imageware_10k-123108.htm

Exhibit Number		Description
2.1		Stock Purchase Agreement, dated March 1, 2005, between the Registrant and Argus Solutions Ltd. (incorporated by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K, filed March 9, 2005).
2.2		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		Bylaws (incorporated by reference to Annex C to the Registrant’s Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).
3.3		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).
3.4		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).
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 May 22, 2002, by and between the Registrant and Perseus 2000 L.L.C. (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed May 24, 2002).
4.3		Warrant to Purchase Common Stock, dated June 13, 2003, issued by the Registrant to L.F. Global Holdings, LLC (incorporated by reference to Exhibit 10.5 to the Registrant’s Current Report on Form 8-K, filed June 20, 2003).
4.4		Form of Warrant dated November 24, 2003 (incorporated by reference to Exhibit 99.2 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
4.5		Form of Registration Rights Agreement dated November 24, 2003 (incorporated by reference to Exhibit 99.3 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
4.6		Form of Registration Rights Agreement dated March 13, 2003 (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-QSB, filed May 15, 2003).
4.7		Form of Warrant dated January 29, 2004 (incorporated by reference to Exhibit 99.5 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
4.8		Form of Registration Rights Agreement dated January 29, 2004 (incorporated by reference to Exhibit 99.8 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
4.9		Form of Warrant dated July 22, 2005 and dated July 28, 2005 (incorporated by reference to Exhibit A to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed July 26, 2005).
4.10		Form of Warrant dated March 17, 2006 (incorporated by reference to Exhibit 4.1 to the Registrant’s Quarterly Report on Form 10-Q, filed May 22, 2006).
4.11		Registration Rights Agreement, dated November 14, 2006 by and among the Registrant and certain investors (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed November 20, 2006).
4.12		Form of Warrant to Purchase Common Stock dated November 14, 2006 (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed November 20, 2006).
4.13		Registration Rights Agreement, dated March 9, 2007, by and among 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).
4.14		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).
4.15		Registration Rights Agreement, dated September 25, 2007, by and among 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).
4.16		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).

4.17		Registration Rights Agreement, dated December 19, 2007, by and among the Registrant, Sol Logic, and Wink Jones, as the representative of Sol Logic (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K, filed December 21, 2007).
4.18		Amendment No. 1 to Registration Rights Agreement, dated March 28, 2008, by and among the Registrant, Sol Logic, and Wink Jones, as the representative of Sol Logic, and Wink Jones, as the representative of Sol Logic (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K, filed April 1, 2008).
4.19		Form of Warrant to Purchase Common Stock dated September 5, 2008.
4.20		Form of Warrant to Purchase Common Stock dated November 14, 2008.
4.21		Registration Rights Agreement, dated February 12, 2009, between the Registrant and BET Funding, LLC.
4.22		Warrant to Purchase Common Stock, dated February 12, 2009, issued by the Registrant to BET Funding, LLC.
4.23		Warrant to Purchase Common Stock, dated June 9, 2009, issued by the Registrant to BET Funding, LLC.
4.24		Warrant to Purchase Common Stock, dated June 22 2009, issued by the Registrant to BET Funding, LLC.
4.25		Warrant to Purchase Common Stock, dated October 5 2009, issued by the Registrant to BET Funding, LLC.
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		Offer of Employment Letter Agreement, dated December 19, 2007, between the Registrant and Frank Mitchell (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K, filed December 21, 2007).
10.5		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).
10.6		1994 Employee Stock Option Plan (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement on Form SB-2 (No. 333-93131), filed December 20, 1999, as amended).
10.7		1994 Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement on Form SB-2 (No. 333-93131), filed December 20, 1999, as amended).
10.8		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).
10.9		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).
10.10		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).
10.11		Form of Restricted Stock Bonus Agreement (incorporated by reference to Exhibit 99.3 to the Registrant’s Registration Statement on Form S-8, filed November 27, 2001).
10.12		Form of Stock Option Agreement (incorporated by reference to Exhibit 99.2 to the Registrant’s Registration Statement on Form S-8, filed November 27, 2001).
10.13		Note and Warrant Purchase Agreement, dated May 22, 2002, by and between the Registrant and Perseus (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed May 24, 2002).
10.14		Form of Securities Purchase Agreement dated November 14, 2003 (incorporated by reference to Exhibit 99.1 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
10.15		Form of Securities Purchase Agreement dated January 29, 2004 (incorporated by reference to Exhibit 99.4 to the Registrant’s Current Report on Form 8-K, filed February 9, 2004).
10.16		Offer of Restricted Stock in Exchange for Certain Stock Options Previously Granted — Offer Made to James Miller (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-QSB, filed August 16, 2004).
10.17		Offer of Restricted Stock in Exchange for Certain Stock Options Previously Granted — Offer Made to Wayne Wetherell, dated March 30, 2004 (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-QSB, filed August 16, 2004).
10.18		Form of Securities Purchase Agreement dated July 22, 2005 and July 28, 2005 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed July 26, 2005).
10.19		Securities Purchase Agreement, dated November 14, 2006 by and among the Registrant and certain accredited investors (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed November 20, 2006).
10.20		Securities Purchase Agreement, dated March 9, 2007, by and among 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).
10.21		Securities Purchase Agreement, dated September 25, 2007, by and among 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).
10.22		Asset Purchase Agreement and Plan of Reorganization, among Sol Logic, Frank Mitchell, as shareholder of Sol Logic, and Wink Jones, as the representative of Sol Logic (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed December 21, 2007).

10.23		Amendment No. 1 to Asset Purchase and Plan of Reorganization, by and between the Registrant and Wink Jones, as the representative of Sol Logic (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K, filed April 1, 2008).
10.24		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).
10.25		Standard Commercial Lease, dated September 26, 2003, by and between Thornmint I and the Registrant (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-QSB, filed November 14, 2003).
10.26		Amendment to Office Lease, dated June 12, 2006, by and between Thornmint I and the Registrant (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q, filed August 14, 2006).
10.27		Office Lease, dated September 7, 2006, by and between Union Bank of California as Trustee for Quest Group Trust VII and the Registrant (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q, filed November 20, 2006).
10.38		Office Space Lease between I.W. Systems Canada Registrant and Dundeal Canada (GP) Inc. dated June 1, 2006 (incorporated by reference to Exhibit 10.40 to the Registrant’s Annual Report on Form 10-K, filed April 17, 2007).
10.39		Office Space Lease between I.W. Systems Canada Registrant and GE Canada Real Estate Equity dated July 25, 2008).
10.40		Form of Securities Purchase Agreement, dated August 29, 2008 by and among the Registrant and certain accredited investors.
10.41		Change of Control and Severance Benefits Agreement, dated September 27, 2008, between Registrant and Charles Aubuchon.
10.42		Change of Control and Severance Benefits Agreement, dated September 27, 2008, between Registrant and David Harding.
10.43		First Amendment to Employment Agreement, dated September 27, 2008, between the Registrant and S. James Miller.
10.44		First Amendment to Employment Agreement, dated September 27, 2008, between the Registrant and Wayne Wetherell.
10.45		Form of Convertible Note dated November 14, 2008.
10.46		Secured Note Agreement, dated February 12, 2009, by and between the Registrant and BET Funding, LLC.
10.47		Security Agreement, dated February 12, 2009, by and between the Registrant and BET Funding, LLC
10.48		Second Amendment to Change of Control and Severance Benefits Agreement, dated April 6, 2009, between Registrant and Charles Aubuchon.
10.49		Second Amendment to Change of Control and Severance Benefits Agreement, dated April 6, 2009, between Registrant and David Harding.
10.50		Second Amendment to Employment Agreement, dated April 6, 2009, between the Registrant and S. James Miller.
10.51		Second Amendment to Employment Agreement, dated April 6, 2009, between the Registrant and Wayne Wetherell.
10.52		Waiver and Amendment Agreement to Secured Note Agreement, dated June 9, 2009 between the Registrant and BET Funding, LLC
10.53		Second Amendment to Secured Note Agreement, dated June 22, 2009 between the Registrant and BET Funding, LLC.
10.54		Office Space Lease between the Registrant and Allen W. Wooddell, dated July 25, 2008.
10.55		Third Amendment to Secured Note Agreement, dated October 5, 2009 between the Registrant and BET Funding, LLC.
10.56		Fourth Amendment to Secured Note Agreement, dated November 11, 2009 between the Registrant and BET Funding, LLC.
10.57		Assignment of Receivable dated November 11, 2009 between the Registrant and BET Funding, LLC.
10.58		Third Amendment to Change of Control and Severance Benefits Agreement, dated December 10, 2009, between Registrant and Charles Aubuchon.
10.59		Third Amendment to Change of Control and Severance Benefits Agreement, dated December 10, 2009, between Registrant and David Harding.
10.60		Third Amendment to Employment Agreement, dated December 10, 2009, between the Registrant and S. James Miller.
10.61		Third Amendment to Employment Agreement, dated December 10, 2009, between the Registrant and Wayne Wetherell.
21.1		Subsidiaries of the Registrant
31.1		Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a)
31.2		Certification of the Principal Financial and Accounting Officer pursuant to Rule 13a-14(a) and 15d-14(a)
32.1		Certification by the Principal Executive Officer and Principal Financial and Accounting Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

5. Investments

In conjunction with the sale of the Company’s wholly-owned subsidiary, Digital Imaging Asia Pacific, as more fully described in Note 7 to these consolidated financial statements, in March 2005, the Company and Argus Solutions Ltd each agreed to purchase $250,000 of each others common stock at a per share price equal to 108% of the closing price of each others’ stock as determined by the American Stock Exchange and Australian Stock Exchange, respectively. As legal consideration, each Company paid the other cash of $250,000. The Company and Argus consummated the transaction through the exchange of common shares. The Company exchanged 71,225 shares of its common stock for 1,929,914 shares of common stock of Argus Solutions Ltd., which represents approximately one percent of the voting equity of Argus. In accordance with Statement of Financial Accounting Standards No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29”, the Company recorded this transaction as a nonmonetary exchange based on the fair value of the shares exchanged as determined by the closing price of the Company’s shares on the American Stock Exchange on the transaction date of $3.25 or $231,000.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and based on the Company’s intentions regarding these instruments, they were classified as marketable equity securities into trading or available-for-sale categories. Marketable securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are reported at fair value, with unrealized gains and losses recognized in earnings. Marketable securities not classified as trading are classified as available-for-sale and are carried at fair market value, with the unrealized gains and losses, net of tax, included in the determination of comprehensive income and reported in shareholders’ equity. Marketable equity securities are included in other non-current assets. The Company reviews its marketable equity holdings in publicly-traded companies on a regular basis to determine if any security has experienced an other-than-temporary decline in fair value. The Company considers the investee company’s cash position, earnings and revenue outlook, and stock price performance, among other factors, in its review. If it is determined that an other-than-temporary decline exists in a marketable equity security, the Company writes down the investment to its market value and records the related write-down as an investment loss in its Statement of Operations.

At December 31, 2007, the Company wrote off its remaining investment in Argus common stock as the market value of the common stock was determined to be $0. The write-down amounted to $39,000 and was due to a decline in the fair value of the equity security which, in the opinion of management, was considered to be other than temporary. The write-down is included in the caption Other income, net in the accompanying consolidated Statement of Operations for the twelve months ended December 31, 2007.

6. Acquisition

In December 2007, the Company entered into an agreement for the purchase of certain assets of Sol Logic, Inc. (“Sol Logic”) pursuant to an Asset Purchase Agreement (the “Asset Purchase Agreement”). The assets acquired include certain customer contracts, software licenses and intellectual property (collectively, the “Acquired Assets”). As a result of this asset acquisition, the Company integrated real-time voice recognition, multiple language translation and voice analytic capabilities into its biometric offerings. The Asset Purchase Agreement contained various customary representations and warranties on behalf of Sol Logic.

In consideration for the acquisition of the Acquired Assets, the Company: (1) issued to Sol Logic on December 19, 2007 (the “Closing”) 935,089 shares of restricted common stock of the Company (the “Initial Shares”), and (2) on June 19, 2008 (the “Additional Issuance Date”) was required to issue to Sol Logic that number of shares of restricted common stock (the “Additional Shares” and collectively with the Initial Shares, the “Shares”) equal to the quotient obtained by dividing $1,502,000 by the greater of (A) $1.633 and (B) the volume weighted average closing price of the Company’s common stock over the 20 trading-day period ending on June 18, 2008, as reported on the Over-the-Counter Bullet Board (“OTCBB”). Fifty percent of the Initial Shares and ten percent of the Additional Shares were held in escrow until the one-year anniversary of the Closing. The Company recorded the obligation to issue the required number of shares on the Additional Issuance Date as a current liability in the accompanying Consolidated Balance Sheet as of December 31, 2007 under the caption “Acquisition related obligation”.

On March 28, 2008, the Company entered into Amendment No. 1 to Asset Purchase Agreement (the “Purchase Agreement Amendment”) to amend the Purchase Agreement. The Purchase Agreement Amendment provided that in consideration for the Acquired Assets, the Company issue to Sol Logic an aggregate of 677,940 shares of restricted Common Stock (the “Initial Shares”). Of these shares, 467,545 were issued to Sol Logic on December 19, 2007, the date of the Purchase Agreement. The remaining 210,395 shares were issued to Sol Logic upon execution of the Purchase Agreement Amendment. In conjunction with these issuances, the Company simultaneously rescinded the issuance of 257,149 common shares originally placed into escrow on December 19, 2007.

In the event the Company’s revenues on certain specified products set forth in the Purchase Agreement Amendment either equal or exceed $3,000,000 for the six-month period commencing on March 6, 2008 and ending on September 6, 2008 or equal or exceed $5,000,000 for the eighteen-month period commencing on March 6, 2008 and ending on September 6, 2009, the Company was obligated to issue that number of additional shares of Common Stock (the “Additional Shares” and together with the Initial Shares, the “Shares”) obtained by dividing $1,921,924 by the greater of $1.10 or the volume weighted average closing price of the Company’s common stock over the 20 trading-day period immediately prior to the date the Additional Shares are issued, subject to the terms of the escrow described below. Pursuant to the Purchase Agreement Amendment, the maximum number of Additional Shares that may be issued is 1,747,204. The Company did not attain the specified revenue levels required pursuant to the terms of the Purchase Agreement Amendment and on September 6, 2009, the contingent consideration provision contained in the Purchase Agreement Amendment expired with no additional consideration due.

Concurrently with the execution of the Purchase Agreement Amendment, the Company entered into Amendment No. 1 to Registration Rights Agreement (the “Rights Agreement Amendment”) to amend the Rights Agreement. Under the terms of the Rights Agreement Amendment, the Company was required to register an additional 371,755 of the Initial Shares, for a total of 677,940 shares of Common Stock, for resale by Sol Logic.

As a result of recording the terms of the Purchase Agreement Amendment, the aggregate purchase price, not including direct transaction costs of approximately $274,000 was approximately $1,019,000. The value of the 677,940 common shares issued was determined based on the average market price of the Company’s common stock over the 2-day period before and after the terms of the Purchase Agreement Amendment were consummated on March 6, 2008 in accordance with EITF 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination’. As of December 31, 2008, the Company had incurred approximately $131,000 in expenses related to the issuance and registration of the Company’s equity securities issued pursuant to the Sol Logic asset purchase. Such issuance and registration costs have been recognized as a reduction of the fair value of the Company’s common stock in accordance with FASB Statement of Financial Accounting Standards No 141, “Business Combinations” (“FAS 141”).

In connection the Purchase Agreement Amendment, the Company agreed to pay additional consideration in future periods, based upon the attainment of certain revenue levels on certain specified products. FAS 141 requires, in situations involving a contingent consideration agreement that might result in the recognition of an additional element of cost when the contingency is resolved, the recognition of a purchase accounting liability in an amount equal to the lesser of the maximum amount of contingent consideration or the excess (the amount by which the amounts assigned to the assets acquired exceeds the cost of the acquired entity). Accordingly, the Company, upon execution of the Purchase Agreement Amendment, recorded a purchase accounting liability of approximately $1,060,000 as a current liability. When the contingency is resolved and the consideration is issued or becomes issuable, any excess of the fair value of the contingent consideration issued or issuable over the amount that was recognized as a liability shall be recognized as an additional cost of the acquisition. Any such additional cost would result in increases in goodwill. If the amount initially recognized as a liability exceeds the fair value of the consideration issued or issuable, that excess shall be allocated as a pro rata reduction of the amounts assigned to the acquired assets. As more fully described in Note 4 to these consolidated financial statements, the Company determined that the intangible assets acquired in the Sol Logic acquisition were impaired at December 31, 2008 as the carrying value of these assets exceeded their estimated fair value determined by the assets’ future discounted cash flows. The Company did not attain the specified revenue levels required pursuant to the terms of the Purchase Agreement Amendment and on September 6, 2009, the contingent consideration provision contained in the Purchase Agreement Amendment expired with no additional consideration due. The Company has recorded the resolution of the purchase accounting contingency as a recognized subsequent event and has allocated the excess of the contingent liability of $1,060,000 as a pro rata reduction of the amounts assigned to the acquired assets prior to the recording of an impairment charge of approximately $742,000.

The following table presents the allocation of the acquisition cost, including professional fees and other related acquisition costs, to the assets acquired and liabilities assumed, based on their fair values:

($ in thousands)	As recorded per Dec. 19, 2007 Asset Purchase Agreement			As adjusted per Mar. 6, 2008 Purchase Agreement Amendment

Fixed assets, net	$	42		$	42
Covenant not to compete		200			200
Customer base		93			93
Developed technology		2,018			2,018
Goodwill		1,036			—
Total assets acquired	$	3,389		$	2,353

Cash and direct transaction costs	$	(410	)	$	(466	)
Acquisition liability		(1,502	)		(1,060	)
Common stock		(9	)		(7	)
Additional paid in capital		(1,468	)		(820	)
Total consideration issued and liabilities incurred	$	(3,389	)	$	(2,353	)

Number of shares issued		935,089			677,940

The following (unaudited) pro forma consolidated results of operations have been prepared as if the acquisition of Sol Logic, Inc. had occurred at January 1, 2007:

($ in thousands)	Twelve Months Ended December 31, 2007
	(unaudited)
Sales	$	8,902
Net loss available to common shareholders	$	(6,690	)
Net loss per share available to common shareholders	$	(0.44	)

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

7. Sale of Businesses and Discontinued Operations

On November 30, 2006, the Company completed the sale of its entire Digital Photography (“PDI”) product line and inventory (the “PDI Products”) to an unaffiliated third party for a total of $400,000, including an initial cash payment of $25,000. The purchaser is required to pay up to the full remaining amount of $375,000 in a series of quarterly installments equal to 12.5% of all newly acquired sales and license revenues relating to the PDI product line (the “Percentage Payments”). Until such time when the Company has received the full purchase price of $400,000, during any 12-month period during which the aggregate Percentage Payments to the Company are less than $50,000, the purchaser will pay the Company the difference between the Percentage Payments and $50,000. This component of the Company’s business was previously classified as the Company’s Digital Photography segment.

The Company decided to sell this component because it has incurred significant operating losses in each of the last five years and has lost significant market share in the last three years. The assets sold consisted primarily of a suite of software and related inventory including source, copyrights, trademarks, documentation and client base.

In 2007, the Company recognized a gain of approximately $50,000 from the disposal of this component representing the cash proceeds received less the value of net assets sold. At December 31, 2007, the Company has recorded the fair value of the remaining amount due of $325,000 offset by a full valuation allowance due to the uncertainty of the ultimate collectability of such amounts. This determination was based upon the maximum repayment period of 6.5 years of amounts owing the Company combined with the purchaser operating in a highly competitive business environment evidenced by rapid technological change. Accordingly, the Company has deferred any remaining gain from the disposal of this component until such time as the Company determines that the realization of the remaining amounts owed is reasonably assured.

In 2008, the Company recognized a gain of approximately $18,000 from the disposal of this component representing the cash proceeds received less the value of net assets sold. At December 31, 2008, the Company has continued to record the fair value of the remaining amount due of $307,000 offset by a full valuation allowance due to the uncertainty of the ultimate collectability of such amounts. This determination was based upon the maximum repayment period of 5.5 years of amounts owing the Company combined with the purchaser operating in a highly competitive business environment evidenced by rapid technological change. Accordingly, the Company has deferred any remaining gain from the disposal of this component until such time as the Company determines that the realization of the remaining amounts owed is reasonably assured.

8. Related Parties

As more fully described in Note 13 to these consolidated financial statements, on November 14, 2008, the Company entered in to a series of convertible promissory notes (the” Convertible Notes”), aggregating $110,000 with certain officers and members of the Company’s Board of Directors. The 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 Notes 13.

In conjunction with the issuance of the 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.

9. Inventory

Inventories at December 31, 2008 were comprised of work in process of $9,000 representing direct labor costs on in-process projects and finished goods of $10,000 net of reserves for obsolete and slow-moving items of $93,000. Inventories at December 31, 2007 were comprised of work in process of $29,000 representing direct labor costs on in-process projects and finished goods of $101,000 net of reserves for obsolete and slow-moving items of $16,000. Appropriate consideration is given to obsolescence, excessive levels, deterioration, and other factors in evaluating net realizable value and required reserve levels.

10. Property and Equipment

Property and equipment at December 31, 2008 and 2007, consists of:

($ in thousands)	2008			2007

Equipment	$	1,397		$	1,411
Leasehold improvements		31			149
Furniture		162			162
		1,590			1,722
Less accumulated depreciation		(1,482	)		(1,434	)
	$	108		$	288

Total depreciation expense for the years ended December 31, 2008 and 2007 was approximately $247,000 and $242,000, respectively.

11. 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 at December 31, 2008 and December 31, 2007 under the caption “Billings in excess of costs and estimated earnings on uncompleted contract”.

Costs and estimated earnings on uncompleted contracts and related amounts billed under contract provisions as of December 31, 2008 and December 31, 2007 are as follows:

($ in thousands)	December 31, 2008			December 31, 2007

Costs incurred on uncompleted contract	$	108		$	—
Estimated earnings		397			—
		505			—

Less: Billings to date		(784	)		—
Billings in excess of costs and estimated earnings on uncompleted contract	$	(279	)	$	—

12. Accrued Liabilities

Principal components of accrued liabilities consist of:

($ in thousands)	2008		2007

Compensated absences	$	230	$	215
Wages and sales commissions		128		113
Customer deposits		336		267
Liquidated damages		280		280
Royalties		251		251
Professional fees		28		73
Employee benefit plans		113		10
Other		164		132
		1,530	$	1,341

13. Notes Payable and Line of Credit

Notes payable consist of the following:

($ in thousands)	2008		2007
Notes payable to related parties:
Convertible promissory notes to accrue interest at 7%. Face value of note $110, net of unamortized discount on note at December 31, 2008 of $12. Note due January 31, 2010		98	$	—
Total notes payable to related parties		98		—

Total notes payable		98	$	—
Less current portion		—		—
Long-term notes payable		98	$	—

Future maturities of long-term debt are as follows as of December 31, 2008:

($ in thousands)
2009	$	—
2010	$	98
2011	$	—
2012	$	—
2013	$	—
	$	98

On November 14, 2008, the Company entered in to a series of convertible promissory notes (the” Convertible Notes”), aggregating $110,000 with certain officers and members of the Company’s Board of Directors. The Convertible Notes bear interest at 7.0% per annum and were originally due February 14, 2009 for which a forbearance waiver was obtained. The principal amount of the 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 Convertible Notes are convertible shall be calculated by dividing the outstanding principal and accrued but unpaid interest by $0.55 (the “Conversion Price”).

The Company initially recorded the convertible notes net of a discount equal to the fair value allocated to the warrants using the relative fair value method of approximately $13,000. The Company estimated the fair value of the warrants using the Black-Scholes option pricing model and 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 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 is accreting the beneficial conversion feature over the life of the note. For the twelve months ended December 31, 2008 the Company recorded $12,000 as interest expense from the amortization of the discount related to the fair value of the warrants and from the accretion of the beneficial conversion feature.

In August 2009, the Company received from the Convertible Note holders a waiver of default and extension to January 31, 2010 of the maturity date of the Convertible Notes. As consideration for the waiver and note extension, the Company issued to the 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 Company is currently seeking an additional waiver of default from the holders of the Convertible Notes.

14. Income Taxes

The significant components of the income tax provision (benefit) are as follows:

($ in thousands)	December 31,
	2008		2007
Current
Federal	$	—	$	—
State		—		—
Foreign		—		—

Deferred
Federal		—		—
State		—		—
Foreign		—		—

	$	—	$	—

The principal components of the Company’s deferred tax assets (liabilities) at December 31, 2008 and 2007 are as follows:

($ in thousands)	2008			2007

Net operating loss carryforwards	$	17,306		$	16,118
Intangible assets		784			713
Impairment loss on intangible assets		296			-
Stock based compensation		552			426
Reserves and accrued expenses		37			(4	)
Other		(46	)		(46	)
		18,929			17,207
Less valuation allowance		(18,929	)		(17,207	)

Net deferred tax assets	$	—		$	—

A reconciliation of the provision (benefit) for income taxes to the amount computed by applying the statutory income tax rates to loss before income taxes is as follows:

	2008			2007

Amounts computed at statutory rates	$	(1,944	)	$	(1,593	)
State income tax, net of federal benefit		(190	)		(125	)
Expiration of net operating loss carryforwards		418			485
Federal research and development credit		—			—
Other		(5	)		6
Net change in valuation allowance		1,721			1,227

	$	—		$	—

The Company has established a valuation allowance against its deferred tax asset due to the uncertainty surrounding the realization of such asset. Management periodically evaluates the recoverability of the deferred tax asset. At such time as it is determined that is more likely than not that deferred tax assets are realizable, the valuation allowance will be reduced.

At December 31, 2008 and 2007, the Company had federal net operating loss carryforwards of approximately $45,490,000 and $42,330,000, respectively, state net operating loss carryforwards of approximately $31,514,000 and $29,576,000, respectively, which may be available to offset future taxable income for tax purposes. The federal net operating loss carryforwards expire at various dates from 2009 through 2028. The state net operating loss carryforwards expire at various dates from 2009 through 2018.

The Internal Revenue Code (“the Code”) limits the availability of certain tax credits that arose prior to certain cumulative changes in a corporation’s ownership resulting in a change of control of the Company. The Company has reduced its deferred tax assets to zero relating to its federal and state research credits because of such limitations.

The Code also limits the availability of net operating losses that arose prior to certain cumulative changes in a corporation’s ownership resulting in a change of control of the Company. The Company’s use of its net operating loss carryforwards and tax credit carryforwards will be significantly limited because the Company underwent “ownership changes” in 1991, 1995, 2000, 2003 and 2004.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. The interpretation prescribes a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of an uncertain tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

The Company adopted the provisions of FIN 48 on January 1, 2007. The implementation of FIN 48 did not have a material impact on the Company’s financial statements. At the adoption date on January 1, 2007, and as of December 31, 2007 and 2008, the Company recorded no cumulative effect adjustments related to the adoption of FIN 48.

Upon adoption of FIN 48 on January 1, 2007, and as of December 31, 2007, the Company had no unrecognized tax benefits or accruals for the potential payment of interest and penalties. For the twelve months ended December 31, 2007 and 2008, no interest or penalties were recorded.

The Company files tax returns in the U.S. federal jurisdiction, and in various states and foreign jurisdictions. The Company is not aware of any jurisdictions currently under examination by tax authorities.

15. Commitments and Contingencies

Employment Agreements

The Company has employment agreements with its Chief Executive Officer and Senior Vice President of Administration and Chief Financial Officer. The Company may terminate the agreements with or without cause. Subject to the conditions and other limitations set forth in each respective employment agreement, each executive will be entitled to the following severance benefits if the Company terminates the executive’s employment without cause or in the event of an involuntary termination (as defined in the employment agreements) by the Company or by the executive: (i) a lump sum cash payment equal to between six months and twenty-four months of base salary, based upon specific agreements; (ii) continuation of the executive’s fringe benefits and medical insurance for a period of three years; and (iii) immediate vesting of 50% of each executive’s outstanding restricted stock awards and stock options. In the event that the executive’s employment is terminated within the six months prior to or the thirteen months following a change of control (as defined in the employment agreements), the executive is entitled to the severance benefits described above, except that 100% of each executive’s restricted stock awards outstanding and stock options will immediately vest. Each executive’s eligibility to receive any severance payments or other benefits upon his termination is conditioned upon him executing a general release of liability.

Litigation

The Company is involved in certain legal proceedings generally incidental to its normal business activities. While the outcome of such proceedings cannot be accurately predicted, the Company does not believe the ultimate resolution of any such existing matters should have a material effect on its financial position, results of operations or cash flows.

Leases

The Company currently leases office and research and development space under operating leases which expire at various dates through December 2013.

At December 31, 2008, future minimum lease payments are as follows:

($ in thousands)
2009	$	251
2010	$	161
2011	$	164
2012	$	164
2013	$	108
	$	848

Rental expense from continuing operations incurred under operating leases for the years ended December 31, 2008 and 2007 was approximately $545,000 and $579,000, respectively.

16.

Equity

The Company’s Articles of Incorporation were amended effective August 31, 1994 and authorize the issuance of two classes of stock to be designated “Common Stock” and “Preferred Stock,” provide that both Common and Preferred Stock shall have a par value of $.01 per share and authorize the Company to issue 50,000,000 shares of Common Stock and 4,000,000 shares of 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

In April 1995, the Company’s Articles of Incorporation were amended to authorize 750,000 shares of Series B Convertible Redeemable Preferred Stock (“Series B”). Each 5.275 shares of Series B are convertible into one share of the Company’s common stock.

The holders of Series B are entitled to cumulative preferred dividends payable at the rate of $.2125 per share per annum commencing April 30, 1996, subject to legally available funds. The Series B plus accrued but unpaid dividends are convertible at the option of the holder into shares of common stock at a conversion price equal to the original Series B issue price as adjusted to prevent dilution. The Series B will automatically be converted into shares of common stock upon the closing of an underwritten public offering at a price per common share of not less than $31.65. If the public offering price is less than $31.65 but at least $21.10 per share, the conversion shall still be automatic upon written consent of a majority of the then outstanding shareholders of Series B.

The holders of Series B, on an as-converted basis, have the same voting rights per share as the Company’s common shares; provided, that the holders of Series B has a special right to elect one director if the Company defaults in the payment of any dividend to the holders of Series B. The holders of Series B are entitled to initial distributions of $2.50 per share of Series B outstanding, upon liquidation and in preference to common shares and any other series of preferred stock plus all accrued but unpaid dividends.

Any time after December 31, 2000, the Company has the right to redeem all or some of the outstanding shares of Series B at a price equal to the original issue price, plus all accrued but unpaid dividends.

The Company had 239,400 shares of Series B outstanding as of December 31, 2008 and 2007. At December 31, 2008 and 2007, the Company had cumulative undeclared dividends of approximately $34,000 and $9,000 respectively.

Series C Convertible Preferred Stock

In November 2006, the Company’s Articles of Incorporation were amended to authorize 3,500 shares of Series C Convertible Preferred Stock (“Series C”). Each share of Series C Preferred Stock is convertible at any time at the option of the holder into a number of shares of common stock equal to the stated value (initially $1,000 per share, subject to adjustment), plus any accrued and unpaid dividends, divided by the conversion price (initially $1.50 per share, subsequently adjusted to $0.50 per share and subject to further adjustment). Subject to certain limitations, the conversion price per share shall be adjusted in the event of certain subsequent stock dividends, splits, reclassifications, dilutive issuances, rights offerings, and reclassifications. Certain activities may not be undertaken by the Company without the affirmative vote of a majority of the holders of the outstanding shares of Series C Preferred Stock. The Series C preferred stock does not have voting rights and is not redeemable except at liquidation. The Company may be subject to losses arising from non-delivery of shares within a specified period of time under the “buy in” provision. At January 1, 2007, the Company had issued a total of 2,500 shares of Series C Convertible Preferred Stock.

The holders of Series C are entitled to receive cumulative dividends, at the option of the Company, (i) in common stock upon conversion of the Series C preferred stock, or (ii) in cash after the payment of cash dividends to the holders of Series B Preferred Stock at the rate per share (as a percentage of the stated value per share) of 8% per annum.

The holders of Series C are entitled to initial distributions of $1,000 per share of Series C outstanding, upon liquidation and in preference to common shares and any other series of preferred stock with the exception of Series B Preferred Stock, plus all accrued but unpaid dividends.

The Company had 2,200 shares of Series C outstanding as of December 31, 2008 and 2007. At December 31, 2008 and 2007, the Company had cumulative undeclared dividends of approximately $404,000 and $234,000.

During the twelve months ended December 31, 2007, 300 shares of Series C were converted into 206,778 shares of the Company’s common stock. There were no conversions during the corresponding period in 2008.

Series D Convertible Preferred Stock

In March 2007, the Company’s Articles of Incorporation were amended to authorize 2,000 shares of Series D 8% Convertible Preferred Stock (“Series D Preferred Stock”). In August 2008, the Company’s Articles of Incorporation were further amended to increase the number of authorized shares of Series D Preferred Stock from 2,000 to 3,000. Each share of Series D Preferred Stock is convertible at any time at the option of the holder into a number of shares of common stock equal to the stated value (initially $1,000 per share, subject to adjustment), plus any accrued and unpaid dividends, divided by the conversion price (initially $1.90 per share, subsequently adjusted to 0.50 per share and subject to further adjustment). Subject to certain limitations, the conversion price per share shall be adjusted in the event of certain subsequent stock dividends, splits, reclassifications, dilutive issuances, rights offerings, and reclassifications. Certain activities may not be undertaken by the Company without the affirmative vote of a majority of the holders of the outstanding shares of Series D Preferred Stock. The Series D Preferred Stock does not have voting rights and is not redeemable except at liquidation. The Company may be subject to losses arising from non-delivery of shares within a specified period of time under the “buy in” provision.

The Company had 2,198 and 1388 shares of Series D outstanding as of December 31, 2008 and 2007, respectively. At December 31, 2008 and 2007, the Company had cumulative undeclared dividends of approximately $230,000 and $98,000.

During March 2007, the Company issued a total of 1,500 shares of Series D Preferred Stock and generated gross proceeds of $1.5 million. During the twelve months ended December 31, 2007, 112 shares of Series D were converted into 79,248 shares of the Company’s common stock.

In conjunction with the March 2007 issuance of the Series D Preferred Stock, the Company issued warrants to the holders of the Series D Preferred Stock to purchase 59,207 shares of the Company’s common stock at $2.33 per share. These warrants have been classified as equity instruments on the balance sheet. The proceeds from the Series D Preferred Stock financing were allocated to the warrants and the Series D Preferred Stock based on the relative fair value of each on the date of issuance. This allocation process resulted in the initial recognition of a discount attributable to an embedded beneficial conversion feature of approximately $344,000. The discount was amortized over the minimum period from the date of issuance to the date at which the preferred shareholders are permitted to convert as a dividend to the Series D Preferred Stock shareholders.

The issuance of common stock and warrants pursuant to the Common Stock Financing triggered certain antidilution clauses in the Company’s Series D Preferred Stock agreement. As a result of these antidilution clauses, the Company was required to adjust the conversion price of the Series D Preferred Stock from $1.90 per share to $1.50 per share. This antidilution feature will cause an additional 210,528 common shares to be issued upon conversion of the Series D Preferred Stock into common stock. In accordance with EITF Issue 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”, this antidilution feature resulted in the additional recognition of a discount attributable to an embedded beneficial conversion feature of approximately $470,000. This discount was amortized over the minimum period from the date of the conversion price adjustment to the date at which the preferred shareholders are permitted to convert as a dividend to the Series D Preferred Stock shareholders.

Commencing in August 2008 and ending in September 2008, (the”2008 Series D Preferred Stock Financing”), the Company issued to certain investors 810 shares of Series D Preferred Stock for aggregate gross proceeds of $810,000. In conjunction with the 2008 Series D Preferred Stock Financing, the Company issued warrants to the investors of the Series D Preferred Stock to purchase 1,620,000 shares of the Company’s common stock at $0.50 per share. These warrants have been classified as equity instruments on the Company’s Consolidated Balance Sheet at December 31, 2008. The proceeds from the 2008 Series D Preferred Stock Financing were allocated to the warrants and the Series D Preferred Stock based on the relative fair value of each on the date of issuance. This allocation process resulted in the initial recognition of a discount attributable to an embedded beneficial conversion feature of approximately $186,000. This discount was amortized over the minimum period from date of issuance to the date at which the preferred shareholders are permitted to convert as a dividend to the Series D Preferred Stock shareholders.

The issuance of the Series D Preferred Stock and warrants pursuant to the 2008 Series D Preferred Stock Financing triggered certain antidilution clauses in the Company’s Series C and previously issued Series D Preferred Stock agreements. As a result of these antidilution clauses, the Company was required to adjust the conversion price of the Series C and Series D Preferred Stocks from $1.00 to $0.50 per share. This antidilution feature will cause an additional 3,588,000 common shares to be issued upon conversion of the Series C and Series D Preferred Stocks into common stock. In accordance with EITF Issue 00-27,”Application of Issue 98-5 to Certain Convertible Instruments”, this antidilution feature resulted in the additional recognition of a discount attributable to an embedded beneficial conversion feature of approximately $3,588,000. This discount was amortized over the minimum period from date of issuance to the date at which the preferred shareholders are permitted to convert as a dividend to the Series D Preferred Stock shareholders.

As compensation to the placement agent for the 2008 Series D Preferred Stock Financing, the Company agreed to pay approximately $33,000 in cash. The cash payment has been recorded as an adjustment to additional paid in capital as a reduction of net proceeds.

Common Stock

On March 12, 2008, the Company received $541,666 from the exercise of 541,666 warrants to purchase shares of the Company’s common stock, par value $0.01 per share (the “Warrant Financing”). The warrants were originally issued in connection with a private placement of Common Stock to certain accredited investors (the “Investors”). The Financing was previously reported in a Current Report on Form 8-K filed on September 26, 2007. The Company agreed to reprice all warrants issued in the Financing, which originally had an exercise price of $1.67 per share, to an exercise price of $1.00 per share, in consideration for their immediate exercise (the “Warrant Repricing”) by the Investors who participated in the Warrant Repricing or their transferees, as applicable (the “Participating Investors”).

In connection with the Warrant Repricing, the Company also issued to the Participating Investors new warrants (the “Warrants”) to purchase up to an aggregate of 270,833 shares of Common Stock with an exercise price of $1.20 per share. The Warrants may be exercised at any time from March 12, 2008 until March 12, 2013. In addition, if the shares of Common Stock issuable upon exercise of the Warrants are not registered for resale with the Securities and Exchange Commission on or before the later of September 12, 2008 or the end of the applicable holding period for resales of securities by non-affiliates under Rule 144 of the Securities Act, but in any event no later than March 12, 2009, the Warrants may be exercised by the Participating Investors by “cashless” exercise.

As more fully disclosed in Note 6 to these condensed consolidated financial statements, in March 2008 the Company amended the Asset Purchase Agreement relating to the purchase of certain assets of Sol Logic, Inc. As a result of amending the Asset Purchase Agreement, the Company rescinded the issuance of 257,149 shares of common stock originally issued to Sol Logic and placed into escrow on December 19, 2007.

In 2008 and 2007, the Company issued 81,144 and 63,240 shares of common stock, respectively, pursuant to stock-based compensation agreements with certain employees.

The issuance of common stock and warrants in March 2008 pursuant to the Warrant Financing triggered certain antidilution clauses in the Company’s Series C and Series D Preferred Stock agreements. As a result of these antidilution clauses, the Company was required to adjust the conversion price of the Series C and Series D Preferred Stock from $1.50 per share to $1.00 per share. This antidilution feature will cause an additional 733,335 common shares to be issued upon conversion of the Series C Preferred Stock into common stock and an additional 462,669 common shares to be issued upon conversion of the Series D Preferred Stock into common stock. In accordance with EITF Issue 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”, this antidilution feature resulted in the additional recognition of a discount attributable to an embedded beneficial conversion feature of approximately $1,100,000 related to Series C Preferred Stock and $694,000 related to Series D Preferred Stock. This discount was amortized over the minimum period from the date of the conversion price adjustment to the date at which the preferred shareholders are permitted to convert as a dividend to the Series C and Series D Preferred Stock shareholders.

On September 25, 2007, the Company sold to certain accredited investors a total of 2,016,666 shares of the Company’s common stock, par value $0.01 per share, at a purchase price of $1.50 per share for aggregate gross proceeds of $3,025,003 (the “Common Stock Financing”).

In conjunction with the issuance of the common stock, the Company issued to the investors warrants (the “Investor Warrants”) to purchase up to an aggregate of 1,008,333 shares of Common Stock with an exercise price of $1.67 per share. The Investor Warrants have been classified as equity instruments on the balance sheet in accordance with the provisions of Emerging Issues Task Force (“EITF”) Issue 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”.

The issuance of common stock and warrants pursuant to the Common Stock Financing triggered certain antidilution and exercise price reduction clauses in existing warrant agreements. As a result of these modifications, the Company was required to issue an additional 113,834 warrants and reduce the exercise price of certain previously issued warrants. As these warrants were classified as permanent equity, and the adjustment was related to antidilution features within these financial instruments, this increase in warrants and reduction of exercise price resulted in no adjustments to the financial statements.

As compensation to the placement agent for the Common Stock Financing, the Company paid approximately $212,000 in placement agent fees and agreed to reimburse up to $25,000 of placement agent legal expense incurred in connection with this financing. In addition, the Company issued the placement agent for the financing, and certain of its affiliates, a 5.5 year warrant (the “Placement Agent Warrants”) to purchase up to an aggregate of 151,249 shares of Common Stock on the same terms and conditions included in the Investor Warrants. The cash payment has been recorded as adjustment to additional paid in capital as a reduction of net proceeds. The Placement Agent Warrants have been classified as equity instruments on the balance sheet.

During the twelve months ended December 31, 2007 the Company issued 206,778 shares of its common stock pursuant to the conversion of 300 shares of Series C Preferred Stock and issued 79,248 shares of its common stock pursuant to the conversion of 112 shares of Series D Preferred Stock.

During the twelve months ended December 31, 2007, the Company issued 795,956 shares of its common stock pursuant to the exercise of common stock purchase warrants. The Company received gross proceeds of approximately $1,121,000 from these warrant exercises.

In December 2007, the Company issued 935,089 shares of its common stock pursuant to its acquisition of substantially all the assets of Sol Logic, Inc.

During the twelve months ended December 31, 2007, 300 shares of Series C were converted into 206,778 shares of the Company’s common stock. During the twelve months ended December 31, 2007, 112 shares of Series D were converted into 79,248 shares of the Company’s common stock.

Warrants

As of December 31, 2008, warrants to purchase 10,471,167 shares of common stock at prices ranging from $0.50 to $5.48 were outstanding. All warrants are exercisable as of December 31, 2008, and expire at various dates through March 2013.

The following table summarizes warrant activity for the following periods:

	Warrants			Weighted- Average Exercise Price

Balance at December 31, 2006		5,821,149		$	2.37
Granted		1,286,776		$	1.34
Expired / Canceled		(224,998	)	$	3.16
Exercised		(927,097	)	$	1.59
Balance at December 31, 2007		5,955,830		$	2.24
Granted		6,251,984		$	0.53
Expired / Canceled		(1,194,981	)	$	2.39
Exercised		(541,666	)	$	1.00
Balance at December 31, 2008		10,471,167		$	1.00

The following table summarized information about warrants outstanding and exercisable at December 31, 2008:

Exercise Price		Number Outstanding	Weighted—Average Remaining Life (Years)	Weighted—Average Exercise Price

$	.50	8,124,138	2.0	$	.50

$	.55	149,996	4.9	$	.55

$	1.20	270,833	4.2	$	1.20

$	1.43	75,149	5.0	$	1.43

$	1.67	617,916	4.24	$	1.67

$	2.14	34,600	0.9	$	2.14

$	2.68	635,767	1.56	$	2.68

$	4.66	63,012	0.1	$	4.66

$	5.48	499,756	0.1	$	5.48

		10,471,167

In conjunction with the issuance of the Series D Preferred Stock, the Company issued warrants to the holders of the Series D Preferred Stock to purchase 1,620,000 of the Company’s common stock at $0.50 per share. These warrants have been classified as equity instruments on the balance sheet.

As partial compensation to the placement agent for the Preferred Stock Financing, the Company issued the placement agent for the financing, and certain of its affiliates, a 5 year warrant (the “Placement Agent Warrants”) to purchase up to an aggregate of 65,600 shares of Common Stock on the same terms and conditions included in the Investor Warrants. The cash payment has been recorded as adjustment to additional paid in capital as a reduction of net proceeds. The Placement Agent Warrants have been classified as equity instruments on the balance sheet.

The issuance of common stock and warrants pursuant to the Common Stock Financing triggered certain antidilution and exercise price reduction clauses in existing warrant agreements. As a result of these modifications, the Company was required to issue an additional 4,145,555 warrants and reduce the exercise price of certain previously issued warrants. As these warrants were classified as permanent equity and their anti-dilution rights were likewise classified as equity, the adjustment was related to the execution of an existing warrant features within these financial instruments rather than an actual modification and this increase in warrants and reduction of exercise price resulted in no adjustment to the financial statements.

17.	Stock Option Plans

On August 31, 1994, the directors of the Company adopted the Company’s 1994 Employee Stock Option Plan (the “1994 Plan”) and the 1994 Nonqualified Stock Option Plan (the “Nonqualified Plan”). The 1992 Stock Option Plan and options previously granted were cancelled by the Board of Directors.

The 1994 Plan originally provided for officers and other key employees to receive nontransferable incentive stock options to purchase up to 170,616 shares of the Company’s common stock. The number of stock options issued and outstanding and the number of stock options remaining available for future issuance are shown in the table below. The option price per share must be at least equal to 100% of the market value of the Company’s common stock on the date of grant and the term may not exceed ten years.

The Nonqualified Plan originally provided for directors and consultants to receive nontransferable options to purchase up to 18,957 shares of the Company’s common stock. The number of options issued and outstanding and the number of options remaining available for future issuance are shown in the table below. The option price per share must be at least equal to 85% of the market value of the Company’s common stock on the date of grant and the term may not exceed five years.

Both the 1994 Plan and the Nonqualified Plan are administered by the Board of Directors or a Committee of the Board which determines the employees, directors or consultants which will be granted options and the terms of the options, including vesting provisions which to date has been over a three year period. Both the 1994 Plan and the Nonqualified Plan expired on August 31, 2004.

On December 17, 1999, the Company’s Board of Directors adopted the ImageWare Systems, Inc. Amended and Restated 1999 Stock Option Plan (the “1999 Plan”). Under the terms of the 1999 Plan, the Company could, originally, issue up to 350,000 non-qualified or incentive stock options to purchase common stock of the Company. The number of options issued and outstanding and the number of options remaining available for future issuance are shown in the table below. The 1999 Plan has substantially the same terms as the 1994 Employee Stock Option Plan and the 1994 Nonqualified Stock Option Plan and expires on December 17, 2009.

We increased the share reserve of the amended and restated 1999 plan by 883,000 shares of our common stock. This number consists of an increase in the share reserve of 800,000 of our shares of common stock and 83,000 shares of our common stock that were reserved and available for grants under the 2001 Equity Incentive Plan, which we refer to as the 2001 plan. Prior to amendment, the 1999 plan had 350,000 shares reserved for issuance under the 1999 plan.

·	Any shares not issued in connection with awards outstanding under the 2001 plan or the 1994 Employee Stock Option Plan (which we refer to as the 1994 plan) on June 7, 2005, will become available for issuance under the amended and restated 1999 plan.

·	Any shares not issued in connection with awards granted under the 1999 plan, will become available for issuance under the amended and restated 1999 plan.

·	The amended and restated 1999 plan prohibits the grant of stock option or stock appreciation right awards with an exercise price less than fair market value of Common Stock on the date of grant.

·	The amended and restated 1999 plan also generally prohibits the “re-pricing” of stock options or stock appreciation rights, although awards may be bought out for a payment in cash or our stock.

·	The amended and restated 1999 plan permits the grant of stock based awards other than stock options, including the grant of “full value” awards such as restricted stock, stock units and performance shares.

·	The amended and restated 1999 plan permits the qualification of awards under the plan (payable in either stock or cash) as “performance-based compensation” within the meaning of Section 162(m) of the Internal Revenue Code.

On September 12, 2001, the Company’s Board of Directors approved adoption of the 2001 Equity Incentive Plan (the “2001 Plan”). Under the terms of the 2001 Plan, the Company may issue stock awards to employees, directors and consultants of the Company, and such stock awards may be given for non-statutory stock options (options not intended to qualify as an “incentive stock option” within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended), stock bonuses, and rights to acquire restricted stock. The Company originally reserved 1,000,000 shares of its common stock for issuance under the 2001 Plan. The number of options issued and outstanding and the number of options remaining available for future issuance are shown in the table below.

The 2001 Plan is administered by the Board of Directors or a Committee of the Board as provided in the 2001 Plan. Options granted under the 2001 Plan shall not be less than 85% of the market value of the Company’s common stock on the date of the grant, and, in some cases, may not be less than 110% of such fair market value. The term of options granted under the 2001 Plan as well as their vesting are determined by the Board and to date, options have been granted with a ten year term and vesting over a three year period. While the Board may suspend or terminate the 2001 Plan at any time, if not terminated earlier, it will terminate on the day before its tenth anniversary of the date of adoption.

On November 9, 2007, the Company’s Board of Directors approved an amendment to the 1999 Plan, subject to shareholder approval, pursuant to which an additional 1,000,000 shares would be reserved for issuance under the plan. In December 2007, the Company’s shareholders approved this amendment resulting in 1,000,000 shares being added to the 1999 Plan.

Stock Option Plans

As of December 31, 2008

	Number of securities to be issued upon exercise of outstanding options (a)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
1994 Plan		20,250		-0-
1999 Plan		1,773,047		653,089
2001 Plan		256,017		-0-
Total		2,049,314		653,089

The following table summarizes employee stock option activity since December 31, 2006:

	Options			Weighted- Average Exercise Price

Balance at December 31, 2006		1,603,164		$	2.45
Granted		165,250		$	2.38
Expired/canceled		(103,206	)	$	2.58
Exercised		—		$	—

Balance at December 31, 2007		1,665,208		$	2.44
Granted		821,221		$	0.89
Expired/canceled		(437,115	)	$	2.19
Exercised		—		$

Balance at December 31, 2008		2,049,314		$	1.87

At December 31, 2008, a total of 1,239,422 options were exercisable at a weighted average price of $2.42 per share. At December 31, 2007, a total of 1,212,753 options were exercisable at a weighted average price of $2.50 per share. At December 31, 2006, a total of 810,527 options were exercisable at a weighted average price of $2.66 per share.

The intrinsic value of options exercised during the twelve months ended December 31, 2008, 2007 and 2006 was $0. The intrinsic value of options exercisable at December 31, 2008, 2007 and 2006 was $0.

The following table summarizes information about employee stock options outstanding and exercisable at December 31, 2008:

		Options Outstanding				Options Exercisable
Exercise Price		Number Outstanding	Weighted- Average Remaining Life (Years)	Weighted- Average Exercise Price		Number Exercisable	Weighted- Average Exercise Price

$	.17 – .52	321,221	9.8	$	.20	0	$	0
$	.58 - 1.04	96,000	9.3	$	.92	0	$	0
$	1.45 - 1.71	455,672	8.4	$	1.52	126,531	$	1.64
$	1.97 – 2.15	157,336	5.4	$	2.01	150,255	$	1.97
$	2.20 – 2.49	552,318	6.5	$	2.39	495,869	$	2.31
$	2.62 – 2.74	276,000	6.6	$	2.63	276,000	$	2.63
$	3.00 – 6.51	190,767	3.5	$	3.28	190,767	$	3.28
Total		2,049,314				1,239,422

The weighted-average grant-date fair value per share of options granted to employees during the years ended December 31, 2008 and 2007 was $0.54 and $1.48, respectively.

18. Employee Benefit Plan

During 1995, the Company adopted a defined contribution 401(k) retirement plan (the “Plan”). All U.S. based employees aged 21 years and older are eligible to become participants after the completion of 60 days employment. The Plan provides for annual contributions by the Company of 50% of employee contributions not to exceed 8% of employee compensation. Participants may contribute up to 100% of the annual contribution limitations determined by the Internal Revenue Service.

Employees are fully vested in their share of the Company’s contributions after the completion of five years of service. In 2007, the Company made contributions of approximately $28,000 for the 2006 plan year and made contributions of approximately $75,000 for the 2007 plan year and has accrued a contribution of approximately $6,000 for the 2007 plan year which was paid in January 2008. In 2008, the Company has accrued a contribution of approximately $108,000 for the 2008 plan year which was paid in 2009.

19. Pension Plan

One of the Company’s foreign subsidiaries maintains a defined benefit pension plan that provides benefits based on length of service and final average earnings. The following table sets forth the benefit obligation, fair value of plan assets, and the funded status of the Company’s plan; amounts recognized in the Company’s consolidated financial statements; and the assumptions used in determining the actuarial present value of the benefit obligations as of December 31:

($ in thousands)	2008			2007
Change in benefit obligation:
Benefit obligation at beginning of year	$	1,636		$	1,457
Service cost		2			2
Interest cost		84			76
Actuarial gain (loss)		(9	)		(8	)
Effect of exchange rate changes		(54	)		109
Effect of curtailment		—			—
Benefits paid		—			—
Benefit obligation at end of year		1,659			1,636

Change in plan assets
Fair value of plan assets at beginning of year		497			441
Actual return of plan assets		14			11
Company contributions		47			45
Benefits paid		—			—
Fair value of plan assets at end of year		558			497

Funded status		(1,101	)		(1,139	)
Unrecognized actuarial loss (gain)		363			342
Unrecognized prior service (benefit) cost		—			—
Additional minimum liability		(363	)		(342	)
Unrecognized transition (asset) liability		—			—
Net amount recognized		(1,101	)	$	(1,139	)

The weighted average assumptions used to determine benefit obligations for the years ended December 31 were:
Discount rate		4.60	%		4.60	%
Expected return on plan assets		4.00	%		4.00	%
Rate of compensation increase		N/A			N/A

Plan Assets
Pension plan assets were comprised of the following asset categories at December 31,
Equity securities		4.60	%		6.90	%
Debt securities		92.00	%		89.50	%
Other		3.40	%		3.60	%
Total		100	%		100	%

Components of net periodic benefit cost are as follows:
Service cost		2			2
Interest cost on projected benefit obligations		84			76
Expected return on plan assets		—			—
Amortization of prior service costs		—			—
Amortization of actuarial loss		—			—
Net periodic benefit costs		86			78

The weighted average assumptions used to determine net periodic benefit cost for the years ended December 31, were
Discount rate		4.60	%		4.60	%
Expected return on plan assets		4.00	%		4.00	%
Rate of compensation increase		N/A			N/A
The following discloses information about our defined benefit pension plan that had an accumulated benefit obligation in excess of plan assets as of December 31,
Projected benefit obligation		1,659			1,636
Accumulated benefit obligation		1,659			1,636
Fair value of plan assets		558			497

The following benefit payments are expected to be paid as follows:

2009			—
2010			—
2011			—
2012			—
2013			—
2014 — 2018			126

The Company made contributions to the plan of approximately $40,289 during 2010.

The investment objectives for the plan are the preservation of capital, current income and long-term growth of capital. All plan assets are managed in a policyholder pool in Germany by outside investment managers. The measurement date used to determine the benefit information of the plan was January 1, 2009.

20. SUBSEQUENT EVENTS

In February 2009, the Company entered in to a secured promissory note (the ‘Note”), for Five Million Dollars ($5,000,000) with a third-party lender (“the Lender”). The Note secures a credit facility for a total of up to Five Million Dollars ($5,000,000). The initial advance under the Note was One Million Dollars ($1,000,000). Subsequent advances shall be in increments of $1,000,000 and are subject to the discretion of the Lender. The Note shall bear interest at 5.0% per annum on the outstanding principal. Principal and interest was originally due June 30, 2010. The Company will also pay the Lender additional interest on the maturity date or such earlier date as may be required under the terms of the Note equal to the greater of Four Hundred Thousand Dollars ($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 (10) trading day period immediately preceding the date of the payment of such interest payment.

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 upon the occurrence of an event of default under the terms of the Note.

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 intends to use the proceeds from the Note for general working capital purposes.

On May 19, 2009, ImageWare Systems, Inc. formed a wholly owned subsidiary in Mexico in order to support the Company’s efforts to develop new business and service existing contracts to provide products and service in Mexico. The Mexican subsidiary, ImageWare Mexico, S. DE R.L., is located in Mexico City and has one employee.

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.

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.

In July and August 2009, the Company undertook a series of warrant financings whereby the Company issued 2,401,075 warrants with an exercise price of $0.50 per share to incentivize certain warrant holders to exercise their existing warrant of cash. Pursuant to this series of warrant financings, the Company issued an aggregate of 2,741,075 shares of common stock and raised approximately $1,371,000 in cash.

In July and August 2009, holders of existing warrants exercised 929,395 of their warrants pursuant to cashless exercise provisions and received 353,702 shares of common stock.

In October 2009, the Lender and the Company amended the Note (“Amendment No. 3”) whereby the Lender agreed to make additional advances in an aggregate amount up to One Million Dollars ($1,000,000) to only be used for the purpose of compromising certain of the Company’s outstanding vendor payables or for paying 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.

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 January of 2010, holders of existing warrants exercised 13,120 of their warrants pursuant to cashless exercise provisions and received 5,665 shares of common stock.

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 warrants held by members of management and the Board.

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

Delaware		33-0224167
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

10883 Thornmint Road, San Diego, California		92127
(Address of Principal Executive Offices)		(Zip Code)

Title of Each Class		Name of Each Exchange on Which Registered
Common Stock, $0.01 par value		N/A
Warrants to Purchase Common Stock		N/A

PART I		3

Item 1.	Business	3

Item 1A.	Risk Factors	14

Item 1B.	Unresolved Staff Comments	22

Item 2.	Properties	22

Item 3.	Legal Proceedings	22

Item 4.	Submission of Matters to a Vote of Security Holders	22

PART II		22

Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	22

Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24

Item 8.	Consolidated Financial Statements and Supplementary Data	34

Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	34

Item 9A.	Controls and Procedures	34

Item 9B.	Other Information	35

PART III		36

Item 10.	Directors, Executive Officers and Corporate Governance	36

Item 11.	Executive Compensation	38

Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	48

Item 13.	Certain Relationships and Related Transactions	50

Item 14.	Principal Accountant Fees and Services	52

PART IV		53

Item 15.	Exhibits and Financial Statement Schedules	53

Exhibit Index		54

Signatures		57

Index to Consolidated Financial Statements		58

2008 Fiscal Quarters	High		Low
First Quarter	$	1.610	$	0.950
Second Quarter	$	1.150	$	0.250
Third Quarter	$	0.800	$	0.340
Fourth Quarter	$	0.480	$	0.050

2007 Fiscal Quarters	High		Low
First Quarter	$	2.810	$	1.450
Second Quarter	$	2.740	$	1.450
Third Quarter	$	2.180	$	1.400
Fourth Quarter	$	2.000	$	1.400

	TWELVE MONTHS ENDED
	DECEMBER 31,
($ in thousands)	2008			Change		2007

Product revenues:
Software and Royalties	$	2,362		-52	%	$	4,966
Percentage of total net product revenue	64		%	-24	%	88		%
Hardware and consumables	$	171		-51	%	$	350
Percentage of total net product revenue	5		%	-2	%	6		%
Services	$	1,174		250	%	$	336
Percentage of total net product revenue	31		%	25	%	6		%
Total net product revenues	$	3,707		-34	%	$	5,652

Name	Age	Principal Occupation/Position Held With the Company
Mr. S. James Miller, Jr.	56	Chief Executive Officer and Chairman of the Board of Directors
Mr. John Callan	63	Director
Mr. David Carey	65	Director
Mr. Guy Steven Hamm	62	Director
Mr. John Holleran	83	Director
Mr. David Loesch	65	Director

Name	Age	Principal Position(s) Held With the Company
Mr. Wayne Wetherell	57	Sr. Vice President, Administration, Chief Financial Officer, Secretary and Treasurer
Mr. Charles AuBuchon	66	Vice President, Business Development
Mr. David Harding	40	Vice President and Chief Technical Officer

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

S. James Miller, Jr. Chairman of the Board and Chief Executive Officer	2008	$	308,988	$	64,718	(3)	$	109,026	(5)	$	12,448	(4)	$	495,180
	2007		314,791		126,119	(3)		52,325	(5)		12,244	(6)		505,479

Wayne G. Wetherell Senior Vice President Administration, Chief Financial Officer, Secretary, and Treasurer	2008		183,160		31,032	(7)		62,966	(5)		10,324	(8)		287,482
	2007		186,631		67,136	(7)		35,588	(5)		10,019	(9)		299,374

Charles AuBuchon Vice President Business Development	2008		152,600		—			89,603	(5)		—			242,203
	2007		155,581		—			62,439	(5)		—			218,020

David Harding Vice President and Chief Technical Officer	2008		185,029		—			62,482	(5)		—			248,511
	2007		182,132		—			48,251	(5)		—			230,383

(1)		All option awards were granted under the 1999 Plan.

(2)		The amounts reflect the dollar amount recognized for financial statement reporting purposes for the fiscal year ended December 31, 2008, in accordance with the provisions of SFAS 123R and thus may include amounts from awards granted prior to 2008. 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 64.4% to 98.5%. 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. 107. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by us as computed by this method ranges from 3.5 years to 6.1 years. 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 2.7% 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 10% for corporate officers, 4% for members of the Board of Directors and 24% 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 124,162 restricted shares granted on March 30, 2004, and the vesting of 109,700 restricted shares granted on September 27, 2005 for Mr. Miller. The restricted shares granted in September 2005 vest one-third after one year with the remainder vesting ratably on a quarterly basis over two years ending September 27, 2008.

(4)		Consists of $9,200 in 401(K) matching contributions, $1,248 in life insurance premiums and $2,000 in club membership.

(5)		The amounts reflect the dollar amount recognized for financial statement reporting purposes for the fiscal year ended December 31, 2007, in accordance with the provisions of SFAS 123R and thus may include amounts from awards granted prior to 2007. Assumptions used in the calculation of these amounts are included in Notes to the Consolidated Financial Statements for the fiscal year ended December 31, 2007, included in our annual report on Form 10-K filed with the SEC on April 15, 2008.

(6)		Consists of $9,000 in 401(K) matching contributions, $1,244 in life insurance premiums and $2,000 in club membership.

(7)		Represents the quarterly vesting of 80,281 restricted shares granted on March 30, 2004 and the vesting of 52,600 restricted shares granted on September 27, 2005. The restricted shares granted in September 2005 vest one-third after one year with the remainder vesting ratably on a quarterly basis over two years ending September 27, 2008.

(8)		Consists of $7,466 in 401(K) matching contributions, $858 in life insurance premiums and $2,000 in club membership.

(9)		Consists of $7,221 in 401(K) matching contributions, $798 in life insurance premiums and $2,000 in club membership.

	Option Awards
	Number of			Number of
	Securities			Securities
	Underlying			Underlying
	Unexercised			Unexercised
	Unearned			Unearned		Option
	Options:			Options:		Exercise		Option
	#			#		Price		Expiration
Name	Exercisable			Unexercisable		($)		Date
S. James Miller, Jr.		75,000			—	$	3.00	9/12/2011
		25,000			—	$	1.97	5/28/2013
		100,000			—	$	2.40	10/28/2014
		100,000			—	$	2.62	8/16/2015
		109,700			—	$	2.36	9/27/2015
		9,000	(1)		9,000	$	2.49	4/3/2017
		—	(4)		100,000	$	1.45	1/2/2018

Wayne G. Wetherell		25,000			—	$	3.00	9/12/2011
		10,000			—	$	1.97	5/28/2013
		50,000			—	$	2.40	10/28/2014
		60,000			—	$	2.62	8/16/2015
		52,600			—	$	2.36	9/27/2015
		7,500	(1)		7,500	$	2.49	4/3/2017
		—	(4)		60,000	$	1.45	1/2/2018

Charles AuBuchon		10,000			—	$	3.00	9/12/2011
		40,000			—	$	2.30	10/15/2014
		30,000			—	$	3.19	4/1/2015
		60,000			—	$	2.62	8/16/2015
		55,000	(2)		5,000	$	1.99	1/13/2016
		5,002	(1)		4,998	$	2.49	4/3/2017
		—	(4)		50,000	$	1.45	1/2/2018

David Harding		91,675	(3)		8,325	$	1.65	1/31/2016
		12,550	(1)		12,450	$	2.49	4/3/2017
		—	(4)		50,000	$	1.45	1/2/2018

(1)		These options vest over three years with one third vesting 4/2/2008 and the remainder vesting in equal quarterly installments thereafter.
(2)		These options vest over three years with one third vesting 1/13/2007 and the remainder vesting in equal quarterly installments thereafter.
(3)		These options vest over three years with one third vesting 1/31/2007 and the remainder vesting in equal quarterly installments thereafter.
(4)		These options vest over three years with one third vesting 1/02/2009 and the remainder vesting in equal quarterly installments thereafter.

	Stock Awards
	Number of
	Shares		Value
	Acquired on		Realized
Name	Vesting		on Vesting

S. James Miller, Jr.(1)		27,423	$	21,299

Wayne G. Wetherell(2)		13,149		10,212

(1)		Represents the quarterly vesting of 109,700 restricted shares granted on September 27, 2005. The restricted shares granted in September 2005 vest one-third after one year with the remainder vesting ratably on a quarterly basis over two years ending September 27, 2008.

(2)		Represents the quarterly vesting of 52,600 restricted shares granted on September 27, 2005. The restricted shares granted in September 2005 vest one-third after one year with the remainder vesting ratably on a quarterly basis over two years ending September 27, 2008.

			Involuntary
Executive Benefits and Payments	Voluntary		Not for Cause			Change in
Upon Termination(1)	Termination		Termination			Control

Cash	$	—	$	662,856	(2)	$	662,856	(2)
Equity	$	—	$	—	(3)(4)	$	—	(3)(4)
Fringe Benefits	$	—	$	72,634	(5)	$	72,634	(5)

(1)		For purposes of this analysis, we assumed Mr. Miller’s compensation is based on his current base salary of $331,428.

(2)		Mr. Miller’s cash severance benefit under an involuntary, good reason termination or a termination due to a change in control is equal to two times annual compensation.

(3)		Mr. Miller’s equity severance benefit under an involuntary or good reason termination is the immediate vesting of 50% of Mr. Miller’s outstanding stock options and restricted stock awards. In the event that Mr. Miller’s employment is terminated within six months prior to or thirteen months following a change in control, Mr. Miller is entitled to the immediate vesting of 100% of Mr. Miller’s outstanding stock options and restricted stock awards.

(4)		This amount was calculated from the unexercisable stock options and unvested stock awards held by Mr. Miller on December 31, 2008. The stock option award amount was calculated by multiplying the number of securities underlying the unexercisable options by the difference between the option price and the price per share of common stock on the date of termination. The unvested stock award amount was calculated by multiplying the number of unvested shares of stock by the price per share on the date of termination.

(5)		Mr. Miller’s fringe benefits consist of medical and life insurance for a period of three years.

(1)		For purposes of this analysis, we assumed Mr. Wetherell’s compensation is based on his current base salary of $198,291.

(2)		Mr. Wetherell’s cash severance benefit under an involuntary, good reason termination or a termination due to a change in control is equal to the amount of his annual compensation.

(3)		Mr. Wetherell’s equity severance benefit under an involuntary or good reason termination is the immediate vesting of 50% of Mr. Wetherell’s outstanding stock options and restricted stock awards. In the event that Mr. Wetherell’s employment is terminated within six months prior to or thirteen months following a change in control, Mr. Wetherell is entitled to the immediate vesting of 100% of Mr. Wetherell’s outstanding stock options and restricted stock awards.

(4)		This amount was calculated from the unexercisable stock options and unvested stock awards held by Mr. Wetherell on December 31, 2008. The stock option award amount was calculated by multiplying the number of securities underlying the unexercisable options by the difference between the option price and the price per share of common stock on the date of termination. The unvested stock award amount was calculated by multiplying the number of unvested shares of stock by the price per share on the date of termination.

(5)		Mr. Wetherell’s fringe benefits consist of medical and life insurance for a period of three years.

(1)		For purposes of this analysis, we assumed Mr. AuBuchon’s compensation is based on his current base salary of $165,000.

(2)		Mr. AuBuchon’s cash severance benefit under an involuntary, good reason termination or a termination due to a change in control is equal to six months of annual compensation.

(3)		Mr. AuBuchon’s fringe benefits consist of medical and life insurance for a period of six months.

(1)		For purposes of this analysis, we assumed Mr. Harding’s compensation is based on his current base salary of $191,000.

(2)		Mr. Harding’s cash severance benefit under an involuntary, good reason termination or a termination due to a change in control is equal to six months of annual compensation.

(3)		Mr. Harding’s fringe benefits consist of medical and life insurance for a period of six months.

Name (1)	Option Awards (number of shares)		Exercise Price Per Share		Fair Market Value on Option Grant Date (2)

John Callan		5,000	$	1.45	$	1.45

John Holleran		5,000		1.45		1.45

David Loesch		5,000		1.45		1.45

Guy Steve Hamm		5,000		1.45		1.45

David Carey		5,000		1.45		1.45

(1)		As of December 31, 2008, no options had been exercised by non-employee directors under any plans maintained by us.

(2)		The fair market value of the common stock underlying such options on the date of grant is based on the closing sales price reported for the date of each such grant.

Name and Principal Position	Fees Earned or Paid in Cash		Option Awards(1)(2)(3)		Total

John Callan	$	28,250	$	11,749	$	39,999

John Holleran		29,450		11,749		41,199

David Loesch		28,875		12,882		41,757

Guy Steven Hamm		31,125		6,609		37,734

David Carey		27,625		13,044		40,669

(1)		The grant date per share fair value of options issued to Messrs. Callan, Downs, Holleran, Loesch, Hamm and Carey in 2008 was $.94.

(2)		The amounts reflect the dollar amount recognized for financial statement reporting purposes for the fiscal year ended December 31, 2008, in accordance with the provisions of SFAS 123R and thus may include amounts from awards granted prior to 2008. 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 64.4% to 98.5%. 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. 107. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by us as computed by this method ranges from 3.5 years to 6.1 years. 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 2.7% 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 10% for corporate officers, 4% for members of the Board of Directors and 24% for all other employees. We review the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.

(3)		The aggregate number of stock option awards outstanding at the end of fiscal 2008 for each director was as follows: John Callan (42,535); John Holleran (40,261); David Loesch (47,000); Guy Steven Hamm (27,000); and David Carey (20,000).


Beneficial Ownership(1)
Name and Address of Beneficial Owner	Number of Shares		Percent of Class (2)
Directors and Named Executive Officers:
S. James Miller, Jr.(3)		913,150		4.1
John Callan(4)		77,193		*
David Carey(5)		33,672		*
G. Steve Hamm(6)		65,072		*
John Holleran(7)		26,491		*
David Loesch(8)		93,072		*
Wayne Wetherell(9)		346,200		1.6
Charles AuBuchon(10)		440,078		2.8
David Harding (11)		121,672		**
Total Shares Held By Directors and Executive Officers		2,116,600		9.3
5% Stockholders:
Gruber & McBaine Capital Management LLC 50 Osgood Place San Francisco, CA(12)		10,941,260		36.5
Bruce Toll (13)		8,539,851		27.9
Goldman Capital (14)		3,400,121		14.2

Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights		Weighted- average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
	(a)		(b)		(c)
Equity compensation plans approved by security holders:
1994 Employee Stock Option Plan		24,250	$	2.15		—
1999 Stock Award Plan amended and restated as of June 7, 2005		1,378,495	$	2.19		1,035,208
Equity compensation plans not approved by security holders:
2001 Equity Incentive Plan		345,654	$	2.89		—
Total		1,748,399	$	2.33		1,035,208

	Fiscal Year Ended
	2008		2007
Audit Fees	$	195,642	$	150,892

Audit-Related Fees		11,422		28,682

Tax Fees		—		—

All Other Fees		26,224		22,821
Total Fees	$	233,288	$	202,395

	IMAGEWARE SYSTEMS, INC.


February 23, 2010	By:	/s/ S. JAMES MILLER, JR.
		S. James Miller, Jr.
		Chief Executive Officer and Chairman of the Board of Directors

Signature	Title	Date

/s/ S. JAMES MILLER, JR.	Chief Executive Officer and Chairman of the Board of Directors	February 24, 2010
S. James Miller, Jr.	(Principal Executive Officer)

/s/ WAYNE G. WETHERELL	Senior Vice President of Administration and Chief Financial Officer	February 24, 2010
Wayne G. Wetherell	(Principal Financial and Accounting Officer)

/s/ JOHN CALLAN	Director	February 24, 2010
John Callan

/s/ JOHN L. HOLLERAN	Director	February 24, 2010
John L. Holleran

/s/ DAVID LOESCH	Director	February 24, 2010
David Loesch

/s/ STEVE HAMM	Director	February 24, 2010
Steve Hamm

/s/ DAVID CAREY	Director	February 24, 2010
David Carey

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM	59

CONSOLIDATED FINANCIAL STATEMENTS:

CONSOLIDATED BALANCE SHEETS	60

CONSOLIDATED STATEMENTS OF OPERATIONS	61

CONSOLIDATED STATEMENTS OF CASH FLOW	62

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS	64

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)	65

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS	67

	December 31, 2008			December 31, 2007
ASSETS

Current Assets:
Cash and cash equivalents	$	171		$	1,044
Accounts receivable, net of allowance for doubtful accounts of $28 and $0
at December 31, 2008 and 2007, respectively		503			425
Inventories, net		19			130
Other current assets		191			441
Total Current Assets		884			2,040

Property and equipment, net		108			288
Other assets		37			24
Pension assets		682			694
Intangible assets, net		110			2,437
Goodwill		3,416			4,452
Total Assets	$	5,237		$	9,935

LIABILITIES AND SHAREHOLDERS’ (DEFICIT) EQUITY

Current Liabilities:
Accounts payable	$	2,388		$	1,415
Deferred revenue		872			1,011
Billings in excess of costs and estimated earnings on uncompleted contracts		279			—
Accrued expenses		1,530			1,341
Acquisition related obligation		—			1,502
Total Current Liabilities		5,069			5,269

Notes payable to related parties		98			—
Pension obligation		1,102			1,139
Total Liabilities		6,269			6,408

Commitments and contingencies		—			—

Shareholders’ equity
Preferred stock, authorized 4,000,000 shares:

Series B convertible preferred stock, designated 750,000 shares,
389,400 shares issued, and 239,400 shares outstanding at December 31, 2008
and 2007, liquidation preference $632 at December 31, 2008 and $607 at December 31, 2007		2			2

Series C convertible preferred stock, designated 3,500 shares,
2,500 shares issued, and 2,200 shares outstanding at December 31, 2008
and 2007, liquidation preference of $2,604 at December 31, 2008 and $2,434 at December 31, 2007		—			—

Series D convertible preferred stock, designated 3,000 shares,
2,310 and 1,500 shares issued at December 31, 2008 and 2007, respectively, and
2,198 and 1,388 shares outstanding at December 31, 2008 and 2007, respectively,
liquidation preference $2,428 and $1,486 at December 31, 2008 and 2007, respectively		—			—

Common stock, $.01 par value, 50,000,000 shares authorized, 18,163,487 and
17,797,826 shares issued at December 31, 2008 and 2007, respectively,
18,156,783 and 17,791,122 shares outstanding at December 31, 2008
and 2007, respectively		180			177

Additional paid in capital		86,007			79,294
Treasury stock, at cost - 6,704 shares		(64	)		(64	)
Accumulated other comprehensive income		44			7
Accumulated deficit		(87,201	)		(75,889	)
Total shareholders’ (deficit) equity		(1,032	)		3,527

Total Liabilities and Shareholders’ (Deficit)Equity	$	5,237		$	9,935

	Twelve Months Ended December 31,			Twelve Months Ended December 31,

	2008			2007

Revenues:
Product	$	3,707		$	5,652
Maintenance		2,808			2,836
		6,515			8,488
Cost of revenues:
Product		1,062			1,380
Maintenance		1,146			1,166

Gross profit		4,307			5,942

Operating expenses:
General and administrative		3,553			3,865
Sales and marketing		2,111			2,647
Research and development		2,956			3,669
Impairment of intangible assets		742			—
Depreciation and amortization		772			258
		10,134			10,439

Loss from operations		(5,827	)		(4,497	)

Interest (income) expense, net		19			215

Other (income) expense, net		(110	)		23

Loss from continuing operations before income taxes		(5,736	)		(4,735	)

Income tax benefit (expense)		—			—

Loss from continuing operations		(5,736	)		(4,735	)

Discontinued operations:
Gain from operations of discontinued Digital Photography Component	$	18		$	50
Income tax benefit (expense)		—			—
Gain (loss) on discontinued operations		18			50

Net loss		(5,718	)		(4,685	)
Preferred dividends		(5,928	)		(1,171	)
Net loss available to common shareholders	$	(11,646	)	$	(5,856	)

Basic and diluted loss per common share - see Note 2
Continuing operations	$	(0.32	)	$	(0.31	)
Discontinued operations		—			—
Preferred dividends		(0.33	)		(0.08	)
Basic and diluted loss per common available to common shareholders	$	(0.65	)	$	(0.39	)

Weighted-average shares outstanding (basic and diluted)		18,056,026			15,070,308


Cash flows from operating activities
Net loss	(5,718	)	$	(4,685	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization	772			258
Amortization of debt discount and debt issuance costs	6			229
Stock based compensation	596			556
Accretion of beneficial conversion feature of convertible debt….	6			—
Prepaid royalty impairment	100			—
Allowance for doubtful accounts	—			25
Impairment of certain long-lived intangible assets	742			—
Impairment of investment in equity securities	—			85
Increase (decreases) in inventory obsolescence reserve	75			(36	)
Change in assets and liabilities
Accounts receivable	(106	)		1,222
Inventories	37			(37	)
Other assets	4			(187	)
Pension assets	12			(85	)
Accounts payable	972			(303	)
Accrued expenses	180			207
Deferred revenue	(111	)		(248	)
Contract costs	279			—
Pension obligation	(38	)		123

Total adjustments	3,526			1,809

Net cash used by operating activities	(2,192	)		(2,876	)

Cash flows from investing activities
Purchase of property and equipment	(67	)		(86	)
Restricted cash and cash equivalents	132			(26	)
Acquisition of businesses, net of cash acquired of $0	(187	)		(410	)

Net cash used by investing activities	(122	)		(522	)

Cash flows from financing activities
Proceeds from issuance of preferred stock, net of issuance costs of $33 and $267, respectively	777			1,233
Proceeds from issuance of common stock, net of issuance costs of $0 and $404, respectively	—			2,621
Proceeds from issuance of notes payable with warrants	110			—
Other financing issuance costs	—			(54	)
Repayment of notes payable	—			(1,310	)
Dividends paid	(25	)		(51	)
Proceeds from exercise of stock purchase warrants	542			1,121

Net cash provided by financing activities	1,404			3,560
Effect of exchange rate changes on cash and cash equivalents	37			(57	)
Net increase (decrease) in cash and cash equivalents	(873	)		105


Cash and cash equivalents at beginning of period		1,044			939

Cash and cash equivalents at end of period	$	171		$	1,044

Supplemental disclosure of cash flow information:
Cash paid for interest	$	—		$	46
Cash paid for income taxes	$	—		$	—
Summary of non-cash investing and financing activities:
Beneficial conversion feature of preferred stock	$	5,568		$	814
Resolution of purchase accounting contingency	$	1060		$	—
Changes in minimum pension liability	$	(48	)	$	(37	)
Allowance for doubtful accounts	$	28		$	—
Warrants issued with notes payable	$	13		$	—
Equipment received in lieu of cash on accounts receivable	$	—		$	50

	Series B Convertible,		Series C			Series D									Addit- ional		Accum- ulated Other
	Redeemable		Convertible,			Convertible,									Paid-		Compre-		Accum-
	Preferred		Preferred			Preferred			Common Stock		Treasury Stock				In		hensive		ulated
	Shares	Amount	Shares		Amount	Shares		Amount	Shares	Amount	Shares		Amount		Capital		Loss		Deficit		Total

Balance at December 31, 2006	239,400	2	2,500		-	-		-	13,700,849	136	(6,704	)	(64	)	71,553		25		(70,333	)	1,320

Issuance of common stock pursuant to warrant exercises									795,956	8					1,113						1,121

Issuance of common stock as compensation									63,240	1					203						204

Issuance of common stock for cash, net									2,016,666	20					2,601						2,621

Issuance of common stock for asset purchase									935,089	9					1,468						1,477

Issuance of preferred stock for cash, net of financing commissions						1,500		-							1,233						1,233

finanincing related expenses															(54	)					(54	)

Beneficial conversion feature of series D preferred stock															814				(814	)	-

Stock-based compensation option expense															359						359

Foreign currency translation adjustment																	(94	)			(94	)

Unrealized holding losses on securities																	39				39

Additional minumum pension liability																	37				37

Conversion of preferred stock to common			(300	)	-				206,778	2					(2	)					-

Conversion of preferred stock to common						(112	)	-	74,666	1					(1	)					-

Dividends on Series B Preferred stock																			(51	)	(51	)

Conversion of Accrued Dividends on Series D Preferred stock to common									4,582	-					7				(7	)	-

Net loss																			(4,685	)	(4,685	)

Balance at December 31, 2007	239,400	2	2,200		-	1,388		-	17,797,826	177	(6,704	)	(64	)	79,294		7		(75,889	)	3,527