10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the period ended	December 31, 2005

	OR
¨	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 of incorporation)	(I.R.S. Employer Identification No.)

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

(401) 274-5658

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

NONE

Securities registered pursuant to Section 12(g) of the Act:

 Common Stock, $.01 Par Value (Title of Class)

Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes:  No:  X

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.	Yes:	No:	X
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 than 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. _______________________________
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. (Check one):

         Large Accelerated filer:  ¨Accelerated filer:  ¨Non-accelerated filer:      x

Indicated by check mark whether the registratnt is a shell company:	Yes:	No:	X
The aggregate market value of the 7,471,357 shares of voting stock held by non-affiliates of the registrant on June 30, 2005, based on the closing price of such stock on June 30, 2005, was $44,828,142.
The number of shares outstanding of the Registrant’s Common Stock at March 24, 2006 was 20,364,876.
DOCUMENTS INCORPORATED BY REFERENCE
Sections of Nestor, Inc.’s definitive Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference into Parts II and III of this report.

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PART I

Restatement of Consolidated Financial Statements

In this Annual Report on Form 10-K we are restating our consolidated balance sheet as of December 31, 2004, and our consolidated statements of operations, stockholders’ equity, cash flows and related disclosures for the years ended December 31, 2004 and 2003 (the “Restatement”). We are also restating the condensed consolidated financial statements for: a) for the first three quarters of fiscal year ended December 31, 2005; and b) the four quarters of the fiscal year ended December 31, 2004. Our Annual Reports on Form 10-K and the Quarterly Reports on Form 10-Q for fiscal 2003 through the third quarter of fiscal 2005 have not been revised to reflect the Restatement, and the financial statements contained in those reports should not be relied upon. Instead, the financial statements for fiscal 2004 and 2003 included in this Annual Report on Form 10-K should be relied upon.

As previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 5, 2005, the Company has been in extensive discussions with the Staff of the Securities and Exchange Commission concerning the proper accounting treatment of certain of its convertible debt, product sales, and unbilled revenue in current and previously reported financial results. The Company has settled its accounting treatment of product sales and unbilled revenue without any financial restatement necessary. However, as a result of these discussions, the Company’s financial statements are restated to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities. We have also modified our footnote disclosure related to the debt.

Refer to Note 3 in our consolidated financial statements for additional information.

ITEM 1. Business

General

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. CrossingGuard, our red light enforcement product, 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, our speed enforcement product, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain sales minimums. By coupling CrossingGuard and Poliscan equipment with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.

CrossingGuard is an automated, video-based monitoring system that predicts and records the occurrence of a red light violation. The system includes our patented collision avoidance technology that anticipates expected violations and can be used to extend the red light phase for cross traffic, preventing collisions between violators and vehicles in the cross traffic. CrossingGuard simultaneously records multiple views of the violation sequence, including close-ups of the vehicle and the license plate, and transmits video evidence electronically to the police department, which reviews the violation and approves the issuance of a citation. Our technology captures over 200 images of each red light violation, which combined with our patented synchronized playback capability, enables us to provide a superior evidence package, resulting in a court dismissal rate of less than 1%.

Poliscan is an automated system for digital speed detection and recording. Poliscan simultaneously captures multiple vehicles in multiple lanes and in bi-directional traffic, a distinct advantage over traditional radar or LiDAR systems limited to one lane, one direction or one car at a time. The laser-based system scans a 45-degree arc 100 times per second, recording the speed, vehicle classification, and distance between vehicles, to create a three-dimensional image of all vehicles in the coverage area. The system uses a high-resolution digital camera for documentation of the speeding violation, including pictures of the license plate, an overview picture specifically identifying the speeding vehicle, and a photo of the driver where required.

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We provide back office processing services for CrossingGuard and Poliscan roadside systems using our proprietary software solution called Citation Composer. These processing services include obtaining data from the roadside systems, reviewing the data, preparing the citations and evidence packages and tracking final resolution of the citations.

We generate recurring revenue through contracts with government entities that provide for equipment lease and services on a fixed monthly and/or per citation fee basis. As of February 28, 2006, we are generating revenue from 171 CrossingGuard-equipped approaches in 29 municipalities in seven states and one Canadian province, and four mobile speed units in one municipality. As of that date, our active contracts with state and local governments (including the City of Los Angeles) authorize the installation of CrossingGuard at up to an additional 172 approaches.

Our Market

Status of the CrossingGuard Market

The market for automated red light enforcement is experiencing significant growth. We estimate that there are over 1 million approaches to signalized intersections in the United States. Technology solutions manage enforcement at less than 0.5% of these approaches. According to the Insurance Institute for Highway Safety, in 2003 red light running caused more than 200,000 crashes, nearly 176,000 injuries, and 934 deaths. Eighty percent of respondents to a 2004 Harris Poll reported that the problem of drivers running red lights should receive “more attention”, including 57% who want it to receive “much more attention”, an increase of 46% since 2001. First-generation red-light camera systems gained early acceptance as a means of automated traffic enforcement. These systems generally rely on in-ground vehicle sensing loops and still photography, and are not preferred because of their intrusive roadbed installation issues, high maintenance requirements and general lack of functionality and accuracy.

The use of automated traffic systems to enforce red light running violations requires specific authority at the state or local government level, either through state enabling or home rule statutes. Twenty-three states and the District of Columbia currently allow the use of automated traffic light systems, such as CrossingGuard; and over the last year, an additional fifteen state legislatures considered bills to enable or expand automated traffic enforcement.

Jurisdictions allowing red light enforcement include:

Alaska Arizona California Colorado Delaware Georgia Illinois Iowa Maryland Minnesota Missouri New Mexico New York North Carolina Ohio Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Washington Washington, D.C.

Recent studies have shown that automated red light enforcement systems are effective in reducing red light running at enforced intersections and at surrounding unenforced intersections. The Federal Highway Administration and other organizations have recently acknowledged that these systems are helpful in the reduction of red light running and correspondingly the number of accidents. Surveys conducted throughout many U.S. cities have found that more than 75% of drivers support red light enforcement systems. However, there remains opposition to these systems, largely based upon concerns regarding individual privacy and due process rights. For example, during 2005, West Virginia passed legislation that bans automated traffic enforcement systems. Many states and communities have or are considering authorization of automated traffic enforcement but need to address these concerns first.

Status of the Poliscan Market

The automated speed enforcement market is potentially more significant than the automated red light enforcement market. While already well established in Europe, Asia and Australia, the automated speed enforcement market in the U.S. is positioned to grow significantly as a result of the enormous costs associated with speeding-related crashes. There were approximately 6.2 million reported crashes occurring in 2004 and the estimated economic cost of these crashes was in the tens of billions of dollars. Speeding was a factor in nearly one-third of all fatal crashes, resulting in over 13,000 deaths. In 2003, 86% of speeding-related fatalities occurred on roads other than interstate highways. Speeding was also involved in 36% of the fatal crashes that occurred in construction/maintenance zones. In 2004, the State of Illinois passed a bill allowing automated enforcement of the speed limit laws for construction zones to better protect construction zone workers.

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Seventy-nine percent of respondents to a 2004 Harris poll regarding attitudes of the American people on highway and auto safety indicated that the issue of speeding on local streets needs “more attention” by public safety officials, including 59% who say it needs “much more attention.”

The use of automated traffic systems to enforce speed limits requires specific authority at the state or local government level, either through state enabling or home rule statutes. Currently, ten states, the District of Columbia and six Canadian provinces permit automated speed enforcement. They are:

UNITED STATES		CANADA
Arizona	Oregon	Alberta	Ontario
Colorado	Tennessee	British Columbia	Quebec
Illinois	Utah	Manitoba	Saskatchewan
Iowa	Washington
New Mexico	Washington, D.C.
Ohio

Our Response to the Market

Our automated traffic solutions respond to the traffic enforcement market by creating a strong overall value proposition for our customers. We offer a complete turnkey solution for a city’s automated traffic enforcement programs. We generally retain ownership of the equipment and bear all of the up-front costs for purchase, installation and maintenance of our systems. We provide the software, data warehousing, processing, printing, mailing, collection, maintenance, and community awareness support for a program. Customers generally provide program management and oversight, approve all citations for issuance, prosecute citations, establish operating and enforcement criteria, and select enforcement locations and times. Our systems increase safety by reducing the number of crashes while enhancing police officer safety and efficiencies. Our systems also reduce the demand for emergency resources without significantly increasing our customer’s administrative costs.

Company History

We were founded in 1975, incorporated in 1981, and completed our initial public offering in 1983. 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 our intelligent traffic-management systems. In January 1997, we organized Nestor Traffic as a wholly-owned subsidiary. In 1999 and 2000, Nestor Traffic raised additional capital through two private placements of its common stock, reducing our ownership to approximately 35%. In 2000, we made the strategic decision to concentrate on our traffic management technologies and we began to dispose of our other product lines. In connection with this restructuring effort, on September 12, 2001, we reacquired 100% ownership of Nestor Traffic through a merger transaction with another subsidiary in which we issued common stock for the Nestor Traffic shares held by outside investors. By 2003, we had exited our financial services, fraud detection and Rail CrossingGuard and TrafficVision business lines, and had refocused our resources on our traffic enforcement systems such as CrossingGuard, our current primary source of revenue.

Our transition to traffic management solutions involved a series of licensing arrangements and transfers of technology rights, including a June 11, 1996 licensing agreement and an asset purchase agreement to transfer the development, production and marketing rights of our character recognition products to National Computer Systems. In early 2001, we also entered into two separate source-code licensing agreements for our fraud detection product line. The first of these was a February 1, 2001 non-exclusive license agreement with Applied Communication, Inc., (ACI), whereby we granted ACI the right to integrate and distribute all of our fraud detection products throughout its worldwide sales and support network. ACI paid us $1,100,000 in the first six months of 2001, and was required to make guaranteed minimum royalty payments during the first year in an amount of approximately $500,000. The license requires the payment of a 15% royalty starting on February 1, 2002, but no further guaranteed minimum royalty payments are required. This agreement replaced an earlier license to ACI. We sold the royalty rights to Churchill Lane Associates (CLA) from this license on July 1, 2002. We do not expect to receive future revenue from this license.

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Additionally, on May 18, 2001, we entered into a license agreement with Retail Decisions, Inc. (ReD). We granted ReD a perpetual, fully-paid, worldwide license in the field of fraud and money laundering detection and risk management in certain defined industries; and a non-exclusive, perpetual, fully-paid, worldwide license solely for use in the field of use of customer relationship management in certain defined industries. Additionally, we transferred to ReD assets that supported the technology licensed under the license agreement to ReD. ReD paid us $1,800,000 under the license agreement, and for certain marketing and transition services, we paid ReD $968,000 in 2001. 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 property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.

On January 15, 2003, Silver Star Partners I, LLC (Silver Star) purchased 49 million shares of our pre-reverse stock split common stock (4,900,000 shares on a post-split basis) for $2,376,500. Following the initial Silver Star investment, on April 11, 2003, we effected a one-for-ten reverse stock split of our common stock. On April 16, 2003, Silver Star purchased an additional 4,013,557 post-reverse stock split shares for $1,946,575. William B. Danzell, our President and Chief Executive Officer is the Managing Director of Silver Star. Upon completion of the second sale, Silver Star owned 64% of our outstanding shares of common stock.

On August 31, 2005, we acquired certain assets of Transol USA, one of our competitors, in a foreclosure sale. The assets included contracts to provide automated red light enforcement services in six U.S. cities at an aggregate of 39 red light approaches, of which approximately 35 are fully installed and operating, as well as related equipment, intellectual property, inventory, work in process, accounts receivable and unbilled contract revenue related to Transol's red light enforcement services. We paid $1,760,000 for the acquired assets.

Products and Services

Our products combine sophisticated digital and analog camera technologies with advanced image processing methods to detect and record traffic-related violations. We complement these roadside products with a full suite of back-office processing support services, providing our customers with a complete turnkey solution. Our roadside systems are a combination of Nestor- and/or Vitronic-developed modular hardware components and software that provide monitoring for traffic-data collection, vehicle detection and tracking and enforcement. These roadside systems include: CrossingGuard for red light enforcement, Poliscan^speed for mobile speed enforcement, and “speed on green” for fixed, intersection speed enforcement. We provide back-office processing and support services across our roadside systems using a proprietary software solution called Citation Composer. These processing and support services include obtaining data from the roadside systems, reviewing the data, preparing the citations and evidence packages and tracking final resolution of the citations. We believe that our strong suite of patents covering our image processing technology provides us with a strategic advantage and enables us to offer a comprehensive traffic enforcement solution.

CrossingGuard Red Light Enforcement

CrossingGuard. Our CrossingGuard system is an automated, video-based monitoring system that predicts and records the occurrence of a red light violation. The system applies high speed image processing and target-tracking technology to real-time video scenes. The products use digital video and still cameras, computers and software to detect red light violators at signalized intersections. Using the captured video frames, our systems apply algorithms to recognize objects as vehicles and predict their motion relative to the stop line. This advanced proprietary technology, which effectively sees and interprets objects captured in video images, is at the core of the CrossingGuard solution.

The CrossingGuard system includes patented collision avoidance technology that anticipates violations and generates a signal that can extend the red light phase for cross traffic. This helps prevent collisions between red light violators and vehicles on the cross streets. Through a system of multiple video cameras set up to monitor and capture violators on a per approach basis, the system simultaneously records the violation sequence, including a view of the vehicle from the front approaching the intersection, a view of the vehicle from the rear entering the intersection, and a close-up of the vehicle and license plate, and transmits video evidence electronically to the police department, which reviews the violation and issues a citation. Our advanced video technology, which combined with our patented synchronized replay capability, enables us to provide a superior evidence package, resulting in a court dismissal rate of less than 1%.

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The CrossingGuard system consists of a video camera installed on top of a traffic signal pole or a roadside pole installed by us that is used to track and record the actions of an approaching vehicle. Another camera is positioned to view the signal lights as they change from green to yellow to red and record the vehicle’s actions as the lights change and it enters the intersection, capturing over 200 images of each violation. The views from these two cameras can also be presented in a side-by-side synchronized mode to demonstrate the complete view of the violation, including extenuating circumstances, aggressive behavior or other factors. Finally, an enforcement camera is positioned to obtain a close-up image of the vehicle license plate and, where needed, the driver image, based upon vehicle location instructions provided by the tracking camera. A personal computer, which we install in an enclosure by the roadside link through a fiber optic connection, runs the intelligent software and controls camera activity. High-speed communications transmit video and data from the intersection to a designated facility for processing. CrossingGuard is built upon standard PC hardware and software components. This design provides the reliability and performance benefits of improving PC hardware and the ability to upgrade and add functionality as needed. We purchase all electronic and mechanical components from third-party vendors, built in accordance with our specifications, and primarily use local contractors to install the systems.

The primary attributes of CrossingGuard are:

Accurate, real-time interpretation of traffic video images. We apply our high-speed pattern-recognition technologies in real-time processing and video-image interpretation for traffic management, enforcement and safety. Previous industry attempts to provide video-based detection of traffic did not prove effective due to the difficulty of designing robust detection algorithms under a variety of illumination, visibility and traffic conditions, as well as the need to implement such algorithms on cost-effective computing platforms that provide real-time operation. Our image recognition technology is able to interpret video images accurately and respond in a real-time environment at affordable cost. Our Citation Composer software can process red light violations with a patented display of the approaching and receding videos presented side-by side, and can re-play the violation sequence in slow motion or frame-by frame, producing a comprehensive evidence package less subject to challenge than any of our competitors’ systems.

Vehicle trajectory analysis for real-time forecasting. As each frame in a video sequence is interpreted, the individual objects in the scene are identified and located. This information, passed from frame to frame, enables the accurate tracing of vehicles' trajectories. Unlike competitive vision systems, which note changing images in a fixed and static area of the image (so-called virtual loops), our proprietary vehicle-centric technology can use the trajectories to predict vehicle positions. Our CrossingGuard system includes a collision avoidance feature that anticipates violations and generates a signal that can extend the red light phase for cross traffic, which helps prevent collisions between violators and vehicles in the cross traffic accelerating on a green signal. Thus, intersections equipped with CrossingGuard have the potential to become smarter and safer.

Compatibility with industry standard platforms. Our traffic monitoring solutions are built upon dominant industry-standard platforms including Microsoft Windows operating systems, tools and communication components and general "WinTel" hardware specifications. This facilitates integration into a customer's existing computing environment, leverages PC economics to offer a compelling price/performance advantage and lowers product engineering development costs. Additionally, the traffic monitoring systems are designed to support the emerging communications standards being mandated in the traffic industry by the National Transportation Communications for Intelligent Transportation Systems Protocol.

CrossingGuard VIP. We also provide the CrossingGuard Video Intersection Profiling program, which is a tool that we have developed to help municipalities pre-qualify intersections. Because intersection violation rates can range from an average of a few per day to over 50 per hour, the system helps the municipality develop an estimate of safety issues at a given intersection and the long-term ticket volume by counting and profiling violations for all directions at a particular intersection.

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Revenue Generation. The economics of the CrossingGuard product are tied to the number of operating systems in the field and, to an increasingly lesser extent, the number of violations processed by the CrossingGuard systems. Many of our early contracts compensate us on a per ticket paid or issued basis in return for equipment lease, maintenance, citation processing and customer support services. However, throughout 2003 and 2004, there was a trend by states and municipalities towards a fixed monthly fee as opposed to variable per ticket fee pricing structures. Since fixed fees are based upon the expected level of violations over the contract term, the shift to monthly fixed fee contracts should result in a more stable revenue stream for these installations.

As of December 31, 2005, we had installed CrossingGuard at 202 approaches and Poliscan^speed in 4 units for 35 customers throughout the United States and Canada, and our contracts authorize up to an additional 172 CrossingGuard approaches for installations and 5 speed units for deployment. Of these installed approaches, 171 approaches are installed and generating revenues. Management believes the majority of the authorized approaches and units under these outstanding and pending contracts will be installed, but no assurances can be given that all approaches under contract will ultimately be installed or that pending contracts will be finalized. Depending upon contract terms and services provided, we realize (a) from $11 to $99 per citation issued or paid or (b) a fixed monthly fee ranging from $2,000 to $12,000 per approach for system delivery and lease and processing services.

State statutes providing for automated red light enforcement may impose liability on 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 driver. As only the license plate is required for identification under a registered owner statute, program operating efficiencies are much higher resulting in lower per citation or monthly fees for systems installed in these jurisdictions. Current trends in the industry are towards compensating red-light program vendors on a fixed-fee basis instead of a variable-fee basis tied to ticket volumes. Actual results from deployment of CrossingGuard systems are expected to fluctuate substantially depending upon intersection selection and configuration, driver response to installed systems and many other factors.

Poliscan^speed Products

Poliscan Speed. Poliscan^speed, an innovative solution for digital speed detection and recording, is the only multi-lane, bi-directional, scanning LiDAR mobile speed enforcement system in the industry. Unlike traditional photo speed enforcement systems, which use radar or conventional LiDAR, Poliscan^speed utilizes scanning LiDAR technology to simultaneously record and measure several vehicles in parallel lanes, with 100 laser beams per second sweeping a 45 degree arc, creating a real-time 3-dimensional image of the scene. The system records the speed, classification (motorcycle, car or truck) and the distance between every vehicle entering the coverage area. Poliscan uses a high-resolution digital camera for documentation of the speeding offense, including pictures of the license plate, an overview picture which specifically targets the speeding vehicle, as well as the image of the driver where required. Detecting all vehicles in all lanes simultaneously avoids the ambiguity and measuring errors that are more common among our competitors' systems, allowing many more speed offenses to be effectively recorded and prosecuted.

The measuring sensor developed for Poliscan^speed is based on a scanning LiDAR that is mounted in a stationary position and transmits short pulses of light out to a target. The transmitted light is reflected back to the receiver of the LiDAR instrument where it is analyzed. While the LiDAR sensor carries out the measurements with a high repetition rate, a rotating polygonal mirror deflects the transmitted signals, so that the LiDAR sensor covers the full region of interest (a sector of 45 degrees), allowing simultaneous monitoring of multiple lanes. Accordingly, the Poliscan^speed system offers the following competitive advantages:

· High resolution all digital camera solution

· All weather, day and night operations with no visible illumination

· 100 scans per second in the 45 degree scan sector

· Multi-lane, multi-vehicle, bi-directional speed enforcement

· Not restricted to straight roads (only needs 20 meters to operate)

· 3D image processing (Scans entire road, all lanes)

· Fully automated, unattended operations

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Deployment and Set Up. With outside dimensions of less than 12 inches per side and weighing less than 45 pounds, the PoliScan^speed unit is designed for ease of use and maximum portability. Additionally, its small size allows maximum versatility. Unlike competing systems, which are confined to either a minivan or a portable unit, PoliScan^speed can be deployed in a variety of different ways giving our customers the flexibility to rotate enforcement to areas that have the greatest need. We offer PoliScan^speed in a variety of configurations, including our Mobile Speed Unit, which is a self-contained violation capture and processing center all in one. Other configurations include SUV mount, tripod mount and our rugged transportable unit. Our proven back office integration and citation processing systems, coupled with PoliScan’s advanced technology, provide a fully integrated automated speed enforcement solution.

Deployment of our competitors’ mobile speed enforcement systems can be an involved process, including precisely aiming LiDAR, measuring radar angles for cosine effect, and searching for level stretches of straight roadway. In contrast to conventional measures such as radar, light barriers, and piezo-section, PoliScan^speed does not require a complex installation and calibration of the system at the measurement site. We require only 20 meters of roadway to deploy the PoliScan^speed system, which can be operational in less than five minutes.

Revenue Generation. We believeLiDAR is rapidly becoming the industry standard and is viewed by an increasing number of police departments as the most capable technology to be used with photo speed enforcement. Other providers who use radar for photo enforcement are generally required to discard photo evidence if there is more than one car in the image due to the highly reflective and unpredictable nature of radar.

Enforcing only a single lane drastically reduces potential citation rates by 2 or 3 times. Poliscan utilizes the vehicle targeting advantages of LiDAR while covering multiple lanes, gaining the advantages of radar. This technology solution couples the advantages of radar and LiDAR into one unique enforcement system. Because the system covers all vehicles in all lanes, we can issue, in some cases, twice as many speed citations as can our competition on multi-lane or bi-directional roads. Unlike traditional laser systems, which can require up to 90 meters of flat, straight roadway to accurately target a speeding vehicle, our speed unit can track at distances as short as 20 meters. This short-range LiDAR tracking capability is a major competitive advantage, enabling speed enforcement on roads with sharp curves and hills and enabling better image quality regardless of lighting conditions.

CrossingGuard Speed and Other Speed Products

CrossingGuard Speed, our "Speed on Green" solution, is specifically designed for intersection applications and can be used as a complement to our CrossingGuard red light enforcement system. Our fixed speed solution uses two independent speed detection sensors to cross-reference and verify the vehicle speed, a feature that we believe is unique to our product. The system uses digital video in conjunction with either certified Ka band radar, traditional single beam LiDAR or the Vitronic scanning LiDAR, providing complete visual evidence of violations and eliminating the "multiple vehicle" uncertainty of competitors’ systems. It is designed to allow for upgrading CrossingGuard installations to enable simultaneous red light and speed intersection monitoring.  The system will deliver video evidence of vehicles speeding with advanced non-intrusive, performance similar to our CrossingGuard systems. The system may also be installed on a stand-alone basis.  

Program Management and Processing Services

We offer our CrossingGuard and Poliscan customers a complete package of services and support, which can be customized. These services consist of site planning and equipment installation, user training and support, violation review, citation preparation and processing, account management, toll free hotline support, public education and expert testimony. In addition, we provide direct, remote and online equipment monitoring and maintenance primarily through our field and office personnel and through local contractors as necessary. We also offer fine collection and processing as an optional service for our customers.

We have been able to leverage the infrastructure and technology developed for our CrossingGuard system to support all of our traffic enforcement products. All of our citation processing services utilize our proprietary Citation Composer software, which allows us to retrieve and review images and format pictures and other data for citation processing. Citation Composer supports the necessary interfaces with state departments of motor vehicles, local police departments and court systems to facilitate review and approval of citations, court scheduling, providing evidence packages and tracking payment and resolution of the citations. Our customer service platform supports our entire product line, and enables us to integrate additional products without significant development costs.

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Other Traffic Products

We have two other traffic management products - Rail CrossingGuard and TrafficVision. We have chosen to focus our efforts on the automated enforcement market and are no longer marketing or developing these products. Therefore, we do not expect to receive material revenue related to them in the future.

Rail CrossingGuard. We developed Rail CrossingGuard, a system to monitor grade-crossing vehicles and train traffic, as well as signalization activity, to provide grade-crossing-integrity measurement, real-time crossing alert capabilities and crossing violation enforcement. This product has the potential to enhance rail-crossing safety by improving signal and crossing gate monitoring, alerting personnel to dangerous crossing situations, and enforcing train and vehicle safety regulations. Rail CrossingGuard may also be integrated with train communications systems to provide a method of alerting trains to dangerous rail crossing conditions.

TrafficVision. TrafficVision is a product that uses video cameras to monitor traffic flow and to send traffic data to a central Traffic Operations Center. Replacing short-life, high-maintenance, road-embedded copper-loop technologies from the 1950's, TrafficVision is a non-intrusive sensor system for traffic management. TrafficVision uses our proprietary high-speed image-processing technology to analyze video content to sense and monitor traffic on highways, roadways and intersections in real-time. TrafficVision recognizes and classifies multiple vehicles continuously so that surveillance and traffic management are based upon detailed, real-time information. TrafficVision is installed at 26 locations in Rhode Island and in the state's centralized Traffic Operations Center in Providence.

Sales, Marketing and Methods of Distribution

We market our products and services to municipalities and governmental traffic management departments. As of December 31, 2005, our nationwide direct sales force had grown to ten individuals from four in early 2005, and our marketing support group consists of four people. In addition, members of senior management are actively involved in sales and marketing. Because our products require technical assistance during the sales and installation processes, our marketing team also accesses our internal staff of program managers and field engineers. Within the last 12 months we have also engaged the services of several consultants and lobbyists to assist with our marketing and sales efforts.

We obtain product inquiries from customer referrals, product mailings, attendance at trade shows, trade press coverage and our Internet site. Most CrossingGuard contracts are obtained through competitive proposal processes in response to requests for proposals, or RFPs, issued by municipalities. In some cases, our customers may issue a sole-source contract, avoiding the RFP process. Our sales force actively engages in direct discussions with potential customers to encourage sole-sourcing or the issuance of RFPs that incorporate our products’ features. We also subscribe to multiple services that advise us of relevant RFPs, issued by state and local governments. Purchasing decisions are influenced by the advantages of a particular product, customer references, existing relationships with the jurisdiction, pricing, and in some cases, consultant and lobbyist activities. In 2005, we submitted 43proposals to state and local governments. As of December 31, 2005, as a result of bids submitted in 2004 and 2005, we were awarded 10 contracts and we have been selected as the provider by, but not entered into a contract with, 5 municipalities. No provider has been selected with respect to 7 of the RFPs to which we responded in 2005.

Our 2006 marketing and sales plan includes state-specific marketing, comprehensive municipal coverage by our expanded sales team and consultant and lobbyist engagements.

Research and Development Activities

The focus of our research and development is on improvements to our products and technologies in order to maintain and increase our products’ competitive advantages as well as customer service and satisfaction. We also consider developing new technologies and products that we believe will complement our traffic enforcement product line.

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We have recently completed development of two new products:

· Our "All Digital" CrossingGuard system, which enhances image quality (up to 12.4 megabytes), efficiency and reliability while reducing installation costs and supporting infrastructure needs.  The All Digital system uses decentralized processing and provides a completely digital Ethernet solution.  With internet protocol addressable cameras, it can provide live video for homeland security or other applications; and

· Our CrossingGuard Speed system, which can utilize any of three speed detection systems - Ka band radar, single beam traditional LiDAR and Vitronic’s scanning LiDAR. The integration of all known types of non-intrusive speed sensors into our product allows us to deliver a full array of solutions to the customer while maintaining the advantage of full motion digital video.

We have begun development of a high-speed enforcement detection system for the CrossingGuard fixed speed platform. This system will allow accurate speed detection and measurement using a video tracking system. This will allow for an inexpensive and non-detectible sensor system to enforce speed through intersections and at fixed speed locations.

We spent $1,737,000, $157,000, and $122,000 in the years ended December 31, 2005, 2004 and 2003 respectively, on research and development. The more significant 2005 research and development expenditures are attributable to development of the CrossingGuard all digital video solution and, to a larger degree, the US commercialization and back office integration of the PoliScan^speed product. We expect these costs to decrease in 2006.

Patents

We have continually sought and obtained patent protection for our traffic enforcement systems and for our proprietary neural networks, which have as a principal feature rapid learning from a relatively small number of examples, or the application of video techniques in traffic management applications. Our patented neural network exhibits rapid learning and minimizes the internal connections needed for it’s functioning. We believe that these capabilities make our technology uniquely suited to applications that require field trainability or self-modification to adapt to new or changing patterns in the data. Our patents also cover multiple-neural-network systems, which enabled us to develop products that combine high accuracy with high processing speeds.

During 2005, we received one patent relative to the CrossingGuard product line. The patent recognizes the use of a virtual violation line for detecting red light violations. During 2004, we received two patents relative to the CrossingGuard product line. The first patent recognizes the transmission of video as part of the user interface in our CitationComposer software for ticket processing and issuance. The second patent recognizes the invention of a traffic sensor. During 2003, we received two patents relative to the CrossingGuard product line. One of the patents recognizes our method of predicting and recording a red light violation with a video-based system including the use of violation probability scores. The other patent defines a system and method of detecting and filtering non-violations in a traffic light enforcement system employing a video camera to improve the effectiveness of the system.

As of December 31, 2005, we own 13 U.S. patents and 2 foreign patents. We have two foreign patent applications pending. We also have one pending U.S. patent application acquired from Transol. Seven of our U.S. patents, both of our foreign patents and all of our patent applications have relevance to our traffic enforcement business. The foreign patents correspond to one or more of the U.S. patents. Our patents expire at various times from 2006 to 2021. None relevant to our traffic enforcement business expire before 2018.

Competition

We believe that our products are more technologically advanced than competing systems for traffic enforcement. In red light enforcement, our competition generally consists of multiple still image red light camera systems. These systems generally rely on digital still cameras (or older wet film 35mm cameras) that record only a few frames of evidence regarding a violation and detect vehicles through the use of in-ground sensor loops. In-ground sensor loops require digging up the pavement and are generally unresponsive to vehicles moving below twelve miles per hour. For wet film systems, there is the added burden of retrieving, replacing, developing and scanning the film. Most competitors have developed digital still systems and do not promote wet film applications.

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CrossingGuard vehicle detection cameras are installed above the ground, on roadside poles or mast arms. This helps avoid some of the logistical problems associated with installing in-ground loop sensors at an intersection. The system’s digital video evidence consists of both front and rear vehicle images. This ensures fairness so that violations are not issued out of context (e.g., if the violation occurred to make way for an emergency vehicle, as part of a funeral procession or to avoid a crash). In case of a dispute, unlike non-video systems, the violation video sequence can be replayed. This perception of fairness makes our video evidence attractive to city councils, law enforcement officials, courts and the general public.

In speed enforcement, competition is generally limited to single-beam LiDAR or indiscriminate radar detection systems.

Our largest competitors in the enforcement market are ACS, which has the greatest number of red-light and speed camera systems installed, and Redflex Traffic Systems, Inc. Among others are Laser Craft, Mulvihill/ATS, Peek Traffic (Quixote Corp.), Traffipax, and Siemens. Although these companies generally use buried loops, digital still cameras and/or wet film systems, single-beam LiDAR or radar, some may pose a competitive threat due to their size, market share, legacy customer relationships, enhanced driver image, additional products offered and/or citation-processing experience.

Most of our competitors have significantly greater financial, marketing and other resources. As a result, they may be able to respond more quickly to new or emerging technologies or to devote greater resources to the development, promotion and sale of their products than we may. Competitive pressures faced by us may materially affect our business, financial condition and results of operations in an adverse way.

Contracts with Governmental Entities

Our agreements are generally service contracts with states or municipalities that in most circumstances may be cancelled by the customer for various reasons. Because these contracts are generally self-funded from ticket fees collected from red-light violators and some contracts contain termination fee provisions, we do not expect termination to be a significant risk. We retain all patent and other proprietary rights from products developed and delivered under government-supported contracts.

Employees

As of March 15, 2006, we had 102full-time employees, comprising 17 in software engineering and product development, 23 in processing and system support, 38 in program management and field services,12 in sales and marketing and 12 in management, finance and office support. None of our employees are represented by a labor union. We have experienced no work stoppages and management believes our employee relationships are generally good.

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ITEM 1A. Risk Factors

This Annual Report on Form 10-K 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 years ended December 31, 2005, 2004, and 2003, our net losses have been approximately $6,764,000, $6,178,000,and $5,325,000, respectively. As of December 31, 2005 we had an accumulated deficit of $60,988,000. 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 will need additional financing, which may be difficult or impossible to obtain and may restrict our operations and dilute stockholder ownership interest.

At December 31, 2005, we had approximately $13.7 million of outstanding debt, at par value. We will need to raise additional funds in the near 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 may 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 unless we raise the additional financing.

If we raise additional funds by issuing equity securities, 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. If we raise additional funds through a debt financing, the terms and conditions of the debt financing may result in restrictions on our operations or require that we grant a security interest in some or all of the assets for which such debt financing would be used. Any debt that we incur could have significant additional negative consequences, including:

· Increasing our vulnerability to general adverse economic and industry conditions;

· Limiting our ability to obtain additional financing;

· Requiring the dedication of a substantial portion of our cash flow from operations to service our debt, thereby reducing the amount of expected cash flow available for other purposes, such as sustaining our operations, capital expenditures and research and development;

· Limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete; and

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· Placing us at a possible competitive disadvantage to competitors with less debt and to competitors that have better access to capital resources.

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.

Substantially all of our current revenue is from a single product and related services.

Currently, substantially all of our revenue is from our red light enforcement systems and services. While we have recently begun to deploy the speed enforcement products, there can be no assurance that we will be able to generate significant revenue from this product or that we will be able to develop other sources of revenue. Because our revenue depends substantially on a single product, any decrease in the market share held by CrossingGuard, unless offset by other revenue sources, would have a substantial adverse effect on our business, financial condition and results of operations. If we fail to meet our expectations for the growth in sales of CrossingGuard and Poliscan or if we are not able to expand our speed enforcement business or develop other sources of revenue, we will not be able to generate the significantly higher revenue that we believe we must generate to achieve profitability.

We have limited experience in the speed enforcement market.

We have limited experience in the speed enforcement market. Currently, we are only party to two speed enforcement contracts, one of which is a pilot program that we expect will run through the end of the current school year, and thereafter be replaced by a longer term program with a vendor selected through an RFP. There can be no assurance that we will obtain additional speed enforcement contracts. Furthermore, since we have only limited experience in deploying the Poliscan automated enforcement system, we cannot assure you that this product will be profitable, new customers will be obtained, or that any revenue from the sale of these systems will be sustainable.

We may not maintain our rights to market Poliscan.

Under our contract with Vitronic, if we fail to generate specific sales volume during each year of the contract beginning with the year ending June 30, 2006, Vitronic can elect to terminate our exclusivity or the entire contract. There can be no assurance that we will meet the performance targets under the contract. Because the growth of our speed business, namely the increased deployment of Poliscan systems, is such a key component of our growth strategy, the termination of the Vitronic contract would adversely affect our business and results of operations.

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, 2005, our active contracts with state and local governments authorized the installation of CrossingGuard at up to an additional 172 approaches. In many cases, we cannot proceed with these installations until the sites 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, 23 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. For example, last year the Virginia General Assembly declined to extend authorization for automated red light enforcement beyond the sunset date of June 30, 2005 in the enabling legislation. We had two revenue-producing red light enforcement contracts with municipalities in Virginia. We anticipate no material revenues from the 14 approaches covered by these contracts unless there is a change in Virginia law. 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 very 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.

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.

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 all 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.

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;

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· 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.

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 the risks discussed in this section as well as:

· 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;

· 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.

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;

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· 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 sales 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 sales 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.

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.

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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.

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;

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· 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.

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.

Our President and Chief Executive Officer beneficially owns a significant amount of our common stock and, accordingly, exercises significant control over our business and affairs, including the approval of change in control transactions.

As of December 31, 2005, our President and Chief Executive Officer beneficially owns approximately 50.1% of our common stock, which includes shares of common stock held by Silver Star Partners I, LLC (Silver Star), of which he serves as the managing director. Based on the number of shares of common stock outstanding as of February 28, 2006, our President and Chief Executive Officer will be able to exert substantial influence over all matters requiring approval by our stockholders. These matters include the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets. This concentration of ownership may have the effect of delaying, deferring or preventing a change in control, or impeding a merger, consolidation, takeover or business combination even if the transaction might be beneficial to our stockholders.

In addition, Section 203 of the General Corporation Law of the State of Delaware restricts business combinations with any “interested stockholder” as defined by the statute. The statute may have the effect of delaying, deferring or preventing a change in control of our company.

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.

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We have a significant number of options, warrants and convertible securities outstanding, which could result in substantial dilution to the purchasers of shares in this offering.

As of December 31, 2005, we have issued and outstanding warrants and options to purchase up to approximately 3,044,358 shares of our common stock, preferred stock convertible into 18,000 shares of our common stock and debt convertible into approximately 1,924,399 shares of our common stock. The exercise of such warrants and options and conversion of convertible securities may dilute the interests of all stockholders. 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 $4.40 per share. Possible future resale of common stock issuable from such warrants and options or conversion of such convertible securities could adversely affect the prevailing market price of our common stock.

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 20,364,876shares of our common stock outstanding as of February 28, 2006, of which approximately 9,047,742 shareswere freely tradable without restrictions or further registration under the Securities Act. Silver Star, our majority stockholder, has the right to require us to register under the Securities Act their resale of all 9,589,941 shares of common stock that it owns, as soon as practicable after Silver Star requests that registration. We are also obligated to register for resale the 1,237,811 shares we sold to accredited investors on January 31, 2006 and 203,774 shares held by Laurus Master Fund, Ltd.

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ITEM 2. Properties.

In October 2005, we relocated our corporate headquarters from 400 Massasoit Avenue, East Providence, Rhode Island to 42 Oriental Street, Third Floor, Providence, Rhode Island. We are party to a five-year lease for 12,700 square feet of office space and 11,000 square feet of warehouse space at this new location with lease payments of approximately $7,400 per month for the office space, subject to increase for renewal terms. The warehouse space is rent-free until the first anniversary of the lease, at which time annual rent for the warehouse space will adjust to $4.00 per square foot. We are still the lessee of 4,800 square feet of our former corporate headquarters in East Providence, at a monthly rent of $6,141, for which we are attempting to find a sublessee. Our obligations under that lease expire on May 31, 2007.

We also maintain a local field office in San Diego, California on a two-year lease dated July 2004, and pay approximately $2,600 per month. In addition, we maintain a local field office in Placentia, California on a two-year lease dated February 2004, and pay approximately $1,400 per month. We are planning on relocating our San Diego offices to the Los Angeles area to improve the support for our customers located in and around the Los Angeles. We may consolidate the Placentia field office with the Los Angeles office, depending on facility layout and availability.

ITEM 3. Legal Proceedings.

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. No decision has been made by the judge on that motion. The judge stayed all discovery pending the outcome of that motion.

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, nusiance, 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. No decision has been made by the judge on that motion. The judge stayed all discovery pending the outcome of that motion.

Sherrod Vans of Jacksonville, Inc., a former vendor that provided van customization services to us, has filed suit against us in the Circuit Court (Duval County, Florida), alleging that we failed to pay for some of the services that they provided. Sherrod is seeking payment from us of $114,075. Among the items for which they are seeking payment are items that have not been delivered to us. If Sherrod delivers those items, the amount in dispute is less than $20,000.

In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. We do not currently have any pending litigation other than that described above.

ITEM 4. Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2005.

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PART II

ITEM 5. Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The Company’s common stock is traded on the Nasdaq National Market under the symbol “NEST.” The following table reflects the range of the reported high and low last sale prices on the Nasdaq National Market for the periods indicated:

	Low		High
Year Ended December 31, 2005
1st Quarter	$	4.50	$	7.43
2nd Quarter	$	5.05	$	7.00
3rd Quarter	$	4.40	$	6.75
4th Quarter	$	4.80	$	9.17
Year Ended December 31, 2004
1st Quarter	$	2.85	$	4.00
2nd Quarter	$	3.16	$	4.10
3rd Quarter	$	4.05	$	5.00
4th Quarter	$	4.75	$	7.85

Holders of Common Stock

At March 24, 2006, the number of holders of record of the issued and outstanding common stock of the Company was 404.

Dividend Policy

The Company has not paid any cash dividends with respect to its common stock since formation and does not expect to pay cash dividends in the foreseeable future.

Securities Authorized for Issuance Under Equity Compensation Plans

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

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ITEM 6. Selected Financial Data.

The following data includes the accounts of Nestor, Inc. for all periods presented and NTS for the years 2004, 2003, and 2002 and for the period September 13, 2001 through December 31, 2001. The Company’s investment in NTS was recorded on the equity method prior to September 13, 2001. The financial statements for fiscal years 2004 and 2003 and for the fiscal quarters therein, along with the first three quarters of fiscal 2005, have been restated. You should read the data set forth below in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Result of Operations,” Item 1A, “Risk Factors,” and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K.

	Years Ended December 31,
	(In Thousands, Except Share And Per Share Information)
				(As Restated)			(As Restated)
	2005			2004			2003			2002			2001
Revenue	$	7,769		$	6,035		$	2,706		$	2,122		$	3,521
Operating loss		(9,277	)		(4,647	)		(4,261	)		(15,127	)		(1,297	)
Gain on debt extinguishment, net		---			508			---			---			---
Loss on debt refinancing		(509	)		---			---			---			---
Contract termination reserve		---			---			(125	)		---			---
Gain on royalty assignment		---			---			---			2,812			---
Loss from investment in affiliate		---			---			---			---			(81	)
Other expense		(704	)		(334	)		(504	)		(319	)		(187	)
Derivative instrument expense, net		3,726			(1,705	)		(435	)		---			---
Net loss	$	(6,764	)	$	(6,178	)	$	(5,325	)	$	(12,634	)	$	(1,565	)
Loss per share:
Weighted number of outstanding shares - basic and diluted		18,826,966			18,223,609			12,964,498			5,047,611			2,881,877
Loss per share	$	(0.36	)	$	(0.34	)	$	(0.41	)	$	(2.50	)	$	(0.54	)
SELECTED BALANCE SHEET DATA:
Total assets	$	19,215		$	18,847		$	16,299		$	9,201		$	22,035
Working capital (deficit)	$	(2,097	)	$	6,786		$	3,294		$	(1,572	)	$	1,775
Long-term liabilities	$	6,420		$	7,812		$	3,322		$	2,849		$	2,830

(Note: Earnings per share information as previously reported for fiscal years ended December 31, 2002 and 2001 have been adjusted to a post-reverse split basis.)

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ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our management’s discussion and analysis of our financial condition and results of our operations contains 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 used the words “believe,” “anticipate,” “plan,” “expect,” “intend,” “may,” “will” and similar expressions to help identify forward-looking statements.

Actual results may differ from those indicated by such forward-looking statements as a result of various important factors, including, without limitation, those factors discussed in this annual report under the heading “Risk Factors.”

The following discussion and analysis gives effect to the restatement described in Note 3 in the Notes to the Consolidated Financial Statements. For this reason, the data in this section may not be comparable to discussions and data in our previously filed annual and quarterly reports.

Executive Summary

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, manages the process of issuing and processing a citation. PoliScan^speed, our new speed enforcement product, uses technology developed by Vitronic. We have exclusive marketing rights to Poliscan in North America through February 2010, subject to meeting certain sales minimums. By coupling CrossingGuard and Poliscan equipment with Citation Composer, our proprietary citation preparation and processing software, we provide fully integrated, turnkey red light and speed enforcement solutions.

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 system as explained below. Beginning in the fourth quarter of 2005, we started generating revenue from our PoliScan system. The economics of the CrossingGuard product are tied to the number of operating systems in the field and, to an increasingly lesser extent, the number of violations processed by such systems. Throughout 2003 and 2004, there was a trend by customers towards a fixed monthly fee as opposed to variable per ticket fee pricing structures for CrossingGuard systems. Because fixed fees are based upon the expected level of violations over the contract term, the shift to monthly fixed fee contracts should result in a more stable revenue stream for these installations. Many of our initial CrossingGuard 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 $11 to $99 per citation issued or paid and/or fixed monthly fees ranging from $2,000 to $12,000 per approach for system delivery and processing services.

State statutes providing for automated red light 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 much higher, resulting in lower per citation costs and monthly fees for CrossingGuard systems installed in these jurisdictions. Of the twenty-four jurisdictions that currently allow for automated red light enforcement programs, five 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, Utah, and Colorado.

Almost all of our contracts provide for the lease of equipment and the services as a bundled, turnkey program over 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. One contract with Delaware DOT provided for a monthly lease of the roadside equipment, and we transferred this lease to GE Municipal Services for the face value of the roadside equipment, or $80,000 per approach. In accordance with FAS 13, this lease qualified as a sales-type financing lease and we recognized the value received from the leased equipment, and expensed the associated costs of the system in the same period. We delivered 11 and 20 systems to Delaware DOT in 2004 and 2005, respectively, and have completed deliveries of units under the current contract terms.

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Our existing CrossingGuard contracts with government entities typically authorize the installation of systems at a specified number of approaches. As of December 31, 2005, our existing active contracts authorized the installation of our CrossingGuard product at up to an additional 172 approaches. 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.

The following table provides summary information regarding our active CrossingGuard contracts.

	December 31,
	2005		2004		2003
Number of Approaches and Units:
Installed, operational and revenue-generating:
CrossingGuard red light approaches		171		111		88
Poliscanspeed Units		4		0		0
Additional Authorized Approaches:
CrossingGuard red light approaches		172		128		47
Poliscanspeed Units		5		0		0
Total		352		239		135

On October 26, 2005, we deployed the first of four approved Poliscan systems in the City of Akron, Ohio. As of December 31, 2005, we had contracts with two municipalities authorizing the installation of up to 9 speed enforcement systems, including Akron. Our agreement with Akron is a pilot program that had an initial 90-day term followed by automatic monthly renewals. The program is still operating under those renewals. We expect that it will run until the end of the school year, and that, thereafter, Akron will seek a longer term program through an RFP. We will receive a fee of $19 to $23 per ticket paid under the agreement with Akron. We expect that our PoliScan^speed contracts will compensate us on a per ticket paid basisin return for both equipment lease and citation processing and customer support services. We anticipate that we will generally receive fees from $10 to $25 per ticket under our future Poliscan contracts depending on factors including number of units ordered, length of contract, service levels provided, and competition.

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; 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, fraud detection and Rail CrossingGuard and TrafficVision business lines, and had refocused our resources on our traffic safety and enforcement systems such as CrossingGuard, our current primary source of revenue. This transition involved a series of licensing arrangements and transfers of our rights. 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 property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.

On August 31, 2005, we acquired certain assets of Transol USA, one of our competitors, in a foreclosure sale. The assets included contracts to provide automated red light enforcement services in six U.S. cities at an aggregate of 39 red light approaches, as well as related equipment, intellectual property, inventory, work in process, accounts receivable and unbilled contract revenue related to Transol’s red light enforcement services. We paid $1.8 million for the acquired assets. We funded the acquisition of the acquired assets with internal working capital.

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 audited 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.

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

a. 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;

b. 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

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c. 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.

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.

Unbilled contract revenue

Unbilled contract revenue represents revenue earned by us in advance of being billable under customer contract terms. Under the terms of some current contracts, we cannot bill the municipality until the court has collected the citation fine. Through September 30, 2005, management recorded unbilled contract revenue in these situations at a net amount, based upon a historical pattern of collections by the courts for the municipalities. The pattern of collections on these citations was periodically reviewed and updated by management.

Based upon review of this policy during discussions with the Securities and Exchange examining division, management decided to defer recognition of income on these contracts until the municipality has collected the applicable citation to which we are entitled to a portion. Management implemented this change in the fourth quarter of 2005 and recorded a cumulative adjustment to reflect the change including a reduction of lease and service revenue and unbilled contract revenues of $149,000.

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 uncollectable. 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. After discussions with the senior management team, a reserve is established so that inventory is appropriately stated at the lower of cost or net realizable value.

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.

The identification of, and accounting for, derivative instruments is complex. Derivative instrument liabilities are re-valued at the end of each reporting period, with changes in fair value of the derivative liability 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 instrument liabilities, 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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Long-Term Asset Impairment

In assessing the recoverability of our long-term assets, 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.

Concentrations of credit risk

Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, marketable equity securities 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. 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 $1,280,000 at December 31, 2005 compared with $6,422,000 at December 31, 2004. At December 31, 2005, we had a working capital deficit of $2,097,000 compared with working capital of $6,785,000 at December 31, 2004.

The $5,142,000 decline in cash is primarily due to the use of $7,782,000 in operating activities that generated our net loss and the use of $5,537,000 in investing activities, primarily to install additional red light and mobile speed technology and acquire assets from a bankrupt competitor. These uses of cash were partially offset by $8,500,000 of net funding obtained during the year through the private placement of notes payable to accredited investors.

Our net worth at December 31, 2005 was $5,407,000 compared with $9,184,000 at December 31, 2004. The decrease in net worth was primarily the result of our twelve month net loss of $6,764,000, partially offset by conversions to common stock by certain holders of our senior convertible notes in the principal amount of $800,000, an increase in additional paid-in capital resulting from the $419,000 ascribed value of warrants issued relating to the issuance of a convertible note in May 2005, and a $1,078,000 increase in additional capital resulting from the ascribed value of stock issued related to our December 28, 2005 debt refinancing. We continue to seek additional sources of equity and debt financing to fund operations 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.

Historically, we have raised capital by/through a series of privately placed debt.See notes 7 and 8 to the consolidated financial statements.

On May 16, 2005, we sold a convertible note in the principal amount of $6,000,000 to an accredited institutional investor, and issued 100,000 warrants at a per share exercise price ranging from $6.69 to $8.43 and expiring on May 16, 2010.

On August 30, 2005 and October 26, 2005, we issued secured promissory notes, each in the principal amount of $1,250,000, to two different accredited investors for the purpose of financing the purchase of mobile speed units.

On December 28, 2005, we sold a new note payable to Laurus Funds for an aggregate principal amount of $6,000,000, and issued common stock equal to 18% of the new financing, or 203,774 shares. The proceeds were used to retire the convertible note issued to Laurus in May 2005.

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In January 2006, we sold 1,237,811 shares of common stock in a private placement at $4.42 per share raising $4,822,000, net of expenses, and issued 371,339 warrants at a per share exercise price of $4.91 that expire on January 31, 2009. We used $1,250,000 of the proceeds to retire a note payable and the remainder is being used for general corporate purposes

.

Commitments, Contractual Obligations and Off-Balance Sheet Arrangements

The following table summarizes the Company’s contractual obligations at December 31, 2005, and the effect such obligations are expected to have on its cash flow in future periods:

Payments due in:	Operating Leases		Heil Secured Promissory Note		Foundation Partners Secured Promissory Note		Senior Convertible Notes		Fourth Laurus Note		Debt Interest		Total
2006	$	205,000	$	1,250,000	$	1,250,000	$	---	$	1,636,000	$	1,120,000	$	5,461,000
2007		166,000		---		---		5,200,000		2,182,000		799,000		8,347,000
2008		135,000		---		---		---		2,182,000		431,000		2,748,000
2009		135,000		---		---		---		---		---		135,000
2010 &		90,000		---		---		---		---		---		90,000
Thereafter		---		---		---		---		---		---		---
	$	731,000	$	1,250,000	$	1,250,000	$	5,200,000	$	6,000,000	$	2,350,000	$	16,781,000

As of December 31, 2005, we have no off balance sheet arrangements.

Future Commitments

For the twelve months ended December 31, 2005, we invested $3,680,000 in capitalized systems for CrossingGuard and speed units and $1,253,000 in roadside system costs expensed under a sales-type lease compared to $1,519,000 invested in capitalized systems and $333,000 in roadside system costs expensed in the comparable period last year. Management expects that we will make significant future commitments for systems related to our CrossingGuard contracts (currently for an additional 172 approaches) and our speed enforcement unit contracts (currently for an additional 5 units).

In November 2005, the Company signed a purchase agreement with one of its vendors. This agreement commits the Company to purchase a minimum of $750,000 over eighteen months expiring in May 2007.

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Results of Operations

The following table sets forth selected operating results, including as a percentage of revenue, for the periods indicated:

	Fiscal Year Ended December 31
	2005			%			2004			%			2003			%
							(As Restated)						(As Restated)
Lease & Service Fees	$	5,975,000			77	%	$	5,118,000			85	%	$	2,677,000			99	%
Sales & Royalty Revenue		1,794,000			23	%		917,000			15	%		29,000			1	%
Total Revenue		7,769,000			100	%		6,035,000			100	%		2,706,000			100	%
Cost of sales		5,732,000			74	%		3,932,000			65	%		1,791,000			66	%
Gross profit		2,037,000			26	%		2,103,000			35	%		915,000			34	%
Operating expenses		11,315,000			146	%		6,750,000			112	%		5,176,000			191	%
Loss from operations		(9,277,000	)		119	%		(4,647,000	)		77	%		(4,261,000	)		157	%
(Loss) Gain on Debt		(509,000	)		7	%		508,000			8	%		---			0	%
Other income (expense)		(704,000	)		9	%		(334,000	)		6	%		(629,000	)		23	%
Derivative instrument expense, net		3,726,000			48	%		(1,705,000	)		28	%		(435,000	)		16	%
Net loss	$	(6,764,000	)		87	%	$	(6,178,000	)		102	%	$	(5,325,000	)		197	%

Analysis of the Years Ended December 31, 2005 and December 31, 2004

Revenue

During the year ended December 31, 2005, revenue increased $1,734,000, or 29%, to $7,769,000 from $6,035,000 in the comparable period in 2004. The increase in overall revenue was primarily the result of an increase in lease and service fees and product sales.

Lease and service fee revenues totaled $5,975,000 in 2005, as compared with $5,118,000 in 2004, an increase of $857,000, or 17%, primarily due to additional revenue generating approaches. For the 2005 year, we began the year with 111 revenue generating approaches and ended with 171 revenue generating approaches. During the 2005 year we installed 51 revenue generating approaches, had 26 installed approaches decommissioned, and acquired 35 approaches on August 31 from Transol USA. The 26 decommissioned approaches resulted from: (i) on June 30, 2005 14 approaches in Falls Church and Vienna, Virginia were turned off due to the expiration of the enabling law in Virginia, and (ii) the conclusion of a contract with one customer with 12 approaches. In 2004, we started the year with 88 revenue generating approaches, installed 23 approaches, and ended the year with 111 revenue generating approaches. Additionally, average monthly revenue generated from approaches installed in 2004 and before, decreased in 2005 as violation rates declined, which typically occurs due to modified driver behavior.

Product sales recognized from sales-type leases for CrossingGuard roadside systems, totaled $1,600,000 in the 2005 period, compared with $880,000 in the 2004 period, an increase of $720,000 or 82%. This primarily represents delivery of 20 roadside systems in the 2005 year, compared to delivery of 11 roadside systems in the 2004 year. Additionally, we recognized $158,000 in direct product sales of our CrossingGuard roadside systems in 2005, while in the 2004 period we did not have direct product sales. Residual royalty streams from two customers relating to technology licenses to IBM and NCS accounted for product royalty revenues of $36,000 and $37,000 in 2005 and 2004, respectively.

30

Cost of Sales

For the year ended December 31, 2005, cost of sales totaled $5,732,000, an increase of $1,800,000, or 46%, compared to $3,932,000 in 2004. The increase in cost of sales is primarily due to the cost of 9 more roadside systems installed under sales-type leases ($1,253,000 in 2005 as compared to $607,000 in 2004), increased amortization of more installed capitalized systems, other direct processing and support costs due to the increase in citation volumes processed, accelerated amortization of capitalized systems in the amount of $201,000 due to the red light enforcement law expiring in Virginia, and because we also recorded a $330,000 charge in 2005 to reserve for obsolete and excess inventory relating to the conversion and upgrade of certain installations from old to new technology to improve violation capture capability.

Gross Profit

For the year ended December 31, 2005, gross profit declined $66,000, or 3%, to $2,037,000 from $2,103,000 in 2004, while gross margin decreased by 9 percentage points to 26% for the year ended December 31, 2005 from 35% for the year ended December 31, 2004. The decline in gross profit is primarily attributable to a higher mix of lower margin sales-type leases in 2005 versus 2004, the $201,000 of accelerated depreciation due to the shutdown of our Virginia customers as a result of the expiration of the red light enforcement law, and the $330,000 of additional excess and obsolete inventory costs related to the conversion and upgrade of certain installations from old to new technology to improve violation capture capability.

Operating Expenses

Total operating expenses amounted to $11,315,000 in 2005, an increase of $4,565,000, or 68%, over total operating expenses of $6,750,000 in 2004. The increase is primarily due to increased engineering and operating expenses from growth in installed CrossingGuard systems and the development of our speed enforcement program, along with increased investments in our sales and marketing efforts.

Engineering and operations expenses totaled $4,050,000 in the year ended December 31, 2005, an increase of $586,000, or 17%, compared to $3,465,000 in 2004. The increase in engineering and operations expenses are primarily attributable to increased personnel and related field support costs driven by our increased installed base as well as an increase in design and engineering consultant expenses.

Research and development expenses totaled $1,737,000 in the year ended December 31, 2005, an increase of $1,579,000 compared with $157,000 in the comparable year of 2004. The increase in research and development expenses primarily resulted from increased spending in salary and related personnel costs and development consultants attributable to projects advancing our CrossingGuard product technology and development and commercialization of our mobile speed enforcement system.

Selling and marketing expenses totaled $2,057,000 in the year ended December 31, 2005, an increase of $1,183,000, or 135%, compared with $874,000 in 2004. Selling and marketing expenses increases in 2005 are primarily attributable to a larger sales force and support personnel with related increases in sales commissions and travel expenses, as well as due to the strategic use of consultants and marketing activities during the year.

General and administrative expenses totaled $3,470,000 for the year ended December 31, 2005, an increase of $1,216,000, or 54%, compared with $2,254,000 in 2004. The increase in general and administrative expenses for the year ended December 31, 2005 compared to 2004 is primarily related to (i) an increase in payroll and related costs, (ii) an increase in accounting and related costs, (iii) an increase in legal expenses for the prosecution of patent infringement cases, which were concluded in June 2005, (iv) an increase in financing fees due to note conversions and a new financing arrangement, and (v) increased costs associated with shareholder communication and meetings.

Gain on Debt Extinguishment

During the year ended December 31, 2004, obligations to Electronic Data Systems, or EDS, under a lease payable and obligations to Laurus under a convertible note originally issued in July 2003 were fully satisfied, resulting in a net gain of $508,000. An early payment on the lease payable resulted in a gain of $681,000, which was partially offset by a prepayment penalty of $173,000 incurred in the repayment of the convertible note.

31

Loss on Debt Refinancing

During December 2005, the company retired a Laurus convertible note issued in May 2005 in the face amount of $6,000,000 which resulted in a loss on retirement of $509,000 related to the write-off of the discount applied to the note for the value of the warrants originally issued with the note. The note was retired in conjunction with the issuance of a new, non-convertible note to Laurus with a face value of $6,000,000.

Other Expense - Net

Other expense, net totaled $704,000 in the year ended December 31, 2005, an increase of $370,000, or 111%, compared with other expense, net of $334,000 in 2004. In the year ended December 31, 2005, we incurred increased interest expense as a result of higher debt levels, which was partially offset by earnings on investments.

Derivative instrument income/expense, net

For the year ended December 31, 2005, derivative instrument income, net was $3,726,000 as compared to derivative instrument expense, net of $1,705,000 for the year ended December 31, 2004. The change was attributable to changes in the fair market value of embedded derivatives issued with convertible debt as well as for the amortization of the related debt discount established at the time the derivative was bifurcated from the debt when the debt was issued. 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 time to maturity of the outstanding debt at different points in time. The major factors contributing to the change for the year ended December 31, 2005 were due to the decline in the fair market value of our derivative instrument liabilities relating to our senior convertible note due to the passage of time partially offset by related debt discount amortization. The major factor contributing to the change for the year ended December 31, 2004 was attributable to the increase in the fair market value of our derivative instrument liabilities relating to the increase in our stock price.

Net Loss

For the year ended December 31, 2005, we incurred a net loss of $6,764,000, or $0.36 per share, an increase of $586,000, compared with a net loss of $6,178,000, or $0.34 per share, in 2004. The increase in the net loss was a result of (i) substantial investment in operating activities during 2005 of $7,782,000 to improve the CrossingGuard technologies, introduce and integrate the Poliscan^speed technology, deliver the increased revenues, and to support overall expansion of the companies business; (ii) additional financing and interest costs, related to our debt and financing arrangements, and; (iii) offset by the change in fair market value of the embedded derivatives in our senior convertible notes.

The increase in net loss per share was primarily due to the increase in our net loss discussed above, partially offset by the increase in outstanding shares. During the year ended December 31, 2005, there were 18,826,966 basic and diluted weighted average shares outstanding compared with 18,223,609 for the year ended 2004.

Analysis of the Years Ended December 31, 2004 and 2003

Revenue

During the year ended December 31, 2004, revenue increased $3,329,000, or 123%, to $6,035,000 from $2,706,000 in 2003. The increase in overall revenue was primarily the result of an increase in lease and service fees and product sales.

Lease and service fees totaled $5,118,000 in 2004, as compared with $2,677,000 in 2003, an increase of $2,441,000, or 91%. The increase in lease and service fees were largely attributable to an entire year of revenue from 88 installed approaches during 2004 compared to an entire year of revenue from 42 installed approaches during 2003 and the installation of an additional 23 approaches during 2004.

Product sales, which are recognized from capital sales-type leases for certain CrossingGuard systems sold to Delaware DOT, totaled $880,000 in 2004, as compared with $0 in 2003, an increase of $880,000. Product sales for 2004 represent six CrossingGuard systems sold to Delaware DOT that were financed through GE Capital. Product royalties totaled $37,000 in 2004, as compared with $29,000 in 2003, an increase of $8,000, or 28%. Residual royalty streams from two customers relating to technology licenses to IBM and NCS accounted for all product royalty.

32

Costs of Sales

Cost of sales totaled $3,932,000 in 2004 as compared to $1,791,000 in 2003, an increase of $2,141,000, or 120%. The increase in cost of sales in 2004 was primarily due to an increase in amortization in the amount of $990,000 because of more installed approaches in 2004 compared to 2003, including $184,000 of accelerated amortization on certain installed approaches that were not renewed, and $558,000 of amortization under sales-type lease accounting for the CrossingGuard systems sold to Delaware DOT.

Gross Profit

For the year ended December 31, 2004, gross profit increased $1,188,000, or 130%, to $2,103,000 from $915,000 in the prior year, while gross margin increased by 1% to 35% for the year ended December 31, 2005 from 34% for 2003. The increase in gross profit is primarily attributable to an average of 100 installed approaches operating during 2004 as compared to an average of 64 approaches in 2003.

Operating Expenses

Total operating expenses amounted to $10,682,000 in the year ended December 31, 2004, an increase of $3,715,000, or 53%, over total operating expenses of $6,967,000 in 2003. The primary changes in 2004 include increased amortization on a greater number of installed approaches, an increase in cost of sales as a result of the sales-type lease accounting for the CrossingGuard systems sold to Delaware DOT, a significant increase in sales consulting expenses and $381,000 of additional patent lawsuit defense expenses. Additionally, headcount increased 33% in 2004 compared 2003, which caused an increase in salaries and fringe benefits and related travel expenses.

Engineering and operations expenses totaled $3,464,000 in 2004, as compared with $2,578,000 in 2003, an increase of $886,000, or 34%. The increase in engineering and operations expenses in 2004 reflected the additional internal and field-based expenses, including expenses for travel, tools and supplies, to support the growing number of installed approaches. Engineering and operations staff growth in 2004 included redeployment of five people from other departments to field support in addition to the hiring of six new employees.

Research and development expenses totaled $157,000 in the year ended December 31, 2004, as compared with $121,000 in 2003, an increase of $36,000, or 30%. The increase in research and development expenses in 2004 was directly attributable to materials purchased in support of on-going research activities.

Selling and marketing expenses increased $519,000 to $874,000, or 146%, in the year ended December 31, 2004, from $355,000 in 2003. The increase in 2004 costs reflected the hiring of a nationwide sales force and the use of outside consultants to support sales activity in strategic markets.

General and administrative expenses totaled $2,254,000 in 2004, as compared with $2,121,000 in 2003, an increase of $133,00, or 6%. The increase in general and administrative expenses was largely the net result of $381,000 for patent lawsuit defense costs in 2004, offset by a $124,000 decrease in financing fees for 2004 and a $180,000 expense for an employee settlement agreement in 2003.

Gain on Debt Extinguishment

Obligations to EDS under a lease payable and obligations to Laurus under a convertible note issued in July 2003 were fully satisfied in January 2004, resulting in a net gain of $508,000. An early payment on the lease payable resulted in a gain of $681,000, which was partially offset by a prepayment penalty of $173,000 incurred in the repayment of the convertible note. There were no corresponding gains or prepayment penalties during 2003.

33

Contract Termination Reserve

A significant customer contract in our former Rail line of business was terminated by mutual agreement prior to its completion as a result of our decision to focus our resources on CrossingGuard systems and services. We accrued $125,000 of estimated contract termination fees in June 2003, the entire amount of which was paid in December 2004.

Other Expense - Net

For 2004, other expense, net was $334,000, as compared with other expense, net of $504,000 in 2003, a decrease of $170,000, or 34%. In 2004, other expense included $80,000 of interest expense accrued as a result of a 2004 sales and use tax audit, a decrease of $144,000 in interest expense associated with notes payable, a $96,000 realized loss on marketable equity securities and a decrease of $44,000 in warrant amortization as warrants were fully amortized in July 2004. Non-recurring 2003 items included $164,000 of interest expense paid to EDS offset by a $64,000 favorable vendor settlement.

Derivative instrument income/expense, net

For the year ended December 31, 2004, derivative instrument expense, net was $1,705,000 as compared to derivative instrument expense, net of $435,000 for the year ended December 31, 2003. The change was attributable to changes in the fair market value of embedded derivatives issued with convertible debt as well as for the amortization of the related debt discount established at the time the derivative was bifurcated from the debt when the debt was issued. 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 time to maturity of the outstanding debt at different points in time. The major factor contributing to the change for the year ended December 31, 2003 was attributable to the increase in the fair market value of our derivative instrument liabilities relating to the increase in our stock price.

Net Loss

During 2004, we recorded a net loss of $6,178,000, as compared with a loss of $5,325,000 in 2003, an increase of $853,000, or 16%. For the year ended December 31, 2004, net loss per share was $0.34 compared to a net loss per share of $0.41 in 2003.

ITEM 7A. Quantitative and Qualitative Disclosure about 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

Our marketable securities, an insured municipal bond fund, valued at $56,000 at December 31, 2005, are exposed to market risk due to changes in U.S. interest rates. The primary objective of our investment activities is the preservation of principal while maximizing investment income. Our exposure to this market risk is moderately high in the short-term. During the year ended December 31, 2005, we had an unrealized loss of $14 on securities held at December 31, 2005. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other expense, net.

We have a senior convertible note payable with interest fixed at 5% through its October 2007 maturity. We have a secured promissory note with a fixed interest rate of approximately 10% that matures in November 2006. Management assesses the exposure to market risk for these obligations as minimal. In addition, we have a non-convertible note payable with a principal amount of $6,000,000 with a variable interest rate, currently the prime rate plus 2%. This three year note begins monthly principal amortization payments in April 2006. Our exposure to this interest rate risk is moderately high in the intermediate term. Management assesses the exposure to market risk for these obligations as minimal.

34

ITEM 8. Financial Statements and Supplementary Data

The following consolidated financial statements and the related notes thereto of NESTOR, Inc. and the Report of Independent Registered Public Accounting Firm are filed as a part of this annual report on form 10-K:

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

35

NESTOR, INC.

CONTENTS

	Page No.
Report of Independent Registered Public Accounting Firm	37
Consolidated Balance Sheets -
December 31, 2005 and 2004 (as restated)	38
Consolidated Statements of Operations -
For the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as restated)	39
Consolidated Statements of Stockholders' Equity -
For the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as restated)	40
Consolidated Statements of Cash Flows -
For the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as restated)	41
Notes to the Consolidated Financial Statements	42

36

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Nestor, Inc.

Providence, Rhode Island

We have audited the accompanying consolidated balance sheets of Nestor, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2005. Our audit also included the financial statement schedule for the year ended December 31, 2005 listed in the index at Item 15(a)(2). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.

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

As discussed in Note 3 to the consolidated financial statements, the Company restated its 2004 and 2003 consolidated financial statements.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nestor, Inc. as of December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming that Nestor, Inc. will continue as a going concern. As disclosed in the consolidated financial statements, Nestor, Inc. has an accumulated deficit at December 31, 2005 and has suffered substantial net losses in recent years, which raise substantial doubt about Nestor, Inc.’s ability to continue as a going concern. Management's plans in regard to these matters are disclosed in Note 1. The financial statements do not include any adjustments that might result from theoutcome of this uncertainty.

/s/ Carlin, Charron, & Rosen, LLP.

Westborough, Massachusetts

April 12, 2006

37

NESTOR, INC.

Consolidated Balance Sheets

IN THOUSANDS, EXCEPT SHARE AND PER SHARE INFORMATION

	DECEMBER 31, 2005			DECEMBER 31, 2004
				(As Restated)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	1,224		$	5,850
Marketable securities		56			572
Accounts receivable, net		1,949			763
Unbilled contract revenue		---			111
Inventory, net		1,671			1,032
Other current assets		391			308
Total current assets		5,291			8,636
NONCURRENT ASSETS:
Capitalized system costs, net		5,379			3,749
Property and equipment, net		925			357
Goodwill		5,581			5,581
Patent development costs, net		146			162
Other long term assets		1,893			362
TOTAL ASSETS	$	19,215		$	18,847
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current portion of notes payable	$	4,136		$	---
Accounts payable		1,071			620
Accrued liabilities		1,470			644
Accrued employee compensation		478			461
Deferred revenue		103			92
Leases payable		1			23
Asset retirement obligation		129			11
Total current liabilities		7,388			1,851
NONCURRENT LIABILITIES:
Long term convertible notes payable		1,650			514
Long term notes payable		3,286			---
Derivative financial instruments		1,419			7,081
Long term asset retirement obligation		65			147
Long term, other		---			70
Total liabilities		13,808			9,663
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 December 31, 2005 and December 31, 2004		180			180
Common stock, $0.01 par value, authorized 30,000,000 shares; issued and outstanding: 19,127,065 shares at December 31, 2005 and 18,673,498 shares at December 31, 2004		191			187
Warrants		9			66
Additional paid-in capital		66,015			62,975
Accumulated deficit		(60,988	)		(54,224	)
Total stockholders’ equity		5,407			9,184
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	19,215		$	18,847

See Notes to the Consolidated Financial Statements.

38

NESTOR, INC.

Consolidated Statements of Operations

In Thousands, Except Share And Per Share Information

	Year Ended December 31,
	2005			2004			2003
				(As Restated)			(As Restated)
Revenues:
Lease and service fees	$	5,975		$	5,118		$	2,677
Product sales		1,758			880			---
Product royalties		36			37			29
Total revenue		7,769			6,035			2,706
Cost of sales:
Lease and service fees		4,341			3,323			1,791
Product sales		1,391			609			---
Product royalties		---			---			---
Total cost of sales		5,732			3,932			1,791
Gross profit:
Lease and service fees		1,634			1,795			886
Product sales		367			271			---
Product royalties		36			37			29
Total gross profit		2,037			2,103			915
Operating expenses:
Engineering and operations		4,050			3,465			2,578
Research and development		1,737			157			122
Selling and marketing		2,057			874			355
General and administrative		3,470			2,254			2,121
Total operating expenses		11,314			6,750			5,176
Loss from operations		(9,277	)		(4,647	)		(4,261	)
Gain on debt extinguishment, net		---			508			---
(Loss) on debt refinancing		(509	)		---			---
Other (expense) income, net		(704	)		(334	)		(629	)
Derivative instrument income (expense), net		3,726			(1,705	)		(435	)
Net loss	$	(6,764	)	$	(6,178	)	$	(5,325	)
Loss per share:
Loss per share, basic and diluted	$	(0.36	)	$	(0.34	)	$	(0.41	)
Shares used in computing loss per share:
Basic and diluted		18,826,966			18,223,609			12,964,498

See Notes to the Consolidated Financial Statements.

39

NESTOR, INC.

Consolidated Statements of Stockholders’ Equity

For the Years Ended December 31, 2005, 2004 and 2003

In Thousands, Except Share And Per Share Information

	Preferred Stock						Common Stock
	Shares			Amount			Shares		Amount		Warrants			Additional Paid-in Capital			Stock Pending Issuance			Accumulated Deficit			Total
Balance at December 31, 2002		235,000		$	235			5,024,111	$	50	$	1,073		$	45,228		$	---		$	(42,721	)	$	3,865
Issuance of Common Stock		---			---			8,968,627		90		---			3,998			---			---			4,088
Conversion of Preferred Stock to Common Stock		(45,000	)		(45	)		4,500		---		---			45			---			---			---
Stock issuance outstanding		---			---			---		---		---			---			6,336			---			6,336
Issuance of warrants		---			---			---		---		---			158			---			---			158
Accretion value of warrants		---			---			---		---		106			---			---			---			106
Variable warrants		---			---			---		---		198			(198	)		---			---			---
Loss for the year ended December 31, 2003		---			---			---		---		---			---			---			(5,325	)		(5,325	)
Balance at December 31, 2003 - Restated		190,000		$	190			13,997,238	$	140	$	1,377		$	49,231		$	6,336		$	(48,046	)	$	9,228
Issuance of Common Stock		---			---			3,519,384		35		---			9,721			(6,336	)		---			3,420
Conversion of notes payable		---			---			865,761		9		---			2,605			---			---			2,614
Exercise of cashless warrants		---			---			262,115		3		---			(3	)		---			---			---
Exercise of incentive stock options		---			---			28,000		---		---			38			---			---			38
Conversion of Preferred Stock to Common Stock		(10,000	)		(10	)		1,000		---		---			10			---			---			---
Accretion value of warrants		---			---			---		---		62			---			---			---			62
Expired warrants		---			---			---		---		(1,225	)		1,225			---			---			---
Variable warrants		---			---			---		---		(148	)		148			---			---			---
Loss for the year ended December 31, 2004		---			---			---		---		---			---			---			(6,178	)		(6,178	)
Balance at December 31, 2004 - Restated		180,000		$	180			18,673,498	$	187	$	66		$	62,975		$	---		$	(54,224	)	$	9,184
Issuance of Common Stock		---			---			203,774		2		---			1,078			---			---			1,080
Conversion of notes payable		---			---			137,456		1		---			799			---			---			800
Exercise of incentive stock options		---			---			100,844		1		---			226			---			---			227
Exercise of warrants		---			---			11,493		---		---			5			---			---			5
Variable warrants		---			---			---		---		(57	)		57			---			---			---
Issuance of Warrants		---			---			---		---		---			705			---			---			705
Issuance of Laurus Note beneficial conversion features		---			---			---		---		---			38			---			---			38
Issuance of Stock Options for sales commissions		---			---			---		---		---			132			---			---			132
Loss for the year ended December 31, 2005		---			---			---		---		---			---			---			(6,764	)		(6,764	)
Balance at December 31, 2005		180,000		$	180			19,127,065	$	191	$	9		$	66,015		$	---		$	(60,988	)	$	5,407

See Notes to the Consolidated Financial Statements.

40

NESTOR, INC.

Consolidated Statements of Cash Flows

In Thousands, Except Share And Per Share Information

	YEARS ENDED DECEMBER 31,
	2005			2004			2003
				(AS RESTATED)			(AS RESTATED)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(6,764	)	$	(6,178	)	$	(5,325	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization		2,398			2,037			1,012
Derivative instrument expense, net		(3,726	)		1,705			435
Loss on disposal of fixed assets		---			5			5
(Gain) on extinguishment of debt, net		---			(508	)		---
Loss on debt refinancing		509			---			---
Unrealized loss on marketable securities		14			10			---
Realized loss on marketable securities		---			96			---
Dividends reinvested		(89	)		(35	)		---
Expenses charged to operations relating to options, warrants and capital transactions		367			62			265
Provision for doubtful accounts		80			34			84
Provision for inventory reserves		317			50			---
Increase (decrease) in cash arising from changes in assets and liabilities:
Accounts receivable, net		(1,258	)		(276	)		(465	)
Unbilled contract revenue		111			48			(36	)
Inventory, net		(752	)		(650	)		(178	)
Other assets		(276	)		(496	)		82
Accounts payable and accrued expenses		1,329			163			(137	)
Deferred income		(42	)		125			20
Restructuring reserve		---			(147	)		(219	)
Net cash used for operating activities		(7,782	)		(3,955	)		(4,457	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in marketable securities		---			(1,500	)		---
Liquidation of marketable securities		591			857			---
Purchase of Transol assets		(1,760	)		---			---
Investment in capitalized systems		(3,562	)		(1,829	)		(2,341	)
Purchase of property and equipment		(799	)		(232	)		(86	)
Investment in patent development costs		(7	)		(7	)		(31	)
Net cash used for investing activities		(5,537	)		(2,711	)		(2,458	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of obligations under capital leases		(39	)		(2,260	)		(293	)
Proceeds from notes payable		14,500			6,098			4,000
Repayment of note payable		(6,000	)		(195	)		---
Proceeds from issuance of common stock, net		232			3,463			4,002
Proceeds from stock pending issuance		---			---			4,307
Net cash provided by financing activities		8,693			7,106			12,016
Net change in cash and cash equivalents		(4,626	)		440			5,101
Cash and cash equivalents - beginning of year		5,850			5,410			309
Cash and cash equivalents - end of year	$	1,224		$	5,850		$	5,410
SUPPLEMENTAL CASH FLOWS INFORMATION:
Interest paid	$	846		$	93		$	362
Income taxes paid	$	---		$	---		$	---

Significant non-cash transactions are further described in Notes 7, 8, and 11.

See Notes to the Consolidated Financial Statements.

41

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 1 - NATURE OF OPERATIONS

A. Organization

Nestor, Inc. was organized on March 21, 1983 in Delaware to acquire and develop certain patent rights and know-how, which we acquired from our predecessor, Nestor Associates, a limited partnership. Our wholly-owned operating subsidiary, Nestor Traffic Systems, Inc. (“NTS”) was formed on January 1, 1997. CrossingGuard, Inc., a wholly owned subsidiary of NTS, was formed July 18, 2003 in connection with a financing. The consolidated financials statements include the accounts of Nestor, Inc. and our wholly-owned subsidiary. All intercompany transactions and balances have been eliminated. Our principal office is located in Providence, RI.

We are a provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States. We provide a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. Our principal product, CrossingGuard, incorporates our patented image processing technology into a solution that predicts and records the occurrence of a red light violation. Our speed enforcement product, Poliscan^speed, or Poliscan, utilizes technology developed by Vitronic GmbH. We have exclusive distribution rights to market in North America. By coupling CrossingGuard or Poliscan equipment with our Citation Composer citation preparation and processing software, we are able to provide fully integrated speed enforcement solutions to municipalities. 

B. Liquidity and management’s plans

The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. We have incurred significant losses since inception, have a working capital deficit of $2,097 at December 31, 2005, and have an accumulated deficit of $60,988 through December 31, 2005. These circumstances raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary in the event we cannot continue in existence.

Although the Company raised $4,847, net of expenses in a private stock placement in January 2006, $1,250 of which was used to pay down debt. Management believes that given its liquidity at December 31, 2005, its current levels of cash being used by operations, and capital requirements necessary to deliver on current contracts with municipalities, we will be required to raise additional capital in the near term. Even if we obtain the capital desired, there can be no assurance that our operations will be profitable in the future, that our product development and marketing efforts will be successful, or that the additional capital will be available on terms acceptable to us, if at all.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

A. Cash equivalents

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

B. Marketable securities

The Company’s marketable securities consist of investments in closed-end insured municipal bond funds. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other income (expense).

42

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

C. Accounts receivable

Accounts receivable represents balances due from customers, net of $164 and $84 reserve for doubtful accounts at December 31, 2005 and 2004. In determining the need for an allowance, objective evidence that a single receivable is uncollectible as well as a historical pattern of collections of accounts receivable that indicate that the entire face amount of a portfolio of accounts receivable may not be collected is considered at each balance sheet date.

D. Unbilled contract revenue

Unbilled contract revenue represented revenue earned by the Company in advance of being billable under customer contract terms. Under the terms of some current contracts, the Company cannot bill the municipality until the court has collected the citation fine. Management recorded unbilled contract revenue in these situations at a net amount, based upon a historical pattern of collections by the courts for the municipalities. In 2005, The Company discontinued this practice and records revenue when the citation has been paid.

E. Inventory

Inventory is valued at the lower of cost or market, with cost determined by the first-in, first-out basis and consists mostly of equipment to be installed as capitalized system costs. The December 31, 2005 and 2004 inventory balances are presented net of a $540 and $50, respectively, inventory reserve.

F. Property and equipment & depreciation and amortization

Property and equipment are recorded at cost. Depreciation and amortization are calculated using the straight-line method at rates sufficient to write off the cost of the assets over their estimated useful lives.

G. 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.

H. Product and patent development costs

The costs of development of the Company’s software - which consist primarily of labor and outside consulting, and are an inherent cost of the Company’s business - and costs of research and development are expensed until technological feasibility has been established for the product. Thereafter, all software production costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized on a straight-line basis over the estimated economic life of the product. The Company currently has no costs eligible for capitalization under the American Institute of Certified Public Accountants Statement of Position 98-1.

Patent-development costs are expensed or capitalized, as appropriate. Amortization of capitalized costs is on a straight-line basis over the shorter of the estimated economic life, or statutory life, of the patent.

I. 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.

43

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

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

a) 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;

b) 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

c) 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.

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.

J. Shipping and handling costs

Shipping and handling costs are capitalized if a material part of a leased system or included in engineering and operations.

K. Research and development

Research and development costs associated with NTS products consist principally of payroll and related costs, facilities costs and the cost of prototype components.

L. Income taxes

The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and the tax bases of assets and liabilities, and are measured using enacted tax rates and tax laws that will be in effect when the differences are expected to reverse. The primary component of the deferred tax asset, which is fully reserved, is net operating loss carry forwards.

Although the Company reports consolidated results and balances for financial reporting purposes, the individual companies file separate tax returns. Due to operating losses throughout the reporting periods, no provision for income tax has been made.

44

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

M. Earnings (loss) per share and common stock

The Company reports its earnings (loss) per share (“EPS”) in accordance with the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic EPS is calculated by dividing the net income (loss) by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted EPS is computed giving effect to common stock equivalents and other dilutive securities, unless the computation results in anti-dilution. Diluted per share computations are not presented since the effect would be anti-dilutive.

N. Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

O. Concentrations of credit risk

The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, marketable equity securities and trade accounts receivable. The Company places its cash and temporary cash investments with high credit quality 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. The Company’s marketable equity securities (primarily cash reserves and an insured municipal bond fund) are exposed to market risk due to changes in U.S. interest rates and fluctuations in foreign currency exchange rates. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other income (expense). The Company routinely assesses the financial strength of its customers, most of which are municipalities, and, as a result, believes that its trade accounts receivable credit risk exposure is limited. The Company does not require collateral from its customers.

Two customers accounted for 51% and 40% of the Company’s total revenues in fiscal 2005 and 2004. Three customers accounted for 42% of the Company’s total revenues during fiscal 2003.

P. Stock option plans

The Company accounts for stock option awards granted to officers, directors and employees (collectively “employees”) under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, no stock-based employee compensation cost is reflected in net income, as all options granted to employees under these plans have been granted at no less than fair market value on the date of grant. The Company applies the disclosure only provision of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for Stock-based Compensation-Transition and Disclosure (“SFAS 148”) for such employee stock option awards. The Company accounts for stock option awards granted to consultants under the fair value recognition provisions of SFAS 123. Under this method, options are valued using the Black-Scholes option pricing model, and the calculated option value is recorded as an expense in the financial statements.

For purposes of providing pro forma disclosures for employee grants, the fair value for options was estimated at the date of grant using the Black-Scholes pricing model with the following weighted average assumptions:

	2005			2004			2003
Expected life (years)		8			8			8
Average risk-free interest rate		3.2 to 4.2	%		1.6 to 6.8	%		1.6 to 6.8	%
Volatility		107.7	%		113.2	%		117.4	%
Dividend yield		0	%		0	%		0	%

The weighted-average fair value of options granted during 2005, 2004 and 2003 was $4.98, $4.17, and $2.55, respectively. The Company recognizes forfeitures as they occur.

45

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

Had the Company determined compensation expense for the Plan in accordance with the fair value methodology prescribed by SFAS 123, the Company’s pro forma net loss and loss per share would have been:

	Years Ended December 31,
	2005			2004			2003
Net loss - reported	$	(6,764	)	$	(6,178	)	$	(5,325	)
Add (Deduct): total stock-based compensation expense determined under fair-value based method for all awards,net of related tax effects	$	(2,754	)	$	(4,913	)	$	150
Pro Forma - net loss	$	(9,518	)	$	(11,091	)	$	(5,175	)
Pro forma net loss per share -basic and diluted	$	(0.51	)	$	(0.61	)	$	(0.40	)

For the purposes of this disclosure, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The effects on pro forma disclosures of applying SFAS 123 may not be representative of the effects on pro forma disclosures of future years.

Q. Asset retirement obligations

The Company’s fixed red light and speed enforcement systems are installed at traffic intersections under three to five year customer contracts. At the end of many contracts, the Company is required to remove all aboveground structures and restore the site. As required by SFAS No. 143, the Company records an obligation for the cost to remove its systems, and remediate the site, if contractually required.

Upon installation, a liability for the asset retirement obligation is initially recorded at its present value . Over time, the liability is accreted to its present value each period. Upon settlement of the liability, a gain or loss is recorded. A reconciliation of the net carrying value of the asset retirement obligations (ARO) is as follows:

	December 31,
	2005		2004
Balance at beginning of year	$	158	$	0
ARO incurred		21		158
Accretion expense		15		0
ARO settled		---		---
Revisions to ARO estimates		---		---
Balance at the end of year	$	194	$	158

R. Deferred Rent

The Company accounts for escalating rental payments on a straight-line basis over the term of the lease.

S. Derivative Instruments

In connection with the sale of debt or equity instruments, the Comapany 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.

46

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The identification of, and accounting for, derivative instruments is complex. Derivative instrument liabilities are re-valued at the end of each reporting period, with changes in fair value of the derivative liability 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 instrument liabilities, 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.

T. Reclassification

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

NOTE 3 - RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS:

The Company is restating its Consolidated Financial Statements for fiscal 2003 and 2004 as well as the first three interim periods of fiscal 2005 in order to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities. The following provides a more detailed discussion of the restatement along with a comparison of the amounts previously reported in the Consolidated Balance Sheet for December 31, 2004, and Statements of Operations in the Company’s Annual Report on Form 10-K for fiscal 2004 and 2003.

The Company’s Annual Reports on Form 10-K and the Quarterly Reports on Form 10-Q for fiscal 2003 through the third quarter of fiscal 2005 have not been revised to reflect the Restatement, and the financial statements contained in those reports should not be relied upon. Instead, the financial statements for fiscal 2004 and 2003 included in this Annual Report on Form 10-K should be relied upon.

As previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 5, 2005, the Company has been in extensive discussions with the Staff of the Securities and Exchange Commission concerning the proper accounting treatment regarding certain of its convertible debt in current and previously reported financial results. However, as a result of these discussions, the Company’s 2005 quarterly and 2004 and 2003 fiscal year financial statements are restated to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities.

More specifically, the Securities and Exchange Commission ("SEC") raised questions with regard to our convertible term notes suggesting that we consider EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" to evaluate whether there were any embedded derivative instruments and if so, whether they should be accounted for as an equity or liability classification.

As a result, the Company reviewed its initial accounting for its (1) First Laurus Convertible Note dated July 31, 2003, (2) Second Laurus Convertible Note dated January 14, 2004, (3) Third Laurus Convertible Note dated May 16, 2005, and (4) Senior Convertible Notes dated November 5, 2004 (See Notes 7 and 8). During the review, the Company identified that EITF 00-19 should be applied to evaluate whether any embedded derivative instruments qualify as equity instruments or as liabilities. As a result, certain embedded derivatives were identified that met the conditions set forth under paragraph 12 of SFAS No. 133. These embedded derivative instruments have been evaluated using EITF 00-19 paragraphs 12 to 32 and determined that these instruments would not be classified as components of stockholders equity. The instruments have been deemed liabilities, and as such, will be subject to SFAS 133 and should be recorded at fair value.

47

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

Features within the debt noted above that have been evaluated and determined to require such treatment include:

· The principal conversion options.

· The monthly payments conversion options.

· The interest rate adjustment provisions.

Management believes the scope and process of its internal review of previously reported financial information was sufficient to identify issues of a material nature that could affect our Consolidated Financial Statements and all dates and periods presented herein have been restated to fairly present the results of our operations.

For the quarterly impact of the restatement see Note 21.

The foregoing restatement adjustments did not affect the Company’s reported cash and cash equivalents balance during these reported periods.

	Net Loss
	Year Ended December 31,
	2004			2003
As previously reported	$	(4,473	)	$	(4,890	)
Restatement adjustments, net:
Derivative instrument expense	$	(1,705	)	$	(435	)
As restated	$	(6,178	)	$	(5,325	)

Impact of the Financial Statement Adjustments on the Consolidated Statements of Operations

The following table presents the impact of the financial statement adjustments on the Company’s previously reported consolidated statements of operations for the fiscal years ended December 31, 2004 and 2003:

	Year Ended December 31,
	2004			2004			2003			2003
	(As reported)			(As restated)			(As reported)			(As restated)
Loss from operations	$	(4,647	)	$	(4,647	)	$	(4,261	)	$	(4,261	)
Gain on debt extinguishment, net		508			508			---			---
(Loss) on debt refinancing		---			---			---			---
Other (expense) income, net		(334	)		(334	)		(629	)		(629	)
Derivative instrument expense		---			(1,705	)		---			(435	)
Net Loss	$	(4,473	)	$	(6,178	)	$	(4,890	)	$	(5,325	)
Basic and diluted net loss per share:	$	(0.25	)	$	(0.34	)	$	(0.38	)	$	(0.41	)
Shares used in computing basic and diluted net loss per share		18,223,609			18,223,609			12,964,498			12,964,498

48

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

Impact of the Financial Statement Adjustments on the Consolidated Balance Sheets

The following is a summary of the impact of the adjustments on the Company’s previously reported consolidated balance sheet as of December 31, 2004.

	December 31, 2004
	(As reported)			(As restated)
TOTAL ASSETS	$	18,847		$	18,847
LIABILITIES AND STOCKHOLDERS’ EQUITY
Total current liabilities	$	1,851		$	1,851
Noncurrent liabilities:
Long term convertible notes payable		6,000			514
Derivative financial instruments		---			7,081
Long term asset retirement obligation		147			147
Long term, other		70			70
Total liabilities		8,068			9,663
Stockholders’ Equity
Preferred stock		180			180
Common stock		187			187
Warrants		66			66
Additional paid-in capital		62,430			62,975
Accumulated deficit		(52,084	)		(54,224	)
Total stockholders’ equity		10,779			9,184
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	18,847		$	18,847

NOTE 4 - CAPITALIZED SYSTEM COSTS:

Equipment, installation, and in some cases interest costs related to operating lease contracts are capitalized and, after acceptance by the municipality (customer), are depreciated over the term of the contract, generally either three or five years, less an applicable residual value. There was no interest capitalized in fiscal years 2005 and 2004. Revenues realized from these agreements, generally in the form of per-citation or monthly fees, are expected to be adequate to cover the capitalized and future costs related to these agreements. Many leases contain minimum payment requirements, which currently aggregate to $4,402 in 2006, $3,815 in 2007, $2,469 in 2008 and $662 in 2009, and $371 in 2010. Management expects that these annual amounts could increase and extend to future years, as additional intersections are installed.

	December 31, 2004
	2005			2004
Equipment under operating leases:
Work-in-process	$	1,019		$	43
Installed and accepted		9,255			6,551
		10,274			6,594
Less: Accumulated depreciation		(4,895	)		(2,845	)
Net investment in leased equipment	$	5,379		$	3,749

49

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 5 - PROPERTY AND EQUIPMENT - NET:

			December 31, 2004
	Depreciable Life		2005			2004
Office furniture and equipment		3 years	$	460		$	147
Computer equipment and software		1-5 years		2,157			1,961
Demonstration equipment		3 years		81			---
Leasehold improvements		5 years		549			246
				3,247			2,354
Less: Accumulated depreciation				(2,322	)		(1,997	)
			$	925		$	357

Depreciation and amortization expense of $325 and $273 on the above assets was recorded for the years ended December 31, 2005 and 2004, respectively.

In 2005, the Company disposed of no equipment. In 2004, the Company disposed of $16 of computer equipment and $8 of demonstration equipment. The loss on disposal of fixed assets for 2004 is included in other expense-net.

NOTE 6 - GOODWILL AND OTHER INTANGIBLE ASSETS, NET:

Under SFAS 142, the Company tests goodwill for impairment on an annual basis, or whenever indicators of impairment are identified. Management considers the Company’s quoted stock price to be the best indicator of fair value for purposes of performing these analyses.

Other intangible assets were comprised of the following as of December 31, 2005:

Identified Intangible Asset	Useful Life In Years		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Patents		7	$	203	$	(57	)	$	146
Customer contracts and related customer relationships (included in Other Assets)		1-5		1,337		(112	)		1,225
Total			$	1,540	$	(169	)	$	1,371

For fiscal 2005, amortization expense related to identified intangible assets was $135, of which $112 was included cost of sales and $23 was included in operating expenses.

The following is the estimated future amortization expense related to other intangible assets as of December 31:

Fiscal Year	Estimated Amortization Expense
2006	$	345
2007		319
2008		317
2009		293
2010		52
Thereafter		45
Total	$	1,371

50

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 7 - NOTES PAYABLE:

The Company considers its long term convertible notes payable, long term notes payable, and derivative financial instruments, which are described in Footnotes 7 and 8, to be its long-term financial obligations.

Long-term financial obligations consisted of the following as of December 31.

	2005			2004
				Restated
Senior Convertible Notes		5,200			6,000
Discount		(3,550	)		(5,486	)
FMV of embedded derivatives		1,419			7,081
Foundation Partners Secured Promissory Note		1,250			---
Heil Secured Promissory Note		1,250			---
Fourth Laurus Note		6,000			---
Discount		(1,078	)		---
		10,491			7,595
Less current portion		4,136			---
Total		6,355			7,595

Aggregate maturities of long-term obligations for the years following December 31, 2005 are as follows:

	2006		2007		2008		Total
Fourth Laurus Note		1,636		2,182		2,182		6,000
Senior Convertible Notes		---		5,200		---		5,200
Foundation Partners Secured Promissory Note		1,250		---		---		1,250
Heil Secured Promissory Note		1,250		---		---		1,250
Total:		4,136		7,382		2,182		13,700

First Laurus Convertible Note:

On July 31, 2003, the Company entered into a Securities Purchase Agreement ("the Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, the Company issued to Laurus a Secured Convertible Note ("Note") in the principal amount of $2,000 that bore interest at the prime rate plus 1.25% (subject to a floor of 5.25%) and maturing on July 31, 2005. The principal amount of the Note was repayable at rates commencing in December 2003 of $20 per month and gradually increasing to $140 per month in April 2005 through the end of the Note. Such amounts may be paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares are registered under the Securities Act of 1933 and no default under the Note exists, or (iii) in a combination of the above. If paid in common stock, the number of shares issued shall equal the total amount due, divided by $1.55. If the average closing price of the common stock for the ten consecutive days prior to a repayment date is equal to or greater than $1.86, we may require the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricts our ability to make repayment in our common stock at the fixed conversion price, if the then current market price is below 120% of the fixed conversion price (or $1.86). The Note may be redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note may require us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued shall equal the total amount to be converted, divided by $1.55. The conversion price of the secured convertible notes may be adjusted if we pay a stock dividend, or subdivide or combine outstanding shares of common stock into a greater or lesser number of shares.

51

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The note was collateralized by a first lien on all available CrossingGuard, Inc. assets. Laurus had a general security interest in four customer contracts assigned by NTS to CrossingGuard, Inc. and NTS had pledged the common stock of CrossingGuard, Inc. In connection with financing, Laurus was paid a fee of $80, had certain of its expenses reimbursed and received a warrant to purchase 140,000 shares of the Company's common stock. The warrant exercise price was as follows: $1.78 per share for the purchase of up to 83,000 shares; $1.94 per share for the purchase of an additional 33,000 shares; and $2.25 per share for the purchase of an additional 24,000 shares. These warrants were exercised on a cashless basis during the quarter-ended September 30, 2004, resulting in the Company issuing 76,466 shares of its common stock at a conversion price of $4.18 per share.

Also in connection with financing, Management Services Group/Sage Investments, Inc. (“Sage”) was paid a fee of $80 and received $4 per month for nine months for continuing consultation. Sage received warrants to purchase 14,000 shares of Company stock as follows: $1.78 per share for the purchase of up to 8,300 shares; $1.94 per share for the purchase of an additional 3,300 shares; and $2.25 per share for the purchase of an additional 2,400 shares. During the period June through August 2004, Sage exercised 11,720 of these warrants on a cashless basis, resulting in the Company issuing 5,953 shares of stock at conversion prices of $3.54 to $4.46 per share. The warrant expiration date is July 31, 2008.

The Black-Scholes values of the warrants issued in connection with this financing totaled $144 (Laurus) and $14 (Sage) and were recorded as additional paid-in capital. The Laurus warrant value was recorded as a discount on the note payable. During the quarter ended September 30, 2003, the Company amortized $12 of the discount as interest expense. As the Note was satisfied on January 14, 2004, the remaining unamortized discount of $114, deferred interest of $55 and deferred financing fees of $131 had negligible continuing value and were consequently written off to interest expense (discount and deferred interest) and financing fees, respectively, at December 31, 2003.

During November and December 2003, Laurus converted $85 of the Note into 55,000 shares of Nestor common stock at $1.55 per share. On January 14, 2004, the Company satisfied its remaining payment obligations on the Note by issuing 492,904 shares of its common stock to Laurus at the fixed conversion price of $1.55 per share and redeeming the remaining $1,151 note balance by a “payment” of $1,341, which included accrued interest and a $173 prepayment penalty. This “payment” was netted against the proceeds from the Second Laurus Convertible Note (see below), resulting in $98 net cash proceeds to the Company.

Second Laurus Convertible Note:

On January 14, 2004, the Company entered into a second securities purchase agreement with Laurus. Pursuant to that agreement, the Company issued to Laurus a new secured convertible note in the principal amount of $1,500 that bore interest at the prime rate plus 1.25% (subject to a floor of 5.25% per year) and matured on January 14, 2006. The principal amount of the Note was repayable at rates commencing in May 2004 of $15 per month and gradually increasing to $105 per month in September 2006 through the end of the Note term. Such amounts may be paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares are registered under the Securities Act of 1933 and no default under the Note exists, or (iii) in a combination of the above. If paid in common stock, the number of shares issued shall equal the total amount due, divided by $3.50. If the average closing price of the common stock for the ten consecutive days prior to a repayment date is equal to or greater than $4.20, we may require the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricts our ability to make repayment in our common stock at the fixed conversion price, if the then current market price is below 120% of the fixed conversion price (or $4.20). The Note may be redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note may require us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued shall equal the total amount to be converted, divided by $3.50. The conversion price of the secured convertible notes may be adjusted if we pay a stock dividend, or subdivide or combine outstanding shares of common stock into a greater or lesser number of shares. In conjunction with this transaction, Sage received a fee of $60 and an affiliate of Laurus received a management fee of $45 and reimbursement of certain expenses. The first lien, security interest and pledge of CrossingGuard, Inc. stock from the first Laurus Note continued to this second note.

52

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

During September 2004, Laurus converted $60 due on this note into 17,143 shares of Nestor common stock at $3.50 per share. Laurus subsequently converted their remaining $1,245 note balance into 355,714 shares of Nestor common stock during the period October to November 3, 2004.

Third Laurus Convertible Note:

On May 16, 2005, we entered into a Securities Purchase Agreement ("the Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, we issued to Laurus a convertible Note ("the Note") in the principal amount of $6,000 (which was fully paid on December 28, 2005). The Note was convertible into our common stock at the option of Laurus at a fixed conversion price of $5.82 per share. The Note beared interest at the coupon rate of the prime rate plus 4.00% and was subject to a floor interest rate of 6.00%. The Agreement provided for a reduction in the interest rate to the prime rate plus 2.00% in months during which the price of our common stock exceeded the fixed conversion price of $5.82 for five consecutive trading days, and additional reductions of 2.00% for every 25% increase in the price of our common stock above the fixed conversion price of $5.82 (an increase of $1.46), subject to a minimum coupon rate of 0.00%. The Note originally matured on May 16, 2008. The principal amount of the Note was repayable at rates commencing in September 2005 of $181 per month through the end of the Note term in December 2006. Such amounts could have been paid (at the company’s option) (i) in cash with a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common stock, assuming the shares were registered under the Securities Act of 1933 and no default under the Note existed, or (iii) in a combination of the above. If paid in common stock, the number of shares issued should have equalled the total amount due, divided by $5.82. If the average closing price of the common stock for the ten consecutive days prior to a repayment date was equal to or greater than $5.82, we could have required the holder to convert into common stock an amount of principal, accrued interest and fees due under the Note equal to a maximum of 25% of the aggregate dollar trading volume of the common stock for the 20 consecutive trading days prior to a notice of conversion. The Note restricted our ability to make repayment in our common stock at the fixed conversion price, if the then current market price was below 120% of the fixed conversion price (or $6.98). The Note could have been redeemed at any time by us in cash by paying the holder 115% of the principal amount, plus accrued interest. The holder of the Note could have required us to convert all or a portion of the Note, together with interest and fees thereon, at any time. The number of shares to be issued should have equalled the total amount to be converted, divided by $5.82. The conversion price of the secured convertible notes could have been adjusted if we payed a stock dividend, or subdivided, or combined outstanding shares of common stock into a greater or lesser number of shares.

The net proceeds from the Note could only be used for the design, engineering, construction, installation and maintenance of certain of our traffic enforcement systems. 

We filed a registration statement for the shares of common stock into which the Note may be converted and for the shares underlying the warrant issued as part of the Agreement (see below). The Agreement requires that the registration statement be declared effective by September 16, 2005. We were obligated to pay Laurus damages because the registration statement was not declared effective by its due date. Under the Agreement, Laurus was entitled to liquidated damages in an amount equal to 1% of the outstanding principal amount for each 30 consecutive days after September 16, 2005 during which the Registration Statement is not effective, prorated daily.  The Agreement and related registration rights obligation was satisfied on December 28, 2005 as described below and any registration rights liquidated damages were waived.

53

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The Note was collateralized by a security interest in the proceeds of our existing CrossingGuard contracts except for our Delaware contract.

In connection with the financing, Laurus was paid a fee of $234 and had approximately $47 of its expenses reimbursed. Laurus received five year warrants to purchase 100,000 shares of our common stock. The exercise prices of the warrants are as follows: $6.69 per share for the purchase of up to 60,000 shares; $7.28 per share for the purchase of an additional 23,000 shares; and $8.43 per share for the purchase of an additional 17,000 shares. The warrants expire on May 16, 2010.

The Black-Scholes value of the warrants issued in connection with this financing totaled approximately $419 and is recorded as additional paid-in capital and a corresponding discount (reduction) to the note payable. The warrant’s entire discount was written off to interest expense in 2005 due to the underlying note being refinanced on December 28, 2005.

After taking into consideration the value of the warrants, we ascribed $38 as a beneficial conversion value and recorded the amount as additional paid-in capital and a corresponding discount to the note payable. This beneficial conversion feature was written off to interest expense in 2005 due to the underlying note being refinanced on December 28, 2005.

Fourth Laurus Note:

On December 28, 2005, Laurus issued a new non-convertible note to the Company in the face amount of $6,000. The note was used to retire the unamortized portion of the May 2005 Laurus convertible note discussed above (having a remaining principal balance of $5,273 on December 28, 2005), plus unpaid interest on the closing date. The Company received a net cash balance of $603 on the closing. In consideration of repaying the note and eliminating conversion rights, prepayment penalty rights, registration rights, and other rights under the third Laurus convertible note, the Company issued 203,774 shares of common stock to Laurus with a market value of $1,078 at the date of close, and recorded the transaction as a discount to the non-convertible note and a credit to Additional Paid in Capital. The principal amount of the Note is repayable at rates commencing in April 2006 of $181 per month through the end of the Note term in December 2008. The Note bears interest at the coupon rate of the prime rate plus 2.00% and is subject to a floor interest rate of 7.00%. The Note contains certain non-financial operating covenants.

The Company also entered into a registration rights agreement covering the common stock issued to Laurus with this non-convertible note, and the Warrants from the May 2005 Laurus Note. The agreement requires the Company to use its best efforts to file for registration of the shares within 120 days after closing of the transaction, and obtaining an effective registration within 180 days. No specific damages are provided for in the agreement in the event a registration statement is not filed or effective within the proposed time periods.

Heil Secured Promissory Note:

On October 26, 2005, we gave a secured promissory note to Edward F. Heil in the principal amount of $1,250 with a maturity date of October 25, 2006. The note bears interest at the rate of one percent (1.00%) per month until the note is paid in full. The due date of the principal and all accrued interest can be accelerated if we default on the note. The note can be prepaid in full or in part on the last calendar day of any month during the term. The note is secured by ten mobile speed enforcement units including all associated speed detection systems and all rights to operate said systems. If Mr. Heil forecloses on the units, we will provide citation processing services for Mr. Heil with respect to violation data generated by the units at commercially reasonable prices and Mr. Heil will have all rights and licenses necessary to so operate the units for their intended uses. If we are unable to provide Mr. Heil with citation processing services, then Mr. Heil may obtain such services from any person or entity, including our competitors. In connection with the loan that the secured promissory note evidences, we paid an origination fee of $25, and we agreed to pay Mr. Heil’s legal fees, related to the loan. We will amortize the origination fee and any legal fees over the 12 month note term.

54

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The Heil Secured Promissory Note was paid in full in January 2006 from the proceeds of the private placement of the company’s common stock. Mr. Heil invested $1,250 in the equity transaction.

Foundation Partners Secured Promissory Note:

On August 30, 2005 we gave a secured promissory note to Foundation Partners I, LLC in the principal amount of $1,250 with a maturity date of August 29, 2006. The note bears interest at the rate of 10% per year. Interest is payable monthly and the principal is payable in full on the maturity date. The due date of the principal and all accrued interest can be accelerated if we default on the note. The note can be prepaid in full or in part on the last calendar day of any month during the term. The note is secured by ten mobile speed enforcement units including all associated speed detection systems and all rights to operate said systems. If Foundation Partners forecloses on the units, we will provide citation processing services for Foundation Partners with respect to violation data generated by the units at commercially reasonable prices and Foundation Partners will have all rights and licenses necessary to so operate the units for their intended uses. If we are unable to provide Foundation Partners with citation processing services, then Foundation Partners may obtain such services from any person or entity, including our competitors, and Foundation Partners will have all rights and licenses necessary to so operate the units for their intended uses. The managing member of Foundation Partners is Danzell Investment Management, Ltd. William B. Danzell is the President and sole stockholder of Danzell Investment Management, Ltd. and the Chief Executive Officer, President, and a director of Nestor. In connection with the loan that the secured promissory note evidences, we paid an origination fee of $25, of which $13 was paid to Foundation Partners and $13 was paid to Danzell Investment Management, Ltd. We are amortizing the origination fee over the 12 month term of the note.

Silver Star Convertible Note:

On October 15, 2003, the Company sold a $2,000 convertible note (“Silver Star Note") to Silver Star Partners I, LLC ("Silver Star"). The Silver Star Note was due on January 15, 2004 and bore interest at the rate of 7% per year. On December 31, 2003, the Company exercised its option to satisfy the Silver Star note and accrued interest by issuing 676,384 shares of Nestor common stock at $3.00 per share. See Common and Preferred Stock footnote also.

Silver Star had the right to require the Company to register with the SEC Silver Star's resale of all shares of common stock that it owned as soon as practicable after Silver Star requested that registration. The Company was obligated to pay all expenses associated with that registration. The Company had other obligations in connection with that registration, including causing the registration statement filed to remain continuously effective until the distribution of shares covered by the registration statement was complete and indemnifying Silver Star from liabilities it might have incurred resulting from any untrue statement or omission of a material fact in the registration statement and related documents and from other liabilities related to the registration. Danzell Investment Management, Ltd. received a 3% finders fee from the Company in connection with the Silver Star Note.

William B. Danzell is the Chief Executive Officer of Nestor, Inc., the President of Danzell Investment Management, Ltd. and the Managing Director of Silver Star Partners I, LLC. David N. Jordan and George L. Ball, directors of Nestor, are each also affiliates of Silver Star Partners I, LLC. Robert M. Krasne and Stephen H. Marbut, former directors of Nestor, are also affiliates of Silver Star Partners I, LLC. The sale of the note by Nestor to Silver Star Partners I, LLC and the satisfaction of our obligations under it by issuing common stock were approved by the directors of Nestor not affiliated with Silver Star Partners I, LLC.

NOTE 8 - PRIVATE PLACEMENT OF SENIOR CONVERTIBLE NOTES:

In November 2004, the Company completed the sale of $6,000 aggregate principal amount of its 5% Senior Convertible Notes due October 31, 2007 (the "Senior Convertible Notes") in a private placement. The Company received $5,555 of note proceeds after $445 of placement fees and related expenses. The Senior Convertible Notes are convertible into Nestor common stock at the option of the investors at $5.82 per share and accrue interest at 5% per year. The Company must make quarterly interest-only payments until the Senior Convertible Notes are either paid in full or are converted into common stock. At the option of the holders, all amounts due may be accelerated upon certain events of default, including failures to pay principal or interest when due, breach of covenants that remain uncured after notice, bankruptcy of the Company or certain similar events and defaults under other material credit arrangements. The Notes contain certain non-financial operating covenants.

55

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The Company may, at its option, redeem the Senior Convertible Notes in whole or in part, at a redemption price of 105% before November 1, 2005, 102.5% before November 1, 2006, and 101% thereafter, plus unpaid interest, upon 30 to 60 days prior written notice. The Company is obligated to offer to repurchase the Senior Convertible Notes at

the then-current redemption price in the event of a change in control of the Company or upon the occurrence certain financing events, as defined. In connection with the Senior Convertible Notes, the Company issued a warrant to a placement agent for the purchase of 60,000 shares of common stock at $5.21 per share exercisable through October 31, 2009.

The Securities and Exchange Commission declared the Registration Statement on Form S-2 (SEC File No. 333-121015) for the resale of these shares effective on January 28, 2005. Pursuant to the terms of the warrant, the Company has agreed to include the resale of the shares of the Company's common stock underlying the warrant in future registration statements upon the request of such holder.

During February 2005, two noteholders converted an aggregate $600 note face value into 103,092 shares of Nestor stock at $5.82 per share. During May 2005, one note holder converted an aggregate $200 note face value into 34,364 shares of Nestor stock at $5.82 per share. Any unamortized deferred financing costs associated with the converted notes was expensed upon conversion.

In January 2006, the Company issued additional common stock at a price of $4.20 per share. In accordance with anti-dilution rights contained in the SMH notes, the conversion price of the outstanding notes decreased from $5.82 to $4.20 on the date of the January transaction.

The senior convertible notes and the convertible notes payable in Note 7 included a variety of conversion options, variable interest rate features, events of default, and certain variable liquidated damage clauses, that may be considered embedded derivative financial instruments.

The accounting treatment of the derivatives require that the Company record the derivatives at their relative fair value as of the inception date of the agreement, and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded as derivative instrument expense at each reporting date, which is a non-operating, non-cash income or expense.

Over the life of the senior convertible notes and the convertible notes payable, the Company recorded the following type of embedded derivative financial instruments:

· Principal’s Conversion Options

· Monthly Payment Conversion Options

· Interest Rate Adjustment provisions

As of December 31, 2005 and 2004, respectively, these derivatives were valued at $1,419 and $7,081. The only embedded derivative remaining at December 31, 2005 relates to the senior convertible notes. The principal's conversion option on the senior convertible note was valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 0%, annual volatility of 56% to 211%; and risk free interest rate of 3.04% to 4.82%.

As of December 31, 2005 and 2004, the derivative as well as warrants were recorded as discounts to the Notes and are being amortized over the expected term of the debt. At December 31, 2005, the unamortized discount on the Notes was $4,628 and $5,486 for 2005 and 2004, respectively.

56

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 9 - TRANSOL ASSET PURCHASE:

On August 31, 2005, we entered into a purchase and sale agreement with Transol Holdings Pty Limited, Transol PTY Limited, Transol Corporation Limited and Alleasing Finance Australia Limited pursuant to which we purchased certain assets of Transol and its Australian and US subsidiaries related to Transol’s red light enforcement business, including assets leased by Transol USA Inc., Transol Holding’s indirect U.S. subsidiary, from Alleasing. Alleasing held a security interest in all of the assets of Transol USA and sold us the acquired assets in a foreclosure sale. Transol was one of our competitors in the automated traffic enforcement business. The transaction was closed from escrow with final adjustments on January 16, 2006.

The assets purchased, as adjusted, include:

· Contracts to provide automated red light enforcement services in six US cities at an aggregate of 39 approaches, of which 35 are fully installed and operating.

· Equipment located at the contracted approaches used for providing automated red light enforcement services.

· Transol’s intellectual property, including one U.S., one Australian and one international patent application (each related to the technology underlying their red light enforcement services, the Transol website, computer source code for Transol’s products and services and all other “technical know how,” except that relating to Transol’s automated driver’s licensing testing business).

· Inventory, work in process, accounts receivable and unbilled contract revenue related to Transol’s red light enforcement services.

· The goodwill of the Transol business, except that relating to the automated driver’s licensing testing business.

Under the agreement, the sellers were obligated to terminate the “Transol Group” trade name registration.

The purchase price we paid into escrow for the acquired assets is $2,000, subject to reduction for any liens on the assets we acquired and subject to reduction if any of the assigned contracts that are terminated before January 16, 2006 by the cities because of their assignment to us or that are terminated by January 16, 2006 pursuant to termination for convenience rights that cities may have under the contracts. The price reduction for any contracts so terminated will be $50 per installed approach and up to $20 per uninstalled approach. In addition, we would receive a price reduction of up to $20 for each unapproved approach for which we do not receive municipal authorization by January 15, 2006 to go forward and for which we did not receive a price reduction because of a contract termination. The final payment from escrow was $1,760.

We also entered into a Transition Services Agreement with Transol USA pursuant to which we were able to use their Tempe, AZ warehouse until October 31, 2005 and their Phoenix, AZ office until December 31, 2005, as well as the services of some of their employees and consultants until December 31, 2005. We paid Transol USA’s direct costs for the services that we receive under the Transition Services Agreement. As of December 31, 2005, we had converted all but one of the existing installations to our back office processing environment. We do not intend to use the Transol name following the transition period.

57

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

The combined purchase price of the acquisition was allocated on a fair value basis as follows:

Gross purchase price:	$	2,000
Adjustment for contracts not expected to be assigned:
Uninstalled approaches		12
Price adjustment per approach		(20	)
Total purchase price adjustment		(240	)
Adjusted purchase price	$	1,760
Purchase price allociation:
Accounts receivable	$	7
Inventory		204
Capitalized system costs1		118
Property and equipment1		94
Contracts (intangible other assets)1 Weighted-average amortization period of 52 months		1,337
	$	1,760

¹ These assets received a fair value allocation reduction totaling $95, due to fair value in excess of the $1,760 adjusted purchase price.

The value of contracts, net of amortization, at December 31, 2005 was $1,225 and was recorded in other assets.

NOTE 10 - LEASES PAYABLE:

On June 28, 2001, NTS executed a Master Lease Purchase Agreement with Electronic Data Systems Corporation (“EDS”), later amended on January 10, 2003, whereby EDS provided lease financing to support installation of the NTS CrossingGuard product to municipalities under leasing terms. NTS received $3,183 in advances, which were collateralized by equipment delivered under leased CrossingGuard systems. During 2003, the Company recorded $164 of EDS interest expense.

On January 26, 2004, the Company satisfied its remaining obligations to EDS by making a payment of $2,179. This transaction resulted in the Company recording a gain on early extinguishment of debt of $681 in January 2004.

58

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 11 - COMMON AND PREFERRED STOCK:

Private Placement and Silver Star Note Conversion:

The Company sold 2,843,000 shares of its common stock to accredited investors in private placements conducted during December 2003 (1,596,560 shares), and January 2004 (1,246,440 shares). The shares were sold at $3.00 per share, with net proceeds to Nestor (after $682 of expenses of the offering) of $2.76 per share totaling $7,847 ($3,440 in January 2004). The Securities and Exchange Commission declared the Registration Statement on Form S-2 (SEC File No. 333-112359) for the resale of these shares effective on April 23, 2004. The Company has continuing obligations in connection with the registration of the resale of the shares offered, including causing the registration statement filed to remain continuously effective for two years or, if earlier, until the sale of shares covered by the registration statement is complete and indemnifying the holders from liabilities it may incur resulting from any untrue statement or omission of a material fact in the registration statement and related documents and from other liabilities related to the registration.

On December 31, 2003, after the initial closing of the private placement above, the Company exercised its right to convert the Silver Star Note and accrued interest (see Note 7 ) by issuing 676,384 shares of Nestor common stock at $3.00 per share.

Although the proceeds from the initial closing above were received in December 2003 and the Silver Star note conversion was effective December 31, 2003, the associated stock certificates were not issued until January 2004. As such, these 2,272,944 shares are classified as “Stock Pending Issuance” on the balance sheet at December 31, 2003.

Laurus Note Conversions:

As more fully described in Note 7, Laurus elected to convert $85 of their first note into 55,000 shares of Nestor common stock in 2003. In January 2004, Laurus further converted $764 of the note into 492,904 shares of Nestor common stock. Both conversions were priced at $1.55 per share. During the period September through November 3, 2004, Laurus converted $1,305 due on its second note into 372,857 shares of Nestor common stock at $3.50 per share.

As more fully described in Note 7, the Company issued 203,774 shares of common stock to Laurus on December 28, 2005 in exchange for Laurus agreeing to retire the unpaid portion of the May 2005 convertible debt and interest amounting to $5,320 in exchange for a non-convertible three year Note for $6,000 and cash of $680. The market value of the common shares issued to Laurus on December 28, 2005 were $1,080 and will be recorded as a discount to the new note, and amortized over the three year life of the Note, unless paid earlier.

One-for-Ten Reverse Stock Split:

The Company filed a certificate of amendment to its certificate of incorporation on April 11, 2003, causing a one-for-ten reverse stock split of the outstanding shares of the Company common stock effective on that date. The Company’s common stock began trading on a post reverse split basis on April 21, 2003 under the new trading symbol “NESO” (previously “NEST”). These financials reflect common stock and loss per share on a post-split basis.

Preferred Stock:

Series B Convertible Preferred Stock is convertible into Common Stock of the Company at any time on a share-for-share basis. Series B Convertible Preferred Stock has the same rights with respect to voting and dividends as the Common Stock, except that each share of Series B Convertible Preferred Stock has the right to receive $1.00 in liquidation before any distribution is made to holders of the Common Stock. The liquidation value of Series B Preferred was $180 at December 31, 2005 and 2004.

59

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 12 - OPTIONS AND WARRANTS:

On April 1, 1984, the Company adopted an Incentive Stock Option Plan, which authorized the grant of options for up to 245,000 shares (post-reverse split) of the Company’s common stock. This plan terminated April 1, 2004.

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 will determine 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 awards are not transferable except by will or domestic relations order.

The following table presents the activity of the Company’s Stock Option Plans for the years ended December 31, 2005, 2004 and 2003 on post-reverse split basis. In 2003, options granted were to directors of the Company; many of which were canceled later in 2003 due to changes in the Board.

The number of options granted and outstanding in 2005 and 2004 rose significantly due to grants made pursuant to employment agreements as well as grants made to each employee and director during the year.

	Years Ended December 31,
	2005				2004				2003
	Shares		Weighted Av. Ex. Price		Shares		Weighted Av. Ex. Price		Shares		Weighted Av. Ex. Price
Outstanding beginning of year		2,887,655	$	4.71		312,397	$	5.75		324,199	$	6.50
Granted		474,665		5.63		2,777,650		4.66		176,250		3.34
Exercised		100,844		3.99		28,000		1.34		---		---
Canceled		395,449		4.81		174,392		6.28		188,052		4.85
Outstanding end of year		2,866,027		4.87		2,887,655		4.71		312,397		5.75
Options exercisable at year end		1,413,243	$	4.79		1,010,236	$	4.87		233,970	$	6.80

The following table presents weighted average price and life information about significant option groups outstanding at December 31, 2005:

Options Outstanding									Options Exercisable
Range of Ex. Price				Number of Outstanding at 12-31-05	Weighted Average Remaining Contractural Life (Years)		Weighted Average Exercise Price		Number Exercisable at 12-31-05	Weighted Averaged Exercisable Price
$	1.00	-	1.90	23,050	$	4.38	$	1.76	17,790	$	1.75
	3.55	-	3.85	163,400		5.83		3.69	115,800		3.75
	4.50	-	5.95	2,627,312		7.44		4.94	1,285,388		4.91
	6.04	-	7.23	52,265	$	7.75		6.47	12,265		6.85
				2,866,027	$	7.33	$	4.87	1,431,243	$	4.79

60

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

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 154,000 warrants in connection with the first Laurus note financing in July 2003, 60,000 warrants in connection with the private placement in November 2004, and 100,000 warrants in connection with the private placement in May 2005.

The following table presents warrants outstanding after adjusting to a post-reverse split basis:

	Years Ended December 31,
	2005		2004		2003
Eligible, end of year for exercise, currently		178,331		80,611		660,936
Warrants issued		100,000		60,000		154,000
Low exercise price	$	4.80	$	0.49	$	1.78
High exercise price	$	8.43	$	2.72	$	2.25

The warrants outstanding as of December 31, 2005 are currently exercisable and expire at various dates through May, 2010. The outstanding warrants entitle the owner to purchase one share of common stock for each warrant, at prices ranging from $4.80 to $8.43 per share.

During the year ended June 30, 1996, the exercise price of 100,000 warrants issued in the prior year was reduced from $15.00 to $6.50 (post-reverse split). The Company recorded, on a prorated basis, the $850 cumulative expense over the life of the warrants through August 1, 2004. Accordingly, the Company recognized expenses totaling $62, $106 and $106 in 2004, 2003 and 2002. During the quarter ended September 30, 2004, all warrants with an expiration date of August 1, 2004 were exercised on a cashless basis. This resulted in Company issuing 136,292 shares of its common stock at conversion prices from $3.98 to $4.28 per share in exchange for 269,856 warrants with exercise prices from $.49 to $2.65 per share. The Company also reclassified $850 related to these warrants and $375 related to other expired warrants from warrants to additional paid-in capital on the balance sheet.

In 2004, Laurus Master Fund, Ltd. exercised their 140,000 warrants with exercise prices from $1.78 to $2.25 per share on a cashless basis, resulting in the Company issuing 76,466 shares of its common stock at a conversion price of $4.18 per share. Sage also exercised 11,720 warrants on a cashless basis, resulting in the issuance of 5,953 shares of Nestor stock at conversion prices of $3.54 to $4.46 per share.

In addition, NTS Investors, LLC (the “Group”) received a warrant right in January 2001 to acquire up to 298,071 additional shares of common stock exercisable at the same price at which the then outstanding warrants of Nestor, Inc. were exercisable, but only in the event the then outstanding warrants were exercised, so as to maintain their initial ownership interest percentage. This warrant right decreased by 125,000 shares on March 1, 2002 with the expiration of TSAI’s warrant on that date. The Group exercised 124,952 warrants on a cashless basis during 2004 at prices of $3.98 to $ 4.63 per share, resulting in 59,898 shares of Nestor stock being issued. Warrants outstanding at December 31, 2005 includes 18,331 warrants belonging to the Group. In addition, the Group received a warrant to acquire 100,0000 shares of the Company’s common stock at $12.80 per share for three years as dilution protection against both the Company’s and NTS’s converted employee stock options outstanding at closing. This warrant expired on September 12, 2004. Such remaining warrants are treated as variable and, accordingly, are revalued quarterly with offsetting adjustments to additional paid-in capital.

NOTE 13 - SEGMENT AND GEOGRAPHIC INFORMATION:

Operating segments are identified as components of an enterprise about which separate discrete financial information is available to the chief operating decision maker, or decision-making group, in assessing performance and allocating resources. The Company’s decision-making group, its executive team, views the Company’s operations and manages its business principally as one segment. Therefore, the financial information presented in these financial statements represents all the material financial information related to the Company’s principal operating segment. The Company principally operates in the United States where its long lived assets are located.

61

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 14 - MASTER LEASE ASSIGNMENT:

The State of Delaware Department of Transportation (DelDOT) executed a Master Lease Agreement with NTS in February 2004 whereby lease financing for equipment installed under this CrossingGuard contract would be financed under lease terms offered by GE Capital Public Finance, Inc. (“GE”). Under this sales-type lease agreement, NTS received $1,600 in 2005 from GE and $880 in 2004 from GE on behalf of DelDOT pursuant to its Assignment and Security Agreement with GE. NTS retains a first priority interest in the equipment and assigned its interest in the DelDOT lease and right to receive rental payments thereunder to GE. As a matter of convenience, NTS monthly billings to DelDOT include their GE repayment of principal and interest, which NTS then remits to GE on their behalf.

NOTE 15 - OTHER EXPENSE - NET:

Other expense as reflected in the consolidated statements of operations consists of the following:

	Years Ended December 31,
	2005			2004			2003
Interest and dividend income	$	113		$	79		$	13
Interest expense		(847	)		(239	)		(470	)
Expense relating to financing operations		---			(63	)		(106	)
Unrealized loss		(3	)		(10	)		---
Realized loss		---			(96	)		---
Other income		33			---			64
Contract termination charge		---			---			(125	)
Gain (Loss) on disposal of fixed assets		---			(5	)		(5	)
Other expense - net	$	(704	)	$	(334	)	$	(629	)

NOTE 16 - INCOME TAXES:

During 2005 and 2004, the Company recorded deferred tax assets primarily for the benefit of net operating losses in the amount of $4,054 and $2,697 respectively. The cumulative amount of these assets, which is $21,523 and $17,469 at December 31, 2005 and 2004, respectively, is fully reserved. Due to the Company’s history of operating losses, management has concluded that realization of the benefit is not likely.

The Company has available at December 31, 2005, $54,007 and $34,180 of net operating loss carryforwards for federal and state purposes, respectively. Approximately $13,318 and $4,062 of these federal and state net operating loss carryforwards were acquired as part of the merger with NTS. These loss carryforwards may be applied against future taxable income and began to expire in 2005.

The Company’s effective income tax rate differs from the statutory federal income tax rate for the years ended December 31, 2005, 2004, and 2003 as follows:

U.S. federal statutory rate	34	%
State tax, net of federal tax benefit	5	%
Provision for valuation allowance	(39	%)
Effective income tax rate	0	%

Pursuant to Section 382 of the Internal Revenue Code, annual use of the tax loss carryforwards may be limited if there is a change in ownership. This limitation applies to the losses incurred by Nestor, Inc., as well as to the losses incurred by NTS. The use of state net operating losses may be limited in the future due to the apportionment of net operating losses among different states and varying net operating loss utilization requirements by state. The Company has not determined the effect of these limitations.

62

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 17 - RELATED PARTY TRANSACTIONS:

On January 1, 1999, Nestor, Inc. entered into an exclusive license with NTS through the expiration date of the underlying patents protecting the technologies used in NTS’s products. The license provides for royalties, as defined, to be paid to Nestor, Inc. that are eliminated in consolidation.

See Note 7, 8, 11, and 20 for transactions with Silver Star and Foundation Partners I, LLC.

NOTE 18 - COMMITMENTS AND CONTINGENCIES:

Minimum rental commitments of non-cancelable operating leases are approximately as follows:

Year ending December 31,
2006	$	205
2007		166
2008		135
2009		135
2010		90
	$	731

Rental expense was approximately $394, $224, and $149 during 2005, 2004, and 2003, respectively.

NTS entered into an operating lease dated June 21, 2000 for office and warehouse facilities in East Providence, Rhode Island. This lease provides for monthly rentals of $10 through July 2003 and then increased to $10 monthly through July 2005. Rent payments for this lease was $127 in 2003, $139 in 2004, and $120 for 2005. Space was leased adjacent to this facility in July 2004, for additional office and warehouse facilities. This lease provides for monthly rentals of $5 through May 2005 then increases two hundred dollars monthly in each of the two following years. Rent expense for this lease was $40 in 2004 and $50 for 2005. The Company relocated to new office and warehouse space in September 2005, and has recorded a reserve for lease termination costs related to the July 2004 adjacent space in the amount of $145 as of December 31, 2005.

In September 2005, the company entered into a new office lease in Providence, RI, which calls for monthly lease payments ranging from $8 to $11 through September 2010.

NTS also leases office space in San Diego, California. The July 2004 operating lease calls for monthly rent of $3 through the lease term expiration of June 2006. Rent expense was $15 in 2004 and $32 for 2005. The Company also leases warehouse space in Placentia, California. The February 2004 operating lease calls for monthly rent of $1 through the lease term expiration of January 2006. Rent expense was $15 in 2004 and $17 in 2005. The Company expects to relocate these California offices into one facility in Los Angeles to support the processing and support requirements of the CrossingGuard agreement with the City of Los Angeles and other California customers in the Los Angeles area.

On October 13, 2004, the Board of Directors approved employment agreements for the Company’s Chief Executive Officer and Chief Operating Officer (now the CFO effective January 2006) through December 31, 2007. The agreements automatically renew for a two-year period unless the Company elects not to renew. The agreements provide for a base salary of not less than $250 (CEO)/$200 (COO) and annual performance-based bonuses to be determined by the Company’s Compensation Committee. The Company also granted 1,000,000 stock options to the CEO and 600,000 stock options to the COO pursuant to the employment agreements. See Form 8-K dated October 13, 2004 for further information. On March 25, 2005, the COO’s position changed to Executive Vice President of Nestor, Inc., and on January 05, 2006 his position was expanded to include the CFO responsibilities, and his compensation remains unchanged.

63

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

Further, in March 2005 the Board of Directors approved employment agreements for a new Chief Operating Officer and a Vice President and General Counsel of Nestor, Inc. through December 31, 2008. The agreements automatically renew for one year unless the Company elects not to renew. The agreements provide for a base salary of not less than $175 (COO)/$165 (Counsel) and the COO is entitled to receive performance-based cash and option bonuses, as defined. The Company also granted 30,000 stock options to the COO and 135,000 stock options to Counsel pursuant to the employment agreements.

In November 2005, the Company signed a purchase agreement with one of its vendors. This agreement commits the Company to purchase a minimum of $750 over eighteen months expiring in May 2007.

NOTE 19 - LITIGATION:

Two suits have been filed against The Company 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. No decision has been made by the judge on that motion. The judge stayed all discovery pending the outcome of that motion.

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, nusiance, 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. No decision has been made by the judge on that motion. The judge stayed all discovery pending the outcome of that motion.

Sherrod Vans of Jacksonville, Inc., a former vendor that provided van customization services to us, has filed suit against us in the Circuit Court (Duval County, Florida), alleging that we failed to pay for some of the services that they provided. Sherrod is seeking payment from us of $114. Among the items for which they are seeking payment are items that have not been delivered to us. If Sherrod delivers those items, the amount in dispute is less than $20.

In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. We do not currently have any pending litigation other than that described above.

NOTE 20 - SUBSEQUENT EVENTS:

On January 31, 2006, the Company sold 1,237,811 shares of its common stock to fifteen accredited investors at $4.42 per share raising $4,822, net of expenses and issued warrants to purchase 371,339 shares of its common stock exercisable at $4.91 per share expiring on January 31, 2009. The Company used $1,250 of the proceeds to immediately retire the Heil Secured Promissory Note. Among the purchasers was Silver Star Partners, an affiliate of the Company, which purchased 220,589 shares and a warrant to purchase an additional 66,176 shares.

On March 6, 2006, the Company initiated steps to reduce costs including the reduction in salaries to most employees of 10% including management under employment contracts, and terminated nine employees. The severance cost is estimated to be $102.

64

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 21- QUARTERLY FINANCIAL INFORMATION (UNAUDITED):

As described in Note 3 “Restatement of Consolidated Financial Statements” the quarterly information for the first three quarters for the fiscal year ended December 31, 2005 and the four quarters for the fiscal year ended December 31, 2004 have been restated. The effects of this restatement are reflected below.

	Year Ended December 31, 2005
	First Quarter					Second Quarter
	(As reported)			(As restated)		(As reported)			(As restated)
Revenues	$	1,852		$	1,852	$	2,414		$	2,414
Gross Profit	$	660		$	660	$	678		$	678
Net income (loss)	$	(1,910	)	$	166	$	(2,325	)	$	(3,444	)
Basic and diluted income (loss) per share	$	(0.10	)	$	0.01	$	(0.12	)	$	(0.18	)
Shares used in computing basic and diluted net income (loss) per share		18,751,942			18,751,942		18,815,049			18,815,049

	Third Quarter						Fourth Quarter			Total
	(As reported)			(As restated)
Revenues	$	1,914		$	1,914		$	1,589		$	7,769
Gross Profit	$	624		$	624		$	75		$	2,037
Net (loss)	$	(2,792	)	$	(2,217	)	$	(1,269	)	$	(6,764	)
Basic and diluted (loss) per share	$	(0.15	)	$	(0.12	)	$	(0.07	)	$	(0.36	)
Shares used in computing basic and diluted net (loss) per share		18,879,464			18,879,464			18,838,148			18,826,966

65

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

	Year Ended December 31, 2004
	First Quarter						Second Quarter
	(As reported)			(As restated)			(As reported)			(As restated)
Revenues	$	1,099		$	1,099		$	1,552		$	1,552
Gross Profit	$	464		$	464		$	600		$	600
Net (Loss)	$	(525	)	$	(490	)	$	(1,120	)	$	(1,385	)
Basic and diluted (loss)Per share	$	(0.03	)	$	(0.03	)	$	(0.06	)	$	(0.08	)
Shares used in computing basic and diluted net(loss) per share		18,030,526			18,030,526			18,035,899			18,035,899

	Third Quarter						Fourth Quarter						Total			Total
	(As reported)			(As restated)			(As reported)			(As restated)			(As reported)			(As restated)
Revenues	$	1,833		$	1,833		$	1,551		$	1,551		$	6,035		$	6,035
Gross Profit	$	796		$	796		$	243		$	243		$	2,103		$	2,103
Net (loss)	$	(869	)	$	(748	)	$	(1,959	)	$	(3,555	)	$	(4,473	)	$	(6,178	)
Basic and diluted (loss)Per share	$	(0.05	)	$	(0.04	)	$	(0.11	)	$	(0.19	)	$	(0.25	)	$	(0.34	)
Shares used in computing basic and diluted net(loss) per share		18,208,242			18,208,242			18,557,669			18,557,669			18,223,609			18,223,609

66

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

	Years Ended December 31, 2005
	First Quarter						Second Quarter						Third Quarter
	(As reported)			(As restated)			(As reported)			(As restated)			(As reported)			(As restated)
Balance Sheet
TOTAL ASSETS		17,089			17,089			21,113			21,113			21,086			21,086
LIABILITIES AND STOCKHOLERS’ EQUITY
Total current liabilities		2,009			2,009			4,236			4,236			6,904			6,904
Noncurrent liabilities:
Long term convertible notes payable		5,400			398			5,200			682			8,436			4,402
Long term notes payable		---			---			3,780			1,750			---			(1,853	)
Long term asset retirement obligation		162			162			95			95			104			104
Long term, other		44			44			33			33			22			22
Derivative financial instruments		---			4,520			---			7,185			---			5,949
Total liabilities		7,615			7,133			13,344			13,981			15,466			15,528
Stockholders’ Equity:
Preferred stock		180			180			180			180			180			180
Common stock		188			188			188			188			189			189
Warrants		36			36			29			29			21			21
Additional paid-in capital		63,065			63,610			63,691			64,235			64,341			64,885
Accumulated deficit		(53,995	)		(54,058	)		(56,319	)		(57,500	)		(59,111	)		(59,717	)
Total Stockholders’ Equity		9,474			9,956			7,769			7,132			5,620			5,558
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		17,089			17,089			21,113			21,113			21,086			21,086

67

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

	Years Ended December 31, 2004
	First Quarter						Second Quarter						Third Quarter
	(As reported)			(As restated)			(As reported)			(As restated)			(As reported)			(As restated)
Balance Sheet
TOTAL ASSETS		16,192			16,192			15,697			15,697			14,924			14,924
LIABILITIES AND STOCKHOLERS’ EQUITY
Total current liabilities		1,901			1,901			2,644			2,644			2,933			2,933
Noncurrent liabilities:
Long term convertible notes payable		---			---			---			---			---			---
Long term notes payable		923			810			698			600			428			345
Long term asset retirement obligation		---			---			---			---			---			---
Long term, other		20			20			100			100			81			81
Derivative financial instruments		---			355			---			604			---			469
Total liabilities		2,844			3,086			3,442			3,948			3,442			3,828
Stockholders’ Equity:
Preferred stock		180			180			180			180			180			180
Common stock		180			180			180			180			183			183
Warrants		1,351			1,351			1,381			1,381			160			160
Additional paid-in capital		59,774			59,933			59,770			59,929			61,085			61,243
Accumulated deficit		(48,137	)		(48,538	)		(49,256	)		(49,921	)		(50,126	)		(50,670	)
Total Stockholders’ Equity		13,348			13,106			12,255			11,749			11,482			11,096
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		16,192			16,192			15,697			15,697			14,924			14,924

68

NESTOR, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

In Thousands, Except Share And Per Share Information

NOTE 22- RECENT ACCOUNTING PRONOUNCEMENTS:

On December 16, 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), which is a revision of SFAS No. 123. SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values at the date of grant. Pro forma disclosure is no longer an alternative. SFAS 123(R) must be adopted in fiscal years beginning after June 15, 2005. The Company adopted SFAS 123(R) on January 1, 2006, the commencement of its first quarter of fiscal 2006. The Company believes the effect will be comparable to the pro forma effect as shown in Note 2P - Stock Option Plans.

The Company adopted the “modified prospective” transition method in which awards that are granted, modified, or settled after the date of adoption should be measured and accounted for in accordance with SFAS 123(R). Unvested equity-classified awards that were granted prior to the effective date should continue to be accounted for in accordance with SFAS 123, except that amounts must be recognized in the income statement.

As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using the intrinsic value method in accordance with APB 25 and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method will have a significant impact on the Company’s results of operations, although it will have no impact on the Company’s overall cash flows.

In March 2005, the SEC issued Staff Accounting Bulletin 107 (SAB 107) to assist preparers by simplifying some of the implementation challenges of SFAS 123(R). In particular, SAB 107 provides supplemental implementation guidance on SFAS 123(R), including guidance on valuation methods, classification of compensation expense, inventory capitalization of share-based compensation cost, income tax effects, disclosures in Management’s Discussion of an Analysis and several other issues. The Company will apply the principles of SAB 107 in conjunction with its adoption of SFAS 123(R).

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and requires the retrospective application to prior periods financial statements for changes in accounting principles, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The retrospective application of the change would be limited to the direct effects of the change, and indirect effects would be recognized in the period of the accounting change. The Company adopted this standard on January 1, 2006, and does not believe that it will have a material impact on the consolidated financial statements.

69

ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

ITEM 9A. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e) and 15d-15(e), that are designed to ensure that information required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding the required disclosures. Any system of controls can provide only reasonable, and not absolute, assurance that the objectives of the control system are met. In addition, the design of any control system is based in part on certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goal under all potential future conditions.

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 of December 31, 2005.

Based upon that evaluation and as a result of comments received in November 2005 from the Staff of the SEC pertaining to our Registration Statement on Form S-2, File No. 333-126047 as discussed in our Currrent Report on Form 8-K filed on December 5, 2005, our Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2005, our disclosure controls and procedures were ineffective with respect to the accounting and reporting of complex financial transactions involving the sale by us of non-conventional convertible debt instruments to Laurus Master Fund, Ltd. in July 2003, January 2004 and May 2005, and to accredited investors in November 2004. Specifically, we did not account for embedded derivatives in those debt instruments in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” That failure to so account for those embedded derivatives constitutes a material weakness in our internal control over financial reporting as set forth in the Guidance in Auditing Standards No. 2 of the Public Company Accounting Oversight Board regarding previously issued financial statements. This material weakness was also noted by our independent auditors in a letter to the Audit Committee of the Company’s Board of Directors dated April 12, 2006. As a result of that material weakness, in April 2006, we restated our financial statements for years ended December 31, 2003 and 2004, as well as for the quarters ended March 31, June 30 and September 30, 2004 and 2005. See Note 3 to the financial statements included in this Report. To address this ineffectiveness of our disclosure controls and procedures and material weakness in our internal control over financial reporting, we have identified and retained outside consultants with experience and expertise in the identification, classification and accounting treatment of embedded derivatives and implemented internal procedures whereby we will use those consultants to advise us on identifying, classifying and accounting for future transactions which could involve embedded derivatives. We believe that this change will remediate the ineffectiveness of our disclosure controls and procedures and material weakness in our internal control over financial reporting relating to the accounting for complex financial instruments; however, given the nature and continuing evolvement of the accounting rules governing these financial transactions there is no assurance that the guidance provided to us by consultants on these transactions will be correctly interpreted.

Based upon the evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2005, except as discussed in the previous paragraph, our disclosure controls and procedures were effective, in that they (i) provide reasonable assurance 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) ensure 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.

70

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 year ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. To remediate the ineffectiveness of our disclosure controls and procedures and material weakness in our internal control over financial reporting relating to the accounting for complex financial instruments discussed above, during the quarter ended March 31, 2006, we identified and retained outside consultants with experience and expertise in the identification, classification and accounting treatment of embedded derivatives and implemented internal procedures whereby we will use those consultants to advise us on identifying, classifying and accounting for future transactions which could involve embedded derivatives.

Management’s Report on Internal Control Over Financial Reporting

We will be required by the Sarbanes-Oxley Act to include an assessment of our internal control over financial reporting and attestation from an independent registered public accounting firm in our Annual Report on Form 10-K beginning with our filing for our fiscal year ending December 31, 2007. Pending revisions to the scope of the Sarbanes-Oxley Act may change our compliance requirements and timing based on our market capitalization and revenue levels.

ITEM 9B. Other Information

None.

ITEM 10. Directors and Executive Officers of the Registrant.

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

The Company has adopted a written code of ethics that applies to all employees, including but not limited to, its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions.  A copy of Nestor’s code of ethics is available without charge by writing to: Nestor, Inc., 42 Oriental Street, Providence, Rhode Island 02908, Attention: Nigel P. Hebborn.

ITEM 11. Executive Compensation.

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management.

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

ITEM 13. Certain Relationships and Related Transactions.

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

ITEM 14. Principal Accounting Fees and Services.

Incorporated by reference from the Company's definitive proxy or information statement to be filed with the Securities and Exchange Commission not later than 120 days following the end of the Company’s fiscal year.

71

PART IV

ITEM 15. Exhibits, Financial Statement Schedules.

(a) The following documents are filed as part of this report:

(1) The financial statements of the Company and accompanying notes, as set forth in the the contents to the financial statements annexed hereto, are included in Part II, Item 8.

(2) Consolidated Financial Statement Schedule: Valuation and Qualifying Accounts and Reserves. All other schedules are omitted because such information is not applicable.

(3) Exhibits numbered in accordance with Item 601 of Regulation S-K and filed herewith.

See Exhibit Index.

(b) See Exhibit Index.

72

PART IV

ITEM 15(a)(2)

NESTOR, Inc.

Consolidated Financial Statement Schedule

Valuation and Qualifying Accounts and Reserves

(In Thousands)

For Years ended December 31, 2005, 2004, 2003

Accounts receivable allowance for doubtful accounts:

	2005		2004			2003
Balance at beginning of year	$	84	$	84		$	---
Provision charged to expense		80		34			84
Write-offs and recoveries		---		(34	)		---
Balance at end of year	$	164	$	84		$	84

Inventory allowance for obsolescence:

	2005			2004			2003
Balance at beginning of year	$	50		$	---		$	---
Provision charged to expense		330			50			---
Provision in other accounts		173			---			---
Write-offs and recoveries		(13	)		---			---
Balance at end of year	$	(540	)	$	(50	)	$	(0	)

73

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused the report to be signed on its behalf by the undersigned, thereunto duly authorized.

NESTOR, INC.

(Registrant)

/s/ William B. Danzell

William B. Danzell, Chief Executive Officer

/s/ Nigel P. Hebborn

Nigel P. Hebborn, Chief Financial Officer

Date: April 14, 2006

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signatures	Title	Date
/s/ George L. Ball
George L. Ball	Chairman of the Board of Directors	April 14, 2006
/s/ William B. Danzell
William B. Danzell	Director, President, and Chief Executive Officer	April 14, 2006
/s/ Albert H. Cox
Albert H. Cox	Director	April 14, 2006
/s/ Terry E. Fields
Terry E. Fields	Director	April 14, 2006
/s/ David N. Jordan
David N. Jordan	Director	April 14, 2006

74

Exhibit No.	Description of Exhibits
3.1	Restated Certificate of Incorporation.
4.1	Specimen Certificate for shares of Common Stock, $.01 par value, of the Registrant filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-2 (File No. 333-108432), filed September 2, 2003, is hereby incorporated herein by reference.
10.1	Asset Purchase Agreement and License Agreement between the Company and National Computer Systems, Inc., filed as an Exhibit to the Company's Current Report on Form 8-K dated June 11, 1996, is hereby incorporated by reference.
10.2	PRISM Non-Exclusive License Agreement between the Company and Applied Communications, Inc., filed as an Exhibit to the Company's Current Report on Form 8-K dated September 19, 1996, is hereby incorporated by reference. Portions of the Exhibit omitted, pursuant to a grant of confidential treatment.
10.3	License Agreement dated as of March 28, 1997, between Nestor, Inc. and Total System Services, Inc. filed as an Exhibit to the Company's Current report on Form 8-K dated April 8, 1997, is hereby incorporated by reference. Portions of the Exhibit omitted, pursuant to a grant of confidential treatment.
10.4	Amendment to the PRISM Non-Exclusive License Agreement dated as of April 18, 1997, between Nestor, Inc. and Applied Communications, Inc. filed as an Exhibit to the Company's Current Report on Form 8-K dated April 30, 1997 is hereby incorporated by reference. Portions of the Exhibit omitted pursuant to a grant of confidential treatment.
10.5	Exclusive License Agreement between Nestor, Inc. and Nestor Traffic Systems, Inc. dated January 1, 1999 filed as an Exhibit to the Company's Current Report on Form 8-K dated March 25, 1999.
10.6	Secured Note Agreement by and among Nestor, Inc., Nestor Traffic Systems, Inc. and NTS Investors LLC dated January 9, 2001 and filed as an Exhibit to the Company's Current Report on Form 8-K on January 18, 2001 is hereby incorporated by reference.
10.7	License Agreement between Nestor, Inc. and ACI Worldwide, Inc. dated February 1, 2001 filed as an Exhibit to the Company's Current Report on Form 8-K on February 9, 2001 is hereby incorporated by reference.
10.8	License Agreement dated May 18, 2001 between the Company and Retail Decisions, Inc. filed as an exhibit to the Company's current report on Form 8K dated May 18, 2001, which is hereby incorporated by reference.
10.9	Security Purchase Agreement dated July 31, 2003 between Nestor, Inc. and Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003, which is hereby incorporated by reference.
10.10	Convertible Note dated July 31, 2003 made by Nestor, Inc. to Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003 which is hereby incorporated by reference.
10.11	Registration Rights Agreement dated July 31, 2003 between Nestor, Inc. and Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003, which is hereby incorporated by reference.
10.12	Common Stock Purchase Warrant dated July 31, 2003 issued by Nestor, Inc. to Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003 which is hereby incorporated by reference.
10.13	Stock Pledge Agreement dated July 31, 2003 between Nestor Traffic Systems, Inc. and Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003, which is hereby incorporated by reference.

75

Exhibit No.	Description of Exhibits
10.14	Pledge and Security Agreement dated July 31, 2003 between CrossingGuard, Inc. and Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003 which is hereby incorporated by reference.
10.15	Guaranty dated July 31, 2003 by CrossingGuard, Inc. to Laurus Master Fund, Ltd. filed as an exhibit to the Company's current report on Form 8-K dated July 31, 2003, which is hereby incorporated by reference.
10.16	Nestor, Inc. Incentive Stock Option Plan, as amended, filed as an Exhibit to the Company’s Registration Statement on Form S-8, filed May 5, 1987, is hereby incorporated herein by reference
10.17	Nestor, Inc. 1997 Incentive Stock Option Plan, as amended, filed as an Exhibit to the Company's Registration Statement on Form S-8, filed May 16, 1997, is hereby incorporated by reference.
10.18	Nestor Traffic Systems, Inc., Form of Subscription Agreement dated March 25, 1999, to sell a 37.5% equity position in its common stock and issue a warrant for an additional 17.5% common stock interest filed as an Exhibit to Nestor's Current Report on Form 8-K dated April 23, 1999 is hereby incorporated by reference.
10.19	Security Purchase Agreement dated January 14, 2004 between Nestor, Inc. and Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 31, 2003 is hereby incorporated by reference.
10.20	Convertible Note dated January 14, 2004 made by Nestor, Inc. to Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 31, 2003 is hereby incorporated by reference.
10.21	Registration Rights Agreement dated January 14, 2004 between Nestor, Inc. and Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 31, 2003 is hereby incorporated by reference.
10.22	Redemption and Conversion Agreement dated January 14, 2004 between Nestor, Inc. and Laurus Master Fund, Ltd. filed as an Exhibit to the Company's Registration Statement on Form S-2, as amended (File No. 333-108432), is hereby incorporated by reference.
10.23	Placement Agent Agreement dated December 24, 2003 among Nestor, Inc., Sanders Morris Harris, Inc., and Barrett & Company, Inc. filed as an Exhibit to the Company's Registration Statement on Form S-2, as amended (File No. 333-108432), is hereby incorporated by reference.
10.24	Registration Rights Agreement dated December 31, 2003 among Nestor, Inc., Sanders Morris Harris, Inc., and Barrett & Company, Inc. filed as an Exhibit to the Company's Registration Statement on Form S-2, as amended (File No. 333-108432), is hereby incorporated by reference.
10.25	Nestor, Inc. 2004 Stock Incentive Plan filed as an Exhibit to Nestor's Current Report on Form 8-K dated June 24, 2003 and filed as an Exhibit to the Company's Registration Statement on Form S-8 filed January 21, 2005, is hereby incorporated by reference.
10.26	Employment Agreement dated October 13, 2004 between Nestor, Inc. and William B. Danzell, filed as an Exhibit to Nestor's Current Report on Form 8-K dated October 13, 2004, is hereby incorporated by reference.
10.27	Employment Agreement dated October 13, 2004 between Nestor, Inc. and Nigel P. Hebborn, filed as an Exhibit to Nestor's Current Report on Form 8-K dated October 13, 2004, is hereby incorporated by reference.
10.28	Note Purchase Agreement dated November 5, 2004 between Nestor, Inc. and the purchasers named therein, filed as an Exhibit to Nestor's Current Report on Form 8-K dated November 5, 2004, is hereby incorporated by reference.
10.29	Registration Rights Agreement dated November 5, 2004 among Nestor, Inc. and the purchasers named therein, filed as an Exhibit to Nestor's Current Report on Form 8-K dated November 5, 2004, is hereby incorporated by reference.

76

Exhibit No.	Description of Exhibits
10.30	Warrant to Purchase Common Stock, issued by Nestor, Inc. to Sanders Morris Harris, Inc. dated November 5, 2004, filed as an Exhibit to Nestor's Current Report on Form 8-K dated November 5, 2004, is hereby incorporated by reference.
10.31	Distributorship Agreement by and between Nestor, Inc. and Vitronics Machine Vision, Ltd. dated August 17, 2004 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is hereby incorporated by reference.
10.32	Incentive Stock Option Agreement by and between Nestor, Inc. and William B. Danzell dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is hereby incorporated by reference.
10.33	Incentive Stock Option Agreement by and between Nestor, Inc. and William B. Danzell dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is hereby incorporated by reference.
10.34	Incentive Stock Option Agreement by and between Nestor, Inc. and Nigel P. Hebborn dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is hereby incorporated by reference.
10.35	Incentive Stock Option Agreement by and between Nestor, Inc. and Nigel P. Hebborn dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is hereby incorporated by reference.
10.36	Employment Agreement dated March 29, 2005 between Nestor, Inc. and Tadas A. Eikinas filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.37	Employment Agreement dated March 29, 2005 between Nestor, Inc. and Benjamin M. Alexander filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.38	Incentive Stock Option Agreement by and between Nestor, Inc. and Tadas A. Eikinas dated March 29, 2005 filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.39	Incentive Stock Option Agreement by and between Nestor, Inc. and Benjamin M. Alexander dated March 29, 2005 filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.40	Bonus Targets Letter to William B. Danzell dated March 29, 2005 filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.41	Bonus Targets Letter to Nigel P. Hebborn dated March 29, 2005 filed as an Exhibit to Nestor's Annual Report on Form 10-K for the year ended December 31, 2004, is hereby incorporated by reference.
10.42	Lease Agreement between Nestor Traffic Systems, Inc. and Admiral Associates dated May 27, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated May 27, 2005, is hereby incorporated by reference.
10.43	Subsidiary Guaranty dated May 16, 2005 by Nestor, Inc. to Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Registration Statement on Form S-2 (File No. 333-126047), is hereby incorporated by reference.
10.44	Security Agreement by Nestor, Inc. and Nestor Traffic Systems, Inc. to Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Registration Statement on Form S-2 (File No. 333-126047), is hereby incorporated by reference.
10.45	NTSI Pledge and Security Agreement dated May 16, 2005, between Laurus Master Fund, Ltd and Nestor Traffic Systems, Inc. filed as an Exhibit to Nestor's Registration Statement on Form S-2 (File No. 333-126047), is hereby incorporated by reference.

77

Exhibit No.	Description of Exhibits
10.46	Common Stock Purchase Warrant dated May 16, 2005 by Nestor, Inc. to Laurus Master Fund, Ltd. filed as an Exhibit to Nestor's Registration Statement on Form S-2 (File No. 333-126047), is hereby incorporated by reference.
10.47	Settlement Agreement and Mutual Release by and between Transol Corporation Ltd., Transol USA, Inc. and Nestor, Inc. dated June 28, 2005 filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005, is hereby incorporated by reference.
10.48	Secured Promissory Note by Nestor, Inc. to Foundation Partners I, LLC. dated August 30, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated August 30, 2005, is hereby incorporated by reference.
10.49	Purchase and Sale Agreement dated August 31, 2005 by and among Transol Holdings Pty Limited (ACN 100 078 046) (receivers and managers appointed), Transol PTY Limited (ABN 65 095 538 828) (receivers and managers appointed), Transol Corporation Limited (ABN 73 089 224 402) (receivers and managers appointed), Alleasing Finance Australia Limited (ABN 94 003 421 136) and Nestor Traffic Systems, Inc. filed as an Exhibit to Nestor's Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is hereby incorporated by reference.
10.50	Securities Purchase Agreement by and between Nestor, Inc. and Laurus Master Fund, Ltd. dated December 28, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 28, 2005, is hereby incorporated by reference.
10.51	Secured Term Note made by Nestor, Inc. to Laurus Master Fund, Ltd. dated December 28, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 28, 2005, is hereby incorporated by reference.
10.52	Registration Rights Agreement by and between Nestor, Inc. and Laurus Master Fund, Ltd. dated December 28, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 28, 2005, is hereby incorporated by reference.
10.53	Reaffirmation and Ratification Agreement and Amendment by and among Nestor, Inc., Nestor Traffic Systems, Inc. and Laurus Master Fund, Ltd. dated December 28, 2005 filed as an Exhibit to Nestor's Current Report on Form 8-K dated December 28, 2005, is hereby incorporated by reference.
10.54	Letter agreement from William B. Danzell to Nestor, Inc. dated March 6, 2006 filed as an Exhibit to Nestor's Current Report on Form 8-K dated March 6, 2006, is hereby incorporated by reference.
10.55	Letter agreement from Nigel P. Hebborn to Nestor, Inc. dated March 6, 2006 dated March 6, 2006 filed as an Exhibit to Nestor's Current Report on Form 8-K dated March 6, 2006, is hereby incorporated by reference.
10.56	Letter agreement from Tadas A. Eikinas to Nestor, Inc. dated March 6, 2006 dated March 6, 2006 filed as an Exhibit to Nestor's Current Report on Form 8-K dated March 6, 2006, is hereby incorporated by reference.
10.57	Letter agreement from Benjamin M. Alexander to Nestor, Inc. dated March 6, 2006 dated March 6, 2006 filed as an Exhibit to Nestor's Current Report on Form 8-K dated March 6, 2006, is hereby incorporated by reference.
10.58	Memorandum of Agreement dated November 10, 2005 by and between Vitronic Machine Vision Ltd., a Georgia limited partnership and Nestor Traffic Systems, Inc.
10.59	Securities Purchase Agreement dated January 31, 2006 by and among Nestor, Inc. and the investors named therein.
10.60	Form of Common Stock Warrant dated January 31, 2006.
23.01	Consent of Carlin, Charron & Rosen LLP dated April 12, 2006
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

78

Exhibit No.	Description of Exhibits
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
32	Statement Pursuant to 18 U.S.C. §1350*

* Certification is not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section. Such certification is not deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

 79

EX-10.58

EXHIBIT 10.58

MEMORANDUM OF AGREEMENT

This MEMORANDUM OF AGREEMENT (the "Memorandum") is made as of November 10, 2005 by and between, Vitronic Machine Vision Ltd., a Georgia limited partnership and Nestor Traffic Systems, Inc., a Delaware corporation, having a place of business at 400 Massasoit ("Distributor" and together with Vitronic, the "Parties" and each singularly a "Party"). Reference is made to that certain Distributorship Agreement by and between the Parties made as of August 17, 2004 (the “Distributorship Agreement”). Distributor and Vitronic intending to be legally bound agree as follows:

That the twelve month periods for minimum turnovers set forth in Section I.D of the Distributorship Agreement shall each be delayed by six months. For example, the minimum turnover set forth in the Distribution Agreement for the twelve months ending December 31, 2005 shall now be the minimum turnover for the twelve month period ending on June 30, 2006.

That for the purposes of calculating turnover for the twelve month period ending June 30, 2006, those Products (as defined in the Distributorship Agreement) purchased in June 2005 shall be deemed to have been purchased on July 1, 2005.

That the initial term of the Distributorship Agreement set forth in Section VIII.A shall be extended by six months.

IN WITNESS WHEREOF, the Parties hereto have set their hands by their duly authorized representatives as of the day and year first above written.

VITRONIC, INC. as General Partner VITRONIC Machine Vision Ltd.		NESTOR TRAFFIC SYSTEMS, INC.
By:	/s/ Gerhard Bar, Michael Schindler	By:	/s/ Nigel P. Hebborn
Name:	Gerhard Bar, Michael Schindler	Name:	Nigel P. Hebborn
Title:	Vice Presidents	Title	President & CEO

For the sole purpose of evidencing Vitronic GmbH's consent to the above modification of the Distributorship Agreement:
VITRONIC GMBH
By:	/s/ Gerhard Bar, Dr. Heiko Frohn
Name:	Gerhard Bar, Dr. Heiko Frohn
Title:	Vice Presidents

EX-10.59

NESTOR, INC.

SECURITIES PURCHASE AGREEMENT

As of

January 31, 2006

TABLE OF CONTENTS

1.	AGREEMENT TO SELL AND PURCHASE		1
2.	FEES		2
3.	CLOSING, DELIVERY AND PAYMENT		2
	3.1	Closing	2
	3.2	Delivery	3
4.	REPRESENTATIONS AND WARRANTIES OF THE COMPANY		3
	4.1	Organization, Good Standing and Qualification	3
	4.2	Subsidiaries	3
	4.3	Capitalization; Voting Rights	3
	4.4	Authorization; Binding Obligations	4
	4.5	Liabilities	5
	4.6	Agreements; Action	5
	4.7	Obligations to Related Parties	6
	4.8	Changes	7
	4.9	Title to Properties and Assets; Liens, Etc.	8
	4.10	Intellectual Property	8
	4.11	Compliance with Other Instruments	8
	4.12	Litigation	9
	4.13	Tax Returns and Payments	9
	4.14	Employees	9
	4.15	Registration Rights and Voting Rights	10
	4.16	Compliance with Laws; Permits	10
	4.17	Environmental and Safety Laws	10
	4.18	Valid Offering	11
	4.19	Full Disclosure	11
	4.20	Insurance	11
	4.21	SEC Reports	11
	4.22	Listing	11
	4.23	No Integrated Offering	12
	4.24	Stop Transfer	12

-i-

5.	REPRESENTATIONS AND WARRANTIES OF THE INVESTORS		12
	5.1	Requisite Power and Authority	12
	5.2	Investment Representations	12
	5.3	Investor Bears Economic Risk	13
	5.4	Acquisition for Own Account	13
	5.5	Investor Can Protect Its Interest	13
	5.6	Accredited Investor	13
	5.7	Legends	13
	5.8	Public Announcement	15
	5.9	No Shorting	15
6.	COVENANTS OF THE COMPANY		15
	6.1	Listing	15
	6.2	Market Regulations	16
	6.3	Use of Funds	16
	6.4	Reissuance of Securities	16
	6.5	Opinion	16
7.	COVENANTS OF THE INVESTORS		16
	7.1	Confidentiality	16
	7.2	Non-Public Information	16
	7.3	Sales of Securities	17
	7.4	Investor Questionnaire	17
	7.5	No Short Sales	17
8.	COVENANTS OF THE COMPANY AND INVESTOR REGARDING INDEMNIFICATION		18
	8.1	Company Indemnification	18
	8.2	Investor's Indemnification	18
	8.3	Procedures	18
9.	REGISTRATION RIGHTS		18
	9.1	Registration Rights Granted	18
	9.2	Delay In Filing Or Effectiveness Of Registration Statement	20
	9.3	Transfer of Shares after Registration; Suspension	21
	9.4	Indemnification	22
10.	REPRESENTATIONS AND WARRANTIES OF INVESTORS REGARDING COMPANY AFFILIATES		24

-ii-

11.	INDEPENDENT NATURE OF INVESTORS' OBLIGATIONS AND RIGHTS		24
12.	MISCELLANEOUS		25
	12.1	Governing Law	25
	12.2	Survival	25
	12.3	Entire Agreement	25
	12.4	Severability	26
	12.5	Assignment	26
	12.6	Amendment and Waiver	26
	12.7	Delays or Omissions	26
	12.8	Notices	26
	12.9	Titles and Subtitles	27
	12.10	Facsimile Signatures; Counterparts	27
	12.11	Broker's Fees	27
	12.12	Construction	27

-iii-

NESTOR, INC.

SECURITIES PURCHASE AGREEMENT

THIS SECURITIES PURCHASE AGREEMENT (the "Agreement") is made and entered into as of January 31, 2006, by and between Nestor, Inc., a Delaware corporation (the "Company"), and each of the Investors set forth on the signature page hereof (the "Investors").

Recitals

WHEREAS, the Company has authorized the sale to the Investors of up to $12 million aggregate purchase price of shares (the "Shares") of the Company's common stock, $0.01 par value per share (the "Common Stock");

WHEREAS,in connection with the sale of the Shares to the Investors, the Company wishes to issue Investors warrants to purchase shares of the Company's Common Stock in the form attached hereto as Exhibit A ("Warrants");

WHEREAS, Investors desire to purchase the Shares and Warrants on the terms and conditions set forth herein; and

WHEREAS, the Company desires to issue and sell the Shares and Warrants to Investors on the terms and conditions set forth herein (the "Offering").

AGREEMENT

NOW, THEREFORE, in consideration of the foregoing recitals and the mutual promises, representations, warranties and covenants hereinafter set forth and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows:

1. AGREEMENT TO SELL AND PURCHASE.

Pursuant to the terms and conditions set forth in this Agreement, on the Closing Date (as defined in Section 0), the Company agrees to sell to each Investor, and each Investor hereby agrees to purchase from the Company (a) the number of Shares of Common Stock set forth immediately next to such Investor's name on the signature page hereunto at the aggregate purchase price immediately next to such Investor's name on the signature page hereto (the "Purchase Price")¹ and (b) Warrants exercisable for the number of shares² set forth immediately next to such Investor's name on the signature page hereto ("Warrant Shares"). Collectively, the Shares, the Warrants and Warrant Shares are referred to as the "Securities".

____________________

¹ Ninety percent (90%) of the 10 day Volume Weighted Average Price (VWAP).

² Thirty percent (30%) of the number of Shares such Investor is purchasing.

1

2. FEES.

On the Closing Date:

(a)The Company shall pay to the broker-dealers listed on Exhibit B attached hereto (each, a "Placing Broker") a placement or finders fee in an amount equal to six and one-half percent (6.50%) of the aggregate Purchase Price paid by those Investors whose names are listed opposite such Placing Broker's name on Exhibit B. The foregoing fees are referred to herein as the "Placement Fees".

(b)The Company shall pay to those Investors for whom a Placing Broker is not identified on Exhibit B a cash rebate ("Investor Rebate") in an amount equal to six and one-half percent (6.50%) of the Purchase Price paid by each such Investor, provided, however, that the Investor Rebate payable to Edward F. Heil ("Heil") on his investment as set forth on the signature page (the "Principal Investment") shall be reinvested in shares of Common Stock and Warrants on the same terms as his Principal Investment. Heil shall be entitled to an Investor Rebate on any Investor Rebate so reinvested, which Investor Rebate shall, in turn, be reinvested in shares of Common Stock and Warrants on the same terms as the Principal Investment, until the amount of the Investor Rebate on any reinvested amount is less than the Purchase Price for one share of Common Stock and the related Warrant. To the extent the foregoing calculation would result in the issuance of any fractional shares of Common Stock or a Warrant for a fractional share of Common Stock, such fractional shares or Warrants for fractional shares shall be aggregated and rounded down to the nearest whole number of Shares and Warrants and the Company shall issue the balance of any Investor Rebate which cannot be issued in whole shares of Common Stock and Warrants to Heil in cash.

(c)The Company shall reimburse KeyBanc Capital Markets, a Division of McDonald Investments Inc. ("KBCM") for its reasonable legal fees for services rendered to the KBCM in preparation of this Agreement and the Related Agreements, and expenses in connection with KBCM's services in placing the Securities.

(d)Amounts required to be paid under this Section 2 will be paid at the Closing (as defined in Section 0) out of funds held pursuant to an Escrow Agreement dated as of January 26, 2006 among the Company, KBCM and Associated Trust Company, N.A., as escrow agent (the "Escrow Agreement").

3. CLOSING, DELIVERY AND PAYMENT.

3.1 Closing.

Subject to the terms and conditions herein, the closing of the transactions contemplated hereby (the "Closing"), shall take place on the date hereof, at such time or place as the Company and KBCM may mutually agree (such date is hereinafter referred to as the "Closing Date").

2

3.2 Delivery.

At the Closing, subject to the terms and conditions hereof, the Company will deliver to each Investor (a) a certificate for the Shares purchased by such Investor and (b) a Warrant for the number of Warrant Shares set forth on the signature page hereto against payment of the Purchase Price therefor. Payment of the Purchase Price for the Shares and Warrants purchased by each Investor shall be made by such Investor to the Company in federal or other funds immediately available in U.S. dollars and shall be made through an escrow agent on terms and instructions set forth in the Escrow Agreement. The certificate for the Shares and the Warrant shall be registered in the name of each Investor or, if so indicated on the signature page hereto, in the name of a nominee designed by such Investor.

4. REPRESENTATIONS AND WARRANTIES OF THE COMPANY.

The Company hereby represents and warrants to the Investors as of the date of this Agreement as set forth below which disclosures are supplemented by, and subject to the Company's filings and other filings identifying the Company as issuer under the Securities Exchange Act of 1934 (collectively, the "Exchange Act Filings").

4.1 Organization, Good Standing and Qualification.

The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. The Company has the corporate power and authority to own and operate its properties and assets, to execute and deliver this Agreement, and all other documents to be issued in connection with this Agreement, the Escrow Agreement and all other agreements referred to herein (collectively, the "Related Agreements"), to issue and sell the Shares, to issue and sell the Warrants, to issue and sell the Warrant Shares upon exercise of the Warrant, to carry out the provisions of this Agreement and the Related Agreements and to carry on its business as presently conducted. The Company is duly qualified and is authorized to do business and is in good standing as a foreign corporation in all jurisdictions in which the nature of its activities and of its properties (both owned and leased) makes such qualification necessary, except for those jurisdictions in which failure to do so has not, or could not reasonably be expected to have, individually or in the aggregate, a material adverse effect on the business, assets, liabilities, condition (financial or otherwise), properties, operations or prospects of the Company and its subsidiaries, taken individually and as a whole (a "Material Adverse Effect").

4.2 Subsidiaries.

Except as disclosed on Schedule 0, the Company does not own or control any equity security or other interest of any other corporation, limited partnership or other business entity.

4.3 Capitalization; Voting Rights.

(a)The authorized capital stock of the Company, as of December 31, 2005, consists of 30,000,000 shares of Common Stock, par value $0.01 per share, of which 19,127,065 are issued and outstanding and 10,000,000 shares of preferred stock, par value $1.00 per share, of which 180,000 shares are outstanding.

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(b)Except as disclosed on Schedule 0, other than (i) the shares reserved for issuance under the Company's stock option plans; and (ii) shares which may be issued pursuant to this Agreement and the Warrants, there are no outstanding options, warrants, rights (including conversion or preemptive rights and rights of first refusal), proxy or stockholder agreements, or arrangements or agreements of any kind for the purchase or acquisition from the Company of any of its securities. Except as disclosed on Schedule 0, neither the offer, issuance or sale of any of the Shares, the Warrants or the Warrant Shares, nor the consummation of any transaction contemplated hereby will result in a change in the price or number of any securities of the Company outstanding, under anti-dilution or other similar provisions contained in or affecting any such securities.

(c)All issued and outstanding shares of the Company's Common Stock (i) have been duly authorized and validly issued and are fully paid and nonassessable and (ii) were issued in compliance with all applicable state and federal laws concerning the issuance of securities.

(d)The rights, preferences, privileges and restrictions of the shares of the Common Stock are as stated in the Company's Certificate of Incorporation (the "Charter"). The Shares have been duly authorized by the Company and the Warrant Shares have been duly and validly reserved for issuance. When issued in compliance with the provisions of this Agreement and the Company's Charter, the Securities will be validly issued, fully paid and nonassessable, and will be free of any liens or encumbrances; provided, however, that the Securities may be subject to restrictions on transfer under state and/or federal securities laws as set forth herein or as otherwise required by such laws at the time a transfer is proposed.

4.4 Authorization; Binding Obligations.

All corporate action on the part of the Company, its officers and directors necessary for the authorization of this Agreement and the Related Agreements, the performance of all obligations of the Company hereunder at the Closing and, the authorization, sale, issuance and delivery of the Shares and Warrants has been taken or will be taken prior to the Closing. The Agreement and the Related Agreements, when executed and delivered and to the extent it is a party thereto, will be valid and binding obligations of the Company enforceable in accordance with their terms, except (a) as limited by applicable bankruptcy, insolvency, reorganization, moratorium or other laws of general application affecting enforcement of creditors' rights, and (b) general principles of equity that restrict the availability of equitable or legal remedies. The sale of the Shares will not be subject to any preemptive rights or rights of first refusal that have not been properly waived or complied with. The issuance of the Warrants and the subsequent exercise of the Warrants for Warrant Shares are not and will not be subject to any preemptive rights or rights of first refusal that have not been properly waived or complied with. The Warrants, when executed and delivered in accordance with the terms of this Agreement, will be valid and binding obligations of the Company, enforceable in accordance with their respective terms.

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4.5 Liabilities.

Except as set forth in Schedule 0, the Company, to the best of its knowledge, knows of no material contingent liabilities, except current liabilities incurred in the ordinary course of business and liabilities disclosed in any Exchange Act Filings.

4.6 Agreements; Action.

Except as contemplated by this Agreement or as disclosed in any Exchange Act Filings:

(a)There are no agreements, understandings, instruments, contracts, proposed transactions, judgments, orders, writs or decrees to which the Company is a party or to its knowledge by which it is bound which may involve (i) obligations (contingent or otherwise) of, or payments to, the Company in excess of $50,000 (other than obligations of, or payments to, the Company arising from purchase or sale agreements entered into in the ordinary course of business), or (ii) the transfer or license of any patent, copyright, trade secret or other proprietary right to or from the Company (other than licenses arising from the purchase or sale of "off the shelf" or other standard products), or (iii) provisions restricting the development, manufacture or distribution of the Company's products or services, or (iv) indemnification by the Company with respect to infringements of proprietary rights (other than obligations of the Company arising from purchase or sale agreements entered into in the ordinary course of business).

(b)The Company has not (i) declared or paid any dividends, or authorized or made any distribution upon or with respect to any class or series of its capital stock, (ii) incurred any indebtedness for money borrowed or any other liabilities individually in excess of $50,000 or, in the case of indebtedness and/or liabilities individually less than $50,000, in excess of $100,000 in the aggregate, (iii) made any loans or advances to any person not in excess, individually or in the aggregate, of $100,000, other than ordinary advances for travel expenses, or (iv) sold, exchanged or otherwise disposed of any of its assets or rights, other than the sale of its inventory in the ordinary course of business.

(c)For the purposes of subsections (a) and (b) above, all indebtedness, liabilities, agreements, understandings, instruments, contracts and proposed transactions involving the same person or entity (including persons or entities the Company has reason to believe are affiliated therewith) shall be aggregated for the purpose of meeting the individual minimum dollar amounts of such subsections.

(d)The Company maintains disclosure controls and procedures ("Disclosure Controls") designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the "Exchange Act") is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission ("SEC").

(e)The Company makes and keeps books, records, and accounts, that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company's assets. The Company maintains internal control over financial reporting ("Financial Reporting Controls") designed by, or under the supervision of, the Company's principal executive and principal financial officers, and effected by the Company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles ("GAAP"), including that:

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transactions are executed in accordance with management's general or specific authorization;

unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements are prevented or timely detected;

transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company's receipts and expenditures are being made only in accordance with authorizations of the Company's management and board of directors;

transactions are recorded as necessary to maintain accountability for assets; and

the recorded accountability for assets is compared with the existing assets at reasonable intervals, and appropriate action is taken with respect to any differences.

(f)There is no weakness in any of the Company's Disclosure Controls or Financial Reporting Controls that is required to be disclosed in any of the Exchange Act Filings, except as so disclosed.

4.7 Obligations to Related Parties.

There are no obligations of the Company to officers, directors, stockholders or employees of the Company other than (a) for payment of salary for services rendered and for bonus payments, (b) reimbursement for reasonable expenses incurred on behalf of the Company, (c) for other standard employee benefits made generally available to all employees (including stock option agreements outstanding under any stock option plan approved by the Board of Directors of the Company) and (d) obligations listed in the Company's financial statements or disclosed in any of its Exchange Act Filings. Except as described above or disclosed in any Exchange Act Filings, none of the officers, directors or, to the best of the Company's knowledge, key employees or stockholders of the Company or any members of their immediate families, are indebted to the Company, individually or in the aggregate, in excess of $50,000 or have any direct or indirect ownership interest in any firm or corporation with which the Company is affiliated or with which the Company has a business relationship, or any firm or corporation which competes with the Company, other than passive investments in publicly traded companies (representing less than 1% of such company) which may compete with the Company.Except as described above, no officer, director or stockholder, or any member of their immediate families, is, directly or indirectly, interested in any material contract with the Company and no agreements, understandings or proposed transactions are contemplated between the Company and any such person. Except as set forth in any Exchange Act Filings, the Company is not a guarantor or indemnitor of any indebtedness of any other person, firm or corporation.

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4.8 Changes.

Since September 30, 2005, except as disclosed in any Exchange Act Filing or in any Schedule to this Agreement or to any of the Related Agreements, there has not been:

(a)Any change in the assets, liabilities, financial condition,prospects or operations of the Company, other than changes in the ordinary course of business, none of which individually or in the aggregate has had or is reasonably expected to have a Material Adverse Effect;

(b)Any resignation or termination of any officer, key employee or group of employees of the Company;

(c)Any material change, except in the ordinary course of business, in the contingent obligations of the Company by way of guaranty, endorsement, indemnity, warranty or otherwise;

(d)              Any damage, destruction or loss, whether or not covered by insurance, materially and adversely affecting the properties, business or prospects or financial condition of the Company;

(e)Any waiver by the Company of a valuable right or of a material debt owed to it;

(f)Any direct or indirect material loans made by the Company to any stockholder, employee, officer or director of the Company, other than advances made in the ordinary course of business;

(g)              Any material change in any compensation arrangement or agreement with any executive employee, officer, director or stockholder;

(h)              Any declaration or payment of any dividend or other distribution of the assets of the Company;

(i)Any labor organization activity related to the Company;

(j)Any debt, obligation or liability incurred, assumed or guaranteed by the Company, except those for immaterial amounts and for current liabilities incurred in the ordinary course of business;

(k)              Any sale, assignment or transfer of any patents, trademarks, copyrights, trade secrets or other intangible assets;

(l)Any change in any material agreement to which the Company is a party or by which it is bound which may materially and adversely affect the business, assets, liabilities, financial condition, operations or prospects of the Company;

(m) Any other event or condition of any character that, either individually or cumulatively, has or may materially and adversely affect the business, assets, liabilities, financial condition, prospectsor operations of the Company; or

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(n) Any arrangement or commitment by the Company to do any of the acts described in subsection (a) through (m) above.

4.9 Title to Properties and Assets; Liens, Etc.

Except as disclosed in any Exchange Act Filings, the Company has good and marketable title to its properties and assets, and good title to its leasehold estates, in each case subject to no mortgage, pledge, lien, lease, encumbrance or charge, other than (a) those resulting from taxes which have not yet become delinquent, (b) minor liens and encumbrances which do not materially detract from the value of the property subject thereto or materially impair the operations of the Company, and (c) those that have otherwise arisen in the ordinary course of business. All facilities, machinery, equipment, fixtures, vehicles and other properties owned, leased or used by the Company are in good operating condition and repair and are reasonably fit and usable for the purposes for which they are being used. Except as disclosed in any Exchange Act Filings, the Company is in compliance with all material terms of each lease to which it is a party or is otherwise bound.

4.10 Intellectual Property.

(a) The Company owns or possesses sufficient legal rights to all patents, trademarks, service marks, trade names, copyrights, trade secrets, licenses, information and other proprietary rights and processes necessary for its business as now conducted and to the Company's knowledge as presently proposed to be conducted (the "Intellectual Property"), without any known infringement of the rights of others. Except as disclosed in any Exchange Act Filings, there are no outstanding options, licenses or agreements of any kind relating to the foregoing proprietary rights, nor is the Company bound by or a party to any options, licenses or agreements of any kind with respect to the patents, trademarks, service marks, trade names, copyrights, trade secrets, licenses, information and other proprietary rights and processes of any other person or entity other than such licenses or agreements arising from the purchase of "off the shelf" or standard products.

(b) Except as disclosed in any Exchange Act Filings, the Company has not received any communications alleging that the Company has violated any of the patents, trademarks, service marks, trade names, copyrights or trade secrets or other proprietary rights of any other person or entity, nor is the Company aware of any basis therefor.

(c) The Company does not believe it is or will be necessary to utilize any inventions, trade secrets or proprietary information of any of its employees made prior to their employment by the Company, except for inventions, trade secrets or proprietary information that have been rightfully assigned to the Company.

4.11 Compliance with Other Instruments.

The Company is not in violation or default of any term of its Charter or Bylaws, or of any material provision of any mortgage, indenture, contract, agreement, instrument or contract to which it is party or by which it is bound or of any judgment, decree, order or writ. The execution, delivery and performance of and compliance with this Agreement and the Related Agreements to which it is a party, and the issuance and sale of the Securities by the Company each pursuant hereto, will not, with or without the passage of time or giving of notice, result in any such material violation, or be in conflict with or constitute a default under any such term or provision, or result in the creation of any mortgage, pledge, lien, encumbrance or charge upon any of the properties or assets of the Company or the suspension, revocation, impairment, forfeiture or nonrenewal of any permit, license, authorization or approval applicable to the Company, its business or operations or any of its assets or properties.

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4.12 Litigation.

Except as set forth on Schedule 0, there is no action, suit, proceeding or investigation pending or, to the Company's knowledge, currently threatened against the Company that prevents the Company to enter into this Agreement or the Related Agreements, or to consummate the transactions contemplated hereby or thereby, or which mighthave or result, in a Material Adverse Effect, or any change in the current equity ownership of the Company, nor is the Company aware that there is any basis for any of the foregoing. The Company is not a party or subject to the provisions of any order, writ, injunction, judgment or decree of any court or government agency or instrumentality. There is no action, suit, proceeding or investigation by the Company currently pending or which the Company intends to initiate.

4.13 Tax Returns and Payments.

The Company has timely filed all tax returns (federal, state and local) required to be filed by it. Except as set forth on Schedule 0, all taxes shown to be due and payable on such returns, any assessments imposed, and to the Company's knowledge all other taxes due and payable by the Company on or before the Closing, have been paid or will be paid prior to the time they become delinquent.Except as set forth on Schedule 0, the Company has not been advised (a) that any of its returns, federal, state or other, have been or are being audited as of the date hereof, or (b) of any deficiency in assessment or proposed judgment to its federal, state or other taxes. The Company has no knowledge of any liability of any tax to be imposed upon its properties or assets as of the date of this Agreement that is not adequately provided for.

4.14 Employees.

The Company has no collective bargaining agreements with any of its employees. There is no labor union organizing activity pending or, to the Company's knowledge, threatened with respect to the Company.Except as disclosed in the Exchange Act Filings, the Company is not a party to or bound by any currently effective employment contract, deferred compensation arrangement, bonus plan, incentive plan, profit sharing plan, retirement agreement or other employee compensation plan or agreement. To the Company's knowledge, no employee of the Company, nor any consultant with whom the Company has contracted, is in violation of any term of any employment contract, proprietary information agreement or any other agreement relating to the right of any such individual to be employed by, or to contract with, the Company because of the nature of the business to be conducted by the Company; and to the Company's knowledge the continued employment by the Company of its present employees, and the performance of the Company's contracts with its independent contractors, will not result in any such violation. The Company is not aware that any of its employees is obligated under any contract (including licenses, covenants or commitments of any nature) or other agreement, or subject to any judgment, decree or order of any court or administrative agency, that would interfere with their duties to the Company. The Company has not received any notice alleging that any such violation has occurred. Except for employees who have a current effective employment agreement with the Company, no employee of the Company has been granted the right to continued employment by the Company or to any material compensation following termination of employment with the Company. The Company is not aware that any officer, key employee or group of employees intends to terminate his, her or their employment with the Company.

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4.15 Registration Rights and Voting Rights.

Except as disclosed in Exchange Act Filings, the Company is presently not under any obligation, and has not granted any rights, to register any of the Company's presently outstanding securities or any of its securities that may hereafter be issued. To the Company's knowledge, no stockholder of the Company has entered into any agreement with respect to the voting of equity securities of the Company.

4.16 Compliance with Laws; Permits.

To its knowledge, the Company is not in violation in any material respect of any applicable statute, rule, regulation, order or restriction of any domestic or foreign government or any instrumentality or agency thereof in respect of the conduct of its business or the ownership of its properties which violation would materially and adversely affect the business, assets, liabilities, financial condition, operations or prospects of the Company. No governmental orders, permissions, consents, approvals or authorizations are required to be obtained and no registrations or declarations are required to be filed in connection with the execution and delivery of this Agreement and the issuance of any of the Securities, except such as has been duly and validly obtained or filed, or with respect to any filings that must be made after the Closing, as will be filed in a timely manner. The Company has all material franchises, permits, licenses and any similar authority necessary for the conduct of its business as now being conducted by it, the lack of which would materially and adversely affect the business, properties, prospects or financial condition of the Company.

4.17 Environmental and Safety Laws.

The Company is not in violation of any applicable statute, law or regulation relating to the environment or occupational health and safety, except for any violations that, individually or in the aggregate, have not had and would not reasonably be expected materially and adversely affect the business, properties, prospects or financial condition of the Company, and to its knowledge, no material expenditures are or will be required in order to comply with any such existing statute, law or regulation. No Hazardous Materials (as defined below) are used or have been used, stored, or disposed of by the Company or, to the Company's knowledge, by any other person or entity on any property owned, leased or used by the Company, except for any use, storage or disposal that, individually or in the aggregate, have not had and would not reasonably be expected materially and adversely affect the business, properties, prospects or financial condition of the Company. For the purposes of the preceding sentence, "Hazardous Materials" shall mean (a) materials which are listed or otherwise defined as "hazardous" or "toxic" under any applicable local, state, federal and/or foreign laws and regulations that govern the existence and/or remedy of contamination on property, the protection of the environment from contamination, the control of hazardous wastes, or other activities involving hazardous substances, including building materials, or (b) any petroleum products or nuclear materials.

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4.18 Valid Offering.

Assuming the accuracy of the representations and warranties of the Investors contained in this Agreement, the offer, sale and issuance of the Securities will be exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act"), and will have been registered or qualified (or are exempt from registration and qualification) under the registration, permit or qualification requirements of all applicable state securities laws.

4.19 Full Disclosure.

All disclosure concerning the Company contained in this Agreement, including the Schedules to this Agreement, is true and correct and does not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading.

4.20 Insurance.

The Company has general commercial, product liability, fire and casualty insurance policies with coverage customary for companies similarly situated to the Company in the same or similar business.

4.21 SEC Reports.

The Company has filed all proxy statements, reports and other documents required to be filed by it under the Exchange Act (the "SEC Reports"). Each SEC Report was, at the time of its filing, in substantial compliance with the requirements of its respective form and none of the SEC Reports, nor the financial statements (and the notes thereto) included in the SEC Reports, as of their respective filing dates, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading.

4.22 Listing.

The outstanding shares of the Company's Common Stock are listed for quotation on The Nasdaq National Market ("Nasdaq") under the symbol "NEST". The Company has taken no action designed to, or likely to have the effect of, terminating the registration of the Common Stock under the Exchange Act or delisting the Common Stock from the Nasdaq, nor has the Company received any notification that the SEC or the Nasdaq is contemplating terminating such registration or listing. The issuance of the Shares and the Warrant Shares does not require stockholder approval, including, without limitation, pursuant to the rules of the National Association of Securities Dealers, Inc. (the "NASD").

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4.23 No Integrated Offering.

Neither the Company, nor any of its affiliates, nor any person acting on its or their behalf, has directly or indirectly made any offers or sales of any security or solicited any offers to buy any security under circumstances that would cause the offering of the Securities pursuant to this Agreement to be integrated with prior offerings by the Company for purposes of the Securities Act which would prevent the Company from selling the Securities pursuant to Rule 506 under the Securities Act, or any applicable exchange-related stockholder approval provisions, nor will the Company or any of its affiliates or subsidiaries take any action or steps that would cause the offering of the Securities to be so integrated with other offerings.

4.24 Stop Transfer.

The Securities are restricted securities as of the date of this Agreement. The Company will not issue any stop transfer order or other order impeding the sale and delivery of any of the Securities at such time as the Securities are registered for public sale or an exemption from registration is available, except as required by federal securities laws.

5. REPRESENTATIONS AND WARRANTIES OF THE INVESTORS.

Each Investor, severally and not jointly, represents and warrants to the Company as follows:

5.1 Requisite Power and Authority.

The Investor has all necessary power and authority under all applicable provisions of law to execute and deliver this Agreement and the Related Agreements and to carry out their provisions. All corporate action on Investor's part required for the lawful execution and delivery of this Agreement and the Related Agreements have been or will be effectively taken prior to the Closing. Upon their execution and delivery, this Agreement and the Related Agreements will be valid and binding obligations of Investor, enforceable in accordance with their respective terms, except (a) as limited by applicable bankruptcy, insolvency, reorganization, moratorium or other laws of general application affecting enforcement of creditors' rights, and (b) as limited by general principles of equity that restrict the availability of equitable and legal remedies.

5.2 Investment Representations.

The Investor understands that the Securities are being offered and sold pursuant to an exemption from registration contained in the Securities Act based in part upon the Investor's representations contained in the Agreement, including, without limitation, that the Investor is an "accredited investor" within the meaning of Regulation D under the Securities Act. The Investor has received or has had full access to all the information it considers necessary or appropriate to make an informed investment decision with respect to the Shares and the Warrants to be purchased by it under this Agreement and the Warrant Shares acquired by it upon the exercise of the Warrants, respectively. The Investor further has had an opportunity to ask questions and receive answers from the Company regarding the Company's business, management and financial affairs and the terms and conditions of the Offering, and the Securities and to obtain additional information (to the extent the Company possessed such information or could acquire it without unreasonable effort or expense) necessary to verify any information furnished to the Investor or to which the Investor had access. The Investor has, in connection with its decision to purchase the number of Shares and Warrants set forth on the signature page hereto, (i) relied only upon the Exchange Act Filings, the representations and warranties of the Company contained in this Agreement and any other information received from the Company pursuant to this Section 0; (ii) has not relied on any information or advice furnished by or on behalf of KBCM or any other person.

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5.3 Investor Bears Economic Risk.

Investor has substantial experience in evaluating and investing in private placement transactions of securities in companies similar to the Company so that it is capable of evaluating the merits and risks of its investment in the Company and has the capacity to protect its own interests. Investor must bear the economic risk of this investment until the Securities are sold pursuant to (i) an effective Registration Statement under the Securities Act, or (ii) an exemption from registration. At no time was the Investor presented with or solicited by any publicly issued or circulated newspaper, mail, radio, television or, to the Investor's knowledge, any other form of general advertising or solicitation in connection with the offer, sale and purchase of the Securities.

5.4 Acquisition for Own Account.

Investor is acquiring the Shares, the Warrants and the Warrant Shares for Investor's own account for investment only, and not as a nominee or agent and with no present intention of distributing any Shares, Warrants or Warrant Shares, or any arrangement or understanding with any other person regarding the distribution thereof.

5.5 Investor Can Protect Its Interest.

Investor represents that by reason of its, or of its management's, business and financial experience, Investor has the capacity to evaluate the merits and risks of its investment in the Securities and to protect its own interests in connection with the transactions contemplated in this Agreement and the Related Agreements. The Investor understands that nothing in this Agreement or any other materials presented to the Investor in connection with the purchase and sale of Securities constitutes legal, tax, accounting or investment advice. The Investor has consulted such legal, tax, accounting and investment advisors as it, in its sole discretion, has deemed necessary or appropriate in connection with its purchase of the Securities.

5.6 Accredited Investor.

Investor represents that it is an accredited investor within the meaning of Regulation D under the Securities Act.

5.7 Legends.

The Investor acknowledges the following:

(a) The certificate evidencing the Shares shall bear substantially the following legend:

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"THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR, IF APPLICABLE, STATE SECURITIES LAWS. THE SHARES REPRESENTED BY THIS CERTIFICATE MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT AS TO SUCH SHARES UNDER SAID ACT AND APPLICABLE STATE SECURITIES LAWS OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO NESTOR, INC. THAT SUCH REGISTRATION IS NOT REQUIRED."

(b)The certificate evidencing Warrant Shares shall bear a legend which shall be in substantially the following form:

"THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR IF APPLICABLE, STATE SECURITIES LAWS. THESE SHARES MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT UNDER SUCH SECURITIES ACT AND APPLICABLE STATE LAWS OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO NESTOR, INC. THAT SUCH REGISTRATION IS NOT REQUIRED."

(c)Each Warrant shall bear substantially the following legend:

"THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR APPLICABLE STATE SECURITIES LAWS. THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT AS TO THIS WARRANT OR THE UNDERLYING SHARES OF COMMON STOCK UNDER SAID ACT AND APPLICABLE STATE SECURITIES LAWS OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO NESTOR, INC. THAT SUCH REGISTRATION IS NOT REQUIRED."

(d)The Investor further acknowledges that, upon receipt of a Suspension Notice (as defined below in Section 0), the Investor will refrain from selling any Shares or Warrant Shares pursuant to the Registration Statement until the Investor receives from the Company copies of a supplemented or amended Prospectus prepared and filed by the Company with the SEC, or until it is advised in writing by the Company that the current Prospectus may be used, and has received copies of any additional or supplemental filings that are incorporated or deemed incorporated by reference in any such Prospectus.

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5.8 Public Announcement.

The Company confirms that neither it nor any other person acting on its behalf has provided any of the Investors or their agents or counsel with any information that constitutes or might constitute material, nonpublic information other than the materials terms of the transactions contemplated by this Agreement. The Company agrees to timely file a Current Report on Form 8-K in compliance with its obligations under the Exchange Act, describing the material terms of the transactions contemplated by this Agreement. The Company agrees that, after the filing of such Form 8-K, none of the Company's communications to any Investor will include material, nonpublic information, unless otherwise agreed by the Company and such Investor in accordance with law.

5.9 No Shorting.

Other than the transaction contemplated hereunder, the Investor has not directly or indirectly, nor has any person acting on behalf of or pursuant to any understanding with such Investor, executed any disposition, including Short Sales (but not including the location and/or reservation of borrowable shares of Common Stock), in the securities of the Company during the period commencing from the time that such Investor first received a term sheet from the Company or any other person setting forth the material terms of the transactions contemplated hereunder until the date hereof ("Discussion Time"). Notwithstanding the foregoing, in the case of an Investor that is a multi-managed investment vehicle whereby separate portfolio managers manage separate portions of such Investor's assets and the portfolio managers have no direct knowledge of the investment decisions made by the portfolio managers managing other portions of such Investor's assets, the representation set forth above shall only apply with respect to the portion of assets managed by the portfolio manager that made the investment decision to purchase the Securities covered by this Agreement. Other than to other persons party to this Agreement, such Investor has maintained the confidentiality of all disclosures made to it in connection with the transaction contemplated hereby (including the existence and terms of the transaction contemplated hereby).

6. COVENANTS OF THE COMPANY.

The Company covenants and agrees with each Investor as follows:

6.1 Listing.

The Company shall maintain the listing of the Shares and Warrant Shares (subject to official notice of issuance, if applicable) on Nasdaq so long as any other shares of Common Stock shall be so listed or traded and will comply in all material respects with the Company's reporting, filing and other obligations under the bylaws or rules of the NASD and Nasdaq, as applicable.

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6.2 Market Regulations.

The Company shall notify the SEC, NASD and applicable state authorities, in accordance with their requirements, of the transactions contemplated by this Agreement, and shall take all other necessary action and proceedings as may be required and permitted by applicable law, rule and regulation, for the legal and valid issuance of the Securities to the Investors.

6.3 Use of Funds.

The Company agrees that it will use the proceeds of the sale of the Shares (i) to prepay that certain promissory note issued by the Company to Heil in the original principal amount of $1.25 million due October 26, 2006 and (ii) to finance the construction, installation and maintenance of its traffic surveillance systems and (iii) for general working capital.

6.4 Reissuance of Securities.

The Company agrees to reissue certificates representing the Securities without the legends set forth in Section 0 above at such time as (a) the holder thereof is permitted to dispose of such Securities pursuant to Rule 144(k) under the Securities Act, or (b) upon resale subject to an effective Registration Statement after such Securities are registered under the Securities Act. The Company agrees to cooperate with an Investor in connection with all resales pursuant to Rule 144(d) and Rule 144(k) and provide legal opinions necessary to allow such resales provided the Company and its counsel receive reasonably requested representations from the selling Investor and broker, if any.

6.5 Opinion.

On the Closing Date, the Company will deliver to each Investor an opinion from the Company's legal counsel substantially in the form set forth in Exhibit C hereto.

7. COVENANTS OF THE INVESTORS.

Each Investor, severally and not jointly, covenants and agrees with the Company as follows:

7.1 Confidentiality.

The Investor agrees that it will not disclose, and will not include in any public announcement, the name of the Company, unless expressly agreed to by the Company or unless and until such disclosure is required by law or applicable regulation, and then only to the extent of such requirement.

7.2 Non-Public Information.

The Investor shall not disclose to any other person (other than to its directors, officers, employees, agents, advisors or representatives to the extent necessary or advisable in connection with the investment decision to purchase Securities hereunder) any information concerning this Agreement or the placement of Securities under this Agreement or any nonpublic information disclosed to the Investor by or on behalf of the Company in connection with the offer and sale of Shares under this Agreement, until the Company shall have made a public announcement of such information as described in Section 0 above. The Investor agrees not to effect any sales in the shares of the Company's Common Stock while in possession of material, non-public information regarding the Company.

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7.3 Sales of Securities.

The Investor will not, directly or indirectly, offer, sell, pledge, transfer or otherwise dispose of (or solicit offers to buy, purchase or otherwise acquire or take a pledge of) any of the Securities, except in compliance with the Securities Act, applicable state and other securities laws and the respective rules and regulations promulgated thereunder. The Investor will deliver a prospectus upon any resale of Shares of Warrant Shares whenever such delivery is required by law.

7.4 Investor Questionnaire.

The Investor will have, on or prior to the Closing Date, furnished to the Company a fully completed Investor Questionnaire substantially in the form attached hereto as Exhibit D for use in preparation of the Registration Statement, and all of the information contained therein will be true and correct in all material respects as of such date and as of the Closing Date.

7.5 No Short Sales

Neither the Investor nor any of the Investor's affiliates acting on such Investor's behalf or pursuant to any understanding with such Investor will execute any Short Sales during the period after the Discussion Time and ending at the time that the transactions contemplated by this Agreement are first publicly announced as described in Section 0 above. Each Investor understands and acknowledges, severally and not jointly with any other Investor, that the Commission currently takes the position that entering into a short sale of the Common Stock "against the box" while holding unregistered shares of the Common Stock, followed by coverage of the short sale with such shares after the Registration Statement has been declared effective by the Commission, is a violation of Section 5 of the Securities Act, as set forth in Item 65, Section 5 under Section A, of the Manual of Publicly Available Telephone Interpretations, dated July 1997, compiled by the Office of Chief Counsel, Division of Corporation Finance. Notwithstanding the foregoing, no Investor makes any representation, warranty or covenant hereby that it will not engage in Short Sales in the securities of the Company after the time that the transactions contemplated by this Agreement are first publicly announced as described in Section 5.8. Notwithstanding the foregoing, in the case of an Investor that is a multi-managed investment vehicle whereby separate portfolio managers manage separate portions of such Investor's assets and the portfolio managers have no direct knowledge of the investment decisions made by the portfolio managers managing other portions of such Investor's assets, the covenant set forth above shall only apply with respect to the portion of assets managed by the portfolio manager that made the investment decision to purchase the Securities covered by this Agreement.

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8. COVENANTS OF THE COMPANY AND INVESTOR REGARDING INDEMNIFICATION.

8.1 Company Indemnification.

The Company agrees to indemnify, hold harmless, reimburse and defend each Investor, each of such Investor's officers, directors, agents, affiliates, control persons, and principal shareholders, against any claim, cost, expense, liability, obligation, loss or damage (including reasonable legal fees) of any nature, incurred by or imposed upon the Investor which results, arises out of or is based upon (i) any misrepresentation by Company or breach of any warranty by Company in this Agreement or in any exhibits or schedules attached hereto or any Related Agreement, or (ii) any breach or default in performance by Company of any covenant or undertaking to be performed by Company hereunder, or any other agreement entered into by the Company and such Investor relating hereto.

8.2 Investor's Indemnification.

Each Investor, severally and not jointly, agrees to indemnify, hold harmless, reimburse and defend the Company and each of the Company's officers, directors, agents, affiliates, control persons and principal shareholders, at all times against any claim, cost, expense, liability, obligation, loss or damage (including reasonable legal fees) of any nature, incurred by or imposed upon the Company which results, arises out of or is based upon (i) any misrepresentation by Investor or breach of any warranty by Investor in this Agreement or in any exhibits or schedules attached hereto or any Related Agreement; or (ii) any breach or default in performance by Investor of any covenant or undertaking to be performed by Investor hereunder, or any other agreement entered into by the Company and Investor relating hereto.

8.3 Procedures.

The procedures and limitations set forth in Section 0 shall apply to the indemnifications set forth in Sections 0 and 0 above.

9. REGISTRATION RIGHTS.

9.1 Registration Rights Granted.

The Company hereby grants the following registration rights to the Investors. The Company shall:

(a) prepare and file with the Commission, as soon as reasonably practicable, but in no event later than the date that is five (5) business days after the Company files its Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (such date, the "Filing Deadline Date"), a Registration Statement on Form S-3 (the "Registration Statement") to enable the resale of Shares and the Warrant Shares (collectively the "Registrable Securities") by the Investors from time to time under the Securities Act (except if the Company is not then eligible to register for resale the Registrable Securities on Form S-3, in which case such registration shall be on another appropriate form in accordance herewith);

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(b) use its best efforts, subject to receipt of information from the Investors set forth in Exhibit D, to cause the Registration Statement to be declared effective under the Securities Act as soon as practicable but in no event later than the date (the "Effectiveness Deadline Date") that is 60 calendar days after the Filing Deadline;

(c) during the period from the date on which the Registration Statement is declared effective until the earlier of (i) such time as all Investors may immediately sell all of the Shares purchased under this Agreement under Rule 144(b) (without giving effect to the volume limitations of Rule 144(e)) and (ii) such time as all Investors have sold all of the Registrable Securities that the Investors purchased under this Agreement (such period, the "Effectiveness Period"), the Company shall: (A) use its best efforts to prepare and file with the SEC such amendments and supplements to the Registration Statement as may be necessary or appropriate to keep such Registration Statement current and continuously effective (including any amendment or supplement through incorporation by reference of any report filed under the Exchange Act); (B) cause the Prospectus used in connection with such Registration Statement to be supplemented by any required Prospectus supplement, and as so supplemented to be filed pursuant to Rule 424 (or any similar provisions then in force) under the Securities Act; and (C) use its best efforts to comply with the provisions of the Securities Act applicable to it with respect to the disposition of all securities covered by such Registration Statement during the Effectiveness Period in accordance with the intended methods of disposition by the sellers thereof set forth in such Registration Statement, as so amended, or such Prospectus, as so supplemented;

(d) as soon as practicable, but in any event within three business days, give notice to each Investor when any Prospectus, Prospectus supplement, or the Registration Statement or any post-effective amendment to the Registration Statement has been filed with the SEC and, with respect to a Registration Statement or any post-effective amendment, when the same has been declared effective;

(e) furnish to each Investor such number of copies of the Registration Statement, Prospectuses (including Prospectus supplements) and preliminary versions of the Prospectus filed with the Commission ("Preliminary Prospectuses") in conformity with the requirements of the Securities Act, and such other documents as such Investor may reasonably request, in order to facilitate the public sale or other disposition of all or any of the Shares and Warrant Shares by such Investor;

(f) file documents required of the Company for normal blue sky clearance in all states requiring blue sky clearance; provided that the Company will not be required to (i) qualify as a foreign corporation or as a dealer in securities in any jurisdiction where it would not otherwise be required to qualify but for this Agreement or (ii) take any action that would subject it to general service of process in suits or to taxation in any such jurisdiction where it is not then so subject;

(g) if NASD Rule 2710 requires any broker-dealer to make a filing prior to executing a sale of Shares by an Investor, make an Issuer Filing with the NASD Corporate Financing Department pursuant to NASD Rule 2710(b)(10)(A)(i) and respond within five trading days to any comments received from NASD in connection therewith, and pay the filing fee required in connection therewith;

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(h) request that the Registration Statement be declared effective by the SEC within five (5) days of receiving a "no comment" letter from the SEC;

(i) advise the Investors at the earliest possible moment after the Company shall receive notice or obtain knowledge of (i) the issuance of any stop order by the Commission delaying or suspending the effectiveness of the Registration Statement or (ii) suspension of the qualification (or exemption from qualification) of any of the Shares for sale in any jurisdiction in which they have been qualified for sale, or, in each case, the initiation of any proceeding for that purpose; and promptly use its best efforts to prevent the issuance of any stop order or suspension or obtain its withdrawal at the earliest possible moment if such stop order should be issued or suspension levied; and

(j) bear all fees and expenses (other than fees and expenses of each Investor's legal counsel or other advisers, and underwriting discounts, brokerage fees and commissions, if any) incurred in connection with the performance by the Company of its obligations under paragraphs (a) through (g) and the registration of Registrable Securities pursuant to the Registration Statement, whether or not the Registration Statement is declared effective.

9.2 Delay In Filing Or Effectiveness Of Registration Statement.

(a) If the Registration Statement is not filed by the Company with the SEC on or prior to the Filing Deadline Date, then for each day following the Filing Deadline Date, until but excluding the date the Registration Statement is filed, or if the Registration Statement is not declared effective by the SEC by the Effectiveness Deadline Date, then for each day following the Effectiveness Deadline Date, until but excluding the date the SEC declares the Registration Statement effective, the Company shall, for each such day, pay each Investor in cash, as liquidated damages ("Liquidated Damages") and not as a penalty, an amount equal to 0.0493% of the Purchase Price of each Share held by such Investor with respect to any such failure and for any such day. Such payment shall be made no later than the fifth business day of the calendar month next succeeding the month in which such day occurs. Such Liquidated Damages shall constitute the Investors' exclusive remedy at law, but not in equity, for such events.

(b) Notwithstanding the foregoing, no Liquidated Damages shall be due or payable hereunder if the Company has filed the Registration Statement with the SEC on or prior to the Filing Deadline Date, has received a "comment letter" from the SEC and has responded within ten (10) days following the Company's receipt of such comment letter, provided that the Company has communicated the SEC's comments to the Investors within ten (10) days of the Company's receipt thereof. The Investors shall be bound by the provisions of this Agreement (including, without limitation, the provisions of Section 7 hereof) with respect to any and all non-public information communicated to them pursuant to this Section 0. Furthermore, commencing on the date that that is one-year after the Closing Date, no Liquidated Damages shall be due or payable with respect to that portion of an Investor's Registrable Securities that can be immediately sold in reliance on Rule 144.

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9.3 Transfer of Shares after Registration; Suspension.

(a) Each Investor agrees that it will not effect any disposition of the Shares, or its right to purchase Shares, that would constitute a sale within the meaning of the Securities Act except as contemplated in the Registration Statement referred to in Section 0 of this Agreement or, in accordance with Section 0 of this Agreement or as otherwise permitted by law.

(b) Except in the event that paragraph (c) below applies, the Company shall:

if it deems necessary, prepare and file from time to time with the SEC one or more post-effective amendments to the Registration Statement or supplements to the related Prospectus so that such Registration Statement will not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading, and so that, as thereafter delivered to purchasers of the Registrable Securities being sold thereunder, such Prospectus will not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading (including any amendment or supplement through incorporation by reference of any report filed under the Exchange Act); and

as soon as practicable provide to each Investor copies of any documents filed pursuant to the preceding Section 9.3(b)(i) (other than any amendment or supplement through incorporation by reference of any report filed under the Exchange Act).

(c) Subject to paragraph (d) below, in the event of:

any request by the SEC or any other federal or state governmental authority during the Effectiveness Period for amendments or supplements to the Registration Statement or related Prospectus or for additional information;

the issuance by the SEC or any other federal or state governmental authority of any stop order suspending the effectiveness of the Registration Statement or the initiation of any proceedings for that purpose;

the receipt by the Company of any notification with respect to the suspension of the qualification (or exemption from qualification) of any of the Registrable Securities for sale in any jurisdiction in which they have been qualified for sale or the initiation of any proceeding for such purpose; or

any event or circumstance which necessitates the making of any changes in the Registration Statement or Prospectus so that, in the case of the Registration Statement, it will not contain any untrue statement of a material fact or any omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading, and that in the case of the Prospectus, it will not contain any untrue statement of a material fact or any omission to state a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading; the Company shall promptly deliver a certificate in writing to each Investor (the "Suspension Notice") to the effect of the foregoing and, upon receipt of such Suspension Notice, such Investor will refrain from selling any Registrable Securities pursuant to the Registration Statement (a "Suspension") until such Investor receives from the Company copies of a supplemented or amended Prospectus prepared and filed by the Company, or until it is advised in writing by the Company that the current Prospectus may be used. In the event of any Suspension, the Company will use its best efforts to cause the use of the Prospectus so suspended to be resumed as soon as practicable after delivery of a Suspension Notice to the Investor, and the Company shall as soon as practicable provide each Investor with copies of any supplemented or amended Prospectus or, as the case may be, advise each Investor in writing that the current Prospectus may be used.

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(d) In addition, subject to compliance with applicable law, the Company shall use its best efforts to ensure that the Company's transfer agent expeditiously effects all sales of Registrable Securities under the Registration Statement that the Investor may have from time to time, including the prompt removal of any restrictive legends.

9.4 Indemnification.

(a) In the event of a registration of any Registrable Securities under the Securities Act pursuant to this Agreement, the Company will indemnify and hold harmless each Investor, and its officers, directors and each other person, if any, who controls the Investor within the meaning of the Securities Act (each, a "Selling Stockholder"), against any losses, claims, damages or liabilities, joint or several, to which each Selling Stockholder may become subject under the Securities Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in any Registration Statement under which such Registrable Securities were registered under the Securities Act pursuant to this Agreement, any preliminary prospectus or final prospectus contained therein, or any amendment or supplement thereof, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, and will reimburse the Selling Stockholder, and each such person for any reasonable legal or other expenses incurred by them in connection with investigating or defending any such loss, claim, damage, liability or action; provided, however, that the Company will not be liable in any such case if and to the extent that any such loss, claim, damage or liability arises out of or is based upon an untrue statement or alleged untrue statement or omission or alleged omission so made in conformity with information furnished by the Selling Stockholder or any such person in writing specifically for use in any such document or the failure of such Selling Stockholder to comply with its covenants and agreements contained herein.

(b) In the event of a registration of the Registrable Securities under the Securities Act pursuant to this Agreement, each Investor will indemnify and hold harmless the Company, and its officers, directors and each other person, if any, who controls the Company within the meaning of the Securities Act, against all losses, claims, damages or liabilities, joint or several, to which the Company or such persons may become subject under the Securities Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in the Registration Statement under which such Registrable Securities were registered under the Securities Act pursuant to this Agreement, any preliminary prospectus or final prospectus contained therein, or any amendment or supplement thereof, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading or the failure of such Selling Stockholder to comply with its covenants and agreements contained herein, and will reimburse the Company and each such person for any reasonable legal or other expenses incurred by them in connectionwith investigating or defending any such loss, claim, damage, liability or action, provided, however, that such Selling Stockholder will be liable in any such case if and only to the extent that any such loss, claim, damage or liability arises out of or is based upon an untrue statement or alleged untrue statement or omission or alleged omission so made in conformity with information furnished in writing to the Company by such Selling Stockholder specifically for use in any such document or the failure of such Selling Stockholder to comply with its covenants and agreements contained herein.

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(c) Promptly after receipt by an indemnified party hereunder of notice of the commencement of any action, such indemnified party shall, if a claim in respect thereof is to be made against the indemnifying party hereunder, notify the indemnifying party in writing thereof, but the omission so to notify the indemnifying party shall not relieve it from any liability which it may have to such indemnified party other than under this Section 00 and shall only relieve it from any liability which it may have to such indemnified party under this Section 00 if and to the extent the indemnifying party is prejudiced by such omission. In case any such action shall be brought against any indemnified party and it shall notify the indemnifying party of the commencement thereof, the indemnifying party shall be entitled to participate in and, to the extent it shall wish, to assume and undertake the defense thereof with counsel satisfactory to such indemnified party, and, after notice from the indemnifying party to such indemnified party of its election so to assume and undertake the defense thereof, the indemnifying party shall not be liable to such indemnified party under this Section 00 for any legal expenses subsequently incurred by such indemnified party in connection with the defense thereof; if the indemnified party retains its own counsel, then the indemnified party shall pay all fees, costs and expenses of such counsel, provided, however, that, if the defendants in any such action include both the indemnified party and the indemnifying party and the indemnified party shall have reasonably concluded that there may be reasonable defenses available to it which are different from or additional to those available to the indemnifying party or if the interests of the indemnified party reasonably may be deemed to conflict with the interests of the indemnifying party, the indemnified parties shall have the right to select one separate counsel and to assume such legal defenses and otherwise to participate in the defense of such action, with the reasonable expenses and fees of such separate counsel and other expenses related to such participation to be reimbursed by the indemnifying party as incurred.

(d) In order to provide for just and equitable contribution in the event of joint liability under the Securities Act in any case in which either (i) the Selling Stockholder makes a claim for indemnification pursuant to this Section 0 but it is judicially determined (by the entry of a final judgment or decree by a court of competent jurisdiction and the expiration of time to appeal or the denial of the last right of appeal) that such indemnification may not be enforced in such case notwithstanding the fact that this Section 0 provides for indemnification in such case, or (ii) contribution under the Securities Act may be required on the part of the Selling Stockholder in circumstances for which indemnification is provided under this Section 0; then, and in each such case, the Company and the Selling Stockholder will contribute to the aggregate losses, claims, damages or liabilities to which they may be subject(after contribution from others) in such proportion so that the Selling Stockholder is responsible only for the portion represented by the percentage that the public offering price of its securities offered by the Registration Statement bears to the public offering price of all securities offered by such Registration Statement, provided, however, that, in any such case, (A) the Selling Stockholder will not be required to contribute any amount in excess of the public offering price of all such securities offered by it pursuant to such Registration Statement; and (B) no person or entity guilty of fraudulent misrepresentation (within the meaning of Section 10 of the Act) will be entitled to contribution from any person or entity who was not guilty of such fraudulent misrepresentation.

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(e) In any proceeding relating to the Registration Statement filed pursuant to this Section 0, each party against whom contribution may be sought under this Section 0 hereby consents to the jurisdiction of any court having jurisdiction over any other contributing party, agrees that process issuing from such court may be served upon him or it by any other contributing party and consents to the service of such process and agrees that any other contributing party may join him or it as an additional defendant in any such proceeding in which such other contributing party is a party.

10. REPRESENTATIONS AND WARRANTIES OF INVESTORS REGARDING COMPANY AFFILIATES.

(a) Silver Star Partners I, LLC (Silver Star") represents and warrants to the Company that although certain current directors and executive officers of the Company ("Company Affiliates") are members and/or managers of Silver Star, (i) such Company Affiliates are not participating in the transactions contemplated hereby indirectly through Silver Star and (iii) notwithstanding such person's status as a member and/or manager of Silver Star, no Company Affiliate, pursuant to any term or provision of Silver Star's governing documents, or any agreement, arrangement or understanding has or will have any economic or pecuniary interest in the Securities purchased by Silver Star or the Silver Star Rebate.

(b) Each Investor other than Silver Star represents and warrants that no Company Affiliate has any interest as a member and/or manager of such Investor or is participating in the transactions contemplated hereby indirectly through such Investor.

11. INDEPENDENT NATURE OF INVESTORS' OBLIGATIONS AND RIGHTS.

The obligations of each Investor under this Agreement are several and not joint with the obligations of any other Investor, and no Investor shall be responsible in any way for the performance of the obligations of any other Investor under this Agreement. The decision of each Investor to purchase the Securities under this Agreement has been made by such Investor independently of any other Investor and independently of any information, materials, statements or opinions as to the business, affairs, operations, assets, properties, liabilities, results of operations, condition (financial or otherwise) or prospects of the Company or any of its subsidiaries that may have been made or given by any other Investor or by any agent or employee of any other Investor, other than with respect to investment advisors who provide discretionary investment services to more than one Investor, and no Investor or any of its agents or employees shall have any liability to any other Investor (or any other person) relating to or arising from any such information, materials, statements or opinions. Nothing contained in this Agreement, and no action taken by any Investor pursuant hereto, shall be deemed to constitute the Investors as a partnership, an association, a joint venture or any other kind of entity, or create a presumption that the Investors are in any way acting in concert or as a group with respect to such obligations or the transactions contemplated by this Agreement. Each Investor acknowledges that no other Investor has acted as agent for such Investor in connection with making its investment hereunder and that no other Investor will be acting as agent of such Investor in connection with monitoring its investment hereunder. Each Investor shall be entitled to independently protect and enforce its rights, including without limitation the rights arising out of this Agreement, and it shall not be necessary for any other Investor to be joined as an additional party in any proceeding for such purpose.

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12. MISCELLANEOUS.

12.1 Governing Law.

This Agreement shall be governed by and construed in accordance with the laws of the State of Delaware, without regard to principles of conflicts of laws. Any action brought by either party against the other concerning the transactions contemplated by this Agreement shall be brought only in the state courts of Delaware or Rhode Island or in the federal courts located in the State of Delaware or State of Rhode Island. Both parties and the individuals executing this Agreement and other agreements on behalf of the Company agree to submit to the jurisdiction of such courts and waive trial by jury. In the event that any provision of this Agreement or any other agreement delivered in connection herewith is invalid or unenforceable under any applicable statute or rule of law, then such provision shall be deemed inoperative to the extent that it may conflict therewith and shall be deemed modified to conform to such statute or rule of law. Any such provision which may prove invalid or unenforceable under any law shall not affect the validity or enforceability of any other provision of any agreement.

12.2 Survival.

The representations, warranties, covenants and agreements made herein shall survive any investigation made by the Investors and the closing of the transactions contemplated hereby to the extent provided therein. All statements as to factual matters contained in any certificate or other instrument delivered by or on behalf of the Company pursuant hereto in connection with the transactions contemplated hereby shall be deemed to be representations and warranties by the Company hereunder solely as of the date of such certificate or instrument.

12.3 Entire Agreement.

This Agreement, the exhibits and schedules hereto, the Related Agreements and the other documents delivered pursuant hereto constitute the full and entire understanding and agreement between the parties with regard to the subjects hereof and no party shall be liable or bound to any other in any manner by any representations, warranties, covenants and agreements except as specifically set forth herein and therein.

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12.4 Severability.

In case any provision of the Agreement shall be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby.

12.5 Assignment.

The rights and obligations of each Investor under this Agreement shall be automatically assigned by such Investor to any transferee of all or any portion of such Investor's Securities in any private transfer of such Securities; provided, however, that within two business days prior to the transfer, (a) such Investor provides the Company notice of the transfer, including the name and address of the transferee and the number of Securities transferred; and (b) that such transferee agrees in writing to be bound by the terms of this Agreement. Upon any transfer permitted by this Section 0, the Company shall be obligated to such transferee to perform all of its covenants under this Agreement as if such transferee were the Investor.

12.6 Amendment and Waiver.

(a) This Agreement may be amended or modified only upon the written consent of the Company and each Investor.

(b) The obligations of the Company and the rights of an Investor under this Agreement may be waived only with the written consent of such Investor.

(c) The obligations of an Investor and the rights of the Company under this Agreement may be waived only with the written consent of the Company.

12.7 Delays or Omissions.

It is agreed that no delay or omission to exercise any right, power or remedy accruing to any party, upon any breach, default or noncompliance by another party under this Agreement or the Related Agreements, shall impair any such right, power or remedy, nor shall it be construed to be a waiver of any such breach, default or noncompliance, or any acquiescence therein, or of or in any similar breach, default or noncompliance thereafter occurring. All remedies, either under this Agreement or the Related Agreements, by law or otherwise afforded to any party, shall be cumulative and not alternative.

12.8 Notices.

All notices required or permitted hereunder shall be in writing and shall be deemed effectively given: (a) upon personal delivery to the party to be notified, (b) when sent by telephonically confirmed facsimile if sent during normal business hours of the recipient, if not, then on the next business day, (c) five days after having been sent by registered or certified mail, return receipt requested, postage prepaid, or (d) one day after deposit with a nationally recognized overnight courier, specifying next day delivery, with written verification of receipt. All communications shall be sent to the Company at the address as set forth on the signature page hereof, to the Investor at the address set forth on the signature page hereto for such Investor, with a copy in the case of the Company to Benjamin M. Alexander, Esq., at the address of the Company or at such other address as the Company or the Investor may designate by ten days advance written notice to the other parties hereto.

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12.9 Titles and Subtitles.

The titles of the sections and subsections of the Agreement are for convenience of reference only and are not to be considered in construing this Agreement.

12.10 Facsimile Signatures; Counterparts.

This Agreement may be executed by facsimile signatures and in any number of counterparts, each of which shall be an original, but all of which together shall constitute one instrument.

12.11 Broker's Fees.

The Company represents and warrants that any agent, broker, investment banker, person or firm acting on behalf of or under the authority of the Company that is or will be entitled to any broker's or finder's fee or any other commission directly or indirectly in connection with the transactions contemplated herein will be paid by the Company. The Company further agrees to indemnify each Investor for any claims, losses or expenses incurred by it as a result of the representation in this Section 0 being untrue. Each Investor represents and warrants that, no agent, broker, investment banker, person or firm acting on behalf of or under the authority of such Investor is or will be entitled to any broker's or finder's fee or any other commission directly or indirectly in connection with the transactions contemplated herein, except the Placement Fee payable to the Placing Broker for such Investor listed on Exhibit B. Each Investor further agrees to indemnify each other party for any claims, losses or expenses incurred by such other party as a result of the representation in this Section 0 being untrue.

12.12 Construction.

Each party acknowledges that its legal counsel participated in the preparation of this Agreement and, therefore, stipulates that the rule of construction that ambiguities are to be resolved against the drafting party shall not be applied in the interpretation of this Agreement to favor any party against the other.

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In Witness Whereof, the parties hereto have executed the Securities Purchase Agreement as of the date set forth in the first paragraph hereof.

COMPANY:

NESTOR, INC.

By: /s/ Nigel P. Hebborn

Name: Nigel P. Hebborn

Title: Executive Vice President and CFO

Address:

Nestor, Inc.

42 Oriental Street

Providence, RI 02908

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INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Sam Belzberg

Investor Name

By: /s/ Sam Belzberg

Name:___________________________________________

Title:____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 56,561

Number of Warrant Shares: 16,968

Aggregate Purchase Price: $250,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Clyde J. Berg, as Trustee of the Clyde J. Berg Trust utd 4/4/95

Investor Name

By: /s/ Clyde J. Berg

Name: Clyde J. Berg

Title: Trustee

Address:_________________________________________

________________________________________________

Number of Shares: 45,248

Number of Warrant Shares: 13,574

Aggregate Purchase Price: $200,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Neal Goldman

Investor Name

By:/s/ Neal Goldman

Name:___________________________________________

Title:____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 113,122

Number of Warrant Shares: 33,936

Aggregate Purchase Price: $500,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Edward F. Heil

Investor Name

By: /s/ Edward F. Heil

Name:___________________________________________

Title:____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 395,927

Number of Warrant Shares: 118,778

Aggregate Purchase Price: $1,750,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Iroquois Master Fund Ltd.

Investor Name

By: /s/ Joshua Silverman

Name: Joshua Silverman

Title: Authorized Signatory

Address:_________________________________________

________________________________________________

Number of Shares: 33,937

Number of Warrant Shares: 10,181

Aggregate Purchase Price: $150,001.54

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Kuekenhof Equity Fund, L.P.

Investor Name

By: /s/ Michael C. James

Name: Michael C. James

Title: General Partner

Address:_________________________________________

________________________________________________

Number of Shares: 56,561

Number of Warrant Shares: 16,968

Aggregate Purchase Price: $250,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Levene Ass. A Partnership

Investor Name

By: /s/ Eunice R. Levene

Name: Eunice R. Levene

Title: General Partner

Address:_________________________________________

________________________________________________

Number of Shares: 28,280

Number of Warrant Shares:  8,484

Aggregate Purchase Price: $125,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Susan Moffit

Investor Name

By: /s/ Susan Moffit

Name: ___________________________________________

Title: ____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 5,656

Number of Warrant Shares:1,696

Aggregate Purchase Price: $25,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Wallace L. Mossop, III, as trustee of the Wallace L. Mossop III Trust dtd 2/3/00

Investor Name

By: /s/ Wallace L. Mossop III

Name: Wallace L. Mossop III

Title: Trustee

Address:_________________________________________

________________________________________________

Number of Shares: 28,280

Number of Warrant Shares:8,484

Aggregate Purchase Price: $125,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Nite Capital, L.P.

Investor Name

By: /s/ Keith A. Goodman

Name: KeithA. Goodman

Title: Manger of General Partner

Address:_________________________________________

________________________________________________

Number of Shares: 45,248

Number of Warrant Shares:13,574

Aggregate Purchase Price: $200,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

RAQ, LLC

Investor Name

By: /s/ Lindsay A. Rosenwald, M.D.

Name: Lindsay A. Rosenwald, M.D.

Title: Managing Member

Address:_________________________________________

________________________________________________

Number of Shares: 56,561

Number of Warrant Shares:16,968

Aggregate Purchase Price: $250,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Wilson G. & Ellen M. Saville, JTWROS

Investor Name

By: /s/ Wilson G. Saville /s/ Ellen M. Saville

Name: ___________________________________________

Title: ____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 28,280

Number of Warrant Shares:8,484

Aggregate Purchase Price: $125,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Silver Star Partners I, LLC

Investor Name

By:/s/ William B. Danzell

Name: William B. Danzell

Title: President

Address:_________________________________________

________________________________________________

Number of Shares: 220,589

Number of Warrant Shares:66,176

Aggregate Purchase Price: $975,003.38

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

Martin L. Solomon

Investor Name

By: /s/ Martin L. Solomon

Name: ___________________________________________

Title: ____________________________________________

Address:_________________________________________

________________________________________________

Number of Shares: 56,561

Number of Warrant Shares:16,968

Aggregate Purchase Price: $250,000

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

INVESTOR SIGNATURE PAGE TO SECURITIES PURCHASE AGREEMENT

By executing this page in the space provided, the undersigned hereby agrees that (a) the undersigned is a party, for all purposes, to the Securities Purchase Agreement dated as of January 31, 2006 by and among Nestor, Inc. and the persons and entities listed as signatories thereto, and (b) upon becoming a party thereto, the undersigned will be deemed an "Investor" thereunder and shall have the benefits of, and shall be subject to the rights and restrictions contained in said Securities Purchase Agreement.

IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above.

TCMP3 Partners

Investor Name

By: /s/ Steven E. Slawson

Name: Steven E. Slawson

Title: Principle

Address:_________________________________________

________________________________________________

Number of Shares: 67,000

Number of Warrant Shares:20,100

Aggregate Purchase Price: $296,140

Tax Identification Number:____________________________

Contact Name: _____________________________________

Telephone:________________________________________

Name in which the Shares should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the

Shares should be registered (if

different):_________________________________________

Name in which the Warrants should be

registered (if different):_______________________________

Relationship between the Investor and

the person in whose name the Warrant

should be registered (if different):_______________________

EXHIBIT A to Securities Purchase

Agreement

THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED. THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT AS TO THIS WARRANT UNDER SAID ACT OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO NESTOR, INC. THAT SUCH REGISTRATION IS NOT REQUIRED.

Right to Purchase [*] Shares of Common Stock of Nestor, Inc. (subject to adjustment as provided herein)

COMMON STOCK PURCHASE WARRANT

No. 2006-1 Issue Date: January 31, 2006

NESTOR, INC., a corporation organized under the laws of the State of Delaware (the "Company"), hereby certifies that, for value received, [Investor Name], or assigns (the "Holder"), is entitled, subject to the terms set forth below, to purchase from the Company from and after the Issue Date of this Warrant and at any time or from time to time before 5:00 p.m., New York time, through January 31, 2009 (three (3) years after the Issue Date) (the "Expiration Date"), up to [*] fully paid and nonassessable shares of Common Stock (as hereinafter defined), $.01 par value per share, of the Company, at the Purchase Price (as defined below). The number and character of such shares of Common Stock and the Purchase Price are subject to adjustment as provided herein. Capitalized terms used but not otherwise defined shall have them in the Securities Purchase Agreement dated the date hereof by and among the Company and the Investors named therein, including Holder.

As used herein the following terms, unless the context otherwise requires, have the following respective meanings:

(a)The term "Company" shall include Nestor, Inc. and any corporation which shall succeed or assume the obligations of Nestor, Inc. hereunder.

(b)The term "Common Stock" includes (a) the Company's Common Stock, $.01 par value per share, as authorized on the date of the Securities Purchase Agreement referred to in Section 9 hereof, and (b) any other securities into which or for which any of the securities described in (a) may be converted or exchanged pursuant to a plan of recapitalization, reorganization, merger, sale of assets or otherwise.

(c)The term "Other Securities" refers to any stock (other than Common Stock) and other securities of the Company or any other person (corporate or otherwise) which the holder of the Warrant at any time shall be entitled to receive, or shall have received, on the exercise of the Warrant, in lieu of or in addition to Common Stock, or which at any time shall be issuable or shall have been issued in exchange for or in replacement of Common Stock or Other Securities pursuant to Section 4 or otherwise.

(d)The term "Purchase Price" shall mean [ ^ŧ:]

_____________

* Based on the price per Share determined as follows: thirty percent (30%) of the number of Shares such Investor is purchasing.

A-1

1.             Exercise of Warrant.

1.1.          Number of Shares Issuable upon Exercise. From and after the date hereof through and including the Expiration Date, the holder hereof shall be entitled to receive, upon exercise of this Warrant in whole in accordance with the terms of subsection 1.2 or upon exercise of this Warrant in part in accordance with subsection 1.3, shares of Common Stock of the Company, subject to adjustment pursuant to Section 4.

1.2.Full Exercise. This Warrant may be exercised in full by the holder hereof by delivery of an original or fax copy of the form of subscription attached as Exhibit A hereto (the "Subscription Form") duly executed by such Holder, to the Company at its principal office or at the office of its warrant agent (as provided hereinafter), accompanied by payment, in cash, wire transfer, or by certified or official bank check payable to the order of the Company, in the amount obtained by multiplying the number of shares of Common Stock for which this Warrant is then exercisable by the Purchase Price then in effect.

1.3.Partial Exercise. This Warrant may be exercised in part (but not for a fractional share) by surrender of this Warrant in the manner and at the place provided in subsection 1.2 except that the amount payable by the holder on such partial exercise shall be the amount obtained by multiplying (a) the number of shares of Common Stock designated by the holder in the Subscription Form by (b) the Purchase Price then in effect. On any such partial exercise, the Company, at its expense, will forthwith issue and deliver to or upon the order of the holder hereof a new Warrant of like tenor, in the name of the holder hereof or as such holder (upon payment by such holder of any applicable transfer taxes) may request, the number of shares of Common Stock for which such Warrant may still be exercised.

1.4. Fair Market Value. Fair Market Value of a share of Common Stock as of a particular date (the "Determination Date") shall mean:

(a)If the Company's Common Stock is traded on an exchange or is quoted on the National Association of Securities Dealers, Inc. Automated Quotation ("NASDAQ") National Market System or the NASDAQ SmallCap Market, then the average closing or last sale price, respectively, reported for the ten business days immediately preceding the Determination Date.

(b)If the Company's Common Stock is not traded on an exchange or on the NASDAQ National Market System or the NASDAQ SmallCap Market but is traded on the NASD OTC Bulletin Board, then the mean of the average of the closing bid and asked prices reported for the ten business days immediately preceding the Determination Date.

(c)If the Company's Common Stock is not publicly traded, then as the Holder and the Company agree or in the absence of agreement by arbitration in accordance with the rules then standing of the American Arbitration Association, before a single arbitrator to be chosen from a panel of persons qualified by education and training to pass on the matter to be decided.

1.5.Company Acknowledgment. The Company will, at the time of the exercise of the Warrant, upon the request of the holder hereof acknowledge in writing its continuing obligation to afford to such holder any rights to which such holder shall continue to be entitled after such exercise in accordance with the provisions of this Warrant. If the holder shall fail to make any such request, such failure shall not affect the continuing obligation of the Company to afford to such holder any such rights.

^ŧ The 10 day Volume Weighted Average Price (VWAP).

A-2

1.6.Trustee for Warrant Holders. In the event that a bank or trust company shall have been appointed as trustee for the Company pursuant to Subsection 3.2, such bank or trust company shall have all the powers and duties of a warrant agent (as hereinafter described) and shall accept, in its own name for the account of the Company or such successor person as may be entitled thereto, all amounts otherwise payable to the Company or such successor, as the case may be, on exercise of this Warrant pursuant to this Section 1.

2.1Delivery of Stock Certificates, etc. on Exercise. The Company agrees that the shares of Common Stock purchased upon exercise of this Warrant shall be deemed to be issued to the holder hereof as the record owner of such shares as of the close of business on the date on which this Warrant shall have been surrendered and payment made for such shares as aforesaid. As soon as practicable after the exercise of this Warrant in full or in part, and in any event within 7 days thereafter, the Company at its expense (including the payment by it of any applicable issue taxes) will cause to be issued in the name of and delivered to the holder hereof, or as such holder (upon payment by such holder of any applicable transfer taxes) may direct in compliance with applicable Securities Laws, a certificate or certificates for the number of duly and validly issued, fully paid and nonassessable shares of Common Stock (or Other Securities) to which such holder shall be entitled on such exercise, plus, in lieu of any fractional share to which such holder would otherwise be entitled, cash equal to such fraction multiplied by the then Fair Market Value of one full share, together with any other stock or other securities and property (including cash, where applicable) to which such holder is entitled upon such exercise pursuant to Section 1 or otherwise.

2.2.Payment of Purchase Price.

(a)Payment may be made either in (i) cash or by certified or official bank check payable to the order of the Company equal to the applicable aggregate Purchase Price, (ii) by delivery of the Warrant, Common Stock and/or Common Stock receivable upon exercise of the Warrant in accordance with Section (b) below, or (iii) by a combination of any of the foregoing methods, for the number of Common Shares specified in such form (as such exercise number shall be adjusted to reflect any adjustment in the total number of shares of Common Stock issuable to the holder per the terms of this Warrant) and the holder shall thereupon be entitled to receive the number of duly authorized, validly issued, fully-paid and non-assessable shares of Common Stock (or Other Securities) determined as provided herein.

(b)Notwithstanding any provisions herein to the contrary, if the Fair Market Value of one share of Common Stock is greater than the Purchase Price (at the date of calculation as set forth below), in lieu of exercising this Warrant for cash, the holder may elect to receive shares equal to the value (as determined below) of this Warrant (or the portion thereof being cancelled) by surrender of this Warrant at the principal office of the Company together with the properly endorsed Subscription Form in which event the Company shall issue to the holder a number of shares of Common Stock computed using the following formula:

X=Y (A-B)

             A

  WhereX=the number of shares of Common Stock to be issued to the holder

Y=the number of shares of Common Stock purchasable under the Warrant or, if only a portion of the Warrant is being exercised, the portion of the Warrant being exercised (at the date of such calculation)

A-3

A=the Fair Market Value of one share of the Company's Common Stock (at the date of such calculation)

B=Purchase Price (as adjusted to the date of such calculation)

3.             Adjustment for Reorganization, Consolidation, Merger, etc.

3.1.Reorganization, Consolidation, Merger, etc. In case at any time or from time to time, the Company shall (a) effect a reorganization, (b) consolidate with or merge into any other person, or (c) transfer all or substantially all of its properties or assets to any other person under any plan or arrangement contemplating the dissolution of the Company, then, in each such case, as a condition to the consummation of such a transaction, proper and adequate provision shall be made by the Company whereby the holder of this Warrant, upon the exercise hereof as provided in Section 1 at any time after the consummation of such reorganization, consolidation or merger or the effective date of such dissolution, as the case may be, shall receive, in lieu of the Common Stock (or Other Securities) issuable on such exercise prior to such consummation or such effective date, the stock and other securities and property (including cash) to which such holder would have been entitled upon such consummation or in connection with such dissolution, as the case may be, if such holder had so exercised this Warrant, immediately prior thereto, all subject to further adjustment thereafter as provided in Section 4.

3.2.Continuation of Terms. Upon any reorganization, consolidation, merger or transfer (and any dissolution following any transfer) referred to in this Section 3, this Warrant shall continue in full force and effect and the terms hereof shall be applicable to the shares of stock and other securities and property receivable on the exercise of this Warrant after the consummation of such reorganization, consolidation or merger or the effective date of dissolution following any such transfer, as the case may be, and shall be binding upon the issuer of any such stock or other securities, including, in the case of any such transfer, the person acquiring all or substantially all of the properties or assets of the Company, whether or not such person shall have expressly assumed the terms of this Warrant as provided in Section 4.

4.             Extraordinary Events Regarding Common Stock. In the event that the Company shall (a) issue additional shares of the Common Stock as a dividend or other distribution on outstanding Common Stock, (b) subdivide its outstanding shares of Common Stock, or (c) combine its outstanding shares of the Common Stock into a smaller number of shares of the Common Stock, then, in each such event, the Purchase Price shall, simultaneously with the happening of such event, be adjusted by multiplying the then Purchase Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such event and the denominator of which shall be the number of shares of Common Stock outstanding immediately after such event, and the product so obtained shall thereafter be the Purchase Price then in effect. The Purchase Price, as so adjusted, shall be readjusted in the same manner upon the happening of any successive event or events described herein in this Section 4. The number of shares of Common Stock that the holder of this Warrant shall thereafter, on the exercise hereof as provided in Section 1, be entitled to receive shall be increased or decreased to a number determined by multiplying the number of shares of Common Stock that would otherwise (but for the provisions of this Section 4) be issuable on such exercise by a fraction of which (a) the numerator is the Purchase Price that would otherwise (but for the provisions of this Section 4) be in effect, and (b) the denominator is the Purchase Price in effect on the date of such exercise.

5.             Certificate as to Adjustments. In each case of any adjustment or readjustment in the shares of Common Stock (or Other Securities) issuable on the exercise of the Warrant, the Company at its expense will promptly cause its Chief Financial Officer or other appropriate designee to compute such adjustment or readjustment in accordance with the terms of the Warrant and prepare a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based, including a statement of (a) the consideration received or receivable by the Company for any additional shares of Common Stock (or Other Securities) issued or sold or deemed to have been issued or sold, (b) the number of shares of Common Stock (or Other Securities) outstanding or deemed to be outstanding, and (c) the Purchase Price and the number of shares of Common Stock to be received upon exercise of this Warrant, in effect immediately prior to such adjustment or readjustment and as adjusted or readjusted as provided in this Warrant. The Company will forthwith mail a copy of each such certificate to the holder of the Warrant and any Warrant agent of the Company (appointed pursuant to Section 10 hereof).

A-4

6.            Reservation of Stock, etc. Issuable on Exercise of Warrant; Financial Statements. The Company will at all times reserve and keep available, solely for issuance and delivery on the exercise of the Warrant, all shares of Common Stock (or Other Securities) from time to time issuable on the exercise of the Warrant. This Warrant entitles the holder hereof to receive copies of all financial and other information distributed or required to be distributed to the holders of the Company's Common Stock.

7.            Assignment; Exchange of Warrant. Subject to compliance with applicable Securities laws, this Warrant, and the rights evidenced hereby, may be transferred by any registered holder hereof (a "Transferor") with respect to any or all of the Shares. On the surrender for exchange of this Warrant, with the Transferor's endorsement in the form of Exhibit B attached hereto (the "Transferor Endorsement Form") and together with evidence reasonably satisfactory to the Company demonstrating compliance with applicable Securities Laws, which shall include, without limitation, a legal opinion from the Transferor's counsel that such transfer is exempt from the registration requirements of federal securities laws, the Company at its expense but with payment by the Transferor of any applicable transfer taxes) will issue and deliver to or on the order of the Transferor thereof a new Warrant of like tenor, in the name of the Transferor and/or the transferee(s) specified in such Transferor Endorsement Form (each a "Transferee"), calling in the aggregate on the face or faces thereof for the number of shares of Common Stock called for on the face or faces of the Warrant so surrendered by the Transferor.

8.            Replacement of Warrant. On receipt of evidence reasonably satisfactory to the Company of the loss, theft, destruction or mutilation of this Warrant and, in the case of any such loss, theft or destruction of this Warrant, on delivery of an indemnity agreement or security reasonably satisfactory in form and amount to the Company or, in the case of any such mutilation, on surrender and cancellation of this Warrant, the Company at its expense will execute and deliver, in lieu thereof, a new Warrant of like tenor.

9.            Registration Rights. The Holder of this Warrant has been granted certain registration rights by the Company. These registration rights are set forth in a Securities Purchase Agreement entered into by the Company and the Investors, including the Holder.

10.          Warrant Agent. The Company may, by written notice to the each holder of the Warrant, appoint an agent for the purpose of issuing Common Stock (or Other Securities) on the exercise of this Warrant pursuant to Section 1, exchanging this Warrant pursuant to Section 7, and replacing this Warrant pursuant to Section 8, or any of the foregoing, and thereafter any such issuance, exchange or replacement, as the case may be, shall be made at such office by such agent.

11.          Transfer on the Company's Books. Until this Warrant is transferred on the books of the Company, the Company may treat the registered holder hereof as the absolute owner hereof for all purposes, notwithstanding any notice to the contrary.

12.          Notices, etc. All notices and other communications from the Company to the holder of this Warrant shall be mailed by first class registered or certified mail, postage prepaid, at such address as may have been furnished to the Company in writing by such holder or, until any such holder furnishes to the Company an address, then to, and at the address of, the last holder of this Warrant who has so furnished an address to the Company.

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13.          Miscellaneous. This Warrant and any term hereof may be changed, waived, discharged or terminated only by an instrument in writing signed by the party against which enforcement of such change, waiver, discharge or termination is sought. This Warrant shall be governed by and construed in accordance with the laws of State of Delaware without regard to principles of conflicts of laws. Any action brought concerning the transactions contemplated by this Warrant shall be brought only in the state courts of Delaware or Rhode Island or in the federal courts located in the State of Delaware or the Sate of Rhode Island. The individuals executing this Warrant on behalf of the Company agree to submit to the jurisdiction of such courts and waive trial by jury. The prevailing party shall be entitled to recover from the other party its reasonable attorney's fees and costs. In the event that any provision of this Warrant is invalid or unenforceable under any applicable statute or rule of law, then such provision shall be deemed inoperative to the extent that it may conflict therewith and shall be deemed modified to conform with such statute or rule of law. Any such provision which may prove invalid or unenforceable under any law shall not affect the validity or enforceability of any other provision of this Warrant. The headings in this Warrant are for purposes of reference only, and shall not limit or otherwise affect any of the terms hereof. The invalidity or unenforceability of any provision hereof shall in no way affect the validity or enforceability of any other provision. The Company acknowledges that legal counsel participated in the preparation of this Warrant and, therefore, stipulates that the rule of construction that ambiguities are to be resolved against the drafting party shall not be applied in the interpretation of this Warrant to favor any party against the other party.

[THIS SPACE INTENTIONALLY LEFT BLANK]

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IN WITNESS WHEREOF, the Company has executed this Warrant under seal as of the date first written above.

	NESTOR, INC.
	By:
		Nigel P. Hebborn
		Chief Financial Officer
Witness:

A-7

Exhibit A

to Warrant

FORM OF SUBSCRIPTION

(To be signed only on exercise of Warrant)

TO: Nestor, Inc.

The undersigned, pursuant to the provisions set forth in the attached Warrant (No.________), hereby irrevocably elects to purchase (check applicable box):

___  ___________________ shares of the Common Stock covered by such Warrant; or

___  the maximum number of shares of Common Stock covered by such Warrant pursuant to the cashless exercise procedure set forth in Section 2.

The undersigned herewith makes payment of the full purchase price for such shares at the price per share provided for in such Warrant, which is $_______________. Such payment takes the form of (check applicable box or boxes):

___  $_______________in lawful money of the United States; and/or

___  the cancellation of such portion of the attached Warrant as is exercisable for a total of ___________shares of Common Stock (using a Fair Market Value of $______ per share for purposes of this calculation); and/or

___  the cancellation of such number of shares of Common Stock as is necessary, in accordance with the formula set forth in Section 2, to exercise this Warrant with respect to the maximum number of shares of Common Stock purchaseable pursuant to the cashless exercise procedure set forth in Section 2.

The undersigned requests that the certificates for such shares be issued in the name of, and delivered to _____________________________________ whose address is _____________________________________.

The undersigned represents and warrants that all offers and sales by the undersigned of the securities issuable upon exercise of the within Warrant shall be made pursuant to registration of the Common Stock under the Securities Act of 1933, as amended (the "Securities Act") or pursuant to an exemption from registration under the Securities Act.

Dated:
	(Signature must conform to name of holder as specified on the face of the Warrant)
	(Address)

A-8

Exhibit B

to Warrant

FORM OF TRANSFEROR ENDORSEMENT

(To be signed only on transfer of Warrant)

For value received, the undersigned hereby sells, assigns, and transfers unto the person(s) named below under the heading "Transferees" the right represented by the within Warrant to purchase the percentage and number of shares of Common Stock of Nestor, Inc. to which the within Warrant relates specified under the headings "Percentage Transferred" and "Number Transferred," respectively, opposite the name(s) of such person(s) and appoints each such person Attorney to transfer its respective right on the books of Nestor, Inc. with full power of substitution in the premises.

  Transferees   Percentage Transferred   Number Transferred

Dated:	,
		(Signature must conform to name of holder as specified on the face of the warrant)

Signed in the presence of:

(Name) (address)

ACCEPTED AND AGREED:	(address)
[TRANSFEREE]

(Name)

A-9

EXHIBIT B to Securities Purchase

Agreement

PLACING BROKERS

Placing Broker Name	Investor Name
Keybanc Capital Markets

 

B-1

EXHIBIT C to Securities Purchase

Agreement

OPINION OF COUNSEL TO THE COMPANY

The opinion of Hinckley, Allen & Snyder LLP, counsel to the Company, to be delivered pursuant to Section 0 of this Agreement shall be substantially to the effect that:

1.The Company has been duly incorporated and is validly existing and in good standing as a corporation under the laws of the State of Delaware, with the requisite corporate power and authority to own and lease its properties and conduct its business as described in the Exchange Act Filings, and to execute, deliver and perform its obligations under the Agreement, the Escrow Agreement and the Warrants.

2.The Agreement, the Escrow Agreement and the Warrants have been duly authorized by all necessary corporate action by the Company, and each has been executed and delivered by the Company and constitutes the valid and binding obligation of the Company, enforceable against the Company in accordance with its terms.

3.The authorized capital stock of the Company consists of 30,000,000 shares of common stock, par value $.01 per share, and 10,000,000 shares of preferred stock, par value $1.00 per share.

4.The Shares to be received by the Investors pursuant to the Agreement have been duly authorized and, upon issuance and delivery against payment therefor in accordance with the terms of the Agreement and the Escrow Agreement, will be validly issued, fully paid and nonassessable. The Warrant Shares, when issued pursuant to and in accordance with the terms of the Agreement and the Warrant and upon delivery, shall be validly issued and outstanding, fully paid and nonassessable.

5.To the knowledge of such counsel, except as set forth in the Agreement or in Exchange Act Filings, the sale of the Shares and the Warrants and the subsequent exercise of the Warrant for Warrant Shares are not subject to any preemptive right or right of first refusal that has not been properly waived or with which the Company has not complied..

6.The execution and delivery of the Agreement and the Escrow Agreement and the consummation of the transactions contemplated thereby (including, but not limited to, the issuance of the Shares, the sale of the Securities and the fulfillment of the terms of the Agreement) will not (a) violate or conflict with the Certificate of Incorporation or By-laws of the Company or violate any statute, rule or regulation normally applicable to transactions of the type contemplated by the Agreement or, to such counsel's knowledge, violate any order of any court, regulatory body, administrative agency or other governmental body applicable to the Company, any of its subsidiaries or any of the properties of the Company or any of its subsidiaries.

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7.To the knowledge of such counsel, there is no approval, consent, order, authorization, designation, declaration or filing by or with any court, regulatory body, administrative agency or other governmental body necessary in connection with the execution and delivery by the Company of the Agreement and the Escrow Agreement and the consummation of the transactions contemplated thereby that has not been obtained and is not in full force and effect, except any such approval, consent, authorization, designation, declaration, or filing required by any securities or Blue Sky statute of any state in connection with the offer and sale of the Securities, or by any U.S. federal or securities statute with respect to the Company's obligations under Section 9 of the Agreement.

8.Assuming the accuracy of the representations and warranties of the Investors contained in the Agreement and the proper filing by the Company with the SEC of Form D describing the sale of the Securities, the offer, sale and issuance of the Securities by the Company to the Investors pursuant to the Agreement will be exempt from the registration requirements of the Securities Act.

9.To such counsel's knowledge, there is not pending against the Company before any court or administrative agency or overtly threatened in writing any action, proceeding or investigation that questions the validity of the Agreement or any of the transactions contemplated thereby.

10.            To such counsel's knowledge and except as set forth in Schedules to the Agreement or the Exchange Act Filings, there are no legal or governmental actions, suits or proceedings, pending or threatened, to which the Company or any of its subsidiaries is a party or to which any of the property or assets of the Company or any of its subsidiaries is subject that, if determined adversely to the Company or any of its subsidiaries, would, individually or in the aggregate, have a Material Adverse Effect.

C-2

EXHIBIT D to

Securities Purchase Agreement

NESTOR, INC.

INVESTOR QUESTIONNAIRE

This Questionnaire requests information necessary to prepare a Registration Statement (the "Registration Statement") for the registration and resale under Rule 415 of the Securities Act of 1933, as amended (the "Securities Act"), of certain shares of common stock of Nestor, Inc. (the "Company"), par value $.01 per share (the "Common Stock"), to be filed by the Company with the Securities and Exchange Commission (the "Commission"), in accordance with the terms of the Securities Purchase Agreement dated as of January 31, 2006 (the "Purchase Agreement"), between the Company and the undersigned beneficial owner (the "Selling Securityholder") of shares of Common Stock purchased pursuant to the Purchase Agreement (the "Shares") and the shares of Common Stock issuable upon exercise of the Warrants purchased pursuant to the Purchase Agreement (the "Warrant Shares" and together with the Shares, the "Registrable Securities"). All capitalized terms not otherwise defined herein shall have the respective meanings ascribed thereto in the Purchase Agreement.

In order to sell or otherwise dispose of any Registrable Securities pursuant to the Registration Statement, you generally will be required to be named as a selling securityholder in the related prospectus, deliver a prospectus to purchasers of the Registrable Securities and be bound by the provisions of the Purchase Agreement (including certain indemnification provisions, as described below). If you do not complete this Questionnaire and deliver it to the Company as provided below you will not be named as a selling securityholder in the prospectus and therefore will not be permitted to sell any Shares pursuant to the Registration Statement. Please complete and deliver this Questionnaire to Benjamin M. Alexander, Esq., General Counsel of the Company, as soon as possible and in any event no later than Closing Date (as defined in the Purchase Agreement).

Certain legal consequences arise from being named as a selling securityholder in the Registration Statement and the related prospectus. Accordingly, holders and beneficial owners of Shares are advised to consult their own securities law counsel regarding the consequences of being named or not being named as a selling securityholder in the Registration Statement and the related prospectus.

The Selling Securityholder, by signing and returning this Questionnaire, understands that it will be bound by the terms and conditions of this Questionnaire and the Purchase Agreement.

Pursuant to the Purchase Agreement, the undersigned has agreed to indemnify and hold harmless the Company, each of its directors, each of its officers who has signed the Registration Statement and each person, if any, who controls the Company within the meaning of the Securities Act, from and against certain losses arising in connection with statements concerning the undersigned made in the Registration Statement or the related prospectus in reliance upon the information provided in this Questionnaire.

D-1

The undersigned hereby provides the following information to the Company and represents and warrants that such information is accurate and complete:

QUESTIONNAIRE

1. (a) Full Legal Name of Selling Securityholder:³

(b) Except as set forth below in this Item 1(b), the undersigned does not hold any or all of the Shares on behalf of another person or entity.

State any exceptions here:

2. Beneficial Ownership:

Immediately after the Closing, there will be no equity securities of the Company of which the undersigned will be the "beneficial owner"⁴, except as set forth below in this Item 2. The disclosure indicates the amount of equity securities which the undersigned beneficially owns, which it has a right to acquire within 60 days after the Closing Date, and as to which it has sole voting power, shared voting power, sole investment power or shared investment power.

3. Except as set forth below in this Item 3, the undersigned wishes that all of the _________ Shares that the undersigned purchased pursuant to the Purchase Agreement and all of the ________ Warrant Shares issuable upon exercise of the Warrants the undersigned purchase pursuant to the Purchase Agreement are to be offered for the account of the undersigned in the Registration Statement.

State any exceptions here:

______________________

³ If this Questionnaire is being completed by or on behalf of a person other than an individual, the entity on whose behalf the Questionnaire is being completed should be stated.

⁴ Defined in Appendix A to this questionnaire.

D-2

4. Relationships with the Company:

Except as set forth below, neither the undersigned nor any of its affiliates, officers, directors or principal equity holders (5% or more) has held any position or office or has had any other material relationship with the Company (or its predecessors or affiliates) during the past three years.

State any exceptions here:

5. Plan of Distribution:

Except as set forth below, the undersigned (including its donees or pledgees) intends to distribute the Registrable Securities pursuant to the Registration Statement only as follows (if at all): Such Registrable Securities may be sold from time to time directly by the undersigned or, alternatively, through underwriters, broker-dealers or agents. If the Registrable Securities are sold through underwriters, broker-dealers or agents, the Selling Securityholder will be responsible for underwriting discounts or commissions or agent's commissions. Such Registrable Securities may be sold in one more or transactions at fixed prices, at prevailing market prices at the time of sale, at varying prices determined at the time of sale, or at negotiated prices. Such sales may be effected in transactions (which may involve block transactions) (a) on any national securities exchange or quotation service on which the Registrable Securities may be listed or quoted at the time of sale, (b) in the over-the-counter market, (c) in transactions otherwise than on such exchanges or services or in the over-the-counter market, or (d) through the writing of options. Under the Purchase Agreement the undersigned may not sell Registrable Securities short.

State any exceptions here:

Note: In no event will such method(s) of distribution take the form of an underwritten offering of the Shares without the prior agreement of the Company.

D-3

The undersigned acknowledges that it understands its obligation to comply with the provisions of the Securities Exchange Act of 1934, as amended, and the rules thereunder relating to stock manipulation, particularly Regulation M thereunder (or any successor rules or regulations), in connection with any offering of the Shares pursuant to the Registration Statement. The undersigned agrees that neither it nor any person acting on its behalf will engage in any transaction in violation of such provisions.

In accordance with the undersigned's obligation under the Purchase Agreement, the undersigned agrees to promptly notify the Company of any inaccuracies or changes in the information provided herein that may occur subsequent to the date hereof at any time while the Registration Statement remains effective.

By signing below, the undersigned consents to the disclosure of the information contained herein in its answers to Items 1 through 6 above and the inclusion of such information in the Registration Statement and the related prospectus. The undersigned understands that such information will be relied upon by the Company in connection with the preparation or amendment of the Registration Statement and the related prospectus.

IN WITNESS WHEREOF, the undersigned, by authority duly given, has caused this Questionnaire to be executed and delivered either in person or by its duly authorized agent.

Dated: _____, 2006

Name of Selling Securityholder:

By:
	Name:
	Title:

D-4

Appendix A to EXHIBIT D

You are the "beneficial owner" of a security if you directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, have or share: (i) voting power which includes the power to vote, or to direct the voting of, such security, or (ii) investment power which includes the power to dispose, or to direct the disposition of, such security. You are deemed the beneficial owner of a security if you, directly or indirectly, create or use a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of divesting yourself of beneficial ownership of a security or preventing the vesting of such beneficial ownership. Finally, you are deemed to be the beneficial owner of a security if you have the right to acquire beneficial ownership of such security at any time within sixty days, including but not limited to any right to acquire (a) through the exercise of any option, warrant or right, or (b) through the conversion of a security, or (c) pursuant to the power to revoke a trust, discretionary account, or similar arrangement, or (d) pursuant to the automatic termination of a trust, discretionary account or similar arrangement. If you have acquired any security or power specified in (a), (b), (c) or (d) above, with the purpose or effect of changing or influencing the control of the issuer, or in connection with or as a participant in any transaction having such purpose or effect, then immediately upon such acquisition you are deemed to be the beneficial owner of the securities which may be acquired through the exercise or conversion of such security or power.

All securities of the same class that are beneficially owned by you, regardless of the form which such beneficial ownership takes, must be aggregated in calculating the number of shares beneficially owned by you.

The above definition is broad and although you may not actually have or share voting or investment power with respect to securities owned by persons in your family or living in your home, you should include such shares in your beneficial ownership disclosure, and then, as appropriate, disclaim beneficial ownership of such securities.

D-5

EX-10.60

EXHIBIT 10.60

Schedule Prepared in Accordance with Instruction 2 to Item 601 of Regulation S-K

The warrants to purchase shares of Common Stock are substantially identical in all material respects except as to the warrantholder and the number of shares.

Name	Warrants
Sam Belzberg	16,968
Clyde J. Berg, as trustee of the Clyde J. Berg Trust utd 4/4/95	13,574
Neal Goldman	33,936
Edward F. Heil	118,778
Iroquois Master Fund Ltd.	10,181
Kuekenhof Equity Fund, L.P.	16,968
Levene Ass. A Partnership	8,484
Susan Moffitt	1,696
Wallace L. Mossop III as trustee of the Wallace L. Mossop III Trust dtd 2/3/00	8,484
Nite Capital, L.P.	13,574
RAQ, LLC	16,968
Wilson G. & Ellen M. Saville, JTWROS	8,484
Martin Solomon	16,968
TCMP3 Partners	20,100
Thomas Vantine Hart, IRA	1,696.83
Louise B. Sheaffer, IRA	678.73
Elisabeth A. Darlington, Trustee of the Elizabeth A. Darlington Trust	1,696.83
Foundation Partners I, LLC	8,376.82
Marima Petroula	6,787.33
Lester M. Wheeler, Jr.	203.62
Joy Mease	678.73
Kenneth & Bridget Mullin	678.73
Norbet Stein	6,787.33
Dolphin Direct Equity Partners LP	16,968.33
Kevin and Denise Donohue	339.37
Kim Davis	6,787.33
Marty and Barbara Olsen	3,393.67
M. Robert Carroll, Trustee of the Carroll Family Trust	3,393.67
Mark Mitchell	6,787.33
Cathrine M. Taylor, SEP IRA	385.85
Barry L. Bennett, SEP IRA	536.20

THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED. THIS WARRANT AND THE COMMON SHARES ISSUABLE UPON EXERCISE OF THIS WARRANT MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT AS TO THIS WARRANT UNDER SAID ACT OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO NESTOR, INC. THAT SUCH REGISTRATION IS NOT REQUIRED.

Right to Purchase 16,968 Shares of Common Stock of Nestor, Inc. (subject to adjustment as provided herein)

COMMON STOCK PURCHASE WARRANT

No. 2006-1 Issue Date: January 31, 2006

NESTOR, INC., a corporation organized under the laws of the State of Delaware (the "Company"), hereby certifies that, for value received, Sam Belzberg, or assigns (the “Holder”), is entitled, subject to the terms set forth below, to purchase from the Company from and after the Issue Date of this Warrant and at any time or from time to time before 5:00 p.m., New York time, through January 31, 2009 (three (3) years after the Issue Date) (the “Expiration Date”), up to 16,968 fully paid and nonassessable shares of Common Stock (as hereinafter defined), $.01 par value per share, of the Company, at the Purchase Price (as defined below). The number and character of such shares of Common Stock and the Purchase Price are subject to adjustment as provided herein. Capitalized terms used but not otherwise defined shall have them in the Securities Purchase Agreement dated the date hereof by and among the Company and the Investors named therein, including Holder.

As used herein the following terms, unless the context otherwise requires, have the following respective meanings:

(a)The term “Company” shall include Nestor, Inc. and any corporation which shall succeed or assume the obligations of Nestor, Inc. hereunder.

(b)The term "Common Stock" includes (a) the Company's Common Stock, $.01 par value per share, as authorized on the date of the Securities Purchase Agreement referred to in Section 9 hereof, and (b) any other securities into which or for which any of the securities described in (a) may be converted or exchanged pursuant to a plan of recapitalization, reorganization, merger, sale of assets or otherwise.

(c)The term "Other Securities" refers to any stock (other than Common Stock) and other securities of the Company or any other person (corporate or otherwise) which the holder of the Warrant at any time shall be entitled to receive, or shall have received, on the exercise of the Warrant, in lieu of or in addition to Common Stock, or which at any time shall be issuable or shall have been issued in exchange for or in replacement of Common Stock or Other Securities pursuant to Section 4 or otherwise.

(d)The term "Purchase Price" shall mean $4.91.

1.              Exercise of Warrant.

1.1.Number of Shares Issuable upon Exercise. From and after the date hereof through and including the Expiration Date, the holder hereof shall be entitled to receive, upon exercise of this Warrant in whole in accordance with the terms of subsection 1.2 or upon exercise of this Warrant in part in accordance with subsection 1.3, shares of Common Stock of the Company, subject to adjustment pursuant to Section 4.

2

1.2.Full Exercise. This Warrant may be exercised in full by the holder hereof by delivery of an original or fax copy of the form of subscription attached as Exhibit A hereto (the “Subscription Form") duly executed by such Holder, to the Company at its principal office or at the office of its warrant agent (as provided hereinafter), accompanied by payment, in cash, wire transfer, or by certified or official bank check payable to the order of the Company, in the amount obtained by multiplying the number of shares of Common Stock for which this Warrant is then exercisable by the Purchase Price then in effect.

1.3.Partial Exercise. This Warrant may be exercised in part (but not for a fractional share) by surrender of this Warrant in the manner and at the place provided in subsection 1.2 except that the amount payable by the holder on such partial exercise shall be the amount obtained by multiplying (a) the number of shares of Common Stock designated by the holder in the Subscription Form by (b) the Purchase Price then in effect. On any such partial exercise, the Company, at its expense, will forthwith issue and deliver to or upon the order of the holder hereof a new Warrant of like tenor, in the name of the holder hereof or as such holder (upon payment by such holder of any applicable transfer taxes) may request, the number of shares of Common Stock for which such Warrant may still be exercised.

1.4.Fair Market Value. Fair Market Value of a share of Common Stock as of a particular date (the "Determination Date") shall mean:

(a) If the Company's Common Stock is traded on an exchange or is quoted on the National Association of Securities Dealers, Inc. Automated Quotation ("NASDAQ") National Market System or the NASDAQ SmallCap Market, then the average closing or last sale price, respectively, reported for the ten business days immediately preceding the Determination Date.

(b) If the Company's Common Stock is not traded on an exchange or on the NASDAQ National Market System or the NASDAQ SmallCap Market but is traded on the NASD OTC Bulletin Board, then the mean of the average of the closing bid and asked prices reported for the ten business days immediately preceding the Determination Date.

(c) If the Company's Common Stock is not publicly traded, then as the Holder and the Company agree or in the absence of agreement by arbitration in accordance with the rules then standing of the American Arbitration Association, before a single arbitrator to be chosen from a panel of persons qualified by education and training to pass on the matter to be decided.

1.5.Company Acknowledgment. The Company will, at the time of the exercise of the Warrant, upon the request of the holder hereof acknowledge in writing its continuing obligation to afford to such holder any rights to which such holder shall continue to be entitled after such exercise in accordance with the provisions of this Warrant. If the holder shall fail to make any such request, such failure shall not affect the continuing obligation of the Company to afford to such holder any such rights.

1.6.Trustee for Warrant Holders. In the event that a bank or trust company shall have been appointed as trustee for the Company pursuant to Subsection 3.2, such bank or trust company shall have all the powers and duties of a warrant agent (as hereinafter described) and shall accept, in its own name for the account of the Company or such successor person as may be entitled thereto, all amounts otherwise payable to the Company or such successor, as the case may be, on exercise of this Warrant pursuant to this Section 1.

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2.1Delivery of Stock Certificates, etc. on Exercise. The Company agrees that the shares of Common Stock purchased upon exercise of this Warrant shall be deemed to be issued to the holder hereof as the record owner of such shares as of the close of business on the date on which this Warrant shall have been surrendered and payment made for such shares as aforesaid. As soon as practicable after the exercise of this Warrant in full or in part, and in any event within 7 days thereafter, the Company at its expense (including the payment by it of any applicable issue taxes) will cause to be issued in the name of and delivered to the holder hereof, or as such holder (upon payment by such holder of any applicable transfer taxes) may direct in compliance with applicable Securities Laws, a certificate or certificates for the number of duly and validly issued, fully paid and nonassessable shares of Common Stock (or Other Securities) to which such holder shall be entitled on such exercise, plus, in lieu of any fractional share to which such holder would otherwise be entitled, cash equal to such fraction multiplied by the then Fair Market Value of one full share, together with any other stock or other securities and property (including cash, where applicable) to which such holder is entitled upon such exercise pursuant to Section 1 or otherwise.

2.2.Payment of Purchase Price.

(a) Payment may be made either in (i) cash or by certified or official bank check payable to the order of the Company equal to the applicable aggregate Purchase Price, (ii) by delivery of the Warrant, Common Stock and/or Common Stock receivable upon exercise of the Warrant in accordance with Section (b) below, or (iii) by a combination of any of the foregoing methods, for the number of Common Shares specified in such form (as such exercise number shall be adjusted to reflect any adjustment in the total number of shares of Common Stock issuable to the holder per the terms of this Warrant) and the holder shall thereupon be entitled to receive the number of duly authorized, validly issued, fully-paid and non-assessable shares of Common Stock (or Other Securities) determined as provided herein.

(b) Notwithstanding any provisions herein to the contrary, if the Fair Market Value of one share of Common Stock is greater than the Purchase Price (at the date of calculation as set forth below), in lieu of exercising this Warrant for cash, the holder may elect to receive shares equal to the value (as determined below) of this Warrant (or the portion thereof being cancelled) by surrender of this Warrant at the principal office of the Company together with the properly endorsed Subscription Form in which event the Company shall issue to the holder a number of shares of Common Stock computed using the following formula:

X=Y (A-B)

A

Where    X= the number of shares of Common Stock to be issued to the holder

Y= the number of shares of Common Stock purchasable under the Warrant or, if only a portion of the Warrant is being exercised, the portion of the Warrant being exercised (at the date of such calculation)

A= the Fair Market Value of one share of the Company’s Common Stock (at the date of such calculation)

B= Purchase Price (as adjusted to the date of such calculation)

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3. Adjustment for Reorganization, Consolidation, Merger, etc.

3.1. Reorganization, Consolidation, Merger, etc. In case at any time or from time to time, the Company shall (a) effect a reorganization, (b) consolidate with or merge into any other person, or (c) transfer all or substantially all of its properties or assets to any other person under any plan or arrangement contemplating the dissolution of the Company, then, in each such case, as a condition to the consummation of such a transaction, proper and adequate provision shall be made by the Company whereby the holder of this Warrant, upon the exercise hereof as provided in Section 1 at any time after the consummation of such reorganization, consolidation or merger or the effective date of such dissolution, as the case may be, shall receive, in lieu of the Common Stock (or Other Securities) issuable on such exercise prior to such consummation or such effective date, the stock and other securities and property (including cash) to which such holder would have been entitled upon such consummation or in connection with such dissolution, as the case may be, if such holder had so exercised this Warrant, immediately prior thereto, all subject to further adjustment thereafter as provided in Section 4.

3.2. Continuation of Terms. Upon any reorganization, consolidation, merger or transfer (and any dissolution following any transfer) referred to in this Section 3, this Warrant shall continue in full force and effect and the terms hereof shall be applicable to the shares of stock and other securities and property receivable on the exercise of this Warrant after the consummation of such reorganization, consolidation or merger or the effective date of dissolution following any such transfer, as the case may be, and shall be binding upon the issuer of any such stock or other securities, including, in the case of any such transfer, the person acquiring all or substantially all of the properties or assets of the Company, whether or not such person shall have expressly assumed the terms of this Warrant as provided in Section 4.

4. Extraordinary Events Regarding Common Stock. In the event that the Company shall (a) issue additional shares of the Common Stock as a dividend or other distribution on outstanding Common Stock, (b) subdivide its outstanding shares of Common Stock, or (c) combine its outstanding shares of the Common Stock into a smaller number of shares of the Common Stock, then, in each such event, the Purchase Price shall, simultaneously with the happening of such event, be adjusted by multiplying the then Purchase Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such event and the denominator of which shall be the number of shares of Common Stock outstanding immediately after such event, and the product so obtained shall thereafter be the Purchase Price then in effect. The Purchase Price, as so adjusted, shall be readjusted in the same manner upon the happening of any successive event or events described herein in this Section 4. The number of shares of Common Stock that the holder of this Warrant shall thereafter, on the exercise hereof as provided in Section 1, be entitled to receive shall be increased or decreased to a number determined by multiplying the number of shares of Common Stock that would otherwise (but for the provisions of this Section 4) be issuable on such exercise by a fraction of which (a) the numerator is the Purchase Price that would otherwise (but for the provisions of this Section 4) be in effect, and (b) the denominator is the Purchase Price in effect on the date of such exercise.

5. Certificate as to Adjustments. In each case of any adjustment or readjustment in the shares of Common Stock (or Other Securities) issuable on the exercise of the Warrant, the Company at its expense will promptly cause its Chief Financial Officer or other appropriate designee to compute such adjustment or readjustment in accordance with the terms of the Warrant and prepare a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based, including a statement of (a) the consideration received or receivable by the Company for any additional shares of Common Stock (or Other Securities) issued or sold or deemed to have been issued or sold, (b) the number of shares of Common Stock (or Other Securities) outstanding or deemed to be outstanding, and (c) the Purchase Price and the number of shares of Common Stock to be received upon exercise of this Warrant, in effect immediately prior to such adjustment or readjustment and as adjusted or readjusted as provided in this Warrant. The Company will forthwith mail a copy of each such certificate to the holder of the Warrant and any Warrant agent of the Company (appointed pursuant to Section 10 hereof).

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6. Reservation of Stock, etc. Issuable on Exercise of Warrant; Financial Statements. The Company will at all times reserve and keep available, solely for issuance and delivery on the exercise of the Warrant, all shares of Common Stock (or Other Securities) from time to time issuable on the exercise of the Warrant. This Warrant entitles the holder hereof to receive copies of all financial and other information distributed or required to be distributed to the holders of the Company's Common Stock.

7. Assignment; Exchange of Warrant. Subject to compliance with applicable Securities laws, this Warrant, and the rights evidenced hereby, may be transferred by any registered holder hereof (a "Transferor") with respect to any or all of the Shares. On the surrender for exchange of this Warrant, with the Transferor's endorsement in the form of Exhibit B attached hereto (the “Transferor Endorsement Form") and together with evidence reasonably satisfactory to the Company demonstrating compliance with applicable Securities Laws, which shall include, without limitation, a legal opinion from the Transferor’s counsel that such transfer is exempt from the registration requirements of federal securities laws, the Company at its expense but with payment by the Transferor of any applicable transfer taxes) will issue and deliver to or on the order of the Transferor thereof a new Warrant of like tenor, in the name of the Transferor and/or the transferee(s) specified in such Transferor Endorsement Form (each a "Transferee"), calling in the aggregate on the face or faces thereof for the number of shares of Common Stock called for on the face or faces of the Warrant so surrendered by the Transferor.

8. Replacement of Warrant. On receipt of evidence reasonably satisfactory to the Company of the loss, theft, destruction or mutilation of this Warrant and, in the case of any such loss, theft or destruction of this Warrant, on delivery of an indemnity agreement or security reasonably satisfactory in form and amount to the Company or, in the case of any such mutilation, on surrender and cancellation of this Warrant, the Company at its expense will execute and deliver, in lieu thereof, a new Warrant of like tenor.

9. Registration Rights. The Holder of this Warrant has been granted certain registration rights by the Company. These registration rights are set forth in a Securities Purchase Agreement entered into by the Company and the Investors, including the Holder.

10.Warrant Agent. The Company may, by written notice to the each holder of the Warrant, appoint an agent for the purpose of issuing Common Stock (or Other Securities) on the exercise of this Warrant pursuant to Section 1, exchanging this Warrant pursuant to Section 7, and replacing this Warrant pursuant to Section 8, or any of the foregoing, and thereafter any such issuance, exchange or replacement, as the case may be, shall be made at such office by such agent.

11.Transfer on the Company's Books. Until this Warrant is transferred on the books of the Company, the Company may treat the registered holder hereof as the absolute owner hereof for all purposes, notwithstanding any notice to the contrary.

12.Notices, etc. All notices and other communications from the Company to the holder of this Warrant shall be mailed by first class registered or certified mail, postage prepaid, at such address as may have been furnished to the Company in writing by such holder or, until any such holder furnishes to the Company an address, then to, and at the address of, the last holder of this Warrant who has so furnished an address to the Company.

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13.Miscellaneous. This Warrant and any term hereof may be changed, waived, discharged or terminated only by an instrument in writing signed by the party against which enforcement of such change, waiver, discharge or termination is sought. This Warrant shall be governed by and construed in accordance with the laws of State of Delaware without regard to principles of conflicts of laws. Any action brought concerning the transactions contemplated by this Warrant shall be brought only in the state courts of Delaware or Rhode Island or in the federal courts located in the State of Delaware or the Sate of Rhode Island. The individuals executing this Warrant on behalf of the Company agree to submit to the jurisdiction of such courts and waive trial by jury. The prevailing party shall be entitled to recover from the other party its reasonable attorney’s fees and costs. In the event that any provision of this Warrant is invalid or unenforceable under any applicable statute or rule of law, then such provision shall be deemed inoperative to the extent that it may conflict therewith and shall be deemed modified to conform with such statute or rule of law. Any such provision which may prove invalid or unenforceable under any law shall not affect the validity or enforceability of any other provision of this Warrant. The headings in this Warrant are for purposes of reference only, and shall not limit or otherwise affect any of the terms hereof. The invalidity or unenforceability of any provision hereof shall in no way affect the validity or enforceability of any other provision. The Company acknowledges that legal counsel participated in the preparation of this Warrant and, therefore, stipulates that the rule of construction that ambiguities are to be resolved against the drafting party shall not be applied in the interpretation of this Warrant to favor any party against the other party.

[THIS SPACE INTENTIONALLY LEFT BLANK]

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IN WITNESS WHEREOF, the Company has executed this Warrant under seal as of the date first written above.

NESTOR, INC.
By:	/s/ William B. Danzell
	William B. Danzell Chief Executive Officer and President

Witness:

/s/ Mary Ann Branin

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Exhibit A

to Warrant

FORM OF SUBSCRIPTION

(To be signed only on exercise of Warrant)

TO: Nestor, Inc.

The undersigned, pursuant to the provisions set forth in the attached Warrant (No.________), hereby irrevocably elects to purchase (check applicable box):

	shares of the Common Stock covered by such Warrant; or
the maximum number of shares of Common Stock covered by such Warrant pursuant to the cashless exercise procedure set forth in Section 2.

The undersigned herewith makes payment of the full purchase price for such shares at the price per share provided for in such Warrant, which is $_______________. Such payment takes the form of (check applicable box or boxes):

$ in lawful money of the United States; and/or

the cancellation of such portion of the attached Warrant as is exercisable for a total of ___________shares of Common Stock (using a Fair Market Value of $______ per share for purposes of this calculation); and/or

the cancellation of such number of shares of Common Stock as is necessary, in accordance with the formula set forth in Section 2, to exercise this Warrant with respect to the maximum number of shares of Common Stock purchaseable pursuant to the cashless exercise procedure set forth in Section 2.

The undersigned requests that the certificates for such shares be issued in the name of, and delivered to
	whose address is

The undersigned represents and warrants that all offers and sales by the undersigned of the securities issuable upon exercise of the within Warrant shall be made pursuant to registration of the Common Stock under the Securities Act of 1933, as amended (the "Securities Act") or pursuant to an exemption from registration under the Securities Act.

Dated:
	(Signature must conform to name of holder as specified on the face of the Warrant
	(Address)

9

Exhibit B

to Warrant

FORM OF TRANSFEROR ENDORSEMENT

(To be signed only on transfer of Warrant)

For value received, the undersigned hereby sells, assigns, and transfers unto the person(s) named below under the heading "Transferees" the right represented by the within Warrant to purchase the percentage and number of shares of Common Stock of Nestor, Inc. to which the within Warrant relates specified under the headings "Percentage Transferred" and "Number Transferred," respectively, opposite the name(s) of such person(s) and appoints each such person Attorney to transfer its respective right on the books of Nestor, Inc. with full power of substitution in the premises.

Transferees   Percentage Transferred Number Transferred

Dated:
	(Signature must conform to name of holder as specified on the face of the warrant)

Signed in the presence of:
(Name)	(address)

ACCEPTED AND AGREED:

[TRANSFEREE]

(Name)

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EX-23.01

EXHIBIT 23.01

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-122183 and No. 333-27271) of Nestor, Inc. of our report dated March 10, 2006 relating to the 2005 consolidated financial statements and financial statement schedules, which appears in this Form 10-K.

/s/ Carlin, Charron & Rosen LLP

Westborough, Massachusetts

April 12, 2006

EX-31.1

EXHIBIT 31.1

CERTIFICATION REQUIRED BY EXCHANGE ACT RULES 13A-14(A) AND 15D-14(A),

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, William B. Danzell, certify that:

1. I have reviewed this annual report on Form 10-K of Nestor, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) [paragraph omitted in accordance with SEC transition instructions contained in SEC Release 34-47986]

c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting.

Date: April 14, 2006

/s/ William B. Danzell

William B. Danzell, President and Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATION REQUIRED BY EXCHANGE ACT RULES 13A-14(A) AND 15D-14(A),

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Nigel P. Hebborn, certify that:

1. I have reviewed this annual report on Form 10-K of Nestor, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) [paragraph omitted in accordance with SEC transition instructions contained in SEC Release 34-47986]

c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting.

Date: April 14, 2006

/s/ Nigel P. Hebborn

Nigel P. Hebborn, Treasurer and Chief Financial Officer

EX-32

EXHIBIT 32

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Nestor, Inc. (the "Company") on Form 10-K for the period ending December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), the undersigned, William B. Danzell, Chief Executive Officer of the Company, and Nigel P. Hebborn, Chief Financial Officer of the Company, each hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to their knowledge:

(1) The Report fully complies with the requirements of section 13(a)or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company

Date: April 14, 2006

/s/ William B. Danzell

William B. Danzell, Chief Executive Officer

Date: April 14, 2006

/s/ Nigel P. Hebborn

Nigel P. Hebborn, Chief Financial Officer