Table of Contents

 

 

 

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

x

QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2008

 

o

TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE EXCHANGE ACT

 

For the Transition Period from              to            

 

Commission file number 1-13463

 

BIO-KEY INTERNATIONAL, INC.

(Exact Name of Small Business Issuer as Specified in Its Charter)

 

DELAWARE

 

41-1741861

(State or Other Jurisdiction of

 

(IRS Employer

Incorporation of Organization)

 

Identification Number)

 

3349 HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ  07719

(Address of Principal Executive Offices)

 

(732) 359-1100

(Issuer’s Telephone Number)

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x   No  o

 

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

Yes  o  No  x

 

Number of shares of Common Stock outstanding as of August 4, 2008 were 64,144,844, par value $.0001 per share.

 

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

 

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o

Smaller Reporting Company x

 

 

 



Table of Contents

 

BIO-KEY INTERNATIONAL, INC.

 

INDEX

 

PART I. FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1 

— 

Condensed Consolidated Financial Statements

 

3

 

 

Balance sheets as of June 30, 2008 (unaudited) and December 31, 2007

 

4

 

 

Statements of operations for the three and six months ended June 30, 2008 and 2007 (unaudited)

 

5

 

 

Statements of cash flows for the six months ended June 30, 2008 and 2007 (unaudited)

 

6

 

 

Notes to condensed consolidated financial statements

 

8

Item 2 

Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

24

Item 3

Controls and Procedures

 

35

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

 

Item 6

Exhibits

 

36

 

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PART I

FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

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BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

Cash and cash equivalents

 

$

624,237

 

$

964,774

 

Restricted cash

 

 

153,094

 

Accounts receivable, net of allowance for doubtful accounts of $112,400 at June 30, 2008 and $113,771 December 31, 2007

 

1,450,980

 

2,129,797

 

Costs and earnings in excess of billings on uncompleted contracts

 

65,705

 

233,805

 

Inventory

 

38,318

 

4,879

 

Investments

 

276,013

 

 

Prepaid expenses

 

79,340

 

119,068

 

Total current assets

 

2,534,593

 

3,605,417

 

Equipment and leasehold improvements, net

 

113,376

 

177,282

 

Deposits and other assets

 

487,815

 

487,815

 

Intangible assets—less accumulated amortization

 

955,557

 

1,324,269

 

Goodwill

 

7,836,986

 

7,836,986

 

Total non-current assets

 

9,393,734

 

9,826,352

 

TOTAL ASSETS

 

$

11,928,327

 

$

13,431,769

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

Accounts payable

 

$

3,159,348

 

$

1,162,690

 

Accrued liabilities

 

1,276,343

 

3,401,749

 

Deferred rent

 

94,761

 

367,986

 

Deferred revenue

 

3,505,493

 

4,468,748

 

Total current liabilities

 

8,035,945

 

9,401,173

 

Warrants

 

105,052

 

64,520

 

Redeemable preferred stock derivatives

 

11,937

 

41,295

 

Deferred revenue

 

24,331

 

34,518

 

Total non-current liabilities

 

141,320

 

140,333

 

TOTAL LIABILITIES

 

8,177,265

 

9,541,506

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Series B redeemable convertible preferred stock: authorized, 1,000,000 shares (liquidation preference of $1 per share); issued and outstanding 970,612 shares of $.0001 par value at June 30, 2008 and December 31, 2007

 

944,580

 

881,340

 

Series C redeemable convertible preferred stock: authorized, 600,000 shares (liquidation preference of $10 per share); issued and outstanding 592,032 shares of $.0001 par value at June 30, 2008 and December 31, 2007

 

6,207,160

 

5,776,231

 

 

 

7,151,740

 

6,657,571

 

 

 

 

 

 

 

STOCKHOLDERS’ DEFICIT:

 

 

 

 

 

Series A convertible preferred stock: authorized, 100,000 shares (liquidation preference of $100 per share); issued and outstanding 30,557 shares of $.0001 par value, at June 30, 2008 and December 31, 2007

 

3

 

3

 

Common stock — authorized, 170,000,000 shares; issued and outstanding; 63,913,383 and 61,153,202 of $.0001 par value at June 30, 2008 and December 31, 2007, respectively

 

6,391

 

6,115

 

Additional paid-in capital

 

51,964,349

 

52,126,595

 

Accumulated other comprehensive income

 

276,013

 

 

Accumulated deficit

 

(55,647,434

)

(54,900,021

)

TOTAL STOCKHOLDERS’ DEFICIT

 

(3,400,678

)

(2,767,308

)

TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT

 

$

11,928,327

 

$

13,431,769

 

 

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

 

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BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

Services

 

$

1,828,345

 

$

1,697,467

 

$

3,545,615

 

$

3,572,643

 

License fees and other

 

1,751,608

 

765,392

 

2,574,756

 

1,605,456

 

 

 

3,579,953

 

2,462,859

 

6,120,371

 

5,178,099

 

Costs and other expenses

 

 

 

 

 

 

 

 

 

Cost of services

 

288,748

 

399,580

 

636,333

 

847,469

 

Cost of license fees and other

 

132,430

 

63,692

 

226,326

 

94,603

 

 

 

421,178

 

463,272

 

862,659

 

942,072

 

Gross Profit

 

3,158,775

 

1,999,587

 

5,257,712

 

4,236,027

 

 

 

 

 

 

 

 

 

 

 

Operating Expenses

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

1,695,306

 

2,212,481

 

3,484,398

 

4,763,776

 

Research, development and engineering

 

1,164,217

 

1,319,982

 

2,411,248

 

2,676,940

 

 

 

2,859,523

 

3,532,463

 

5,895,646

 

7,440,716

 

Operating Profit (loss)

 

299,252

 

(1,532,876

)

(637,934

)

(3,204,689

)

Other income (deductions)

 

 

 

 

 

 

 

 

 

Derivative and warrant fair value adjustments

 

(41,915

)

(158,916

)

(11,174

)

670,452

 

Interest income

 

399

 

1,331

 

1,298

 

1,331

 

Interest expense

 

(7,884

)

(260,801

)

(18,007

)

(799,317

)

Loss on extinguishment of debt

 

 

(403,940

)

 

(403,940

)

Other

 

(16,142

)

(18,000

)

(16,142

)

(23,902

)

 

 

(65,542

)

(840,326

)

(44,025

)

(555,376

)

Income (loss) from continuing operations

 

233,710

 

(2,373,202

)

(681,959

)

(3,760,065

)

Income (loss) from discontinued operations

 

(65,454

)

(34,385

)

(65,454

)

440,105

 

Gain on disposal of discontinued operations, net of expected
tax of $0.

 

 

4,070,859

 

 

4,070,859

 

Net Income (loss)

 

$

168,256

 

$

1,663,272

 

$

(747,413

)

$

750,899

 

 

 

 

 

 

 

 

 

 

 

Basic and Diluted Earnings per Common Share:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

0.00

 

$

(0.05

)

$

(0.03

)

$

(0.08

)

Income (loss) from discontinued operations

 

0.00

 

0.00

 

0.00

 

0.01

 

Gain on disposal of discontinued operations

 

0.00

 

0.07

 

0.00

 

0.07

 

Net income (loss)

 

$

0.00

 

$

0.02

 

$

(0.03

)

$

0.00

 

 

 

 

 

 

 

 

 

 

 

Weighted Average Shares Outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

63,180,281

 

58,067,198

 

62,483,507

 

57,354,818

 

Diluted

 

63,180,281

 

58,067,198

 

62,483,507

 

57,354,818

 

 

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

 

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BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

Six Months Ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

CASH FLOW FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net Income (loss)

 

$

(747,413

)

$

750,899

 

Less:

 

 

 

 

 

(Income) loss from discontinued operations

 

65,454

 

(440,105

)

Gain on disposal of discontinued operations

 

 

(4,070,859

)

Loss from continuing operations

 

(681,959

)

(3,760,065

)

Adjustments to reconcile net loss to cash used in operating activities:

 

 

 

 

 

Derivative and warrant fair value adjustments

 

11,174

 

(670,452

)

Loss on extinguishment of debt

 

 

403,003

 

Depreciation

 

68,745

 

129,851

 

Amortization

 

 

 

 

 

Intangible assets

 

368,712

 

368,033

 

Deferred financing costs

 

 

83,871

 

Discounts on convertible debt related to warrants and beneficial conversion features

 

 

360,245

 

Allowance for doubtful receivables

 

(1,371

)

(9,127

)

Deferred rent

 

(273,225

)

(242,473

)

Fair market value adjustment on equity issuance and warrant modification

 

 

124,999

 

Share-based compensation

 

332,201

 

388,984

 

Change in assets and liabilities:

 

 

 

 

 

Accounts receivable trade

 

680,188

 

1,424,602

 

Costs and earnings in excess of billings on uncompleted contracts

 

168,100

 

2,591

 

Inventory

 

(33,439

)

(3,271

)

Prepaid expenses and other

 

39,728

 

35,367

 

Accounts payable

 

1,996,658

 

(172,840

)

Billings in excess of costs and earnings on uncompleted contracts

 

 

(2,680

)

Accrued liabilities

 

(2,125,406

)

(354,171

)

Deferred revenue

 

(973,442

)

(908,026

)

Net cash used for continuing operations

 

(423,336

)

(2,801,559

)

Net cash provided by (used for) discontinued operations

 

(15,454

)

574,768

 

Net cash used for operating activities

 

(438,790

)

(2,226,791

)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Capital expenditures

 

(15,371

)

(44,575

)

Deposits

 

 

312,539

 

Proceeds from the sale of the Fire business

 

 

7,000,000

 

Transfer of funds from (to) restricted cash

 

153,094

 

(401,331

)

Proceeds from sale of Assets

 

10,530

 

 

Patent costs

 

 

(19,109

)

Net cash provided by continuing operations

 

148,253

 

6,847,524

 

Net cash used for discontinued operations

 

(50,000

)

(7,615

)

Net cash provided by investing activities

 

98,253

 

6,839,909

 

CASH FLOW FROM FINANCING ACTIVITIES:

 

 

 

 

 

Repayment of long term obligations

 

 

(4,661,958

)

Net cash used for continuing operations

 

 

(4,661,958

)

Net cash used for discontinued operations

 

 

 

Net cash used for financing activities

 

 

(4,661,958

)

NET DECREASE IN CASH AND CASH EQUIVALENTS

 

(340,537

)

(48,840

)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

 

964,774

 

627,167

 

CASH AND CASH EQUIVALENTS, END OF PERIOD

 

$

624,237

 

$

578,327

 

 

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SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

 

 

 

Six Months Ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cash paid for:

 

 

 

 

 

Interest

 

 

370,090

 

 

 

 

 

 

 

Noncash Investing and Financing Activities:

 

 

 

 

 

Conversion of convertible notes and related obligations, net of discount, and accrued interest into common stock

 

 

772,764

 

Issuance of common stock through conversion of principal and dividends outstanding on preferred stock

 

342,349

 

777,870

 

 

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

 

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BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

June 30, 2008 (Unaudited)

 

1.                BASIS OF PRESENTATION

 

The accompanying unaudited interim 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 (the “SEC”).  The operating results for interim periods are not necessarily indicative of results that may be expected for any other interim period or for the full year. Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. Significant intercompany accounts and transactions have been eliminated in consolidation.

 

In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all necessary adjustments, consisting only of those of a recurring nature, and disclosures to present fairly the Company’s financial position and the results of its operations and cash flows for the periods presented. The balance sheet at December 31, 2007 was derived from the audited financial statements, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. It is suggested that these unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the related notes thereto included in the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007 (the “Form 10-KSB”).

 

Recently Issued Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which is effective for calendar year companies on January 1, 2008. This Statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. The adoption of SFAS 157 had no impact on the Company’s financial condition and results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (SFAS 159), which is effective for calendar year companies on January 1, 2008. This Statement allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis. Subsequent changes in fair value of these financial assets and liabilities would be recognized in earnings when they occur. SFAS 159 further establishes certain additional disclosure requirements. The adoption of SFAS 159 had no impact on the Company’s financial condition and results of operations.

 

In December 2007, the SEC issued SAB No. 110.  SAB 110 allows for the continued use of a “simplified” method, as discussed in SAB No. 107, in developing an estimate of expected term of “plain vanilla” share options in accordance with SFAS 123 (revised 2004).  Originally the SEC staff stated in SAB 107 that it would not expect a company to use the simplified method for share option grants after December 31, 2007.  Accordingly, the SEC staff will continue to accept, under certain circumstances, the use of the simplified method beyond December 31, 2007.  The Company will continue to use of the simplified method for determining the value of options granted as allowed by SAB 110.

 

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (SFAS No. 141(R)) which establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.  SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users

 

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of the financial statements to evaluate the nature and financial effects of the business combination. The provisions of SFAS No. 141(R) are applicable to business combinations consummated on or after December 15, 2008 with early adoption prohibited.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51”  (SFAS No. 160) which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary for the deconsolidation of a subsidiary.  SFAS No. 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim statements within those fiscal years. The Company does not currently have any noncontrolling interests.

 

Reclassifications

 

Certain amounts in the 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation. These reclassifications had no effect on the previously reported net loss or stockholders’ deficit.

 

2.                LIQUIDITY AND CAPITAL RESOURCE MATTERS

 

We have only recently begun to generate significant revenues and have incurred significant losses to date, and at June 30, 2008, we had an accumulated deficit of approximately $56 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues.

 

If the Company is unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing 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. No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained by the Company in order to meet its needs, or that such financing would not be dilutive to existing shareholders

 

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, and assumes continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. 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 sheets is dependent upon the Company’s ability to meet its financing requirements on a continuing basis and become profitable in its future operations. The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

 

3.                DISCONTINUED OPERATIONS

 

On May 22, 2007, the Company and ZOLL Data Systems, Inc. (“ZOLL”), a subsidiary of ZOLL Medical Corporation, entered into an Asset Purchase Agreement (the “Purchase Agreement”), pursuant to which ZOLL acquired substantially all of the assets related to the Company’s Fire/EMS Services division (the “Fire Segment” or “Fire”).

 

At the closing of the sale, the Company received approximately $1.8 million in cash, which represented the purchase price of $7 million, less closing adjustments of approximately $4.3 million, which was paid to the Senior Noteholder (see Note 9), approximately $450,000, which was paid to the leaseholder of the Company’s premises, $400,000, which was placed in escrow pursuant to the Purchase Agreement, and approximately $40,000 credited to Zoll on the assumption of certain liabilities.

 

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During the quarter ended September 30, 2007, $250,000 of the escrow balance was released to ZOLL. The remaining escrow balance was remitted to the Company May 6, 2008.  From the remaining balance, $50,000 was paid as a settlement of a customer claim associated with the discontinued Fire business, and $15,454 was paid as related professional fees to settle the claim which resulted in the $65,454 loss .

 

Prior to the sale, Fire had been reported as a separate segment. The Company sold its Fire operating segment to better focus on its core lines of business. The Fire business has been reported as a discontinued operation in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and all periods presented have been recast accordingly to reflect these operations as discontinued.

 

Revenues and net income (loss) for the Fire Segment for the three and six month periods ended June 30, 2008 and 2007 were as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

 

389,489

 

$

 

1,546,746

 

Net income (loss)

 

(65,454

)

(34,385

)

(65,454

)

440,105

 

 

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4.                SHARE BASED COMPENSATION

 

The Company accounts for share based compensation in accordance with the provisions of SFAS 123R, 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. 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, 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 under SFAS 123R increased the Company’s loss from continuing operations by $65,408 and $168,007 with no effect per share (basic and diluted) for the three months ended June 30, 2008 and 2007 respectively, and $332,201 and $388,984 with a $0.01 effect per share (basic and diluted), for the six months ended June 30, 2008 and 2007 respectively.

 

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

 

 

 

Three Months Ended
June 30,

 

Three Months Ended
June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cost of services

 

$

2,666

 

$

4,507

 

Selling, general and administrative

 

47,749

 

126,879

 

Research, development and engineering

 

14,993

 

36,621

 

 

 

$

65,408

 

$

168,007

 

 

 

 

Six Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cost of services

 

$

13,639

 

$

9,477

 

Selling, general and administrative

 

232,934

 

298,198

 

Research, development and engineering

 

85,628

 

81,309

 

 

 

$

332,201

 

$

388,984

 

 

Valuation Assumptions for Stock Options

 

For the three months ended June 30, 2008 and 2007, 564,272 and 64,000 stock options were granted, respectively. For the six months ended June 30, 2008 and 2007, 564,272 and 153,000 stock options were granted, respectively. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

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Three Months Ended
June 30,

 

 

 

2008

 

2007

 

Risk free interest rate

 

2.95-3.72

%

4.58

%

Expected life of options (in years)

 

4.5

 

4.5

 

Expected dividends

 

0

%

0

%

Volatility of stock price

 

88

%

86

%

 

 

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

Risk free interest rate

 

2.95-3.72

%

4.58-4.68

%

Expected life of options (in years)

 

4.5

 

4.5

 

Expected dividends

 

0

%

0

%

Volatility of stock price

 

88

%

86-87

%

 

The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical daily price changes of the Company’s common stock over the expected option term. The expected term was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

 

EQUITY COMPENSATION PLAN INFORMATION

 

1996 Stock Option Plan

 

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 1996 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 1996 Plan expired in May 2005.

 

1999 Stock Option Plan

 

During 1999, the Board of Directors of the Company adopted the 1999 Stock Option Plan (the “1999 Plan”). The 1999 Plan was not presented to stockholders for approval and thus incentive stock options are not available under the plan. Under the 1999 Plan, 2,000,000 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 nonstatutory stock options granted may not exceed ten years. Options issued under the 1999 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 1999 Plan expires in August 2009.

 

2004 Stock Option Plan

 

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 the 2004 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

 

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Table of Contents

 

agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 2004 Plan expires in October 2014.

 

Non-Plan Stock Options

 

Periodically, the Company has granted options outside of the 1996, 1999, and 2004 Plans to various employees and consultants. In the event of change in control, as defined, certain of the non-plan options outstanding vest immediately.

 

  Stock Option Activity

 

The following table summarizes stock option activity for the six months ended June 30, 2008:

 

 

 

Number of Options

 

Weighted
average
exercise

 

Weighted
average
remaining
life

 

Aggregate
intrinsic

 

 

 

1996 Plan

 

1999 Plan

 

2004 Plan

 

Non Plan

 

Total

 

price

 

(in years)

 

value

 

Outstanding, as of December 31, 2007

 

80,000

 

805,000

 

2,221,415

 

3,943,000

 

7,049,415

 

$

0.85

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

 

564,272

 

 

564,272

 

0.11

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

 

 

 

 

Forfeited

 

 

 

(31,002

)

 

(31,002

)

0.51

 

 

 

 

 

Expired

 

 

 

(87,078

)

(48,000

)

(135,078

)

2.83

 

 

 

 

 

Outstanding, as of June 30, 2008

 

80,000

 

805,000

 

2,667,607

 

3,895,000

 

7,447,607

 

0.76

 

3.44

 

$

21,831

 

Vested or expected to vest at June 30, 2008

 

 

 

 

 

 

 

 

 

7,289,616

 

0.77

 

3.38

 

$

18,796

 

Exercisable at June 30, 2008

 

 

 

 

 

 

 

 

 

6,765,401

 

0.80

 

3.21

 

$

11,091

 

 

The options outstanding and exercisable at June 30, 2008 were in the following exercise price ranges:

 

 

 

Options Outstanding

 

Options Exercisable

 

Range of exercise prices

 

Number of
shares

 

Weighted
average
exercise
price

 

Weighted
average
remaining
life (in years)

 

Number
exercisable

 

Weighted
average
exercise
price

 

$

 

0.11-0.21

 

631,272

 

$

0.12

 

6.72

 

293,937

 

$

0.19

 

 

0.22-0.40

 

871,000

 

0.33

 

1.45

 

837,330

 

0.33

 

 

0.41-0.68

 

2,090,666

 

0.56

 

2.91

 

1,779,465

 

0.55

 

 

0.69-1.11

 

2,183,169

 

0.90

 

4.13

 

2,183,169

 

0.97

 

 

1.12-1.62

 

1,671,500

 

1.30

 

2.98

 

1,671,500

 

1.44

 

$

 

0.11-1.62

 

7,447,607

 

 

 

 

 

6,765,401

 

 

 

 

The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Company’s closing stock price of $0.15 as of June 30, 2008, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of June 30, 2008 was 564,272.

 

The weighted average fair value of options, as determined under SFAS No.123R, granted during the three months ended June 30, 2008 and June 30, 2007 was $0.07 and $0.14 per share, respectively, and during the six months ended June 30, 2008 and June 30, 2007 was $0.07 and $0.19 per share, respectively.

 

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As of June 30, 2008 future compensation cost related to nonvested stock options is approximately $127,925 and will be recognized over an estimated weighted average period of approximately 1.26 years.

 

5.                EARNINGS (LOSS) PER SHARE COMMON STOCK (“EPS”)

 

The Company’s basic EPS is calculated using net income (loss) available to common shareholders and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuance of common stock, such as stock issuable pursuant to the exercise of stock options and warrants and the assumed conversion of convertible notes and preferred stock. For the three and six months ended June 30, 2008 and 2007, diluted per share computations are not presented since this effect would be antidilutive.

 

The reconciliation of the numerators of the basic and diluted EPS calculations was as follows for both of the following three and six month periods ended June 30:

 

 

 

Three Months ended June 30,

 

Six Months ended June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

233,710

 

$

(2,373,202

)

$

(681,959

)

$

(3,760,065

)

Convertible preferred stock dividends and accretion

 

(470,893

)

(471,518

)

(941,786

)

(942,907

)

Income (loss) available to common stockholders (basic EPS)

 

$

(237,183

)

$

(2,844,720

)

$

(1,623,745

)

$

(4,702,972

)

 

 

 

 

 

 

 

 

 

 

Weighted-average shares used to compute diluted EPS

 

63,180,281

 

58,067,198

 

62,483,507

 

57,354,818

 

 

The following table summarizes the potential weighted average shares of common stock that were excluded from the diluted per share calculation, because the effect of including these potential shares was antidilutive.

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Preferred Stock

 

33,155,440

 

19,926,204

 

33,155,440

 

19,939,051

 

Convertible Debt

 

 

4,906,320

 

 

6,852,234

 

Stock Options

 

564,272

 

6,284

 

564,272

 

18,485

 

 

 

 

 

 

 

 

 

 

 

Potentially dilutive securities

 

33,719,712

 

24,838,808

 

33,719,712

 

26,809,770

 

 

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Table of Contents

 

Items excluded from the diluted per share calculation because the exercise price was greater than the average market price of the common shares:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

6,883,335

 

7,587,405

 

6,883,335

 

7,587,405

 

Warrants

 

10,566,375

 

10,566,375

 

10,566,375

 

10,566,375

 

 

 

 

 

 

 

 

 

 

 

Total

 

17,449,710

 

18,153,780

 

17,449,710

 

18,153,780

 

 

6.                EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

Equipment and leasehold improvements consisted of the following:

 

 

 

 

 

 

 

June 30,

 

December 31,

 

 

 

 

 

 

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Equipment

 

 

 

 

 

$

533,029

 

$

517,658

 

Furniture and fixtures

 

 

 

 

 

148,494

 

187,984

 

Software

 

 

 

 

 

136,355

 

136,355

 

Leasehold improvements

 

 

 

 

 

198,889

 

198,889

 

 

 

 

 

 

 

1,016,767

 

1,040,886

 

 

 

 

 

 

 

 

 

 

 

Less accumulated depreciation and amortization

 

 

 

 

 

(903,391

)

(863,604

)

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

$

113,376

 

$

177,282

 

 

7.                GOODWILL AND OTHER INTANGIBLE ASSETS

 

The Company’s goodwill resulted from the acquisition of Public Safety Group, Inc. and certain assets and assumed liabilities of the Mobile Government Division of Aether Systems, Inc. in 2004. 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. Impairment charges from existing operations or other acquisitions, if any, are reflected as an operating expense in the statement of operations.  As of June 30, 2008 goodwill totaled $7,836,986.

 

Other intangible assets as of June 30, 2008 consisted of the following:

 

 

 

June 30, 2008

 

December 31, 2007

 

 

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net Carrying
Amount

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net Carrying
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Copyrighted software

 

$

1,181,429

 

$

(1,004,215

)

$

177,214

 

$

1,181,429

 

$

(886,071

)

$

295,358

 

Customer relationships

 

617,271

 

(462,953

)

154,318

 

617,271

 

(401,225

)

216,046

 

Trademarks

 

807,872

 

(643,885

)

163,987

 

807,872

 

(563,099

)

244,773

 

Developed technology

 

434,353

 

(325,765

)

108,588

 

434,353

 

(282,330

)

152,023

 

Marketing agreements

 

605,340

 

(514,539

)

90,801

 

605,340

 

(454,005

)

151,335

 

Patents and patents pending

 

298,059

 

(37,410

)

260,649

 

298,059

 

(33,325

)

264,734

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

3,944,324

 

$

(2,988,767

)

$

955,557

 

$

3,944,324

 

$

(2,620,055

)

$

1,324,269

 

 

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Table of Contents

 

Aggregate amortization expense for the three months ended June 30, 2008 and 2007, was $184,379 and $185,521 respectively, and was $368,712 and $368,033 for the six months ended June 30, 2008 and 2007 respectively.

 

8.                INVESTMENTS

 

During 2005, BIO-key was issued shares in a private company, which specialized in providing security products and associated software. There was no cost to the investment for these shares, and because BIO-key had a minimal ownership interest in the company and was unable to exhibit any influence on the company’s management or board, BIO-key treated the investment on the cost basis as promulgated under APB 18, “Equity Method of Accounting for Investments in Common Stock.

 

In February 2008, the above mentioned private company consummated a reverse merger with a publicly traded US company. As a result of the merger, BIO-key’s investment was converted into shares of the public company. This change in circumstances enabled the fair value of the investment to be “readily determinable” under the provisions of FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Accordingly, BIO-key now classifies its investment as an “available-for-sale” security, and accounts for it at its market value as specified on a securities exchange.

 

Unrealized gains and temporary losses on investments classified as available-for-sale are included within accumulated other comprehensive income, net of any related tax effect. Upon realization, those amounts are reclassified from accumulated other comprehensive income to investment income. Realized gains and losses and other than temporary impairments on investments are reflected in the income statement in investment income or expense. Gains or losses are calculated primarily using the first-in, first-out method.

 

The following table summarizes our investment at June 30, 2008 and December 31, 2007. The investment is classified within current assets in the balance sheet. Fair value for publicly-traded available-for-sale investments is determined based upon quoted prices. Fair value is not readily available for privately-held investments.

 

 

 

June 30, 2008

 

December 31, 2007

 

 

 

Cost

 

Fair Value

 

Cost

 

Fair Value

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale security

 

$

 

$

276,013

 

$

 

$

 

 

 

 

 

 

 

 

 

 

 

Balance as of June 30, 2008

 

$

 

$

276,013

 

$

 

$

 

 

Unrealized gain on the available-for-sale security was $276,013 at June 30, 2008.

 

9.             CONVERTIBLE DEBT FINANCING / WARRANTS

 

Long-term obligations consisted of the following as of:

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

2004

 

 

 

 

 

FMV of warrants

 

$

23,395

 

$

11,663

 

2005

 

 

 

 

 

FMV of warrants

 

52,730

 

34,644

 

2006

 

 

 

 

 

FMV of warrants

 

28,927

 

18,213

 

Total

 

$

105,052

 

$

64,520

 

 

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Table of Contents

 

Senior Convertible Term Notes

 

2004 and 2005 Senior Notes

 

On September 29, 2004, the Company entered into a Securities Purchase Agreement (the “2004 Senior Purchase Agreement”) with Laurus Master Fund, Ltd. (“Laurus”) to issue secured convertible term notes in the aggregate principal amount of $5,050,000.  On June 8, 2005, we entered into a second Securities Purchase Agreement (the “2005 Senior Purchase Agreement”) with Laurus.

 

On May 22, 2007, the Company used approximately $4,300,000 of the net cash proceeds received in connection with the sale of the Fire Segment (see Note 3) to repay in full its obligations to Laurus under the 2004 and 2005 Senior Notes.

 

The account balance shown represents the fair market value of warrants issued in conjunction with debt offerings undertaken from the 2004 to 2006 fiscal years. The Warrants are classified as liabilities and were valued as of June 30, 2008, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 91% to 108% and risk-free interest rate of 2.4% to 2.8%.

 

2004 and 2005 Senior Note Derivatives and Discounts

 

The 2004 and 2005 Senior Notes contained features that were considered embedded derivative financial instruments, such as: Principal’s conversion option, Monthly Payments Conversion Option, Interest Rate Adjustment provision, and the Default provision. These features were bifurcated and recorded on the Company’s balance sheet at their fair value.

 

Following the repayment of the 2004 and 2005 Senior Notes on May 22, 2007, the value of the embedded derivatives and amortized discounts related to the Notes were written off to Loss on Extinguishment of Debt.

 

10.                                 ACCRUED LIABILITIES

 

Accrued liabilities consisted of the following:

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Contract costs not yet invoiced by vendors

 

$

91,888

 

$

2,185,610

 

Compensation

 

94,733

 

140,314

 

Compensated absences

 

395,237

 

367,731

 

Royalties

 

347,570

 

371,158

 

Interest

 

176,083

 

176,083

 

Other

 

170,832

 

160,853

 

 

 

 

 

 

 

Total

 

$

1,276,343

 

$

3,401,749

 

 

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Table of Contents

 

11.                                           REDEEMABLE PREFERRED STOCK

 

Series B Convertible Preferred Stock

 

The Company issued 1,000,000 shares of redeemable Series B Convertible Preferred Stock on February 23, 2006, upon the conversion of certain convertible term notes. Each share of Series B Preferred Stock has an Original Issue Price of $1.00 per share. The holder has the option to redeem the shares of Series B Preferred Stock at any time for a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.30 per share of Common. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series B Preferred Stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series B shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.10. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.10 the Company shall mandatorily redeem all remaining outstanding Series B Preferred Stock by paying cash equal to $1.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem any or all of the remaining outstanding Series B shares in cash at a conversion price equal to $1.20 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series B Preferred Stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly. In any liquidation of the Company, each share of Preferred Stock is entitled to a liquidation preference on a pari passu basis with the Series A and Series C Preferred Stock before any distribution may be made on the Company’s common stock.

 

As of June 30, 2008, 1,000,000 shares of Series B Preferred Stock were authorized, 970,612 of which were issued and outstanding, at a par value of $0.0001 and a liquidation preference of $1.00 with accumulated dividends in arrears of $36,802, which have been accreted to the principal balance of the Series B preferred stock.

 

The Preferred Stock contains features that are considered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at the Holder’s option at any time at the fixed conversion price of $0.30 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’s quarterly dividend payment at a conversion price of the average 10 days closing price prior to the dividend record date.  These features have been bifurcated and recorded on the Company’s balance sheet at their fair value.

 

As of June 30, 2008 the derivatives were valued at $1,811.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 49%; and risk free annual interest rate of 2.17% as well as probability analysis related to trading volume restrictions.

 

An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock.  The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the Preferred Stock.  At June 30, 2008, the unamortized discount on the Preferred Stock was $63,240.

 

Series C Convertible Preferred Stock

 

The Company issued 592,032 shares of redeemable Series C Convertible Preferred Stock on August 10, 2006, upon the exchange of certain convertible term notes. Each share of Series C Preferred Stock has an Original Issue Price of $10.00 per share. The holder has the option to redeem the shares of Series C Preferred Stock at any time for a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.30 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series C Preferred Stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series C shares will be automatic if, for

 

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the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.20. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.20 the Company shall mandatorily redeem all remaining outstanding Series C preferred stock by paying cash equal to $10.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem any or all of the remaining outstanding Series C shares in cash at a conversion price equal to $12.00 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series C preferred stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly. In any liquidation of the Company, each share of Preferred Stock is entitled to a liquidation preference on a pari passu basis with the Series A and Series B Preferred Stock before any distribution may be made on the Company’s common stock.

 

As of June 30, 2008, 600,000 Shares of Series C Preferred Stock were authorized, 592,032 of which were issued and outstanding, at a par value of $0.0001 and a liquidation preference of $10.00 with accumulated dividends in arrears of $532,219, which have been accreted to the principal balance of the Series C Preferred Stock.

 

The Preferred Stock contains features that are considered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at the Holder’s option at any time at the fixed conversion price of $0.30 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’s quarterly dividend payment at a conversion price of the average 10 days closing price prior to the dividend record date.  These features have been bifurcated and recorded on the Company’s balance sheet as liabilities, at their fair value.

 

As of June 30, 2008 the derivatives were valued at $10,126.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 49%; and risk free annual interest rate of 2.17% as well as probability analysis related to trading volume restrictions.

 

An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock.   The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the Preferred Stock.  At June 30, 2008, the unamortized discount on the Preferred Stock was $224,722.

 

Together with the above transaction, the terms of certain warrants held by the Company’s investment bankers and their associates were modified. The incremental value of the modification was calculated to be $110,453, and was allocated against the proceeds of the Series C Convertible Preferred Stock as a cost of financing, and is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock.  At June 30, 2008, the net amount remaining to be accreted was $23,123.

 

12.                                           STOCKHOLDERS EQUITY

 

Common Stock

 

The Company is authorized to issue 170,000,000 shares of common stock, $.0001 par value per share, of which 63,913,383 were outstanding as of June 30, 2008.

 

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.

 

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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.

 

During the three months and the six months ended June 30, 2008, preferred stockholders converted accumulated dividends of $171,705 into 1,402,211 shares and accumulated dividends of $342,349 into 2,760,181 shares of the Company’s common stock respectively.

 

Series A Convertible 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.

 

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 on January 1, 2005, 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 30,557 were issued and outstanding June 30, 2008.

 

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 $0.30 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 November 17, 2008, 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.

 

As of June 30, 2008, cumulative dividends in arrears related to the Series A preferred stock were approximately $352,091, which have been accreted to the principal balance of the Series A preferred stock.

 

Warrants

 

The Company has issued warrants to certain creditors, investors, investment bankers and consultants. A summary of warrant activity is as follows:

 

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Total Warrants

 

Weighted
average
exercise
price

 

Weighted
average
remaining
life
(in years)

 

Aggregate
intrinsic
value

 

Outstanding, as of December 31, 2007

 

10,566,375

 

$

0.95

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding, as of June 30, 2008

 

10,566,375

 

0.95

 

1.52

 

$

 

Vested or expected to vest at June 30, 2008

 

10,566,375

 

0.95

 

1.52

 

 

Exercisable at June 30, 2008

 

10,566,375

 

0.95

 

1.52

 

 

 

The warrants outstanding and exercisable at June 30, 2008 were in the following exercise price ranges:

 

 

 

Warrants outstanding and Exercisable

 

Range of exercise prices

 

Number of
warrants

 

Weighted average
remaining life (in years)

 

 

 

 

 

 

 

$

0.30

 

2,798,014

 

2.61

 

 

0.75

 

533,333

 

3.11

 

 

0.97

 

150,000

 

1.04

 

 

1.00

 

2,655,552

 

1.37

 

 

1.35

 

4,429,476

 

.75

 

 

 

 

10,566,375

 

 

 

 

As part of sale of the Fire business to ZOLL, and repayment of the Company’s convertible debt, both in May 2007, the exercise price of certain warrants was adjusted to $0.30 per share.  The incremental fair value of the modification of $33,817 was allocated to interest expense as a cost of financing.

 

13.              COMPREHENSIVE LOSS

 

The component of accumulated other comprehensive income was as follows:

 

 

 

June 30,

 

 

 

2008

 

 

 

 

 

Unrealized gain on available-for-sale securities, net of tax

 

$

276,013

 

 

 

 

 

Total accumulated other comprehensive income

 

$

276,013

 

 

The components of comprehensive income (loss) for the six months ended June 30, 2008 and 2007 were as follows:

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Net Profit (loss)

 

$

(747,413

)

$

750,899

 

Unrealized gain on securities, net of tax

 

276,013

 

 

 

 

 

 

 

 

Total comprehensive income (loss)

 

$

(471,400

)

$

750,899

 

 

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14.                                           SEGMENT INFORMATION

 

The Company’s consolidated operations are divided into two segments: Law and Biometric. 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 segment’s budgeted revenues. The segmentation of operating income (loss) 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.

 

Prior to the sale of the Fire business in May 2007, Fire had been reported as a separate segment.  Prior periods presented have been recast accordingly to reflect these operations as discontinued.  Geographically, North American sales accounted for approximately 99% and 100% of the Company’s total sales for the three month periods and 98% and 100% for the six month periods ended June 30, 2008 and 2007 respectively.

 

Summarized financial information concerning our reportable segments is shown in the following table:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Law

 

$

2,358,677

 

$

2,309,407

 

$

4,546,476

 

$

4,907,078

 

Biometrics

 

1,221,276

 

153,452

 

1,573,895

 

271,021

 

Consolidated Revenue

 

$

3,579,953

 

$

2,462,859

 

$

6,120,371

 

$

5,178,099

 

Segment operating profit/(loss)

 

 

 

 

 

 

 

 

 

Law

 

(319,600

)

(998,399

)

(1,018,402

)

(2,045,676

)

Biometrics

 

618,852

 

(534,477

)

380,468

 

(1,159,013

)

Total Segment Operating Income (Loss)

 

299,252

 

(1,532,876

)

(637,934

)

(3,204,689

)

Reconciliation to net loss

 

 

 

 

 

 

 

 

 

Derivative and warrant fair value adjustments

 

(41,915

)

(158,916

)

(11,174

)

670,452

 

Interest income

 

399

 

1,331

 

1,298

 

1,331

 

Interest expense

 

(7,884

)

(260,801

)

(18,007

)

(799,317

)

Loss on extinguishment of debt

 

 

(403,940

)

 

(403,940

)

Other expense

 

(16,142

)

(18,000

)

(16,142

)

(23,902

)

Net income (loss) from continuing operations

 

233,710

 

(2,373,202

)

(681,959

)

(3,760,065

)

Income (loss) from discontinued operations

 

(65,454

)

(34,385

)

(65,454

)

440,105

 

Gain on disposal of discontinued operations

 

 

4,070,859

 

 

4,070,859

 

Net income (loss)

 

$

168,256

 

$

1,663,272

 

$

(747,413

)

$

750,899

 

 

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15.                                          INCOME TAXES

 

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

 

As a result of the implementation of FIN No. 48, the Company reduced its deferred tax assets and the associated valuation allowance for gross unrecognized tax affected benefits by approximately $4,000,000. There was no adjustment to accumulated deficit as a result of these unrecognized tax benefits since there was a full valuation allowance against the related deferred tax assets. If these unrecognized tax benefits are ultimately recognized, they would have no impact on the effective tax rate due to the existence of the valuation allowance.

 

The Company has not been audited by the Internal Revenue Service (“IRS”) or any states in connection with income taxes. The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The periods from 2004-2007 remain open to examination by the IRS and state jurisdictions. The Company believes it is not subject to any tax risk beyond the preceding discussion. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. The Company does not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the three and six months ended June 30, 2008 and 2007.

 

16.                                SUBSEQUENT EVENTS

 

On July 28, 2008, the Company entered into an Office Lease Agreement, effective as of June 30, 2008 (the “Lease”), with a new landlord (the “Landlord”) to lease office space located at 300 Nickerson Road, Marlborough, Massachusetts and consisting of approximately 14,907 square feet.  Since September 20, 2004, the Company has subleased approximately 38,000 square feet of space at this location pursuant to a Sublease (the “Sublease”) as subtenant.  The Sublease will expire in accordance with its terms on August 31, 2008.  The term of the Lease will commence on September 1, 2008 and will end on August 31, 2011.  Under the Lease, the Company will be required to make monthly rental payments of $20,250.from September 1, 2008 through August 31, 2009, $26,398 from September 1, 2009 through August 31, 2010 and $27,640 from September 1, 2010 through August 31, 2011.  The Lease also provides for the payment of certain additional rent to the Landlord for certain operating expenses and taxes.  Upon execution of the Lease, the Company delivered a security deposit to the Landlord in the form of an irrevocable letter of credit in the amount of $40,500.

 

Also on July 28, 2008, the Company entered into a Settlement and Mutual Release Agreement (the “Settlement Agreement”) with a vendor in order to resolve all matters relating to invoices totaling approximately $2,350,000 that the Company received in January 2008 for materials that had been delivered by the vendor, as a subcontractor on a long-term project for which the Company had served as the prime contractor.  Pursuant to the Settlement Agreement, the parties agreed to a payment schedule under which the Company will be required to satisfy this outstanding balance, plus interest at seven percent (7%) per annum on the unpaid portion of the balance, in full on or before June 1, 2009.  In return, the vendor agreed to forbear from exercising any of its rights and remedies against the Company with respect to these amounts so long as the Company remains in compliance with its obligations under of the Settlement Agreement.

 

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ITEM 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

 

CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS

 

The information contained in this Report on Form 10-Q and in other public statements by the Company and Company officers include or may contain certain forward-looking statements. All statements other than statements of historical facts contained in this Report on Form 10-Q, 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 from the forward-looking statements contained herein due to a number of factors.

 

Many of these factors are set forth in the Company’s Annual Report on Form 10-KSB under the caption “Risk Factors” and other filings with the Securities and Exchange Commission. 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.

 

OVERVIEW

 

BIO-key develops and delivers advanced identification solutions and information services to customers in both the private sector and government, including law enforcement departments, and public safety agencies. Our high-performance, yet easy-to-deploy biometric finger identification technology accurately identifies and authenticates users of wireless and enterprise data, improving security, convenience and privacy while reducing identity theft. Our mobile wireless technology provides first responders with critical, reliable, real-time data and images from local, state and national databases. Today, over 750 police departments in North America depend on BIO-key solutions, making us one of the leading supplier of mobile and wireless solutions for public safety worldwide

 

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

 

On September 30, 2004, BIO-key acquired Aether Systems, Inc.’s 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. Our PacketCluster mobile information software, originally acquired as part of this transaction, 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.

 

On May 22, 2007, BIO-key completed a transaction with ZOLL Data Systems, Inc. (“ZOLL”), a subsidiary of ZOLL Medical Corporation, in which ZOLL acquired substantially all of the assets related to the Company’s Fire/EMS Services division.

 

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CRITICAL ACCOUNTING POLICIES

 

For detailed information on our critical accounting policies and estimates, see our financial statements and notes thereto included in this Report and in our Annual Report on Form 10-KSB, for the fiscal year ended December 31, 2007.  There have been no material changes to our critical accounting policies and estimates from those disclosed in our 10-KSB filed on March 26, 2008.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which is effective for calendar year companies on January 1, 2008. This Statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. Management has adopted SFAS 157.  The adoption of SFAS 157 had no impact on the Company’s financial condition and results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159), which is effective for calendar year companies on January 1, 2008. The statement allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis. Subsequent changes in fair value of these financial assets and liabilities would be recognized in earnings when they occur. SFAS 159 further establishes certain additional disclosure requirements. The adoption of SFAS 159 had no impact on the Company’s financial condition and results of operations.

 

In December 2007, the SEC issued SAB No. 110.  SAB 110 allows for the continued use of a “simplified” method, as discussed in SAB No. 107, in developing an estimate of expected term of “plain vanilla” share options in accordance with SFAS 123 (revised 2004).  Originally the SEC staff stated in SAB 107 that it would not expect a company to use the simplified method for share option grants after December 31, 2007.  Accordingly, the SEC staff will continue to accept, under certain circumstances, the use of the simplified method beyond December 31, 2007.  The Company will continue to use of the simplified method for determining the value of options granted as allowed by SAB 110.

 

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (SFAS No. 141(R)) which establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.  SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The provisions of SFAS No. 141(R) are applicable to business combinations consummated on or after December 15, 2008 with early adoption prohibited.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51”  (SFAS No. 160) which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary for the deconsolidation of a subsidiary.  SFAS No. 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim statements within those fiscal years. The Company does not currently have any noncontrolling interests.

 

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RESULTS OF OPERATIONS

 

THREE MONTHS ENDED JUNE 30, 2008

AS COMPARED TO JUNE 30, 2007

 

INTRODUCTION

 

Over the past few years, the Company has integrated the products, operations and technology acquired from PSG and AMG and restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety, the last of which was sold in May 2007 to ZOLL. Our Biometrics and Law Enforcement segments are headed by a General Manager and are organized to quickly respond to market needs as well as to drive down costs to achieve profitability.

 

A detailed analysis of both segments can be found below.

 

Consolidated Results of Operations - Percent Trend

 

 

 

Three Months Ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

Services

 

51

%

69

%

License fees and other

 

49

%

31

%

 

 

100

%

100

%

Costs and other expenses

 

 

 

 

 

Cost of services

 

8

%

16

%

Cost of license fees and other

 

4

%

3

%

 

 

12

%

19

%

Gross Profit

 

88

%

81

%

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

Selling, general and administrative

 

47

%

90

%

Research, development and engineering

 

33

%

53

%

 

 

80

%

143

%

Operating Income (Loss)

 

8

%

-62

%

 

 

 

 

 

 

Other deductions

 

 

 

 

 

Total other deductions

 

-1

%

-34

%

Net Income (Loss) from continuing operations

 

7

%

-96

%

Net Loss from discontinued operations

 

-2

%

-1

%

Gain on disposal of discontinued operations

 

 

165

%

Net Income

 

5

%

68

%

 

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.

 

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Three months ended
June 30,

 

 

 

 

 

 

 

2008

 

2007

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

Law Enforcement

 

 

 

 

 

 

 

 

 

Service

 

$

1,781,915

 

$

1,688,112

 

$

93,803

 

6

%

License & other

 

576,762

 

621,295

 

(44,533

)

-7

%

 

 

2,358,677

 

2,309,407

 

49,270

 

2

%

Biometrics

 

 

 

 

 

 

 

 

 

Service

 

46,430

 

9,355

 

37,075

 

396

%

License & other

 

1,174,846

 

144,097

 

1,030,749

 

715

%

 

 

1,221,276

 

153,452

 

1,067,824

 

696

%

 

 

 

 

 

 

 

 

 

 

Total Revenue

 

$

3,579,953

 

$

2,462,859

 

$

1,117,094

 

45

%

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

 

 

 

 

 

 

 

 

Law Enforcement

 

 

 

 

 

 

 

 

 

Service

 

$

270,107

 

$

362,339

 

$

(92,232

)

-25

%

License & other

 

103,908

 

29,588

 

74,320

 

251

%

 

 

374,015

 

391,927

 

(17,912

)

-5

%

Biometrics

 

 

 

 

 

 

 

 

 

Service

 

18,641

 

37,240

 

(18,599

)

-50

%

License & other

 

28,522

 

34,105

 

(5,583

)

-16

%

 

 

47,163

 

71,345

 

(24,182

)

-34

%

 

 

 

 

 

 

 

 

 

 

Total COGS

 

$

421,178

 

$

463,272

 

$

(42,094

)

-9

%

 

Revenues

 

Law Enforcement

 

Service revenue for the segment for the three month period ended June 30, 2008 increased by 6% as a result of increased maintenance revenue from new orders.

 

Although license & other revenue for the three month period ended June 30, 2008 decreased 7% from the same period in 2007, the 2007 revenue included $310,000 from a cash payment that the Company received from a long-term project it had participated in as a subcontractor.   Eliminating the effect of this revenue, license and other revenue for the three month period ended June 30, 2008 increased approximately $265,000 due to the receipt of a $243,000 order from an existing customer.

 

Biometrics

 

For the three months ended June 30, 2008, Service revenue increased $37,000 from the same period in 2007 as the Company added new maintenance customers.

 

License and other revenue for the three months ended June 30, 2008 increased $1,031,000 largely as a result of revenue generated from a new OEM customer, as well as additional license revenue from existing customers.

 

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Table of Contents

 

Costs of goods sold

 

Law Enforcement

 

Cost of services for the three months ended June 30, 2008 decreased approximately $92,000 from the same period in 2007 due to lower personnel related expenses.

 

Cost of licenses for the three months ended June 30, 2008 increased by approximately $74,000 from the same period in 2007 due to an increase in third-party software and royalty costs.

 

Biometrics

 

For the three months ended June 30, 2008, cost of services decreased approximately $19,000 from the same period in 2007 due to lower personnel related expenses.  The Company expects these costs will increase in future periods as additional Biometric customers are added.

 

License and other costs decreased for the three months ended June 30, 2008 from the same period in 2007 by approximately $6,000 as a result of reduced hardware costs

 

Selling, general and administrative

 

 

 

Three months ended

 

 

 

 

 

 

 

June 30,

 

 

 

 

 

 

 

2008

 

2007

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Law Enforcement

 

$

1,413,216

 

$

1,857,826

 

$

(444,610

)

-24

%

Biometrics

 

282,090

 

354,655

 

(72,565

)

-20

%

 

 

 

 

 

 

 

 

 

 

Total

 

$

1,695,306

 

$

2,212,481

 

$

(517,175

)

-23

%

 

Law Enforcement & Biometrics

 

SG&A expenses decreased by 23% for the three months ended June 30, 2008 from the same period in 2007 due to lower personnel related expenses, stock compensation charges and fees for professional services.  The Company expects that SG&A expenses will remain at approximately the same level for the remainder of 2008.

 

Research, development and engineering

 

 

 

Three months ended
June 30,

 

 

 

 

 

 

 

2008

 

2007

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Law Enforcement

 

$

891,047

 

$

1,058,054

 

$

(167,007

)

-16

%

Biometrics

 

273,170

 

261,928

 

11,242

 

4

%

 

 

 

 

 

 

 

 

 

 

Total

 

$

1,164,217

 

$

1,319,982

 

$

(155,765

)

-12

%

 

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Law Enforcement & Biometrics

 

Research, development and engineering expenses decreased by 12% for the three months ended June 30, 2008 from the same period in the prior year, driven largely by reductions in facilities and personnel related expenses.

 

Other income and expense

 

 

 

Three months ended
June 30,

 

 

 

 

 

 

 

2008

 

2007

 

$

 Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Derivative and warrant fair value adjustments

 

$

(41,915

)

$

(158,916

)

$

117,001

 

-74

%

Interest income

 

399

 

1,331

 

(932

)

-70

%

Interest expense

 

(7,884

)

(260,801

)

252,917

 

-97

%

Loss on extinguishment of debt

 

 

(403,940

)

403,940

 

-100

%

Other income (expense)

 

(16,142

)

(18,000

)

1,858

 

-10

%

 

 

 

 

 

 

 

 

 

 

Total

 

$

(65,542

)

$

(840,326

)

$

774,784

 

-92

%

 

For the quarter ended June 30, 2008, derivative and warrant fair value adjustments increased, when compared to the 2007 period, due to changes in the fair market value of embedded derivatives and detachable warrants issued with convertible debt issued in 2004 and 2005, as well as additional derivatives recorded as a result of financings in 2006. 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 instruments at different points in time.

 

For the quarter ended June 30,