iwsy-s1.htm

9% Secured Promissory Note

In February 2009, we entered into a secured promissory note (the "Note"), for $5,000,000 with a third-party lender (“the Lender”). The Note secures a credit facility for a total of up to $5,000,000. The initial advance under the Note was $1,000,000. Subsequent advances are subject to the discretion of the Lender. The note bears interest at 5.0% per annum on the outstanding principal and interest and are due on June 30, 2010. We will also pay the Lender additional financing fees (the “Additional Financing Obligation”) on the maturity date or such earlier date as may be required under the terms of the note equal to the greater of $400,000 or an amount equal to 2,000,000 multiplied by the average of the closing prices for the common stock of the Company for the ten trading day period immediately preceding the date of such interest payment.

In conjunction with the issuance of the Note, we issued a warrant to purchase 4,500,000 shares of our common stock. The warrant has an exercise price $0.50 per share and may be exercised at any time from February 12, 2009 until February 12, 2014. Additionally, we entered into a Registration Rights Agreement requiring us to provide certain registration rights to the Lender relative to the 4,500,000 shares of our common stock issuable pursuant to the warrant.

We recorded the Note and Additional Financing Obligation net of a discount equal to the fair values allocated to the various financial instruments issued to the Lender. The warrants issued in conjunction with the Note contained anti-dilution provisions, which require derivative liability classification. We estimated the fair value of the warrants using a Monte-Carlo simulation, which resulted in note discount from the issuance of the warrants of approximately $562,000. We recorded the Additional Financing Obligation equal to the fair values of the additional financing component using the Black-Scholes option-pricing model, which resulted in additional note discount of approximately $169,000. In addition, we accreted the $400,000 minimum payment to interest expense over the term of the agreement.

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The Note is secured by all our assets. Under the terms of the Note, the entire outstanding balance together with all accrued interest shall be payable on (i) the maturity date (June 30, 2010), (ii) a change of control transaction, (iii) our receipt of proceeds from the sale of equity or equity linked securities in excess of $2,500,000, (iv) our receipt of proceeds from the issuance of any type of additional debt instruments, or (v) upon the occurrence of an event of default under the terms of the Note.

In June 2009, we and the Lender agreed to amend the Note (“Amendment No. 1”) whereby we received a waiver of default and extension of certain date sensitive covenants contained in the Note. As consideration for the waiver and extension, we issued to the Lender warrants to purchase 1,000,000 shares of our common stock at an exercise price of $0.50 per share. Such warrants may be exercised at any time from June 9, 2009 until June 9, 2014. In conjunction with the June 2009 waiver and extension, the interest rate on the Note was changed to 9% per annum, retroactive to February 2009.

We evaluated the waiver of default and interest rate change under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. We determined that, because the change in fair value of the debt instruments was greater than 10% of the present value of the cash flows between the modified debt instruments and original debt instruments, the debt modification was substantial and therefore we accounted for the modification as a debt extinguishment. Accordingly, we recorded the new debt instrument at fair value and recorded a loss on debt extinguishment of approximately $750,000 during 2009. The loss on debt extinguishment of $750,000 includes approximately $132,000 of unamortized deferred financing fees written off due to the debt extinguishment. We recorded the new debt instruments net of a discount equal to the fair values allocated to the various financial instruments issued to the Lender. We estimated the fair value of the warrants using a Monte-Carlo simulation, which resulted in a note discount from the issuance of the warrants of approximately $188,000. We are accreting the note discount and the Additional Financing Obligation discount using the effective interest rate method over the life of the Note.

In June 2009, we and the Lender further amended the Note (“Amendment No. 2”) whereby the Lender advanced us an additional $350,000 and amended certain terms of the Note. As consideration for the additional advance, we issued to the Lender warrants to purchase 700,000 shares of our common stock at an exercise price of $0.50 per share. Such warrants may be exercised at any time from June 22, 2009 until June 22, 2014.

We recorded Amendment No. 2 net of a discount equal to the fair value allocated to warrants. We estimated the fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in a note discount from the issuance of the warrants of approximately $238,000.

In October 2009, we and the Lender further amended the Note (“Amendment No. 3”) whereby the Lender agreed to make additional advances in an aggregate amount up to $1,000,000 (“Third Amendment Advance”) to only be used for the purpose of compromising certain of our outstanding vendor payables or for paying for the audit of our financial statements. The amendment calls for us to repay the lender in full the amount of any and all Third Amendment Advances, together with all accrued and unpaid interest thereon, on or before January 31, 2010. On October 5, 2009, the Lender made an advance of $300,000 to us pursuant to these provisions. As consideration for the additional advance, we issued to the Lender warrants to purchase 200,000 shares of our common stock at an exercise price of $0.60 per share. Such warrants may be exercised at any time from October 5, 2009 until October 5, 2014. As additional consideration, we assigned certain patents related to discontinued product lines to the Lender with the condition that we would participate in future proceeds generated from efforts by the Lender to monetize the patents.

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We recorded the Amendment No. 3 borrowing net of a discount equal to the fair value allocated to warrants and the patent assignment. The warrants issued in conjunction with the Third Amendment Advance contained anti-dilution provisions, which require derivative liability classification. We estimated the fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in note discount from the issuance of the warrants of approximately $105,000. We estimated the fair value of the patent assignment to be $0 based on the unsuccessful attempt to monetize the patents.

On November 4, 2009, we and the Lender amended the Note (“Amendment No. 4”) whereby the Lender made an additional $350,000 advance (the “Additional Advance”) under the Note. As consideration for the Additional Advance, we executed an assignment of all accounts receivable (the “Assignment of Receivables”) whereby we assigned to the Lender all of our rights, title and interest in all accounts receivable as of the date of Amendment No. 4. In December 2009, we paid back the $350,000 advance plus accrued interest.

In December 2009, the Lender advanced an additional $325,000 under Amendment No. 3. In December 2009, the Lender added approximately $12,000 in legal fees to the principal balance of the note.

In February 2010, we and the Lender further amended the Note (“Amendment No. 5”) whereby the Lender extended the due date of amounts due on January 31, 2010 to March 15, 2010.

In March 2010, we and the Lender further amended the Note (“Amendment No. 6”) whereby the Lender made an additional advance of $250,000 under the Note. As consideration for the advance, we will pay the Lender additional interest on the maturity date or such earlier date as may be required under the terms of the Note in an amount equal to 200,000 multiplied by the average of the closing prices of our common stock for the ten trading day period immediately preceding the date of the payment of such interest payment. As additional consideration for making the advance, we assigned to the Lender its rights, title and interest in and to fifty percent of certain after-cost proceeds that may be received in connection with our prosecution of certain commercial tort claims (including, but not limited to, claims related to the infringement of our intellectual property). In conjunction with Amendment No. 6, the interest rate on the Note was changed to 10% per annum, retroactive to February 2009. Also in conjunction with Amendment No. 6, the Lender extended the due dates of amounts due on March 15, 2010 to June 30, 2010.

In conjunction with Amendments No. 5 and No. 6, the Lender added an aggregate of $15,000 to the note principal during 2010.

We recorded the borrowing under Amendment No. 6 net of a discount equal to the fair value of the change in the additional interest obligation of approximately $140,000. We estimated the fair value of the change in the additional interest obligation using the Black-Scholes option pricing model using the following assumptions: term of 0.3 years, a risk free interest rate of 0.20%, a dividend yield of 0%, and volatility of 107%.

Amendments Nos. 2 through 6 were evaluated under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. Based on such analysis, we determined that such amendments were not substantial.

In June 2010, we did not repay the outstanding note principal and interest due under the terms of the Note, which were due on June 30, 2010. In August 2010, we further amended the Note (“Amendment No. 7”) whereby the Lender extended the maturity date to September 15, 2010. The Note was further amended to allow us a 60 day grace period beyond September 15, 2010 if, prior to September 15, 2010, we can deliver a customer contract (or contracts) sufficient to generate aggregate revenue of not less than $25 million. In conjunction with the amendment, we agreed to pay a $50,000 amendment fee (such fee to be added to the principal balance of the Note as of the date of the amendment). We also agreed to amend the clause in the Note requiring us to pay additional interest on the Note equal to the greater of $400,000 or an amount equal to 2,200,000 times the average of the five highest closing prices for our common stock from February 12, 2009 to the maturity date of the Note. The additional interest will, however, not exceed $2,200,000. Prior to the amendment this payment was based upon the average of the 10 daily closing prices immediately preceding the date of payment and had no upper limit.

We evaluated the Amendment No. 7 modification under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. We determined that because the change in fair value of the debt instruments was greater than 10% of the present value of the cash flows between the modified debt instruments and original debt instruments, the debt modification was substantial and therefore we accounted for the modification as a debt extinguishment. Accordingly, we recorded the new debt instrument at fair value and recorded a loss on debt extinguishment of approximately $1,763,000 during 2010.

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On October 6, 2010, we entered into a Settlement Agreement (the “Agreement”) with the Lender whereby we agreed to pay the Lender the sum of $4,703,465 (consisting of outstanding principal, interest, amounts due under the terms of the Additional Financing Obligation and legal fees) in three payments to be made in the amount of $1,567,821 due on or before October 8, 2010; $1,567,822 due on or before November 30, 2010; and a third and final payment of $1,567,822 due on or before December 30, 2010. Interest continued to accrue at a rate of 18% per annum on the outstanding indebtedness until the date of payment. The Lender retained a first priority security interest in our assets pursuant to the terms of the Note. The Company made the scheduled installment payments in accordance with the Agreement with the final payment being made on December 8, 2010.

6% Secured Convertible Promissory Notes

On October 5, 2010, we entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 1”) in the amount of $2,000,000 purchased by an existing shareholder. Convertible Note No. 1 is convertible into common shares at $0.50 per share. In conjunction with the issuance of the Convertible Note No. 1, we issued warrants to purchase 1,000,000 shares of common stock with an exercise price of $0.50.

We recorded Convertible Note No. 1 net of a discount equal to the fair value allocated to the warrants of approximately $408,000. We utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $408,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. We will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

On November 5, 2010, we entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 2”) in the amount of $2,000,000 purchased by the same shareholder. Convertible Note No. 2 is convertible into common shares at $0.50 per share. In conjunction with the issuance of Convertible Note No. 2, we issued warrants to purchase 5,000,000 shares of common stock with an exercise price of $0.50.

We recorded Convertible Note No. 2 net of a discount equal to the fair value allocated to the warrants of approximately $2,000,000. The Company estimated the fair value of the warrants to be approximately $2,074,000 using a Monte-Carlo simulation performed by an independent valuation firm, Vantage Point Advisors, Inc. We also recorded an additional $74,000 in financing expense based on the fair value of the warrants as the grant date fair value of the warrants exceeded the face amount of the convertible note. We will accrete the note discount over the life of the note using the effective interest rate method.

On December 8, 2010, we entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 3”) in the amount of $1,500,000 purchased by the same shareholder. Convertible Note No. 3 is convertible into common shares at $0.50 per share. In conjunction with the issuance of Convertible Note No. 3, we issued warrants to purchase 2,250,000 shares of common stock with an exercise price of $0.50.

We recorded Convertible Note No. 3 net of a discount equal to the fair value allocated to the warrants of approximately $830,000. We utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $671,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. We will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

On December 8, 2010, we entered into a security agreement with the Lender of Convertible Notes Nos. 1 through 3 (collectively the “6% Convertible Notes”) whereby Company granted the 6% Convertible Note holder a first priority lien on and security interest in all our assets.

In June 2011, we entered into a new, two year secured convertible 6% note (“Convertible Note No. 4”) in the amount of $500,000 purchased by the existing holder of the 6% Convertible Notes. Convertible Note No. 4 is convertible into common shares at $1.25 per share and is due June 9, 2013. In conjunction with the issuance of Convertible Note No. 4, we issued warrants to purchase 300,000 shares of common stock with an exercise price of $1.25. The Warrant terminates, if not previously exercised, two years from the date of issuance, or June 9, 2013. The Warrant contains a cashless exercise provision allowing the Lender to exercise the Warrant without tendering the exercise price of the Warrant, subject to a reduction of the number of shares of common stock issuable upon exercise of the Warrant.

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We recorded Convertible Note No. 4 net of a discount equal to the fair value allocated to the warrants of approximately $188,000. The Company utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $188,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The Company will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

7% Convertible Promissory Notes to Related Parties

On November 14, 2008, we entered into a series of convertible promissory notes (the "Related-Party Convertible Notes"), aggregating $110,000 with certain officers and members of our Board of Directors. The Related-Party Convertible Notes bear interest at 7.0% per annum and were due February 14, 2009. The principal amount of the Related-Party Convertible Notes plus accrued but unpaid interest is convertible at the option of the holder into our common stock. The number of shares into which the Related-Party Convertible Notes are convertible shall be calculated by dividing the outstanding principal and accrued but unpaid interest by $0.55 (the “Conversion Price”).

In conjunction with the issuance of the Related-Party Convertible Notes, we issued an aggregate of 149,996 warrants to the note holders to purchase our common stock. The warrants have an exercise price of $0.55 per share and may be exercised at any time from November 14, 2008 until November 14, 2013.

We, in 2008, initially recorded the convertible notes net of a discount equal to the fair value allocated to the warrants of approximately $13,000. We estimated the fair value of the warrants using the Black-Scholes option pricing model using the following assumptions: term of 5 years, a risk free interest rate of 2.53%, a dividend yield of 0%, and volatility of 96%. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $12,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. We have accreted the beneficial conversion feature over the life of the note.

We did not repay the Related-Party Convertible Notes on the due date. In August 2009, we received, from the Related-Party Convertible Note holders, a waiver of default and extension to January 31, 2010 of the maturity date of the Related-Party Convertible Notes. As consideration for the waiver and note extension, we issued, to the Related-Party Convertible Note holders, an aggregate of 150,000 warrants to purchase shares of our common stock. The warrants have an exercise price of $0.54 per share and expire on August 25, 2014. We did not repay the notes on January 31, 2010 and is currently seeking an additional waiver of default from the holders of the Related-Party Convertible Notes.

The warrants issued in conjunction with the August 2009 waiver of default contain anti-dilution provisions, which require derivative liability classification. We recorded the grant date fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in the recognition of expense of approximately $52,000 included as a component of interest expense in our consolidated statements of operations for the year ended December 31, 2009.

Contractual Obligations

Total contractual obligations and commercial commitments as of September 30, 2011 are summarized in the following table (in thousands):

	Payment Due by Year
	Total		2011 (3 months)		2012		2013		2014		2015		Thereafter
9% secured promissory note*	$	—	$	—	$	—	$	—	$	—	$	—	$	—
7% related party promissory note**		110		110		—		—		—		—		—
6% promissory note		6,000		—		5,500		500		—		—		—
Operating lease obligations		773		104		431		238		—		—		—

Total	$	6,883	$	214	$	5,931	$	738	$	—	$	—	$	—

* Note was settled in December 2010.

** Note had a maturity date of January, 2010. We did not repay the notes on January 31, 2010 and we are currently seeking an additional waiver of default from the holders of the Related-Party Convertible Notes.

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Real Property Leases

In December 2010, we entered into a new lease agreement and relocated our corporate headquarters to Rancho Bernardo Road in San Diego, California. The lease term commenced in December 2010 and ends on December 31, 2013. We are obligated under the lease to pay base rent and certain operating costs and taxes for the building. Aggregate base rent payable by us will be approximately $54,000, $111,000 and $114,000 during the first, second and third years of the lease, respectively. Our rent was abated at a rate of 50% for the first 12 months of the lease. Under the lease, we were required to provide a security deposit in the amount of approximately $9,500.

In addition to the corporate headquarters lease in San Diego, California, we also lease space in Ottawa, Province of Ontario, Canada; Portland, Oregon and Mexico City, Mexico. Those contractual lease obligations, as well as the San Diego lease, are included in the “contractual obligations” summary table above.

Stock-based Compensation

Stock-based compensation has been classified as follows in the accompanying condensed consolidated statements of operations (in thousands, except per share data):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
Cost of revenues	$	1	$	1	$	4	$	4
General and administrative		38		33		141		102
Sales and marketing		16		19		50		58
Research and development		15		7		45		20

Total	$	70	$	60	$	240	$	184

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, except share and per share data)

	September 30, 2011			December 31, 2010
	(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents	$	267		$	103
Accounts receivable, net of allowance for doubtful accounts of $5 at September 30, 2011 and December 31, 2010		305			239
Inventory, net		30			12
Other current assets		74			57
Total Current Assets		676			411

Property and equipment, net		18			19
Other assets		59			58
Intangible assets, net of accumulated amortization		67			78
Goodwill		3,416			3,416
Total Assets	$	4,236		$	3,982

LIABILITIES AND SHAREHOLDERS’ DEFICIT

Current Liabilities:
Accounts payable	$	1,104		$	1,161
Deferred revenue		1,473			1,073
Billings in excess of costs and estimated earnings on uncompleted contracts		—			241
Accrued expenses		2,082			1,822
Notes payable to related parties		110			110
Total Current Liabilities		4,769			4,407

Convertible secured notes payable, net of discount		3,228			1,427
Derivative liabilities		11,573			15,653
Pension obligation		431			401
Total Liabilities		20,001			21,888

Shareholders’ deficit:
Preferred stock, authorized 4,000,000 shares:
Series B convertible redeemable preferred stock, $0.01 par value; designated 750,000 shares, 389,400 shares issued, and 239,400 shares outstanding at September 30, 2011 and December 31, 2010; liquidation preference $772 and $734 at September 30, 2011 and December 31, 2010, respectively		2			2
Series C convertible preferred stock, $0.01 par value; designated 3,500 shares, 2,500 shares issued, and 2,200 shares outstanding at September 30, 2011 and December 31, 2010; liquidation preference $3,087 and $2,956 at September 30, 2011 and December 31, 2010, respectively		—			—
Series D convertible preferred stock, $0.01 par value; designated 3,000 shares, 2,310 shares issued, and 2,085 shares outstanding at September 30, 2011 and December 31, 2010; liquidation preference $2,792 and $2,660 at September 30, 2011 and December 31, 2010, respectively		—			—
Common stock, $0.01 par value, 50,000,000 shares authorized; 26,334,766 and 23,845,481 shares issued at September 30, 2011 and December 31, 2010, respectively, and 26,328,062 and 23,838,777 shares outstanding at September 30, 2011 and December 31, 2010, respectively		262			237
Additional paid in capital		86,261			85,186
Treasury stock, at cost - 6,704 shares		(64	)		(64	)
Accumulated other comprehensive loss		(81	)		(62	)
Accumulated deficit		(102,145	)		(103,205	)
Total Shareholders’ deficit		(15,765	)		(17,906	)

Total Liabilities and Shareholders’ Deficit	$	4,236		$	3,982

The accompanying notes are an integral part of these condensed consolidated financial statements.

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Revenues:
Product	$	310		$	769		$	2,367		$	2,640
Maintenance		750			653			2,113			1,961
		1,060			1,422			4,480			4,601
Cost of revenues:
Product		65			249			371			921
Maintenance		227			198			674			699
Gross profit		768			975			3,435			2,981

Operating expenses:
General and administrative		617			512			1,610			1,888
Sales and marketing		343			385			1,076			1,158
Research and development		683			576			1,995			1,939
Depreciation and amortization		7			13			21			39
		1,650			1,486			4,702			5,024
Loss from operations		(882	)		(511	)		(1,267	)		(2,043	)

Interest expense, net		686			60			1,955			636
Change in fair value of additional financing obligation		—			(38	)		—			(553	)
Change in fair value of derivative liabilities		(6,955	)		(506	)		(4,268	)		(4,183	)
Loss on debt modification		—			1,100			—			1,100
Other income, net		(10	)		(12	)		(19	)		(314	)
Income (loss) before income taxes		5,397			(1,115	)		1,065			1,271
Income tax expense		2			2			6			201
Net income (loss)		5,395			(1,117	)		1,059			1,070
Preferred dividends		(99	)		(99	)		(301	)		(296	)
Net income (loss) available to common shareholders	$	5,296		$	(1,216	)	$	758		$	774

Basic income (loss) per common share:
Net income (loss)	$	0.20		$	(0.05	)	$	0.04		$	0.04
Preferred dividends		(0.00	)		(0.00	)		(0.01	)		(0.01	)
Basic income (loss) per share available to common shareholders	$	0.20		$	(0.05	)	$	0.03		$	0.03
Basic weighted-average shares		26,328,062			23,753,994			25,816,120			22,916,554

Diluted income (loss) per common share:
Diluted income (loss) per share	$	0.10		$	(0.05	)	$	0.02		$	0.03
Diluted weighted-average shares		57,166,212			23,753,994			58,993,965			37,824,505

The accompanying notes are an integral part of these condensed consolidated financial statements.

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(unaudited)

	Nine Months Ended September 30,
	2011			2010
Cash flows from operating activities
Net income	$	1,059		$	1,070
Adjustments to reconcile net income to net cash used in operating activities
Depreciation and amortization		21			39
Amortization of debt discount and debt issuance costs		1,676			431
Accretion of additional financing obligation costs		—			142
Loss on debt modification		—			1,100
Change in fair value of additional financing obligation		—			(695	)
Change in fair value of derivative liabilities		(4,268	)		(4,183	)
Stock issued in lieu of cash		13			—
Stock based compensation		240			184
Change in assets and liabilities
Accounts receivable, net		(65	)		247
Inventory, net		(18	)		198
Other assets		(18	)		9
Accounts payable		(57	)		214
Accrued expenses		261			358
Deferred revenue		399			(332	)
Billings in excess of costs and estimated earnings on uncompleted contracts		(241	)		161
Pension obligation		30			12
Total adjustments		(2,027	)		(2,115	)
Net cash used in operating activities		(968	)		(1,045	)

Cash flows from investing activities
Purchase of property and equipment		(8	)		(17	)
Net cash used in investing activities		(8	)		(17	)

Cash flows from financing activities
Proceeds from exercised stock options		4			—
Proceeds from exercised stock purchase warrants		655			500
Proceeds from issuance of notes payable		500			250

Net cash provided by financing activities		1,159			750
Effect of exchange rate changes on cash		(19	)		(30	)
Net increase (decrease) in cash and cash equivalents		164			(342	)

Cash and cash equivalents at beginning of period		103			342

Cash and cash equivalents at end of period	$	267		$	—

Supplemental disclosure of cash flow information:
Cash paid for interest	$	—		$	—
Cash paid for income taxes	$	—		$	—
Summary of non-cash investing and financing activities:
Warrants issued with notes payable	$	188		$	—
Additional financing obligation issued with notes payable	$	—		$	140
Non-cash fees added to secured note payable	$	—		$	85
Beneficial conversion feature of convertible debt	$	188		$	—
Conversion of preferred stock into common stock	$	—		$	27
Issuance of common stock pursuant to cashless warrant exercises	$	12		$	5

The accompanying notes are an integral part of these condensed consolidated financial statements.

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IMAGEWARE SYSTEMS, INC

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(IN THOUSANDS)

(unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2011		2010			2011			2010
Net income (loss)	$	5,395	$	(1,117	)	$	1,059		$	1,070

Foreign currency translation adjustment		65		(152	)		(19	)		(30	)
Comprehensive income (loss)	$	5,460	$	(1,269	)	$	1,040		$	1,040

The accompanying notes are an integral part of these condensed consolidated financial statements.

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IMAGEWARE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1. ORGANIZATION AND DESCRIPTION OF BUSINESS

Overview

ImageWare Systems, Inc. (the “Company”) is incorporated in the state of Delaware. The Company is a pioneer and leader in the emerging market for biometrically enabled software-based identity management solutions. Using those human characteristics that are unique to us all, the Company creates software that provides a highly reliable indication of a person’s identity. The Company’s “flagship” product is the patented IWS Biometric Engine®. The Company’s products are used to manage and issue secure credentials, including national IDs, passports, driver licenses and access control credentials. The Company’s products also provide law enforcement with integrated mug shot, fingerprint LiveScan and investigative capabilities. The Company also provides comprehensive authentication security software using biometrics to secure physical and logical access to facilities or computer networks or Internet sites. Biometric technology is now an integral part of all markets the Company addresses and all of the products are integrated into the IWS Biometric Engine.

Recent Developments

During the first three quarters of fiscal 2010, the Company was faced with limited funds for operations. As a result, the Company suspended filings with the Securities and Exchange Commission (“SEC”), and took measures to reduce operating costs. On December 20, 2011, the Company consummated an equity financing resulting in gross proceeds of $10.0 million (“Qualified Financing”), including the $750,000 of promissory notes converted into the Qualified Financing. In connection with the Qualified Financing, the Company issued 20.0 million shares of its common stock (the “Shares”), and warrants to purchase 12,207,500 shares of its common stock exercisable for $0.50 per share (“Warrants”). The Warrants expire five years from the date of grant. The Company also issued 90,000 shares of common stock and a Warrant exercisable for 45,000 shares of common stock in lieu of cash in payment for legal fees related to the Qualified Financing.

As a result of the consummation of the Qualified Financing, the Company was able to complete the audit of its financial statements for the fiscal year ended December 31, 2010, and is currently in the process of filing all subsequent reports required to be filed with the SEC. Management believes that the Company’s current cash and cash equivalents will be sufficient to meet working capital and capital expenditure requirements for at least the next 12 months from the date of the filing of this Quarterly Report and that the Company will have sufficient liquidity to fund its business and meet its contractual obligations over a period beyond the next 12 months.

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NOTE 2. SIGNIFICANT ACCOUNTING POLICIES AND BASIS OF PRESENTATION

Basis of Presentation

The accompanying condensed consolidated balance sheet as of December 31, 2010, which has been derived from audited financial statements, and the unaudited interim condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) and the rules and regulations of the Securities and Exchange Commission (“SEC”) related to a quarterly report on Form 10-Q. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. The interim financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2010, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 that was filed with the SEC on January 17, 2012.

Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ended December 31, 2011, or any other future periods.

Significant Accounting Policies

Accounts Receivable

In the normal course of business, the Company extends credit without collateral requirements to its customers that satisfy pre-defined credit criteria. Accounts receivable are recorded net of an allowance for doubtful accounts. The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts receivable balances, the credit quality of its customers, current economic conditions and other factors that may affect customers’ ability to pay to determine the level of allowance required. Accounts receivable are written off against the allowance for doubtful accounts when all collection efforts by the Company have been unsuccessful.

Fair Value of Financial Instruments

For certain of the Company’s financial instruments, including accounts receivable, accounts payable, accrued expenses, deferred revenues and notes payable to related parties, the carrying amounts approximate fair value due to their relatively short maturities.

Derivative Financial Instruments

The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks.

The Company reviews the terms of the common and preferred stock, warrants and convertible debt it issues to determine whether there are embedded derivative instruments, including embedded conversion options, which are required to be bifurcated and accounted for separately as derivative financial instruments. In circumstances where the host instrument contains more than one embedded derivative instrument, including the conversion option, that is required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument.

Bifurcated embedded derivatives are initially recorded at fair value and are then revalued at each reporting date with changes in the fair value reported as non-operating income or expense. When the equity or convertible debt instruments contain embedded derivative instruments that are to be bifurcated and accounted for as liabilities, the total proceeds received are first allocated to the fair value of all the bifurcated derivative instruments. The remaining proceeds, if any, are then allocated to the host instruments themselves, usually resulting in those instruments being recorded at a discount from their face value.

The discount from the face value of the convertible debt, together with the stated interest on the instrument, is amortized over the life of the instrument through periodic charges to interest expense, using the effective interest method.

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Revenue Recognition

The Company recognizes revenue from the following major revenue sources:

	●	Long-term fixed-price contracts involving significant customization
	●	Fixed-price contracts involving minimal customization

	●	Software licensing
	●	Sales of computer hardware and identification media

●

Postcontract customer support (PCS)

The Company’s revenue recognition policies are consistent with U.S. GAAP including ASC 985-605, “Software Revenue Recognition”, ASC 605-35 “Revenue Recognition, Construction-Type and Production-Type Contracts”, “Securities and Exchange Commission Staff Accounting Bulletin 104”, and ASC 605-25 “Revenue Recognition , Multiple Element Arrangements”. Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectability is reasonably assured.

The Company recognizes revenue and profit as work progresses on long-term, fixed-price contracts involving significant amount of hardware and software customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. The primary components of costs incurred are third party software and direct labor cost including fringe benefits. Revenues recognized in excess of amounts billed are classified as current assets under “Costs and estimated earnings in excess of billings on uncompleted contracts”. Amounts billed to customers in excess of revenues recognized are classified as current liabilities under “Billings in excess of costs and estimated earnings on uncompleted contracts”. Revenue from contracts for which the Company cannot reliably estimate total costs or there are not significant amounts of customization are recognized upon completion. The Company also generates non-recurring revenue from the licensing of its software. Software license revenue is recognized upon the execution of a license agreement, upon deliverance, when fees are fixed and determinable, when collectability is probable and when all other significant obligations have been fulfilled. The Company also generates revenue from the sale of computer hardware and identification media. Revenue for these items is recognized upon delivery of these products to the customer. The Company’s revenue from periodic maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectability of the related receivable is probable. Amounts collected in advance for maintenance services are included in current liabilities under "Deferred revenues". Sales tax collected from customers is excluded from revenue.

Customer Concentration

For the three and nine months ended September 30, 2011, one customer accounted for approximately 14% and 38% or $147,000 and $1,684,000, respectively, of total revenues and had trade receivables at September 30, 2011 of $0. For the three and nine months ended September 30, 2010, two customers accounted for approximately 32% and 39% or $448,000 and $1,808,000, respectively, of total revenues and had trade receivables at September 30, 2010 of $0.

Recently Issued Accounting Standards

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies, which are adopted by us as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company’s consolidated financial statements upon adoption.

FASB ASU 2010-06. In January 2010, the FASB issued FASB Accounting Standards Update, or ASU 2010-06, which amends the disclosure requirements relating to recurring and nonrecurring fair value measurements. New disclosures are required about transfers into and out of the levels 1 and 2 fair value hierarchy and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. This ASU also requires an entity to present information about purchases, sales, issuances and settlements for significant unobservable inputs on a gross basis rather than as a net number. This ASU was effective for us with the reporting period beginning January 1, 2010, except for the disclosures on the roll forward activities for Level 3 fair value measurements, which became effective for the Company beginning January 1, 2011. The adoption of this ASU had no impact on the Company’s financial position and results of operations, as it only requires additional disclosures.

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FASB ASU 2010-29. In December 2010, the FASB issued FASB ASU 2010-29, which requires an entity to disclose revenue and earnings of a combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual period only. It also requires pro forma disclosures to include a description of the nature and amount of the material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The adoption of ASU 2010-29 did not impact the Company’s condensed consolidated financial statements as there were no business combinations to report.

FASB ASU 2011-05. In June 2011 the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, (“ASU 2011-05”). This new accounting standard: (1) eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity; (2) requires the consecutive presentation of the statement of net income and other comprehensive income; and (3) requires an entity to present reclassification adjustments on the face of the financial statements from other comprehensive income to net income. This new standard does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income, nor does it affect how earnings per share is calculated or presented. ASU 2011-05 is required to be applied retrospectively and is effective for fiscal years and interim periods within those years beginning after December 15, 2011, with early adoption permitted. As this new standard only requires enhanced disclosure, the adoption of ASU 2011-05 will not impact the Company’s financial position or results of operations.

FASB ASU 2011-08. In September 2011 the FASB issued ASU No. 2011-08, Goodwill and Other (Topic 350): Testing Goodwill for Impairment, (“ASU 2011-08”). This new accounting standard simplifies goodwill impairment tests and states that a qualitative assessment may be performed to determine whether further impairment testing is necessary. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of ASU 2011-08 did not have a material impact on the Company’s condensed consolidated financial statements.

FASB ASU 2011-09. The FASB has issued Accounting Standards Update (ASU) No. 2011-09, Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer’s Participation in a Multiemployer Plan. ASU 2011-09 is intended to address concerns from various users of financial statements on the lack of transparency about an employer’s participation in a multiemployer pension plan. Users of financial statements have requested additional disclosure to increase awareness of the commitments and risks involved with participating in multiemployer pension plans. The amendments in this ASU will require additional disclosures about an employer’s participation in a multiemployer pension plan. Previously, disclosures were limited primarily to the historical contributions made to the plans. ASU 2011-09 applies to nongovernmental entities that participate in multiemployer plans. For public entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2011. For nonpublic entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2012. Early adoption is permissible for both public and nonpublic entities. ASU 2011-09 should be applied retrospectively for all prior periods presented. The adoption of ASU 2011-09 did not have a material impact on the Company’s consolidated financial statements.

NOTE 3. NET INCOME (LOSS) PER COMMON SHARE

Basic income (loss) per common share is calculated by dividing net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net income available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, adjusted to include, if dilutive, potential dilutive shares consisting of convertible preferred stock, convertible notes payable, stock options and warrants, calculated using the treasury stock method. For diluted earnings per share calculation purposes, the net income available to commons shareholders is adjusted to add back any preferred stock dividends and any interest on convertible debt reflected in the condensed consolidated statement of operations for the respective periods.

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The table below presents the computation of basic and diluted earnings income (loss) per share:

(Amounts in thousands except share and per share amounts)	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Numerator for basic earnings (loss) per share:
Net income (loss)	$	5,395		$	(1,117	)	$	1,059		$	1,070
Preferred dividends		(99	)		(99	)		(301	)		(296	)
Net income (loss) available to common shareholders	$	5,296		$	(1,216	)	$	758		$	774

Numerator for diluted earnings (loss) per share:
Net income (loss) available to common shareholders	$	5,296		$	(1,216	)	$	758		$	774
Preferred dividends		99			—			301			296
Interest expense on convertible debt		93			—			261			6
Net income (loss) for diluted earnings (loss) per share	$	5,488		$	(1,216	)	$	1,320		$	1,076

Denominator for basic earnings (loss) per share — weighted-average shares outstanding		26,328,062			23,753,994			25,816,120			22,916,554
Effect of dilutive securities		30,838,150			—			33,177,845			14,907,951
Denominator for diluted earnings (loss) per share — weighted-average shares outstanding		57,166,212			23,753,994			58,993,965			37,824,505

Basic income (loss) per share:
Net income (loss)	$	0.20		$	(0.05	)	$	0.04		$	0.04
Preferred dividends		(0.00	)		(0.00	)		(0.01	)		(0.01	)
Net income (loss) available to common shareholders	$	0.20		$	(0.05	)	$	0.03		$	0.03

Diluted income (loss) per share:
Net income (loss)	$	0.10		$	(0.05	)	$	0.02		$	0.03

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The Company has excluded the following securities from the calculation of diluted loss per share, as their effect would have been antidilutive:

Dilutive securities	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010

Convertible notes payable		—		226,236		—		—
Convertible preferred stock		57,490		10,982,759		56,584		52,954
Stock options		603,930		942,721		135,342		879,199
Warrants		1,254,029		11,730,948		812,925		1,426,779
Total dilutive securities		1,915,449		23,882,664		1,004,851		2,358,932

NOTE 4. SELECT BALANCE SHEET DETAILS

Inventory

Inventories of $30,000 at September 30, 2011 were comprised of work in process of $11,000 representing direct labor costs on in-process projects and finished goods of $19,000 net of reserves for obsolete and slow-moving items of $2,000. Inventories of $12,000 at December 31, 2010 were comprised of work in process of $7,000 representing direct labor costs on in-process projects and finished goods of $5,000 net of reserves for obsolete and slow-moving items of $2,000. Appropriate consideration is given to obsolescence, excessive levels, deterioration, and other factors in evaluating net realizable value and required reserve levels.

Intangible Assets

The Company has one intangible in the form of trademarks and trade names. The carrying amounts of the Company’s acquired intangible assets were $67,000 and $78,000 as of September 30, 2011 and December 31, 2010, respectively, which include accumulated amortization of $280,000 and $269,000 as of September 30, 2011 and December 31, 2010, respectively. Amortization expense for the intangible assets was $4,000 for the three months ended September 30, 2011 and 2010 and $11,000 for the nine months ended September 30, 2011 and 2010. All intangible assets are being amortized over their estimated useful lives with no estimated residual values. Any costs incurred by the Company to renew or extend the life of intangible assets will be evaluated under ASC 350 “Intangibles – Goodwill and Other” for proper treatment.

The estimated acquired intangible amortization expense for the next five fiscal years is as follows:

Fiscal Year Ended December 31,	Estimated Amortization Expense ($ in thousands)
2011 (3 months)	$	5
2012		16
2013		16
2014		16
2015		14
Thereafter		—
Total	$	67

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Goodwill

The Company annually, or more frequently if events or circumstances indicate a need, tests the carrying amount of goodwill for impairment. The Company performs its annual impairment test in the fourth quarter of each year. A two-step impairment test is used to first identify potential goodwill impairment and then measure the amount of goodwill impairment loss, if any. These tests were conducted by determining and comparing the fair value, employing the market approach, of the Company’s reporting units to the carrying value of the reporting unit. The Company has determined that its only reporting unit is Identity Management. Based on the results of these impairment tests, the Company determined that its goodwill assets were not impaired as of December 31, 2010 and there have been no indications of impairment during the nine months ended September 30, 2011 or 2010.

Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts

The Company recognizes sales and cost of sales on long-term, fixed price contracts involving significant amounts of customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Such amounts are included in the accompanying consolidated balance sheets under the caption “Billings in excess of costs and estimated earnings on uncompleted contracts”.

Costs and estimated earnings on uncompleted contracts and related amounts billed under contract provisions as of September 30, 2011 and December 31, 2010 are as follows:

($ in thousands)	September 30, 2011			December 31, 2010

Costs incurred on uncompleted contract	$	619		$	539
Estimated earnings		1,141			980
		1,760			1,519

Less: billings to date		(1,760	)		(1,760	)
Billings in excess of costs and estimated earnings on uncompleted contract	$	—		$	(241	)

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NOTE 5. NOTES PAYABLE

Notes payable consist of the following:

($ in thousands)	September 30,			December 31,
	2011			2010
Secured Promissory Note
9% secured promissory note. Face value of note $0 at September 30, 2011 and December 31, 2010. Discount on note is $0 at September 30, 2011 and December 31, 2010. Note settled in December 2010.	$	—		$	—
Total secured notes payable		—			—
Secured Convertible Notes Payable
6% secured convertible notes payable. Face value of notes $6,000 and $5,500 at September 30, 2011 and December 31, 2010, respectively. Discount on notes is $2,772 and $4,073 at September 30, 2011 and December 31, 2010, respectively. Notes due October 2012 through June 2013.		3,228			1,427
Total convertible notes payable		3,228			1,427
Notes payable to related parties:
7% convertible promissory notes. Face value of notes $110 at September 30, 2011 and December 31, 2010. Discount on notes at is $0 at September 30, 2011 and December 31, 2010. Notes were due February 14, 2009 and extended to January 31, 2010.		110			110
Total notes payable to related parties		110			110

Total notes payable		3,338			1,537
Less current portion		(110	)		(110	)
Long-term notes payable	$	3,228		$	1,427

Future maturities of long-term debt are as follows as of September 30, 2011:

($ in thousands)
2012	$	5,500
2013		500
2014		—
2015		—
Thereafter		—
	$	6,000

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9% Secured Promissory Note

In February 2009, the Company entered into a secured promissory note (the "Note"), for $5,000,000 with a third-party lender (“the Lender”). The Note secures a credit facility for a total of up to $5,000,000. The initial advance under the Note was $1,000,000. Subsequent advances are subject to the discretion of the Lender. The note bears interest at 5% per annum on the outstanding principal and interest and is due on June 30, 2010. The Company will also pay the Lender additional financing fees (the “Additional Financing Obligation”) on the maturity date or such earlier date as may be required under the terms of the note equal to the greater of $400,000 or an amount equal to 2,000,000 multiplied by the average of the closing prices for the common stock of the Company for the ten trading day period immediately preceding the date of such interest payment.

In conjunction with the issuance of the Note, the Company issued a warrant to purchase 4,500,000 shares of common stock of the Company. The warrant has an exercise price $0.50 per share and may be exercised at any time from February 12, 2009 until February 12, 2014. Additionally, the Company entered into a Registration Rights Agreement requiring the Company to provide certain registration rights to the Lender relative to the 4,500,000 shares of common stock of the Company issuable pursuant to the warrant.

The Company recorded the Note and Additional Financing Obligation net of a discount equal to the fair values allocated to the various financial instruments issued to the Lender. The warrants issued in conjunction with the Note contained anti-dilution provisions, which require derivative liability classification (see Note 7). The Company estimated the fair value of the warrants using a Monte-Carlo simulation, which resulted in note discount from the issuance of the warrants of approximately $562,000. The Company recorded the Additional Financing Obligation equal to the fair values of the additional financing component using the Black-Scholes option-pricing model, which resulted in additional note discount of approximately $169,000. In addition, the Company accreted the $400,000 minimum payment to interest expense over the term of the agreement.

The Note is secured by all of the assets of the Company. Under the terms of the Note, the entire outstanding balance together with all accrued interest shall be payable on (i) the maturity date (June 30, 2010), (ii) a change of control transaction, (iii) receipt by the Company of proceeds from the sale of equity or equity linked securities of the Company in excess of $2,500,000, (iv) receipt by the Company of proceeds from the issuance by the Company of any type of additional debt instruments, or (v) upon the occurrence of an event of default under the terms of the Note.

In June 2009, the Lender and the Company agreed to amend the Note (“Amendment No. 1”) whereby the Company received a waiver of default and extension of certain date sensitive covenants contained in the Note. As consideration for the waiver and extension, the Company issued to the Lender warrants to purchase 1,000,000 shares of common stock of the Company at an exercise price of $0.50 per share. Such warrants may be exercised at any time from June 9, 2009 until June 9, 2014. In conjunction with the June 2009 waiver and extension, the interest rate on the Note was changed to 9% per annum, retroactive to February 2009.

The Company evaluated the waiver of default and interest rate change under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. The Company determined that because the change in fair value of the debt instruments was greater than 10% of the present value of the cash flows between the modified debt instruments and original debt instruments, the debt modification was substantial and therefore the Company accounted for the modification as a debt extinguishment. Accordingly, the Company recorded the new debt instrument at fair value and recorded a loss on debt extinguishment of approximately $750,000 during 2009. The loss on debt extinguishment of $750,000 includes approximately $132,000 of unamortized deferred financing fees written off due to the debt extinguishment. The Company recorded the new debt instruments net of a discount equal to the fair values allocated to the various financial instruments issued to the Lender. The Company estimated the fair value of the warrants using a Monte-Carlo simulation, which resulted in a note discount from the issuance of the warrants of approximately $188,000. The Company is accreting the note discount and the Additional Financing Obligation discount using the effective interest rate method over the life of the Note.

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In June 2009, the Lender and the Company further amended the Note (“Amendment No. 2”) whereby the Lender advanced the Company an additional $350,000 and amended certain terms of the Note. As consideration for the additional advance, the Company issued to the Lender warrants to purchase 700,000 shares of common stock of the Company at an exercise price of $0.50 per share. Such warrants may be exercised at any time from June 22, 2009 until June 22, 2014.

The Company recorded Amendment No. 2 net of a discount equal to the fair value allocated to warrants. The Company estimated the fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in a note discount from the issuance of the warrants of approximately $238,000.

In October 2009, the Lender and the Company further amended the Note (“Amendment No. 3”) whereby the Lender agreed to make additional advances in an aggregate amount up to $1,000,000 (“Third Amendment Advance”) to only be used for the purpose of compromising certain of the Company’s outstanding vendor payables or for paying for the audit of the Company’s financial statements. The amendment calls for the Company to repay the lender in full the amount of any and all Third Amendment Advances, together with all accrued and unpaid interest thereon, on or before January 31, 2010. On October 5, 2009, the Lender made an advance of $300,000 to the Company pursuant to these provisions. As consideration for the additional advance, the Company issued to the Lender warrants to purchase 200,000 shares of common stock of the Company at an exercise price of $0.60 per share. Such warrants may be exercised at any time from October 5, 2009 until October 5, 2014. As additional consideration, the Company assigned certain patents related to discontinued product lines to the Lender with the condition that the Company would participate in future proceeds generated from efforts by the Lender to monetize the patents.

The Company recorded the Amendment No. 3 borrowing net of a discount equal to the fair value allocated to warrants and the patent assignment. The warrants issued in conjunction with the Third Amendment Advance contained anti-dilution provisions, which require derivative liability classification (see Note 7). The Company estimated the fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in note discount from the issuance of the warrants of approximately $105,000. The Company estimated the fair value of the patent assignment to be $0 based on the unsuccessful attempt to monetize the patents.

On November 4, 2009, the Lender and the Company amended the Note (“Amendment No. 4”) whereby the Lender made an additional $350,000 advance (the “Additional Advance”) under the Note. As consideration for the Additional Advance, the Company executed an assignment of all accounts receivable (the “Assignment of Receivables”) whereby the Company assigned to the Lender all of the Company’s rights, title and interest in all accounts receivable as of the date of Amendment No. 4. In December 2009, the Company paid back the $350,000 advance plus accrued interest.

In December 2009, the Lender advanced an additional $325,000 under Amendment No. 3. In December 2009, the Lender added approximately $12,000 in legal fees to the principal balance of the note.

In February 2010, the Lender and the Company further amended the Note (“Amendment No. 5”) whereby the Lender extended the due date of amounts due on January 31, 2010 to March 15, 2010.

In March 2010, the Lender and the Company further amended the Note (“Amendment No. 6”) whereby the Lender made an additional advance of $250,000 under the Note. As consideration for the advance, the Company will pay the Lender additional interest on the maturity date or such earlier date as may be required under the terms of the Note in an amount equal to 200,000 multiplied by the average of the closing prices for the common stock of the Company for the ten trading day period immediately preceding the date of the payment of such interest payment. As additional consideration for making the advance, the Company assigned to the Lender its rights, title and interest in and to fifty percent of certain after-cost proceeds that may be received in connection with the Company’s prosecution of certain commercial tort claims (including, but not limited to, claims related to the infringement of the Company’s intellectual property). In conjunction with Amendment No. 6, the interest rate on the Note was changed to 10% per annum, retroactive to February 2009. Also in conjunction with Amendment No. 6, the Lender extended the due dates of amounts due on March 15, 2010 to June 30, 2010.

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In conjunction with Amendments No. 5 and No. 6, the Lender added an aggregate of $15,000 to the note principal during 2010.

The Company recorded the borrowing under Amendment No. 6 net of a discount equal to the fair value of the change in the additional interest obligation of approximately $140,000. The Company estimated the fair value of the change in the additional interest obligation using the Black-Scholes option pricing model using the following assumptions: term of 0.3 years, a risk free interest rate of 0.20%, a dividend yield of 0%, and volatility of 107%.

Amendments Nos. 2 through 6 were evaluated under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. Based on such analysis, the Company determined that such amendments were not substantial.

In June 2010, the Company did not repay the outstanding note principal and interest due under the terms of the Note, which were due on June 30, 2010. In August 2010, the Company further amended the Note (“Amendment No. 7”) whereby the Lender extended the maturity date to September 15, 2010. The Note was further amended to allow the Company a 60 day grace period beyond September 15, 2010 if, prior to September 15, 2010, the Company can deliver a customer contract (or contracts) sufficient to generate aggregate revenue of not less than $25 million. In conjunction with the amendment, the Company agreed to pay a $50,000 amendment fee (such fee to be added to the principal balance of the Note as of the date of the amendment). The Company also agreed to amend the clause in the Note requiring the Company to pay additional interest on the Note equal to the greater of $400,000 or an amount equal to 2,200,000 times the average of the five highest closing prices for the Company’s common stock from February 12, 2009 to the maturity date of the Note. The additional interest will, however, not exceed $2,200,000. Prior to the amendment this payment was based upon the average of the 10 daily closing prices immediately preceding the date of payment and had no upper limit.

The Company evaluated the Amendment No. 7 modification under ASC 470-50, Debtor’s Accounting for a Modification or Exchange of Debt Instruments, (ASC 470-50) to determine if the modification was substantial. The Company determined that because the change in fair value of the debt instruments was greater than 10% of the present value of the cash flows between the modified debt instruments and original debt instruments, the debt modification was substantial and therefore the Company accounted for the modification as a debt extinguishment. Accordingly, the Company recorded the new debt instrument at fair value and recorded a loss on debt extinguishment of approximately $1,763,000 during 2010.

On October 6, 2010, the Company entered into a Settlement Agreement (the “Agreement”) with the Lender whereby the Company agreed to pay the Lender the sum of $4,703,465 (consisting of outstanding principal, interest, amounts due under the terms of the Additional Financing Obligation and legal fees) in three payments to be made in the amount of $1,567,821 due on or before October 8, 2010; $1,567,822 due on or before November 30, 2010; and a third and final payment of $1,567,822 due on or before December 30, 2010. Interest continued to accrue at a rate of 18% per annum on the outstanding indebtedness until the date of payment. The Lender retained a first priority security interest in the assets of the Company pursuant to the terms of the Note. The Company made the scheduled installment payments in accordance with the Agreement with the final payment being made on December 8, 2010.

6% Secured Convertible Promissory Notes

On October 5, 2010, the Company entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 1”) in the amount of $2,000,000 purchased by an existing shareholder. Convertible Note No. 1 is convertible into common shares at $0.50 per share. In conjunction with the issuance of the Convertible Note No. 1, the Company issued warrants to purchase 1,000,000 shares of common stock with an exercise price of $0.50.

The Company recorded Convertible Note No. 1 net of a discount equal to the fair value allocated to the warrants of approximately $408,000. The Company utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $408,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The Company will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

On November 5, 2010, the Company entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 2”) in the amount of $2,000,000 purchased by the same shareholder. Convertible Note No. 2 is convertible into common shares at $0.50 per share. In conjunction with the issuance of Convertible Note No. 2, the Company issued warrants to purchase 5,000,000 shares of common stock with an exercise price of $0.50.

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The Company recorded Convertible Note No. 2 net of a discount equal to the fair value allocated to the warrants of approximately $2,000,000. The Company estimated the fair value of the warrants to be approximately $2,074,000 using a Monte-Carlo simulation performed by an independent valuation firm, Vantage Point Advisors, Inc. The Company also recorded an additional $74,000 in November 2010 in financing expense based on the fair value of the warrants as the grant date fair value of the warrants exceeded the face amount of the convertible note. The Company will accrete the note discount over the life of the note using the effective interest rate method.

On December 8, 2010, the Company entered into a new, two year unsecured convertible 6% note (“Convertible Note No. 3”) in the amount of $1,500,000 purchased by the same shareholder. Convertible Note No. 3 is convertible into common shares at $0.50 per share. In conjunction with the issuance of Convertible Note No. 3, the Company issued warrants to purchase 2,250,000 shares of common stock with an exercise price of $0.50.

The Company recorded Convertible Note No. 3 net of a discount equal to the fair value allocated to the warrants of approximately $830,000. The Company utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $671,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The Company will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

On December 8, 2010, the Company entered into a security agreement with the Lender of Convertible Notes Nos. 1 through 3 (collectively the “6% Convertible Notes”) whereby Company granted the 6% Convertible Note holder a first priority lien on and security interest in all the assets of the Company.

In June 2011, the Company entered into a new, two year secured convertible 6% note (“Convertible Note No. 4”) in the amount of $500,000 purchased by the existing holder of the 6% Convertible Notes. Convertible Note No. 4 is convertible into common shares at $1.25 per share and is due June 9, 2013. In conjunction with the issuance of Convertible Note No. 4, the Company issued warrants to purchase 300,000 shares of common stock with an exercise price of $1.25. The Warrant terminates, if not previously exercised, two years from the date of issuance, or June 9, 2013. The Warrant contains a cashless exercise provision allowing the Lender to exercise the Warrant without tendering the exercise price of the Warrant, subject to a reduction of the number of shares of common stock issuable upon exercise of the Warrant.

The Company recorded Convertible Note No. 4 net of a discount equal to the fair value allocated to the warrants of approximately $188,000. The Company utilized the services of an independent valuation firm, Vantage Point Advisors, Inc., to perform the Monte-Carlo simulations used to arrive at the estimate of fair value. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $188,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The Company will accrete the note discount and beneficial conversion feature over the life of the note using the effective interest rate method.

7% Convertible Promissory Notes to Related Parties

On November 14, 2008, the Company entered into a series of convertible promissory notes (the "Related-Party Convertible Notes"), aggregating $110,000 with certain officers and members of the Company’s Board of Directors. The Related-Party Convertible Notes bear interest at 7.0% per annum and were due February 14, 2009. The principal amount of the Related-Party Convertible Notes plus accrued but unpaid interest is convertible at the option of the holder into common stock of the Company. The number of shares into which the Related-Party Convertible Notes are convertible shall be calculated by dividing the outstanding principal and accrued but unpaid interest by $0.55 (the “Conversion Price”).

In conjunction with the issuance of the Related-Party Convertible Notes, the Company issued an aggregate of 149,996 warrants to the note holders to purchase common stock of the Company. The warrants have an exercise price of $0.55 per share and may be exercised at any time from November 14, 2008 until November 14, 2013.

The Company, in 2008, initially recorded the convertible notes net of a discount equal to the fair value allocated to the warrants of approximately $13,000. The Company estimated the fair value of the warrants using the Black-Scholes option pricing model using the following assumptions: term of 5 years, a risk free interest rate of 2.53%, a dividend yield of 0%, and volatility of 96%. The convertible notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $12,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The Company has accreted the beneficial conversion feature over the life of the note.

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The Company did not repay the Related-Party Convertible Notes on the due date. In August 2009, the Company received from the Related-Party Convertible Note holders a waiver of default and extension to January 31, 2010 of the maturity date of the Related-Party Convertible Notes. As consideration for the waiver and note extension, the Company issued to the Related-Party Convertible Note holders an aggregate of 150,000 warrants to purchase shares of the Company’s common stock. The warrants have an exercise price of $0.54 per share and expire on August 25, 2014.

The warrants issued in conjunction with the August 2009 waiver of default contain anti-dilution provisions, which require derivative liability classification (see Note 7). The Company recorded the grant date fair value of the warrants using a Monte-Carlo simulation analysis, which resulted in the recognition of expense of approximately $52,000 which was included as a component of interest expense in the Company’s consolidated statements of operations for the year ended December 31, 2009.

The Company did not repay the notes on January 31, 2010 and is currently seeking an additional waiver of default from the holders of the Related-Party Convertible Notes.

The following tables set forth the various components of interest expense, amortization of debt discounts and beneficial conversion features, changes in fair value of the additional financing obligation and losses recorded on debt modification for the three and nine months ended September 30, 2011 and 2010:

	Three Months Ended September 30, 2011								Three Months Ended September 30, 2010
	7% Convertible Notes		9% Secured Debt		6% Secured Convertible Notes		Totals		7% Convertible Notes		9% Secured Debt		6% Secured Convertible Notes		Totals
($ in Thousands)
Coupon interest rate	$	2	$	-	$	91	$	93	$	2	$	52	$	-	$	54

Accretion of note discount	$	-	$	-	$	431	$	431	$	-	$	-	$	-	$	-

Accretion of beneficial conversion feature	$	-	$	-	$	155	$	155	$	-	$	-	$	-	$	-

Change in Fair Value of Additional Financing Obligation	$	-	$	-	$	-	$	-	$	-	$	(38)	$	-	$	(38	)

Total of expense recorded on debt instruments	$	2	$	-	$	677	$	679	$	2	$	14	$	-	$	16

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	Nine Months Ended September 30, 2011								Nine Months Ended September 30, 2010
	7% Convertible Notes		9% Secured Debt		6% Secured Convertible Notes		Totals		7% Convertible Notes		9% Secured Debt			6% Secured Convertible Notes		Totals
($ in Thousands)
Coupon interest rate	$	6	$	-	$	255	$	261	$	6	$	170		$	-	$	176

Accretion of note discount	$	-	$	-	$	1,252	$	1,252	$	-	$	431		$	-	$	431

Accretion of beneficial conversion feature	$	-	$	-	$	424	$	424	$	-	$	-		$	-	$	-

Accretion of Additional Financing Obligation	$	-	$	-	$	-	$	-	$	-	$	142		$	-	$	142

Change in Fair Value of Additional Financing Obligation	$	-	$	-	$	-	$	-	$	-	$	(695	)	$	-	$	(695	)

Total of expense recorded on debt instruments	$	6	$	-	$	1,931	$	1,937	$	6	$	48		$	-	$	54

NOTE 6. EQUITY

The Company’s Articles of Incorporation, as amended, authorize the issuance of two classes of stock to be designated “Common Stock” and “Preferred Stock”. The Preferred Stock may be divided into such number of series and with the rights, preferences, privileges and restrictions as the Board of Directors may determine.

Series B Convertible Redeemable Preferred Stock

The Company had 239,400 shares of Series B Preferred outstanding as of September 30, 2011 and December 31, 2010. At September 30, 2011 and December 31, 2010, the Company had cumulative undeclared dividends of approximately $174,000 and $136,000, respectively. There were no conversions of Series B Preferred into common stock during the nine months ended September 30, 2011 or 2010.

Series C Convertible Preferred Stock

The Company had 2,200 shares of Series C Preferred outstanding as of September 30, 2011 and December 31, 2010. At September 30, 2011 and December 31, 2010, the Company had cumulative undeclared dividends of approximately $887,000 and $756,000, respectively. There were no conversions of Series C Preferred into common stock during the nine months ended September 30, 2011 or 2010.

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Series D Convertible Preferred Stock

The Company had 2,085 shares of Series D outstanding as of September 30, 2011 and December 31, 2010. At September 30, 2011 and December 31, 2010, the Company had cumulative undeclared dividends of approximately $707,000 and $575,000, respectively. During the quarter ended September 30, 2010, 113 shares of Series D Convertible Preferred Stock were converted into 281,428 shares of common stock. There were no conversions of Series D Preferred into common stock during the nine months ended September 30, 2011.

Common Stock

The following table summarizes common stock activity for the nine months ended September 30, 2011:

	Common Stock

Shares outstanding at December 31, 2010		23,838,777
Shares issued pursuant to warrants exercised for cash		1,310,000
Shares issued pursuant to cashless warrants exercised		1,154,698
Shares issued pursuant to options exercised		14,587
Shares issued as compensation in lieu of cash		10,000
Shares outstanding at September 30, 2011		26,328,062

During the nine months ended September 30, 2011, the Company issued 1,310,000 shares of common stock pursuant to the exercise of 1,310,000 warrants for cash proceeds of $655,000. During the nine months ended September 30, 2011, the Company also issued 1,154,698 shares of common stock pursuant to the cashless exercise of 1,966,358 warrants.

Warrants

As of September 30, 2011, warrants to purchase 16,401,254 shares of common stock at prices ranging from $0.50 to $1.67 were outstanding. All warrants are exercisable as of September 30, 2011 and expire at various dates through October 2014.

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The following table summarizes warrant activity for the following periods:

	Warrants			Weighted- Average Exercise Price

Balance at December 31, 2010		19,737,612		$	0.54
Granted		300,000		$	1.25
Expired / Canceled		(360,000	)	$	0.50
Exercised		(3,276,358	)	$	0.50
Balance at September 30, 2011		16,401,254		$	0.56

As more fully described in Note 4 to these condensed consolidated financial statements, in conjunction with the issuance of Convertible Note No. 4, the Company issued warrants to purchase 300,000 shares of common stock with an exercise price of $1.25. The Warrant terminates, if not previously exercised, two years from the date of issuance, or June 9, 2013.

During the nine months ended September 30, 2011, the Company issued 1,310,000 shares of common stock pursuant to the exercise of 1,310,000 warrants for cash proceeds of approximately $655,000. During the nine months ended September 30, 2011, the Company also issued 1,154,698 shares of common stock pursuant to the cashless exercise of 1,966,358 warrants.

There were 2,324,873 warrants exercised for 1,458,531 shares of common stock during the nine months ended September 30, 2010. Of the 2,324,873 warrants exercised, 1,000,000 were exercised for cash resulting in proceeds to the Company of $500,000, while the remaining warrants were exercised pursuant to cashless exercise. There were 635,767 warrants that expired and no warrants granted during the three and nine months ended September 30, 2010.

Stock Based Compensation

At September 30, 2011, the Company had two stock-based compensation plans for employees and nonemployee directors, which authorize the granting of various equity-based incentives including stock options and restricted stock.

The Company estimates the fair value of its stock options using a Black-Scholes option-pricing model, consistent with the provisions of ASC No. 718, Compensation – Stock Compensation. The fair value of stock options granted is recognized to expense over the requisite service period. Stock-based compensation expense for all share-based payment awards is recognized using the straight-line single-option method. Stock-based compensation expense is reported in operating expenses based upon the departments to which substantially all of the associated employees report and credited to additional paid-in-capital. Stock-based compensation expense related to equity options was approximately $70,000 and $50,000 for the three months ended September 30, 2011 and 2010, respectively. Stock-based compensation expense related to equity options was approximately $210,000 and $154,000 for the nine months ended September 30, 2011 and 2010, respectively.

ASC 718 requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The Company is required to make various assumptions in the application of the Black-Scholes option-pricing model. The Company has determined that the best measure of expected volatility is based on the historical weekly volatility of the Company’s common stock. Historical volatility factors utilized in the Company’s Black-Scholes computations for the nine months ended September 30, 2011 and 2010 ranged from 135% to 144%. The Company has elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 110. The expected term used by the Company during the nine months ended September 30, 2011 and 2010 was 5.9 years. The difference between the actual historical expected life and the simplified method was immaterial. The interest rate used is the risk free interest rate and is based upon U.S. Treasury rates appropriate for the expected term. Interest rates used in the Company’s Black-Scholes calculations for the nine months ended September 30, 2011 and 2010 was 2.6%. Dividend yield is zero as the Company does not expect to declare any dividends on the Company’s common shares in the foreseeable future.

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In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption. The Company has estimated an annualized forfeiture rate of approximately 10% for corporate officers, 4% for members of the Board of Directors and 6% for all other employees. The Company reviews the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.

In January of 2010, the Company issued 847,258 shares of restricted stock to members of management and the Board. These shares will vest quarterly over a three-year period. The restricted shares were issued as compensation for the cancellation of 1,412,096 options held by members of management and the Board. The Company evaluated the exchange in accordance with ASC 718 and determined there was no incremental cost to be recorded in conjunction with the exchange as the fair value of the options surrendered at the modification date exceeded the fair value of the restricted shares issued at the modification date. Stock-based compensation expense related to these restricted stock grants was approximately $10,000 for the three months ended September 30, 2011 and 2010, respectively. Stock-based compensation expense related to these restricted stock grants was approximately $30,000 for the nine months ended September 30, 2011 and 2010, respectively.

During March 2011, the Company granted 880,000 performance units to certain key employees that grant the holder the right to receive compensation based on the appreciation in the Company’s common stock in the event of transfer of control of the Company ("Performance Units"). As the vesting of the Performance Units is contingent upon the sale of the Company, the expense associated with the granting of the Performance Units was not material. The Performance Units issued to such key employees were terminated, and exchanged for options to purchase a total of 435,000 shares of common stock on January 30, 2012. See Note 10.

On July 22, 2011, the Company’s Board of Directors approved an amendment to the Amended and Restated 1999 Plan Stock Option Plan (the “1999 Plan”), subject to shareholder approval, pursuant to which an additional 2,159,442 shares would be reserved for issuance under the plan. In October 2011, the Company’s shareholders approved this amendment resulting in 2,159,442 shares being added to the 1999 Plan.

NOTE 7. DERIVATIVE LIABILITIES

The Company accounts for its derivative instruments under the provisions of ASC 815, Derivatives and Hedging-Contracts in Entity’s Own Equity-Scoped and Scope Exceptions (“ASC 815”). Under the provisions of ASC 815, the embedded conversion feature in the Company’s Series C and Series D Preferred Stock and the anti-dilution provisions in certain warrants are not considered indexed to the Company’s stock because future equity offerings of the Company’s stock are not an input to the fair value of a “fixed-for-fixed” option on equity shares. Accordingly, beginning January 1, 2009, the Company is required to account for the embedded derivatives related to the conversion feature in its Series C and Series D Preferred Stocks and certain warrants as derivative liabilities (collectively the “Derivative Liabilities”).

The Company is required to mark to market at the end of each reporting period the value of the derivative liabilities. The Company revalues these derivative liabilities at the end of each reporting period by using available market information and commonly accepted valuation methodologies. The periodic change in value of the derivative liabilities is recorded as either non-cash derivative income (if the value of the embedded derivative and warrants decrease) or as non-cash derivative expense (if the value of the embedded derivative and warrants increase). Although the values of the embedded derivative and warrants are affected by interest rates, the remaining contractual conversion period and the Company’s stock volatility, the primary cause of the change in the values of the derivative liabilities will be the value of the Company’s common stock. If the stock price goes up, the value of these derivatives will generally increase and if the stock price goes down the value of these derivatives will generally decrease.

The Company uses a Monte-Carlo simulation methodology in the determination of the fair value of the Derivative Liabilities. The Monte-Carlo simulation methodology is affected by the Company’s stock price as well as assumptions regarding the expected stock price volatility over the term of the Derivative Liabilities and assumptions regarding future financings.

During the year ended December 31, 2010, the Company issued 8,250,000 warrants requiring derivative liability classification with a grant date fair value of approximately $3,312,000. During the nine months ended September 30, 2011, the Company issued 300,000 warrants requiring derivative liability classification with a grant date fair value of approximately $188,000.

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NOTE 8. FAIR VALUE ACCOUNTING

The Company accounts for fair value measurements in accordance with ASC Topic No. 820, “Fair Value Measurements and Disclosures,” (“Topic No. 820”) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.

ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC Topic 820 are described below:

Level 1

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2

Applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.

Level 3

Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).

The following table sets forth the Company’s financial assets and liabilities measured at fair value by level within the fair value hierarchy. As required by ASC Topic 820, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

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	Fair Value at September 30, 2011
($ in thousands)	Total		Level 1		Level 2		Level 3

Assets:
Pension assets	$	1,517	$	1,517	$	—	$	—
Totals	$	1,517	$	1,517	$	—	$	—
Liabilities:
Derivative liabilities	$	11,573	$	—	$	—	$	11,573
Totals	$	11,573	$	—	$	—	$	11,573

	Fair Value at December 31, 2010
($ in thousands)	Total		Level 1		Level 2		Level 3

Assets:
Pension assets	$	1,369	$	1,369	$	—	$	—
Totals	$	1,369	$	1,369	$	—	$	—
Liabilities:
Derivative liabilities	$	15,653	$	—	$	—	$	15,653
Totals	$	15,653	$	—	$	—	$	15,653

The Company’s pension assets are classified within Level 1 of the fair value hierarchy because they are valued using market prices. The pension assets are primarily comprised of the cash surrender value of insurance contracts. All plan assets are managed in a policyholder pool in Germany by outside investment managers. The investment objectives for the plan are the preservation of capital, current income and long-term growth of capital.

Beginning January 1, 2009, the Company recorded derivative liabilities on its consolidated balance sheet as derivative liabilities related to certain warrants and the conversion feature embedded in its Series C and Series D Preferred Stock. The fair value of the Company’s derivative liabilities are classified within Level 3 of the fair value hierarchy because they are valued using pricing models that incorporate management assumptions that cannot be corroborated with observable market data. The Company uses Monte-Carlo simulation methodologies in the determination of the fair value of the derivative liabilities. The Monte-Carlo simulation methodologies is affected by the Company’s stock price as well as assumptions regarding the expected stock price volatility over the term of the derivative liabilities in addition to the probability of future financings.

The Company monitors the activity within each level and any changes with the underlying valuation techniques or inputs utilized to recognize if any transfers between levels are necessary. That determination is made, in part, by working with outside valuation experts for Level 3 instruments and monitoring market related data and other valuation inputs for Level 1 and Level 2 instruments.

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A reconciliation of the Company’s liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) is as follows:

($ in thousands)	Derivative Liabilities

Balance at December 31, 2010	$	15,653
Total unrealized gains		—
Included in earnings		(4,268	)
Settlements		—
Issuances		188
Transfers in and/or out of Level 3		—
Balance at September 30, 2011	$	11,573

All unrealized gains or losses resulting from changes in value of any Level 3 instruments are reflected as a separate line in the condensed consolidated statement of operations in arriving at net loss. The Company is not a party to any hedge arrangements, commodity swap agreement or any other derivative financial instruments.

NOTE 9. RELATED PARTY TRANSACTIONS

As more fully described in Note 4, on November 14, 2008, the Company entered into a series of convertible promissory notes (the “Related Party Convertible Notes”), aggregating $110,000 with certain officers and members of the Company’s Board of Directors. The Related Party Convertible Notes bear interest at 7.0% per annum and were originally due February 14, 2009 for which a forbearance waiver was obtained which is more fully described in Note 5.

In conjunction with the issuance of the Related Party Convertible Notes, the Company issued an aggregate of 149,996 warrants to the note holders to purchase Common Stock of the Company. The warrants have an exercise price $0.55 per share and may be exercised at any time from November 14, 2008 until November 14, 2013.

NOTE 10. SUBSEQUENT EVENTS

During October and November of 2011, the Company entered into a series of new unsecured short-term notes aggregating $750,000 with the existing holder of the 6% Convertible Notes. The notes bear interest at 6% per annum and are due February 13, 2012.

On October 13, 2011, the Company filed with the Secretary of State of the State of Delaware a Certificate of Amendment to its Certificate of Incorporation increasing the authorized number of shares of its common stock to 150,000,000 from 50,000,000 shares ("Certificate of Amendment"). In addition, the Company filed with the Secretary of State of the State of Delaware Certificates of Amendment to its Certificate of Designation of Preferences, Rights and Limitations of Series C 8% Convertible Preferred Stock ("Series C Preferred"), and its Certificate of Designation of Preferences, Rights and Limitations of Series D 8% Convertible Preferred Stock ("Series D Preferred") of the Company (together, the "Preferred Amendments"), in each case to, among other things, provide for the automatic conversion of the Series C Preferred and Series D Preferred into shares of the Company's common stock in the event the Company consummates a qualified financing of at least $10.0 million on or before December 31, 2011 ("Qualified Financing").

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The Certificate of Amendment and the Preferred Amendments were approved by shareholders acting by written consent, dated October 5, 2011, and were approved by shareholders holding in excess of 50% of the shares of common stock entitled to vote with respect to each matter. In addition to the approval of the Certificate of Amendment and the Preferred Amendments, shareholders, acting by written consent dated October 5, 2011, approved a proposal to amend the Company's 1999 Stock Award Plan ("Plan") to increase the number of shares of common stock available for issuance under the Plan by 2,159,442 shares.

On December 20, 2011, the Company consummated the Qualified Financing, resulting in gross proceeds of $10.0 million, including the $750,000 of promissory notes converted into the Qualified Financing. In connection with the Qualified Financing, the Company issued 20,000,000 shares of its common stock (the “Shares”), and warrants to purchase 12,207,500 shares of its common stock exercisable for $0.50 per share (“Warrants”), which number includes 2,207,500 shares issuable upon exchange of warrants issued to MDB Capital Group in consideration for acting as placement agent in connection with the Qualified Financing. The Warrants expire five years from the date of grant. The Company also issued 90,000 shares of common stock and a Warrant exercisable for 45,000 shares of common stock in lieu of cash in payment for legal fees related to the Qualified Financing.

As a result of the Qualified Financing, the Company’s Series C 8% Convertible Preferred Stock (“Series C Preferred”) and Series D 8% Convertible Preferred Stock (“Series D Preferred”) were automatically converted into 11,768,525 shares of common stock. In addition, in connection with the Qualified Financing, (i) the anti-dilution provision contained in certain of the Company's existing warrants were amended resulting in such warrants no longer qualifying as derivative liabilities; and (ii) a significant investor ("Investor") exchanged $4.5 million principal amount of convertible promissory notes of the Company ("Exchanged Notes"), and accrued but unpaid interest on the Exchanged Notes and on an additional $2.25 million in promissory notes, into 9,774,559 shares of the Company’s common stock ("Exchange Shares"). The Investor also agreed to convert $750,000 principal amount of additional promissory notes held by the Investor and invest the proceeds into the Qualified Financing. In addition, in connection with the Qualified Financing, several significant investors agreed to amend certain warrants they hold to change anti-dilution provisions allowing for reductions in strike price such that the strike price could not be lowered below $0.50. The amended warrants cover a total of 7,576,643 shares of common stock. The Company is obligated to file a registration statement with the Securities and Exchange Commission on or before February 20, 2012 to register for resale the Shares and the common stock issuable upon exercise of the Warrants.

The net proceeds from the Qualified Financing, approximately $9.2 million, will be used for (i) the customization of identity management products for enterprise and consumer applications; (ii) further development of intellectual property; (iii) development of SaaS capabilities for existing products; (iv) the payment of $1.5 million principal amount of convertible promissory notes; and (v) for working capital and general corporate purposes.

On January 30 2012, the Performance Units issued to certain key employees of the Company were terminated, and exchanged for options to purchase a total of 435,000 shares of common stock. The Performance Units were originally issued to the Company in March 2011, in lieu of employee stock options or other equity-based incentives since the Company did not have sufficient shares of common stock available for issuance under its 2001 Equity Incentive Plan.

Exhibit No.		Description
2.1		Agreement and Plan of Merger, dated October 27, 2005 (incorporated by reference to Annex A to the Registrant’s Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).
3.1		Certificate of Incorporation (incorporated by reference to Annex B to the Registrant’s Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).
3.2		Certificate of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K, filed October 14, 2011).
3.3		Bylaws (incorporated by reference to Annex C to the Registrant’s Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).
3.4		Certificate of Designations of Preferences, Rights and Limitations of Series C 8% Convertible Preferred Stock dated November 2, 2006 (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K, filed November 20, 2006).
3.5		Certificate of Designations of Preferences, Rights and Limitations of Series C 8% Convertible Preferred Stock dated November 2, 2006, as amended (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K, filed November 20, 2006).
3.6		Certificate of Designations of Preferences, Rights and Limitations of Series C 8% Convertible Preferred Stock, as amended (incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K filed October 14, 2011).
3.7		Certificate of Designations of Preferences, Rights and Limitations of Series D 8% Convertible Preferred Stock dated March 8, 2007 (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K, filed March 15, 2007).
3.8		Certificate of Designations of Preferences, Rights and Limitations of Series D 8% Convertible Preferred Stock, as amended, dated February 10, 2009, (incorporated by reference to Exhibit 3.8 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
3.9		Certificate of Designations of Preferences, Rights and Limitations of Series D 8% Convertible Preferred Stock, as amended (incorporated by reference to Exhibit 3.3 to the Registrant's Current Report on Form 8-K filed October 14, 2011).
4.1		Warrant to Purchase Common Stock in favor of Imperial Bank, dated January 15, 1998 (incorporated by reference to Exhibit 10.42 to the Registrant’s Registration Statement on Form SB-2 (No. 333-93131), filed December 20, 1999, as amended).
4.2		Registration Rights Agreement, dated March 9, 2007, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed March 15, 2007).
4.3		Form of Warrant to Purchase Common Stock dated March 9, 2007 (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed March 15, 2007).
4.4		Registration Rights Agreement, dated September 25, 2007, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed September 26, 2007).
4.5		Form of Warrant to Purchase Common Stock dated September 25, 2007 (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed September 26, 2007).
4.6		Form of Warrant to Purchase Common Stock dated September 5, 2008 (incorporated by reference to Exhibit 4.19 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.7		Form of Warrant to Purchase Common Stock dated November 14, 2008 (incorporated by reference to Exhibit 4.20 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.8		Registration Rights Agreement, dated February 12, 2009, between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 4.21 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.9		Warrant to Purchase Common Stock, dated February 12, 2009, issued by the Registrant to BET Funding, LLC (incorporated by reference to Exhibit 4.22 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.10		Warrant to Purchase Common Stock, dated June 22 2009, issued by the Registrant to BET Funding, LLC (incorporated by reference to Exhibit 4.24 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.11		Warrant to Purchase Common Stock, dated October 5, 2009, issued by the Registrant to BET Funding, LLC (incorporated by reference to Exhibit 4.25 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
4.12		Warrant to Purchase Common Stock, dated June 9, 2011, issued by the Registrant to Neal Goldman (Incorporated by reference to Exhibit 99.2 to the Registrant's Current Report on Form 8-K filed on June 14, 2011).
4.13		Warrant to Purchase Common Stock, dated December 12, 2011(Incporated by reference to Exhibit 10.3 to the Registrant's Current Report on Form 8-K filed on December 21, 2011).
4.14		Registration Rights Agreement, dated December 12, 2011, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.4 to the Registrant’s Current Report on Form 8-K, filed December 21, 2011).
4.15		Form of Amendment to Warrant, dated December 14, 2011, (incorporated by reference to Exhibit 4.15 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
5.1		Opinion of The Disclosure Law Group, dated February 10, 2012, filed herewith.
10.1		Employment Agreement, dated September 27, 2005, between the Registrant and S. James Miller (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed September 30, 2005).
10.2		Employment Agreement, dated September 27, 2005, between the Registrant and Wayne G. Wetherell (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed September 30, 2005).
10.3		Change of Control and Severance Benefits Agreement, dated October 31, 2005, between Registrant and Charles Aubuchon (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed November 3, 2005).
10.4		Form of Indemnification Agreement entered into by the Registrant with its directors and executive officers (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement on Form SB-2 (No. 333-93131), filed December 20, 1999, as amended).
10.5		Amended and Restated 1999 Stock Plan Award (incorporated by reference to Appendix B of the Registrant’s Definitive Proxy Statement on Schedule 14A, filed November 21, 2007).
10.6		Form of Stock Option Agreement (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed July 14, 2005).
10.7		2001 Equity Incentive Plan (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-QSB, filed November 14, 2001).
10.8		Securities Purchase Agreement, dated March 9, 2007, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.1 to the Registrant Current Report on Form 8-K, filed March 15, 2007).
10.9		Securities Purchase Agreement, dated September 25, 2007, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed September 26, 2007).
10.10		Product Line Purchase Agreement, dated November 30, 2006, by and between the Registrant and PhotoLynx, Inc. (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed December 26, 2006).
10.11		Office Space Lease between I.W. Systems Canada Registrant and GE Canada Real Estate Equity dated July 25, 2008 (incorporated by reference to Exhibit 10.39 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.12		Form of Securities Purchase Agreement, dated August 29, 2008 by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.40 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.13		Change of Control and Severance Benefits Agreement, dated September 27, 2008, between Registrant and Charles Aubuchon (incorporated by reference to Exhibit 10.41 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.14		Change of Control and Severance Benefits Agreement, dated September 27, 2008, between Registrant and David Harding (incorporated by reference to Exhibit 10.42 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.15		First Amendment to Employment Agreement, dated September 27, 2008, between the Registrant and S. James Miller (incorporated by reference to Exhibit 10.43 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.16		First Amendment to Employment Agreement, dated September 27, 2008, between the Registrant and Wayne Wetherell (incorporated by reference to Exhibit 10.44 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.17		Form of Convertible Note dated November 14, 2008 (incorporated by reference to Exhibit 10.45 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.18		Secured Note Agreement, dated February 12, 2009, by and between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.46 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.19		Security Agreement, dated February 12, 2009, by and between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.47 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.20		Second Amendment to Change of Control and Severance Benefits Agreement, dated April 6, 2009, between Registrant and Charles Aubuchon (incorporated by reference to Exhibit 10.48 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.21		Second Amendment to Change of Control and Severance Benefits Agreement, dated April 6, 2009, between Registrant and David Harding (incorporated by reference to Exhibit 10.49 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.22		Second Amendment to Employment Agreement, dated April 6, 2009, between the Registrant and S. James Miller (incorporated by reference to Exhibit 10.50 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.23		Second Amendment to Employment Agreement, dated April 6, 2009, between the Registrant and Wayne Wetherell (incorporated by reference to Exhibit 10.51 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.24		Waiver and Amendment Agreement to Secured Note Agreement, dated June 9, 2009 between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.52 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.25		Second Amendment to Secured Note Agreement, dated June 22, 2009 between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.53 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.26		Office Space Lease between the Registrant and Allen W. Wooddell, dated July 25, 2008 (incorporated by reference to Exhibit 10.54 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.27		Third Amendment to Secured Note Agreement, dated October 5, 2009 between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.55 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.28		Fourth Amendment to Secured Note Agreement, dated November 11, 2009 between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.56 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.29		Assignment of Receivable dated November 11, 2009 between the Registrant and BET Funding, LLC (incorporated by reference to Exhibit 10.57 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.30		Third Amendment to Change of Control and Severance Benefits Agreement, dated December 10, 2009, between Registrant and Charles Aubuchon (incorporated by reference to Exhibit 10.58 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.31		Third Amendment to Change of Control and Severance Benefits Agreement, dated December 10, 2009, between Registrant and David Harding (incorporated by reference to Exhibit 10.59 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.32		Third Amendment to Employment Agreement, dated December 10, 2009, between the Registrant and S. James Miller (incorporated by reference to Exhibit 10.60 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.33		Third Amendment to Employment Agreement, dated December 10, 2009, between the Registrant and Wayne Wetherell (incorporated by reference to Exhibit 10.61 to the Registrant’s Annual Report on Form 10-K, filed February 24, 2010).
10.34		Security Agreement, dated December 28, 2010 (incorporated by reference to Exhibit 99.3 to the Registrant's Current Report on Form 8-K, filed on June 14, 2011).
10.35		Promissory Note dated June 9, 2011 (incorporated by reference to Exhibit 99.1 to the Registrant's Current Report on Form 8-K, filed on June 14, 2011).
10.36		Security Agreement, amended, dated June 9, 2011 (incorporated by reference to Exhibit 99.4 to the Registrant's Current Report on Form 8-K, filed on June 14, 2011).
10.37		Amendment to Secured Promissory Note dated August 5, 2011 by and among the Company and BET Funding LLC (incorporated by reference to Exhibit 10.1 to the Registrant's Current Report on Form 8-K, filed on August 11, 2010).
10.38		Securities Purchase Agreement, dated December 12, 2011, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed December 21, 2011).
10.39		Note Exchange Agreement, dated December 12, 2011, by and between the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed December 21, 2011).
10.40		Fourth Amendment to Employment Agreement, dated March 10, 2011, between the Registrant and S. James Miller, (incorporated by reference to Exhibit 10.40 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
10.41		Fourth Amendment to Employment Agreement, dated March 10, 2011, between the Registrant and Wayne Wetherell, (incorporated by reference to Exhibit 10.41 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
10.42		Fourth Amendment to Employment Agreement, dated March 10, 2011, between the Registrant and David Harding, (incorporated by reference to Exhibit 10.42 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
10.43		Fourth Amendment to Employment Agreement, dated March 10, 2011, between the Registrant and Charles Aubuchon, (incorporated by reference to Exhibit 10.43 to the Registrant’s Current Report on Form 10-K, filed January 17, 2012).
21.1		List of Subsidiaries (incorporated by reference to Exhibit 21.1 to the Registrant’s Current Report on Form 10-K, filed February 24, 2010).
23.1		Consent of The Disclosure Law Group (included in Exhibit 5.1)
23.2		Consent of Mayer Hoffman McCann P.C., dated February 10, 2012
23.3		Consent of Independent Valuation Form, dated February 8, 2012
24.1		Power of Attorney (included in signature page to registration statement)
101.INS*		XBRL Instance Document
101.SCH*		XBRL Taxonomy Extention Schema
101.CAL*		XBRL Taxonomy Extention Calculation Linkbase
101.DEF*		XBRL Taxonomy Extention Definition Linkbase
101.LAB*		XBRL Taxonomy Extention Label Linkbase
101.PRE*		XBRL Taxonomy Extention Presentation Linkbase


Delaware	7372	33-0224167
(State or Other Jurisdiction of Incorporation or Organization)	(Primary Standard Industrial Classification Code Number)	(I.R.S. Employer Identification Number)

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨	Smaller reporting company	x


Title of Each Class of Securities to be Registered	Amount to be Registered(2)	Proposed Maximum Offering Price per Share(3)		Proposed Maximum Aggregate Offering Price(3)	Amount of Registration Fee(3)
Common Stock, $0.001 par value per share	58,985,584(1)	$	0.50	$29,492,792	$ 3,379.88

		Page

Prospectus Summary		1
The Offering		4
Risk Factors		4
Use of Proceeds		11
Special Note Regarding Forward-Looking Statements		11
Business		13
Description of Property		24
Legal Proceedings		24
Market Price of Common Stock and Other Stockholder Matters		25
Selected Consolidated Financial Data		26
Management’s Discussion and Analysis of Financial Condition and Results of Operations		27
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		56
Directors, Execute Officers, Promoters and Control Persons		56
Executive Compensation		60
Certain Relationships and Related Transactions		67
Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters		69
Description of Capital Stock		71
Selling Stockholders		71
Relationships Between the Issuer and the Selling Security Holders		75
Plan of Distribution		75
Experts		77
Legal Matters		77
Interests of Named Experts and Counsel		77
Where You Can Find More Information		77
Index to Consolidated Financial Statements		F-1


	High		Low
Fiscal Year Ended December 31, 2011
First Quarter	$	1.70	$	0.78
Second Quarter	$	1.45	$	0.91
Third Quarter	$	1.25	$	0.56
Fourth Quarter	$	0.80	$	0.50
Fiscal Year Ended December 31, 2010
First Quarter	$	0.99	$	0.65
Second Quarter	$	0.92	$	0.46
Third Quarter	$	0.60	$	0.27
Fourth Quarter	$	0.98	$	0.27
Fiscal Year Ended December 31, 2009
First Quarter	$	0.30	$	0.14
Second Quarter	$	0.75	$	0.20
Third Quarter	$	0.95	$	0.45
Fourth Quarter	$	0.90	$	0.55

	(1)	Consists of up to (i) 20,090,000 shares of common stock issued in a private placement transaction consummated on December 20, 2011 (the “Private Placement”); (ii) 12,252,500 shares of common stock issuable upon exercise of warrants issued in connection with the Private Placement; (iii) 6,195,682 shares of common stock issued upon conversion of the Registrant’s Series C 8% Convertible Preferred Stock upon consummation of the Private Placement; (iv) 5,572,843 shares of common stock issued upon conversion of the Registrant’s Series D 8% Convertible Preferred Stock upon consummation of the Private Placement; (v) 9,774,559 shares of common stock issued to a significant investor in exchange for certain outstanding convertible promissory notes, and related accrued but unpaid interest thereon; (vi) 600,000 shares of common stock owned by BET Funding, LLC (BET Funding”); and (vi) 4,500,000 shares of common stock issuable upon exercise of certain warrants owned by BET Funding.
	(2)	In the event of a stock split, stock dividend or similar transaction involving the common stock of the Registrant, in order to prevent dilution, the number of shares registered shall be automatically increased to cover additional shares in accordance with Rule 416(a) under the Securities Act of 1933, as amended (“Securities Act”).
	(3)	Estimated solely for the purpose of calculating the registration fee in accordance with Rule 457(c) and (g) under the Securities Act based on the average of the high and low prices of the common stock on February 8, 2012, as reported on the Pink Sheets.

	Year Ended December 31,						Nine Months Ended September 30,
Statement of Operations Data:	2009			2010			2010			2011
(in thousands, except share and per share data)							(unaudited)			(unaudited)
Net sales	$	6,029		$	5,811		$	4,601		$	4,480
Cost of sales		1,979			1,997			1,620			1,045
Gross margin (loss)		4,050			3,814			2,981			3,435
Operating expenses:
General and administrative		2,433			2,546			1,888			1,610
Sales and marketing		1,705			1,528			1,158			1,076
Research and development		2,367			2,531			1,939			1,995
Depreciation and amortization		98			50			39			21
Total operating expenses		6,603			6,655			5,024			4,702
Loss from operations		(2,553	)		(2,841	)		(2,043	)		(1,267	)
Total other (expense) income		(10,083	)		(2,082	)		3,314			2,332
Income (loss) before income taxes		(12,636	)		(4,923	)		1,271			1,065
Income tax expense		-			126			201			6
Net (loss) income	$	(12,636	)	$	(5,049	)	$	1,070		$	1,059
Net (loss) income per share – basic	$	(0.67	)	$	(0.24	)	$	0.03		$	0.03
Net (loss) income per share – diluted	$	(0.67	)	$	(0.24	)	$	0.03		$	0.02
Weighted average number of shares of common stock outstanding – basic		19,416,569			23,175,405			22,916,554			25,816,120
Weighted average number of shares of common stock outstanding – basic		19,416,569			23,175,405			37,824,505			58,993,965

	December 31,						September 30,
Balance Sheet Data:	2009			2010			2011
(in thousands)							(unaudited)
Cash and cash equivalents	$	342		$	103		$	267
Total current assets		1,255			411			676
Property and equipment, net		41			19			18
Total assets		4,866			3,982			4,236
Current liabilities		7,546			4,407			4,769
Long-term obligations		12,023			17,481			15,232
Total liabilities		19,569			21,888			20,001
Total stockholders’ deficit	$	(14,703	)	$	(17,906	)	$	(15,765	)

	Years Ended December 31,
Net Product Revenue	2010			2009			$ Change		% Change
(dollars in thousands)

Software and royalties	$	1,882		$	2,307		$	(425)	(18)	%
Percentage of total net product revenue		59	%		67	%
Hardware and consumables	$	381		$	230		$	151	66	%
Percentage of total net product revenue		12	%		7	%
Services	$	929		$	893		$	36	4	%
Percentage of total net product revenue		29	%		26	%
Total net product revenue	$	3,192		$	3,430		$	(238)	(7)	%

	Years Ended December 31,
Net Maintenance Revenue	2010		2009		$ Change		% Change
(dollars in thousands)
Maintenance Revenues	$	2,619	$	2,599	$	20		1	%

	Years Ended December 31,
Cost of Product Revenue	2010			2009			$ Change		% Change
(dollars in thousands)

Software and royalties	$	266		$	310		$	(44)		(14)	%
Percentage of software and royalty product revenue		14	%		13	%
Hardware and consumables	$	289		$	228		$	61		27	%
Percentage of hardware and consumables product revenue		76	%		99	%
Services	$	504		$	627		$	(123)		(20)	%
Percentage of services product revenue		54	%		70	%
Total cost of product revenues	$	1,059		$	1,165		$	(106)		(9)	%
Percentage of total product revenue		33	%		34	%

	Years Ended December 31,
Cost of Maintenance Revenue	2010			2009			$ Change		% Change
(dollars in thousands)
Total maintenance cost of revenue	$	938		$	814		$	124		15	%
Percentage of total maintenance revenue		36	%		31	%

	Years Ended December 31,
Product Gross Profit	2010			2009			$ Change		% Change
(dollars in thousands)
Software and royalties	$	1,616		$	1,997		$	(381)		(19)	%
Percentage of software and royalty product revenue		86	%		87	%
Hardware and consumables	$	92		$	2		$	90		4,500	%
Percentage of hardware and consumables product revenue		24	%		1	%
Services	$	425		$	266		$	159		60	%
Percentage of services product revenue		46	%		30	%
Total product gross profit	$	2,133		$	2,265		$	(132)		(6)	%
Percentage of total product revenue		67	%		66	%

	Years Ended December 31,
Maintenance Gross Profit	2010			2009			$ Change		% Change
(dollars in thousands)

Total maintenance gross profit	$	1,681		$	1,785		$	(104)		(6)	%
Percentage of total maintenance revenue		64	%		69	%

	Years Ended December 31,
Operating Expense	2010			2009			$ Change		% Change
(dollars in thousands)

General and administrative	$	2,546		$	2,433		$	113		5	%
Percentage of total net revenue		44	%		40	%
Sales and marketing	$	1,528		$	1,705		$	(177)		(10)	%
Percentage of total net revenue		26	%		28	%
Research and development	$	2,531		$	2,367		$	164		7	%
Percentage of total net revenue		44	%		39	%
Depreciation and amortization	$	50		$	98		$	(48)		(49)	%
Percentage of total net revenue		1	%		2	%

	Nine Months Ended September 30,
Net Product Revenue	2011			2010			$ Change			% Change
(dollars in thousands)

Software and royalties	$	1,925		$	1,516		$	409			27	%
Percentage of total net product revenue		81	%		57	%
Hardware and consumables	$	183		$	343		$	(160	)		(47	)%
Percentage of total net product revenue		8	%		13	%
Services	$	259		$	781		$	(522	)		(67	)%
Percentage of total net product revenue		11	%		30	%
Total net product revenue	$	2,367		$	2,640		$	(273	)		(10	)%

	Nine Months Ended September 30,
Maintenance Revenue	2011		2010		$ Change		% Change
(dollars in thousands)

Maintenance revenue	$	2,113	$	1,961	$	152		8	%

	Nine Months Ended September 30,
Cost of Product Revenue:	2011			2010			$ Change			% Change
(dollars in thousands)

Software and royalties	$	101		$	257		$	(156	)		(61	)%
Percentage of software and royalty product revenue		5	%		17	%
Hardware and consumables	$	112		$	267		$	(155	)		(58	)%
Percentage of hardware and consumables product revenue		61	%		78	%
Services	$	158		$	397		$	(239	)		(60	)%
Percentage of services product revenue		61	%		51	%
Total cost of product revenue	$	371		$	921		$	(550	)		(60	)%
Percentage of total product revenue		16	%		35	%

	·	Decrease in contract services expense of $143,000 due primarily to the more significant audit related fees incurred in the first quarter of 2010 when compared to 2011

	·	Decrease in personnel related expense of approximately $123,000

	·	Decrease in Canadian operating expense of $51,000

	·	Decrease in rent and office related costs of approximately $21,000

	·	Increase in financing fees of approximately $25,000

	·	Increase in stock based compensation of approximately $16,000

	·	Increase in contract and other costs of approximately $19,000

	·	Decrease in personnel related expense of approximately $95,000 due to reductions in headcount and the consolidation of certain positions

	·	Increase in stock-based compensation of approximately $13,000

	·	Increase in personnel expenditures of approximately $46,000

	·	Increase in contract services of $11,000

	·	Decrease in rent and office related costs of approximately $37,000

	·	Increase in stock-based compensation of approximately $26,000

	·	Increase in trade and trade show costs of approximately $10,000

	·	Coupon interest of approximately $261,000 related to our 6% secured convertible notes and 7% convertible notes

	·	Accretion of note discount and beneficial conversion feature classified as interest expense of approximately $1,252,000 and $424,000, respectively

	·	Other interest expense of approximately $18,000

	·	Coupon interest of approximately $176,000 related to our 7% convertible notes and 9% secured notes payable

	·	Accretion of note discount classified as interest expense of approximately $431,000

	·	Other interest expense of approximately $29,000

	Years Ended
	December 31, 2010			December 31, 2009
	(in thousands)
Net cash used in operating activities	$	(2,070	)	$	(2,874	)
Net cash used in investing activities	$	(13	)	$	(16	)
Net cash provided by financing activities	$	1,820		$	3,191
Net (decrease) increase in cash and cash equivalents	$	(239	)	$	171
Cash and cash equivalents, end of period	$	103		$	342

Name	Age	Principal Occupation/Position Held With the Company
Mr. S. James Miller, Jr.	58	Chief Executive Officer and Chairman of the Board of Directors
Mr. Wayne Wetherell	59	Sr. Vice President, Chief Financial Officer, Secretary and Treasurer
Mr. John Callan	65	Director
Mr. David Carey	67	Director
Mr. Guy Steve Hamm	64	Director
Mr. David Loesch	67	Director

Name and Principal Position	Year	Salary		Stock Awards			Option Awards (1)(2)			All Other Compensation		Total

S. James Miller, Jr. Chairman of the Board and Chief Executive Officer	2010	$	326,630	$	-	(3)	$	68,539	(6)	$	4,560	$	399,729
	2009		338,570		-			51,358	(6)		5,744		395,672
					-
Wayne G. Wetherell Senior Vice President Chief Financial Officer, Secretary, and Treasurer	2010		195,240		-	(4)		47,644	(6)		2,967		245,851
	2009		202,563		-			33,327	(6)		5,012		240,902

David Harding Vice President and Chief Technical Officer	2010		188,061		-	(5)		35,822	(6)		-		223,883
	2009		185,029		-			35,249	(6)		-		220,278

(1)		All option awards were granted under the 1999 Stock Award Plan (the “1999 Plan”).

(2)		The amounts reflect the dollar amount recognized for financial statement reporting purposes for the fiscal year ended December 31, 2010, in accordance with the provisions of ASC 718 and thus may include amounts from awards granted prior to 2010. We have elected to use the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. We are required to make various assumptions in the application of the Black-Scholes option-pricing model and have determined that the best measure of expected volatility is based on the historical weekly volatility of our common stock. Historical volatility factors utilized in our Black-Scholes computations range from 64% to 119%. We have elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 110. The expected term used by us as computed by this method ranges from 5.5 years to 6.1 years. The difference between the actual historical expected life and the simplified method was immaterial. The interest rate used is the risk free interest rate and is based upon U.S. Treasury rates appropriate for the expected term. Interest rates used in our Black-Scholes calculations range from 4.1 % to 4.6 %. Dividend yield is zero, as we do not expect to declare any dividends on our common shares in the foreseeable future. In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption. We have estimated an annualized forfeiture rate of 9.7 % for corporate officers, 4.1 % for members of the Board of Directors and 24.3 % for all other employees. We review the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.

(3)		Represents the quarterly vesting of 316,620 restricted shares granted on January 11, 2010. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they held with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.

(4)		Represents the quarterly vesting of 163,560 restricted shares granted on January 11, 2010. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they hold with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.

(5)		Represents the quarterly vesting of 105,000 restricted shares granted on January 11, 2010. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they hold with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.

	Option Awards					Stock Awards
Name	Number of Securities Underlying Unexercised Unearned Options: Exercisable (#)		Number of Securities Underlying Unexercised Unearned Options: Unexercisable (#)	Option Exercise Price ($)		Option Expiration Date	Number of Shares That Have Not Vested (#)		Market Value of Shares That Have Not Vested
S. James Miller, Jr.	58,375	(1)	41,628	$	0.20	1/27/2019	237,465	$	232,716
	—	(2)	183,000	$	0.73	1/29/2020

Wayne G. Wetherell	35,000	(1)	25,000	$	0.20	1/27/2019	122,670	$	120,217
	—	(2)	60,000	$	0.73	1/29/2020

David Harding	29,170	(1)	20,830	$	0.20	1/27/2019	78,750	$	77,175
	—	(2)	80,000	$	0.73	1/29/2020

(1)		These options vest over three years with one third vesting 1/27/2010 and the remainder vesting in equal quarterly installments thereafter.
(2)		These options vest over three years with one third vesting 1/29/2011 and the remainder vesting in equal quarterly installments thereafter.


	Year	Fees Earned or Paid in Cash ($)		Stock Awards ($)		Option Awards ($)(7)		All Other Compensation ($)	Total ($)
John Callan	2010		41,000	-	(2)		4,799	-	45,799
	2009		41,000	-			4,996	-	45,996

John Holleran (1)	2010		41,000	-	(3)		4,799	-	45,799
	2009		41,000	-			4,996	-	45,996

Guy Steve Hamm	2010		41,500	-	(4)		4,799	-	46,299
	2009		41,500				4,996	-	46,496

David Carey	2010		38,500	-	(5)		4,799	-	43,299
	2009		38,500	-			4,996	-	43,496

David Loesch	2010		38,500	-	(6)		4,799	-	43,299
	2009		38,500	-			4,996	-	43,496

(3)	Represents the quarterly vesting of 24,157 restricted shares granted on January 11, 2010. The restricted shares vest quarterly over three years ending January 11, 2013. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they held with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.
(4)	Represents the quarterly vesting of 16,200 restricted shares granted on January 11, 2010. The restricted shares vest quarterly over three years ending January 11, 2013. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they held with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.
(5)	Represents the quarterly vesting of 12,000 restricted shares granted on January 11, 2010. The restricted shares vest quarterly over three years ending January 11, 2013. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they held with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.
(6)	Represents the quarterly vesting of 28,200 restricted shares granted on January 11, 2010. The restricted shares vest quarterly over three years ending January 11, 2013. In January 2010, the Compensation Committee approved a proposal that certain members of management and board members holding stock options be offered restricted stock awards in exchange for the cancellation of the stock options they held with strike prices of $1.45 or more. The restricted stock awards were offered on a 3 for 5 basis (for each 5 stock options surrendered, 3 shares of restricted stock are granted). The shares of restricted stock vest over three years on a quarterly basis with the participant to receive 1/12 of the shares on each three-month anniversary of the date of grant. As the fair value of the stock options exchanged exceeded the fair value of the restricted shares issued, no incremental compensation expense is incurred for the restricted shares.
(7)	The amounts reflect the dollar amount recognized for financial statement reporting purposes for the fiscal year ended December 31, 2010, in accordance with the provisions of SFAS 123R and thus may include amounts from awards granted prior to 2010. Assumptions used in the calculation of these amounts are included in Notes to the Consolidated Financial Statements.

Name and Address	Number of Shares (1)	Percent of Class (2)

Directors and Named Executive Officers:
S. James Miller, Jr. (3)	1,112,765		1.6	%
Chairman, Chief Executive Officer

John Callan (4)	85,521		0	%*
Director

David Carey (5)	42,000		0	%*
Director

G. Steve Hamm (6)	77, 516		0	%*
Director

David Loesch (7)	103, 848		0	%*
Director

Wayne Wetherell (8)	426,200		0	%*
SVP of Administration, Chief Financial Officer, Secretary

Charles AuBuchon (9)	537, 754		0	%*
VP of Business Development

David Harding (10)	208,332		0	%*
Chief Technical Officer

Total beneficial ownership of directors and officers as a group (8 persons):	2,602,514		3.8	%

5% Stockholders:

Gruber & McBaine Capital Management LLC 50	11,935,517		17.5	%
Osgood Place San Francisco, CA (11)

Bruce Toll (12)	8,539,851		11.6	%

Neal I. Goldman (13)	32,460,145		41.5	%

(1)	All entries exclude beneficial ownership of shares issuable pursuant to options that have not vested or that are not otherwise exercisable as of the date hereof or which will not become vested or exercisable within 60 days of January 1, 2012.

(2)	Percentages are rounded to nearest one-tenth of one percent. Percentages are based on 67,124,357 shares of common stock outstanding as of January 1, 2012. Options that are presently exercisable or exercisable within 60 days of the January 1, 2012 are deemed to be beneficially owned by the stockholder holding the options for the purpose of computing the percentage ownership of that stockholder, but are not treated as outstanding for the purpose of computing the percentage of any other stockholder.
(3)	Includes 75,201 shares held jointly with spouse and 222,000 options exercisable within 60 days of January 1, 2012. Also includes 122,727 warrants and notes convertible into 100,695 shares of common stock.


(4)	Includes of 10,000 options exercisable within 60 days of January 1, 2012.

(5)	Includes of 10,000 options exercisable within 60 days of January 1, 2012.

(6)	Includes of 11,668 options exercisable within 60 days of January 1, 2012. Also includes 27,271 warrants and notes convertible into 22,377 shares of common stock.

(7)	Includes of 10,000 options exercisable within 60 days of January 1, 2012. Also includes 27,271 warrants and notes convertible into 22,377 shares of common stock.

(8)	Includes 100,000 options exercisable within 60 days of January 1, 2012.

(9)	Includes 128,332 options exercisable within 60 days of January 1, 2012. Also includes 122,727 warrants and notes convertible into 100,695 shares of common stock.

(10)	Includes 103,332 options exercisable within 60 days of January 1, 2012.

(11)	Includes 922,438 shares issuable upon exercise of warrants. Patrick McBaine exercises sole voting and dispositive power over all reported shares.

(12)	Includes 5,400,000 shares issuable upon exercise of warrants.

(13)	Includes 11,025,000 shares issuable upon exercise of warrants. Mr. Goldman exercises sole voting and dispositive power over 29,395,085 shares, and shared voting and dispositive power over 9,095,060 reported shares, of which 3,065,060 shares are owned by Goldman Capital Management, Inc., 6,000,000 shares are owed by Goldman Partners, LP and 30,000 shares are owed by The Neal and Marlene Goldman Foundation.