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As filed with the Securities and Exchange Commission on October 24, 2006

Registration No. 333-137240



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Amendment No. 1

to

FORM SB-2

REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933

BIO-key International, Inc.
(Exact name of registrant as specified in its charter)

Delaware
(State of incorporation)
  3577
(Primary Standard Industrial
Classification Code Number)
  41-1741861
(IRS Employer
Identification No.)

3349 Highway 138, Building D, Suite B, Wall, NJ 07719, (732) 359-1100
(Address and telephone number of registrant's principal executive offices)

Michael W. DePasquale
Chief Executive Officer
BIO-key International, Inc., 3349 Highway 138, Building D, Suite B, Wall, NJ 07719, (732) 359-1100
(Name, address and telephone number of agent for service)

Copy to:
Charles J. Johnson, Esq.
Choate, Hall & Stewart LLP
Two International Place
Boston, MA 02110
Telephone: (617) 248-5000
Facsimile: (617) 248-4000


        Approximate date of commencement of proposed sale to public: From time to time after this registration statement becomes effective.

        If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended, or the Securities Act, check the following box.  ý

        If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

        If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

        If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

        If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box.  o


        The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission acting pursuant to said Section 8(a), may determine.




Calculation of Registration Fee


Title of each class of
securities to be registered

  Number of units to be registered(1)
  Proposed maximum aggregate offering price per unit(2)
  Proposed maximum aggregate offering price(2)
  Amount of registration fee(3)

Common Stock, $.0001 par value per share, issuable upon conversion of Series C Convertible Preferred Stock   16,098,404 shares(4)   $0.42   $6,761,329.68   $723.46

Common Stock, $.0001 par value per share   150,000 shares(5)   $0.42   $63,000.00   $6.74

Common Stock, $.0001 par value per share   3,000,000 shares(6)   $0.42   $1,260,000.00   $134.82

Common Stock, $.0001 par value per share, issuable upon exercise of warrants   400,000 shares(7)   $0.42   $168,000.00   $17.98

Common Stock, $.0001 par value per share   1,000,000 shares(8)   $0.42   $420,000.00   $44.94

Common Stock, $.0001 par value per share, issuable upon exercise of warrants   133,333 shares(9)   $0.42   $55,999.86   $5.99

Common Stock, $.0001 par value per share   612,166 shares(10)   $0.42   $257,109.72   $27.51

Common Stock, $.0001 par value per share   263,705 shares(11)   $0.42   $110,756.10   $11.85

Common Stock, $.0001 par value per share   150,000 shares(12)   $0.42   $63,000.00   $6.74

Common Stock, $.0001 par value per share, issuable upon conversion of Series B Convertible Preferred Stock   2,856,438 shares(13)   $0.42   $1,199,703.96   $128.37

Common Stock, $.0001 par value per share, issuable upon exercise of warrants   500,000 shares(14)   $0.42   $210,000.00   $22.47

TOTAL:   25,164,046 shares       $10,568,899.32   $1,130.87

(1)
Pursuant to Rule 416 under the Securities Act, this registration statement also covers an indeterminate number of additional shares of the registrant's common stock as may be issuable upon any stock split, stock dividend or similar transaction.
(2)
Estimated pursuant to Rule 457(c) under the Securities Act solely for the purpose of calculating the registration fee, based upon the average of the high and low sale prices of the registrant's common stock as reported on the OTC Bulletin Board on September 5, 2006, a date within five days of the original filing date of this registration statement.
(3)
The registration fee has been previously paid by the registrant.
(4)
Shares of the registrant's common stock issuable upon conversion of Series C Convertible Preferred Stock issued pursuant to a securities exchange agreement dated as of August 10, 2006.
(5)
Shares of the registrant's common stock issuable in connection with a secured notes amendment and waiver agreement dated as of August 10, 2006.
(6)
Shares of the registrant's common stock issuable in connection with a securities purchase agreement dated as of August 10, 2006.
(7)
Shares of the registrant's common stock issuable upon the exercise of warrants issued pursuant to a securities purchase agreement dated as of August 10, 2006.
(8)
Shares of the registrant's common stock issuable in connection with a securities purchase agreement dated as of August 10, 2006.
(9)
Shares of the registrant's common stock issuable upon the exercise of warrants issued pursuant to a securities purchase agreement dated as of August 10, 2006.
(10)
Shares of the registrant's common stock issuable in connection with a secured notes amendment and waiver agreement dated as of August 31, 2005.
(11)
Shares of the registrant's common stock issuable in connection with a subordinated notes amendment and waiver agreements dated as of August 31, 2005.
(12)
Shares of the registrant's common stock issuable in connection with a secured notes amendment and waiver agreement dated as of January 23, 2006.
(13)
Shares of the registrant's common stock issuable upon conversion of Series B Convertible Preferred Stock issued pursuant to a securities purchase agreement dated as of January 23, 2006.
(14)
Shares of the registrant's common stock issuable upon the exercise of warrants issued pursuant to a securities purchase agreement dated as of January 23, 2006.

The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

Subject to completion, dated October 24, 2006

PROSPECTUS

25,164,046 Shares

BIO-key International, Inc.

Common Stock


        We are registering up to 25,164,046 shares of our common stock for offer or sale by the selling security holders named in this prospectus. Of the shares being registered, 18,954,842 shares are issuable upon conversion of preferred stock, 912,166 shares have been issued pursuant to secured notes amendment and waiver agreements, 263,705 shares have been issued pursuant to a subordinated notes amendment and waiver agreement, 4,000,000 shares have been issued to the selling security holders pursuant to securities purchase agreements, and 1,033,333 shares are issuable upon exercise of warrants issued in conjunction with the securities purchase agreements. The selling security holders may offer or sell all or a portion of their shares publicly or through private transactions at prevailing market prices or at negotiated prices. We will not receive any proceeds from the shares being registered for offer and sale by the selling security holders. We will, however, receive proceeds from the exercise price of certain warrants held by the selling security holders to the extent that such warrants are exercised.

        Investing in our common stock involves a high degree of risk. See "Risk Factors" beginning on page 4.

        Our common stock is traded on the OTC Bulletin Board under the symbol "BKYI." The last reported sale price of our common stock on October 23, 2006 was $0.47 per share.

        In addition to the shares being registered for offer or sale by the selling security holders under this prospectus, the registrant is also concurrently conducting three other separate offerings under additional prospectuses. Specifically, a separate offering of up to 15,755,500 is being concurrently conducted by the registrant by means of a prospectus dated as of July 8, 2004 (as amended), another separate offering of up to 13,896,038 is being concurrently conducted by the registrant by means of a prospectus dated as of December 28, 2004 (as amended), and another separate offering of up to 11,777,191 is being concurrently conducted by the registrant by means of a prospectus dated as of July 24, 2006.

        Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.


October    , 2006



TABLE OF CONTENTS

 
  Page
PROSPECTUS SUMMARY   1
RISK FACTORS   4
FORWARD-LOOKING STATEMENTS   13
USE OF PROCEEDS   13
MARKET FOR OUR COMMON STOCK AND RELATED STOCKHOLDER MATTERS   14
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION   15
DESCRIPTION OF THE BUSINESS   51
DESCRIPTION OF PROPERTY   62
LEGAL PROCEEDINGS   62
MANAGEMENT   62
EXECUTIVE COMPENSATION   65
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS   68
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT   69
DESCRIPTION OF SECURITIES   72
FINANCING TRANSACTIONS   74
SELLING SECURITY HOLDERS   80
PLAN OF DISTRIBUTION   84
DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION FOR SECURITIES ACT LIABILITIES   87
EXPERTS   87
WHERE YOU CAN FIND ADDITIONAL INFORMATION   87
FINANCIAL STATEMENTS   F-1

        You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information that is different. This prospectus may only be used where it is legal to sell these securities. The information in this prospectus may only be accurate on the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock. Applicable rules of the Securities and Exchange Commission may require us to update this prospectus in the future.

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PROSPECTUS SUMMARY

About BIO-key International, Inc.

        BIO-key International, Inc., a Delaware corporation (the "Company," "BIO-key," "we," or "us"), was founded in 1993 to develop and market proprietary biometric technology and software solutions. Biometric technology is the science of analyzing specific human characteristics which are unique to each individual in order to identify a specific person from a broader population.

        On March 30, 2004, BIO-key acquired Public Safety Group, Inc. (PSG), a privately held company that is a leader in wireless solutions for law enforcement and public safety markets. PSG's primary technology is PocketCop™, a handheld solution that provides mobile officers, such as detectives who are not typically in their vehicles, a hand-held mobile information software solution.

        On September 30, 2004, BIO-key completed a transaction with Aether Systems, Inc. to purchase its Mobil Government Division ("Mobile Government" or "AMG"), a leading provider of wireless data solutions for use by public safety organizations, primarily state, local police, fire and rescue and emergency medical services organizations. The PacketCluster mobile information software is integrated with 50 separate State/NCIC databases, as well as other state, local and federal databases. Its open architecture and its published Application Programming Interface (API) make it easy to interface with a wide range of information sources. PacketCluster products deliver real-time information in seconds, freeing dispatchers to handle more pressing emergencies.

        Effective January 1, 2005, BIO-key International, Inc., a Minnesota corporation ("Old BIO-key"), reincorporated in the State of Delaware. The reincorporation was effected pursuant to an Agreement and Plan of Merger (the "Merger Agreement") whereby Old BIO-key was merged with and into the Company, its wholly owned subsidiary, in order to reincorporate in the State of Delaware (the "Reincorporation"). As a result of the Reincorporation, the legal domicile of the Company is now Delaware.

        Pursuant to the Merger Agreement, at the effective time of the Reincorporation: (i) each outstanding share of Common Stock of Old BIO-key, $0.01 par value per share, was automatically converted into one share of Common Stock, $0.0001 par value per share, of the Company; (ii) each outstanding share of Series C 7% Convertible Preferred Stock of Old BIO-key, $0.01 par value per share, was automatically converted into one share of Series A 7% Convertible Preferred Stock, $0.0001 par value per share, of the Company, with such Series A 7% Convertible Preferred Stock containing substantially identical terms and conditions as the Series C 7% Convertible Preferred Stock of Old BIO-key; (iii) each option to purchase shares of Old BIO-key's Common Stock granted by Old BIO-key under any warrant, stock option plan or similar plan of Old BIO-key outstanding immediately before the Reincorporation was, by virtue of the Merger Agreement and without any action on the part of the holder thereof, converted into and become an option to purchase, upon the same terms and conditions, the same number of shares of the Company's Common Stock at an exercise price per share equal to the exercise price per share thereunder immediately before the Reincorporation; and (iv) each warrant, option or stock option plan of Old BIO-key was assumed by, and continues to be, a warrant, option or plan of the Company. Accordingly, as a result of the Reincorporation, the shareholders of Old BIO-key became shareholders of the Company, and Old BIO-key has been merged out of existence by operation of law. Each certificate representing shares of capital stock of Old BIO-key outstanding immediately before the Reincorporation, is deemed from and after the Reincorporation for all corporate purposes to represent the same number of shares of capital stock of the Company.

        As a result of these recent mergers, and as discussed in Note M to the Consolidated Financial Statements included in this prospectus, we have organized the Company into three reporting segments: Law Enforcement, Fire Safety and Biometrics. During 2005, the Company continued to integrate the

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products, operations and technologies acquired from Public Safety Group, Inc. and Aether Systems, Inc.

        We have evolved from a development stage company to a revenue generating company, but we have sustained substantial losses to date. We may need to obtain additional funding to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base, and (ii) provide working capital. Due to, among other factors, our history of losses and limited revenue, our former independent auditors included an explanatory paragraph in their opinion for the year ended December 31, 2005 as to the substantial doubt about our ability to continue as a going concern. Our long-term viability and growth will depend upon the successful commercialization of our technologies and our ability to obtain adequate financing. To the extent that we require such additional financing, no assurance can be given that any form of additional financing will be available on terms acceptable to us, that adequate financing will be obtained to meet our needs, or that such financing would not be dilutive to existing stockholders. If available financing is insufficient or unavailable or we fail to continue to generate meaningful revenue, we may be required to further reduce operating expenses, delay the expansion of operations, or be unable to pursue merger or acquisition candidates.

        Our principal executive offices are located at 3349 Highway 138, Building D, Suite B, Wall, NJ 07719 and our telephone number is (732) 359-1100.

About the Offering

        This prospectus covers the public resale of up to 25,164,046 shares of our common stock to be sold by the selling security holders identified herein. 612,166 shares of our common stock covered by this prospectus were issued to Laurus Master Fund, Ltd. ("Laurus") pursuant to an Amendment and Waiver agreement dated as of August 31, 2005 by and between the Company and Laurus in connection with the secured convertible term notes held by Laurus. 150,000 shares of our common stock covered by this prospectus were issued to Laurus pursuant to an Amendment and Waiver agreement dated as of January 23, 2006 by and between the Company and Laurus in connection with the secured convertible term notes held by Laurus. 150,000 shares of our common stock covered by this prospectus were issued to Laurus pursuant to an Amendment and Waiver agreement dated as of August 10, 2006 by and between the Company and Laurus in connection with the secured convertible term notes held by Laurus.

        263,705 shares of our common stock covered by this prospectus were issued to The Shaar Fund, Ltd. ("Shaar") and other institutional and accredited investors pursuant to an Amendment and Waiver agreement dated as of August 31, 2005 by and between the Company and such investors in connection with the subordinated convertible term notes then held by such investors.

        2,856,438 shares of our common stock covered by this prospectus are issuable upon conversion of our Series B Convertible Preferred Stock issued to Shaar, Longview Fund, L.P. ("Longview") and Longview Special Finance, Inc. ("LSF") pursuant to a Securities Purchase Agreement dated as of January 23, 2006 (the "Series B Purchase Agreement") by and among the Company and such investors. 500,000 shares of our common stock covered by this prospectus are issuable upon exercise of warrants issued to the investors party to the Series B Purchase Agreement. 16,098,404 shares of our common stock covered by this prospectus are issuable upon conversion of our Series C Convertible Preferred Stock issued to Shaar, Longview, LSF and other institutional and accredited investors pursuant to a Securities Exchange Agreement dated as of August 10, 2006 by and among the Company and such investors.

        3,000,000 shares of our common stock covered by this prospectus were issued to Trellus Partners, L.P. ("Trellus") pursuant to a Securities Purchase Agreement dated as of August 10, 2006 by and between the Company and Trellus. The aggregate purchase price paid by Trellus for such shares

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pursuant to such Securities Purchase Agreement was $1,500,000. 400,000 shares of our common stock covered by this prospectus are issuable upon exercise of a warrant issued to Trellus pursuant to such Securities and Purchase Agreement. 1,000,000 shares of our common stock covered by this prospectus were issued to Shaar pursuant to a Securities Purchase Agreement dated as of August 10, 2006 by and between the Company and Shaar. The aggregate purchase price paid by Shaar for such shares pursuant to such Securities Purchase Agreement was $500,000, to be paid by exchanging Shaar's rights in an aggregate amount of $500,000 in declared and unpaid dividends on the shares of Series A Convertible Preferred Stock currently held by Shaar. 133,333 shares of our common stock covered by this prospectus are issuable upon exercise of a warrant issued to Shaar pursuant to such Securities Purchase Agreement.

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RISK FACTORS

        An investment in our common stock involves a high degree of risk. You should carefully consider the following information about certain of the risks of investing in our common stock, together with other information contained in this prospectus, before you decide to purchase our common stock.


Business and Financial Risks

Based on our lack of significant revenue since inception and recurring losses from operations, our auditors have included an explanatory paragraph in their opinion as to the substantial doubt about our ability to continue as a going concern.

        Due to, among other factors, our history of losses (excluding gains from valuation changes in embedded derivatives) and limited revenue, our former independent auditors included an explanatory paragraph in their opinion for the year ended December 31, 2005 as to the substantial doubt about our ability to continue as a going concern. Our financial statements have been prepared in accordance with accounting principals generally accepted in the United States, which contemplate that we will continue to operate as a going concern. Our financial statements do not contain any adjustments that might result if we are unable to continue as a going concern.

Since our formation, we have historically generated minimal revenue and have sustained substantial operating losses.

        As of June 30, 2006, we had negative working capital of approximately $11,268,000 and an accumulated deficit of approximately $47,757,000. Since our inception, we have focused almost exclusively on developing our core technologies and, until the fourth quarter of 2004 have not generated any significant revenue. In order to increase revenue, we have developed a direct sales force and anticipate the need to retain additional sales, marketing and technical support personnel and may need to incur substantial expenses. We cannot assure you that we will be able to secure these necessary resources, that a significant market for our technologies will develop or that we will be able to achieve our targeted revenue.

We have identified material weaknesses in our internal control over financial reporting and have failed to maintain an effective system of disclosure controls and procedures. If we are unable to successfully address such material weaknesses or if we continue to maintain an ineffective system of disclosure controls and procedures, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting; this would harm our business and the trading price of our common stock.

        After a review of our March 31, 2005, June 30, 2005, September 30, 2005, March 31, 2006 and June 30, 2006 quarterly operating results, as well as our 2005 annual operating results, conducted pursuant to Rules 13a-15 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), our Chief Executive Officers ("CEO's") and Chief Financial Officer ("CFO") have determined that, as of each such date, our disclosure controls and procedures were not effective to provide reasonable assurance that information that we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission rules and forms. Our management reached this conclusion after identifying our system to capture disclosure items, our internal process of review for account reconciliations, our documentation of internal controls and our internal process for preparing our annual report on Form 10-KSB for the fiscal year ended December 31, 2005 as being inadequate to provide such assistance.

        In order to ensure that the Company adequately addresses all existing internal control issues, the Company initiated follow-up discussions with its former auditors to better determine what constituted

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these material weaknesses. During these discussions, the auditors and the Company identified the following weaknesses in the Company's internal controls: an inadequate system to capture disclosure items, an inadequate internal process of review for account reconciliations, an inadequate documentation of internal controls and an inadequate internal process around drafting of periodic filings with the Securities and Exchange Commission.

        Effective internal control over financial reporting and disclosure controls and procedures are necessary for us to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. We have in the past discovered, as described above, and may in the future discover, areas of our disclosure and internal controls that need improvement. We are in the process of addressing these issues to ensure that our internal control over financial reporting and disclosure controls and procedures are improved so as to provide reasonable assurance that the information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange rules and forms. If, however, we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed.

        We cannot be certain that our efforts to improve the material weaknesses in our internal control over financial reporting and the ineffectiveness of our disclosure controls and procedures will be successful or that we will be able to maintain adequate controls over our financial processes and reporting in the future. We will need to commit substantial resources, including substantial time from our management team's accounting personnel and from external consultants, to implement and integrate into our organization improved disclosure controls and additional procedures generally and to improve systems to report financial information on a timely basis. Any failure or delay to develop or maintain effective controls, or difficulties encountered in their implementation or in other effective improvement of our internal and disclosure controls could materially harm our operating results or cause us to fail to meet our reporting obligations. If we are unable to adequately establish or improve our internal controls over financial reporting, our external auditors may not be able to issue an unqualified opinion on the effectiveness of our internal controls. Ineffective internal and disclosure controls could also cause investors to lose confidence in our reported financial information, which would likely have a significant negative effect on the trading price of our securities.

Our biometric technology has yet to gain widespread market acceptance and we do not know how large of a market will develop for our technology.

        Biometric technology has received only limited market acceptance, particularly in the private sector. Our technology represents a novel security solution and we have not yet generated significant sales. Although recent security concerns relating to identification of individuals has increased interest in biometrics generally, it remains an undeveloped, evolving market. Biometric based solutions compete with more traditional security methods including keys, cards, personal identification numbers and security personnel. Acceptance of biometrics as an alternative to such traditional methods depends upon a number of factors including:

        For these reasons, we are uncertain whether our biometric technology will gain widespread acceptance in any commercial markets or that demand will be sufficient to create a market large enough to produce significant revenue or earnings. Our future success depends, in part, upon business customers adopting biometrics generally, and our solution specifically.

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Biometric technology is a new approach to Internet security which must be accepted in order for our WEB-key® solution to generate significant revenue.

        Our WEB-key® authentication initiative represents a new approach to Internet security which has been adopted on a limited basis by companies which distribute goods, content or software applications over the Internet. The implementation of our WEB-key® solution requires the distribution and use of a finger scanning device and integration of database and server side software. Although we believe our solutions provides a higher level of security for information transmitted over the Internet than existing traditional methods, unless business and consumer markets embrace the use of a scanning device and believe the benefits of increased accuracy outweigh implementation costs, our solution will not gain market acceptance.

Our software products may contain defects which will make it more difficult for us to establish and maintain customers.

        Although we have completed the development of our core biometric technology, it has only been used by a limited number of business customers. Despite extensive testing during development, our software may contain undetected design faults and software errors, or "bugs" that are discovered only after it has been installed and used by a greater number of customers. Any such default or error in new or existing software or applications could cause delays in delivering our technology or require design modifications. These could adversely affect our competitive position and cause us to lose potential customers or opportunities. Since our technologies are intended to be utilized to secure physical and electronic access, the effect of any such bugs or delays will likely have a detrimental impact on us. In addition, given that biometric technology generally, and our biometric technology specifically, has yet to gain widespread acceptance in the market, any delays would likely have a more detrimental impact on our business than if we were a more established company.

        While we have commenced a significant sales and marketing effort, we have only begun to develop a significant distribution channel and may not have the resources or ability to sustain these efforts or generate any meaningful sales.

In order to generate revenue from our biometric products, we are dependent upon independent original equipment manufacturers, system integrators and application developers, which we do not control. As a result, it may be more difficult to generate sales.

        We market our technology through licensing arrangements with:

        As a technology licensing company, our success will depend upon the ability of these manufacturers and developers to effectively integrate our technology into products and services which they market and sell. We have no control over these licensees and can not assure you that they have the financial, marketing or technical resources to successfully develop and distribute products or applications acceptable to end users or generate any meaningful revenue for us. These third parties may also offer the products of our competitors to end users.

We derive nearly all of our revenue from government contracts, which are often non-standard, involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue.

        Most of our business involves providing products and services under contracts with U.S. federal, state and local government agencies. Obtaining contracts from government agencies is challenging, and

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government contracts often include provisions that are not standard in private commercial transactions. For example, government contracts may:


        Securing government contracts can be a protracted process involving competitive bidding. In many cases, unsuccessful bidders may challenge contract awards, which can lead to increased costs, delays and possible loss of the contract for the winning bidder.

We face intense competition and may not have the financial and human resources necessary to keep up with rapid technological changes, which may result in our technology becoming obsolete.

        The Internet, facility access control and information security markets are subject to rapid technological change and intense competition. We compete with both established biometric companies and a significant number of startup enterprises as well as providers of more traditional methods of access control. Most of our competitors have substantially greater financial and marketing resources than we do and may independently develop superior technologies, which may result in our technology becoming less competitive or obsolete. We may not be able to keep pace with this change. If we are unable to develop new applications or enhance our existing technology in a timely manner in response to technological changes, we will be unable to compete in our chosen markets. In addition, if one or more other biometric technologies such as voice, face, iris, hand geometry or blood vessel recognition are widely adopted, it would significantly reduce the potential market for our fingerprint identification technology.

We depend on key employees and members of our management team, including our Chairman of the Board and Chief Executive Officer, in order to achieve our goals. We cannot assure you that we will be able to retain or attract such persons.

        A loss of our current Chairman of the Board of Directors or Chief Executive Officer could severely and negatively impact our operations. We have had an employment contract with Michael W. DePasquale, our Chief Executive Officer through March 28, 2008. Although the contract does not prevent him from resigning, it does contain confidentiality and non-compete clauses which are intended to prevent him from working for a competitor within one year after leaving our Company. Our success depends on our ability to attract, train and retain employees with expertise in developing, marketing and selling software solutions. In order to successfully market our technology, we will need to retain additional engineering, technical support and marketing personnel. The market for such persons remains highly competitive and our limited financial resources will make it more difficult for us to recruit and retain qualified persons.

We cannot assure you that the limited intellectual property protection for our core technology provides a meaningful competitive advantage or barrier to entry against our competitors.

        Our success and ability to compete is dependent in part upon proprietary rights to our technology. We rely primarily on a combination of patent, copyright and trademark laws, trade secrets and technical measures to protect our propriety rights. We have filed a patent application relating to both the optic technology and biometrics solution components of our technology wherein several claims have been allowed. In May 2005, the U.S. Patent Office issued us a patent for our Vector Segment fingerprint technology (VST), BIO-key's core biometric analysis and identification technology. We

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cannot assure you that any additional patents will be issued that we will have the resources to protect any patent from infringement. Although we believe our technology does not currently infringe upon patents held by others, we can not assure you that such infringements do not exist or will not exist in the future, particularly as the number of products and competitors in the biometric industry segment grows.

We may need to obtain additional financing to execute our business plan, which may not be available. If we are unable to raise additional capital or generate significant revenue, we may not be able to continue operations.

        Since our inception, we have not generated any significant revenue (other than revenue from acquired businesses) and have experienced substantial losses, including approximately $12,828,000 during 2005, excluding the impact related to embedded derivative and warrant fair value adjustments. In March 2004, we completed a private placement equity offering that resulted in approximately $12,000,000 in gross proceeds to the Company and a private placement convertible debt offering in September 2004 that resulted in approximately $10,000,000 in gross proceeds to the Company (a portion of which was used to finance the acquisition of Aether Mobile Government). In June 2005, we raised approximately $5,000,000 in gross proceeds through a private placement convertible debt offering, in January 2006 we received approximately $1,000,000 in another private placement convertible debt offering, and in August 2006 we raised approximately $2,000,000 in gross proceeds through a private issuance of equity securities, of which $1,500,000 was received in cash, and $500,000 was paid in declared and unpaid dividends. To the extent that we will require additional capital to support our operations, expand our marketing and sales efforts and to execute our business plan to substantially increase revenue, we may need to obtain additional financing through the issuance of debt or equity securities. Our long-term viability and growth will depend upon the successful commercialization of our technologies and our ability to obtain adequate financing. We have not and cannot assure you that we will ever be able to secure any such financing on terms acceptable to us. If we cannot obtain such financing or generate such revenues, we may not be able to execute our business plan or continue operations.

We may not be able to successfully complete the integration of PSG and AMG into our operations.

        The integration of PSG and AMG into our operations involves a number of risks, including:

        Failure to overcome these risks or any other problems encountered in connection with the acquisitions of PSG and AMG could slow our growth or lower the quality of our services, which could reduce customer demand. The result could be a material adverse effect on our financial position and results of operations.

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We may not achieve profitability with respect to the law enforcement and public safety components of our business if we are unable to maintain, improve and develop the wireless data services we offer.

        We believe that our future business prospects depend in part on our ability to maintain and improve our current services and to develop new ones on a timely basis. Our services will have to achieve market acceptance, maintain technological competitiveness and meet an expanding range of customer requirements. As a result of the complexities inherent in our service offerings, major new wireless data services and service enhancements require long development and testing periods. We may experience difficulties that could delay or prevent the successful development, introduction or marketing of new services and service enhancements. Additionally, our new services and service enhancements may not achieve market acceptance. If we cannot effectively develop and improve services we may not be able to recover our fixed costs or otherwise become profitable.

Our law enforcement and public safety division depends upon wireless networks owned and controlled by others.

        If we do not have continued access to sufficient capacity on reliable networks, we may be unable to deliver services and our sales could decrease. Our ability to grow and achieve profitability partly depends on our ability to buy sufficient capacity on the networks of wireless carriers such as Verizon Wireless, Bell South Corporation, Metrocall, Motient and Cingular/AT&T Wireless and on the reliability and security of their systems. All of our services are delivered using airtime purchased from third parties. We depend on these companies to provide uninterrupted and bug free service and would not be able to satisfy our customers' needs if they failed to provide the required capacity or needed level of service. In addition, our expenses would increase and our profitability could be materially adversely affected if wireless carriers were to increase the prices of their services. Our existing agreements with the wireless carriers generally have one-year terms. Some of these wireless carriers are, or could become, our competitors and if they compete with us they may refuse to provide us with their services.

New laws and regulations that impact our law enforcement and public safety division could increase our costs or reduce our opportunities to earn revenue.

        We are not currently subject to direct regulation by the Federal Communications Commission or any other governmental agency, other than regulations applicable to businesses in general. However, in the future, we may become subject to regulation by the FCC or another regulatory agency. In addition, the wireless carriers who supply us airtime and certain of our hardware suppliers are subject to regulation by the FCC and regulations that affect them could increase our costs or reduce our ability to continue selling and supporting our services.

If we fail to adequately manage our resources, it could have a severe negative impact on our financial results or stock price.

        We could be subject to fluctuations in technology spending by existing and potential customers. Accordingly, we will have to actively manage expenses in a rapidly changing economic environment. This could require reducing costs during economic downturns and selectively growing in periods of economic expansion. If we do not properly manage our resources in response to these conditions, our results of operations could be negatively impacted.

9



We granted a blanket security interest in all of our assets to the holders of our secured debt. If we are unable to make our required monthly payments on such debt, or any other event of default occurs, it could have a material adverse effect on our business and operations, and the debt holders may foreclose on our assets.

        As part of our secured convertible debt financing transactions, we granted to Laurus Master Fund, Ltd. and another holder of such secured debt a blanket security interest in all of our assets, including assets of our subsidiary. See the "Management's Discussion and Analysis or Plan of Operation" section of this report. In the event we default in payment on such debt, or any other event of default occurs under the relevant financing documents, and the default is not cured, 120% of the outstanding principal amount of the secured notes, plus accrued interest and fees will accelerate and be due and payable in full. See the "Long Term Obligations" footnote to this report for a list of such potential events of default.

        The cash required to pay such accelerated amounts on the secured notes following an event of default would most likely come out of our working capital. As we rely on our working capital for our day to day operations, such a default could have a material adverse effect on our business, operating results, or financial condition to such extent that we are forced to restructure, file for bankruptcy, sell assets or cease operations. In addition, upon an event of default, the holder of the secured debt could foreclose on our assets or exercise any other remedies available to them. If our assets were foreclosed upon, we were forced to file for bankruptcy or cease operations; stockholders may not receive any proceeds from disposition of our assets and may lose their entire investment in our stock.

Our obligations under our debt securities may adversely affect our ability to enter into potential significant transactions with other parties.

        As a result of our debt financing transactions with Laurus Master Fund, Ltd., the Shaar Fund, Ltd. and other institutional and accredited investors, we incurred significant repayment obligations, and we agreed to certain restrictive covenants. In particular, for so long as 25% of the aggregate principal amount of the convertible term notes remains outstanding, we will need the consent of the holders of such notes before we can take certain actions, including the following:

        Accordingly, unless we obtain the noteholders' consent, we may not be able to enter into certain transactions. In addition, in connection with any potential significant transaction (such as a merger, sale of substantially all our assets, joint venture, or similar transaction), it is likely that we would have to pay off such debt obligations and have the applicable security interests released. Although we have the right at any time to prepay our debt obligations, we can only do so upon payment of either 110% or 120% of the then principal balance, plus all other amounts owing under the notes. See the "Long Term Obligations" footnote of this report. Based on an aggregate principal balance of $4.8 million at August 10, 2006, a complete prepayment would require a cash payment of approximately $5.3 million. These provisions could have the practical effect of increasing the costs of any potential significant transaction, and restrict our ability to enter into any such transaction.

10



Our obligations to the holders of our outstanding preferred stock may further affect our ability to enter into potential significant transactions with other parties.

        We will need to obtain the consent of the holders of a majority of the then outstanding shares of our Convertible Preferred Stock before we can take certain actions, including the following:

Accordingly, unless we obtain such consent, we may not be able to enter into certain transactions.


Risks Related To Our Common Stock

We have issued a substantial number of securities that are convertible into shares of our common stock which will result in substantial dilution to the ownership interests of our existing shareholders.

        As of August 10, 2006, approximately 56,179,800 shares of our common stock were reserved for issuance upon exercise or conversion of the following securities (at conversion prices applicable as at August 10, 2006):

        The exercise or conversion of these securities will result in a significant increase in the number of outstanding shares and substantially dilute the ownership interests of our existing shareholders.

A substantial number of our convertible securities are convertible into shares of common stock at a conversion price of $.50 per share. Most of these shares are eligible for public resale. The trading price of our common stock and our ability to raise additional financing may be adversely affected by the influx into the market of such a substantial number of shares.

        Our outstanding Series A Convertible Preferred Stock and cumulative dividends in arrears are convertible into 8,299,424 shares of common stock as of August 10, 2006 at a per share conversion price of $.50. Although many of the shares issuable upon conversion of our Series A Convertible Preferred Stock are eligible for public resale under Securities Exchange Commission Rule 144, we agreed to file a registration statement to cover the public resale of all of these shares. This significant increase in the number of shares available for public sale may have a negative impact on the trading price of our shares and substantially dilute the ownership interests of our existing shareholders. In the event that our stock trades below $.50 per share, in order to raise additional financing we would likely be required to issue additional shares of common stock or securities convertible into common stock at a purchase or conversion price, as applicable, of less than $.50 per share. Any issuance of shares at a purchase price of less than $.50 per share would reduce the conversion price of our Series A Convertible Preferred Shares to such lower price. This would require us to issue additional shares upon conversion of our Series A Shares and further dilute the ownership interests of our existing shareholders. To the extent these factors are viewed negatively by the market, it may provide an

11



incentive for persons to execute short sales of our common stock that could adversely affect the trading price of our common stock.

        In January 2006, the Company issued Convertible Term Notes in the aggregate principal amount of $1,000,000 to certain investors. The Convertible Notes subsequently converted into 1,000,000 shares of Series B Convertible Preferred Stock of the Company, which shares and cumulative dividends are convertible into shares of the Common Stock of the Company at a fixed conversion of $0.50 per share for an aggregate amount of 2,147,945 shares as at August 10, 2006. Although many of the shares issuable upon conversion of our Series B Convertible Preferred Stock are eligible for public resale under Securities Exchange Commission Rule 144, we agreed to file a registration statement to cover the public resale of all of these shares. This significant increase in the number of shares available for public sale may have a negative impact on the trading price of our shares and substantially dilute the ownership interests of our existing shareholders. In the event that our stock trades below $.50 per share, in order to raise additional financing we would likely be required to issue additional shares of common stock or securities convertible into common stock at a purchase or conversion price, as applicable, of less than $.50 per share. Any issuance of shares at a purchase price of less than $.50 per share would reduce the conversion price of our Series B Convertible Preferred Shares to such lower price. This would require us to issue additional shares upon conversion of our Series B Shares and further dilute the ownership interests of our existing shareholders. To the extent these factors are viewed negatively by the market, it may provide an incentive for persons to execute short sales of our common stock that could adversely affect the trading price of our common stock.

        In August 2006, certain subordinated terms noted were converted to shares of Series C Convertible Preferred Stock of the Company, which shares and cumulative dividends are convertible into shares of the Common Stock of the Company at an initial fixed conversion of $0.50 per share for an aggregate amount of 11,840,640 shares as at August 10, 2006. Although many of the shares issuable upon conversion of our Series C Convertible Preferred Stock are eligible for public resale under Securities Exchange Commission Rule 144, we agreed to file a registration statement to cover the public resale of all of these shares. This significant increase in the number of shares available for public sale may have a negative impact on the trading price of our shares and substantially dilute the ownership interests of our existing shareholders. In the event that our stock trades below $.50 per share, in order to raise additional financing we would likely be required to issue additional shares of common stock or securities convertible into common stock at a purchase or conversion price, as applicable, of less than $.50 per share. Any issuance of shares at a purchase price of less than $.50 per share would reduce the conversion price of our Series C Convertible Preferred Shares to such lower price. This would require us to issue additional shares upon conversion of our Series C Shares and further dilute the ownership interests of our existing shareholders. To the extent these factors are viewed negatively by the market, it may provide an incentive for persons to execute short sales of our common stock that could adversely affect the trading price of our common stock.

Applicable SEC Rules governing the trading of "penny stocks" limits the trading and liquidity of our common stock, which may affect the trading price of our common stock.

        Our common stock currently trades on the OTC Bulletin Board. Since our common stock continues to trade below $5.00 per share, our common stock is considered a "penny stock" and is subject to SEC rules and regulations, which impose limitations upon the manner in which our shares can be publicly traded. These regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the associated risks. Under these regulations, certain brokers who recommend such securities to persons other than established customers or certain accredited investors must make a special written suitability determination regarding such a purchaser and receive such purchaser's written agreement to a transaction prior to

12



sale. These regulations have the effect of limiting the trading activity of our common stock and reducing the liquidity of an investment in our common stock.

We do not intend to pay dividends in the foreseeable future.

        We have never declared or paid a dividend on our common stock. In addition, the terms of our outstanding Convertible Preferred Shares preclude us from declaring or paying a dividend on our common stock unless a dividend is also declared or paid, as applicable, on our Convertible Preferred Shares. We intend to retain earnings, if any, for use in the operation and expansion of our business and, therefore, do not anticipate paying any dividends on our common stock in the foreseeable future.

The trading price of our common stock may be volatile.

        The trading price of our shares has from time to time fluctuated widely and in the future may be subject to similar fluctuations. The trading price may be affected by a number of factors including the risk factors set forth in this Report as well as our operating results, financial condition, announcements of innovations or new products by us or our competitors, general conditions in the biometrics and access control industries, and other events or factors. Although we believe that approximately 15 registered broker dealers currently make a market in our common stock, we can not assure you that any of these firms will continue to serve as market makers or have the financial capability to stabilize or support our common stock. A reduction in the number of market makers or the financial capability of any of these market makers could also result in a decrease in the trading volume of and price of our shares. In recent years broad stock market indices, in general, and the securities of technology companies, in particular, have experienced substantial price fluctuations. Such broad market fluctuations may adversely affect the future-trading price of our common stock.


FORWARD-LOOKING STATEMENTS

        All statements other than statements of historical facts contained in this prospectus, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words "anticipate," "believe," "estimate," "will," "may," "future," "plan," "intend" and "expect" and similar expressions generally identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure that they will be achieved. Actual results may differ materially due to a number of factors. Many of these factors are set forth in the "RISK FACTORS" section of this prospectus. Actual results may differ materially from the forward-looking statements contained in this prospectus. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, may be significant, presently or in the future. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.


USE OF PROCEEDS

        The shares are being registered hereunder for resale by the selling security holders. We will not receive any proceeds from the sale of the shares by the selling security holders. We will, however, receive proceeds from the exercise price of certain warrants held by the selling security holders to the extent that such warrants are exercised. We expect to use the proceeds of any such sales for general working capital purposes.

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MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS

        Our common stock currently trades on the OTC Bulletin Board under the symbol "BKYI". The following table sets forth the range of high and low bid prices per share of our common stock for each of the calendar quarters identified below as reported by the OTC Bulletin Board. These quotations represent inter-dealer prices, without retail mark-up, markdown or commission, and may not represent actual transactions.

2006:

  High
  Low
Quarter ended September 30, 2006   $ 0.49   $ 0.39
Quarter ended June 30, 2006   $ 0.67   $ 0.40
Quarter ended March 31, 2006     0.94     0.58
2005:

  High
  Low
Quarter ended December 31, 2005   $ 0.81   $ 0.50
Quarter ended September 30, 2005     1.21     0.74
Quarter ended June 30, 2005     1.39     0.99
Quarter ended March 31, 2005     1.63     1.13
2004:

  High
  Low
Quarter ended December 31, 2004   $ 1.61   $ 0.74
Quarter ended September 30, 2004     1.43     0.60
Quarter ended June 30, 2004     3.00     1.26
Quarter ended March 31, 2004     1.85     1.03
2003:

  High
  Low
Quarter ended December 31, 2003   $ 1.40   $ 0.53
Quarter ended September 30, 2003     0.59     0.38
Quarter ended June 30, 2003     0.64     0.30
Quarter ended March 31, 2003     0.73     0.35

        The last price of our common stock as reported on the OTC Bulletin Board on October 23, 2006 was $0.47 per share.

Holders

        As of September 5, 2006, the number of stockholders of record of our common stock was 192. Based on broker inquiry conducted in connection with the distribution of proxy solicitation materials in connection with the Company's special meeting of shareholders in February 2006, we believe that there are approximately 4,816 beneficial owners of our common stock.

Dividends

        We have not paid any cash dividends on our common stock to date, and have no intention of paying any cash dividends on our common stock in the foreseeable future. The terms of our outstanding Convertible Preferred Stock preclude us from declaring or paying a dividend on our common stock unless a dividend is also declared or paid, as applicable, on our Convertible Preferred Stock. The declaration and payment of dividends on our common stock is also subject to the discretion of our Board of Directors and certain limitations imposed under the Delaware General Corporation Law. The timing, amount and form of dividends, if any, will depend on, among other things, our results of operations, financial condition, cash requirements and other factors deemed relevant by our Board of Directors.

14



MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

        This Management's Discussion and Analysis or Plan of Operation and other parts of this Report contain forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this Report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth in the section captioned "RISK FACTORS" in Item 1 and elsewhere in this Report. The following should be read in conjunction with our audited financial statements included elsewhere herein.

        The following Management's Discussion and Analysis or Plan of Operation ("MD&A") is intended to help you understand BIO-key International (the "Company", "we", "us" or "our"). MD&A is provided as a supplement to and should be read in conjunction with our financial statements and the accompanying notes. The results included in this MD&A have been restated. Our MD&A includes the following sections:

        OVERVIEW provides a description of our business, the major items that affected our business, and how we analyze our business. It then provides an analysis of our overall 2005 performance and a description of the significant events impacting 2005 and thereafter.

        RESULTS OF OPERATIONS provides an analysis of the consolidated and segment results of operations for 2005 compared to 2004 and 2004 compared to 2003. It also includes an analysis of the consolidated and segment results of operations for the three and six months ended June 30, 2006 compared to the three and six months ended June 30, 2005.

        LIQUIDITY AND CAPITAL RESOURCES provides an overview of our cash flows, financing, contractual obligations and embedded derivatives activities.

        RESTATEMENT provides a description and reconciliation of the restatement. For additional information, see Item 8, Financial Statements and Supplementary Data, Note B, Restatement of Previously Issued Financial Statements.

        CRITICAL ACCOUNTING POLICIES provides a discussion of our accounting policies that require critical judgment, assumptions and estimates.

        OTHER MATTERS provides a discussion of our significant non-operational items which impact our financial statements, such as the SEC comment letter.

        RECENT ACCOUNTING STANDARDS by reference to Note 1 to the Consolidated Financial Statements provides a description of accounting standards which we have not yet been required to implement and may be applicable to our operations, as well as those significant accounting standards which were adopted during 2005.

OVERVIEW

        Our Business

        We develop and market proprietary fingerprint identification biometric technology and software solutions. We also deliver advanced identification solutions and information services to law enforcement departments, public safety agencies and other government and private sector customers. Our mobile wireless technology provides first responders with critical, reliable, real-time data and images from local, state and national databases.

        We pioneered the development of automated, finger identification technology that can be used without the aid of non-automated methods of identification such as a personal identification, password, token, smart card, ID card, credit card, passport, driver's license or other form of possession or knowledge based identification. This advanced BIO-key™ identification technology improves both the

15



accuracy and speed of finger-based biometrics and is the only finger identification algorithm that has been certified by the International Computer Security Association (ICSA).

        Since our inception in 1993, we have spent substantial time and effort in completing the development of what we believe is the most discriminating and effective finger biometric technology available. During the past two years, our focus has shifted to marketing and selling this technology and completing strategic acquisitions that can help us leverage our capability to deliver identification solutions. We have built a direct sale force of professionals with substantial experience in selling technology solutions to government and corporate customers. We expect to continue to add additional qualified personnel beyond 2006.

        On March 30, 2004, we acquired all of the outstanding capital stock of Public Safety Group, Inc., a privately-held provider of wireless solutions for law enforcement and public safety markets based in Winter Park, Florida, in exchange for an aggregate of 2,422,108 shares of our common stock, $500,000 in cash, and our assumption of $600,000 in aggregate net liabilities of PSG. The acquisition was completed pursuant to the terms of an agreement and plan of merger by and among the Company, BIO-key Acquisition Corp., a wholly-owned subsidiary of the Company, PSG and all of the shareholders of PSG. As a result of this transaction, PSG became a wholly-owned subsidiary of the Company.

        On September 30, 2004, we completed our acquisition of the Mobile Government Division from Aether Systems Inc. Pursuant to the Asset Purchase Agreement dated as of August 16, 2004 by and among the Company, Aether, Cerulean Technology, Inc. and SunPro, Inc., the Company paid Aether a purchase price of $10,000,000 in cash, subject to post-closing adjustments to reflect changes in Aether Mobile Government's working capital and cash flows since June 30, 2004. Post-closing working capital adjustments resulted in an additional payment by the Company of $341,878 in December 2004. In connection with this acquisition, the Company issued a subordinated secured promissory note to Aether in the face amount of $6,884,588 (the "Aether Note"). The Aether Note evidences a contingent reimbursement obligation of the Company to Aether and a surety fee payable by the Company to Aether, in each case with respect to a letter of credit maintained by Aether for the Company's benefit in connection with the acquisition. The Company's obligations under the Aether Note are secured by a security interest granted to Aether in all or substantially all of the Company's assets, subordinate to the security interest described in the "Long-Term Obligations" footnote to this annual report.

        Aether Mobile Government provides wireless data solutions for use by public safety organizations, primarily state and local police, fire and rescue and emergency medical services organizations that enable such organizations to access law enforcement databases to validate identities and obtain suspect information. Its public safety solutions are integrated into fifty (50) different state databases, as well as local and federal databases, and its products deliver real-time information in seconds, without the need for human dispatchers or other resources.

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2005, AS COMPARED TO DECEMBER 31, 2004, AND DECEMBER 31, 2004 AS COMPARED TO DECEMBER 31, 2003

INTRODUCTION

        During 2005, the Company continued to integrate the products, operations and technology of the Mobile Government business, acquired from Aether Systems in September 2004, in an effort to leverage new business opportunities. Our financial objective is to increase revenue, manage expenses and attain profitability. While total expenses have increased in dollars, they have declined as a percentage of revenue in 2005 and 2004. In the fourth quarter of 2005, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety. Each segment

16



is headed by a General Manager and organized to quickly respond to market needs as well as to drive down costs to achieve profitability. Management believes that this initiative will lead to increased opportunities throughout 2006 as the General Managers continue to develop their business units.

RESULTS OF OPERATIONS

Consolidated Results of Operations

Three Year % trend

 
  Years ended December 31,
 
 
  2005
  2004
  2003
 
 
  (Restated)

  (Restated)

  (Restated)

 
Revenues              
  Services   76 % 59 % 5 %
  License fees and other   24 % 41 % 95 %
   
 
 
 
    100 % 100 % 100 %
Costs and other expenses              
  Services   20 % 21 % 1 %
  Cost of license fees and other   7 % 16 % 41 %
  Selling, general and administrative   83 % 124 % 975 %
  Research, development and engineering   48 % 52 % 481 %
   
 
 
 
    158 % 213 % 1,498 %
   
 
 
 
Operating loss   (58 )% (113 )% (1,398 )%
Other income (deductions)              
  Total other income (deductions)   (32 )% (77 )% (486 )%
   
 
 
 
NET INCOME (LOSS)   (26 )% (190 )% (1,884 )%
   
 
 
 

        As discussed in Note M to the Consolidated Financial Statements, we have three reporting segments: Law Enforcement, Fire Safety and Biometrics. The Law Enforcement and Fire Safety segments were purchased during 2004. As noted earlier, in the fourth quarter of 2005 the Company restructured its operations into three business segments, prior to this segmentation of the business management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods have been estimated.

        The Company evaluates performance and allocates resources based on revenues and operating income (loss). Operating income (loss) for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues. The segmentation of operating income as noted above and detailed below reflects how management now evaluates its business. Assets for the company are commingled and are

17



related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.

 
   
   
   
  2005–2004
   
   
 
 
   
   
   
  2004–2003
 
 
   
   
   
   
  % Chg
 
 
  2005
  2004
  2003
  $ Chg
  $ Chg
  % Chg
 
 
   
  Restated

  Restated

   
   
   
   
 
Revenues                                        
Law Enforcement                                        
  Service   $ 7,886,000   $ 2,562,136   $   $ 5,323,864   208 % $ 2,562,136   n/a  
  License & other     2,638,938     1,920,642         718,296   37 %   1,920,642   n/a  
   
 
 
 
     
     
      10,524,938     4,482,778         6,042,160   135 %   4,482,778   n/a  
Fire Safety                                        
  Service     2,814,616     693,967         2,120,649   306 %   693,967   n/a  
  License & other     406,470     187,229         219,241   117 %   187,229   n/a  
   
 
 
 
     
     
      3,221,086     881,196         2,339,890   266 %   881,196   n/a  
Biometrics                                        
  Service     161,033     95,303     10,694     65,730   69 %   84,609   791 %
  License & other     319,038     261,674     204,787     57,364   22 %   56,887   28 %
   
 
 
 
     
     
      480,071     356,977     215,481     123,094   34 %   141,496   66 %
   
 
 
 
     
     
  Total Revenue   $ 14,226,095   $ 5,720,951   $ 215,481   $ 8,505,144   149 % $ 5,505,470   2,555 %
   
 
 
 
     
     
Cost of goods sold                                        
Law Enforcement                                        
  Service   $ 2,260,845   $ 902,794   $   $ 1,358,051   150 % $ 902,794   n/a  
  License & other     679,170     686,806         (7,636 ) (1 )%   686,806   n/a  
   
 
 
 
     
     
      2,940,015     1,589,600         1,350,415   85 %   1,589,600   n/a  
Fire Safety                                        
  Service     602,317     253,913         348,404   137 %   253,913   n/a  
  License & other     165,074     96,081         68,993   72 %   96,081   n/a  
   
 
 
 
     
     
      767,391     349,994         417,397   119 %   349,994   n/a  
Biometrics                                        
  Service     42,980     17,617     1,694     25,363   144 %   15,923   940 %
  License & other     93,247     107,009     87,387     (13,762 ) 13 %   19,622   22 %
   
 
 
 
     
     
      136,227     124,626     89,081     11,601   9 %   35,545   40 %
   
 
 
 
     
     
  Total COGS   $ 3,843,633   $ 2,064,220   $ 89,081   $ 1,779,413   86 % $ 1,975,139   2,217 %
   
 
 
 
     
     

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Revenues

Law Enforcement

        The increase in these revenue components from 2004 is primarily attributable to the fact that the business was acquired in the third quarter of 2004. Therefore 2004 represents only one quarter of revenue, whereas 2005 reflects four quarters of revenue. The increase was partially offset with a reduction of revenues related to long-term project work, which during 2005 has diminished as a result of the Company focusing the business to more of a licensing model.

Fire Safety

        The increase in these revenue components from 2004 is primarily attributable to the fact that the business was acquired in the third quarter of 2004. Therefore 2004 represents only one quarter of revenue, whereas 2005 reflects four quarters of revenue. This was compounded by a general increase in overall revenue that can be attributed to a strengthened market presence through concerted efforts toward penetrating new markets by actively pursuing and marketing our Fire Safety products. Additionally revenue growth can be also attributable to functionality that was added across the entire Fire Safety product suite as well as the release of new FireRMS mobile product which was released in the middle of 2005.

Biometrics

        During 2004 and 2005 Biometric segment continues to show strong revenue growth year over year. This is reflective of continued market acceptance of the product and strategic channel relationships that have been developed. Additionally, the product has been a proven solution in the educational industry as well has shown continued commercial integration and acceptance of the product.

Costs of goods sold

Law Enforcement

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. The slight decrease in cost is primarily driven by the sales mix and is solely dependent specifically on what products were sold.

        Service costs increased primarily because of personnel related costs that have increased over the prior year primarily from the inclusion of a full year of costs as compared to only one quarter in 2004. This was offset by reductions related to a reduced concentration of project related revenues which are heavily burdened with labor costs, both employees and contracted labor. As significant project revenues declined after the first two quarters of 2005, this reduction offset the increase that would have occurred related to maintaining a full twelve months of expense.

Fire Safety

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. The slight increase in cost is primarily driven by the sales volume in addition to product mix. These costs are solely dependent specifically on what products were sold.

        Services costs have increased over the prior year primarily from the inclusion of a full year of costs as compared to only one quarter as well as contractors and related costs that have been incurred related to project and service related revenues. There was a significant growth in service revenues for which additional outside contractors were used in providing some of those services.

19



Biometrics

        License and other costs are primarily related to the hardware costs related to sales of biometric fingerprint readers. The change in cost of goods sold is directly attributable to the product mix between types of readers sold and the volume of readers sold. During 2004 and 2003 the volume attributable to readers remained fairly constant whereas in 2005 volume decreased resulting in a reduction of related product cost.

        Service cost has increased during 2005 related primarily to a higher percentage of revenue requiring software customization and integration costs as compared to 2004 and 2003.

Selling, general and administrative

 
   
   
   
  2005-2004
  2004-2003
 
 
  2005
  2004
  2003
  $ Chg
  % Chg
  $ Chg
  % Chg
 
 
   
  Restated

  Restated

   
   
   
   
 
Law Enforcement   $ 7,471,524   $ 3,047,247   $   $ 4,424,277   145 % $ 3,047,247   n/a  
Fire Safety     2,802,220     783,948         2,018,272   257 %   783,948   n/a  
Biometrics     1,550,865     3,283,093     2,099,922     (1,732,228 ) (53 )%   1,183,171   56 %
   
 
 
 
     
     
  Total   $ 11,824,609   $ 7,114,288   $ 2,099,922   $ 4,710,321   66 % $ 5,014,366   238 %
   
 
 
 
     
     

        SG&A costs increased during the year as a result of 2005 representing a full 12 months worth of expenses as compared to 2004 which included only 3 months of expenses of the Law and Fire segments. As noted above, these costs are allocated based on the Segment's percentage of revenue. Changes in SG&A costs between business segments are the result of the change in their respective percentage of BIO-key's total revenue.

        During 2004 the increase in SG&A was primarily attributable to the acquisition of Mobile Government. The additional costs incurred were the result of legal and audit costs surrounding both the acquisition of Mobile Government as well as Public Safety Group. Additionally, the increase was due to an increased workforce in sales and administration functions as well as the associated overhead which results from fully loaded labor charges associated with supporting larger operations. This increase was offset slightly by the elimination of non essential functions done in order to align the business with its revised model of focusing sales through channel partners and creating a model focused on licensing as oppose to integration projects.

Research, development and engineering

 
   
   
   
  2005-2004
  2004-2003
 
 
  2005
  2004
  2003
  $ Chg
  % Chg
  $ Chg
  % Chg
 
Law Enforcement   $ 3,931,265   $ 1,309,026   $   $ 2,622,239   200 % $ 1,309,026   n/a  
Fire Safety     1,207,263     337,310         869,953   258 %   337,310   n/a  
Biometrics     1,707,507     1,333,568     1,037,330     373,939   28 %   296,238   29 %
   
 
 
 
     
     
  Total   $ 6,846,035   $ 2,979,904   $ 1,037,330   $ 3,866,131   130 % $ 1,942,574   187 %
   
 
 
 
     
     

Law Enforcement

        R&D costs have increased over 2004 primarily related to the acquisition of Mobile Government in Q3 of 2004. During 2005 the Company spent significant R&D resources in sustaining engineering related to the large customer base as well as developing new version releases that incorporated these changes. While remaining focused on achieving these operational objectives the Company also

20



undertook cost reduction initiatives which resulted in an approximately 25-30% reduction of the fourth quarter 2004 run rate for R&D costs in the Law Enforcement segment.

Fire Safety

        R&D costs have increased over 2004 primarily related to the acquisition of Mobile Government in Q3 of 2004. Additionally, subsequent to the acquisition, the company had several engineering initiatives in the Fire segment. As noted above a number of product enhancements were made to functionality across the entire software suite in addition to focused development of the new FireRMS mobile solution delivered to the market mid 2005. While remaining focused on achieving these product objectives, in conjunction with the Company wide cost reduction initiatives, Fire Safety was able to realize an approximate reduction of 10% the fourth quarter 2004 run rate for R&D costs.

Biometrics

        R&D costs have increased sequentially from 2003 to 2005. This is representative of the increased spending to enhance the interoperability and functionality of the software. The company continues to spend in R&D to enhance the products usability in different markets as well as to develop the product for integration with products from BIO-key's other segments. During 2005, BIO-key released IdentityMatch, a product which integrates BIO-key's advanced biometric offerings with BIO-key's mobile data and fire records management solutions. BIO-key continues to develop further integration of its Biometric software solutions in other products with in Company as well as partnering with other solutions in the marketplace. Additionally, in May of 2005 the Company was awarded a patent for its award-winning leadership Vector Segment fingerprint technology or "Image Identification System."

Other income and expense

 
   
   
   
  2005–2004
  2004–2003
 
 
  2005
  2004
  2003
  $ Chg
  % Chg
  $ Chg
  % Chg
 
 
  Restated

  Restated

  Restated

   
   
   
   
 
Interest expense   $ (4,521,344 ) $ (1,415,535 ) $ (1,909,788 ) $ (3,105,809 ) 219 % $ 494,253   26 %
Interest income     35,958     66,824         (30,866 ) (46 )%   66,824   n/a  
Gain on sale of marketable securities     (20,000 )   33,125         (53,125 ) (160 )%   33,125   n/a  
Non-cash interest income (expense)     9,154,951     (3,008,419 )   857,545     12,163,370   (404 )%   (3,865,964 ) (451 )%
Other income (expense)     (34,767 )   (88,425 )   4,145     53,658   (61 )%   (92,570 ) (2,233 )%
   
 
 
 
     
     
    $ 4,614,798   $ (4,412,430 ) $ (1,048,098 ) $ 9,027,228   (205 )% $ (3,364,332 ) 321 %
   
 
 
 
     
     

        For the year ended December 31, 2005, consolidated interest expense increased $3,105,809 or 219% as compared to 2004, which was attributable to the increase in long term debt from issuance of the 2004 and 2005 Senior and Subordinated notes. For the year ended December 31, 2004, consolidated interest expense increased $494,253 or 26% from 2003.

        For the year ended December 31, 2005, consolidated interest income decreased $30,866 or 46% as compared to 2004, which was attributable to the average amount of cash held on hand in interest bearing accounts. For the year ended December 31, 2004, consolidated interest income increased $66,824 as compared to 2003, which was attributable to deposits held in interest bearing accounts in 2004. No deposits were held in interest bearing accounts in 2003.

        For the year ended December 31, 2005, consolidated derivative and warrant fair value adjustments increased $12,163,370 or 404% as compared to 2004, which was attributable to changes in the fair

21



market value of embedded derivatives and detachable warrants issued with convertible debt. The fair value of the derivatives will fluctuate based on; our stock price at particular points in time, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the time to maturity of the outstanding debt at different points in time. The major factor contributing to this change was due to the decline in the market price of our stock from $1.60 as of December 31, 2004 to $.69 as of December 31, 2005. For the year ended December 31, 2004, derivative and warrant fair value adjustments decreased $3,865,964 or 451% as compared to 2003, which was also attributable to changes in the fair value of embedded derivatives and detachable warrants issued with convertible debt. The major factor contributing to the large fluctuation in the fair value was due to the net increase in the market price of our stock from $1.03 as of September 29, 2004 to $1.60 as of December 31, 2004.

THREE AND SIX MONTHS ENDED JUNE 30, 2006 AS COMPARED TO JUNE 30, 2005

 
  Three Months Ended June 30,
 
 
  2006
  2005
 
Revenues          
  Services   76 % 75 %
  License fees and other   24 % 25 %
   
 
 
    100 % 100 %
   
 
 
Costs and other expenses          
  Services   18 % 28 %
  Cost of license fees and other   3 % 6 %
  Selling, general and administrative   73 % 85 %
  Research, development and engineering   41 % 45 %
   
 
 
    135 % 164 %
   
 
 
Operating loss   -35 % -64 %

Other income (deductions)

 

 

 

 

 
  Total other income (deductions)   7 % 23 %
   
 
 
NET LOSS   -28 % -41 %
   
 
 

        The Law Enforcement and Fire Safety segments were purchased during 2004. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods has been estimated.

        The Company evaluates performance and allocates resources based on revenues and operating income (loss). Operating income (loss) for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues and other factors. The segmentation of operating income as noted above and detailed below reflects how management now evaluates its business. Assets for the Company are

22



commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.

 
  Three months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Revenues                        
Law Enforcement                        
  Service   $ 2,380,970   $ 2,086,719   $ 294,251   14 %
  License & other     494,618     746,814     (252,196 ) -34 %
   
 
 
 
 
      2,875,588     2,833,533     42,055   1 %
   
 
 
 
 
Fire Safety                        
  Service     523,063     657,188     (134,125 ) -20 %
  License & other     275,597     86,067     189,530   220 %
   
 
 
 
 
      798,660     743,255     55,405   7 %
   
 
 
 
 
Biometrics                        
  Service     19,996     17,979     2,017   11 %
  License & other     138,527     90,785     47,742   53 %
   
 
 
 
 
      158,523     108,764     49,759   46 %
   
 
 
 
 
  Total Revenue   $ 3,832,771   $ 3,685,552   $ 147,219   4 %
   
 
 
 
 
Cost of goods sold                        
Law Enforcement                        
  Service   $ 416,113   $ 825,916   $ (409,803 ) -50 %
  License & other     101,946     157,634     (55,688 ) -35 %
   
 
 
 
 
      518,059     983,550     (465,491 ) -47 %
   
 
 
 
 
Fire Safety                        
  Service     254,901     200,880     54,021   27 %
  License & other     2,589     27,240     (24,651 ) -90 %
   
 
 
 
 
      257,490     228,120     29,370   13 %
   
 
 
 
 
Biometrics                        
  Service     7,205     7,330     (125 ) -2 %
  License & other     27,040     20,512     6,528   32 %
   
 
 
 
 
      34,245     27,842     6,403   23 %
   
 
 
 
 
  Total COGS   $ 809,794   $ 1,239,512   $ (429,718 ) -35 %
   
 
 
 
 

Revenues

Law Enforcement

        The revenue for this segment in 2006 includes $635,000 of service revenue from a long-term project that the Company had participated in as a subcontractor. The revenue was deferred until evidence of full acceptance by the end user was received by the Company. That increase was offset by a reduction in revenue from other longer-term project work that was included in 2005 as the Company moves to more of a licensing-based model.

23



Fire Safety

        The overall revenue for this segment increased 7% over the same quarter in the prior year. However, the mix between service and license revenue continued to reflect the Company's efforts to move to more of a licensing-based model.

Biometrics

        The Biometric segment continued to show revenue growth. As the Biometric market continues to grow, the Company expects to see increased revenue in this segment.

Costs of goods sold

Law Enforcement

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty and is primarily driven by the sales mix and is solely dependent specifically on what products were sold.

        Due to the change in focus from long-term project revenue to licensing agreements, cost of good sold in total for the segment decreased from 2005 as labor costs, for both employees' and consultants are eliminated as projects are completed.

Fire Safety

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. These costs are solely dependent specifically on what products were sold.

        Overall costs of goods sold for the segment were higher in 2006 due to increased sales volume in the period.

Biometrics

        License and other costs are primarily related to the hardware costs related to sales of biometric fingerprint readers. The change in cost of goods sold is directly attributable to the product mix between types of readers sold and the volume of readers sold.

Selling, general and administrative

 
  Three months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Law Enforcement   $ 1,326,876   $ 1,974,866   $ (647,990 ) -33 %
Fire Safety     816,346     740,681     75,665   10 %
Biometrics     646,714     409,924     236,790   58 %
   
 
 
 
 
  Total   $ 2,789,936   $ 3,125,471   $ (335,535 ) -11 %
   
 
 
 
 

        As discussed previously, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety in the fourth quarter of 2005. For 2005, SG&A costs were allocated to the segments based on several factors including management's estimates and percentage of revenue. For 2006, sales expenses are a direct cost to the segment and G&A costs are allocated between business segments on fixed percentages that were established by management during the budgeting process.

24



        The overall decline in total SG&A costs for the quarter ended June 30, 2006 as compared to 2005 are primarily attributable to the continued focus by management on cost reduction initiatives taken during the fourth quarter of 2005 after the acquisitions of Public Safety Group and Aether Mobile Government were completed. Management believes the appropriate resources are in place to support its strategic goals but also continues to analyze the expense structure and continues to explore ways to further reduce costs. During the quarter ended June 30, 2006, these reductions have been partially offset by additional costs related to reporting and compliance that the Company has experienced due to the restatements of our previously filed financial statements.

Research, development and engineering

 
  Three months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Law Enforcement   $ 945,234   $ 1,039,072   $ (93,838 ) -9 %
Fire Safety     310,693     319,091     (8,398 ) -3 %
Biometrics     326,507     312,308     14,199   5 %
   
 
 
 
 
  Total   $ 1,582,434   $ 1,670,471   $ (88,037 ) -5 %
   
 
 
 
 

Law Enforcement and Fire Safety

        R&D costs have decreased in the second quarter of 2006 as compared to 2005 primarily related to the staff and cost structure reductions undertaken to move the Company toward the break-even point while still supporting sales growth.

Biometrics

        R&D costs in this segment have increased slightly over the second quarter of 2006 as compared to 2005 as the Company continues to develop further integration of its Biometric software solutions in other products with in Company as well as partnering with other solutions in the marketplace.

Other income and expense

 
  Three months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Interest income   $   $ 2,988   $ (2,988 ) -100 %
Interest expense     (2,262,632 )   (552,093 )   (1,710,539 ) 310 %
Derivative and warrant fair value adjustments     2,556,159     1,373,367     1,182,792   86 %
Other income (expense)     (17,118 )   (532 )   (16,586 ) 3,118 %
   
 
 
 
 
  Total   $ 276,409   $ 823,730   $ (547,321 ) -66 %
   
 
 
 
 

        For the quarter ended June 30, 2006, consolidated interest expense increased $1,710,539 or 310% as compared to the same quarter in 2005. The increase was attributable to increases in long term debt, related discount and other debt related instruments. Interest expense includes actual cash paid for interest as well non-cash charges for amortization of debt discounts, and interest expense on the letter of credit arrangement, as well as deferred rent obligations. The increase in interest expense during 2006 was primarily related to the default interest provisions and the liquidating damages provisions with respect to the convertible debt instruments.

25



        For the quarters ended June 30, 2006 and 2005, derivative and warrant fair value adjustments increased, which was attributable to changes in the fair market value of embedded derivatives and detachable warrants issued with convertible debt, including the additional derivatives recorded as a result of the May, June and July 2005 and January 2006 debt tranches. The changes represent non-cash income and expenses charges to the statement of operations. The fair value of the derivatives will fluctuate based on; our stock price on the valuation date, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the time to maturity of the outstanding debt at different points in time.

SIX MONTHS ENDED JUNE 30, 2006 AS COMPARED TO JUNE 30, 2005

Consolidated Results of Operations—Percent Trend

 
  Six Months Ended June 30,
 
 
  2006
  2005
 
Revenues          
  Services   74 % 76 %
  License fees and other   26 % 24 %
   
 
 
    100 % 100 %
Costs and other expenses          
  Services   20 % 25 %
  Cost of license fees and other   3 % 7 %
  Selling, general and administrative   77 % 78 %
  Research, development and engineering   46 % 49 %
   
 
 
    146 % 159 %
   
 
 
Operating loss   -46 % -59 %

Other income (deductions)

 

 

 

 

 
  Total other income (deductions)   -24 % 47 %
   
 
 
NET LOSS   -70 % -12 %
   
 
 

        The Law Enforcement and Fire Safety segments were purchased during 2004. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods has been estimated.

26


        The Company evaluates performance and allocates resources based on revenues and operating income (loss). Operating income (loss) for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues and other factors. The segmentation of operating income as noted above and detailed below reflects how management now evaluates its business. Assets for the Company are commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.

 
  Six months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Revenues                        
Law Enforcement                        
  Service   $ 3,979,530   $ 4,439,496   $ (459,966 ) -10 %
  License & other     920,682     1,464,547     (543,865 ) -37 %
   
 
 
 
 
      4,900,212     5,904,043     (1,003,831 ) -17 %
   
 
 
 
 

Fire Safety

 

 

 

 

 

 

 

 

 

 

 

 
  Service     1,154,795     1,319,416     (164,621 ) -12 %
  License & other     348,997     191,934     157,063   82 %
   
 
 
 
 
      1,503,792     1,511,350     (7,558 ) -1 %
   
 
 
 
 

Biometrics

 

 

 

 

 

 

 

 

 

 

 

 
  Service     36,613     62,828     (26,215 ) -42 %
  License & other     541,344     146,922     394,422   268 %
   
 
 
 
 
      577,957     209,750     368,207   176 %
   
 
 
 
 
  Total Revenue   $ 6,981,961   $ 7,625,143   $ (643,182 ) -8 %
   
 
 
 
 

Cost of goods sold

 

 

 

 

 

 

 

 

 

 

 

 
Law Enforcement                        
  Service   $ 862,271   $ 1,501,389   $ (639,118 ) -43 %
  License & other     135,034     408,885     (273,851 ) -67 %
   
 
 
 
 
      997,305     1,910,274     (912,969 ) -48 %
   
 
 
 
 

Fire Safety

 

 

 

 

 

 

 

 

 

 

 

 
  Service     471,810     347,709     124,101   36 %
  License & other     40,148     82,810     (42,662 ) -52 %
   
 
 
 
 
      511,958     430,519     81,439   19 %
   
 
 
 
 

Biometrics

 

 

 

 

 

 

 

 

 

 

 

 
  Service     18,010     20,594     (2,584 ) -13 %
  License & other     37,877     41,547     (3,670 ) -9 %
   
 
 
 
 
      55,887     62,141     (6,254 ) -10 %
   
 
 
 
 
  Total COGS   $ 1,565,150   $ 2,402,934   $ (837,784 ) -35 %
   
 
 
 
 

27


Revenues

Law Enforcement

        The revenue for this segment in 2006 includes $635,000 of service revenue from a long-term project that the Company had participated in as a subcontractor. The revenue was deferred until evidence of full acceptance by the end user was received by the Company. That increase was offset by a reduction in revenue from other longer-term project work that was included in 2005 as the Company moves to more of a licensing-based model.

Fire Safety

        The revenue for this segment decreased slightly over the same quarter in the prior year. Although revenue decreased, the mix between service and license revenue continued to reflect the Company's efforts to move to more of a licensing-based model.

Biometrics

        The Biometric segment continued to show strong revenue growth in the first six months of 2006. The growth in 2006 is primarily attributable to a large license order in Q1 2006 from a new customer. The Biometric business continues to gain traction and acceptance in the market place and is pursuing new customers to grow its installed customer base.

Costs of goods sold

Law Enforcement

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. The decrease in cost is primarily driven by the sales mix and is solely dependent specifically on what products were sold.

        Due to the change in focus from long-term project revenue to licensing agreements, cost of good sold also decreased as labor costs, both employees' costs are reduced and consultants are eliminated as projects are completed.

Fire Safety

        License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. The slight decrease in cost is primarily driven by the sales volume in addition to product mix. These costs are solely dependent specifically on what products were sold.

        Services costs have increased over the same period in the prior year, as this segment represents a higher percentage of overall revenue to the Company.

Biometrics

        License and other costs are primarily related to the hardware costs related to sales of biometric fingerprint readers. The change in cost of goods sold is directly attributable to the product mix between types of readers sold and the volume of readers sold.

28



Selling, general and administrative

 
  Six months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Law Enforcement   $ 2,591,725   $ 3,773,541   $ (1,181,816 ) -31 %
Fire Safety     1,558,780     1,415,280     143,500   10 %
Biometrics     1,215,885     783,273     432,612   55 %
   
 
 
 
 
  Total   $ 5,366,390   $ 5,972,094   $ (605,704 ) -10 %
   
 
 
 
 

        As discussed previously, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety in the fourth quarter of 2005. For 2005, SG&A costs were allocated to the segments based on several factors including management's estimates and percentage of revenue. For 2006, sales expenses are a direct cost to the segment and G&A costs are allocated between business segments on fixed percentages that were established by management during the budgeting process.

        The overall decline in total SG&A costs for the six months ended June 30, 2006 as compared to the same period in 2005 are primarily attributable to the cost reduction initiatives taken during the fourth quarter of 2005 after the acquisitions of Public Safety Group and Aether Mobile Government were completed. Management believes the appropriate resources are in place to support its strategic goals but also continues to analyze the expense structure and continues to explore ways to further reduce costs.

Research, development and engineering

 
  Six months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Law Enforcement   $ 1,972,592   $ 2,329,813   $ (357,221 ) -15 %
Fire Safety     611,249     715,468     (104,219 ) -15 %
Biometrics     653,230     700,260     (47,030 ) -7 %
   
 
 
 
 
  Total   $ 3,237,071   $ 3,745,541   $ (508,470 ) -14 %
   
 
 
 
 

Law Enforcement and Fire Safety

        R&D costs have decreased for the six months ended June 30 of 2006 as compared to 2005 primarily related to the staff and cost structure reductions undertaken to move the Company toward the break-even point while still supporting sales growth.

Biometrics

        R&D costs have decreased for the six months ended June 30 of 2006 as compared to 2005, however the reduction in costs was due to higher costs in 2005 and not related to any significant staff reductions or other cost savings initiatives. The Company continues to develop further integration of its Biometric software solutions in other products with in Company as well as partnering with other solutions in the marketplace.

29



Other income and expense

 
  Six months ended
June 30,

   
   
 
 
   
  % Change
 
 
  2006
  2005
  $ Change
 
Interest income   $   $ 29,050   $ (29,050 ) -100 %
Interest expense     (4,329,156 )   (1,387,009 )   (2,942,147 ) 212 %
Loss on extinguishment of debt     (2,322,016 )       (2,322,016 ) %
Derivative and warrant fair value adjustments     5,000,852     4,950,248     50,604   1 %

Other income (expense)

 

 

(32,294

)

 

(20,532

)

 

(11,762

)

57

%
   
 
 
 
 
  Total   $ (1,682,614 ) $ 3,571,757   $ (5,254,371 ) -147 %
   
 
 
 
 

        For the second quarter ended June 30, 2006, consolidated interest expense increased $2,942,147 or 212% as compared to the same quarter in 2005. The increase was attributable to increases in long term debt, related discount and other debt related instruments. Interest expense includes actual cash paid for interest as well non-cash charges for amortization of debt discounts, and interest expense on the letter of credit arrangement, as well as deferred rent obligations. The increase in interest expense during 2006 was primarily related to the default interest provisions and the liquidating damages provisions with respect to the convertible debt instruments.

        For the six months ended June 30, 2006 and 2005, derivative and warrant fair value adjustments increased, which was attributable to changes in the fair market value of embedded derivatives and detachable warrants issued with convertible debt, including the additional derivatives recorded as a result of the May, June and July 2005 and January 2006 debt tranches. The changes represent non-cash income and expenses charges to the statement of operations. The fair value of the derivatives will fluctuate based on; our stock price on the valuation date, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the time to maturity of the outstanding debt at different points in time.

30


LIQUIDITY AND CAPITAL RESOURCES

OPERATING ACTIVITIES OVERVIEW

YEARS ENDED DECEMBER 31, 2005, AS COMPARED TO DECEMBER 31, 2004, AND DECEMBER 31, 2004 AS COMPARED TO DECEMBER 31, 2003

        The net cash used in operating activities during 2005 was $4,513,497, as compared to $5,644,759 and $2,857,145 in 2004 and 2003, respectively. Some of the major drivers of this change are discussed in more detail below.

        The Company's income statement includes four non-cash items which made the most significant contributions to the net cash used in operating activities in 2004 and 2005.

        For the year ended December 31, 2005, the Company reported positive cash flows related to a decrease in costs and earnings in excess of billings on uncompleted contracts of $2,468,770. Costs and earnings in excess of billings on uncompleted contracts represent services which have been performed on long term contracts but have not been invoiced at year end due to milestones contained within the contracts. In 2005, the Company was able to bill the customer due to the fact that the milestones have been reached.

        The Company experienced positive cash flows of $1,029,404 in 2005 due to increased accrued liabilities related to interest on the 2005 debt as well as contract related costs not being invoiced by vendors. In 2004, the Company experienced positive cash flows of $955,050 related to interest on the 2004 debt as well as liabilities assumed through acquisitions.

        The Company also experienced a positive cash flow from an increase of $1,191,958 in deferred revenue from 2004 to 2005 due to customers who had purchased and paid for maintenance agreements which the company had to earn typically over a one year period.

        The overall major drivers in operating cash flow are the current operating costs which are greater than the current revenues. The company has experienced improvements related to the ratio of operating expenses to revenues and expects this trend to continue to improve until such time as the Company is able to generate sustained profitability.

31



SIX MONTHS ENDED JUNE 30, 2006 AS COMPARED TO JUNE 30, 2005

        Net cash used in operations during the six months ended June 30, 2006 was approximately $1,905,000 compared to approximately $3,752,000 during the six months ended June 30, 2005. Some of the major drivers of this change are discussed in more detail below.

        The following non-cash items that are reflected in the Company's statement of operations are used to reconcile the net loss to the net cash used in operating activities during the six months ended June 30, 2006:

        Net cash used in investing activities for the six months ended June 30, 2006 was approximately $907,000, largely a result of the return of deposits related to long-term contracts. This compares to net cash provided by investing activities of approximately $1,389,000 for the corresponding period in 2005. The 2005 amount consisted of approximately $980,000 from sale of marketable securities and $50,000 in proceeds from the sale of a trademark.

        Net cash provided by financing activities during the six months ended June 30, 2006 was approximately $859,000 compared to net cash provided by financing activities of approximately $3,380,000 in the corresponding period in 2005. The 2006 amount included debt proceeds of $988,000 offset by $85,000 of debt repayments and $53,000 for costs to issue the new debt. The 2005 amount included debt proceeds of approximately $4,515,000, proceeds from warrants and option exercises of approximately $539,000, offset by debt repayments of approximately $1,405,000.

        Working capital deficit at June 30, 2006 was approximately $11,268,000 as compared to a deficit of approximately $8,952,000 at December 31, 2005.

32



        Since January 7, 1993 (date of inception), our capital needs have been principally met through proceeds from the sale of equity and debt securities.

        We do not expect any material capital expenditures during the next twelve months.

        We do not currently maintain a line of credit or term loan with any commercial bank or other financial institution.

FINANCING ACTIVITIES OVERVIEW

Financing Activities

        On June 8, 2005, we entered into a Securities Purchase Agreement (the "Senior Purchase Agreement") with an institutional investor. Under the Senior Purchase Agreement, the Company issued a Secured Convertible Term Note (the "Senior Convertible Note") in the aggregate principal amount of $2,000,000, convertible into Common Stock of the Company in certain circumstances at $0.85 per share, and issued a warrant (the "Senior Warrant") to purchase an aggregate of 444,444 shares of the Common Stock at a per share exercise price of $1.00. The aggregate consideration received by the Company, net of all fees and expenses, for the Senior Convertible Note and the Senior Warrant was approximately $1,841,000. The proceeds from this transaction are to be used for working capital purposes. The Company's obligations under the Senior Purchase Agreement and the Senior Convertible Notes are secured by a security interest in all or substantially all of the Company's assets.

        Under the terms of the Senior Convertible Note, we are required to make monthly payments of accrued interest only beginning on July 1, 2005. In addition, the Senior Convertible Note provides for monthly payments of principal in equal 1/32 increments thereof, plus accrued interest, commencing October 1, 2005.

        We entered into a Securities Purchase Agreement, effective as of May 31, 2005, (the "Subordinated Purchase Agreement") with existing shareholders of the Company and other accredited investors (collectively, the "Subordinated Investors"). Under the Subordinated Purchase Agreement, the Company issued Convertible Term Notes (the "Subordinated Convertible Notes") in the aggregate principal amount of $2,794,723, respectively convertible into Common Stock of the Company in certain circumstances at $0.70 per share, and issued warrants (the "Subordinated Warrants") to purchase an aggregate of 828,066 shares of the Common Stock at a per share exercise price of $1.00. The aggregate consideration received by the Company, net of all fees and expenses, for such Subordinated Convertible Notes and Subordinated Warrants was approximately $2,411,000. The proceeds from this transaction are to be used for working capital purposes. The Subordinated Convertible Notes were issued at a purchase price equal to $900 for each $1,000 of principal amount of the Note.

        Certain Subordinated Investors purchased additional Subordinated Convertible Notes in the aggregate principal amount of $450,000 and received additional Subordinated Warrants to purchase an aggregate of 133,333 shares of Common Stock at a per share exercise price of $1.00. The aggregate consideration received by the Company net of all fees and expenses for such Subordinated Convertible Notes and Subordinated Warrants was $404,500, which was paid by the Subordinated Investors on July 8, 2005.

        Under the terms of the Subordinated Convertible Notes, we are required to make quarterly payments of accrued interest only beginning on September 1, 2005. In addition, the Subordinated Convertible Notes provide for quarterly payments of principal in equal increments thereof, plus accrued interest, commencing September 1, 2006 through May 31, 2008, which payments may be made in shares of common stock at the option of each note holder.

33



        The Company entered into an Amendment and Waiver with Laurus, dated as of August 31, 2005, pursuant to which the Company was permitted to defer the payment of the monthly principal amounts due and payable for the months of September, October, November and December 2005 under both (a) the Secured Convertible Term Note in the original principal amount of $5,000,000 issued by the Company to Laurus on September 29,2004 (the "September 2004 Note"), and (b) the Secured Convertible Term Note in the original principal amount of $2,000,000 issued by the Company to Laurus on June 8, 2005 (the "June 2005 Note"), such aggregate deferred principal amounts being equal to $625,000 and $187,500, respectively. The deferred principal amount under the September 2004 Note is now due on September 29, 2007, the maturity date of that note, and will be paid at the same time the final payments due with respect to that note upon maturity. The deferred principal amount under the June 2005 Note is now due on June 7, 2008, the maturity date of that note, and will be paid at the same time the final payments due with respect to that note upon maturity. The Company will remain obligated to pay all monthly interest amounts under these notes as they are currently due.

        The Company also entered into Amendment and Waivers, dated as of August 31, 2005, pursuant to which certain Subordinated Investors allowed the Company to defer the payment of the monthly principal amounts due and payable for the months of September, October, November and December 2005 under the Convertible Term Notes in the aggregate original principal amount of $2,800,000 issued by the Company to the Subordinated Investors on September 29, 2004 (the "Subordinated Notes"), such aggregate deferred principal amount being equal to $350,004. The deferred principal amount under each Subordinated Note is now due on September 29, 2007, the maturity date of each such note, and will be paid at the same time the final payments due with respect to each such note upon maturity. The Company will remain obligated to pay all monthly interest amounts under these notes as they are currently due.

        The Company entered into an Amendment No. 1 to its Subordinated Secured Promissory Note, dated as of January 23, 2006, with Aether Systems, Inc. Pursuant to the Aether Note Amendment, the Subordinated Secured Promissory Note issued by the Company to Aether on September 30, 2004 in the aggregate maximum principal amount of $6,884,588 was amended to increase such aggregate maximum principal amount to $7,884,588.

        The Company entered into a Securities Purchase Agreement, effective as of January 23, 2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance. Under the Securities Purchase Agreement, the Company issued to the Purchasers Convertible Term Notes in the aggregate principal amount of $1,000,000. The Convertible Notes converted into shares of the Series B Preferred Stock of the Company, which shares are convertible into shares of the Common Stock of the Company at an initial fixed conversion price of $0.70 per share.

        Effective as of January 23, 2006, BIO-key International, Inc. entered into an Amendment and Waiver with Laurus Master Fund Ltd. in connection with the Secured Convertible Notes currently held by Laurus. Under the Secured Notes Amendment and Waiver, the Secured Notes issued by the Company to Laurus on September 29, 2004 in the aggregate principal amount of $5,000,000 and on June 7, 2008 in the aggregate principal amount of $2,000,000 were amended as follows: (i) the maturity date of the September 2004 Note was extended to January 1, 2008; (ii) the maturity date of the June 2005 Note was extended to December 1, 2008, and (iii) the fixed conversion price under each of the Secured Notes was reset from $1.35 to $0.85 per share. In addition, the exercise price of all warrants to purchase Common Stock of the Company held by Laurus was reset to $1.00 per share.

        Effective as of January 23, 2006, the Company also entered into an Amendment and Waiver with certain holders of its Subordinated Convertible Promissory Notes. Under the Subordinated Notes

34



Amendment and Waiver, the Subordinated Notes issued by the Company on September 29, 2004 in the aggregate principal amount of $5,288,221 and on May 31, 2005 in the aggregate principal amount of $3,244,723 were amended as follows: (i) the maturity dates were extended from September 29, 2007 and May 31, 2008, respectively, to January 1, 2009; (ii) the interest rate was fixed at fifteen percent (15%); (iii) all principal amounts are due at the maturity date and shall be paid in shares of Common Stock priced at $0.70 per share if the average closing price of the Common Stock for the thirty (30) trading days immediately preceding the maturity date is greater than $1.10; (iv) interest shall be paid, at the Company's election, in cash or shares of Common Stock, with the Common Stock priced at the average closing price of the Common Stock for the ten (10) trading days immediately preceding the repayment date; and (v) the currently applicable fixed conversion price was amended to $0.70 per share. In addition, the exercise price of all warrants to purchase Common Stock held by the Subordinated Note Holders that currently have an exercise price greater than $1.00 per share was reset to $1.00 per share. In connection with this financing, we also reduced the conversion price of the Series A Convertible Preferred shares held by the Shaar Fund Ltd. to $0.70 per share.

        Effective as of August 10, 2006, the Company also entered into an Amendment and Waiver with Laurus in connection with the holder of its Secured Convertible Notes currently held by Laurus. Under the Amendment and Waiver, the September 2004 Note and June 2005 Note were amended as follows: (i) the principal amounts due and payable under the 2004 Note and the 2005 Note for the months of August and September 2006, respectively, shall be paid in shares of the Company's Common Stock priced at $0.50 per share; and (ii) the principal amount due and payable under the 2004 Note for the months of October, November and December 2006 is deferred until January 1, 2008, the final maturity date of the 2004 Note, and the principal amount due and payable under the 2005 Note for the months of October, November and December 2006 is deferred until December 1, 2008, the final maturity date of the 2005 Note. Pursuant to this Amendment and Waiver, the Company issued 150,000 shares of its common stock to Laurus as consideration for the principal payment deferral. In connection with this financing, the Company reduced the conversion price under each of the September 2004 Note and June 2005 Note to $0.50 per share.

        Effective as of August 10, 2006, the Company also entered into a Securities Exchange Agreement with certain holders of its Subordinated Convertible Promissory Notes. Under the Securities Exchange Agreement, certain Subordinated Notes issued by the Company on September 29, 2004 in the aggregate principal amount of $5,288,221 and on May 31, 2005 in the aggregate principal amount of $3,244,723 were amended as follows: (i) the aggregate principal amount outstanding under the Notes, plus accrued and unpaid interest, and liquidated damages were exchanged for shares of Series C Convertible Preferred Stock; and (ii) in addition, the exercise price of all warrants held by Subordinated Note Holders dated May 31, 2005 and January 23, 2006, to purchase Common Stock of the Company was reset to $0.50 per share. In connection with this financing, the Company also reduced the conversion price of the Series A and Series B Convertible Preferred shares to $0.50 per share.

        The Company entered into (i) a Securities Purchase Agreement (the "Trellus Securities Purchase Agreement"), dated as of August 10, 2006, with Trellus Partners, L.P. ("Trellus") and (ii) a Securities Purchase Agreement (the "Shaar Securities Purchase Agreement"), dated as of August 10, 2006, with Shaar. Under the Trellus Securities Purchase Agreement, the Company (i) issued and sold 3,000,000 shares of its Common Stock (the "Trellus Shares") to Trellus, at a purchase price of $0.50 per share, for an aggregate purchase price of $1,500,000 and (ii) issued a warrant to Trellus (the "Trellus Warrant") to purchase up to an aggregate of 400,000 shares of the Company's Common Stock at an exercise price of $0.75 per share.

        Under the Shaar Securities Purchase Agreement, the Company agreed to (i) issue and sell 1,000,000 shares of its Common Stock (the "Shaar Shares") to Shaar, at a purchase price of $0.50 per share, for an aggregate purchase price of $500,000 to be paid by exchanging Shaar's rights in an aggregate amount of $500,000 in declared and unpaid dividends on the Shares of Series A Convertible

35



Preferred Stock currently held by Shaar; and (ii) issue a warrant to Shaar (the "Shaar Warrant") to purchase up to an aggregate of 133,333 shares of the Company's Common Stock at an exercise price of $0.75 per share.

Liquidity outlook

        At June 30, 2006 our total of cash and cash equivalents was $1,284,123 as compared to $1,422,827 at December 31, 2005. As discussed above, the Company has financed itself through access to the capital markets by issuing debt securities, Convertible Preferred Stock and common stock.

        As discussed above, subsequent to June 30, 2006, the Company entered into securities purchase agreements to issue and sell 4,000,000 shares of its common stock to several investors at a price of $0.50 per share for an aggregate purchase price of $2,000,000 of which $1,500,000 was received in cash, and $500,000 was paid in declared and unpaid dividends.

        Also, as discussed above, subsequent to June 30, 2006, the Company entered into a securities exchange agreement under which approximately $5,000,000 of subordinated convertible debt plus accrued interest was exchanged for the Company's Series C Convertible Preferred Stock.

        We currently require approximately $1,700,000 per month to conduct our operations. During the first half of 2006, we generated approximately $6,982,000 of revenue and expect to increase quarterly revenue in 2006.

        The Company has undertaken strategic steps to position itself to realize positive cash flows from operations in the future by increasing revenues and better managing expenses. These steps include the acquisition of two enterprises in 2004. Although the acquisitions inherently produced a greater demand for cash than we would have liked, we are confident that many of the initial costs are isolated in nature and will not be recurring year after year. The Company has also taken strategic steps to downsize the workforce in areas that we felt were either non-essential or not in line with where we wanted the Company to develop in the near future. The Company has also recently experienced additional costs associated with various compliance related activities.

        We may need to obtain additional funding to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. Due to several factors, including our history of losses and limited revenue, our former independent auditors have included an explanatory paragraph in opinions that they have previously issued related to our annual financial statements as to the substantial doubt about our ability to continue as a going concern. Our long-term viability and growth will depend upon the successful commercialization of our technologies and our ability to obtain adequate financing. To the extent that we require such additional financing, no assurance can be given that any form of additional financing will be available on terms acceptable to us, that adequate financing will be obtained to meet our needs, or that such financing would not be dilutive to existing stockholders. If available financing is insufficient or unavailable or we fail to continue to generate meaningful revenue, we may be required to further reduce operating expenses, delay the expansion of operations, be unable to pursue merger or acquisition candidates, or continue as a going concern.

36



CONTRACTUAL OBLIGATIONS

        We have various contractual obligations impacting our liquidity. The following represents some of our contractual obligations as of December 31, 2005:

 
  Total
  2006
  2007
  2008
  2009
Non-cancelable operating leases   $ 3,427,000   $ 1,260,000   $ 1,278,000   $ 866,000   $ 23,000
Senior secured convertible term notes     5,599,999     1,524,211     3,048,421     1,027,367    
Subordinated unsecured convertible term notes     5,677,028     18,750     14,063         5,644,215
   
 
 
 
 
Total   $ 14,704,027   $ 2,802,961   $ 4,340,484   $ 1,893,367   $ 5,667,215
   
 
 
 
 

        The Company does not own any real estate but conducts operations from four leased premises. These non-cancelable operating leases expire a various dates through 2009. In addition to base rent, the Company pays for property taxes, maintenance, insurance and other occupancy expenses according to the terms of the individual leases.

RESTATEMENT

        In the process of reviewing our registration statement for the securities issued in our June 2005 financing, the staff of the Securities and Exchange Commission ("SEC") raised questions with regard to our convertible term notes suggesting that we consider EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" to evaluate whether there were any embedded derivative instruments and if so, whether they should be accounted for as an equity or liability classification. The SEC staff suggested that we review the methodology used in the valuations of the embedded derivative instruments and also review whether warrants issued with our 2004 financing should be accounted for as an equity or liability classification. The SEC staff also commented that the Company should review the convertible notes issued in fiscal 2003 and 2004. The SEC staff also asked us to review adjustments to revenue made in the fourth quarter of 2004. The SEC staff raised the question of whether the transactions had a material impact on previously filed Exchange Act reports and would be better characterized as restatements. Further, the Company recalculated the Convertible Preferred Stock dividends and accretion including the accrued but unpaid dividends in accordance with FAS 128—Earnings per Share.

        There were several items that were identified as requiring restatement, these items were:

37


        Additionally, it was identified that certain other components of the related financings were also incorrectly accounted for. This includes the warrants issued with the above financing and the costs incurred by Company in obtaining the above financings. The correction of prior errors affected the subsequent accounting for debt conversions to equity as well as the amortization of related discounts and deferred finance charges associated with the above financings.

        The Company reviewed the earnout calculations performed in the prior year for the PSG acquisition and identified an error in the calculation. As a result the Company has restated the prior year's impact relating to this error. At December 31, 2004 the Company had accrued $43,635 for the earnout provision. The corrected calculation resulted in no accrual being required, and as such the related accrual and goodwill balances have been reduced by $43,635.

        Management believes the scope and process of its internal review of previously reported financial information was sufficient to identify issues of a material nature that could affect our Consolidated

38



Financial Statements and all dates and periods presented herein have been restated to fairly present the results of our operations.

        The errors in our previously reported financial information, and the failure to prevent them or detect them in our financial reporting process, were largely attributable to weak internal controls, an inadequate staff of competent accounting personnel with an appropriate level of knowledge of GAAP and to errors in the valuations of the previously identified embedded derivatives.

        As a result of our review and communications with the SEC, we determined that a restatement of previously reported financial information was required. Our previously reported financial information should no longer be relied upon. Accordingly, we have restated our previously reported financial information for the years ended December 31, 2003 and 2004 and our previously reported unaudited financial statements for the first, second and third quarters of 2003, 2004 and 2005 (the "restatement"). The restatement covers a number of separate matters, each of which is described above.

        For the quarterly impact of the restatement and the restated financial results for the first, second and third quarters of 2003, 2004 and 2005 see Note X, Results by Quarter in the Notes to the Financial Statements on Page F-7.

        The following tables summarize the impact of all of these adjustments on previously reported revenue and assets, liabilities, and stockholders' equity (deficit) for the years ended December 31, 2005, 2004 and 2003.

 
  Impact of Adjustments on Revenue
For the Years Ended December 31,

 
 
  2005
  2004
  2003
 
As previously reported   $ 14,226,095   $ 5,558,231   $ 524,101  
Revenue recognition           162,720     (308,620 )
   
 
 
 
As restated   $ 14,226,095   $ 5,720,951   $ 215,481  
   
 
 
 
 
  Impact of Adjustments on Consolidated
Balance Sheet Accounts

 
 
  As of December 31, 2005
 
 
  Total
Assets

  Liabilities
  Stockholders'
Equity
(Deficit)

 
As previously reported   $ 26,357,934   $ 17,050,206   $ 9,307,728  
Revenue recognition and related SG&A expense              
Debt financing         3,143,724     (3,143,724 )
   
 
 
 
Total Adjustments         3,143,724     (3,143,724 )
   
 
 
 
As restated   $ 26,357,934   $ 20,193,930   $ 6,164,004  
   
 
 
 
 
  Impact of Adjustments on Consolidated Balance Sheet Accounts
 
 
  As of December 31, 2004
  As of December 31, 2003
 
 
  Total
Assets

  Liabilities
  Stockholders'
Equity
(Deficit)

  Total
Assets

  Total Liabilities
  Stockholders'
Equity
(Deficit)

 
As previously reported   $ 30,844,681   $ 20,223,283   $ 10,621,398   $ 1,864,742   $ 11,000,731   $ (9,135,989 )
Revenue recognition and related SG&A expense     (122,090 )   23,810     (145,900 )   (308,620 )   (18,200 )   (290,420 )
Debt financing     816,501     4,742,344     (3,925,843 )       (57,543 )   57,543  
   
 
 
 
 
 
 
Total Adjustments     694,411     4,766,154     (4,071,743 )   (308,620 )   (75,743 )   (232,877 )
   
 
 
 
 
 
 
As restated   $ 31,539,092   $ 24,989,437   $ 6,549,655   $ 1,556,122   $ 10,924,988   $ (9,368,866 )
   
 
 
 
 
 
 

39


        The following tables present the effect of the restatement adjustments on the consolidated Statement of Operations for the years ended December 31, 2005, 2004 and 2003.

 
  Year Ended December 31, 2005
 
 
  As Previously
Reported

  Effect of
Restatement

  As
Restated

 
Revenues                    
  Services   $ 10,861,649   $   $ 10,861,649  
  License fees and other     3,364,446         3,364,446  
   
 
 
 
      14,226,095         14,226,095  

Costs and other expenses

 

 

 

 

 

 

 

 

 

 
  Services     2,906,142         2,906,142  
  Cost of license fees and other     937,491         937,491  
  Selling, general and administrative     11,824,609         11,824,609  
  Research, development and engineering     6,846,035         6,846,035  
   
 
 
 
      22,514,277         22,514,277  
   
 
 
 
Operating loss     (8,288,182 )       (8,288,182 )
Other income (deductions)                    
  Interest income     35,958         35,958  
  Interest expense     (6,548,130 )   2,026,786     (4,521,344 )
  Derivative and warrant fair value adjustments     15,213,186     (6,058,235 )   9,154,951  
  Loss on sale of marketable securities     (20,000 )       (20,000 )
  Other expense     (34,767 )       (34,767 )
   
 
 
 
    Total other income (deductions)     8,646,247     (4,031,449 )   4,614,798  
   
 
 
 
NET INCOME (LOSS)   $ 358,065   $ (4,031,449 ) $ (3,673,384 )
   
 
 
 

Basic Loss per Share:

 

 

 

 

 

 

 

 

 

 
  Numerator                    
    Net loss   $ 358,065   $ (4,031,449 ) $ (3,673,384 )
   
Convertible Preferred Stock dividends and accretion

 

 

(313,517

)

 

 

 

 

(313,517

)
   
 
 
 
    Net Income (Loss) attributable to common shareholders   $ 44,548   $ (4,031,449 ) $ (3,986,901 )
   
 
 
 
  Denominator                    
    Weighted average common shares outstanding     44,787,807     44,787,807     44,787,807  
   
 
 
 
Basic Loss per Share   $ 0.00   $ (0.09 ) $ (0.09 )
   
 
 
 

Diluted Loss per Share:

 

 

 

 

 

 

 

 

 

 
  Numerator                    
    Net Income (loss) attributable to common shareholders   $ 44,548   $ (4,031,449 ) $ (3,986,901 )
   
Effect of Dilutive Securities: Convertible Debentures

 

 

(8,795,834

)

 

6,758,889

 

 

(2,036,945

)
   
 
 
 
   
Net loss attributable to common shareholders and assumed conversions

 

$

(8,751,286

)

$

2,727,440

 

$

(6,023,846

)
  Denominator                    
    Weighted average shares outstanding     44,787,807         44,787,807  
   
Effect of Dilutive Securities: Convertible Debentures

 

 

7,258,496

 

 


 

 

7,258,496

 
   
 
 
 
   
Diluted weighted average common shares and common equivalents outstanding

 

 

52,046,303

 

 

52,046,303

 

 

52,046,303

 
   
 
 
 
Diluted Loss per Share   $ (0.17 ) $ 0.05   $ (0.12 )
   
 
 
 

40


 
  Year Ended December 31, 2004
 
 
  As Previously
Reported

  Effect of
Restatement

  As
Restated

 
Revenues                    
  Services   $ 3,351,406   $   $ 3,351,406  
  License fees and other     2,206,825     162,720     2,369,545  
   
 
 
 
      5,558,231     162,720     5,720,951  

Costs and other expenses

 

 

 

 

 

 

 

 

 

 
  Services     1,174,324         1,174,324  
  Cost of license fees and other     889,896         889,896  
  Selling, general and administrative     7,096,088     18,200     7,114,288  
  Research, development and engineering     2,979,904         2,979,904  
   
 
 
 
      12,140,212     18,200     12,158,412  
   
 
 
 
Operating loss     (6,581,981 )   144,520     (6,437,461 )
Other income (deductions)                    
  Interest income     66,824         66,824  
  Interest expense     (667,008 )   (748,527 )   (1,415,535 )
  Derivative and warrant fair value adjustments         (3,008,419 )   (3,008,419 )
  Other expense     (55,300 )       (55,300 )
   
 
 
 
    Total other income (deductions)     (655,484 )   (3,756,946 )   (4,412,430 )
   
 
 
 
NET LOSS   $ (7,237,465 ) $ (3,612,426 ) $ (10,849,891 )
   
 
 
 

Basic Loss per Share:

 

 

 

 

 

 

 

 

 

 
  Numerator                    
    Net loss   $ (7,237,465 ) $ (3,612,426 ) $ (10,849,891 )
   
Convertible Preferred Stock dividends and accretion

 

 

(414,240

)

 

28,885

 

 

(385,355

)
   
 
 
 
    Net Loss attributable to common shareholders   $ (7,651,705 ) $ (3,583,541 ) $ (11,235,246 )
   
 
 
 
  Denominator                    
    Weighted average common shares outstanding     34,806,201     34,806,201     34,806,201  
   
 
 
 
Basic Loss per Share   $ (0.22 ) $ (0.10 ) $ (0.32 )
   
 
 
 

Diluted Loss per Share:

 

 

 

 

 

 

 

 

 

 
  Numerator                    
    Net loss attributable to common shareholders   $ (7,651,705 ) $ (3,583,541 ) $ (11,235,246 )
   
Effect of Dilutive Securities: Convertible Debentures

 

 


 

 


 

 


 
   
 
 
 
   
Net loss attributable to common shareholders and assumed conversions

 

$

(7,651,705

)

$

(3,583,541

)

$

(11,235,246

)
 
Denominator

 

 

 

 

 

 

 

 

 

 
    Weighted average shares outstanding     34,806,201     34,806,201     34,806,201  
   
Effect of Dilutive Securities: Convertible Debentures

 

 


 

 


 

 


 
   
 
 
 
   
Diluted weighted average common shares and common equivalents outstanding

 

 

34,806,201

 

 

34,806,201

 

 

34,806,201

 
   
 
 
 
Diluted Loss per Share   $ (0.22 ) $ (0.10 ) $ (0.32 )
   
 
 
 

41


 
  Year Ended December 31, 2003
 
 
  As Previously
Reported

  Effect of
Restatement

  As
Restated

 
Revenues                    
  Services   $ 10,694   $   $ 10,694  
  License fees and other     513,407     (308,620 )   204,787  
   
 
 
 
      524,101     (308,620 )   215,481  
Costs and other expenses                    
  Cost of services     1,694         1,694  
  Cost of license fees and other     87,387         87,387  
  Selling, general and administrative     2,118,122     (18,200 )   2,099,922  
  Research, development and engineering     1,037,330         1,037,330  
   
 
 
 
      3,244,533     (18,200 )   3,226,333  
   
 
 
 
Operating loss     (2,720,432 )   (290,420 )   (3,010,852 )
Other income (deductions)                    
  Interest expense     (1,109,786 )   (800,002 )   (1,909,788 )
  Derivative and warrant fair value adjustments         857,545     857,545  
  Other income     4,145         4,145  
   
 
 
 
    Total other income (deductions)     (1,105,641 )   57,543     (1,048,098 )
   
 
 
 
NET LOSS   $ (3,826,073 ) $ (232,877 ) $ (4,058,950 )
   
 
 
 
Basic Loss per Share:                    
  Numerator                    
    Net loss   $ (3,826,073 ) $ (232,877 ) $ (4,058,950 )
    Convertible Preferred Stock dividends and accretion     (136,755 )       (136,755 )
   
 
 
 
    Net loss attributable to common shareholders   $ (3,962,828 ) $ (232,877 ) $ (4,195,705 )
   
 
 
 
  Denominator                    
    Weighted average common shares outstanding     17,543,586     17,543,586     17,543,586  
   
 
 
 
Basic Loss per Share   $ (0.23 ) $ (0.01 ) $ (0.24 )
   
 
 
 
Diluted Loss per Share:                    
  Numerator                    
    Net loss attributable to common shareholders   $ (3,962,828 ) $ (232,877 ) $ (4,195,705 )
    Effect of Dilutive Securities: Convertible Debentures              
   
 
 
 
    Net loss attributable to common shareholders and assumed conversions   $ (3,962,828 ) $ (232,877 ) $ (4,195,705 )
  Denominator                    
    Weighted average shares outstanding     17,543,586     17,543,586     17,543,586  
    Effect of Dilutive Securities: Convertible Debentures              
   
 
 
 
    Diluted weighted average common shares and common equivalents outstanding     17,543,586     17,543,586     17,543,586  
   
 
 
 
Diluted Loss per Share   $ (0.23 ) $ (0.01 ) $ (0.24 )
   
 
 
 

42


        The following tables present the effect of the restatement adjustments on the Consolidated Balance Sheet as of December 31, 2005, 2004 and 2003.


CONSOLIDATED BALANCE SHEET

 
  As of December 31, 2005
 
 
  As Previously
Reported

  Effect of
Restatement

  As Restated
 
ASSETS                    
Cash and cash equivalents   $ 1,422,827   $   $ 1,422,827  
Receivables                    
  Billed less allowance for doubtful receivables as of $160,000     1,635,371         1,635,371  
  Unbilled     201,942         201,942  
Costs and earnings in excess of billings on uncompleted contracts     4,321,392         4,321,392  
Inventory     8,760         8,760  
Prepaid expenses     137,000         137,000  
   
 
 
 
  Total current assets     7,727,292           7,727,292  
   
 
 
 
Equipment and leasehold improvements, net     548,267         548,267  
Deposits     1,828,560         1,828,560  
Intangible assets—less accumulated amortization     3,301,823         3,301,823  
Deferred financing costs, net     1,562,338         1,562,338  
Goodwill     11,389,654         11,389,654  
   
 
 
 
  Total non-current assets     18,630,642         18,630,642  
   
 
 
 
TOTAL ASSETS   $ 26,357,934   $   $ 26,357,934  
   
 
 
 
LIABILITIES                    
Current maturities of long-term obligations   $ 4,924,224   $ 3,143,724   $ 8,067,948  
Accounts payable     833,608         833,608  
Billing in excess of costs and earnings on uncompleted contracts     32,385         32,385  
Accrued liabilities     5,520,515         5,520,515  
Deferred rent     443,603         443,603  
Deferred revenue     3,264,283         3,264,283  
   
 
 
 
  Total current liabilities     15,018,618     3,143,724     18,162,342  
   
 
 
 
Long-term obligations, net of discount and current maturities              
Deferred rent     867,850         867,850  
Deferred revenue     1,163,738         1,163,738  
   
 
 
 
  Total non-current liabilities     2,031,588         2,031,588  
   
 
 
 
TOTAL LIABILITIES     17,050,206     3,143,724     20,193,930  
   
 
 
 
STOCKHOLDERS' EQUITY (DEFICIT)                    
Preferred stock-authorized, 5,000,000 shares (liquidation preference of $100 per share) Series A 7% Convertible; issued and outstanding, 44,557shares of $.0001 par value     4         4  
Common stock-authorized, 85,000,000 shares, 46,306,589 issued and outstanding of $.0001 par value     4,632         4,632  
Additional paid-in capital     51,529,332     (2,608,016 )   48,921,316  
Accumulated deficit     (42,226,240 )   (535,708 )   (42,761,948 )
   
 
 
 
TOTAL STOCKHOLDERS' EQUITY (DEFICIT)     9,307,728     (3,143,724 )   6,164,004  
   
 
 
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)   $ 26,357,934   $   $ 26,357,934  
   
 
 
 

43



CONSOLIDATED BALANCE SHEET

 
  As of December 31, 2004
 
 
  As Previously
Reported

  Effect of
Restatement

  As Restated
 
ASSETS                    
Cash and cash equivalents   $ 956,230   $   $ 956,230  
Marketable debt securities     1,000,000         1,000,000  
Receivables                    
  Billed less allowance for doubtful receivables as of $422,393     1,698,144     (90,090 )   1,608,054  
  Unbilled     310,523         310,523  
Due from selling stockholders and other     60,793     (32,000 )   28,793  
Costs and earnings in excess of billings on uncompleted contracts     6,292,603         6,292,603  
Inventory     29,599         29,599  
Prepaid expenses     113,130         113,130  
   
 
 
 
  Total current assets     10,461,022     (122,090 )   10,338,932  
   
 
 
 
Equipment and leasehold improvements, net     644,101         644,101  
Costs and earnings in excess of billings on uncompleted contracts     657,000         657,000  
Deposits     2,838,031         2,838,031  
Intangible assets—less accumulated amortization     4,177,279     (77,982 )   4,099,297  
Deferred financing costs, net         938,118     938,118  
Goodwill     12,067,248     (43,635 )   12,023,613  
   
 
 
 
  Total non-current assets     20,383,659     816,501     21,200,160  
   
 
 
 
TOTAL ASSETS   $ 30,844,681   $ 694,411   $ 31,539,092  
   
 
 
 
LIABILITIES                    
Current maturities of long-term obligations   $ 3,255,182   $ (192,460 ) $ 3,062,722  
Advances from stockholders     12,753         12,753  
Accounts payable     1,325,282     23,810     1,349,092  
Billing in excess of costs and earnings on uncompleted contracts     760,807         760,807  
Accrued liabilities     4,639,619     (43,635 )   4,595,984  
Deferred rent     393,676         393,676  
Deferred revenue     3,166,356         3,166,356  
   
 
 
 
  Total current liabilities     13,553,675     (212,285 )   13,341,390  
   
 
 
 
Long-term obligations, net of discount and current maturities     5,286,951     4,978,439     10,265,390  
Deferred rent     1,311,454         1,311,454  
Deferred revenue     71,203         71,203  
   
 
 
 
  Total non-current liabilities     6,669,608     4,978,439     11,648,047  
   
 
 
 
TOTAL LIABILITIES     20,223,283     4,766,154     24,989,437  
   
 
 
 
STOCKHOLDERS' EQUITY (DEFICIT)                    
Preferred stock-authorized, 5,000,000 shares (liquidation preference of $100 per share) Series C 7% Convertible; issued and outstanding, 62,182 shares of $.01 par value     623         623  
Common stock-authorized, 85,000,000 shares, 40,680,691 issued and outstanding of $.01 par value     406,808         406,808  
Additional paid-in capital     45,325,172     (226,441 )   45,098,731  
Accumulated deficit     (35,111,205 )   (3,845,302 )   (38,956,507 )
   
 
 
 
TOTAL STOCKHOLDERS' EQUITY (DEFICIT)     10,621,398     (4,071,743 )   6,549,655  
   
 
 
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)   $ 30,844,681   $ 694,411   $ 31,539,092  
   
 
 
 

44



CONSOLIDATED BALANCE SHEET

 
  As of December 31, 2003
 
 
  As Previously
Reported

  Effect of
Restatement

  As Restated
 
ASSETS:                    
Cash and cash equivalents   $ 1,012,790   $   $ 1,012,790  
Receivables billed     409,803     (308,620 )   101,183  
Inventory     65,857         65,857  
Prepaid expenses     165,929         165,929  
   
 
 
 
  Total current assets     1,654,379     (308,620 )   1,345,759  
   
 
 
 
Equipment and leasehold improvements, net     60,157         60,157  
Intangible assets—less accumulated amortization     68,306         68,306  
Deferred financing costs, net     81,900         81,900  
   
 
 
 
  Total non-current assets     210,363         210,363  
   
 
 
 
TOTAL ASSETS   $ 1,864,742   $ (308,620 ) $ 1,556,122  
   
 
 
 
LIABILITIES:                    
Advances from stockholders   $ 34,030   $   $ 34,030  
Accounts payable     351,742         351,742  
Accrued liabilities     173,736     (18,200 )   155,536  
Deferred revenue     10,000         10,000  
   
 
 
 
  Total current liabilities     569,508     (18,200 )   551,308  
   
 
 
 
Long-term obligations, net of discount and current maturities     10,431,223     (57,543 )   10,373,680  
   
 
 
 
Total non-current liabilities     10,431,223     (57,543 )   10,373,680  
   
 
 
 
TOTAL LIABILITIES     11,000,731     (75,743 )   10,924,988  
   
 
 
 
STOCKHOLDERS' EQUITY (DEFICIT)                    
Preferred stock-authorized, 5,000,000 shares (liquidation preference of $100 per share) Series B 9% Convertible; issued and outstanding, 4,180 shares of $.01 par value     42         42  
Common stock-authorized, 85,000,000 shares, issued and outstanding 21,222,990 of $.01 par value     212,229         212,229  
Additional paid-in capital     18,327,992         18,327,992  
Accumulated deficit     (27,676,252 )   (232,877 )   (27,909,129 )
   
 
 
 
TOTAL STOCKHOLDERS' EQUITY (DEFICIT)     (9,135,989 )   (232,877 )   (9,368,866 )
   
 
 
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)   $ 1,864,742   $ (308,620 ) $ 1,556,122  
   
 
 
 

45


CRITICAL ACCOUNTING POLICIES

1.
Basis of Consolidation

        The accompanying consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly owned subsidiary (collectively, the Company) and are stated in conformity with accounting principles generally accepted in the United States, pursuant to the rules and regulations of the Securities and Exchange Commission. Intercompany accounts and transactions have been eliminated in consolidation.

2.
Revenue Recognition

        Revenues from software licensing are recognized in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9. Accordingly, revenue from software licensing is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.

        The Company intends to enter into arrangements with end users for items which may include software license fees, usage fees and services or various combinations thereof. For each arrangement, revenues will be recognized when evidence of an agreement has been documented, the fees are fixed or determinable, collection of fees is probable, delivery of the product has occurred and no other significant obligations remain.

        Multiple-Element Arrangements: For multiple-element arrangements, each element of the arrangement will be analyzed and the Company will allocate a portion of the total fee under the arrangement to the elements using vendor specific objective evidence of fair value of the element, regardless of any separate prices stated within the contract for each element. Vendor specific objective evidence is based on the price the customer is required to pay when the element is sold separately (i.e., software license fees charged when consulting or other services are not provided, hourly rates charged for consulting services when sold separately from a software license or usage fees). If vendor specific objective evidence of fair value does not exist for any undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services, or until sufficient objective evidence of fair value exists or all elements have been delivered.

        License Revenues: Amounts allocated to license revenues are recognized at the time of delivery of the software and all other revenue recognition criteria discussed above have been met.

        Revenue from licensing software, which requires significant customization and modification, is recognized using the percentage of completion method, based on the hours of effort incurred by the company in relation to the total estimated hours to complete. In instances where third party hardware, software or services form a significant portion of a customer's contract, the company recognizes revenue for the element of software customization by the percentage of completion method described above. Third party hardware, software, and services are recognized upon shipment or acceptance as appropriate. If the company makes different judgments or utilizes different estimates of the total amount of work expected to be required to customize or modify the software, the timing and revenue recognition, from period to period, and the margins on the project in the reporting period, may differ materially from amounts reported. Revenues earned but not yet billed are shown as an asset in Costs and Earnings in Excess of Billings in the balance sheet. Billings in excess of cost and earnings are reflected as a liability in the balance sheet. Anticipated contract losses are recognized as soon as they become known and are estimable.

        Service Revenues: Revenues from services are comprised of maintenance and consulting and implementation services. Maintenance revenues include providing for unspecified when-and-if available product updates and customer telephone support services, and are recognized ratably over the term of

46



the service period. Consulting services are generally sold on a time-and-materials basis and include a range of services including installation of software and assisting in the design of interfaces to allow the software to operate in customized environments. Services are generally separable from other elements under the arrangement since performance of the services are not essential to the functionality of any other element of the transaction and are described in the contract such that the total price of the arrangement would be expected to vary as the result of the inclusion or exclusion of the services. Revenues from services are generally recognized as the services are performed.

        Usage Fees: Usage fees are charged on certain applications based on the customer's volume of use. Usage revenue is recognized based on the actual level of activity used by the customer or, in the case of fixed-fee arrangements, ratably over the arranged time period.

        The Company provides customers, free of charge or at a minimal cost, testing kits which potential licensing customers may use to test compatibility/acceptance of the Company's technology with the customer's intended applications.

3.
Accounting for Acquisitions

        We have completed our acquisitions of PSG and AMG. These acquisitions have been accounted for under the purchase method of accounting, which has resulted in recording significant goodwill and other intangible asset balances. The purchase prices have been allocated to assets acquired and liabilities assumed at their estimated fair values on the date of the acquisitions, as determined by management, and by appraisals with respect to identifiable intangible assets. Our accounting for these acquisitions involves significant judgments and estimates regarding fair values of acquired intangible assets, which are based on projections of future revenues and cash flows, assumptions regarding discount factors, royalty rates, tax rates, amortization methodologies and related useful lives. The developed technology (software), copyrighted software, marketing agreements, customer relationships and trademarks were valued using the income approach and are being amortized on a straight line basis over their estimated useful lives, which range from 5 to 7 years.

4.
Marketable Debt Securities

        The Company accounts for marketable securities pursuant to Statement of Financial Accounting Standards No. 115—Accounting for Certain Investments in Debt and Equity Securities ("SFAS 115"). SFAS 115 requires classification of debt and equity securities in three categories: trading securities, available-for-sale securities and held-to-maturity securities. Debt and equity securities classified as trading securities are carried at fair value with unrealized gains or losses included in income. Debt and equity securities designated as available-for-sale, whose fair values are readily determinable, are carried at fair value with unrealized gains or losses included as a component of accumulated other comprehensive income, net of applicable taxes. Debt securities that are expected to be held-to-maturity are carried at amortized cost. On December 31, 2004, the Company's investments were all classified as available-for-sale. In January 2005 the Company sold these investments and did not purchase any additional Marketable Debt Securities as of June 30, 2006.

5.
Derivative and Warrant financial instruments

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

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

47



the derivative liability recorded as charges or credits to income, in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instrument liabilities, we determine the fair value of these instruments using the Black-Scholes option pricing model. That model requires assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price over the life of the option. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.

6.
Goodwill and Intangible Assets

        Goodwill represents the excess of costs of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets., which requires the Company to test goodwill for impairment annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable, rather than amortize. Accordingly, the Company has not amortized goodwill. As provided by SFAS No. 142, the Company has elected to perform the annual assessment of the carrying value of all goodwill as of September 30 of each year using a number of criteria, including the value of the overall enterprise. As of June 30, 2006, the Company believes that no material impairment exists. Future impairment charges from previous or future acquisitions, if any, will be reflected as an operating expense in the statement of operations.

7.
Deferred Revenue

        Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have not been recognized as revenue. The majority of these amounts are related to maintenance contracts for which the revenue is recognized ratably over the applicable term, which generally is 12 months from the date the customer accepts the products.

8.
Research and Development Expenditures

        Research and development expenses include costs directly attributable to the conduct of research and development programs primarily related to the development of our software products and improving the efficiency and capabilities of our existing software. Such costs include salaries, payroll taxes, employee benefit costs, materials, supplies, depreciation on research equipment, services provided by outside contractors, and the allocable portions of facility costs, such as rent, utilities, insurance, repairs and maintenance, depreciation and general support services. All costs associated with research and development is expensed as incurred.

9.
Earnings Per Share Common Stock

        Earnings per share of common stock-basic is computed by dividing Net Income applicable to common stockholders by the weighted-average number of common shares outstanding for the period. Earnings per share of common stock-assuming dilution reflects the maximum potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock and would then share in the net income of the company. See note U "Earnings Per Share of Common Stock," for additional information.

10.
Income Taxes

        The provision for, or benefit from, income taxes includes deferred taxes resulting from the temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from the differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carry back, carry forward period available under tax law. The Company evaluates, on a quarterly basis whether, based on all available evidence, if it is probable that the deferred income tax assets are

48


realizable. Valuation allowances are established when it is more likely than not that the tax benefit of the deferred tax asset will not be realized. The evaluation, as prescribed by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carry forward from expiring unused. Because of the Companies historical performance and estimated future taxable income a full valuation allowance has been established.

11.
Accounting for Stock-Based Compensation

        As of January 1, 2006, the Company adopted SFAS 123R using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Accordingly, financial statement amounts for the prior periods presented have not been restated to reflect the fair value method of expensing share-based compensation.

        Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant.

        The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS 123, as amended by SFAS 148, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the "expected option term"), the estimated volatility of our common stock price over the option's expected term, the risk-free interest rate over the option's expected term, and the Company's expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods.

        The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. The compensation expense recognized in connection with the adoption of SFAS 123R increased the Company's net loss by $169,352 with no effect per share for the three months ended June 30, 2006 and increased the Company's net loss for the six months ended June 30, 2006 by $289,919. There was no impact on cash flows from operations, investment, or financing in connections with the adoptions of SFAS 123R. As the Company uses the full valuation allowance with respect to deferred taxes, the adoption of SFAS 123R had no impact on deferred taxes.

12.
Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported

49



amounts of assets and liabilities at the date of the financial statements, the reported amounts of revenues and expenses during the reporting period, and disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

        Estimates and assumptions which, in the opinion of management are used in accounting for, among other things, long-term contracts, allowances for uncollectible receivables, recoverability of goodwill and other long-lived assets, depreciation and amortization, valuation of deferred income taxes, convertible notes and related preferred stock, and stock options, discounts, embedded derivatives, and warrants outstanding.

OTHER MATTERS

        Not Applicable

RECENT ACCOUNTING STANDARDS

        In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 will be effective beginning Q1 2007. We have not yet evaluated the impact of implementation on our consolidated financial statements.

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DESCRIPTION OF BUSINESS

Overview

        BIO-key International, Inc., a Delaware corporation ("the Company," "BIO-key," "we," or "us"), was founded in 1993 to develop and market proprietary biometric technology and software solutions. Biometric technology is the science of analyzing specific human characteristics which are unique to each individual in order to identify a specific person from a broader population.

        On March 30, 2004, BIO-key acquired Public Safety Group, Inc. (PSG), a privately held company that is a leader in wireless solutions for law enforcement and public safety markets. PSG's primary technology is PocketCop™, a handheld solution that provides mobile officers, such as detectives who are not typically in their vehicles, a hand-held mobile information software solution.

        On September 30, 2004, BIO-key completed a transaction with Aether Systems, Inc. to purchase its Mobile Government Division ("Mobile Government" or "AMG"), a leading provider of wireless data solutions for use by public safety organizations, primarily state, local police, fire and rescue and emergency medical services organizations. The PacketCluster mobile information software is integrated with 50 separate State/NCIC databases, as well as other state, local and federal databases. Its open architecture and its published Application Programming Interface (API) make it easy to interface with a wide range of information sources. PacketCluster products deliver real-time information in seconds, freeing dispatchers to handle more pressing emergencies.

        Effective January 1, 2005, BIO-key International, Inc., a Minnesota corporation ("Old BIO-key"), reincorporated in the State of Delaware. The reincorporation was effected pursuant to an Agreement and Plan of Merger (the "Merger Agreement") whereby Old BIO-key was merged with and into the Company, its wholly owned subsidiary, in order to reincorporate in the State of Delaware (the "Reincorporation"). As a result of the Reincorporation, the legal domicile of the Company is now Delaware.

        Pursuant to the Merger Agreement, at the effective time of the Reincorporation: (i) each outstanding share of Common Stock of Old BIO-key, $0.01 par value per share, was automatically converted into one share of Common Stock, $0.0001 par value per share, of the Company; (ii) each outstanding share of Series C 7% Convertible Preferred Stock of Old BIO-key, $0.01 par value per share, was automatically converted into one share of Series A 7% Convertible Preferred Stock, $0.0001 par value per share, of the Company, with such Series A 7% Convertible Preferred Stock containing substantially identical terms and conditions as the Series C 7% Convertible Preferred Stock of Old BIO-key; (iii) each option to purchase shares of Old BIO-key's Common Stock granted by Old BIO-key under any warrant, stock option plan or similar plan of Old BIO-key outstanding immediately before the Reincorporation was, by virtue of the Merger Agreement and without any action on the part of the holder thereof, converted into and become an option to purchase, upon the same terms and conditions, the same number of shares of the Company's Common Stock at an exercise price per share equal to the exercise price per share thereunder immediately before the Reincorporation; and (iv) each warrant, option or stock option plan of Old BIO-key was assumed by, and continues to be, a warrant, option or plan of the Company. Accordingly, as a result of the Reincorporation, the shareholders of Old BIO-key became shareholders of the Company, and Old BIO-key has been merged out of existence by operation of law. Each certificate representing shares of capital stock of Old BIO-key outstanding immediately before the Reincorporation, is deemed from and after the Reincorporation for all corporate purposes to represent the same number of shares of capital stock of the Company.

        As a result of the recent mergers, and as discussed in Note M to the Consolidated Financial Statements, we have organized BIO-key International, Inc. into three reporting segments: Law Enforcement, Fire Safety and Biometrics. During 2005, the Company continued to integrate the

51



products, operations and technologies acquired from Public Safety Group, Inc. and Aether Systems, Inc.

Products

        BIO-key® operates in three major segments—biometrics, law enforcement and fire safety. These segments are described below and a list of products in each line is noted.

Biometrics

        BIO-key's finger identification algorithm—Vector Segment Technology (VST™) is the core intellectual property behind its full suite of biometric products that include:


        The Company's biometric identification technology improves both the accuracy and speed of finger-based biometrics. The Company's proprietary biometric technology scans a fingerprint and identifies a person, typically within a few seconds or less, in databases of a million people or more. BIO-key can accomplish this without using any other identifying data—a key differentiator for BIO-key since other biometric solutions may also require traditional token/card identification. BIO-key's core technology supports user enrollment on over 40 different commercially available readers and in turn can offer compatibility among those readers through a single fingerprint template. We have also added INCITS 378-2004 support to our software development kits which makes our products compatible with all of the Registered Traveler projects, PIV initiatives, and FIXS consortium solutions. We believe our fingerprint identification technology has a broad range of possible information security and access control applications, including:

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Law Enforcement

        BIO-key also provides a number of optional features designed to augment the core Law Enforcement products. These include:

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Fire Safety

        In addition to law enforcement/fire service mobile data solutions, BIO-key offers its Sunpro fire service/EMS records management software, FireRMS™, that helps large and small agencies manage operations, track incidents and support fire prevention initiatives. FireRMS Mobile provides wireless query and messaging solutions that extend computer aided dispatch, fire records, and other in-house data sources to a mobile environment and provide mission-critical information to emergency response personnel where and when they need it.

        BIO-key also offers the following Fire/EMS Partner solutions:

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Current Business Plan

        BIO-key's current business plan is to:

Markets

Law Enforcement

        BIO-key's InfoServer™, MobileCop™ and PocketCop® Law Enforcement products are the leading wireless mobile data communications client/server solution, implemented in more than 1,200 agencies nationwide. Providing immediate access to mission-critical data and enabling in-field reporting, BIO-key software keeps officers on the street, improving their productivity and enhances officer safety. BIO-key solutions are able to run across any and all wireless infrastructures and integrate with virtually all computer-aided dispatch (CAD) and records management systems. This makes us a proven leader in multi-agency cooperation and interoperability, which are absolutely critical in times of large-scale natural and terrorist threats.

        These capabilities position BIO-key well to work with leading CAD vendors, even with vendors that have mobile data solutions but do not have the depth of interoperability capability that BIO-key offers.

        An additional growth area is the introduction of BIO-key's finger-based biometric identification to law enforcement. In addition to now offering biometric login to our traditional InfoServer™ product, we have introduced the IdentityMatch™ fingerprint identification solution, which lets law enforcement personnel capture fingerprints in the field and, using BIO-key's patented Vector Segment Technology®, then analyzes and categorizes fingerprints the same way a fingerprint expert would—only faster.

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IdentityMatch™ also enables multiple law enforcement agencies to share fingerprint data with other agencies. This powerful tool, built on BIO-key's understanding of law enforcement requirements and its fingerprint technology, present opportunities for the law enforcement business segment in the coming year.

Fire Safety

        BIO-key's FireRMS fire records management software is a flexible solution available for Fire Service and EMS agencies. It is a comprehensive collection of modules that manage a range of activities from daily scheduling to vehicle maintenance. FireRMS streamlines data collection across all areas of department operations, and integrates with other department systems to provide a seamless solution for data access, whether in the station or on the scene of an incident. In addition to helping first responders efficiently deliver traditional fire safety and services and respond to massive emergency situations, it enables adherence to NFIRS, NEMSIS, HIPAA, and ISO requirements. The solutions also bring the station into the field with mobile data communications solutions, and most recently, FireRMS Mobile, which brings the capabilities of FireRMS to first responders where and when they most need to report and access critical information.

Finger-based Biometric Identification

        Finally, BIO-key is a leader in finger-based biometric identification. In partnerships with OEMs, integrators, and solution providers, we provide biometric software solutions to private and public sector customers. BIO-key's patented vector segment technology is the foundation for these solutions.

        BIO-key's WEB-key® is a cost-effective, easy-to-deploy, fingerprint-based strong authentication system. This unique solution allows users to positively identify themselves to any application with the simple scan of their finger. This capability is a significant improvement in both convenience and security over other alternatives and provides companies with a cost-effective solution to thwart phishing attacks and comply with government regulations and legislation such as FFIEC compliance, HIPAA, Sarbanes-Oxley, and the Electronic Signatures Act. BIO-key couples these capabilities with device interoperability and system flexibility and scalability. BIO-key enables the use of about 40 different fingerprint sensor technologies to enroll and identify employees, customers or business partners. Most recently, BIO-key integrated its biometric capabilities with its public safety mission with the introduction of IdentityMatch™, a real-time, in-station solution that allows law enforcement professionals to capture fingerprints from a suspect or captured from a crime scene and compare them to fingerprints. BIO-key has also formed relationships with providers of biometric logon software like IdentiPHI, Softex, and Computer Associates to provide enterprise-ready SingleSignOn systems to many large companies in the US and abroad. Also, BIO-key has integrated to a pure physical access solution in NextGenID, which has been deployed at BIO-key facilities.

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Competition

        The markets for BIO-key products and technologies are developing and are characterized by intense competition and rapid technological change. No assurance can be given that our competitors will not develop new or enhanced technologies that will offer superior price, performance, or features, or render BIO-key products or technologies obsolete.

Biometrics

        In addition to companies that provide existing commonplace methods of restricting access to facilities and logical access points such as pass cards, PIN numbers, passwords, locks and keys, there are numerous companies involved in the development, manufacturing and marketing of fingerprint biometrics products to commercial, government, law enforcement and prison markets. These companies include, but are not limited to, Cogent, NEC, IDENTIX, Sagem-Morpho, and Bioscrypt.

        The most recent automated fingerprint identification product sales in the market have been deployed for government and law enforcement applications, typically at more cost than BIO-key's products and licensing arrangements. Although most companies that target consumer application markets have completed development of their biometric products, such technologies have not been widely accepted in the commercial markets to date. Most companies competing for commercial opportunities are in the business of selling scanning devices and tie their algorithm to a specific device. BIO-key has created a "device independent" algorithm that provides flexibility in choosing the correct device and optical or tactile sense to fit the application served.

        BIO-key has found that commercial markets have been slow to widely purchase biometrics as a viable alternative to their current security methods. As a result, the primary competition for biometric technology consists of traditional security methods such as passwords, PINs, cards, and tokens.

        With respect to competing biometrics technologies, each has its strength and weaknesses and none has emerged as a market leader:


        The market for biometric technology is evolving. Computer breaches, identity theft, phishing and other events in the recent past are driving a large-scale shift to biometric deployments. In addition, companies such as IBM, Dell, Gateway, MPC, Samsung and HP have all introduced computers with integrated finger scanning devices to complement the conventional username/password technique since

57


it is highly susceptible to hackers and security breaches. BIO-key supports these integrated devices for broader enterprise level security solutions.

Law Enforcement

        The public safety market comprises agencies at all government levels, with a range of users, from a few to many hundreds. BIO-key competitors in the mobile data market include Computer Aided Dispatch/Records Management companies such as Printrak, InfoCop and Motorola. Each has comprehensive CAD and/or RMS offerings and has augmented those with their own mobile data and field reporting solutions. While these solutions may not be as functionally rich as the BIO-key suite of products, they are sometimes less expensive. They also provide a complete solution from one vendor.

Fire Safety

        The fire records management market includes a large number of RMS vendors including Firehouse, FDM and ETI. These and other competing companies represent a wide range of organizations, from large integration companies, to small garage companies, and offer products similar in scope to BIO-key's FireRMS. The functionality and price of these products also encompass wide ranges of features and costs.

Marketing and Distribution

        BIO-key's marketing and distribution efforts comprise the following major initiatives:

        Following are the specific marketing/sales programs in place:

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Licensing

        BIO-key targets both Internet infrastructure companies and large portal providers as possible licensees for its WEB-key® solution. On the Internet infrastructure side, BIO-key seeks to partner with Internet server manufacturers, providers of database and data warehouse engine software, horizontally positioned application engines, firewall solution providers and peripheral equipment manufacturers. On the portal side, BIO-key is targeting financial service providers such as credit and debit card authorization and issuing institutions, Internet retailers, business-to-business application service providers (ASPs) and corporate intranets. In the past three years, BIO-key has undertaken a WEB-key® and VST direct selling effort, and entered into license agreements with OEMs and system integrators to develop applications for distribution to their respective customers.

        BIO-key is also addressing the security needs of application providers in the following vertical markets:

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Intellectual Property Rights

        We believe that our intellectual property is important to our biometric, law enforcement and fire information management segments:

        Patents—our biometrics segment uses patented technology and trade secrets developed or acquired by us. In May 2005, the U.S. Patent Office issued us a patent for our Vector Segment fingerprint technology (VST), BIO-key's core biometric analysis and identification technology. Additionally, we have a number of U.S. and foreign patent applications in process related to this intellectual property.

        Trademarks—We have registered our trademarks ("BIO-key", "SACman", "SACcat", "SACremote", "True User Identification", "WEB-key", "PacketCluster", "PacketCluster Patrol", "PacketWriter", "PacketBlue", "SunPro" and the design mark for "Ceurulean" with the U.S. Patent and Trademark Office. We have also applied for trademarks for "PocketCop" and "Cerulean".

        Copyrights and trade secrets—We take measures to ensure copyright and license protection for our software releases prior to distribution. When possible, the software is licensed in an attempt to ensure that only licensed and activated software functions to its full potential. We also take measures to protect the confidentiality of our trade secrets.

Research and Development

        Our research and development efforts are concentrated on enhancing the functionality, reliability and integration of our current products as well as developing new and innovative products for the biometrics, law enforcement and fire markets. Although BIO-key believes that its identification technology is one of the most advanced and discriminating fingerprint technologies available today, the markets in which BIO-key compete are characterized by rapid technological change and evolving standards. In order to maintain its position in the market, BIO-key will continue to upgrade and refine its existing technologies.

        In 2005, BIO-key announced the launch of IdentityMatch, our fingerprint identification system. IdentityMatch offers a tool for agencies to store and search fingerprints and the associated demographic data, the ability to compare new prints with those previously captured as a low-cost AFIS alternative or to be used for a wide variety of routine identification transactions not supported by AFIS. IdentityMatch™ is currently being tested by a number of customers.

        During fiscal years ended December 31, 2004 and 2005, BIO-key spent approximately $2,980,000, and $6,846,000 respectively, on research and development. BIO-key's limited customer base during that time did not directly bear these costs, which were principally funded through outside sources of equity and debt financing.

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Government Regulations

        BIO-key is not currently subject to direct regulation by any government agency, other than regulations generally applicable to businesses or related to specific project requirements. In the event of any international sales, the company would be subject to various domestic and foreign laws regulating such exports and export activities.

Environmental Regulations

        As of the date of this report, BIO-key has not incurred any material expenses relating to our compliance with federal, state, or local environmental laws and does not expect to incur any material expenses in the foreseeable future.

Employees and Consultants

        BIO-key currently employs ninety-six (96) individuals on a full-time basis: sixty (60) in engineering, customer support, research and development; fifteen (15) in finance and administration; and twenty-one (21) in sales and marketing. BIO-key also uses the services of seven (7) consultants who provide engineering and technical services.

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DESCRIPTION OF PROPERTY

        We do not own any real estate. We conduct operations from leased premises in Marlborough, Massachusetts (38,000 square feet), Eagan, Minnesota (6,800 square feet), Wall, New Jersey (2,180 square feet) and Winter Park, Florida (900 square feet). We believe that our current facilities are adequate for the foreseeable future.


LEGAL PROCEEDINGS

        Prior to our acquisition of PSG in March 2004, PSG had been named as a defendant in a civil action initiated in the Superior Court Department in Hampden County, Commonwealth of Massachusetts by The Vince Group, Inc. ("TVG"). The case was then removed to the United States District Court for the District of Massachusetts at the request of the parties. The complaint claimed that PSG was obligated to pay a percentage of certain of its revenues to TVG in consideration for a strategic business introduction allegedly made by an agent of TVG. PSG denied the allegations and filed an answer in the litigation. On April 20, 2006, the action was reported settled to the Court, and on June 20, 2006 a Stipulation of Dismssal with Prejudice was filed.


MANAGEMENT

Directors and Executive Officers

        The following sets forth certain information about each director and executive officer of the Company.

Name

  Age
  Positions Held
Thomas J. Colatosti   58   Chairman of the Board of Directors
Michael W. DePasquale   51   Chief Executive Officer and Director
Jeffrey J. May   46   Director
Charles P. Romeo(a)   64   Director
John Schoenherr   53   Director
Francis J. Cusick   51   Chief Financial Officer
Randy Fodero   47   Vice President of Sales
Kenneth S. Souza   51   General Manager, Law Enforcement and Chief Technology Officer

(a)
From April 2004 to February 2005, Mr.Romeo was employed by the Company.

        The following is a brief summary of the business experience of each of the above-named individuals:

        THOMAS J. COLATOSTI has served as a Director of the Company since September 2002 and as Chairman of the Board since January 3, 2003. He has served as Co-Chief Executive Officer from July 2005 to August 2006. Mr. Colatosti also currently serves as the Chief Executive Officer of American Security Ventures, a Lexington, Massachusetts based consulting firm he founded which specializes in providing strategic management consulting services to emerging and developing companies in the homeland security industry. From 1997 through June 2002, Mr. Colatosti served as the Chief Executive Officer of Viisage Technology, Inc., a publicly traded biometric technology company focusing on biometric face-recognition technology and delivering highly secure identification documents and systems. Between 1995 and 1997, Mr. Colatosti served as President and Chief Executive Officer of CIS Corporation, a higher education industry leader that designed and implemented integrated and flexible systems solutions to manage entire university administrative operations. Prior to CIS, Mr. Colatosti had a 20-year career with Digital Equipment Corporation. His most recent responsibility was Vice President and General Manager, Northeast Area, where he was responsible for

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a business unit with annual revenues of more than $1.2 billion and 3,000 people. Mr. Colatosti is an active industry security spokesperson testifying before Congressional Committees and advising the White House and other Federal security agencies on homeland security issues. Since August 18, 2005, Mr. Colatosti has served as a Director and Chief Financial Officer of Good Harbor Partners Acquisition Corp., a publicly-traded blank check company formed to acquire businesses in the security sectors. Mr. Colatosti earned a Bachelor of Science degree in Management and Finance as well as a Masters degree in Business Administration from Suffolk University.

        MICHAEL W. DEPASQUALE has served as the Chief Executive Officer and a Director of the Company since January 3, 2003. He served as Co-Chief Executive Officer from July 2005 to August 2006. Mr. DePasquale brings more than 20 years of executive management, sales and marketing experience to the Company. Prior to joining the Company, Mr. DePasquale served as the President and Chief Executive Officer of Prism eSolutions, Inc., a Pennsylvania based provider of professional consulting services and online solutions for ISO-9001/14000 certification for customers in manufacturing, healthcare and government markets, since February 2001. From December 1999 through December 2000, Mr. DePasquale served as Group Vice President for WRC Media, a New York based distributor of supplemental education products and software. From January 1996 until December 1999, Mr. DePasquale served as Senior Vice President of Jostens Learning Corp., a California based provider of multi media curriculum. Prior to Jostes, Mr. DePasquale held sales and marketing management positions with McGraw-Hill and Digital Equipment Corporation. Mr. DePasquale earned a Bachelor of Science degree from the New Jersey Institute of Technology.

        JEFFREY J. MAY has served as a Director of the Company since October 29, 2001. Since 1997, Mr. May has served as the President of Gideons Point Capital, a Tonka Bay Minnesota based financial consulting firm and angel investor focusing on assisting and investing in start-up technology companies. In 1983, Mr. May co-found Advantek, Inc., a manufacturer of equipment and materials which facilitate the automatic handling of semi-conductors and other electrical components which was sold in 1993. Mr. May continued to serve as a director and Vice-President of Operations of Advantek until 1997, at which time it had over 600 employees and sales in excess of $100 million. Mr. May earned a Bachelor of Science degree in Electrical Engineering from the University of Minnesota in 1983.

        CHARLES P. ROMEO has served as a director of the Company since February 28, 2005 and from January 29, 2003 to April 19, 2004. From April 2004 until February 2005, he served as Vice President of Sales, Public Safety Division of the Company. From September 2002 until April 2004 Mr. Romeo has served as the President and Chief Executive Officer of FreedomBridge Technologies, Inc., a Rhode Island based consulting firm to technology companies in the homeland security industry specializing in implementing direct and channel selling programs, strategic alliances and partnerships in the law enforcement market. Prior to founding FreeedomBridge, Mr. Romeo had a 33 year sales and marketing management career with Digital Equipment Corporation, Compaq Computer Corporation and Hewlett Packard. During his career, Mr. Romeo served as Vice President of Service Sales for a $500 million business unit, and Director of Public Sector Sales, a $275 million division of Hewlett Packard. Mr. Romeo authored The Sales Manager's Troubleshooter, Prentice Hall 1998, which was named as one of the "top 10 must reads" by Sales and Marketing Magazine. Mr. Romeo earned a Bachelor of Science degree in Mathematics and Economics from the University of Massachusetts and an Executive MBA from Babson College.

        JOHN SCHOENHERR has served as a Director of the Company since December 30, 2004. Mr. Schoenherr serves as Vice President of Corporate Performance Management for Oracle Corporation, and has served as an Oracle Vice President for over five years. Mr. Schoenherr has over 25 years of experience in the area of business intelligence. His career includes a number of product development and management positions.

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        FRANCIS J. CUSICK has served as the Chief Financial of the Company since February 28, 2005. Mr. Cusick joined the Company as the Corporate Controller in September 2004. Mr. Cusick served as an independent business consultant to public and private companies in a variety of strategic and financial executive roles from March 2002 until September 2004. From January 2001 through February 2002, Mr. Cusick was Chief Financial Officer for SANgate Systems, a multi-national provider of storage hardware and software. Between November 1999 and December 2000, Mr. Cusick served as Corporate Controller for Equipe Communications Corporation and was responsible for all accounting and finance functions. Prior to Equipe, Mr. Cusick held senior financial management positions at Parametric Technology Corp., Cascade Communications Corp. and Synernetics Inc.

        RANDY FODERO has served as the Vice President of Sales since February 1, 2006. From July 22, 2005 until February 1, 2006, he was a sales consultant to the Company. Between July 18, 2003 and July 22, 2005, Mr. Fodero was the Vice President of Sales and Marketing of the Company. Mr. Fodero joined the Company as a member of the sales organization in March 2003. Mr. Fodero brings more than 20 years of successful executive and sales management experience to the Company. Prior to joining the Company, Mr. Fodero served as director of Global Accounts from Veritas Software from February 2002 until January 2003. Between 1999 and February 2002, Mr. Fodero served in executive sales capacities with both companies in the enterprise software industry, including Agile Software. From 1998 to 1999, Mr. Fodero served as Regional Vice President of Sales for Memco Software, a leading provider of information security software to Fortune 1000 companies, where he was instrumental in increasing sales and enhancing shareholder value in connection with the sale of Memco to Platinum Technology. From 1990 through 1998, Mr. Fodero served as Vice President of Sales of AT&T CommVault Systems, where he grew sales from startup to over $36 million and participated in a management buyout.

        KENNETH S. SOUZA has served as Chief Technology Officer of the Company since October 4, 2004 and the General Manager, Law Enforcement since October 18, 2005. Prior to joining the Company, Mr. Souza was Vice President of Industry Solutions for EMC Corporation. Prior to joining EMC, he was Vice President for e-Commerce Enterprise Systems Solutions for Compaq Computer Corporation. His 25-year technology and market career includes serving in a number of executive positions with Digital Equipment Corporation including Vice President Worldwide Solutions Services and Training, and Director of Workstations Marketing. In the early 1980's, Mr. Souza held technical sales management positions with Hewlett Packard and Burroughs. Mr. Souza also held executive positions with a venture funded MRP software company.

Directors' Terms of Office

        Mr. May was initially elected to serve as a director in 2001, and was re-elected in 2004. Mr. Colatosti was initially elected to serve as a director in 2002, and was re-elected in 2004. Mr. DePasquale was initially elected as a director in 2003, and was re-elected in 2004. Mr. Schoenherr was initially elected as a director in 2004. Mr. Romeo was initially elected as a director in 2005. Each such director was elected to serve until the Company's next annual meeting or until his successor is duly elected and qualified in accordance with the By-laws of the Company.

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EXECUTIVE COMPENSATION

        The following table sets forth a summary of the compensation paid to or accrued by our chief executive officer and all of our other executive officers as of December 31, 2005 (the "named executive officers") for each of the fiscal years ended December 31, 2003, 2004 and 2005:


SUMMARY COMPENSATION TABLE

 
  Annual Compensation
  Long Term Compensation
 
   
   
   
   
   
   
  Payouts
   
 
  Fiscal
Year

  Salary ($)
  Bonus ($)
  Other Annual
Compensation
($)

  Restricted
Stock
Award

  Awards
Securities
Underlying
Options/SARs

  LTIP
Payouts

  All
Other

Michael W. DePasquale(1)
Chief Executive Officer
  2005
2004
2003
  250,000
210,000
148,943
 
35,000
25,000
 

 

 

1,080,000
 

 


Francis J. Cusick(2)
Chief Financial Officer

 

2005
2004
2003

 

168,333
36,196

 




 




 




 

155,000
45,000

 




 




Randy Fodero(3)
Vice President Sales

 

2005
2004
2003

 

237,681
197,674
125,986

(4)




10,000

 




 




 

600,000

600,000



(5)




 




Kenneth S. Souza(6)
General Manager, Law
Enforcement and Chief Technology Officer

 

2005
2004
2003

 

200,000
50,000

 


19,000

 




 




 


300,000

 




 




(1)
Mr. DePasquale became employed as our Chief Executive Officer on January 3, 2003.

(2)
Mr. Cusick became our Chief Financial Officer on February 28, 2005.

(3)
Mr. Fodero became Vice President of Sales on February 1, 2006. He was a sales consultant to the Company from July 22, 2005 until February 1, 2006. Between July 18, 2003 and July 22, 2005, Mr. Fodero was the Senior Vice President of Sales and Marketing of the Company.

(4)
Includes $48,176, $47,674 and $10,282 of commission income in 2005, 2004 and 2003, respectively.

(5)
These options expired unexercised on October 20, 2005.

(6)
Mr. Souza became an executive officer of the Company on October 4, 2004.


OPTION GRANTS IN YEAR ENDED DECEMBER 31, 2005

        The following table sets forth all options granted during the year ended December 31, 2005 to each of the named executive officers.

Name

  Number of
Securities
Underlying
Options Granted

  Percent of Total
Options Granted to
Employees in
Fiscal Year

  Exercise
Price
$/Share

  Expiration
Date

Francis J. Cusick(1)   155,000   10.0 % $ 1.33   02/27/2012
Randy Fodero   600,000   38.7 %   0.60   11/10/12

(1)
Options vested in three (3) annual installments commencing February 28, 2006.

(2)
Options vest 33.3% upon grant and thereafter at 22.2222% in three (3) annual installments commencing November 11, 2006.

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AGGREGATED OPTION EXERCISES IN THE YEAR ENDED
DECEMBER 31, 2005 AND FISCAL YEAR-END OPTION VALUE

        The following table sets forth for each named executive officer, information regarding stock options exercised by such officer during the year ended December 31, 2005, together with the number and value of stock options held at December 31, 2005, each on an aggregated basis.

Name

  Number Of
Shares
Acquired On
Exercise

  Value
Realized

  Number Of
Unexercised
Options At Fiscal
Year-End
Exercisable/
Unexercisable(#)

  Value Of
Unexercised
In-The-Money
Options At Fiscal
Year-End
Exercisable/
Unexercisable($)(1)

Michael W. DePasquale       1,080,000   92,800/0
Francis J. Cusick       15,000/185,000   0/0
Randy Fodero       200,000/400,000   18,000/36,000
Kenneth S. Souza       100,000/200,000   0/0

(1)
The last sales price of the Company's Common Stock as reported on the OTC Bulletin Board on December 30, 2005 was $0.69.

Directors Compensation

        Directors who are also officers of the Company receive no additional compensation for serving on the Board of Directors, other than reimbursement of reasonable expenses incurred in attending meetings. The Company's 1996 stock incentive plan provides for the grant of options to purchase 50,000 shares of common stock to each non-employee director upon first being elected or appointed to the Board of Directors. The Company's current policy is to issue options to purchase 50,000 shares of common stock to each non-employee director on an annual basis.

Employment Agreements

        MICHAEL W. DEPASQUALE.    On March 28, 2006, the Company entered into a two-year employment agreement with Michael W. DePasquale to serve as the Chief Executive Officer of the Company at an annual base salary of $250,000 subject to adjustment by the Board of Directors as well as $1,000 per month in lieu of participating in the Company's medical plan. In addition to the Base Salary and Stock Options, a "Discretionary Bonus" may be awarded to Mr. DePasquale on the basis of merit performance on an annual basis in the sole discretion of the Board of Directors. The employment agreement also provides for the grant of options to purchase up to 400,000 shares of Company common stock payable at the discretion of the Board of Directors.

        In the event that Mr. DePasquale is terminated without cause, Mr. DePasquale will receive severance payment equal to his base salary for 6 months. The employment agreement contains standard and customary confidentiality, non-solicitation and "work made for hire" provisions as well as a covenant not to compete which prohibits Mr. DePasquale from doing business with any current or prospective customer of the Company or engaging in a business competitive with that of the Company during the term of his employment and for the one year period thereafter. The Company may terminate the agreement at any time with or without cause. In the event of termination without cause, Mr. DePasquale shall continue to be paid his then current base salary for the greater of six months from the date of such termination or the number of months remaining until the end of the term of the employment agreement.

        KENNETH S. SOUZA.    In connection with his appointment as Senior Vice President and Chief Technology Officer of the Company on October 4, 2004, we entered into a one (1) year employment

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agreement with Kenneth S. Souza. The employment agreement provides for an annual base salary of $200,000 and a performance bonus in the amount of up to $76,000 payable upon achievement of certain performance criteria. Unless notice of non-renewal is provided to Mr. Souza at least two months prior to the end of the term, the employment agreement automatically renews for successive one year terms. In the event that Mr. Souza is terminated without cause, Mr. Souza will receive severance payment equal to his base salary for the greater of 6 months and that number of months remaining until the end of the term. The employment agreement contains standard and customary confidentiality, non-compete and work made for hire provisions.

        Upon execution of the employment agreement, we issued to Mr. Souza a stock option to purchase 300,000 shares of our common stock at an exercise price of $1.11 per share, the last sale price of our common stock as reported on the OTC Bulletin Board on the date of grant. The option has a term of seven (7) years and vests in three equal annual installments commencing on October 4, 2005. Upon completion of one (1) year of service, Mr. Souza shall be eligible to receive a stock option to purchase up to an additional 300,000 shares of Company stock based upon his performance as determined by the Company in its sole discretion.

Change in Control Provisions

        The Company's 1996 Stock Option Plan (as amended to date, the "1996 Plan"), 1999 Stock Option Plan and 2004 Stock Incentive Plan (the "1999 Plan" and together with the 1996 Plan and 2004 Plan, the "Plans") provide for the acceleration of the vesting of unvested options upon a "Change in Control" of the Company. A Change in Control is defined in the Plans to include (i) a sale or transfer of substantially all of the Company's assets; (ii) the dissolution or liquidation of the Company; (iii) a merger or consolidation to which the Company is a party and after which the prior shareholders of the Company hold less than 50% of the combined voting power of the surviving corporation's outstanding securities; (iv) the incumbent directors cease to constitute at least a majority of the Board of Directors; or (v) a change in control of the Company which would otherwise be reportable under Section 13 or 15(d) of the Exchange Act.

        In the event of a "Change In Control" each Plan provides for the immediate vesting of all options issued thereunder. The 1999 Plan provides for the Company to deliver written notice to each optionee under the 1999 Plan fifteen (15) days prior to the occurrence of a Change In Control during which all options issued under the 1999 Plan may be exercised. Thereafter, all options issued under the 1999 Plan which are neither assumed or substituted in connection with such transaction, automatically expire unless otherwise determined by the Board. The 1996 Plan provides for all options to remain exercisable for the remainder of their respective terms and permits the Company to make a cash payment to any or all optionees equal to the difference between the exercise price of any or all such options and the fair market value of the Company's common stock immediately prior to the Change In Control. The 2004 Plan enables the Board to provide that all outstanding options be assumed, or equivalent options be substituted by the acquiring or succeeding corporation upon the occurrence of a "Reorganization Event" as defined. If such Reorganization Event also constitutes a Change in Control, then such assumed or substituted options shall be immediately exercisable in full. If the acquiring or succeeding corporation does not agree to assume, or substitute for such options, then the Board, upon written notice to the Participants, may provide that all unexercised options become exercisable in full as of a specified time prior to the Reorganization Event and terminate prior to the consummation of the Reorganization Event. Alternatively, if under the terms and conditions of the Reorganization Event, holders of common stock will receive a cash payment for their shares, then the Board may provide that all Participants receive a cash payment equal to the difference between the Acquisition Price and the Option Price multiplied by the number of options held by such Participants.

        Options issued to executive officers outside of the Plans contain change in control provisions substantially similar to those contained in the 1999 Plan.

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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Employment Arrangements

        The Company has entered into an employment agreements with Michael W. DePasquale and Kenneth S. Souza. See "EXECUTIVE COMPENSATION—Employment Agreements."

Options Granted to Executive Officers and Directors

        During 2002, the Company issued options to purchase 200,000 shares of common stock to Thomas J. Colatosti upon his appointment as a director of the Company. During 2003, 2004 and 2005, the Company issued options to purchase an aggregate of 2,180,000, 400,000 and 1,155,000 shares, respectively of common stock to its officers and directors. The options were issued at exercise prices equal to the last sales price of the Company's common stock as reported on the OTC Bulletin Board on the date of grant, have terms of three (3) to seven (7) years, and vest over a one to three year period.

Consulting Arrangement with Thomas J. Colatosti

        In connection with his appointment to the Board of Directors in September 2002, the Company entered into a consulting arrangement with Thomas J. Colatosti. Under the arrangement, the Company paid Mr. Colatosti $4,000 per month through December 2003 and issued him options to purchase 150,000 shares of common stock at an exercise price of $0.31 per share, the closing price of the Company's common stock on the date of grant. In December 2003, a committee of independent directors renewed this arrangement through December 31, 2004. The committee also issued options to Mr. Colatosti to purchase 200,000 shares of common stock at an exercise price of $1.32 per share, the closing price of the Company's common stock on the date of grant, for serving as Chairman. Effective November 1, 2004, Mr. Colatosti's monthly consulting fee was increased to $14,500. Mr. Colatosti has substantial experience in the biometric industry and in addition to his role as the Chairman of the Board of Directors of the Company, provides extensive service to the Company in the areas of strategic planning and corporate finance.

        In March 2004, Mr. Colatosti entered into a three year consulting arrangement with the Shaar Fund Ltd., a principal creditor and shareholder of the Company. Under the terms of the arrangement, The Shaar Fund transferred $375,000 principal amount of our secured convertible notes due October 1, 2005 to Mr. Colatosti. On April 28, 2004 the Company issued 3,750 shares of the Company's Series A 7% Convertible Preferred Stock to Mr. Colatosti in conversion of the $375,000 secured convertible note.

        On February 7, 2006, the Company entered into a consulting agreement with Mr. Colatosti, the current Chairman of the Board of Directors. Pursuant to the Agreement, Mr. Colatosti will provide services to the Company and its subsidiaries and affiliates for the year ending December 31, 2006, at a rate of $14,500 per month.

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SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The following table sets forth, as of August 10, 2006, information with respect to the securities holdings of all persons which the Company, pursuant to filings with the Securities and Exchange Commission, has reason to believe may be deemed the beneficial owners of more than five percent (5%) of the Company's outstanding common stock. The following table also sets forth, as of such date, the beneficial ownership of the Company's common stock by all officers and directors, individually and as a group. Unless otherwise indicated, the address of each person listed below is c/o BIO-key International, Inc., 3349 Highway 138, Building D, Suite B, Wall, NJ 07719.

Name and Address of Beneficial Owner

  Amount and Nature
of Beneficial
Ownership(1)

  Percentage of
Class(1)

 
Thomas J. Colatosti   905,000 (2) 1.7 %
Michael W. DePasquale   1,100,000 (3) 2.0 %
Francis J. Cusick   66,666 (4) *  
Jeffrey May   250,000 (5) *  
Charles P. Romeo   300,000 (6) *  
John Schoenherr   25,000 (7) *  
Randy Fodero   200,000 (8) *  
Kenneth S. Souza   200,000 (9) *  
Kingdon Capital Management, LLC   2,696,112   5.0 %
152 West 57th Street
50th Floor
New York, NY 10019
         
Trellus Management Company, LLC   8,083,500   15.0 %
350 Madison Avenue
9th Floor
New York, NY 10017
         
All officers and directors as a group (8) persons   3,046,666   5.7 %

*
Less than 1%

(1)
The securities "beneficially owned" by an individual are determined in accordance with the definition of "beneficial ownership" set forth in the regulations promulgated under the Securities Exchange Act of 1934 and, accordingly, may include securities owned by or for, among others, the spouse and/or minor children of an individual and any other relative who has the same home as such individual, as well as, other securities as to which the individual has or shares voting or investment power or which each person has the right to acquire within 60 days through the exercise of options or otherwise. Beneficial ownership may be disclaimed as to certain of the securities. This table has been prepared based on 53,822,435 shares of common stock outstanding as of August 28, 2006.

(2)
Includes 550,000 shares issuable upon exercise of options and 350,000 shares issuable upon conversion of Series A Preferred Stock.

(3)
Includes 1,080,000 shares issuable upon exercise of options. Does not include 400,000 shares issuable upon exercise of options subject to vesting.

(4)
Includes 66,666 shares issuable upon exercise of options. Does not include 283,334 shares issuable upon exercise of options subject to vesting.

(5)
Consists of shares issuable upon exercise of options.

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(6)
Includes 300,000 shares issuable upon exercise of options. Does not include 100,000 shares issuable upon exercise of options subject to vesting.

(7)
Includes 25,000 shares issuable upon exercise of options. Does not include 25,000 shares issuable upon exercise of options subject to vesting.

(8)
Includes 200,000 shares issuable upon exercise of options. Does not include 500,000 shares issuable upon exercise of options subject to vesting.

(9)
Includes 200,000 shares issuable upon exercise of options. Does not include 350,000 shares issuable upon exercise of options subject to vesting.

        The following table sets forth, as of December 31, 2005, information with respect to securities authorized for issuance under equity compensation plans.


EQUITY COMPENSATION PLAN INFORMATION

 
  Number of securities
to be issued upon
exercise of outstanding
options, warrants
and rights
(a)

  Weighted-average exercise
price of outstanding options,
warrants and rights
(b)

  Number of securities remaining
available for future issuance
under equity compensation
plans (excluding securities
reflected in column (a))
(c)

Equity compensation plans approved by security holders    150,000   $ 0.45  
Equity compensation plans not approved by security holders   6,197,835   $ 0.93   2,594,272
   
 
 
  Total   6,347,835   $ 0.92   2,594,272
   
 
 

        During 1996, the Board of Directors and stockholders of the Company adopted the 1996 Stock Option Plan (the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 100% of fair market value for incentive stock options and 50% for all others. The term of stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The Plan terminated in May 2005.

        The Company's 1999 Stock Option Plan (the "1999 Plan") was adopted by the Board of Directors of the Company on or about August 31, 1999. The material terms of the 1999 Plan are summarized below.

        The 1999 Plan is currently administered by the Board of Directors of the Company (the "Plan Administrator"). The Plan Administrator is authorized to construe the 1999 Plan and any option issued under the 1999 Plan, select the persons to whom options may be granted, and determine the number of shares to be covered by any option, the exercise price, vesting schedule and other material terms of such option.

        The 1999 Plan provides for the issuance of options to purchase up to 2,000,000 shares of common stock to officers, employees, directors and consultants of the Company at exercise prices not less than 85% of the last sale price of the Company's common stock as reported on the OTC Bulletin Board on the date of grant. Options have terms of not more than 10 years from the date of grant, are subject to vesting as determined by the Plan Administrator and are not transferable without the permission of the Company except by will or the laws of descent and distribution or pursuant to a domestic relations order. Options terminate three (3) months after termination of employment or other association with

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the Company or one (1) year after termination due to disability, death or retirement. In the event that termination of employment or association is for a cause, as that term is defined in the 1999 Plan, options terminate immediately upon such termination. The Plan Administrator has the discretion to extend options for up to three years from the date of termination or disassociation with the Company.

        The 1999 Plan provides for the immediate vesting of all options in the event of a "Change In Control" of the Company. In the event of a Change In Control, the Company is required to deliver written notice to each optionee under the 1999 Plan fifteen (15) days prior to the occurrence of a Change in Control, during which time all options issued under 1999 Plan may be exercised. Thereafter, all options issued under the 1999 Plan which are neither assumed or substituted in connection with such transaction, automatically expire, unless otherwise determined by the Board. Under the 1999 Plan, a "Change In Control" is defined to include (i) a sale or transfer of substantially all of the Company's assets; (ii) the dissolution or liquidation of the Company; (iii) a merger or consolidation to which the Company is a party and after which the prior shareholders of the Company hold less than 50% of the combined voting power of the surviving corporation's outstanding securities; (iv) the incumbent directors cease to constitute at least a majority of the Board of Directors; or (v) a change in control of the Company which would otherwise be reportable under Section 13 or 15(d) of the Exchange Act.

        As of December 31, 2005, there were outstanding options under the 1996 Plan to purchase 150,000 shares of common stock, and no shares were available for future grants.

        As of December 31, 2005, there were outstanding options under the 1999 Plan to purchase 1,062,125 shares of common stock, and options to purchase an aggregate of 647,132 shares were available for future grants.

        On October 12, 2004, the Board of Directors of the Company approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan has not yet been presented to stockholders for approval and thus incentive stock options are not available under this plan. Under the terms of this plan, 4,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of stock options granted may not exceed ten years. Options issued under the 2004 Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 2004 Plan terminates in October 2014.

        As of December 31, 2005, there were outstanding options under the 2004 Plan to purchase 2,052,860 shares of common stock, and options to purchase an aggregate of 1,947,140 shares were available for future grants.

        In addition to options issued under the 1996, 1999 and 2004 Plans, the Company has issued options to employees, officers, directors and consultants to purchase common stock under the non plan. As of December 2005, there were outstanding options under the non plan to purchase 3,082,850 shares of common stock. The terms of these options are substantially similar to the provisions of the 1999 Plan and options issued thereunder.

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DESCRIPTION OF SECURITIES

Common Stock

        The Company is authorized to issue 170,000,000 shares of common stock, $.0001 par value per share, of which 53,822,435 were outstanding as of August 10, 2006.

        Holders of common stock have equal rights to receive dividends when, as and if declared by the Board of Directors, out of funds legally available therefor. Holders of common stock have one vote for each share held of record and do not have cumulative voting rights.

        Holders of common stock are entitled, upon liquidation of the Company, to share ratably in the net assets available for distribution, subject to the rights, if any, of holders of any preferred stock then outstanding. Shares of common stock are not redeemable and have no preemptive or similar rights. All outstanding shares of common stock are fully paid and nonassessable.

Preferred Stock

        Within the limits and restrictions provided in the Company's Certificate of Incorporation, the Board of Directors has the authority, without further action by the shareholders, to issue up to 5,000,000 shares of preferred stock, $.0001 par value per share, in one or more series, and to fix, as to any such series, any dividend rate, redemption price, preference on liquidation or dissolution, sinking fund terms, conversion rights, voting rights, and any other preference or special rights and qualifications.

        Series A Convertible Preferred Stock.    In March 2004, we designated 100,000 shares of preferred stock as Series C Convertible Preferred Stock. In connection with the Company's reincorporation in Delaware, each share of Series C Convertible Preferred Stock was automatically converted into one share of Series A Convertible Preferred Stock (the "Series A Shares"), of which 35,557 were issued and outstanding August 10, 2006. The following describes the material provisions of the Series A Shares which are more fully set forth in the Certificate of Designation on file with the Delaware Secretary of State.

        The Series A Shares accrue a cumulative annual dividend of 7% on the $100 face amount of such shares payable June 15 and December 15 each year in shares of common stock. In the event of a liquidation, dissolution or winding up of the Company, the Series A shares have a liquidation preference of $100 per share (plus all accrued and unpaid dividends thereon) prior to any payment or distribution to holders of our common stock. The Series A Shares are convertible into common stock at a conversion price of $.50 per share. The conversion price is subject to proportional adjustment in the event of stock splits, stock dividends or reclassifications. Subject to certain exceptions, in the event we issue additional shares of common stock at a purchase price less than the conversion price of the Series A Shares, the conversion price shall be lowered to such lesser price. In the event that the average closing bid price of our common stock is less than $1.00 per share for thirty (30) consecutive trading days at any time after March 3, 2007, we will be required to redeem the Series A Shares by payment of $100 per share plus all accrued and unpaid dividends due thereon.

        We are required to obtain the consent of the holders of a majority of the Series A Shares in order to, among other things, issue any shares of preferred stock that are equal to or have a preference over the Series A shares or issue any shares of preferred stock, rights, options, warrants, or any other securities convertible into common stock of the Company, other than those issued to employees of the Company in the ordinary course of their employment or to consultants or other persons providing services to the Company so long as such issuances do not exceed 500,000 shares of common stock. We are also required to obtain such consent in order to, among other things, complete a sale or other disposition of any material assets, complete an acquisition of a material amount of assets, engage in a merger, reorganization or consolidation, or incur or guaranty any indebtedness in excess of $50,000.

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        Series B Convertible Preferred Stock.    In January 2006, the Company designated 1,000,000 shares of preferred stock as Series B Convertible Preferred Stock, all of which are issued and outstanding. The following describes the material provisions of the Series B Convertible Preferred Shares which are more fully set forth in the Certificate of Designation on file with the Delaware Secretary of State.

        The Series B Convertible Preferred Shares accrue a cumulative annual dividend of 15% on the $1 face amount of such shares payable January 1, April 1, July 1 and October 1 each year in shares of common stock, or cash at the Company's election. In the event of a liquidation, dissolution or winding up of the Company, the Series B Convertible Preferred Shares have a liquidation preference of $1 per share (plus all accrued and unpaid dividends thereon) prior to any payment or distribution to holders of our common stock. The Series B Convertible Preferred Shares are convertible into common stock at a conversion price of $.50 per share. The conversion price is subject to proportional adjustment in the event of stock splits, stock dividends or reclassifications. Subject to certain exceptions, in the event we issue additional shares of common stock at a purchase price less than the conversion price of the Series B Convertible Preferred Shares, the conversion price shall be lowered to such lesser price.

        If during the thirty (30) consecutive trading day period occurring prior to January 1, 2009, the average closing bid price for one share of Common Stock, as reported by Bloomberg, L.P. is at least $1.10, all outstanding Series B shares shall automatically be converted into Common Stock, at the then effective conversion rate. Upon conversion, all accrued or declared but unpaid dividends on the Series B shares shall be paid in shares of Common Stock. In the event that the average closing bid price of our common stock is less than $1.10 per share for thirty (30) consecutive trading days at any time after January 1, 2009, we will be required to redeem the Series A Convertible Preferred Shares by payment of $1 per share plus all accrued and unpaid dividends due thereon.

        For as long as twenty-five percent (25%) of the Series B Convertible Preferred Stock are outstanding, we are required to obtain the consent of the holders of a majority of the Series B Convertible Preferred Shares in order to, among other things, issue any shares of preferred stock that are equal to or have a preference over the Series B Convertible Preferred Shares or issue any shares of preferred stock, rights, options, warrants, or any other securities convertible into common stock of the Company, other than those issued to employees of the Company in the ordinary course of their employment or to consultants or other persons providing services to the Company. We are also required to obtain such consent in order to, among other things, complete a sale or other disposition of any material assets, complete an acquisition of a material amount of assets, engage in a merger, reorganization or consolidation, or incur or guaranty any indebtedness in excess of $50,000.

        Series C Convertible Preferred Stock.    In August 2006, the Company designated 600,000 shares of preferred stock as Series C Convertible Preferred Stock, 592,032 of which are issued and outstanding, as of August 10, 2006. The following describes the material provisions of the Series C Convertible Preferred Shares, which are more fully set forth in the Certificate of Designation on file with the Delaware Secretary of State.

        The Series C Convertible Preferred Shares accrue a cumulative annual dividend of 15% on the $10 face amount of such shares payable December 1, March 1, June 1 and September 1 each year in shares of common stock, or cash at the Company's election. In the event of a liquidation, dissolution or winding up of the Company, the Series C Convertible Preferred Shares have a liquidation preference of $10 per share (plus all accrued and unpaid dividends thereon) prior to any payment or distribution to holders of our common stock. The Series C Convertible Preferred Shares are convertible into common stock at a conversion price of $.50 per share. The conversion price is subject to proportional adjustment in the event of stock splits, stock dividends or reclassifications. Subject to certain exceptions, in the event we issue additional shares of common stock at a purchase price less than the conversion price of the Series C Convertible Preferred Shares, the conversion price shall be lowered to such lesser price.

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        If during the thirty (30) consecutive trading day period occurring prior to January 1, 2009, the average closing bid price for one share of Common Stock, as reported by Bloomberg, L.P. is at least $1.20, all outstanding Series C shares shall automatically be converted into Common Stock, at the then effective conversion rate. Upon conversion, all accrued or declared but unpaid dividends on the Series C shares shall be paid in shares of Common Stock.

        For as long as any of the Series C Convertible Preferred Stock are outstanding, we are required to obtain the consent of the holders of the Series C Convertible Preferred Shares in order to, among other things, issue any shares of preferred stock that are equal to or have a preference over the Series C Convertible Preferred Shares or issue any shares of preferred stock, rights, options, warrants, or any other securities convertible into common stock of the Company, other than those issued to employees of the Company in the ordinary course of their employment or to consultants or other persons providing services to the Company.

Dividend Policy

        The Company has never paid cash dividends on its common stock. The Board of Directors does not anticipate paying cash dividends in the foreseeable future as it intends to retain future earnings, if any, to finance the growth of the business. The payment of future dividends on our common stock will depend on such factors as earnings levels, anticipated capital requirements, the operating and financial condition of the Company and other factors deemed relevant by the Board of Directors.

Anti-Takeover Provisions of the Company's Certificate of Incorporation

        As described above, the Board of Directors is authorized without further stockholder action, to designate any number of series of preferred stock with such rights, preferences and designations as determined by the Board. Shares of preferred stock issued by the Board of Directors could be utilized, under certain circumstances, to make an attempt to gain control of the Company more difficult or time consuming. For example, shares of preferred stock could be issued with certain rights that might have the effect of diluting the percentage of common stock owned by a significant stockholder or issued to purchasers who might side with management in opposing a takeover bid that the Board of Directors determines is not in the best interest of the Company and its stockholders. The existence of the preferred stock may, therefore, be viewed as having possible anti-takeover effects.

Transfer Agent

        The transfer agent for the Company's common stock is StockTrans, Inc., 44 West Lancaster Avenue, Ardmore, Pennsylvania 19003, (610) 649-7300.


FINANCING TRANSACTIONS

Secured Debt Financing Transactions

        On June 8, 2005, we entered into a Securities Purchase Agreement (the "Senior Purchase Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Under the Senior Purchase Agreement, the Company issued a secured convertible term note (the "2005 Senior Note") in the aggregate principal amount of $2,000,000, convertible into common stock of the Company in certain circumstances at an initial conversion price of $1.35 per share, and issued a warrant (the "Senior Warrant") to purchase an aggregate of 444,444 shares of our common stock at an initial exercise price of $1.55 per share. As consideration for the 2005 Senior Note and Senior Warrant, the Company received approximately $1,841,000, net of all fees and expenses, from Laurus, which amount was disbursed to the Company on June 9, 2005. The proceeds from this transaction have been used for the Company's general working capital purposes. The Company's obligations under the Senior Purchase Agreement, the 2005 Senior

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Note and the Senior Warrant are secured by a security interest in all or substantially all of the Company's assets.

        Under the terms of the 2005 Senior Note, we are required to make monthly payments of accrued interest only beginning on July 1, 2005. In addition, the 2005 Senior Note provides for monthly payments of principal in equal 1/32 increments thereof, plus accrued interest, commencing October 1, 2005. The 2005 Senior Note bears interest at an initial rate equal to the prime rate plus two percent (2%), subject to a six percent (6%) floor. The interest rate on the 2005 Senior Note is subject to reduction on a month-by-month basis if the following conditions are met: If (a) we register the common stock underlying the 2005 Senior Note and Senior Warrant on a registration statement declared effective by the Securities and Exchange Commission and (b) our common stock is trading at a 25% or greater premium to the note conversion price, then the interest rate will be adjusted downward by 2.0% for each incremental 25% increase over the note conversion price. Alternatively, if (x) we have not registered such common stock under an effective registration statement, but (y) our common stock is trading at a 25% or greater premium to the note conversion price, then the interest rate will be adjusted downward by 1.0% for each incremental 25% increase over the note conversion price. In no event shall the interest rate be less than 0%.

        For any cash payments we make on the 2005 Senior Note (e.g., any amounts due that are not converted into common stock), we are required to pay an amount equal to 102% of the principal amount due. In addition, we can prepay the note at any time upon payment of an amount equal to 110% of the then outstanding principal balance, plus accrued and unpaid interest.

        Laurus has the option at any time to convert any or all of the outstanding principal and accrued and unpaid interest on the 2005 Senior Note into shares of our common stock at a conversion price of $0.50 per share, as reduced pursuant to subsequent transactions which are described further below. In addition, for each monthly payment under the note, Laurus will be obligated to convert a portion of the monthly payment into common stock at the applicable conversion price, so long as:

        The terms of the 2005 Senior Note and Senior Warrant prohibit conversion of the note or exercise of the warrant to the extent that conversion of the note and exercise of the warrant would result in any holder thereof, together with its affiliates, beneficially owning in excess of 4.99% of our outstanding shares of common stock. A holder may waive the 4.99% limitation upon 75 days' prior written notice to us. Also, this limitation does not preclude the holder from converting or exercising the note or warrant and selling shares underlying the note or warrant in stages over time where each stage does not cause the holder and its affiliates to beneficially own shares in excess of the limitation amount.

        As security for our obligations to Laurus, we, along with our wholly-owned subsidiary Public Safety Group, Inc. ("PSG"), have granted to Laurus a blanket security interest in all of our assets, and we have entered into a stock pledge with Laurus for the capital stock in PSG. If an event of default occurs under the 2005 Senior Note or the other related investment agreements, 120% of the unpaid principal balance on the 2005 Senior Note, plus accrued interest and fees, shall become immediately due and

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Laurus shall be entitled to payment of a default interest rate of 1.5% per month on all amounts due under the 2005 Senior Note. Such events of default include the following:

        Upon an event of default, Laurus will be entitled to specified remedies, including remedies under the Uniform Commercial Code.

        We agreed to register with the Securities and Exchange Commission for resale the shares of common stock that are issuable upon conversion of the 2005 Senior Note and upon exercise of the Senior Warrant. Under the registration rights agreement, we were obligated to file a registration statement with the Securities and Exchange Commission on or before July 8, 2005, and to use reasonable commercial efforts to have the registration statement declared effective not later than September 6, 2005. The resale registration statement of which this prospectus is a part was initially filed with the Securities and Exchange Commission on July 8, 2005 for the shares underlying the 2005 Senior Note and Senior Warrant. If we fail to comply with our registration obligations, Laurus will be entitled to certain specified remedies, including monetary liquidated damages. In particular, for each 30 days (or such pro rated number of days) that we are out of compliance with our registration obligations, we will be subject to a liquidated damage assessment of 2% of the original principal amount of the 2005 Senior Note. Laurus has agreed to waive such liquidated damages through August 10, 2006. As of June 30, 2006, the balance of liquidated damages owing to Laurus was $353,333.

        Laurus has agreed, pursuant to the Senior Purchase Agreement, that neither it nor any of its affiliates and investment partners will (and will not cause any other person or entity, directly or indirectly, to) engage in "short sales" of our common stock for as long as any 2005 Senior Note held by it remain outstanding. "Short sales" are contracts for the sale of shares of stock that the seller does not own, or certificates which are not within the seller's control, so as to be available for delivery at the time when, under applicable rules, delivery must be made.

        The Company subsequently entered into an Amendment and Waiver agreement with Laurus, dated as of August 31, 2005, pursuant to which the Company was permitted to defer the payment of the monthly principal amounts due and payable for the months of September, October, November and December 2005 under both (a) the Secured Convertible Term Note in the original principal amount of $5,000,000 issued by the Company to Laurus on September 29, 2004 (the "2004 Senior Note"), and (b) the 2005 Senior Note, such aggregate deferred principal amounts being equal to $625,000 and

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$187,500, respectively. The deferred principal amount under the 2004 Senior Note is now due on September 29, 2007, the maturity date of that note, and will be paid at the same time the final payments due with respect to that note upon maturity. The deferred principal amount under the 2005 Senior Note is now due on June 7, 2008, the maturity date of that note, and will be paid at the same time the final payments due with respect to that note upon maturity. The Company will remain obligated to pay all monthly interest amounts under these notes as they are currently due.

        Pursuant to this Amendment and Waiver, the Company issued an aggregate of 612,166 shares of its Common Stock to Laurus as consideration for this principal payment deferral. The Company entered into a Registration Rights Agreement dated as of August 31, 2005 pursuant to which the Company has agreed to file a registration statement with the Securities and Exchange Commission (the "SEC") covering the resale of these shares of Common Stock. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

        Effective as of January 23, 2006, the Company entered into an Amendment and Waiver with Laurus in connection with all Secured Convertible Notes then held by Laurus. Under that Secured Notes Amendment and Waiver, the 2004 Senior Note and the 2005 Senior Note were amended as follows: (i) the maturity date of the 2004 Senior Note was extended to January 1, 2008; (ii) the maturity date of the 2005 Senior Note was extended to December 1, 2008, and (iii) the fixed conversion price under each of these Secured Notes was reset from $1.35 to $0.85 per share. In addition, the exercise price of all warrants to purchase Common Stock of the Company held by Laurus was reset to $1.00 per share. Pursuant to this Amendment and Waiver, the Company issued an aggregate of 150,000 shares of its Common Stock to Laurus as consideration for this principal payment deferral. The Company entered into a Registration Rights Agreement dated as of January 23, 2006 pursuant to which the Company has agreed to file a registration statement with the SEC covering the resale of these shares of Common Stock. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

        Effective as of August 10, 2006, the Company also entered into an Amendment and Waiver with Laurus in connection with the holder of its Secured Convertible Notes currently held by Laurus. Under the Amendment and Waiver, the September 2004 Note and June 2005 Note were amended as follows: (i) the principal amounts due and payable under the 2004 Note and the 2005 Note for the months of August and September 2006, respectively, shall be paid in shares of the Company's Common Stock priced at $0.50 per share; and (ii) the principal amount due and payable under the 2004 Note for the months of October, November and December 2006 is deferred until January 1, 2008, the final maturity date of the 2004 Note, and the principal amount due and payable under the 2005 Note for the months of October, November and December 2006 is deferred until December 1, 2008, the final maturity date of the 2005 Note. Pursuant to this Amendment and Waiver, the Company issued 150,000 shares of its common stock to Laurus as consideration for the principal payment deferral. In connection with this financing, the Company also reduced the conversion price of the Series A and Series B Convertible Preferred shares to $0.50 per share. The Company entered into a Registration Rights Agreement dated as of August 10, 2006 pursuant to which the Company has agreed to file a registration statement with the SEC covering the resale of these shares of Common Stock. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

Subordinated Debt and Preferred Stock Financing Transactions

        We entered into a Securities Purchase Agreement, effective as of May 31, 2005, (the "Subordinated Purchase Agreement") with The Shaar Fund, Ltd. ("Shaar"), Longview Fund, L.P. ("Longview") and other existing shareholders of the Company and accredited investors (collectively, the "Subordinated Investors"). Under the Subordinated Purchase Agreement, the Company issued Convertible Term Notes (the "Subordinated Convertible Notes") in the aggregate principal amount of $2,794,723, convertible into Common Stock of the Company in certain circumstances at an initial

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conversion price of $1.35 per share, and issued warrants (the "Subordinated Warrants") to purchase an aggregate of 828,066 shares of the Common Stock at an initial per share exercise price of $1.50. The aggregate consideration received by the Company, net of all fees and expenses, for such Subordinated Convertible Notes and Subordinated Warrants was approximately $2,411,000. The proceeds from this transaction have been used for working capital purposes. The Subordinated Convertible Notes were issued at a purchase price equal to $900 for each $1,000 of principal amount of the Note.

        Certain Subordinated Investors purchased additional Subordinated Convertible Notes in the aggregate principal amount of $450,000 and received additional Subordinated Warrants to purchase an aggregate of 133,333 shares of Common Stock at an initial per share exercise price of $1.50. The aggregate consideration received by the Company net of all fees and expenses for such Subordinated Convertible Notes and Subordinated Warrants was $404,500, which was paid by the Subordinated Investors on July 8, 2005.

        The Company entered into Amendment and Waiver agreements, each dated as of August 31, 2005, pursuant to which certain Subordinated Investors allowed the Company to defer the payment of the monthly principal amounts due and payable for the months of September, October, November and December 2005 under the Convertible Term Notes in the aggregate original principal amount of $2,800,000 issued by the Company to the Subordinated Investors on September 29, 2004 (the "Subordinated Notes"), such aggregate deferred principal amount being equal to $350,004. The deferred principal amount under each Subordinated Note is now due on September 29, 2007, the maturity date of each such note, and will be paid at the same time the final payments due with respect to each such note upon maturity. The Company will remain obligated to pay all monthly interest amounts under these notes as they are currently due.

        Pursuant to these Amendment and Waivers, the Company issued an aggregate of 263,705 shares of its Common Stock to the Subordinated Investors as consideration for this principal payment deferral. The Company entered into the Registration Rights Agreement with each of the Subordinated Investors, pursuant to which the Company has agreed to file a registration statement with the SEC covering the resale of these shares of Common Stock. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

        Effective as of January 23, 2006, the Company also entered into an Amendment and Waiver with certain holders of its Subordinated Convertible Promissory Notes. Under the Subordinated Notes Amendment and Waiver, the Subordinated Notes issued by the Company on September 29, 2004 in the aggregate principal amount of $5,288,221 and on May 31, 2005 in the aggregate principal amount of $3,244,723 were amended as follows: (i) the maturity dates were extended from September 29, 2007 and May 31, 2008, respectively, to January 1, 2009; (ii) the interest rate was fixed at fifteen percent (15%); (iii) all principal amounts are due at the maturity date and shall be paid in shares of Common Stock priced at $0.70 per share if the average closing price of the Common Stock for the thirty (30) trading days immediately preceding the maturity date is greater than $1.10; (iv) interest shall be paid, at the Company's election, in cash or shares of Common Stock, with the Common Stock priced at the average closing price of the Common Stock for the ten (10) trading days immediately preceding the repayment date; and (v) the currently applicable fixed conversion price was amended to $0.70 per share. In addition, the exercise price of all warrants to purchase Common Stock held by the Subordinated Note Holders that had an exercise price greater than $1.00 per share was reset to $1.00 per share.

        Effective as of August 10, 2006, the Company also entered into a Securities Exchange Agreement (the "Securities Exchange Agreement") with certain holders (the "Subordinated Note Holders") of its outstanding Subordinated Convertible Promissory Notes (the "Subordinated Notes"). Under the Securities Exchange Agreement, the Subordinated Notes were exchanged for shares (the "Series C Shares") of the Company's Series C Convertible Preferred Stock, which shares are initially convertible

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into Common Stock at $0.50 per share, having an aggregate value equal to the principal amount outstanding under the Subordinated Notes, plus accrued and unpaid interest thereon, and certain liquidated damages payments owed by the Company to the Subordinated Note Holders. In connection with the transaction, the Company also reduced the conversion price of the Series A and Series B Convertible Preferred shares to $0.50 per share. The Company entered into a Registration Rights Agreement dated as of August 10, 2006 (the "Exchange Registration Rights Agreement") with the Subordinated Note Holders, pursuant to which the Company has agreed to file a registration statement with the Commission covering the resale of the shares of Common Stock underlying the Series C Shares. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

        The Company also entered into a Securities Purchase Agreement, effective as of January 23, 2006, with Shaar, Longview and Longview Special Finance, Inc. Under this Securities Purchase Agreement, the Company issued to such investors Convertible Term Notes in the aggregate principal amount of $1,000,000. On February 22, 2006, the Convertible Notes converted by their terms into shares of the Company's Series B Preferred Stock, which shares are convertible into shares of the Company's Common Stock at a fixed conversion price of $0.50 per share. Pursuant to this Securities Purchase Agreement, the Company also issued warrants to such investors to purchase an aggregate of 500,000 shares of the Company's Common Stock at an initial per share exercise price of $1.00.

Common Stock Financing Transaction

        The Company entered into (i) a Securities Purchase Agreement (the "Trellus Securities Purchase Agreement"), dated as of August 10, 2006, with Trellus Partners, L.P. ("Trellus") and (ii) a Securities Purchase Agreement (the "Shaar Securities Purchase Agreement"), dated as of August 10, 2006, with Shaar. Under the Trellus Securities Purchase Agreement, the Company (i) issued and sold 3,000,000 shares of its Common Stock (the "Trellus Shares") to Trellus, at a purchase price of $0.50 per share, for an aggregate purchase price of $1,500,000 and (ii) issued a warrant to Trellus (the "Trellus Warrant") to purchase up to an aggregate of 400,000 shares of the Company's Common Stock at an exercise price of $0.75 per share. The proceeds from this transaction will be used for general working capital purposes. The Company entered into a Registration Rights Agreement dated as of August 10, 2006 (the "Trellus Registration Rights Agreement") with Trellus, pursuant to which the Company has agreed to file a registration statement with the Commission covering the resale of the Trellus Shares and the shares of Common Stock underlying the Trellus Warrants. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

        Under the Shaar Securities Purchase Agreement, the Company agreed to (i) issue and sell 1,000,000 shares of its Common Stock (the "Shaar Shares") to Shaar, at a purchase price of $0.50 per share, for an aggregate purchase price of $500,000 to be paid by exchanging Shaar's rights in an aggregate amount of $500,000 in declared and unpaid dividends on the Shares of Series A Convertible Preferred Stock currently held by Shaar; and (ii) issue a warrant to Shaar (the "Shaar Warrant") to purchase up to an aggregate of 133,333 shares of the Company's Common Stock at an exercise price of $0.75 per share. The Company entered into a Registration Rights Agreement dated as of August 10, 2006 (the "Shaar Registration Rights Agreement") with Shaar, pursuant to which the Company has agreed to file a registration statement with the Commission covering the resale of the Shaar Shares and the shares of Common Stock underlying the Shaar Warrants. The resale registration statement of which this prospectus is a part was initially filed with the SEC on September 11, 2006.

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SELLING SECURITY HOLDERS

        We are registering for resale shares of our common stock issued to the selling security holders identified below. The selling security holders identified in the following table are offering for sale up to 25,164,046 shares of our common stock, of which 18,954,842 shares are issuable upon conversion of preferred stock, 912,166 shares have been issued pursuant to secured notes amendment and waiver agreements, 263,705 shares have been issued pursuant to a subordinated notes amendment and waiver agreement, 4,000,000 shares have been issued to the selling security holders pursuant to securities purchase agreements, and 1,033,333 shares are issuable upon exercise of warrants issued in conjunction with the securities purchase agreements. The following table sets forth:


        We prepared this table based on the information supplied to us by the selling security holders named in the table and we have not sought to verify such information. We are unable to determine the exact number of shares that will actually be sold or when, or if, these sales will occur. Additionally, we are unable to determine the exact number of shares, if any, that will be issued to the selling security holders who hold our convertible preferred stock upon conversion of such preferred stock.

        Each of the selling security holders is offering for sale with this prospectus the number of shares listed below subject to the limitations described in the section of this prospectus entitled "Plan of Distribution". Beneficial ownership is determined in accordance with the rules and regulations of the Securities and Exchange Commission. Except as indicated in the footnotes to this table and subject to applicable community property laws, each of the selling security holders named in this table has sole voting power with respect to all shares of common stock listed as beneficially owned by such selling security holders.

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        The applicable percentages of beneficial ownership set forth below are based on an aggregate of 53,822,435 shares of our common stock issued and outstanding on August 10, 2006.

 
   
   
  Shares Beneficially Owned
After Offering is Complete

 
Name of Selling Security Holder

  Number of Shares
Beneficially Owned
Prior to Offering

  Shares Offered
Pursuant to
This Prospectus

 
  Number
  Percent
 
Laurus Master Fund, Ltd.(1)   4,807,001   912,166   3,894,835   7.2 %
The Shaar Fund Ltd.(2)   9,289,774   9,289,774      
Longview Fund, LP(3)   5,997,085   5,997,085      
Douglass Bermingham(4)   165,190   165,190      
Mason Sexton IRA(5)   165,190   165,190      
Longview Special Finance(6)   2,329,485   2,329,485      
Cordillera Fund, LP(7)   173,266   173,266      
Eric Huber(8)   4,710   4,710      
Etienne Des Roys(9)   9,418   9,418      
Investors Management Company(10)   470,565   470,565      
US Bank FBO The Tocqueville Fund(11)   1,129,350   1,129,350      
The Tocqueville Amerique Fund(12)   452,491   452,491      
The CCJ Trust(13)   665,356   665,356          
Trellus Partners, LP(14)   11,483,500   3,400,000   8,083,500   15.0 %
   
 
 
     
Total   37,142,381   25,164,046   11,978,335   22.2 %

*
Less than one percent (1%) of the outstanding common stock.

(1)
Includes (i) 612,166 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005, (ii) 150,000 shares of common stock issued in connection with the amendment and waiver agreement dated as of January 23, 2006, and (iii) 150,000 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 10, 2006. This selling security holder has identified Laurus Master Fund, Ltd. as having voting and dispositive power with respect to these securities. Laurus Capital Management, LLC, a Delaware limited liability company, is a control person of the securities held by Laurus Master Fund, Ltd, and David Grin and Eugene Grin are the sole members of Laurus Capital Management, LLC. This selling security holder has been the senior lender to the Company since September 2004.

(2)
Includes (i) 6,529,072 and 1,285,397 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock and Series B Preferred Stock, respectively, in each case together with accrued dividends thereon, held by this selling security holder, (ii) 1,000,000 shares of common stock issued in connection with the securities purchase agreement dated as of August 10, 2006, (iii) 116,972 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005, (iv) 133,333 shares issuable upon exercise of a warrant held by this selling security holder at exercise prices of $0.75, and (v) 225,000 shares issuable upon exercise of a warrant held by this selling security holder at an exercise price of $0.50. This selling security holder has identified Andy Senior as having voting and dispositive power with respect to these securities. This selling security holder has been a principal creditor and source of financing for the Company since June 1998.

(3)
Includes (i) 4,990,154 and 856,931 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock and Series B Preferred Stock, respectively, in each case together with accrued dividends thereon, held by this selling security holder, and (ii) 150,000 shares issuable upon exercise of the warrant held by

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(4)
Includes 165,190 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder. This selling security holder has identified itself as an affiliate of a registered broker-dealer. See "Plan of Distribution" section of this prospectus for required disclosure regarding such selling security holder's status as an affiliate of a registered broker-dealer.

(5)
Includes 165,190 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder. This selling security holder has identified itself as an affiliate of a registered broker-dealer. See "Plan of Distribution" section of this prospectus for required disclosure regarding such selling security holder's status as an affiliate of a registered broker-dealer. This selling security holder has identified Mason Sexton as having voting and dispositive power with respect to these securities.

(6)
Includes (i) 1,443,285 and 714,110 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock and Series B Preferred Stock, respectively, in each case together with accrued dividends thereon, held by this selling security holder, (ii) 47,090 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005, and (iii) 125,000 shares issuable upon exercise of the warrant held by this selling security holder at an exercise price of $0.50. This selling security holder has identified Francis Horn as having voting and dispositive power with respect to these securities.

(7)
Includes 173,266 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder. This selling security holder has identified Stephen J. Carter as having voting and dispositive power with respect to these securities.

(8)
Includes 4,710 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005.

(9)
Includes 9,418 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005.

(10)
Includes (i) 450,976 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder, and (ii) 19,589 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005. This selling security holder has identified Richard A. Urquhart, III as having voting and dispositive power with respect to these securities.

(11)
Includes (i) 1,082,260 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder, and (ii) 47,090 shares of common stock issued in connection with the amendment and waiver agreement dated as of August 31, 2005. This selling security holder has identified Robert W. Kleinschmidt as having voting and dispositive power with respect to these securities. In addition, this selling security holder has identified itself as an affiliate of a registered broker-dealer. See "Plan of Distribution" section of this prospectus for required disclosure regarding such selling security holder's status as an affiliate of a registered broker-dealer.

(12)
Includes (i) 433,655 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder, and (ii) 18,836 shares of common stock issued in connection with the amendment

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(13)
Includes 665,356 shares as our estimate of the number of shares of common stock that may be issuable upon conversion, from time to time, of Series C Preferred Stock held by this selling security holder. This selling security holder has identified Charles C. Johnston as having voting and dispositive power with respect to these securities.

(14)
Includes (i) 3,000,000 shares of common stock issued in connection with the securities purchase agreement dated as of August 10, 2006, and (ii) 400,000 shares issuable upon exercise of the warrant held by this selling security holder at an exercise price of $0.75. This selling security holder has identified Adam Usden as having voting and dispositive power with respect to these securities.

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PLAN OF DISTRIBUTION

        The selling security holders may, from time to time after the registration statement which includes this prospectus becomes effective, sell any or all of their shares of common stock on any stock exchange, market or trading facility on which the shares are traded or in private transactions. These sales may be at fixed or negotiated prices. The selling security holders may use any one or more of the following methods when selling shares:

        The selling security holders may also sell shares under Rule 144 under the Securities Act, if available, rather than under this prospectus.

        The Shaar Fund Ltd., and the other selling security holders offering shares of our common stock under this prospectus upon conversion of our Series C Convertible Preferred Stock have each agreed, pursuant to the applicable securities purchase agreement with us, that neither it nor any of its affiliates and investment partners will (and will not cause any other person or entity, directly or indirectly, to) engage in "short sales" of our common stock for as long as such preferred stock held by it remains outstanding. "Short sales" are contracts for the sale of shares of stock that the seller does not own, or certificates which are not within the seller's control, so as to be available for delivery at the time when, under applicable rules, delivery must be made.

        Broker-dealers engaged by the selling security holders may arrange for other brokers-dealers to participate in sales. Broker-dealers may receive commissions or discounts from the selling security holders (or, if any broker-dealer acts as agent for the purchaser of shares, from the purchaser) in amounts to be negotiated. The selling security holders do not expect these commissions and discounts to exceed what is customary in the types of transactions involved. Any profits on the resale of shares of common stock by a broker-dealer acting as principal might be deemed to be underwriting discounts or commissions under the Securities Act. Discounts, concessions, commissions and similar selling expenses, if any, attributable to the sale of shares will be borne by a selling security holder. The selling security holders may agree to indemnify any agent, dealer or broker-dealer that participates in transactions involving sales of the shares if liabilities are imposed on that person under the Securities Act.

        In order to comply with the securities laws of certain states, if applicable, the shares being offered hereby must be sold in such jurisdictions only through registered or licensed brokers or dealers. In addition, in certain states such shares may not be sold unless they have been registered or qualified for sale in the applicable state or an exemption from the registration or qualification requirement is available and there has been compliance thereof.

        The selling security holders may from time to time pledge or grant a security interest in some or all of the shares of common stock owned by them and, if they default in the performance of their secured obligations, the pledgees or secured parties may offer and sell the shares of common stock

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from time to time under this prospectus after we have filed an amendment to this prospectus under Rule 424(b)(3) or other applicable provision of the Securities Act amending the list of selling security holders to include the pledgee, transferee or other successors in interest as selling security holders under this prospectus.

        The selling security holders also may transfer the shares of common stock in other circumstances, in which case the transferees, pledgees or other successors in interest will be the selling beneficial owners for purposes of this prospectus and may sell the shares of common stock from time to time under this prospectus after we have filed an amendment to this prospectus under Rule 424(b)(3) or other applicable provision of the Securities Act amending the list of selling security holders to include the pledgee, transferee or other successors in interest as selling security holders under this prospectus.

        The selling security holders and any broker-dealers or agents that are involved in selling the shares of common stock may be deemed to be "underwriters" within the meaning of the Securities Act in connection with such sales. In such event, any commissions received by such broker-dealers or agents and any profit on the resale of the shares of common stock purchased by them may be deemed to be underwriting commissions or discounts under the Securities Act.

        We are required to pay all fees and expenses incident to the registration of the shares of common stock. We have agreed to indemnify the selling security holders against certain losses, claims, damages and liabilities, including liabilities under the Securities Act. The selling security holders will be responsible, however, for all selling commissions applicable to the sale of shares pursuant to this prospectus.

        Each selling security holder that is an affiliate of a registered broker-dealer has represented to us that it purchased our securities for its own account for investment only and that at the time of such purchase, such selling security holder had no agreements, plans or understandings, directly or indirectly, with any person to distribute such securities.

        The selling security holders have advised us that they have not entered into any agreements, understandings or arrangements with any underwriters or broker- dealers regarding the sale of their shares of common stock, nor is there an underwriter or coordinating broker acting in connection with a proposed sale of shares of common stock by any selling security holder. If we are notified by any selling security holder that any material arrangement has been entered into with a broker-dealer for the sale of shares of common stock, if required, we will file a supplement to this prospectus. If the selling security holders use this prospectus for any sale of the shares of common stock, they will be subject to the prospectus delivery requirements of the Securities Act.

        The anti-manipulation rules of Regulation M under the Exchange Act may apply to sales of our common stock and activities of the selling security holders. We have informed the selling security holders that, during such time as they may be engaged in a distribution of any of the shares we are registering by this registration statement, they are required to comply with Regulation M, and the selling security holders have agreed, and will cause each of their affiliates and investment partners, to comply with Regulation M in all respects during such time. In general, Regulation M precludes any selling security holder, any affiliated purchasers and any broker-dealer or other person who participates in a distribution from bidding for or purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of the distribution until the entire distribution is complete. Regulation M defines a "distribution" as an offering of securities that is distinguished from ordinary trading activities by the magnitude of the offering and the presence of special selling efforts and selling methods. Regulation M also defines a "distribution participant" as an underwriter, prospective underwriter, broker, dealer or other person who has agreed to participate or who is participating in a distribution.

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        Regulation M also prohibits any bids or purchases made in order to stabilize the price of a security in connection with the distribution of that security, except as specifically permitted by Rule 104 of Regulation M. These stabilizing transactions may cause the price of our common stock to be more than it would otherwise be in the absence of these transactions. We have informed the selling security holders that stabilizing transactions permitted by Regulation M allow bids to purchase our common stock if the stabilizing bids do not exceed a specified maximum, and the selling security holders have agreed, and will cause each of their affiliates and investment partners, to comply with Regulation M in all respects during such time as they may be engaged in a distribution of any of the shares we are registering by this registration statement. Regulation M specifically prohibits stabilizing that is the result of fraudulent, manipulative or deceptive practices. Selling security holders and distribution participants are required to consult with their own legal counsel to ensure compliance with Regulation M.

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DISCLOSURE OF COMMISSION POSITION OF INDEMNIFICATION
FOR SECURITIES ACT LIABILITIES

        The Company's Certificate of Incorporation limits the personal liability of the Company's officers and directors for monetary damages for breach of their fiduciary duty as directors, except for liability that cannot be eliminated under the Delaware General Corporation Law (the "DGCL"). The Company's Bylaws also provide for the Company to indemnify directors and officers to the fullest extent permitted by the DGCL.

        The indemnification provisions described above would provide coverage for claims arising under the Securities Act and the Exchange Act. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Company pursuant to the Company's Certificate of Incorporation, Bylaws, the DGCL, or otherwise, the Company has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable.


EXPERTS

        Our financial statements as of December 31, 2005 and for each of the three years in the period ended December 31, 2005 included in this prospectus have been audited by DS&B, Ltd., independent certified public accountants, as stated in their report appearing herein, and have been so included in reliance upon the report of such firm given upon their authority as experts in accounting and auditing.


WHERE YOU CAN FIND ADDITIONAL INFORMATION

        We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission under the Exchange Act. Such reports and other information may be inspected and copied at the Securities and Exchange Commission's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the Public Reference Room. The Securities and Exchange Commission also maintains an Internet site that contains reports, proxy statements and other information about issuers, like us, who file electronically with the Securities and Exchange Commission. The address of the Securities and Exchange Commission's web site is http://www.sec.gov.

        This prospectus is part of a registration statement that we have filed with the Securities and Exchange Commission. The prospectus, which forms a part of such registration statement, and any accompanying prospectus supplement do not contain all of the information included in the registration statement. We have omitted a few parts of the registration statement according to the rules and regulations of the Securities and Exchange Commission. For further information, we refer you to the registration statement, including its exhibits and schedules. Statements contained in this prospectus and any accompanying prospectus supplement about the provisions or contents of any contract, agreement or any other document referred to are not necessarily complete. For each of these contracts, agreements or documents filed as an exhibit to the registration statement, we refer you to the actual exhibit for a more complete description of the matters involved. You should not assume that the information in this prospectus or any supplement is accurate as of any date other than the date on the front of those documents. We do not intend to distribute annual reports or audited financial statements to our shareholders. This information may be found in our filings with the Securities and Exchange Commission.

87


FINANCIAL STATEMENTS

        The following consolidated financial statements of BIO-key International, Inc. and Subsidiary are included herein at the indicated page numbers.

 
  Page No.
BIO-key International, Inc. and Subsidiary    
Fiscal Year Ended December 31, 2005    
 
Report of Independent Certified Public Accountants

 

F-2
  Balance Sheet at December 31, 2005, 2004 and 2003   F-3
  Statements of Operations—Years ended December 31, 2005, 2004 and 2003   F-4
  Statement of Stockholders' Equity (Deficit)—Years ended December 31, 2005, 2004 and 2003   F-5
  Statements of Cash Flows—Years ended December 31, 2005, 2004 and 2003   F-7
  Notes to Consolidated Financial Statements—December 31, 2005, 2004 and 2003   F-8
Six Months Ended June 30, 2006    
  Balance sheet as of June 30, 2006 (unaudited) and December 31, 2005   F-107
  Statements of operations for the three and six months ended June 30, 2006 and 2005 (unaudited)   F-108
  Statements of cash flows for the six months ended June 30, 2006 and 2005 (unaudited)   F-109
  Notes to consolidated financial statements for the six months ended June 30 2006   F-111

F-1



Report of Independent Certified Public Accountants

Board of Directors and Stockholders
BIO-key International, Inc.

        We have audited the accompanying consolidated balance sheets of BIO-key International, Inc. and Subsidiary as of December 31, 2005, 2004 and 2003, and the related statements of operations, stockholders' equity (deficit) and cash flows for each of the years in the three year period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

        As described in Note B to the consolidated financial statements, the Company restated its 2005, 2004, and 2003 consolidated financial statements.

        In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of BIO-key International, Inc. and Subsidiary as of December 31, 2005, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States.

        The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which contemplate continuation of the Company as a going concern. However, as discussed in note A to the financial statements, the Company has only recently begun to generate significant revenues, has suffered recurring losses from operations and has a working capital deficit. These aforementioned issues, among others, raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might result front this uncertainty. Management's plans in regard to these matters are also discussed in Note A.

/s/ DS&B, Ltd.

Minneapolis, Minnesota
June 14, 2006

F-2



BIO-key International, Inc. and Subsidiary

Consolidated Balance Sheets

 
  December 31,

 
 
  2005
  2004
  2003
 
 
  (Restated)

  (Restated)

  (Restated)

 
ASSETS:                    
Cash and cash equivalents   $ 1,422,827   $ 956,230   $ 1,012,790  
Marketable debt securities         1,000,000      
Receivables                    
  Billed, less allowance for doubtful receivables of $160,000, $422,393
and $2,000, respectively
    1,635,371     1,608,054     101,183  
  Unbilled     201,942     310,523      
Due from selling stockholders and other         28,793      
Costs and earnings in excess of billings on uncompleted contracts     4,321,392     6,292,603      
Inventory     8,760     29,599     65,857  
Prepaid expenses     137,000     113,130     165,929  
   
 
 
 
  Total current assets     7,727,292     10,338,932     1,345,759  
   
 
 
 
Equipment and leasehold improvements, net     548,267     644,101     60,157  
Costs and earnings in excess of billings on uncompleted contracts         657,000      
Deposits     1,828,560     2,838,031      
Intangible assets—less accumulated amortization     3,301,823     4,099,297     68,306  
Deferred financing costs, net     1,562,338     938,118     81,900  
Goodwill     11,389,654     12,023,613      
   
 
 
 
  Total non-current assets     18,630,642     21,200,160     210,363  
   
 
 
 
TOTAL ASSETS   $ 26,357,934   $ 31,539,092   $ 1,556,122  
   
 
 
 
LIABILITIES:                    
Current maturities of long-term obligations, net of discount   $ 8,067,948   $ 3,062,722   $  
Advances from stockholders         12,753     34,030  
Accounts payable     833,608     1,349,092     351,742  
Billings in excess of costs and earnings on uncompleted contracts     32,385     760,807      
Accrued liabilities     5,520,515     4,595,984     155,536  
Deferred rent     443,603     393,676      
Deferred revenue     3,264,283     3,166,356     10,000  
   
 
 
 
  Total current liabilities     18,162,342     13,341,390     551,308  
   
 
 
 
Long-term obligations, net of discount and current maturities         10,265,390     10,373,680  
Deferred rent     867,850     1,311,454      
Deferred revenue     1,163,738     71,203      
   
 
 
 
  Total non-current liabilities     2,031,588     11,648,047     10,373,680  
   
 
 
 
TOTAL LIABILITIES     20,193,930     24,989,437     10,924,988  
   
 
 
 
Commitments and contingencies                    
STOCKHOLDERS' EQUITY (DEFICIT):                    
Preferred stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)                    
    Series A 7% Convertible; issued and outstanding 44,557 Shares of
$.0001 par value
    4          
    Series B 9% Convertible; issued and outstanding, 4,180 shares of $.01
par value
            42  
    Series C 7% Convertible; issued and outstanding, 62,182 shares of $.01
par value
        623      
Common stock—authorized, 85,000,000 shares; issued and outstanding; 46,306,589 shares of $.0001 par value in 2005 and 40,680,691 and 21,222,889 shares of $.01 par value in 2004 and 2003, respectively     4,632     406,808     212,229  
Additional paid-in capital     48,921,316     45,098,731     18,327,992  
Accumulated deficit     (42,761,948 )   (38,956,507 )   (27,909,129 )
   
 
 
 
TOTAL STOCKHOLDERS' EQUITY (DEFICIT)     6,164,004     6,549,655     (9,368,866 )
   
 
 
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)   $ 26,357,934   $ 31,539,092   $ 1,556,122  
   
 
 
 

The accompanying notes are an integral part of these statements.

F-3



BIO-key International, Inc. and Subsidiary

STATEMENTS OF OPERATIONS

 
  Years ended December 31,

 
 
  2005
  2004
  2003
 
 
  (Restated)

  (Restated)

  (Restated)

 
Revenues                    
  Services   $ 10,861,649   $ 3,351,406   $ 10,694  
  License fees and other     3,364,446     2,369,545     204,787  
   
 
 
 
      14,226,095     5,720,951     215,481  
Costs and other expenses                    
  Services     2,906,142     1,174,324     1,694  
  Cost of license fees and other     937,491     889,896     87,387  
  Selling, general and administrative     11,824,609     7,114,288     2,099,922  
  Research, development and engineering     6,846,035     2,979,904     1,037,330  
   
 
 
 
      22,514,277     12,158,412     3,226,333  
   
 
 
 

Operating loss

 

 

(8,288,182

)

 

(6,437,461

)

 

(3,010,852

)
Other income (deductions)                    
  Interest income     35,958     66,824      
  Interest expense     (4,521,344 )   (1,415,535 )   (1,909,788 )
  Derivative and warrant fair value adjustments     9,154,951     (3,008,419 )   857,545  
  Gain (Loss) on sale of marketable securities     (20,000 )   33,125      
  Other income (expense)     (34,767 )   (88,425 )   4,145  
   
 
 
 
    Total other income (deductions)     4,614,798     (4,412,430 )   (1,048,098 )
   
 
 
 
NET INCOME (LOSS)   $ (3,673,384 ) $ (10,849,891 ) $ (4,058,950 )
   
 
 
 
Earnings (Loss) Per Share:                    
  Basic   $ (0.09 ) $ (0.32 ) $ (0.24 )
   
 
 
 
  Diluted   $ (0.12 ) $ (0.32 ) $ (0.24 )
   
 
 
 

Weighted Average Shares Outstanding:

 

 

 

 

 

 

 

 

 

 
  Basic     44,787,807     34,806,201     17,543,586  
  Diluted     52,046,303     34,806,201     17,543,586  

The accompanying notes are an integral part of these statements.

F-4



BIO-key International, Inc. and Subsidiary

STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)

 
  Series A 7%
Convertible
Preferred Stock

  Series B 9%
Convertible
Preferred Stock

  Series C 7%
Convertible
Preferred Stock

   
   
   
   
   
 
 
  Common Stock
   
   
   
 
 
  Additional
Contributed
Capital

  Accumulated
Deficit

   
 
 
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
  Total
 
Balance as of December 31, 2002     $   18,430   $ 184     $   14,377,406   $ 143,774   $ 16,284,399   $ (23,605,404 ) $ (7,177,047 )
Conversion of Series B Preferred Stock and cumulative dividends in arrears into common stock         (14,250 )   (142 )       4,239,206     42,392     202,525     (244,775 )    
Conversion of note, debenture and accrued interest into common stock                     2,097,953     20,980     1,552,486         1,573,466  
Exercise of options into common stock                     308,324     3,083     58,582         61,665  
Options and warrants issued for services and other                             156,000         156,000  
Common stock issued in exchange for services and other                     200,000     2,000     74,000         76,000  
Net loss                                 (4,058,950 )   (4,058,950 )
   
 
 
 
 
 
 
 
 
 
 
 
Balance as of December 31, 2003 (Restated)     $   4,180   $ 42     $   21,222,889   $ 212,229   $ 18,327,992   $ (27,909,129 ) $ (9,368,866 )
   
 
 
 
 
 
 
 
 
 
 
 
Issuance of Series C Preferred Stock for Series B Preferred Stock and cumulative dividends in arrears         (4,180 )   (42 ) 5,257     53           107,682     (107,693 )    
Issuance of Series C Preferred Stock in exchange for debt               83,275     833           8,326,630         8,327,463  
Sale in March 2004 of common stock and warrants at $1.35 per unit, less offering costs of $743,895                     8,888,928     88,889     11,330,117         11,419,006  
Issuance of common stock in conjunction with PSG acquisition                     2,422,108     24,221     3,584,719         3,608,940  
Conversion of debentures, bridge notes, convertible notes, accrued interest and related discounts and derivatives into common stock                     3,455,725     34,558     2,462,593         2,497,151  
Conversion of Series C Preferred Stock and cumulative dividends in arrears into common stock               (30,100 )   (301 ) 4,133,060     41,331     48,764     (89,794 )    
Issuance of Series C Preferred Stock in exchange for note payable to officer               3,750     38           374,962         375,000  
Exercise of options and warrants into common stock                     557,982     5,580     92,554         98,134  
Repurchase warrants                             (221,183 )       (221,183 )
Options and warrants issued for services and other                             129,700         129,700  
Issuance of warrants in conjunction with convertible notes offering                             534,201         534,201  
Net loss                                                   (10,849,891 )   (10,849,891 )
   
 
 
 
 
 
 
 
 
 
 
 
Balance as of December 31, 2004 (Restated)     $     $   62,182   $ 623   40,680,692   $ 406,808   $ 45,098,731   $ (38,956,507 ) $ 6,549,655  
   
 
 
 
 
 
 
 
 
 
 
 

The accompanying notes are an integral part of these statements.

F-5


 
  Series A 7%
Convertible
Preferred Stock

  Series B 9%
Convertible
Preferred Stock

  Series C 7%
Convertible
Preferred Stock

   
   
   
   
   
 
 
  Common Stock
   
   
   
 
 
  Additional
Contributed
Capital

  Accumulated
Deficit

   
 
 
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
  Total
 
Balance as of December 31, 2004 (Restated)     $     $   62,182   $ 623   40,680,692   $ 406,808   $ 45,098,731   $ (38,956,507 ) $ 6,549,655  
   
 
 
 
 
 
 
 
 
 
 
 
Conversion of Series C Preferred Stock to Series A Preferred Stock   62,182     6         (62,182 )   (623 )         617          
Adjust par values to $0.0001                         (402,739 )   402,739          
Costs incurred in conjunction with issuance of debt                             (56,642 )       (56,642 )
Issuance of shares in exchange for debt payment delay                     875,871     88     788,196         788,284  
Conversion of debentures, bridge notes, convertible notes, accrued interest and related discounts and derivatives into common stock                     1,575,135     158     1,179,341         1,179,499  
Conversion of Series A Preferred Stock and cumulative dividends in arrears into common stock   (17,625 )   (2 )             2,512,426     251     121,569     (132,057 )   (10,239 )
Exercise of options and warrants into common stock                     662,465     66     558,722         558,788  
Issuance of warrants in conjunction with convertible notes offering                             234,150         234,150  
Options and warrants issued for services and other                             593,893         593,893  
Net loss                                 (3,673,384 )   (3,673,384 )
   
 
 
 
 
 
 
 
 
 
 
 
Balance as of December 31, 2005 (Restated)   44,557   $ 4     $     $   46,306,589   $ 4,632   $ 48,921,316   $ (42,761,948 ) $ 6,164,004  
   
 
 
 
 
 
 
 
 
 
 
 

The accompanying notes are an integral part of these statements.

F-6



BIO-key International, Inc. and Subsidiary

STATEMENTS OF CASH FLOWS

 
  Years ended December 31,

 
 
  2005
  2004
  2003
 
 
  (Restated)

  (Restated)

  (Restated)

 
CASH FLOW FROM OPERATING ACTIVITIES:                    
  Net Loss   $ (3,673,384 ) $ (10,849,891 ) $ (4,058,950 )
  Adjustments to reconcile net loss to net cash used in operating activities:                    
    Derivative and warrant fair value adjustments     (9,154,951 )   3,008,419     (857,545 )
    Depreciation     244,450     77,912     6,386  
    Amortization                    
      Intangible assets     1,323,601     535,799      
      Deferred financing costs     186,279     14,622      
      Discounts on convertible debt related to warrants and beneficial conversion features     2,097,973     757,318     1,215,636  
    Allowance for doubtful receivables     48,148     71,384      
    (Gain) Loss on sale of marketable debt securities     20,000     (33,125 )    
    Write down of investment         50,000      
    Non-cash interest             1,131,053  
    Deferred rent     (393,677 )   (91,291 )    
    Options and warrants issued for services and other     664,043     55,150     156,000  
    Common stock issued for services and other             76,000  
  Change in assets and liabilities:                    
    Accounts receivable trade     345,050     1,268,791     (33,185 )
    Costs and earnings in excess of billings on uncompleted contracts     2,468,770     (906,649 )    
    Inventories     20,839     36,258     (65,857 )
    Prepaid expenses and other     (65,227 )   273,588     (115,032 )
    Accounts payable     (549,036 )   (362,505 )   (2,951 )
    Billings in excess of costs and earnings on uncompleted contracts     (317,737 )   899,857      
    Accrued liabilities     1,029,404     955,050     (318,700 )
    Deferred revenue     1,191,958     (1,405,446 )   10,000  
   
 
 
 
        Net cash used in operating activities     (4,513,497 )   (5,644,759 )   (2,857,145 )
   
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:                    
      Acquisition of PSG         (498,937 )    
      Acquisition of AMG         (10,431,878 )    
      Capital expenditures     (148,616 )   (275,193 )   (66,543 )
      Purchases of marketable debt securities         (5,887,500 )    
      Proceeds from sale of marketable debt securities     980,000     4,920,625      
      Deposits     1,009,471     (2,760,583 )    
      Patents and patents pending     (65,786 )   (149,687 )    
      Other     50,000     (46,552 )   (28,215 )
   
 
 
 
        Net cash provided by (used in) investing activities     1,825,069     (15,129,705 )   (94,758 )
   
 
 
 
CASH FLOW FROM FINANCING ACTIVITIES:                    
      Net advance from (to) stockholders     (12,753 )   (54,437 )   34,030  
      Issuance of convertible bridge notes     250,000          
      Repayment of convertible bridge notes     (250,000 )        
      Issuance of long-term obligations     4,822,250     10,601,839     3,852,250  
      Repayment of long term obligations     (1,908,212 )   (401,563 )    
      Financing costs     (248,406 )   (522,000 )    
      Sale of common stock         11,248,803     61,665  
      Exercise of warrants     558,788     1,950      
      Repurchase of warrants and other         (125,000 )    
      Payment of offering costs     (56,642 )   (31,688 )    
   
 
 
 
        Net cash provided by financing activities     3,155,025     20,717,904     3,947,945  
   
 
 
 
NET INCREASE (DECREASE) IN CASH     466,597     (56,560 )   996,042  
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR     956,230     1,012,790     16,748  
   
 
 
 
CASH AND CASH EQUIVALENTS, END OF YEAR   $ 1,422,827   $ 956,230   $ 1,012,790  
   
 
 
 

The accompanying notes are an integral part of these statements.

F-7



BIO-key International, Inc. and Subsidiary

NOTES TO THE FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE A—THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Change in Name of Company and State of Incorporation

        Effective January 1, 2005, BIO-key International, Inc., a Minnesota corporation ("Old BIO-key"), reincorporated as BIO-key International, Inc., a Delaware corporation (the "Company," "BIO-key"). The reincorporation was effected pursuant to an Agreement and Plan of Merger (the "Merger Agreement"); whereby Old BIO-key was merged with and into the Company, its wholly owned subsidiary, in order to reincorporate in the State of Delaware (the "Reincorporation"). As a result of the Reincorporation, the legal domicile of the registrant is now Delaware.

Nature of Business

        The Company, founded in 1993, made two strategic acquisitions in 2004. The Company acquired Public Safety Group Inc. ("PSG") in March, 2004, and the Mobile Government division of Aether Systems, Inc. ("AMG" or "Mobile Government") in September, 2004. The Company is now focused on delivering advanced finger based biometric identification and security solutions and information services to law enforcement, fire service and emergence medical service agencies as well as other government and private sector customers. The Company's mobile wireless technology provides first responders throughout North America with critical, reliable, real-time data and images from local, state and national databases.

Basis of Presentation

        Broad commercial acceptance of the Company's technology is critical to the Company's success and ability to generate revenues. As a result of two acquisitions, the Company's only significant revenues to date have began in the fourth quarter of 2004. The Company recorded approximately $14,226,000 in revenues in 2005. The Company has accumulated losses during 2003 and 2004 of approximately $14,909,000, of which approximately $10,850,000 was incurred during 2004. The Company reported a loss of approximately $3,673,684 in 2005. As of December 31, 2005, there was a working capital deficit of approximately $10,400,000.

        The Company issued notes in 2004 as well as 2005 in amount of approximately $10,101,000 and $5,300,000, respectively. The Company is also currently considering various alternatives to improve its operating results. No assurance can be given that the Company's operating results will improve as a result of this additional funding or that such funding would not be dilutive to existing stockholders.

        The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which contemplate continuation of the Company as a going concern. The matters described in the preceding paragraphs raise substantial doubt about the Company's ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet is dependent upon the Company's ability to obtain additional funding, meet its funding requirements on a continuing basis, and succeed in its future operations. The accompanying financial statements do not include any adjustments that might be necessary should the Company be unable to continue in existence.

F-8



Summary of Significant Accounting Policies

        A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows:

1.    Basis of Consolidation    

        The accompanying consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly owned subsidiary (collectively, the Company) and are stated in conformity with accounting principles generally accepted in the United States, pursuant to the rules and regulations of the Securities and Exchange Commission. Intercompany accounts and transactions have been eliminated in consolidation.

2.    Revenue Recognition    

        Revenues from software licensing are recognized in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9. Accordingly, revenue from software licensing is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.

        The Company intends to enter into arrangements with end users for items which may include software license fees, usage fees and services or various combinations thereof. For each arrangement, revenues will be recognized when evidence of an agreement has been documented, the fees are fixed or determinable, collection of fees is probable, delivery of the product has occurred and no other significant obligations remain.

        Multiple-Element Arrangements: For multiple-element arrangements, each element of the arrangement will be analyzed and the Company will allocate a portion of the total fee under the arrangement to the elements using vendor specific objective evidence of fair value of the element, regardless of any separate prices stated within the contract for each element. Vendor specific objective evidence is based on the price the customer is required to pay when the element is sold separately (i.e., software license fees charged when consulting or other services are not provided, hourly rates charged for consulting services when sold separately from a software license or usage fees). If vendor specific objective evidence of fair value does not exist for any undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services, or until sufficient objective evidence of fair value exists or all elements have been delivered.

        License Revenues: Amounts allocated to license revenues are recognized at the time of delivery of the software and all other revenue recognition criteria discussed above have been met.

        Revenue from licensing software, which requires significant customization and modification, is recognized using the percentage of completion method, based on the hours of effort incurred by the company in relation to the total estimated hours to complete. In instances where third party hardware, software or services form a significant portion of a customer's contract, the company recognizes revenue for the element of software customization by the percentage of completion method described above. Third party hardware, software, and services are recognized upon shipment or acceptance as appropriate. If the company makes different judgments or utilizes different estimates of the total amount of work expected to be required to customize or modify the software, the timing and revenue recognition, from period to period, and the margins on the project in the reporting period, may differ materially from amounts reported. Revenues earned but not yet billed are shown as an asset in Costs and Earnings in Excess of Billings in the balance sheet. Billings in excess of cost and earnings are reflected as a liability in the balance sheet. Anticipated contract losses are recognized as soon as they become known and are estimable.

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        Service Revenues: Revenues from services are comprised of maintenance and consulting and implementation services. Maintenance revenues include providing for unspecified when-and-if available product updates and customer telephone support services, and are recognized ratably over the term of the service period. Consulting services are generally sold on a time-and-materials basis and include a range of services including installation of software and assisting in the design of interfaces to allow the software to operate in customized environments. Services are generally separable from other elements under the arrangement since performance of the services are not essential to the functionality of any other element of the transaction and are described in the contract such that the total price of the arrangement would be expected to vary as the result of the inclusion or exclusion of the services. Revenues from services are generally recognized as the services are performed.

        Usage Fees: Usage fees are charged on certain applications based on the customer's volume of use. Usage revenue is recognized based on the actual level of activity used by the customer or, in the case of fixed-fee arrangements, ratably over the arranged time period.

        The Company provides customers, free of charge or at a minimal cost, testing kits which potential licensing customers may use to test compatibility/acceptance of the Company's technology with the customer's intended applications.

3.    Cash and Cash Equivalents    

        Cash equivalents consist of certificates of deposit and all other liquid investments with original maturities of three months or less. The Company maintains its cash balances in a financial institution in Nevada. These balances are insured by the Federal Deposit Insurance Corporation up to $100,000.

4.    Accounts Receivable    

        Accounts receivable billed and unbilled are carried at original amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful receivables by regularly evaluating individual customer receivables and considering a customer's financial condition, credit history, and current economic conditions. Accounts receivable are written off when deemed uncollectible. Recoveries of accounts receivable previously written off are recorded when received.

5.    Accounting for Acquisitions    

        The Company completed the acquisitions of PSG and AMG. These acquisitions have been accounted for under the purchase method of accounting, which has resulted in recording significant goodwill and other intangible asset balances. The purchase prices have been allocated to assets acquired and liabilities assumed at their estimated fair values on the date of the acquisitions, as determined by management, and by appraisals with respect to identifiable intangible assets. Our accounting for these acquisitions involves significant judgments and estimates regarding fair values of acquired intangible assets, which are based on projections of future revenues and cash flows, assumptions regarding discount factors, royalty rates, tax rates, amortization methodologies and related useful lives. The developed technology (software), copyrighted software, marketing agreements, customer relationships and trademarks were valued using the income approach and are being amortized on a straight line basis over five years, their estimated useful lives.

6.    Depreciation and Amortization    

        Depreciation is provided for in amounts sufficient to relate the cost of depreciable assets to operations over the estimated service lives, principally using straight-line methods. Leasehold improvements are amortized over the shorter of the life of the improvement or the lease term, using the straight-line method. Intangible assets other than patent costs are amortized on the straight-line method over their expected useful lives. Patent costs are capitalized until patents are awarded. Upon award, such costs are amortized over their respective lives. If a patent is denied, all costs are charged

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to operations in that year. Deferred financing fees related to the issuance of long-term obligations are capitalized and amortized to interest expense over the lives of the related debt using the effective interest rate method.

        The estimated useful lives used to compute depreciation and amortization for financial reporting purposes are as follows:

Equipment and leasehold improvements    
  Equipment   3-5 years
  Furniture and fixtures   3-5 years
  Software   3 years
  Leasehold improvements   life or lease term

Intangible assets

 

 
  Copyrighted software   5 years
  Customer relationships   5 years
  Trademarks   5 years
  Developed technology   5 years
  Marketing agreements   5 years
  Patents   life

Deferred financing fees

 

3 years

        The estimated aggregate amortization expense of intangible assets for the five years following December 31, 2005 is approximately as follows:

Year ending December 31,

   
2006   $ 1,826,000
2007   $ 1,384,000
2008   $ 931,000
2009   $ 430,000
2110   $

7.    Marketable Debt Securities    

        The Company accounts for marketable securities pursuant to Statement of Financial Accounting Standards No. 115—"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 requires classification of debt and equity securities in three categories: trading securities, available-for-sale securities and held-to-maturity securities. Debt and equity securities classified as trading securities are carried at fair value with unrealized gains or losses included in income. Debt and equity securities designated as available-for-sale, whose fair values are readily determinable, are carried at fair value with unrealized gains or losses included as a component of accumulated other comprehensive income, net of applicable taxes. Debt securities that are expected to be held-to-maturity are carried at amortized cost. On December 31, 2004, the Company's investments were all classified as available-for-sale. In January 2005, the Company sold these investments and did not purchase any additional Marketable Debt Securities as of December 31, 2005.

8.    Derivative and Warrant Financial Instruments    

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

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        The identification of, and accounting for, derivative instruments is complex. Our derivative instrument liability is re-valued at the end of each reporting period, with changes in the fair value of the derivative liability recorded as charges or credits to income, in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instrument liabilities, we determine the fair value of these instruments using the Black-Scholes option pricing model. That model requires assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price over the life of the option. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.

9.    Goodwill and Intangible Assets    

        Goodwill represents the excess of costs of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets, which requires the Company to test goodwill for impairment annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable, rather than amortize. Accordingly, the Company has not amortized goodwill. As provided by SFAS No. 142, the Company has elected to perform the annual assessment of the carrying value of all goodwill as of September 30th of each year using a number of criteria, including the value of the overall enterprise. As of December 31, 2005, the Company believes that no material impairment exists. Future impairment charges from previous or future acquisitions, if any, will be reflected as an operating expense in the statement of operations.

10.    Impairment of Long-Lived Assets    

        The Company has adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 144, long-lived assets subject to depreciation and amortization are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. The Company's long-lived assets consist primarily of its equipment and leasehold improvements and its intangible assets. Upon indication of possible impairment, the Company evaluates the recovery of held-for-use long-lived assets by measuring the carrying value of the assets against the related estimated undiscounted future cash flows. When an evaluation indicates that the future undiscounted cash flows are not sufficient to recover the carrying value of the asset, the asset is adjusted to its estimated fair value. The following circumstances would be considered important and could lead to an impairment review; significant changes in the manner of our using the asset, negative industry or economic trends and underperformance relative to projected operating results.

11.    Advertising Expense    

        The Company expenses the costs of advertising as incurred. Advertising expenses for the years ended December 31, 2005, 2004, and 2003, were approximately $108,000, $146,000, and $18,000, respectively.

12.    Deferred Revenue    

        Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have not been recognized as revenue. The majority of these amounts are related to maintenance contracts for which the revenue is recognized ratably over the applicable term, which generally is 12 months from the date the customer accepts the products.

13.    Research and Development Expenditures    

        Research and development expenses include costs directly attributable to the conduct of research and development programs primarily related to the development of our software products and

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improving the efficiency and capabilities of our existing software. Such costs include salaries, payroll taxes, employee benefit costs, materials, supplies, depreciation on research equipment, services provided by outside contractors, and the allocable portions of facility costs, such as rent, utilities, insurance, repairs and maintenance, depreciation and general support services. All costs associated with research and development is expensed as incurred.

14.    Earnings Per Share Common Stock    

        Earnings per share of common stock-basic is computed by dividing net income applicable to common stockholders by the weighted-average number of common shares outstanding for the period. Earnings per share of common stock-assuming dilution reflects the maximum potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock and would then share in the net income of the company. See Note U, "Earnings Per Share of Common Stock," for additional information.

15.    Accounting for Stock-Based Compensation    

        The Company's employee stock compensation plans are accounted for in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations. Under this method, no compensation expense is recognized as long as the exercise price equals or exceeds the market price of the underlying stock on the date of the grant. The Company elected the disclosure-only alternative permitted under Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), as amended by FAS 148, for fixed stock-based awards to employees. All non-employee stock-based awards are accounted for at fair value and recorded as compensation expense over the period of service in accordance with FAS 123 and related interpretations.

        On December 31, 2005, the Company accelerated the vesting of certain of the outstanding options to purchase shares of the Company's common stock with option exercise prices greater than the fair market value of the Company's common stock on such date. The acceleration applies to all such options outstanding as of December 31, 2005 under the Company's 1996 Stock Option Plan, 1999 Stock Option Plan and 2004 Stock Option Plan, except for options held by the Company's executive officers subject to Section 16(b) of the Securities Exchange Act of 1934, as amended, and the members of the Company's Board of Directors. Options to purchase up to 897,614 shares of the Company's common stock, or 14% of the total shares of the Company's common stock subject to outstanding options, with a weighted average exercise price of approximately $1.09 and varying remaining vesting schedules, are subject to this acceleration and become immediately vested and exercisable as of December 31, 2005. The number of shares, exercise prices and other terms of the options subject to the acceleration remain unchanged.

        As a result of this acceleration, the Company expects to reduce its exposure to the effects of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS 123R), which requires companies to recognize stock-based compensation expense associated with stock options based on the fair value method. The Company currently expects reductions in stock-based compensation expense associated with this acceleration of approximately $330,000 for fiscal year 2006 and approximately $225,000 for fiscal year 2007.

Proforma Compensation Disclosure

        In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No.148, Accounting for Stock-Based Compensation-Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 149 requires expanded, more prominent disclosure in both annual and interim

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financial statements about the method of stock-based employee compensation and the effect of the method on reported results.

        The Company has not adopted a method under SFAS No. 148 to expense stock options, but rather continues to apply the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock issued to Employees, and related interpretations in accounting for those plans. No stock-based employee compensation expense for options is reflected in net income or losses for the fiscal periods presented as all options granted under those plans had an exercise price equal to or lower than the market price of the underlying common stock at the date of grant.

        If compensation expense for the stock options granted had been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's proforma net income (loss) available to common shareholders and proforma income (loss) available to common shareholders per share would have been as follows:

 
  Years ended December 31,
 
 
  2005
  2004
  2003
 
 
  (Restated)

  (Restated)

  (Restated)

 
Net loss available to common shareholders   (4,013,152 ) (11,245,689 ) (4,195,705 )
Stock-based compensation expense if the fair value method had been adopted   (1,496,086 ) (268,000 ) (136,000 )
   
 
 
 
Pro forma net loss available to common shareholders   (5,509,238 ) (11,513,689 ) (4,331,705 )
   
 
 
 
Basic loss per common shares   (0.09 ) (0.32 ) (0.24 )
Basic loss per common shares—pro forma   (0.12 ) (0.33 ) (0.25 )
Diluted loss per common shares   (0.12 ) (0.32 ) (0.24 )
Diluted loss per common shares—pro forma   (0.14 ) (0.33 ) (0.25 )

        In determining the proforma compensation cost of the options granted, the fair value of each grant was estimated on the date of grant using the Black-Scholes option pricing model. The assumptions used to determine the fair value of each grant included the following weighted average assumptions:

 
  2005
  2004
  2003
 
Risk free interest rate   3.95-4.51 % 3.00 % 1.90 %
Expected life of options (in years)   7.00   3.00   3.00  
Expected dividends        
Volatility of stock price   132 % 90 % 120 %

16.    Income Taxes    

        The provision for, or benefit from, income taxes includes deferred taxes resulting from the temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from the differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carryback, carryforward period available under tax law. The Company evaluates, on a quarterly basis whether, based on all available evidence, if it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is more likely than not that the tax benefit of the deferred tax asset will not be realized. The evaluation, as prescribed by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carryforward from

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expiring unused. Because of the Company's historical performance and estimated future taxable income a full valuation allowance has been established.

17.    Use of Estimates    

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

        Estimates and assumptions, in the opinion of management are used in accounting for, among other things, long-term contracts, allowances for uncollectible receivables, recoverability of goodwill and other long-lived assets, depreciation and amortization, valuation of deferred income taxes, convertible notes and related discounts, embedded derivates, preferred stock, stock options, and warrants outstanding.

18.    Recent Accounting Pronouncements    

        In November 2005, FASB issued FSP FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP FAS 115-1"), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP FAS 115-1 also includes accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP FAS 115-1 is required to be applied to reporting periods beginning after December 15, 2005. We are required to adopt FSP FAS 115-1 in the first quarter of fiscal 2006. We do not expect that the adoption of the statement will have a material impact on our consolidated results or financial condition.

        In May 2005, FASB issued SFAS 154, "Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3". SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle, and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. We do not expect that adoption of this statement will have a material impact on our results of operations or financial condition.

        In March 2005, the FASB issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143 (FIN 47), which requires companies to recognize a liability for the fair value of a legal obligation to perform asset retirement activities that are conditional on a future event if the amount can be reasonably estimated. We adopted the provisions of FIN 47 on December 31, 2005. No conditional asset retirement obligations were recognized and, accordingly, the adoption of FIN 47 had no effect on our financial statements.

        In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R). This statement replaces SFAS No. 123 and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair value. The pro-forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. For the Company, SFAS 123R is effective for periods beginning after December 15, 2005. We plan to adopt SFAS 123R on January 1, 2006 using the modified prospective application method described in the statement. Under the modified prospective application method, we

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will apply the standard to new awards and to awards modified, repurchased, or cancelled after the required effective date. Additionally, compensation cost for the unvested portion of awards outstanding as of the required effective date will be recognized as compensation expense as the requisite service is rendered after the required effective date. We are evaluating the impact of adopting SFAS 123R and expect that we will record substantial non-cash stock compensation expenses. The adoption of SFAS 123R is not expected to have a significant effect on our cash flows but is expected to have a significant adverse effect on our results of operations. The future impact of the adoption of SFAS 123R cannot be predicted at this time because it will depend upon the levels of share-based payments granted in the future. However, had we adopted SFAS 123R in prior periods, the impact would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net loss attributable to common stockholders included in the Stock-Based Compensation footnote.

        In November 2004, the FASB issued Statement No. 151, Inventory Costs—an amendment of ARB No. 43, Chapter 4, which amends and clarifies existing accounting literature regarding abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005, with earlier application permitted. The provisions of this statement are to be applied prospectively. The adoption of this standard is not expected to have a material effect on the Company's financial position, results of operations, or liquidity.

NOTE B—RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

RESTATEMENT

        In the process of reviewing our registration statement for the securities issued in our June 2005 financing, the Securities and Exchange Commission ("SEC") raised questions with regard to our convertible term notes suggesting that we consider EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" to evaluate whether there were any embedded derivative instruments and if so, whether they should be accounted for as an equity or liability classification. The SEC suggested that we review the methodology used in the valuations of the embedded derivative instruments and also review whether warrants issued with our 2004 financing should be accounted for as an equity or liability classification.