engineering and operations		65		43		189		180
Research and development		9		43		27		106
Selling and marketing		2		3		8		81
General and administrative		49		525		200		1,551
Share-based compensation expense before tax	$	130	$	619	$	439	$	1,940
Provision for income tax		---		---		---		---
Net share-based compensation expense	$	130	$	619	$	439	$	1,940

The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted in the three and nine months ended September 30, 2007 and 2006. Estimates of fair value are not intended to predict actual future events of the value ultimately realized by persons who receive equity awards.

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INDEX

The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:

	Quarter Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Expected option term ⁽¹⁾	5.25 yrs.		5.25 yrs.		5.25 yrs.		5.25 yrs.
Expected volatility factor ⁽²⁾		164 %		165%	163 to 165 %		165 to 168 %
Risk-free interest rate ⁽³⁾		4.6 %		4.7%	4.5 to 5.0 %		4.5 to 5.0 %
Expected annual dividend yield ⁽⁴⁾		0 %		0%		0 %		0 %

⁽¹⁾	The option life was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.

⁽²⁾	The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical weekly price changes of the Company’s common stock over the expected option term.

⁽³⁾	The risk-free interest rate for periods equal to the expected term of the share option is based on the U. S. Treasury yield curve in effect at the time of grant.

⁽⁴⁾	The Company has not paid a dividend historically nor plans to declare a dividend in the near future.

Stock incentive plans

On May 6, 1997, the Company adopted the 1997 Stock Option Plan under which the Board of Directors granted incentive or non-qualified stock options to employees, directors and consultants to purchase shares of the Company’s common stock at a price equal to the market price of the stock at the date of grant. In June 2001, the 1997 Stock Option Plan was amended to increase the aggregate number of options authorized to 500,000 shares (post-reverse split) of the Company’s common stock. Options vest over four years and are exercisable for up to ten years from the date of grant, although most options currently outstanding expire eight years from the date of grant. The options are not transferable except by will or domestic relations order. No further grants may be made under this Plan pursuant to the adoption of the 2004 Stock Incentive Plan.

On June 24, 2004, the Company adopted the 2004 Stock Incentive Plan, which provides for the grant of awards to employees, officers and directors. Subject to adjustments for changes in the Company’s common stock and other events, the stock plan is authorized to grant up to 4,500,000 shares, either in the form of options to purchase Nestor common stock or as restricted stock awards. The Board of Directors determines the award amount, price usually equal to the market price of the stock on the date of the grant, vesting provisions and expiration period (not to exceed ten years) in each applicable agreement. The Board has authorized the Chief Executive Officer to award options to non-executive employees in an amount not to exceed 10,000 shares per employee and 200,000 in the aggregate on an annual basis. All such grants must be approved by the Compensation Committee and be consistent with the Plan. The awards are not transferable except by will or domestic relations order.

The following table presents the activity of the Company’s Stock Option Plans from December 31, 2006 through September 30, 2007.

	2007
	Shares		Weighted Average Exercise Price
Outstanding at December 31, 2006		2,953,853	$	4.55
Granted		739,500		0.82
Exercised		---		---
Canceled		510,600		4.34
Outstanding at September 30, 2007		3,182,753		3.72

Options exercisable at September 30, 2007		2,186,203	$	4.42

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INDEX

The following table presents weighted average price and life information about significant option groups outstanding at September 30, 2007:

Options Outstanding									Options Exercisable
Range of Ex. Price				Number of Outstanding at Sept. 30, 2007	Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable at Sept. 30, 2007	Weighted Averaged Exercisable Price
$	0.00	-	0.99	594,500		7.8	$	0.74	179,150	$	0.74
	1.00	-	2.99	342,650		7.1		1.83	49,650		2.15
	3.00	-	3.99	226,000		3.8		3.60	173,500		3.66
	4.00	-	4.99	1,835,775		3.1		4.86	1,640,450		4.86
	5.00	-	5.99	177,163		3.2		5.61	140,538		5.62
	6.00	-	8.00	6,665		4.6		6.20	2,915		6.13
				3,182,753		4.5		3.72	2,186,203		4.42

During the nine months ended September 30, 2007, and September 30, 2006, there were no intrinsic value of options exercised (i.e. the difference between the market price and the price paid by the employee to exercise the options) and no amount of cash was received from the exercise of options.

The total grant date fair value of stock options that vested during the nine months ended September 30, 2007 was approximately $659 with a weighted average remaining contractual term of 5.3 years. The weighted average fair value of options, as determined under SFAS123(R), granted during the quarter ended September 30, 2007 and 2006 was $0.72 and $2.80 per share, respectively.

As of September 30, 2007, there was $2,967 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Company’s stock option plans. That cost is expected to be recognized over a weighted-average period of 1.2 years. The Company amortizes stock-based compensation on the straight-line method.

The Company did not realize any actual tax benefit for tax deductions from option exercise of the share-based payment arrangements for the nine months ended September 30, 2007 or 2006.

Warrants

The Company, at the discretion of the Board of Directors, has granted warrants from time to time, generally in conjunction with the sale of equities. The Company issued 60,000 warrants in connection with the private placement in November 2004, 100,000 warrants in connection with the private placement in May 2005, 371,339 warrants in connection with the private stock placement in January 2006, and 2,394,262 warrants in connection with the Senior Secured Notes placement in May 2006, that were increased to 2,864,247 as part of the July 2007 private equity offering.

The following table presents warrants outstanding:

	September 30, 2007

Eligible, end of quarter for exercise		3,395,586

Warrants issued in the quarter		---

Low exercise price	$	2.82
High exercise price	$	8.44

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INDEX

The warrants outstanding as of September 30, 2007 are currently exercisable and expire at various dates through May, 2011. The outstanding warrants entitle the owner to purchase one share of common stock for each warrant, at prices ranging from $2.82 to $8.44 per share, subject to certain anti-dilution rights.

Note 4

–

Long Term Financial Obligations

The Company considers its senior convertible notes payable, senior secured convertible notes payable, variable rate senior notes payable and derivative financial instruments, net of debt discounts, to be its long-term financial obligations.

Long-term financial obligations consisted of the following.

	September 30, 2007			December 31, 2006
Senior Convertible Notes
Principal	$	2,850		$	2,850
Debt discount		(1,331	)		(1,930	)
FMV of embedded derivatives		12			164

Senior Secured Convertible Notes
Principal		22,840			22,840
Debt discount		(11,853	)		(14,277	)
FMV of embedded derivatives, including warrants		2,792			4,807


Variable Rate Senior Notes		1,500			---
	$	16,810		$	14,454
Less current portion		---			---
Total	$	16,810		$	14,454

Aggregate maturities of long-term obligations for the years ending following September 30, 2007 are as follows:

	2009		2011		Total

Senior Secured Convertible Notes	$	---	$	22,840	$	22,840
Senior Convertible Notes		2,850		---		2,850
Variable Rate Senior Notes Payable		---		1,500		1,500
Total:	$	2,850	$	24,340	$	27,190

In addition, the holders of the Senior Secured Convertible Notes have the right to require the Company to redeem all or any portion of the outstanding balance of the Secured Notes on May 25, 2009, if the Company’s modified EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R) for the twelve-month period ended December 31, 2008 as reported on the Form 10-K does not exceed $14,000.

On March 30, 2007, the Company entered into a Note Purchase Agreement, which became effective on April 1, 2007, pursuant to which accredited investors (some of whom are affiliates of the Company) agreed to purchase $1,500 of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units.

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Speed Note holders will receive interest payments equal to (a) $5.00 per paid citation issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed fee” contracts), subject to a minimum return of 10% per annum, payable quarterly in arrears. Payments will be made based upon citations issued up to 16 speed units per $1,500 million in aggregate outstanding principal on all Notes. Once the Company has entered into contracts for the operation of a minimum of 16 speed units, the Company may, but is not obligated to, sell an additional $1,500 million of Speed Notes. The effective interest rate for the third quarter of 2007 was 10%.

The Speed Notes will mature on May 25, 2011, at which time the Company will pay all unpaid principal together with all accrued but unpaid interest. The Company may at any time redeem the Speed Notes at 110% of face value plus accumulated but unpaid interest.

The proceeds from the Speed Notes will be used, either prospectively or retrospectively, to fund the purchase price or cost of design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment used in speed contracts signed after October 1, 2006 at a customer site, including without limitation, costs of site analysis and preparation.

Note 5

–

Income Taxes:

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” ("FIN No. 48"), on January 1, 2007. FIN No. 48 requires that the impact of tax positions be recognized in the financial statements if they are more likely than not of being sustained upon examination, based on the technical merits of the position. As discussed in the consolidated financial statements in the 2006 Form 10-K, the Company has a valuation allowance against the full amount of its net deferred tax assets. The Company currently provides a valuation allowance against deferred tax assets when it is more likely than not that some portion, or all of its deferred tax assets, will not be realized.

As a result of the implementation of FIN No. 48, the Company reduced its deferred tax assets and the associated valuation allowance for gross unrecognized tax affected benefits of approximately $11,545. There was no adjustment to accumulated deficit as a result of these unrecognized tax benefits, since there was a full valuation allowance against the related deferred tax assets. If these unrecognized tax benefits are ultimately recognized, they would have no impact on the effective tax rate due to the existence of the valuation allowance.

The Company is subject to U.S. federal income tax as well as income tax of certain state jurisdictions. The periods from 1999-2006 remain open to examination by the I.R.S. and state authorities. The Company has not been audited by the I.R.S. or any states in connection with income taxes for this period of time.

We recognize interest accrued related to unrecognized tax benefits in interest expense, if any. Penalties, if incurred, are recognized as a component of income tax expense.

Note 6

–

Litigation:

On April 13, 2007, the Company filed suit against Place Motor, Inc. and Clair Ford, Lincoln Mercury, Inc. (Nestor Traffic Systems, Inc. Plaintiff, vs. Place Motor, Inc., et al., Rhode Island Superior Court, C.A. No. PC-07-1963). Place Motor, Inc. and Clair Ford, Lincoln Mercury, Inc. are in possession of title for eight vans for which Nestor has paid in full. Nestor has alleged that it paid for these vans by making payment to the defendants’ agent, Northeast Conversions, LLC. Although Northeast Conversions never forwarded our payment to the defendants, Nestor believes that it satisfied its obligation to pay for the vans when it delivered payment to the defendants’ agent. Accordingly, Nestor seeks declaratory judgment in favor stating that the Defendants’ must take any action necessary to deliver the vans together with valid title certificates to Nestor Traffic Systems. The defendants have answered the complaint with general denials of the basis for Nestor’s claims and asserting certain affirmative defenses. Neither party asserted any counterclaims. We have initiated discovery and, under Rhode Island law, discovery requests must be answered within 40 days.

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Two suits have been filed against us and the City of Akron seeking to enjoin the City of Akron speed program and damages. These cases have been consolidated in the U.S. District Court for the Northern District of Ohio. These cases are:

Mendenhall v. The City of Akron, et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against City of Akron and all of its City Council members in their official capacity and us alleging federal and state constitutional violations. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. The plaintiff amended her complaint on August 8, 2006 to include equal protection violations among her federal constitutional claims. We filed an answer to that amended complaint on August 18, 2006 and all dispositive motions in the case were filed by November 22, 2006.

Sipe, et al. v. Nestor Traffic Systems, Inc., et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against us, various past and present employees of ours and the City of Akron and alleging fraud, civil conspiracy, common plan to commit fraud, violations of the Consumer Sales Practices Act, nuisance, conversion, invasion of privacy, negligence, and federal constitutional violation. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006 and all dispositive motions in the case were filed by November 22, 2006.

With respect to both of the above cases, final resolution can be determined only after disposition of the Court’s certified question to the Ohio Supreme Court; namely:

Whether a municipality has the power under home rule to enact civil penalties for the offense of violating a traffic signal light or for the offense of speeding, both of which are criminal offenses under the Ohio Revised Code.

On February 7, 2007, the Ohio Supreme Court accepted the case for determination of the question presented. The Ohio Supreme Court has received briefs from all parties, and oral arguments were heard on September 18, 2007. Although the Ohio Supreme Court is not bound to render a decision in a specific period of time, we anticipate that a decision will be rendered not later than March 2008.

With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.

If the Ohio Supreme Court renders judgment adverse to Nestor, our ability to continue operations in the State of Ohio would be severely limited and we may not be able to operate at all. A significant portion of our revenues derive from Ohio and the loss of that business could have a material and adverse effect on our business and operations.

We do not currently have any pending material litigation other than that described above.

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Note 7

–

New Accounting Pronouncements:

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. We are currently evaluating the potential impact of this statement.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” which is effective for fiscal years beginning after November 15, 2007. This statement permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. We are currently evaluating the potential impact of this statement.

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ITEM 2:

Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward Looking Statements

The following discussion includes “forward-looking statements” within the meaning of Section 21E of the Securities and Exchange Act of 1934, and is subject to the safe harbor created by that section. Forward-looking statements give our current expectations or forecasts of future events. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Factors that could cause results to differ materially from those projected in the forward-looking statements are set forth in this section and in Part I – Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. The following discussion should also be read in conjunction with the Condensed Consolidated Financial Statements and accompanying Notes thereto.

Readers are cautioned not to place undue reliance on these prospective statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission.

Executive Summary

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and in Canada. We provide:

CrossingGuard®, a fully video-based automated red light enforcement system

PoliScan^Speed™,a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system; and

ViDAR™, a new video-based speed detection and imaging system that complements our other systems or stands alone as a speed enforcement system.

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In addition to our automated traffic enforcement systems, we offer state of the art back office solutions for the processing and management of citation issuance, prosecution and collection. Our Citation Composer software, the staple of our back-office citation processing service, is now supplemented by an Internet-based customer support application. Our new i-Citation software application assists customers with all event tasks. i-Citation provides customers with the ability to review the complete evidence package online. i-Citation provides police and other officials with convenient and quick access to all event information. i-Citation provides ready access over the web to violation information such as location and date/time; and disposition status of an event. Our suite of traffic safety solutions in combination with our advanced back-office software make customer-friendly, fully integrated and turnkey services available. i-Citation is now being used by a major customer and, although not required, will ultimately replace customer-facing Citation Composer functions as part of our planned roll out which begins in the fourth quarter of 2007.

A recent innovation by our research and development team is video signal sensing or VSS. VSS integrates with commercially available cameras to read the phase of a traffic signal day or night without any connection to the signal control box or any physical connections. We expect that VSS will reduce intersection construction costs. Early results of VSS software testing and quality assurance are positive and we expect to complete testing before year end.

We generate recurring revenue through contracts that provide for equipment leasing and services on a fixed and/or per citation fee basis. Essentially all of our revenue prior to September 30, 2005 was generated through contracts for our CrossingGuard red light system. Beginning in the fourth quarter of 2005, we started generating revenue from our PoliScan^speed system. The economics of products and services are tied to the number of operating systems in the field and in many cases the number of violations processed by such systems. Customer pricing entails fixed monthly fees, variable per ticket fee pricing structures, or a combination of both. A shift to monthly fixed fee contracts may result in a more stable revenue stream for installations. Many of our initial red light and speed contracts, however, compensate us on a per-ticket-paid or issued basis in return for both equipment lease and maintenance and citation processing and customer support services. Depending on the terms of each contract, we realize from $19 to $99 per citation issued or paid and/or fixed monthly fees ranging from $2,000 to $7,000 per approach for system delivery and processing services.

State statutes providing for automated enforcement may impose liability on either the driver or the registered owner of a vehicle for a violation. Driver liability statutes require that the driver be identified, from the photographic evidence, and that the citation be issued and sent to the driver. Registered owner statutes require that the vehicle’s owner be identified, through registration records, and that the citation be issued and sent to the registered owner. Because only the license plate is required for identification under a registered owner statute, program operating efficiencies are higher, generally resulting in lower per citation costs and monthly fees for CrossingGuard systems installed in these jurisdictions. Of the nineteen jurisdictions that have active automated red light enforcement programs, four require that a driver be identified; the other states limit identification to the vehicle license plate and impose liability on the registered owner. Driver identification states are generally in the western part of the US, and include California, Arizona, Oregon and Colorado.

Almost all of our contracts provide for the lease of equipment and the services as a bundled, turnkey program over initial terms of three to five years. The equipment leases are generally classified as operating leases under FAS 13 “Accounting for Leases” and the revenues are realized along with service revenues as services are delivered to a customer over the life of the contract.

Our existing contracts with government entities typically authorize the installation of systems at a specified number of approaches. As of September 30, 2007, our active contracts had 287 installed approaches and speed units and authorized the installation of up to an additional 207 approaches and speed units. Management believes the majority of the authorized approaches under existing active contracts will be installed, but no assurances can be given that all approaches under contract will ultimately be installed due to factors including locating qualifying intersections, budget or personnel considerations, etc.

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The following table provides summary information regarding our active contracts.

	Quarter Ended September 30,
Number of Approaches and Units:	2007		2006

Installed, operational and revenue-generating
CrossingGuard red light approaches		280		202
Poliscan^speed Units		7		10
Additional Authorized Approaches:
CrossingGuard red light approaches		195		225
Poliscan^speed Units		12		10
Total		494		447

During the third quarter of 2007, the Company added 33 CrossingGuard red light approaches and decommissioned no approaches and added three PoliScan^Speed™ units and decommissioned no units. Three speed units that operate in school zone speed enforcement contracts were shut down for the summer school vacation season in June and restarted in September.

The management team focus is to expand our market share in the emerging traffic safety market. We plan to expand that market share by:

Continuing to aggressively market CrossingGuard video-based red light enforcement systems and services to targeted states and municipalities for red light enforcement and safety

Implementing a marketing program for speed enforcement systems and services to states and municipalities for speed enforcement and safety

Focusing our research and development team on streamlining our current technical offering and reducing cost and complexity.

Exploring new applications of our technology and new distribution centers

Participating in efforts to increase the public’s acceptance of, and state’s authorization of, automated traffic safety systems

Participating in industry standards setting bodies

Enhancing and seeking patents for our traffic safety technology to maintain or improve our position and competitive advantages in the industry

Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. We may incur significant expenses in anticipation of revenue, which may not materialize and we may not be able to reduce spending quickly if our revenue is lower than expected. In addition, our ability to forecast revenue, particularly with respect to our new speed products, is limited. As a result, our operating results are volatile and difficult to predict and you should not rely on the results of one quarter as an indication of future performance. Factors that may cause our operating results to fluctuate include, costs related to customization of our products and services; announcements or introductions of new products and services by our competitors; the failure of additional states to adopt or maintain legislation enabling the use of automated traffic enforcement systems or existing states that may prohibit it in the future; determinations by state and local government bodies to utilize our equipment without the additional processing services we provide; equipment defects and other product quality problems; a shift towards fixed rate, as opposed to per ticket, compensation arrangements for our speed products, which could adversely affect revenues; the discretionary nature of our customers’ internal evaluation, approval and order processes; the varying size, timing and contractual terms of orders for our products and services; and the mix of revenue from our products and services.

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During our first 25 years of operations, we developed a number of patented intelligent software solutions for decision and data-mining applications, including financial services, fraud detection and intelligent traffic-management systems. In 2000, we made the strategic decision to concentrate on our traffic management technologies and began to dispose of our other product lines. By 2003, we had exited our financial services and fraud detection business lines, and had refocused our resources on our traffic safety and enforcement systems such as CrossingGuard, our current primary source of revenue. In early 2001, we also entered into two separate source-code licensing agreements for our fraud detection product line appointing Applied Communications, Inc., or ACI, and Retail Decisions, Inc., or ReD, as co-exclusive resellers in the transaction processing industry. Royalty revenues from ACI continued through June 2002 when the royalty stream was assigned to Churchill Lane Associates, or CLA. We do not expect to receive future revenues from this license. Additionally, we transferred to ReD certain of our assets that supported the technology licensed under our license to ReD. No ongoing revenues are expected to be realized from ReD. The licensing, royalty and other payments we received under these licensing arrangements and other transfers of our noncore property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.

The following is a summary of key financial measurements monitored by management:

	Quarter Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Financial
Revenue	$	3,349,000		$	1,982,000		$	8,791,000		$	5,737,000
Loss from operations		(612,000	)		(2,768,000	)		(2,786,000	)		(8,919,000	)
Net income (loss)		(1,967,000	)		2,648,000			(5,436,000	)		(4,848,000	)
Modified EBITDA		432,000			(1,455,000	)		111,000			(4,639,000	)

Investment in capitalized systems		1,257,000			1,924,000			4,118,000			3,538,000
Cash and marketable securities		5,216,000			12,941,000
Working capital		4,653,000			11,079,000

We are a capital-intensive business, so in addition to focusing on GAAP measures, we focus on modified EBITDA to measure our results. We calculate this number by first calculating EBITDA, which we define as net income before interest expense, debt restructuring or debt extinguishment costs (if any during the relevant measurement period), provision for income taxes, and depreciation and amortization. Then we exclude derivative instrument income or expense, debt discount expense, share-based compensation expense, and asset impairment charges These measures eliminate the effect of financing transactions that we enter into on an irregular basis based on capital needs and market opportunities, and these measures provide us with a means to track internally generated cash from which we can fund our interest expense and our growth. In comparing modified EBITDA from period to period, we also ignore the effect of what we consider non-recurring events not related to our core business operations to arrive at what we define as modified EBITDA. Because modified EBITDA is a non-GAAP financial measure, we include in the tables below reconciliations of modified EBITDA to the most directly comparable financial measures calculated and presented in accordance with accounting principles generally accepted in the United States.

We present modified EBITDA because we believe it provides useful information regarding our ability to meet our future debt payment requirements, capital expenditures and working capital requirements, and that it provides an overall evaluation of our financial condition. In addition, modified EBITDA is defined in certain financial covenants under our 7% Senior Secured Convertible Notes and was used to adjust the interest rate on those notes to 9% at July 1, 2007 and will be used January 1, 2009 to determine whether the holders of those notes have a redemption right at May 25, 2009.

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Modified EBITDA has certain limitations as an analytical tool and should not be used as a substitute for net income, cash flows or other consolidated income or cash flow data prepared in accordance with generally accepted accounting principles in the United States or as a measure of our profitability or our liquidity.

When evaluating modified EBITDA as a performance measure, and excluding the above-noted items, all of which have material limitations, investors should consider, among other factors, the following:

	•		increasing or decreasing trends in modified EBITDA;

	•		how modified EBITDA compares to levels of debt and interest expense.

Because modified EBITDA, as defined, excludes some but not all items that affect our net income, modified EBITDA may not be comparable to a similarly titled performance measure presented by other companies.

The table below is a reconciliation of modified EBITDA to net loss for the three and nine month periods ended September 30, 2007 and 2006:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
GAAP net income (loss)	$	(1,967,000	)	$	2,648,000		$	(5,436,000	)	$	(4,848,000	)
Interest expense, net of interest income		685,000			562,000			1,830,000			1,360,000
Income tax expense		---			---			---			---
Depreciation and amortization		914,000			694,000			2,458,000			2,165,000
EBITDA	$	(368,000	)	$	3,904,000		$	(1,148,000	)	$	(1,323,000	)
Derivative instrument (income) expense		(338,000	)		(7,145,000	)		(2,204,000	)		(10,112,000	)
Debt discount expense		1,008,000			1,167,000			3,024,000			4,681,000
Stock-based compensation expense		130,000			619,000			439,000			1,940,000
Asset impairment charge		---			---			---			175,000
Modified EBITDA	$	432,000		$	(1,455,000	)	$	111,000		$	(4,639,000	)

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. For more information, see Note 2 to the condensed consolidated financial statements included elsewhere in this report. We believe that of our significant accounting policies, the following may involve a higher degree of judgment and complexity.

Revenue Recognition

In accordance with Staff Accounting Bulletin 104 – Revenue Recognition in Financial Statements (“SAB 104”), revenue is generally recognized and earned when all of the following criteria are satisfied: (a) persuasive evidence of sales arrangements exist, (b) delivery has occurred, (c) the sales price is fixed or determinable, and (d) collectability is reasonably assured. In those cases where all four criteria are not met, we defer recognition of revenue until the period these criteria are satisfied.

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The majority of our revenue is derived from three types of customer arrangements:

We provide hardware and equipment, and related third party embedded software (“roadside systems”). The third party embedded software is considered incidental to the system as a whole. In these arrangements, we typically sell or lease the system as a stand alone roadside system and account for it either as a direct sale, in one instance as a sales type lease, as it met the criteria of a sales type lease in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (FAS) No. 13 – Accounting for Leases, or in most other cases as an operating lease accounted for on a monthly basis. For each arrangement, usually upon delivery for the sales type lease or monthly for operating type leases, revenue is recognized as there exists evidence that an arrangement exists, the system is delivered, the price is fixed or determinable, and collectability is reasonably assured in accordance with SAB 104;

We provide services, which typically include citation processing, back office and hosting services. Software is more than incidental to the services as a whole, but 1) is used by us to capture and internally process the violations and 2) customers do not have the right to and do not take possession of our detection and tracking, or our citation processing and back office software. For these services, we typically recognize revenue on a fixed monthly fee or a per citation fee basis. Revenue usually commences for these service arrangements, upon the first month after inception of operations, as there exists evidence that an arrangement exists, services have been rendered or delivered (citations and other services are delivered), the price is fixed or determinable, and collectability is reasonably assured; and

For two current customers who want to process their own citations, we lease them our detection and tracking and citation processing and back office software and provide monthly customer support on the software. For this arrangement, we recognize revenue in accordance with Statement of Position 97–2 Software Revenue Recognition. Although all software deliverables are complete in the initial month of operations, and the monthly customer support is the only undelivered element, we recognize revenue on a monthly basis as the citations are issued or paid.

Some contracts include penalty provisions relating to timely performance and delivery of systems and services by us. Penalties are charged to operations in the period the penalty is determinable. In the first half of 2007 and 2006, four and two customers, respectively, each exceeded ten percent of revenue.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is evaluated on a regular basis and adjusted based on management’s best estimate of probable losses inherent in receivables, based on historical experience. Receivables are considered to be past due if they have not been paid by the payment due dates. Debts are written off against the allowance when deemed to be uncollectible. Subsequent recoveries, if any, are credited to the allowance when received.

Inventory Obsolescence

We evaluate our inventory for excess and obsolescence on a quarterly basis. In preparing our evaluation, we look at the expected demand for our products for the next three to twelve months in order to determine whether or not such equipment to be installed requires a change in the inventory reserve in order to record the inventory at net realizable value. Based upon the evaluation, a reserve is established so that inventory is appropriately stated at the lower of cost or net realizable value.

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Capitalization of Internal Buildout Costs

The Company's CrossingGuard red light enforcement business requires us to install our technology in the communities that we serve. To do this, the Company deploys internal and external resources to design, help install, and configure its software and equipment in those communities (i.e. build out). Internal build out costs are defined as directly related payroll, fringe, and travel and entertainment expense. Those build out costs are capitalizable as part of the cost of the system deployed under contract in a community we serve and depreciated over a minimum of 3 years or the initial term of the contract. The Company accumulates the amount of those internal build out costs incurred on a quarterly basis and capitalizes them. Internal build out costs capitalized in the third quarter of 2007 and 2006 were approximately $107,000 and $336,000, respectively, and $349,000 and $336,000 for the nine months ending September 30, 2007 and 2006, respectively.

Share-Based Compensation

In the first quarter of 2006, we adopted Statement of Financial Accounting Standards No. 123(R) "Share-Based Payments" ("SFAS 123(R)"), which required all share-based payments to employees to be recognized in our financial statements at their fair value. We have continued to use the Black-Scholes option pricing model to determine fair value of options under SFAS 123(R) and have elected to use the modified-prospective transition method.

The calculation of stock-based compensation requires the use of a valuation model and related assumptions. The use of the Black-Scholes option pricing model requires the use of subjective assumptions including an estimate of the volatility of our stock, the expected life of our share-based instruments, the expected forfeitures of share-based instruments, the expected dividend rate on our common stock, and the risk free interest rates that can materially affect our fair value estimate of our share-based instruments. Changes in these estimates and assumptions could materially impact the calculation of stock-based compensation.

Derivative Instruments

In connection with the sale of debt or equity instruments, we may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.

Long-Term Asset Impairment

In assessing the recoverability of our long-term assets, including capitalized system costs, management must make assumptions regarding estimated future cash flows, contract renewal options and other factors to determine its fair value. If these estimates change in the future, we may be required to record impairment charges that were not previously recorded.

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Concentrations of credit risk

Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. We place our cash and temporary cash investments with high credit quality financial institutions. At times such investments may be in excess of the FDIC limit. However, senior management continually reviews the financial stability of these financial institutions. We routinely assess the financial strength of our customers, most of which are municipalities, and, as a result, believe that our trade accounts receivable credit risk exposure is limited. However, one customer represents 42% of our Accounts Receivable balance as of September 30, 2007. We do not require collateral from our customers.

Liquidity and Capital Resources

Cash Position and Working Capital

We had cash, cash equivalents and marketable securities totaling $5,216,000 at September 30, 2007 compared with $3,010,000 at December 31, 2006. At September 30, 2007, we had working capital of $4,653,000 compared with $3,433,000 at December 31, 2006. Our net worth at September 30, 2007 was $5,379,000 compared with $5,502,000 at December 31, 2006.

The increase in cash and working capital is primarily due to (1) proceeds of $4,873,000, net of expenses, from our private equity offering in July 2007 and (2) proceeds of $1,415,000, net of expenses, received from our placement of $1,500,000 in Variable Rate Senior Notes Payable, offset by (3) our investment in capitalized systems of $4,118,000 which are expected to generate revenue in future quarters, and (4) cash flow from operations of $116,000.

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On March 30, 2007, the Company entered into a Note Purchase Agreement, which became effective on April 1, 2007, pursuant to which accredited investors including affiliates of the Company agreed to purchase $1,500,000 of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units.

We continue to seek additional sources of equity and debt financing to fund future investments and to position ourselves to capitalize on new market and growth opportunities; however, there can be no assurance that the funds will be available on terms acceptable to us, if at all.

Commitments, Contractual Obligations and Off-Balance Sheet Arrangements

The following table summarizes the Company’s contractual obligations at September 30, 2007, and the effect such obligations are expected to have on its liquidity and cash flow in future periods:

Payments due in:	Operating Leases⁽¹⁾		Senior Convertible Notes		Senior Secured Convertible Notes		Variable Rate Senior Notes Payable		Debt Interest		Total
2007	$	89,000	$	---	$	---	$	---	$	587,000	$	676,000
2008		357,000		---		---		---		2,348,000		2,705,000
2009		357,000		2,850,000		---		---		2,254,000		5,461,000
2010		313,000		---		---		---		2,206,000		2,519,000
2011		113,000		---		22,840,000		1,500,000		882,000		25,335,000
Thereafter		---		---		---		---		---		---
	$	1,229,000	$	2,850,000	$	22,840,000	$	1,500,000	$	8,277,000	$	36,696,000

⁽¹⁾	Primarily facility lease obligations in Providence, RI and Los Angeles, CA.

The interest rate on our 7% Senior Secured Convertible Notes is subject to adjustment if certain targets in the Company’s modified EBITDA are or are not met. As modified EBITDA reported on the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ending June 30, 2007 was less than $1,250,000, the interest rate was increased to 9% effective July 1, 2007. As a result, the above table reflects interest on the 7% Senior Secured Convertible Notes at 9% for all future fiscal periods through maturity. The effect of increasing the interest rate is an increase in interest expense by $114,000 quarterly beginning in the third quarter of 2007.

In addition, the holders of the Senior Secured Convertible Notes have the right to require the Company to redeem all or any portion of the outstanding balance of the Secured Notes on May 25, 2009, if the Company’s modified EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R) for the twelve-month period ending December 31, 2008 as reported on the Form 10-K does not exceed $14.0 million.

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On April 23, 2007, the Company received notice from The Nasdaq Stock Market (“Nasdaq”) that because the Company’s stock traded below $1.00 for a period of 30 consecutive business days, it did not comply with the minimum requirement for continued inclusion in Nasdaq under Marketplace Rule 4310(c)(4). Accordingly, the Company had been notified that it had 180 calendar days or until October 22, 2007, to meet this compliance requirement. Although the Company did not bring the bid price of its stock back above $1.00 per share for 10 or more consecutive business days as of that date, the Company was nevertheless entitled to an automatic 180 day extension through April 21, 2008 to meet this Nasdaq threshold. Nasdaq rules provide for this automatic extension because the Company met all of Nasdaq’s initial listing requirements (other than the closing bid price) on October 22, 2007. The Nasdaq staff has determined that the Company meets the applicable Nasdaq Capital Market initial listing criteria as set forth in Marketplace Rule 4310(c) except for the 10-day bid price requirement. Accordingly, the Company has until April 21, 2008 to meet the 10-day bid price requirement. If the Company does not achieve this threshold as of that date, Nasdaq staff will provide written notification to the Company that its securities will be delisted. In that event, the Company may appeal the staff’s determination and would be permitted to cure the non-compliance by effecting a reverse stock split. A delisting of the Company’s stock for more than five consecutive days or for more than an aggregate of 10 days in any 365-day period would constitute an event of default under the terms of the Company’s 7% Senior Secured Convertible Notes dated May 25, 2006. A default under the 7% Notes would in turn be a default under the Company’s 5% Senior Convertible Notes due in 2009.

As of September 30, 2007, we have no off balance sheet arrangements.

For the nine months ended September 30, 2007, we invested $4,118,000 in capitalized systems compared to $3,538,000 invested in capitalized systems costs in the same period last year. Management expects that NTS will make substantial future commitments for systems related to our CrossingGuard contracts.

Results of Operations

Revenues

Total revenues for the third quarter of 2007 were $3,349,000 as compared to $1,982,000 for the third quarter of 2006. Total revenues for the nine months ending September 30, 2007 were $8,791,000 as compared to $5,737,000 for the nine months ending September 30, 2006. Lease and service fee revenue grew 68% in the third quarter and 53% in the first nine months of 2007 as our base of revenue-generating CrossingGuard red light approaches and revenue per Poliscan Speed Units increased. At the end of the third quarter of 2007 we had 280 revenue generating CrossingGuard approaches and 7 PoliScan^speed Units as compared to 202 revenue generating CrossingGuard approaches and 10 PoliScan^speed Units in the third quarter of 2006. The average per approach/unit revenue increased in the third quarter and period of 2007 for both red light and speed business as we decommissioned unproductive and added productive approaches and units in 2007.

Cost of sales

Cost of sales for the third quarter of 2007 was $1,943,000 as compared to $1,659,000 for the third quarter of 2006, an increase of $284,000, or 17%. Cost of sales for the nine months ending September 30, 2007 was $5,164,000 as compared to $4,715,000 for the nine months ending September 30, 2006, an increase of $449,000, or 10%. In both the quarter and the nine months ending September 30, 2007, amortization of new capitalized systems and associated direct processing and support costs increased as a result of more revenue-generating red-light approaches in the periods presented. However, these increases were offset by (1) cost reductions and efficiencies in our mature contracts, (2) the reduction of higher costs on our Transol contracts, which we acquired in September 2005. Most depreciable Transol assets were written off as part of the impairment charge taken in the fourth quarter of 2006 on underperforming Transol contracts, thereby reducing 2007 depreciation on ongoing Transol business, and (3) included in the second quarter of 2006 were charges totaling $325,000 for inventory and impairment that did not repeat in 2007.

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Gross Profit

Gross Profit for the third quarter of 2007 totaled $1,406,000 or 42% as compared to $323,000 or 16% for the third quarter of 2006, an increase of $1,083 or 26 percentage points. Gross Profit for the nine months ending September 30, 2007 totaled $3,627,000 or 41% as compared to $1,022,000 or 18% for the nine months ending September 30, 2006, an increase of $2,605,000 or 23 percentage points. The increase in gross profit in both the quarter and nine months ending September 30, 2007 is primarily attributable to higher levels of revenue, the reduction in costs on our mature contracts and in one-time charges, and the favorable effect created in 2007 by the write-off of depreciable assets related to our Transol contracts in the fourth quarter of 2006.

Operating Expenses

In November 2006, we instituted additional operational cost reductions in an internal reorganization intended to focus the Company's operations on program delivery and support and reduce current operating expense levels. The reorganization resulted in the reduction of 27 employees, or approximately 20% of the workforce, which is expected to result in an annual payroll reduction of over $1.5 million. The cost savings of the actions taken in the fourth quarter of 2006 began to affect our financial results in the first quarter of 2007.

In addition, certain executive stock option vesting and associated non-cash stock compensation expense charges were completed in the fourth quarter of 2006. These charges were approximately $400,000 on a quarterly basis in 2006. These charges do not reoccur in 2007.

Total operating expenses for the third quarter of 2007 totaled $2,018,000 as compared to $3,091,000 for the third quarter of 2006, a decline of $1,073,000. Total operating expenses for the nine months ending September 30, 2007 totaled $6,413,000 as compared to $9,941,000 for the nine months ending September 30, 2006, a decline of $3,528. The 35% decline in operating expenses for both periods was due to (1) the above-mentioned cost reduction actions taken by the Company in the fourth quarter of 2006, and (2) the above-mentioned decline in the Company’s non-cash stock compensation charges.

Engineering and operations expense for the third quarter of 2007 totaled $926,000 as compared to $861,000 in the third quarter of 2006, an increase of $65,000. Engineering and operations expense for the nine months ending September 30, 2007 totaled $3,019,000 as compared to $3,162,000 in the nine months ending September 30, 2006, a decline of $143,000. These costs include the salaries and related costs of field and office personnel, as well as, operating expenses related to delivery, configuration, maintenance and service of our installed base. The increase in the 2007 quarter is attributable to additional costs incurred in support of our increasing revenue base. The decline in the 2007 period is still primarily attributable to the cost reduction actions taken in 2006 as mentioned above.

Research and development expenses for the third quarter of 2007 totaled $99,000 as compared to $365,000 in the third quarter of 2006, a decline of $266,000. Research and development expenses for the nine months ended September 30, 2007 totaled $318,000 as compared to $1,137,000 in the nine months ending September 30, 2006, a decline of $819,000. The reduction in research and development expenses for both periods is primarily due to the successful completion of our transition to digital CrossingGuard and speed technology in 2006.

Selling and marketing expenses for the third quarter of 2007 totaled $181,000 as compared to $549,000 in the third quarter of 2006, a decline of $368,000. Selling and marketing expenses for the nine months ending September 30, 2007 totaled $552,000 as compared to $1,598,000 for the nine months ended September 30, 2006, a decline of $1,046,000. The decline is primarily due to the cost reduction actions taken as mentioned above. The Company is in the process of implementing a new sales and marketing strategy and expects its costs in future quarters to increase as a result.

General and administrative expenses for the third quarter of 2007 totaled $812,000 as compared to $1,316,000 in the third quarter of 2006, a decline of $504,000. General and administrative expenses for the nine months ended September 30, 2007 totaled $2,524,000 as compared to $4,044,000 for the nine months ending September 30, 2006, a decline of $1,520,000. The decline is primarily attributable to the above-mentioned decline in our non-cash stock compensation charges offset by an increase in our corporate governance costs.

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Derivative instrument income (expense), net

Derivative instrument income for the third quarter of 2007 totaled $338,000 as compared to $7,145,000 for the third quarter of 2006. Derivative instrument income for the nine months ending September 30, 2007 totaled $2,204,000 as compared to $10,112,000 for the nine months ending September 30, 2006.

The changes were attributable to changes in the fair market value of embedded derivatives issued with our convertible debt. The fair value of the derivatives will fluctuate based on: our stock price at particular points in time, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the remaining time to maturity of the outstanding debt.

The major factors contributing to the change for the third quarter and nine months ending September 30, 2007 was due to the passage of time and a decline in our stock price.

Debt discount expense

Debt discount expense for the third quarter of 2007 totaled $1,008,000 as compared to an expense of $1,167,000 for the third quarter of 2006. Debt discount expense for the nine months ending September 30, 2007 totaled $3,024,000 as compared to an expense of $4,681,000 for the nine months ending September 30, 2006.

The decline in both the quarter and nine months ending September 30, 2007 is primarily attributable to a write-off of debt discounts associated with the repayment of the Fourth Laurus Note in the second quarter of 2006 and the put exercised in the fourth quarter of 2006. This charge was partially offset by higher debt discounts associated with the sale of our Senior Secured Convertible Notes, and higher debt discounts on the extension of our Senior Convertible Notes in May 2006. These debt discounts are established at the time a derivative instrument is bifurcated from the host debt agreement (at issuance) and amortized over the life of the note.

Other Expense, net

Other expense, net for the third quarter of 2007 totaled $685,000 as compared to $562,000 in the third quarter of 2006. Other expense, net for the nine months ending September 30, 2007 totaled $1,830,000 as compared to $1,360,000 for the nine months ending September 30, 2006. Other Expense, net is primarily interest expense, but also includes interest income, debt financing cost amortization, banking fees, and foreign exchange gains and losses. The increase in both periods is primarily attributable to interest on higher levels of debt and higher interest rates.

The interest rate on our Senior Secured Convertible Notes is subject to adjustment if certain targets in the Company’s modified EBITDA are or are not met. As modified EBITDA reported on the Company’s Quarterly Report on Form 10-Q for the second quarter of 2007 was less than $1,250,000, the interest rate was increased from 7% to 9% effective July 1, 2007. The effect of increasing the interest rate is an increase in interest expense by $114,000 quarterly beginning in the third quarter of 2007.

Net Loss

Net loss for the third quarter of 2007 was $1,967,000 or 7 cents per share as compared to a net income of $2,648,000 or 13 cents per share for the third quarter of 2006. Net loss for the nine months ending September 30, 2007 was $5,436,000 or 24 cents per share as compared to a net loss of $4,848,000 or 24 cents per share for the nine months ending September 30, 2006. The increase in losses for both periods was primarily attributable to (1) the decline in non-cash derivative instrument income and (2) the increase in interest costs related to our debt arrangements, offset by (3) the increase in revenues, (4) improved gross margins on ongoing business, (5) the reduction in our non-cash stock compensation costs beginning in the first quarter of 2007, and (6) the reduction in debt discount expense.

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ITEM 3. Quantitative and Qualitative Disclosure of Market Risk.

The following discussion of our market risk includes forward-looking statements that involve risk and uncertainty. Actual results could differ materially from those projected in the forward-looking statements. Market risk represents risk of changes in value of a financial instrument caused by fluctuations in interest rates, foreign exchange rates and equity and bond prices.

Interest Rates

We have a senior convertible note payable with interest fixed at 5% and 9% through their maturity in May 2011. Interest on the Senior Secured Convertible Notes was changed based on the financial performance of the Company starting in the third quarter of 2007. The effect of increasing the interest rate for future quarters from 7% to 9% is an increase in interest expense by $114,000 quarterly.

Variable Rate Senior Note holders will receive interest payments equal to (a) $5.00 per paid citation issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed fee” contracts), subject to a minimum return of 10% per annum, payable quarterly in arrears. Payments will be made based upon citations issued from up to 16 speed units per $1.5 million in aggregate outstanding principal on all Notes. Once the Company has entered into contracts for the operation of a minimum of 16 speed units, the Company may, but is not obligated to sell an additional $1.5 million of Speed Notes. The effective interest rate for the second quarter of 2007 was 10%.

Management assesses the exposure to market risk for these obligations as minimal.

ITEM 4. Controls and Procedures.

The management of Nestor, Inc., including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e) and 15d-15(e) as of September 30, 2007. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2007, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (i) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 1.

Legal Proceedings

With respect to both of the above cases, final resolution can be determined only after disposition of the Court’s certified question to the Ohio Supreme Court; namely:

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With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.

We do not currently have any pending material litigation other than that described above.

Item 1A. Risk Factors

This Quarterly Report on Form 10-Q and other communications made by us contain forward-looking statements, including statements about our growth and future operating results, development of products, sales and intellectual property. For this purpose, any statement that is not a statement of historical fact should be considered a forward-looking statement. We often use the words “believe,” “anticipate,” “plan,” “expect,” “intend,” “will” and similar expressions to help identify forward-looking statements. References to “we,” “us,” and “our” refer to Nestor, Inc. and its subsidiaries.

We cannot assure investors that our assumptions and expectations will prove to have been correct. Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Such factors that could cause or contribute to such differences include those factors discussed below. We undertake no intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Risks Related to Our Business

We have a history of losses and expect to incur losses in the future.

We have a history of net losses. For the nine months ended September 30, 2007 and 2006, our net loss was approximately $5,436,000 and 4,848,000, respectively. As of September 30, 2007 we had an accumulated deficit of $73,915,000. We expect to incur continuing losses for the foreseeable future due to significant marketing, product delivery, engineering and general and administrative expenses, and those losses could be substantial. We will need to generate significantly higher revenue, or reduce costs, to achieve profitability, which we may be unable to do. Even if we do achieve profitability, we may not be able to sustain or increase our profitability in the future.

We have substantial indebtedness.

As a result of the May 2006 offering of secured notes due May 2011, we have substantial indebtedness and we are highly leveraged. As of September 30, 2007, we have total indebtedness of approximately $27,190,000. Our substantial indebtedness may limit our strategic operating flexibility and our capacity to meet competitive pressures and withstand adverse economic conditions. In addition, our secured notes contain restrictive covenants which, among other things, limit our ability to borrow additional funds, sell equity, repay indebtedness, including the secured notes, before maturity or grant security interests on our assets. Under the terms of the secured notes, we will be unable to refinance our existing debt on more favorable terms.

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Our substantial indebtedness could have significant adverse consequences, including:

requiring us to dedicate a substantial portion of the net proceeds of the debt and any cash flow from operations to the payment of interest, and potentially principal, on our indebtedness, thereby reducing the availability of such proceeds and cash flow to fund working capital, capital expenditures or other general corporate purposes.

increasing our vulnerability to general adverse economic and industry conditions,

limiting our ability to obtain additional financing to fund future working capital, capital expenditures, research and development and other general corporate requirements;

limiting our flexibility in planning for, or reacting to, changes in our business and the industry; and

placing us at a disadvantage compared to our competitors with less debt and competitors that have better access to capital resources.

Furthermore, in order to repay our indebtedness at maturity, if not converted into common stock, including the secured notes, we will need to refinance all or a portion of that indebtedness. There can be no assurance that we will be able to effect any such refinancing on commercially reasonable terms or at all.

Our debt service costs exceed our current operating cash flow.

For the nine months ended September 30, 2007, and in prior fiscal years, our debt service costs exceeded current operating cash flow, and this may continue in future periods if we are unable to achieve our current projections. Our ability to make scheduled payments of interest or principal, if any, on our indebtedness, including the secured notes, or to fund planned capital expenditures, will depend on our future performance, which, to some extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. There can be no assurance that future revenue growth will be realized or that our business will generate sufficient cash flow from operations to enable us to service our indebtedness or to fund our other liquidity needs.

We have granted a lien on substantially all of our assets.

Our obligations under the secured notes are secured by substantially all of our assets and substantially all of the assets of our principal subsidiaries, except as to contracts we enter into after October 1, 2006 and all assets directly related thereto. Upon an event of default under the secured notes, these lenders could elect to declare all amounts outstanding, together with accrued and unpaid interest thereon, to be immediately due and payable. If we were unable to repay those amounts, such lenders will have a first claim on our assets and the assets of our subsidiaries. If these creditors should attempt to foreclose on their collateral, it is unlikely that there would be any assets remaining after repayment in full of such secured indebtedness and our financial condition and, thus, the value of our common stock, would be materially adversely affected.

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We will need additional financing, which may be difficult or impossible to obtain and may restrict our operations and dilute stockholder ownership interest.

At September 30, 2007, we had approximately $27,190,000 million of outstanding debt, at par value. On July 27, 2007, we raised $4,873,000 (net of expenses) through a private sale of our equity securities. Although we believe that the financing obtained in 2007 mentioned above and our liquidity at September 30, 2007 will enable us to continue with the development and delivery of our products and sustain operations through the next twelve months, we may need to raise additional funds in the future to fund our operations, deliver our products, expand or enhance our products and services, finance acquisitions and respond to competitive pressures or perceived opportunities. Because the nature of our operations requires us to bear all the up-front costs of deploying our technology, additional funds will be crucial to our continuing operations. We cannot provide any assurance that additional financing will be available on acceptable terms, or at all. If adequate funds are not available or not available on acceptable terms, our business and results of operations may suffer. We cannot provide any assurance that we can continue as a going concern if we are unable to raise additional financing as it becomes necessary.

Our outstanding debt contains restrictive covenants that limit our ability to raise additional funds through debt financings. As a result of these restrictions, any additional debt must be for the sole purpose of financing the design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment at customer sites pursuant to customer contracts entered into after October 1, 2006 and will not be available to fund general overhead expenses. If we raise additional funds through a debt financing, the terms and conditions of the debt financing may result in further restrictions on our operations or require that we grant a security interest in some or all of the assets related to the customer contracts toward which such financing would be applied. Any debt that we incur would increase our leverage and could exacerbate the negative consequences described above in “— We have substantial indebtedness.”

Additionally, we could be required to seek funds through arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, product candidates or products which we would otherwise pursue on our own.

Our outstanding debt consists of convertible notes, which contain anti-dilution provisions which would lower the conversion price if we were to issue equity for a price less than the conversion price. We also have outstanding warrants to purchase our common stock which contain anti-dilution provisions which would lower the exercise price and increase the number of shares issuable upon exercise if we were to issue equity for a price less than the exercise price. If we raise additional funds by issuing equity securities, which would require the consent of our secured Noteholders, further dilution to our then-existing stockholders will result and the terms of the financing may adversely affect the holdings or the rights of such stockholders.

We depend on a small group of customers for a substantial portion of our revenues, and the loss of, or a significant reduction in revenue resulting from a default by this key customer could significantly reduce our revenue.

A significant portion of our revenue is derived from a single customer. Our largest customer accounted for 24% of our revenues in the first nine months of 2007 and 2% of our revenues in 2006. Our four largest customers, defined as our key customers, account for 57% of our revenues in the first nine months of 2007 and 48% of our revenues in 2006. The loss of, or a significant reduction in revenue from any of our key customers, or a default by any key customer on its contractual obligations would significantly reduce our revenue and, if we are unable to replace such key customer, could materially and adversely affect our business and results of operations. We can offer no assurances that we will be able to replace a key customer should it become necessary.

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We no longer have exclusive rights to market Poliscan.

Vitronic has elected to terminate our exclusive right to purchase and market Poliscan in the United States because we failed to generate specific the necessary sales volume prior to June 30, 2007. Although we remain a non-exclusive distributor of Poliscan, we cannot make assurances that Vitronic will continue to allow us to distribute on their behalf or that Vitronic will continue to support our Poliscan units. Because the growth of our speed business, namely the increased deployment of Poliscan systems, is a key component of our growth strategy, the loss of our exclusive relationship with Vitronic, or Vitronic’s failure to support our Poliscan units could adversely affect our business and results of operations.

A substantial portion of our debt is subject to redemption at the holder’s option prior to maturity.

The holders of our secured notes have the right to require us to redeem all or any portion of those notes on May 25, 2009, unless our consolidated EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment”) for 2008 exceeds $14,000,000. The terms of our secured notes do not permit us to refinance those notes or to borrow to redeem the notes prior to maturity. Thus, our ability to redeem the secured notes if tendered will depend upon our operating performance as well as prevailing economic and market conditions and other factors beyond our control. Failure to redeem properly tendered notes would constitute an event of default, which, if not cured or waived, could have a material adverse effect on our financial condition, and thus, the value of our common stock.

Our financial condition and results of operations may be adversely affected if we are unable to secure and maintain future contracts with government entities.

Contracts with government entities account for essentially all of our revenue. The majority of these contracts may be terminated at any time on short notice with limited penalties. Accordingly, we might fail to derive any revenue from sales to government entities in any given future period. If government entities fail to renew or if they terminate any of these contracts, it would adversely affect our business and results of operations. Our existing contracts typically authorize the installation of our products at a specified number of approaches. As of December 31, 2006, our active contracts with state and local governments authorized the installation of CrossingGuard at up to an additional 245 approaches. In many cases, we cannot proceed with these installations until the sites and related installation plans have been approved by the contracting entities, which can be a lengthy process. In those cases, if government entities fail to approve sites, we will not be able to deliver products and services or generate revenue associated therewith. We cannot assure you that all approaches under contract will ultimately be installed.

We face substantial competition and may not be able to compete successfully.

Many other companies offer products that directly compete with CrossingGuard and our speed products. Many of our current and potential competitors have significantly greater financial, marketing, technical and other competitive resources than we do and may be able to bring new technologies to market before we are able to do so. Some of our competitors may have a competitive advantage because of their size, market share, legacy customer relationships, enhanced driver imaging, additional products offered and/or citation-processing experience. Current and potential competitors may establish cooperative relationships with one another or with third parties to compete more effectively against us. One of our competitors, Affiliated Computer Services, Inc. (ACS), offers state and local governments solutions to a wide variety of data processing issues, has the greatest number of red light camera systems installed, and may have a competitive advantage because of the scope of its relationship with, and the volume of transactions it conducts for, a particular government. It is also possible that new competitors may emerge and acquire market share. Additionally, if we are not successful in protecting our patents, we could lose a competitive advantage. We cannot assure you that we will be able to compete successfully with our competitors. Failure to compete successfully could have a material adverse effect on our business, financial condition and results of operations.

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The failure of governments to authorize or maintain automated traffic enforcement may hinder our growth and harm our business.

Currently, 24 states and the District of Columbia either authorize some use of automated red light enforcement or allow municipalities to elect to do so under “home rule” laws, whereby the authority to act in local affairs is transferred from the state to local counties and municipalities through a local home rule charter. It is uncertain at this time which additional states, if any, will allow the use of automated red light enforcement or if there will be other changes in the states that currently allow the practice. If additional states do not authorize the use of automated red light enforcement, our opportunities to generate additional revenue from the sale of CrossingGuard systems and related services will be limited.

Additionally, some states that had previously authorized some use of automated red light enforcement could fail to maintain such authorization. It is possible that other states or municipalities could prohibit the use of red light enforcement systems in the future, which could adversely affect our business, financial condition and results of operations.

The market for automated speed enforcement products in the United States is limited. Ten states and the District of Columbia either authorize some use of automated speed enforcement or allow municipalities to elect to do so under “home rule” laws. Some of these states authorize automated speed enforcement only in limited circumstances such as school or work zones. If additional states do not authorize automated speed enforcement, our opportunities to generate additional revenue from the sale of automated speed enforcement systems and related services will be limited.

We could be subject to differing and inconsistent laws and regulations with respect to our products. If that were to happen, we may find it necessary to eliminate, modify or cancel components of our services that could result in additional development costs and the possible loss of revenue. Future legislative changes or other changes in the laws of states authorizing automated red light or speed enforcement in the administration of traffic enforcement programs could have an adverse effect on our business, financial condition and results of operations.

In states in which municipalities or counties are allowed to use automated enforcement under home rule laws, those municipalities or counties must act in accordance with state law in exercising that authority. The failure to act in accordance with state law would subject its automated enforcement program to legal challenge, which, if successful, could invalidate the program. As a result, we could lose our contract with that municipality or county and be required to refund revenue from that program. Currently, our program in Davenport, Iowa is suspended following a district court ruling that Davenport’s ordinance authorizing automated traffic enforcement exceeds the city's home rule authority.

Our products might not achieve market acceptance, which could adversely affect our growth.

The market for our products is still emerging. The rate at which state and local government bodies have accepted automated enforcement programs has varied significantly by locale. We expect to continue to experience variations in the degree to which these programs are accepted. Our ability to grow will depend on the extent to which our potential customers accept our products. This acceptance may be limited by:

The failure of states to adopt or maintain legislation enabling the use of automated traffic enforcement systems;

The failure of prospective customers to conclude that our products are valuable and should be used;

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The reluctance of our prospective customers to replace their existing solutions with our products;

Marketing efforts of our competitors; and

The emergence of new technologies that could cause our products to be less competitive or obsolete.

Because automated traffic enforcement in the United States is still in an early stage of development, we cannot accurately predict how large the market will become, and we have limited insight into trends that may emerge and affect our business. For example, without knowing how commonplace automated enforcement will become, we may have difficulties in predicting the competitive environment that will develop.

Our speed products are not certified by the International Association of Chiefs of Police.

Potential customers may require or prefer IACP certification of automated speed enforcement equipment. Were a potential customer to require or prefer IACP certification, we would or could lose that potential customer, which would have a material adverse effect on our business, financial condition and results of operations.

Earnings for future periods may be affected by impairment charges.

Because of the nature of our business, long-lived assets, including intangibles, represent a substantial portion of our assets. The Company evaluates long-lived assets for impairment when events or changes in circumstances indicate, in management’s judgment, that the carrying value of such assets used in operations may not be recoverable. The determination of whether an impairment has occurred is based on management’s estimate of undiscounted future cash flows attributable to the assets as compared to the carrying value of the assets. If an impairment occurs, the amount of the impairment recognized will be determined by estimating the fair value for the assets and we will record a charge against earnings if the carrying value is greater than fair value.

Concerns about privacy rights and negative publicity regarding our industry could slow acceptance of our products.

Various advocacy groups and some politicians have expressed concerns that automated traffic enforcement products infringe individual privacy and due process rights. Such concerns can delay the acceptance of our products and result in legal challenges that impede implementation of our traffic enforcement systems. Our business is more vulnerable to these types of challenges because the automated traffic enforcement industry is emerging. Furthermore, in the event of adverse publicity, whether directed at us or our competitors’ products, due to processing errors or other system failures, the automated traffic enforcement industry could suffer as a whole, which would have a material adverse effect on our business, financial condition and results of operations.

Concentration of our processing operations in one location exposes us to potential business interruption in the event of a natural disaster.

We maintain substantially all of our operations, including a majority of our red light and speed enforcement equipment, at our Providence, Rhode Island headquarters. A disruption of our operations for any reason, including theft, government intervention or a natural disaster such as fire, earthquake, flood or other casualty could cause us to limit or cease our operations, which would have a material adverse effect on our business, financial condition and results of operation. Although we maintain business interruption insurance to cover natural disasters, no assurance can be given that such insurance will continue to be available to us on commercially reasonable terms, if at all, or that such insurance would be sufficient to compensate us for damages resulting from such casualty. In addition, no assurance can be given that an interruption in our operations would not result in permanent loss of significant customers, which would have a material adverse effect on our business, financial condition and results of operation.

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Our financial results will depend significantly on our ability to continually develop our products and technologies.

Our financial performance will depend to a significant extent on our ability to successfully develop and enhance our products. We must successfully identify product and service opportunities, and develop and bring our products and technologies to market in a timely manner. The success of our product introductions will depend on several factors, including:

Proper product definition;

Timely completion and introduction of enhanced product designs;

The ability of subcontractors and component manufacturers to effectively design and implement the manufacture of new or enhanced products and technologies;

The quality of our products and technologies;

Product and technology performance as compared to competitors' products and technologies;

Market acceptance of our products; and

Competitive pricing of products, services and technologies.

We have in the past experienced delays in completing the development or the introduction of new products. Our failure to successfully develop and introduce new or enhanced products and technologies or to achieve market acceptance for such products and technologies may materially harm our business and results of operations.

Fluctuations in our results of operations make it difficult to predict our future performance and may result in volatility in the market price of our common stock.

Costs related to customization of our products and services;

Announcements or introductions of new products and services by our competitors;

The failure of additional states to adopt or maintain legislation enabling the use of automated traffic enforcement systems;

Determinations by state and local government bodies to utilize our equipment without the additional processing services we provide;

Software defects and other product quality problems;

A shift towards fixed rate, as opposed to per ticket, compensation arrangements for our speed products, which could adversely affect revenues;

Adjustments in the estimates used to report revenue under contracts that require payment only after our customer has collected the fine;

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The discretionary nature of our customers’ internal evaluation, approval and order processes;

The varying size, timing and contractual terms of orders for our products and services;

The mix of revenue from our products and services;

The change in market value of our embedded debt and warrant derivatives; and

The change in our stock compensation charges relative to our equity incentive programs.

Our sales cycles vary significantly, making it difficult to plan our expenses and forecast our results.

Our sales cycles typically range from several months to over a year. Accordingly, it is difficult to predict the quarter in which a particular sale will occur and to plan our expenses accordingly. The period between our initial contact with potential customers and the installation of our products, the use of our services and our generation of revenue, if any, varies due to several factors, including:

The complex nature of our products and services;

Political or legal challenges to legislation authorizing the use of automated traffic enforcement systems;

The novelty of automated traffic enforcement in many jurisdictions and a lack of familiarity with automated traffic enforcement systems on the part of legislative, executive and judicial bodies and the public;

The selection, award and contracting processes at municipalities and other government entities, including protests by other bidders with respect to competitive awards;

Our customers’ internal evaluation, approval and order processes;

The site evaluation and analysis process; and

Our customers' delays in issuing requests for proposals or in awarding contracts because of announcements or planned introductions of new products or services by our competitors.

Any delay or failure to complete installations in a particular quarter could reduce our revenue in that quarter, as well as subsequent quarters over which revenue would likely be recognized. If our installation cycles unexpectedly lengthen in general or for one or more large customers, it would delay our generation of the related revenue. If we were to experience a delay of several weeks or longer on a large customer, it could harm our ability to meet our forecasts for a given quarter.

Our intellectual property might not be protectible, and if we fail to protect and preserve our intellectual property, we may lose an important competitive advantage.

We rely on a combination of copyright, trademark, patent and trade-secret laws, employee and third-party nondisclosure agreements and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. In addition, some of our competitors have been able to offer products with some similar features that do not infringe our patents. For example, during the past 18 months we initiated two patent infringement suits against competitors, Redflex Traffic Systems, Inc. and Transol USA, Inc., both of which have been dismissed without a finding of infringement. The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because some patent applications in the United States are not publicly disclosed until the patent is issued or 18 months after the filing date, applications may exist that would relate to our products and are not publicly accessible. Moreover, a patent search has not been performed in an attempt to identify patents applicable to our business and, even if such a search were conducted, all patents applicable to the business might not be located. If we are unable to protect our proprietary rights, we may lose an important competitive advantage, and our business, financial condition and results of operations could suffer.

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We are at risk of claims that our products or services infringe the proprietary rights of others.

Given our ongoing efforts to develop and market new technologies and products, we may from time to time be served with claims from third parties asserting that our products or technologies infringe their intellectual property rights. If, as a result of any claims, we were precluded from using technologies or intellectual property rights, licenses to the disputed third-party technology or intellectual property rights might not be available on reasonable commercial terms, or at all, which could restrict our ability to sell our products and services. We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation, either as plaintiff or defendant, could result in significant expense and divert the efforts of our technical and management personnel from productive tasks, whether or not litigation is resolved in our favor. An adverse ruling in any litigation might require us to pay substantial damages, to discontinue our use and sale of infringing products and to expend significant resources in order to develop non-infringing technology or obtain licenses for our infringing technology. A court might also invalidate our patents, trademarks or other proprietary rights. A successful claim against us, coupled with our failure to develop or license a substitute technology, could cause our business, financial condition and results of operations to be materially adversely affected. As the number of software products increase and the functionality of these products further overlaps, we believe that our risk of infringement claims will increase.

If we are unable to safeguard the integrity, security and privacy of our data or our customers' data, our revenue may decline, our business could be disrupted and we may be sued.

We need to preserve and protect our data and our customers' data against loss, corruption and misappropriation caused by system failures and unauthorized access. We could be subject to liability claims by individuals, whose data resides in our databases, for misuse of personal information. These claims could result in costly litigation. A party who is able to circumvent our security measures could misappropriate or destroy proprietary information or cause interruptions in our operations. We may be required to make significant expenditures to protect against systems failures, security breaches or to alleviate problems caused by any failures or breaches. Any failure that causes the loss or corruption of, or unauthorized access to, this data could reduce customer satisfaction, expose us to liability and, if significant, could cause our revenue to decline and our expenses to increase.

We may be subject to product liability claims that could result in costly and time-consuming litigation.

Although our customer contracts typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Any product liability claim brought against us, even if unsuccessful, would likely be time-consuming and costly, and potential liabilities could exceed our available insurance coverage, which could have an adverse effect on our financial condition and results of operations.

The failure of our suppliers to deliver components, equipment and materials in sufficient quantities and in a timely manner could adversely affect our business.

Our business employs a wide variety of components, equipment and materials from a limited number of suppliers. To date, we have found that the components, equipment and materials necessary for the development, testing, production and delivery of our products and services have sometimes not been available in the quantities or at the times we have required. Our failure to procure components, equipment and materials in particular quantities or at a particular time may result in delays in meeting our customers’ needs, which could have a negative effect on customer satisfaction and on our business, financial condition and results of operations.

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If we lose our key personnel or are unable to attract and retain additional personnel, our operations could be disrupted and our business could be harmed.

We believe that the hiring and retaining of qualified individuals at all levels in our organization will be essential to our ability to sustain and manage growth successfully. Competition for highly qualified technical personnel is intense and we may not be successful in attracting and retaining the necessary personnel, which may limit the rate at which we can develop products and generate sales. We will be particularly dependent on the efforts and abilities of our senior management personnel. The departure of any of our senior management members or other key personnel could harm our business.

We may make acquisitions, which could divert management’s attention, cause ownership dilution to our stockholders and be difficult to integrate.

We may seek to expand our operations through the acquisition of complementary businesses. Our future growth may depend, in part, upon the continued success of our acquisitions. Acquisitions involve many risks, which could have a material adverse effect on our business, financial condition and results of operations, including:

Acquired businesses may not achieve anticipated revenues, earnings or cash flow;

Integration of acquired businesses and technologies may not be successful and we may not realize anticipated economic, operational and other benefits in a timely manner, particularly if we acquire a business in a market in which we have limited or no current expertise or with a corporate culture different from ours;

Potential dilutive effect on our stockholders from the issuance of common stock as consideration for acquisitions;

Adverse effect on net income from impairment charges related to goodwill and other intangible assets, and other acquisition-related charges, costs and expenses effects on net income;

Competing with other companies, many of which have greater financial and other resources, to acquire attractive companies, making it more difficult to acquire suitable companies on acceptable terms or at all; and

Disruption of our existing business, distraction of management, diversion of other resources and difficulty in maintaining our current business standards, controls and procedures.

Risks Related to Our Common Stock

Our common stock price is volatile and may decline in the future.

The market price of our common stock has fluctuated significantly and may be affected by our operating results, changes in our business, changes in the industry in which we conduct business, and general market and economic conditions that are beyond our control. In addition, the stock market in general has recently experienced extreme price and volume fluctuations. These fluctuations have affected stock prices of many companies without regard to their specific operating performance. These market fluctuations may make it difficult for stockholders to sell their shares at a price equal to or above the price at which the shares were purchased. In addition, if our results of operations are below the expectations of market analysts and investors, the market price of our common stock could be adversely affected.

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Our board of directors can, without stockholder approval, cause preferred stock to be issued on terms that could adversely affect common stockholders.

Under our certificate of incorporation, our board of directors is authorized to issue up to 10,000,000 shares of preferred stock, of which 180,000 shares are issued and outstanding, and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. If the board causes any additional preferred stock to be issued, the rights of the holders of our common stock could be adversely affected. The board's ability to determine the terms of preferred stock and to cause its issuance, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no current plans to issue additional shares of preferred stock.

Provisions of our secured notes and secured note warrants could delay or prevent a change of control

There are provisions in our secured notes and secured note warrants that may discourage, delay or prevent a merger or acquisition because, upon a change of control (as defined in the notes), the holders of the secured notes have the right to redeem some or all of their secured notes and the holders of the secured note warrants will have the right to effectively accelerate the maturity date and demand payment.

We have not paid, and do not intend to pay, dividends and therefore, unless our common stock appreciates in value, our investors may not benefit from holding our common stock.

We have not paid any cash dividends since inception. We intend on retaining any future earnings to support the development and expansion of our business, and, therefore, we do not anticipate paying any cash dividends in the foreseeable future. As a result, our investors will not be able to benefit from owning our common stock unless the market price of our common stock becomes greater than the basis that these investors have in their shares.

We have a significant number of options, warrants and convertible securities outstanding, which if exercised or converted, will have a dilutive effect upon our stockholders. The anti-dilution provisions of some of these securities could magnify that dilutive effect..

As of September 30, 2007, we have issued and outstanding warrants and options to purchase up to approximately 6,260,139 shares of our common stock, preferred stock convertible into 18,000 shares of our common stock and debt convertible into approximately 7,136,111 shares of our common stock.

Furthermore, the documents governing our convertible debt have anti-dilution provisions, pursuant to which the conversion price is reduced if we sell common stock at a price below the conversion price, which is now $3.60 per share. The secured notes provide “full ratchet” anti-dilution protection until May 25, 2009 and “weighted average” anti-dilution protection thereafter. The holders of our 5% notes also have “full ratchet” anti-dilution protection until maturity of the notes. In addition, some of our warrants contain weighted average anti-dilution provisions that would lower the exercise price and increase the number of shares issuable upon exercise if we sell stock at a price below $4.35.

Unlike ordinary anti-dilution provisions, “full ratchet” anti-dilution provisions have the effect of extending a “lowest price guarantee” to the holders of the secured notes and the 5% notes.

If the holders of these securities convert the notes or exercise the options and warrants, we will issue shares of our common stock and such issuances will be dilutive to our stockholders. Because the conversion price of the notes and the exercise price of the warrants may be adjusted from time to time in accordance with the anti-dilution provisions of the notes and the warrants, the number of shares that could actually be issued may be greater than the amount described above. In addition, if such investors or our other stockholders sell substantial amounts of our common stock in the public market during a short period of time, our stock price may decline significantly.

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The price of our common stock may decline because a substantial amount of our common stock is available for trading in the public market.

Availability of shares of our common stock could depress the price of our common stock. A substantial amount of common stock is available for trading in the public market. This amount of stock in the market may cause the price of our common stock to decline. In addition, if our stockholders sell substantial amounts of our common stock in the public markets, the market price of our common stock could fall. These sales might also make it more difficult for us to sell equity or equity-related securities at a time and price that we would deem appropriate. We also have issued options, warrants and convertible securities that can be exercised for, or converted to, shares of common stock, many of which would be freely tradable without restrictions or further registration under the Securities Act.

There were approximately 28,954,219 shares of our common stock outstanding as of September 30, 2007, of which approximately 9,329,390 shares were freely tradable without restrictions or further registration under the Securities Act. Silver Star, a significant stockholder, has the right to require us to register under the Securities Act their resale of all 9,836,430 shares of common stock that it owns, as soon as practicable after Silver Star requests that registration, of which 220,589 were registered on our registration statement (File No. 333-133468) that was declared effective on July 14, 2006.

The Nasdaq Capital Market may cease to list our common stock which may cause the value of an investment in our Company to substantially decrease and may result in a default under our senior secured notes.

We have been out of compliance with the Nasdaq Capital Market continued listing minimum bid price requirement and remain so to this date. We presently remain listed on the Nasdaq Capital Market pursuant to a grace period which expires on April 21, 2008. We are susceptible to volatility of our stock and could remain out of compliance if appropriate steps are not taken to cure our non-compliance. We can give no assurances that the steps we propose will be approved by our stockholders or that they will be effective in curing our non-compliance. In addition, we may not meet other Nasdaq Capital Market continued listing requirements which could result in our common stock being delisted from the Nasdaq Capital Market. If our common stock is not listed on the Nasdaq Capital Market or other national stock market or exchange, we would be in default of our senior secured notes and could be subject to the remedies available to the holders of such notes, including acceleration of the indebtedness hereunder. In addition, delisting from the Nasdaq Capital Market would adversely affect the trading price and limit the liquidity of our common stock and therefore cause the value of an investment in our Company to decrease.

Our business and results of operations could be materially and adversely affected if the Ohio Supreme Court makes an adverse ruling in pending cases in Ohio

We are parties to two pending lawsuits, Mendenhall v. The City of Akron, et al., and Sipe, et al. v. Nestor Traffic Systems, Inc., et al., which lawsuits; have been consolidated in the United States District Court, Northern District of Ohio, Eastern Division. There presently is pending a certified question before the Ohio Supreme Court, an adverse ruling on which would render us unable to continue to operate in Ohio without substantial modifications to our programs there. We can offer no assurances that our programs in Ohio can be sufficiently modified such that they would conform to an adverse ruling in these lawsuits or that the affected municipalities would agree to such modifications. The loss of business in Ohio would have a material adverse effect on our business and results of operations.

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Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

None other than as disclosed in the Form 8-K filed with the SEC on July 27, 2007.

Item 3:

Defaults Upon Senior Securities

None

Item 4:

Submission of Matters to a Vote of Security Holders

None

Item 5:

Other Information

None

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Item 6:

Exhibits

Exhibit Number Description

31.1

Certification of principal executive officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended

31.2

Certification of principal financial officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended

Statement Pursuant to 18 U.S.C. §1350

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FORM 10-Q

NESTOR, INC.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: October 31, 2007	NESTOR, INC.
	(REGISTRANT)




	/s/ Nigel P. Hebborn
	Nigel P. Hebborn
	Treasurer and Chief Financial Officer

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