biokey_10k-123111.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2011
Commission File Number 1-13463
BIO-KEY INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
 
41-1741861
(State or other jurisdiction of
Incorporation or organization)
 
(IRS Employer
Identification Number)
3349 HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ 07719
(Address of Principal Executive Offices) (Zip Code)
(732) 359-1100
Issuer’s telephone number, including area code.
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Exchange on which Registered
 
 
Common Stock, $0.0001 par value per share
 
None
 
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes  o    No  x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   Yes  o    No  x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x   No  o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer  o
 
Accelerated filer  o
     
Non-accelerated filer  o
 
Smaller reporting company  x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
The aggregate market value of the registrant’s voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant’s most recently completed second fiscal quarter was $9,729,713.
As of April 4, 2012, the registrant had 78,155,413 shares of common stock outstanding.
Documents Incorporated by Reference: None


 
 

 
 
TABLE OF CONTENTS

   
PART I
1
       
Item 1.
Description of Business
1
Item 1A
Risk Factors
8
Item 2
Description of Property
12
Item 3
Legal Proceedings
13
Item 4
Mine Safety Disclosures
13
       
   
PART II
14
       
Item 5
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
14
Item 6
Selected Financial Data
16
Item 7
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16
Item 7A
Quantitative and Qualitative Disclosures about Market Risk
25
Item 8
Financial Statements and Supplementary Data
25
Item 9
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
25
Item 9A
Controls and Procedures
25
Item 9B
Other Information
26
       
   
PART III
27
       
Item 10
Directors, Executive Officers and Corporate Governance
27
Item 11
Executive Compensation
30
Item 12
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
35
Item 13
Certain Relationships and Related Transactions, and Director Independence
37
Item 14
Principal Accountant Fees and Services
38
Item 15
Exhibits
39
 
Signatures
68
 
PRIVATE SECURITIES LITIGATION REFORM ACT

All statements other than statements of historical facts contained in this Annual Report on Form 10-K, 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 our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure 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 under the caption “Risk Factors” in Item 1A of this Annual Report 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.

 
 

 
 
PART I

ITEM 1.      DESCRIPTION OF BUSINESS

BIO-key International, Inc., a Delaware corporation (the “Company,” “BIO-key,” “we,” or “us), was founded in 1993 to develop and market advanced fingerprint 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. First incorporated as BBG Engineering, the company became SAC Technologies in 1994.  The BIO-key name was introduced in 2002.

We develop and market advanced fingerprint identification biometric technology and software solutions. We were among the initial pioneers in developing 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 accuracy and speed of finger-based biometrics.

We have developed what we believe is the most discriminating and effective commercially available finger-based biometric technology. Our primary focus is in 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 sales force of professionals, and also team with resellers, integrators and partner networks with substantial experience in selling technology solutions to government and corporate customers.

”As discussed in Note M to the Consolidated Financial Statements included in this report, we have organized the Company into one reporting segment: Biometrics. During the year ended December 31, 2011, the Company continued to focus on its primary objectives of increasing revenue and managing expenses, by developing leadership technology and applications and by providing its customers with high quality support and service.
 
Markets

Finger-based Biometric Identification

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 provides the ability to positively identify individuals before granting access to valuable corporate resources, web portals or applications in seconds. Powered by our patented Vector Segment Technology™ our VST™, WEB-key® and BSP development kits are fingerprint biometric solutions that provide true interoperability with all major reader manufacturers, enabling application developers and integrators to seamlessly integrate fingerprint biometrics into virtually any application.  BIO-key development tools deliver a tangible return on a security platform investment that can:
 
·
Reduce risk of identity or data theft
 
·
Improve convenience for the end user
 
·
Lower operational and administrative costs
 
·
Future proof a company's authentication and identification process
 
BIO-key’s patented Vector Segment Technology (VST) is the foundation for these solutions. BIO-key’s unique solutions provide users with the ability to positively identify themselves to applications with the simple scan of their finger. This capability is a significant improvement in both convenience and security over other competitive offerings and provides companies with a cost-effective solution to thwart phishing attacks and comply with government regulations and legislation such as FFIEC compliance, HIPAA, HSPD-12, and the Electronic Signatures Act. BIO-key couples these capabilities with device interoperability, system flexibility and scalability.
 
 
1

 

BIO-key has formed relationships with providers of biometric logon software including IBM, Oracle, Microsoft, Indigo and CA Technologies to provide enterprise-ready SingleSignOn systems to many large companies in the US and abroad.. BIO-key also has partnership agreements with leading technology companies including MorphoTrak, McKesson, LexisNexis, and IBM to deliver advanced biometric applications for government, civil and commercial clients.

BIO-key believes there is potential for significant growth in four key areas.  Providing biometric technology to support electronic medical records (EMR) and electronic health records (EHR) for hospital and other medical practice group clients is one of BIO-key’s primary areas of focus.  Second, we focus on providing donor ID solutions for blood centers, expanding the company’s existing footprint in this area.  In additions, government agencies continue to recognize BIO-key as a world-class provider of biometric solutions therefore our government contracting business is another primary focus of ours.  Lastly, we believe that the popularity of smartphones and tablets is creating a demand for much stronger security, which presents another significant opportunity for BIO-key, and we have already introduced several mobile identification solutions.
  
Products

The Company’s biometric identification technology improves both the accuracy and speed of identifying individuals by extracting unique data from a fingerprint and using it to positively identify an individual.  The technology has been built to be completely scalable to handle databases containing millions of fingerprints. BIO-key achieves the highest levels of discrimination without requiring any other identifying data such at a userID, smart card, or token.  BIO-key’s core technology supports interoperability on over 60 different commercially available fingerprint readers.  The technology is also interoperable across Windows, Linux, Apple iOS, and Android operating systems. This interoperability is a key differentiator for BIO-key in the biometric market.
 
In regard to performance, BIO-key has full support for industry standards and received National Institute of Standards and Technology (“NIST”) certification on its ability to support HSPD-12 supported INCITS-378 templates.  We believe we have the largest deployment of ISO standard templates in the world with over 300 million created in Bangladesh.  Moving forward we anticipate a growing acceptance of fingerprint biometric technology along with a growing demand to provide biometric identification support for advanced mobile devices.  Overall, BIO-key’s most significant deliverables will be:

 
·
Securing access to Internet sites and Internet apps

 
·
Securing access to logical networks and enterprise apps

 
·
Providing fast, accurate civil ID solutions

 
·
Providing patients and medical staff with secure biometric access to records and ePrescriptions

 
·
Provide blood donors with a safe, secure and convenient way to ID and donate.

 
·
Securing mobile devices such as biometric enabled phones and tablets

 
·
Preventing identity theft through positive user identification and false alias validation
 
BIO-key’s finger identification algorithm—Vector Segment Technology (VST™) is the core intellectual property behind its full suite of biometric products that include:

 
·
Vector Segment Technology SDK (VST) —BIO-key’s biometric software development kit (“SDK”) that provides developers the ability to take advantage of a highly accurate, device interoperable algorithm. VST is available as a low level SDK for incorporation into any application architecture to increase security while not sacrificing convenience. VST runs on Windows, Linux, iOS and Android systems.

 
·
True User Identification ®—BIO-key’s biometric identification solution that offers large scale one-to-many user lookup with nothing but a single fingerprint. This solution enables customers to perform false alias checks and manage fraudulent access to systems.  True User Identification leverages databases to scale the identification capabilities to millions of users.  The solution runs on commercially available hardware making it truly scalable for any size system.
 
 
2

 
 
 
·
WEB-key ®—BIO-key’s biometric security platform for managing fingerprint authentication across unprotected networks including the Internet. It extends all features and functionalities of the VST algorithm to customers looking to add an enhanced level of security to their thin client and client/server applications. WEB-key currently is supported by both Windows and Linux operating systems. Clients are available on Windows, iOS and Android systems.

 
·
Biometric Service Provider™ BIO-key provides support for the BioAPI (a standards-based solution meeting worldwide needs) for a compliant interface to applications using biometrics for verification and identification. BIO-key enhances the traditional use of the BioAPI by having added support for WinCE devices years ago, supporting identification calls and also providing a single user interface for multiple fingerprint readers.

 
·
ID Director ™—BIO-key’s solution for single sign on integration with CA Technologies SiteMinder, Oracle’s Fusion Middleware SSO, and other solutions, utilizing the power and security of WEB-key. This solution provides a simple to implement, custom authentication scheme for companies looking to enhance authentication. ID Director can easily add a level of security and convenience to the transaction level of any application.

Current Business Plan

BIO-key’s current business plan is to:

 
·
License its core technology “VST” and True User Identification® to original equipment manufacturers, systems integrators, and application developers who develop products and applications that utilize its biometric finger matching solutions.

 
·
License WEB-key®, the Company’s security centric web-based biometric authentication solution.

 
·
Integrate its core technology competencies to leverage new business opportunities and develop new markets for its innovative products.

Competition

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, 3M (Cogent), NEC, and MorphoTrak.

The majority of sales for automated fingerprint identification products in the market to date have been deployed for government agencies, healthcare facilities and law enforcement applications. The consumer and commercial markets represent areas of significant growth potential for biometrics, led by the use of mobile devices.
 
The epidemic of security and data breaches reported in 2011 is one of the driving factors for identifying new methods of protecting valuable data.  After attempting to create a more sophisticated password or more efficient token or PIN, it’s become apparent that each of these methods is easily compromised and the downside risks are significant.

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

 
·
Fingerprint identification is generally viewed as very accurate, inexpensive and non-intrusive.

 
·
Palmvein scanning is expensive, technique-sensitive and offers mobility challenges.

 
·
Iris scanning is viewed as accurate, but the hardware is significantly more expensive.

 
·
Facial recognition can have accuracy limitations and is typically highly dependent on ambient lighting conditions, angle of view and other factors.
 
 
3

 
 
We are starting to witness a change in the way biometric technology is viewed.  Up until recently, there was a general consensus that fingerprint biometric technology was exclusively used for forensics.  Today as we see fingerprint biometric technology deployed at schools, testing centers, airports, retail stores, fast food franchises, hospitals, government agencies and healthcare it is clear that fingerprint biometrics is becoming part of everyday life.

Advanced mobile devices with all of their advanced capabilities and applications will generate a high demand for strong security / identification to protect the financial, business and personal information stored or accessed on each device.

BIO-key is already working with leading healthcare providers and government agencies introducing mobile ID solutions for the iPad – iPhone and Android.

Marketing and Distribution

BIO-key’s marketing and distribution efforts consist of the following major initiatives:

 
·
BIO-key remains committed to our partner program and the leverage sales model.  The company has achieved premier status with Allscripts and will soon be a premier partner with CA.  IBM is launching a new division called IBM Security and we believe that BIO-key has the opportunity to become that division’s preferred biometric partner.  As the coming year progresses, we also hope to leverage our relationship with Oracle to generate greater returns.

 
·
BIO-key is also promoting biometric technology and its offerings through industry trade shows, public speaking engagements, press activities and partner marketing programs

 
·
The BIO-key social marketing network is active and growing.  Our YouTube videos have generated over 9,000 views and the company has over 100+ followers on LinkedIn and Twitter.

 
·
BIO-key is directing licensing efforts to original equipment manufacturers, application developers and system integrators.

 
·
BIO-key is continuing to build a reseller, integrator and partner network as well as a direct sales team.

Addressing the Market

Following are the specific marketing/sales programs in place:

 
·
Direct Selling Efforts — BIO-key’s direct sales force focuses on OEMs and large entities in the commercial and Government markets. The sales team has extensive sales experience and expertise in emerging biometric technologies. The BIO-key sales force is rounded out by Inside Sales, which is responsible for maintaining and supporting our existing installed base, acting as a front-line support for any inquiries on our product line, and facilitating activities that make the field team more productive.

 
·
Conferences and Trade Shows — BIO-key attends and actively participates in various product-related conferences and trade shows in the technology and security industries to generate market awareness of biometric and wireless mobile data technology generally and our offerings specifically.

 
·
Strategic Alliance — BIO-key’s strategic alliances and reseller agreements with other vendors play a significant role in our overall sales efforts. In the past year, BIO-key has initiated and bolstered numerous important and promising long-term relationships. Just a few examples include:

 
·
BIO-key is an active member in CA, IBM and Oracle partner programs, delivering authentication and identification solutions integrated with their Identity Management platform to their customers worldwide.

 
·
BIO-key is focusing on specific vertical markets including healthcare where it continues to grow upon successful integration of its identification technology to provide convenient, accurate and fast user identification in partner solutions including McKesson and Allscripts
 
 
4

 
 
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 five 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:

 
·
Government Using BIO-key’s technology, Northup Grumman deployed an application within the Department of Defense to cross-credential visitors and contractors to certain military bases.  In addition, BIO-key, in conjunction with MorphoTrak, is providing the finger matching platform for the FBI’s Next Generation IAFIS system, which today is one of the world’s largest biometric systems.

 
·
Education —Educational Biometric Technologies and Identimetrics have incorporated BIO-key technology to enable school children to pay for school lunch programs and checkout library books using their fingerprints. VST technology enables schools to enroll these children and reduces the administrative costs of managing passwords and collecting payments.

 
·
Commerce: LexisNexis has implemented various solutions in thousands of locations in over 70 countries using BIO-key’s VST technology to reduce fraud and identity theft.

 
·
Patient Records and Information Management: Allscripts has integrated and deployed BIO-key’s biometric solution as a standard part of its Enterprise EHR solution.  The integrated solution has been deployed at George Washington University, Holzer Clinic, Medisync, and many other Allscripts customers. HBOC, one of the largest healthcare patient records and information management companies, has integrated BIO-key technology into their portal and has deployed their solution in a pilot for the Baptist Hospital System. EPIC, another well recognized company, has integrated BIO-key technology into their information management systems. Also, the Indiana Blood Center, Oklahoma Blood Center and the Institute for Transfusion Medicine in Pittsburgh are incorporating BIO-key’s large scale identity assurance platform to provide a safe, secure and convenient means for donors to confirm their identity.  McKesson Provider Services has incorporated BIO-key’s “one-to-many” finger matching software into their Accudose line of medication and supplies dispensing systems solutions and is selling that equipment to clinics and hospitals nationwide. Sentillion (A Microsoft Company) and Healthcast are using BIO-key technology for the single sign on process.

 
·
Financial: BIO-key is working with several companies focusing on financial applications such as point of sale systems and employee trusted identification cards, as well as customer facing applications over the Internet. BIO-key has also begun work with several financial institutions to incorporate its technology for secure access to money transfers for institutional customers.

Intellectual Property Rights

We believe that our intellectual property is important to our biometric operation:

 
·
PatentsWe use patented technology and trade secrets developed or acquired by us.

In May 2005, the U.S. Patent & Trademark Office issued us a patent for our Vector Segment fingerprint technology (VST), BIO-key’s core biometric analysis and identification technology.

On August 29, 2006, BIO-key announced that the Company’s patent for biometric identification indexing, a core feature of its VST™ software, has been granted in Europe. In addition, a WEB-key® authentication security patent for “Systems and Methods of Secure Biometric Authentication” has been issued in South Africa. These patents enhance the worldwide protection of BIO-key’s technology. The European patent for VST, which provides BIO-key with protection of its intellectual property in Europe, was issued on March 29, 2006 and covers a similar set of claims for a patent BIO-key was granted in 2005 in the United States.

On October 3, 2006, BIO-key announced that the Company’s patent for a biometric authentication security framework has been granted by the U.S. Patent & Trademark Office. The patent No. 7,117,356 was issued to BIO-key for a biometric authentication security framework that enhances commercial and civil biometric use.  BIO-key’s authentication security framework protects privacy and security while also facilitates ease of use of biometric systems.  The technology that this patent is based on is the foundation for the authentication security incorporated in BIO-key’s WEB-key® product line.    WEB-key is a mature enterprise authentication solution that functions in a wide variety of application environments.  The solution supports a variety of implementation alternatives including card technologies for ‘two-factor’ authentication and also supports  ‘single-factor’ authentication.  Partners and customers implementing BIO-key’s WEB-key software to provide convenient and secure user identity include a number of institutions including the Allscripts Healthcare Solutions, American Association of Medical Colleges, Empresa de Telecomunicaciones de Bogotá (Columbia) and Iomedex Corporation.
 
 
5

 

On January 11, 2007, BIO-key announced that the U.S. Patent & Trademark Office has issued US patent No. 7,155,040 covering BIO-key’s unique image processing technology, which is critical for enhancing information used in the extraction of biometric minutiae. The issued patent protects a critical part of an innovative four-phase image enhancement process developed by BIO-key, and represents the third U.S. patent granted to the company for its biometric technology.

On April 15, 2008, BIO-key announced that the U.S. Patent and Trademark Office has issued US patent No. 7,359,553 covering BIO-key’s image enhancement and data extraction core algorithm components. The solution protected under this recently issued patent provides the capability to quickly and accurately transform a fingerprint image into a computer image that can be analyzed to determine the critical data elements

On October 15, 2008 BIO-key announced that the U.S. Patent and Trademark Office has issued US patent No. 7,415,605 for the Company’s “Biometric Identification Network Security” method. The solution protected under this recently issued patent provides a defense against hackers and system attacks, while leveraging the industry standard Trusted Platform Module (TPM) specification for encryption key management.

On December 3, 2008 BIO-key announced that the U.S. Patent and Trademark Office has issued US patent No. 7,454,624 for the Company’s “Match Template Protection within a Biometric Security System” method. The solution protected under this recently issued patent limits the scope of enrollment templates usage and also eliminates the need for revocation or encryption processes, which can be expensive and time consuming.

On March 10, 2009 BIO-key announced that the U.S. Patent and Trademark Office has issued US patent No. 7502938 for the Company’s “Trusted Biometric Device” which covers a simple, yet secure method of protecting a user’s biometric information. It covers the transmission of information from the point the information is collected at the biometric reader until the data reaches the computer or device that is authenticating the user’s identity.

On May 26, 2009 BIO-key announced that the U.S. Patent and Trademark Office has issued US patent No. 7539331 for the Company’s  “Image Identification System” method for improving the performance and reliability of image analysis within an image identification system.

On December 19, 2011 BIO-key announced that the U.S. Patent and Trademark Office has issued US Patent No 8,055,027 for the Company’s “Generation of Directional Information in the Context of Image Processing” method for image enhancement and processing.

 
·
Trademarks— We have registered our trademarks “BIO-key”, “True User Identification”, “Intelligent Image Indexing” and “WEB-key with the U.S. Patent & Trademark Office.

 
·
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 biometrics. 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.

During the fiscal years ended December 31, 2011 and 2010, BIO-key spent approximately $1,117,000 and $1,056,000 respectively, on its Biometric segment’s research, development and engineering. 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.
 
 
6

 

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

As of March 1, 2012, BIO-key employed fourteen (14) individuals on a full-time basis as follows - five (5) in engineering, customer support, research and development; four (4) in finance and administration; and five (5) in sales and marketing. BIO-key also uses the services of two (2) consultants (full-time), who provide engineering and technical services, one (1) part-time contracts administrator, and one (1) part-time sales support.


ITEM 1A.   RISK FACTORS

Set forth below are the risks that we believe are material to our investors. This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements appearing just before our Description of Business section above.

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 independent auditors have included an explanatory paragraph in their opinion for the year ended December 31, 2011 as to the substantial doubt about our ability to continue as a going concern. Our financial statements have been prepared in accordance with accounting principles 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 December 31, 2011, we had a working deficit of approximately $1,539,000 and an accumulated deficit of approximately $52,292,000. Since our inception, we have focused almost exclusively on developing our core technologies and, until the fourth quarter of 2004 had not generated any significant revenue. In 2009 we sold our Law Enforcement division, losing the benefit of significant recurring revenue streams. 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.
  
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:
 
 
·
the reliability of biometric solutions

 
·
public perception regarding privacy concerns
 
 
7

 
 
 
·
costs involved in adopting and integrating biometric solutions

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.

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 provide 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 defect 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:

 
·
Original equipment manufacturers, system integrators and application developers which develop and market products and applications which can then be sold to end users

 
·
Companies which distribute goods, services or software applications over the Internet

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 cannot 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 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.
 
 
8

 

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. Our consulting contract with Thomas J. Colatosti, our Chairman of the Board, expired in December 2011. Mr. Colatosti continues, however, to assist the Company in the areas of strategic planning and corporate finance. In addition, our employment contract with Michael W. DePasquale, our Chief Executive Officer, expires in March each year, and renews automatically for successive one year periods unless notice of non-renewal is provided by the Company. 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 intellectual property protection for our core technology provides a sustainable 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. Over the last few years, the U.S. Patent Office has issued us a series of patents for our Vector Segment fingerprint technology (VST), and our other core biometric analysis and identification technologies. We cannot assure you that any additional patents will be issued or 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 cannot assure you that such infringements do not exist or will not exist in the future.

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 significant, recurring revenue (other than revenue from acquired businesses) and have experienced substantial losses. In December 2010, we restructured the payment terms of our $4,000,000 Note Receivable and exchanged all of our remaining shares of Preferred Stock and outstanding Convertible Notes for Secured Notes. In May 2011, our Note Receivable was paid in full to the Company, and the Company used all of these proceeds towards paying the balance of its Secured Promissory Notes.

If we are 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. Therefore, we may need to obtain additional financing through the issuance of debt or equity securities, or to restructure our financial position through similar transactions to those consummated during the 2010 to 2011 period.

We 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, we may not be able to execute our business plan or continue operations.

We may not achieve sustainable profitability with respect to the biometric component 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.
 
 
9

 

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.

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 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 debt financing transactions, we granted to the holders 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 of Financial Condition and Results of Operations” 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, 100% of the outstanding principal amount of the secured notes, plus accrued interest and fees will accelerate and be due and payable in full.

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 holders of the secured debt could foreclose on our assets or exercise any other remedies available to them.  If our assets were foreclosed upon, we would most likely be 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 to the holder of our outstanding Secured Notes may adversely affect our ability to enter into potential significant transactions with other parties.

We will need to obtain the consent of the holder of our Secured Notes before we can take certain actions, including the issuance of any loan or debt secured by the assets of the Company. 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 December 31, 2011, approximately 13,822,000 shares of our common stock were reserved for issuance upon exercise or conversion of the following securities (at conversion prices applicable as at December 31, 2010):

 
·
12,654,000 shares upon exercise of outstanding stock options and warrants;

 
·
1,168,000 shares upon exercise of options available for future grant under our existing option plans; and

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.

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 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.
 
 
10

 

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

We have never declared or paid a dividend on our common stock. 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 cannot 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.


ITEM 2.      DESCRIPTION OF PROPERTY

We do not own any real estate. We conduct operations from leased premises in Eagan, Minnesota (6,822 square feet), Wall, New Jersey (4,179 square feet) and North Billerica, Massachusetts (shared services center). We believe our current facilities are adequate for the foreseeable future.


ITEM 3.      LEGAL PROCEEDINGS

In the normal course of business, the Company periodically becomes involved in litigation. As of December 31, 2011, in the opinion of management, the Company had no pending litigation that would have a material adverse effect on the Company’s financial position, results of operations or cash flows.


ITEM 4.      MINE SAFETY DISCLOSURES

N/A
 
 
11

 

PART II
 
ITEM 5.      MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
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.

2011:
 
High
   
Low
 
             
Quarter ended December 31, 2011
  $ 0.14     $ 0.06  
Quarter ended September 30, 2011
    0.14       0.10  
Quarter ended June 30, 2011
    0.16       0.13  
Quarter ended March 31, 2011
    0.19       0.14  
 
2010:
 
High
   
Low
 
             
Quarter ended December 31, 2010
  $ 0.19     $ 0.14  
Quarter ended September 30, 2010
    0.21       0.10  
Quarter ended June 30, 2010
    0.23       0.14  
Quarter ended March 31, 2010
    0.28       0.20  
 
Holders

As of April 4, 2012, the number of stockholders of record of our common stock was 122.

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 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.

Equity Compensation Plan Information

For information regarding our equity compensation plans, see Item 12 included in this Annual Report on Form 10-K.

Recent Sales of Unregistered Securities; use of Proceeds from Registered Securities

On December 31, 2010, the Company entered into a Securities Exchange Agreement with The Shaar Fund Ltd. (“Shaar”) and Mr. Thomas J. Colatosti (collectively, the “Holders”), pursuant to which these investors agreed to exchange all of their outstanding shares of the Company’s Series D Convertible Preferred Stock, including all accrued and unpaid dividends thereon, and the 7% Convertible Promissory Note dated as of December 28, 2009 issued by the Company to each of these investors, for new non-convertible 7% Secured Promissory Notes in the aggregate original principal amount of $3,508,563. The Company also exchanged all existing 5,108,333 warrants previously issued by the Company to Shaar for a new five-year warrant to allow Shaar to purchase up to an aggregate of 8,000,000 shares of the Company’s common stock at an initial exercise price of $0.30 per share. These securities were issued in a private placement transaction exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof directly by the Company without engaging in any advertising or general solicitation of any kind and without payment of underwriting discounts or commissions to any person.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

None.

 
12

 
 
ITEM 6.      SELECTED FINANCIAL DATA

N/A


ITEM 7.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion And Analysis Of Financial Condition And Results Of Operations, 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 1A 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 Of Financial Condition And Results Of Operations (“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. 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 2011 performance and a description of the significant events impacting 2011 and thereafter.

RESULTS OF OPERATIONS provides an analysis of the consolidated results of operations for 2011 compared to 2010.

LIQUIDITY AND CAPITAL RESOURCES provides an overview of our cash flows, financing, contractual obligations, and liquidity outlook.

CRITICAL ACCOUNTING POLICIES provides a discussion of our accounting policies that require critical judgment, assumptions and estimates.
 
RECENT ACCOUNTING STANDARDS 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 2011 See Note A to the Consolidated Financial Statements included elsewhere in this Annual Report.

 
OVERVIEW

BIO-key develops and markets advanced fingerprint identification biometric technology and software solutions. We were among the initial pioneers in developing 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 accuracy and speed of finger-based biometrics.

Through partnerships with OEMs, integrators, and solution providers, we provide biometric software solutions to private and public sector customers.  BIO-key provides the ability to positively identify individuals in seconds before granting access to valuable corporate resources, web portals or applications.  Powered by our patented Vector Segment Technology™ our VST™, WEB-key® and BSP development kits are fingerprint biometric solutions that provide true interoperability with all major reader manufacturers, enabling application developers and integrators to seamlessly integrate fingerprint biometrics into virtually any application.

While our growth has been sluggish due to market acceptance, and lengthy processes involved with building relationships with large integrators, we believe that due to current market conditions, specifically identity theft, we are well-positioned for growth as solutions empower users to take control of their identities in a way that cannot be replicated, stolen or mistaken for unauthorized use. Organizations that employ BIO-key’s solutions to authenticate employees and protect company data also experience a measurable return on investment.  For example, we have received a large order in the first quarter of 2012 in the blood bank industry that we believe will materially increase our sales in this industry.

 
13

 

RESULTS OF OPERATIONS

Consolidated Results of Operations

Two Year % trend

   
Years ended December 31,
 
   
2011
   
2010
 
Revenues
           
Services
    24 %     12 %
License fees and other
    76 %     88 %
      100 %     100 %
Costs and other expenses
               
Cost of services
    5 %     3 %
Cost of license fees and other
    19 %     13 %
      23 %     16 %
Gross Profit
    77 %     84 %
                 
Operating expenses
               
Selling, general and administrative
    86  %     88 %
Research, development and engineering
    32 %     30 %
      118 %     118 %
Operating loss
    -41 %     -34 %
                 
Other income (deductions)
               
Total other income (deductions)
    -13 %     16 %
Loss from continuing operations
    -54 %     -18 %
Income from discontinued operations
            9 %
Net (loss) income
    -54 %     -9 %
 
Revenues and Costs of goods sold

                2011 - 2010  
   
2011
   
2010
   
$ Chg
   
% Chg
 
                           
Revenues
                         
Service
    848,483       439,759       408,724       93 %
License & other
    2,660,321       3,080,649       (420,328 )     -14 %
Total Revenue
  $ 3,508,804     $ 3,520,408     $ (11,604 )     0 %
                                 
Cost of goods sold
                               
Service
    159,223       102,661       56,562       55 %
License & other
    651,236       456,480       194,756       43 %
Total COGS
  $ 810,459     $ 559,141     $ 251,318       45 %
 
Revenues

For the years ended December 31, 2011 and 2010, service revenues included approximately $680,000 and $411,000, respectively, of recurring maintenance and support revenue, and approximately $168,000 and $28,000, respectively, of non-recurring custom services revenue.  Recurring service revenue increased 65% from 2010 to 2011 as the Company continued to bundle maintenance agreements to its expanding customer license base, and renewed existing maintenance agreements from its legacy customers.

For the year ended December 31, 2011, license and other revenue (comprised of third party hardware and royalty income) decreased as a result of several contributing factors.  The Company realized an approximate $785,000 decrease (32%) in its core software license revenue from both new and existing customers. The percentage of license and other revenue as a proportion of total revenue decreased from 87% to 76%. Third-party hardware sales increased by approximately $357,000 (63%) primarily as a result of revenue from new customers in the healthcare industry, who required initial start-up investments in hardware, which is not currently a typical scenario across all of BIO-key’s target markets.  Depending on the size and the timing requirements of the customers’ software deployment roadmap, hardware purchases may be solely within the initial software order, or, as with our OEM partners in the healthcare industry, a recurring activity. McKesson continued their deployment of our identification technology in their AccuDose® product line, and our partners Allscripts, Medflow, ChoicePoint/LexisNexis, Educational Biometric Technology and Identimetrics all continued expansion of biometric ID deployments. The Company’s royalty income for the year ended December 31, 2011 was derived from a December 2009 OEM agreement, and resulted in a17% increase in revenue from approximately $80,000 to $94,000. The Company expects this revenue stream to be recurring.
 
 
14

 

Costs of goods sold

For the year ended December 31, 2011, cost of services increased from 2010 due to increased customer support, as needed for the expanding customer base and increased non-recurring custom services.  The Company expects these costs will increase in future periods as additional Biometric customers are added and non-recurring custom services increase with diversification of markets.

For the year ended December 31, 2011, cost of license and other increased from 2010 due to an increase in third party hardware costs commensurate with the increase in hardware orders discussed in the “Revenues” section above.

Selling, general and administrative

                 2011 - 2010  
   
2011
   
2010
   
$ Chg
   
% Chg
 
                           
Total
  $ 3,036,299     $ 3,105,291     $ (68,992 )     -2 %
 
Selling, general and administrative costs decreased 2% for the year ended December 31, 2011 as compared to the same period 2010.   Reductions included legal fees by approximately $59,000 including the costs incurred for exploring the previously announced  SIC acquisition, a decrease in accounting fees of approximately $81,000 and professional fees by $16,000 primarily attributable to our 2010 change in auditors and issues related to the sale of the Law segment. The reduction in expenses also included decreases in channel marketing fees of approximately $86,000 related to decreased revenue from the healthcare industry, a decrease of $50,000 in director fees paid, a decrease of $94,000 for commission relative to reduced overall Company revenues as well as decreased marketing expenses of approximately $19,000, and decreased travel expenses of approximately $55,000.  The decreases were offset by an increase in bad debt expense related to a contract whose payments are behind schedule,  As a result of the payment delays, the Company has reserved $386,000 which represents 50% of the remaining balance owed under the contract.
 
Research, development and engineering

                 2011 - 2010  
   
2011
   
2010
   
$ Chg
   
% Chg
 
                           
Total
  $ 1,116,658     $ 1,055,980     $ 60,678       6 %
 
For the year ended December 31, 2011, R & D costs increased as compared to 2010, primarily due to increased consultant expenses related to the development of a new software application. The Company expects to devote similar amounts of funding to its R & D function as in prior years.

Other income and expense
 
                 2011 - 2010  
   
2011
   
2010
   
$ Chg
   
% Chg
 
                           
Interest income
  $ 95,033     $ 241,416     $ (146,383 )     -61 %
Interest expense
    (411,527 )     (711,348 )     299,821       -42 %
Income tax
    (26,500 )     -       (26,500 )     n/a  
Net discounts of notes payable and receivable
    (100,000 )     -       (100,000 )     n/a  
Derivative and warrant fair value adjustments
          1,020,164       (1,020,164 )     -100 %
                                 
    $ (442,994 )   $ 550,232     $ (993,226 )     -181 %
 
Interest income for the fiscal years ended 2011 and 2010, was attributable to the Note Receivable, which was fully paid in May 2011.
 
 
15

 

Interest expense for the year ended December 31, 2011 was comprised of approximately $104,000 owing to the holders of the Secured Notes, and approximately $308,000 in non-cash amortization of the discount attached to the Secured Notes. Interest expense during 2010 was comprised of $52,000 owing to the holders of the Convertible Notes, and approximately $659,000 in non-cash amortization of the discount attached to the Convertible Notes. The Company expects to incur approximately $25,000 in interest expense from its Secured Notes until the end of 2012, at which point the Notes are expected to be paid in full.

For the year ended December 31, 2011, the net discounts of notes payable and receivable were non-cash items with respect to the value of the net early payment discount granted to the holder of the note receivable.

For the year ended December 31, 2010, the derivative and warrant fair value income was attributable to embedded derivatives and detachable warrants issued with convertible debt in 2005, 2006 and 2009. The fair value of the derivatives fluctuated 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.

DISCONTINUED OPERATIONS

On December 8, 2009, we completed the sale of our Law Enforcement division for approximately $11.3 million, amounting to a net gain to the Company of approximately $4.5 million. This business had previously been reported as a separate segment in our financial statements. For fiscal year 2010, $0.3 million of operating income net of tax was reflected as discontinued operations in the accompanying consolidated statement of operations.  Net sales associated with the discontinued operations were $0.5 million for 2010. See “Note B — Discontinued Operations” for further discussion.

LIQUIDITY AND CAPITAL RESOURCES

OPERATING ACTIVITIES OVERVIEW

Net cash used for operations during the year ended December 31, 2011 was approximately $523,000. The cash used by operating activities of continuing operations was primarily used to fund the operating loss for the year.  Other items of note were as follows:

 
·
Negative cash flows related to an increase in accounts receivable of approximately $622,000, due to a large partially paid order received late in the first quarter of 2011. Payments of the contract are behind schedule due to delays in deliverables by other parties, for which, we have no control over.  As a result, we have reserved $386,000 which represents 50% of the balance due.

 
·
Positive cash flows from an increase of approximately $507,000 in accounts payable of which approximately $142,000 is for third party hardware shipped in the fourth quarter, and delayed payments for other vendors due to inadequate cash to meet the current obligations, and an increase in accrued expenses of approximately $222,000, attributable to the accrued commission, and an increase in deferred revenue for maintenance renewals and a new prepaid order.

 
·
The Company recorded approximately $57,000 of charges in 2011 for the expense of issuing options to employees for services.

INVESTING ACTIVITIES OVERVIEW

Net cash provided by investing activities of $3,293,796 was the result of the early receipt of proceeds from the note receivable of $3,350,000 net of capital expenditures of $56,204.

FINANCING ACTIVITIES OVERVIEW

Net cash used for financing activities of $3,737,344 included the early repayment of the Shaar note of $3,612,135 and outstanding dividends of $125,209.

Net working deficit at December 31, 2011 was approximately $1,539,000 as compared to net working capital of approximately $88,000 at December 31, 2010. The change was due to the Company’s reduction in cash due primarily to funding the operating loss of the business.

 
16

 

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.

As of December 2011, the Company entered into a 24-month accounts receivable factoring arrangement with a financial institution (the “Factor”). Pursuant to the terms of this arrangement, BIO-key, from time to time shall sell to the Factor certain of its accounts receivable balances on a non-recourse basis for credit approved accounts. The Factor shall then remit 75% of the accounts receivable balance to BIO-key (the “Advance Amount”), with the remaining balance, less fees to be forwarded to the Company once the Factor collects the full accounts receivable balance from the customer. Factoring fees range from 2.75% to 15% of the face value of the invoice factored and are determined by the number of days required for collection of the invoice. BIO-key expects to use this factoring arrangement periodically to assist with its general working capital requirements.

Liquidity outlook

At December 31, 2011, our total of cash and cash equivalents was approximately $43,000, as compared to approximately $1,010,000 at December 31, 2010.

As discussed above, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, as well as convertible preferred stock and common stock. We currently require approximately $385,000 per month to conduct our operations. During 2011, we generated approximately $3,500,000 of revenue, which is below our average monthly requirements.

The balance of the Company’s Secured Notes of approximately $346,000 will be due and payable to the holder together with all accumulated and unpaid interest on December 31, 2012.

If we are 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. Therefore, we may need to obtain additional financing through the issuance of debt or equity securities, or to restructure our financial position through similar transactions to those consummated during the 2009 to 2010 period.

Due to several factors, including our history of losses and limited revenue, our independent auditors have included an explanatory paragraph in their opinion 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.

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements that have, or are in the opinion of management reasonably likely to have, a current or future effect on our financial condition or results of operations.

CRITICAL ACCOUNTING POLICIES

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates under different assumptions or conditions. There have been no material changes to these estimates for the periods presented in this Annual Report on Form 10-K.
 
 
17

 

We believe that of our significant accounting policies, which are described in Note A of the notes to our consolidated financial statements included in this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations.

1. Revenue Recognition

Revenues from software licensing are recognized in accordance with ASC 985-605, “Software Revenue Recognition. 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, 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, the Company applies the residual method in accordance with ASC 985-605. The residual method requires that the portion of the total arrangement fee attributable to the undelivered elements be deferred based on its VSOE of fair value and subsequently recognized as the service is delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, which is generally the software license. VSOE of fair value for all elements in an arrangement is based upon the normal pricing for those products and services when sold separately. VSOE of fair value for support services is additionally determined by the renewal rate in customer contracts. The Company has established VSOE of fair value for support as well as consulting services.

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. Otherwise, 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. 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 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.

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.

Costs and other expenses: Includes professional compensation and other direct contract expenses, as well as costs attributable to the support of client service professional staff, depreciation and amortization costs related to assets used in revenue-generating activities, and other costs attributable to serving the Company’s client base. Professional compensation consists of payroll costs and related benefits including stock-based compensation and bonuses. Other direct contract expenses include costs directly attributable to client engagements, such as out-of-pocket costs including travel and subsistence for client service professional staff, costs of hardware and software and costs of subcontractors. The allocation of lease and facilities charges for occupied offices is included in costs of service.
 
 
18

 

The Company accounts for its warranties under the FASB ASC 450 “Contingencies.” The Company generally warrants that its products are free from defects in material and workmanship for a period of one year from the date of initial delivery to our customers. The warranty does not cover any losses or damage that occurs as a result of improper installation, misuse or neglect or repair or modification by anyone other than the Company or its authorized repair agent. The Company’s policy is to accrue anticipated warranty costs based upon historical percentages of items returned for repair within one year of the initial sale. The Company’s repair rate of products under warranty has been minimal, and a historical percentage has not been established. The Company’s software license agreements generally include certain provisions for indemnifying customers against liabilities if the Company’s software products infringe upon a third party’s intellectual property rights. The Company has not provided for any reserves for warranty liabilities as it was determined to be immaterial.

2. 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.

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 or Binomial 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.

3. Impairment or Disposal of Long Lived Assets, including Intangible Assets

We review our long-lived assets, including intangible assets subject to amortization, whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to the future undiscounted cash flows the assets are expected to generate. If such assets are considered impaired, the impairment to be recognized is equal to the amount by which the carrying value of the assets exceeds their fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. In assessing recoverability, we must make assumptions regarding estimated future cash flows and discount factors. If these estimates or related assumptions change in the future, we may be required to record impairment charges. Intangible assets with determinable lives are amortized over their estimated useful lives, based upon the pattern in which the expected benefits will be realized, or on a straight-line basis, whichever is greater. We did not record any impairment charges in any of the years presented.

4.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 are expensed as incurred.

5. 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 ASC 740-10, “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 expiring unused. Because of the Companies historical performance and estimated future taxable income a full valuation allowance has been established.
 
 
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6. Accounting for Stock-Based Compensation

The Company accounts for share based compensation in accordance with the provisions of ASC 718-10, “Compensation — Stock Compensation,” 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.


ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

N/A


ITEM 8.      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See financial statements appearing at pages 39-67 of this report


ITEM 9.      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

N/A


ITEM 9A.   CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2011. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of December 31, 2011, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Management’s Annual Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
 
20

 

Under the supervision and with the participation of our management, including our CEO and CFO, we have conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011, based upon the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that our internal control over financial reporting was effective as of December 31, 2011.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.

Changes in Internal Control Over Financial Reporting

No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


ITEM 9B.   OTHER INFORMATION

None.

 
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PART III

ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

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

NAME
 
AGE
 
POSITIONS HELD
Thomas J. Colatosti
 
63
 
Chairman of the Board of Directors
Michael W. DePasquale
 
57
 
Chief Executive Officer and Director
Jeffrey J. May (b)
 
52
 
Director
Charles P. Romeo (a) (c)
 
70
 
Director
John Schoenherr (b) (c)
 
59
 
Director
         
Cecilia Welch
 
52
 
Chief Financial Officer
Mira K. LaCous
 
50
 
Vice President of Technology & Development
Scott Mahnken
 
52
 
Vice President of Marketing


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

 
(b)
Audit Committee Member

 
(c)
Compensation Committee Member

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, as Chairman of the Board since January 3, 2003, and as Chief Financial Officer from November 17, 2008 to December 21, 2009.  Mr. Colatosti also served as Co-Chief Executive Officer of the Company 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. Since November 2010, Mr. Colatosti has been serving as a President and CEO of Oasis Systems LLC, a privately held IT services company. Since August 2009, Mr. Colatosti has served as Chairman of Commodore Advanced Sciences Corporation a non-reporting environmental services and remediation company. From August 18, 2005 until August 18, 2008 Mr. Colatosti served as Director and President of Good Harbor Partners Acquisition Corp., a publicly-traded special purpose acquisition company formed to acquire businesses in the security sectors. From 1997 through June 2002, Mr. Colatosti served as the Chief Executive Officer of Viisage Technology, Inc., a publicly traded biometric technology company. Between 1995 and 1997, Mr. Colatosti served as President and Chief Executive Officer of CIS Corporation. Prior to CIS, Mr. Colatosti had a 21 year career with Digital Equipment Corporation. Among his executive positions he was Vice President and General Manager of the company’s $1.2 billion Government Systems Division.

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 of the Company from July 2005 to August 2006. Mr. DePasquale brings more than 27 years of executive management, sales and marketing experience to the Company. Prior to joining BIO-key, 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 Jostens, 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. He serves on the Board of Directors of the International Biometrics and Identification Industry Association.

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 Minnesota-based investment and consulting firm focusing on assisting start-up technology companies. Mr. May served as the CEO and Director of MagnaLynx, a semiconductor company specializing in high speed chip level communications from December 2006 until the company was sold in March 2010. In 1983, Mr. May co-found Advantek, Inc., a manufacturer of equipment and materials for the semiconductor industry, which was sold in 1993. Mr. May continued to serve as a director and Vice-President of Operations of Advantek until 1997, when 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.
 
 
22

 

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 November 2005 to November 2007, Mr. Romeo served as the Vice President of Sales and Marketing for UNICOM, a Rhode Island systems integrator. 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 FreedomBridge, 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 served as Vice President of Corporate Performance Management for Oracle Corporation from 1995 through 2006.  Prior to Oracle he served as Senior Vice President of Business Intelligence and Analytics at Information Resources, Inc.   Mr. Schoenherr has over 25 years of experience in the area of business intelligence and strategic planning.  His career includes a number of product development and management positions.

CECILIA WELCH has served as Chief Financial Officer of the Company since December 21, 2009. Ms. Welch joined the Company in 2007 and has served since then as the Company’s Corporate Controller. Prior to joining the Company, from January 2006 to December 2006 she was the Controller for Savaje Technologies (acquired by Sun Microsystems), a developer of advanced mobile telephone software. From October 2004 to January 2006, she was Controller for Crystal Systems, a manufacturer of sapphire crystals used for industrial, semiconductor, defense and medical applications.  From December 1988 to July 2004, she was the Controller for ATN Microwave (acquired by Agilent Technologies), a manufacturer of automated test equipment. Ms. Welch has a Bachelor’s degree in Accounting from Franklin Pierce University.

MIRA K. LACOUS has served as Vice President of Technology & Development of the Company since May 15, 2000. Ms. LaCous has over 27 years of product / project management, solution architecture, software development, team leadership and customer relations experience with a background that includes successfully bringing numerous technologies to market, including automated voice response systems, automated building control systems, software piracy protection, intranet training materials and testing, page layout and design software, image scanning software and systems, biometric security, biometric algorithms and more. Ms. LaCous is also the author of five US Patented technologies, multiple international patents, and other patent pending solutions.  She has been an officer or director of two other companies; National Computer Systems (NCS), and TEL-Line Systems. Ms. LaCous has a Bachelors in Computer Science from North Dakota State University.  Ms. LaCous also serves on the Board of Directors of the Minnesota Sinfonia, a not-for-profit arts and education organization, as its chairperson emeritus.

SCOTT MAHNKEN has served as Vice President of Marketing since February 2011. He brings over 20 years of marketing experience and success through strategic marketing and building dynamic relationships with channel partners. Prior to joining the Company, from August 2009 until February 2011 he was President of Edge Marketing, a leading marketing consulting firm in the dental and medical devices industries. From February 2008 until August 2009, Mr. Mahnken served as Director of Marketing at Milestone Scientific Inc, a manufacturer of computer controlled anesthetic delivery medical devices. From August 2002 until January 2008, he served as Director of Partnership Relations at ArcMesa Educators, an organization dedicated to providing accredited continuing education to medical and dental providers. Prior to ArcMesa, Mr. Mahnken held a number of marketing roles with the Lanmark Group a leading healthcare advertising agency. Mr. Mahnken is a graduate of the University of New Orleans, where he earned a Bachelors of Art degree in Marketing.

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.
 
 
23

 

Audit Committee

The Audit Committee is comprised of John Schoenherr and Jeffrey J. May, who may not qualify as “audit committee financial experts” under the applicable rules adopted by the Securities and Exchange Commission. However, the Board believes that each Audit Committee member has sufficient knowledge in financial and auditing matters to serve on the Audit Committee. Additionally, the Audit Committee has the ability on its own to retain independent accountants or consultants whenever it deems appropriate.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the U.S. Securities and Exchange Act of 1934, as amended (the “Exchange Act”), requires the Company’s officers and directors and persons who own more than ten percent (10%) of the Company’s Common Stock to file with the Securities and Exchange Commission (“SEC”) initial reports of ownership and reports of changes in ownership of the Company’s Common Stock. Such officers, directors and ten percent (10%) stockholders are also required by applicable SEC rules to furnish the Company with copies of all forms filed with the SEC pursuant to Section 16(a) of the Exchange Act. Based solely on its review of the copies of such forms received by it, or written representations from such persons that no other reports were required for such persons, the Company believes that during the fiscal year ended December 31, 2011, all Section 16(a) filing requirements applicable to the Company’s officers, directors and ten percent (10%) stockholders were satisfied in a timely fashion.

Code of Ethics

We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Ethics is designed to deter wrongdoing and promote: (i) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; (ii) full, fair, accurate, timely and understandable disclosure in reports and documents that we file with, or submit to, the SEC and in our other public communications; (iii) compliance with applicable governmental laws, rules, and regulations; (iv) the prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and (v) accountability for adherence to the code.  Any person may obtain a copy of our Code of Ethics free of charge by sending a written request for such to the attention of the Chief Financial Officer of the Company, 3349 Highway 138, Building D Suite B, Wall, NJ 07719.

Internet Address and SEC Reports

We maintain a website with the address www.BIO-key.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge through our website our Annual Reports on Form 10-K (and, where applicable, 10-KSB), Quarterly Reports on Form 10-Q (and, where applicable, 10-QSB) and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the SEC. Our SEC filings are also available over the Internet at the SEC’s website www.sec.gov. Members of the public may read and copy any materials the Company files with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the public reference room is available by calling the SEC on 1800-SEC-0330.

 
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ITEM 11.    EXECUTIVE COMPENSATION

The following table sets forth a summary of the compensation paid to or accrued by our chief executive officer (principal executive officer) and the two most highly compensated executive officers other than the principal executive officer, who were serving as executive officers at the end of December 31, 2011, for the fiscal years ended December 31, 2011 and 2010:

SUMMARY COMPENSATION TABLE
Name
 
Fiscal
Year
 
Salary ($)
   
Bonus ($)
   
Stock
Awards
($)
   
Option
Awards
($)
   
Non-Equity
Incentive Plan
Compensation
($)
   
Nonqualified
Deferred
Compensation
Earnings
($)
   
All Other
Compensation
($)
   
Total
($)
 
                                                     
Michael W. DePasquale
 
2011
    226,504                                     449       226,953  
Chief Executive Officer
 
2010
    250,000                                     407       250,407  
                                                                     
Randy Fodero (2)
 
2011
    144,223                                     284       144,507  
Vice President Sales
 
2010
    170,000       4,000                   37,560             289       211,849  
                                                                     
Mira K. LaCous
 
2011
    134,018                   8,340 (1)                 266       142,624  
Vice President Technology & Development
 
2010
    147,420                   67,974 (1)                 251       215,645  
                                                                     
Scott Mahnken
 
2011
    102,527                   11,120 (1)                 154       113,801  
Vice President Marketing
 
2010
                                               
 

(1)
The aggregate grant date fair value of the option awards was estimated using the Black-Scholes option pricing model, with the assumptions listed in Note A to the Company’s financial statements. The amount shown in this column represents the grant date fair value calculated under ASC 718

(2)
The compensation for Randy Fodero, the Company’s former Vice President of Sales is included in the above table pursuant to Item 402(m)(2)(iii) of Regulation S-K.
 
Narrative Disclosure to Summary Compensation Table

Compensation for BIO-key’s executives is comprised of three main components: base salary, annual performance-based cash bonus and long-term equity awards. We do not target a specific weighting of these three components or use a prescribed formula to establish pay levels. Rather, the board of directors and compensation committee considers changes in the business, external market factors and our financial position each year when determining pay levels and allocating between long-term and current compensation for the named executive officers.

Cash compensation is comprised of base salary and an annual performance-based cash bonus opportunity. The committee generally seeks to set a named executive officer’s targeted total cash compensation opportunity within a range that is the average of the applicable peer company and/or general industry compensation survey data, adjusted as appropriate for individual performance and internal pay equity and labor market conditions.

In setting cash compensation levels, we favor a balance in which base salaries are generally targeted at slightly below the peer average and a bonus opportunity that is targeted at slightly above the average. The committee believes that this higher emphasis on performance-based cash bonuses places an appropriate linkage between a named executive officer’s pay, his or her individual performance and the achievement of specific business goals by placing a higher proportion of annual cash compensation at risk, thereby aligning executive opportunity with the interests of stockholders.

We include an equity component as part of our compensation package because we believe that equity-based compensation aligns the long-term interests of our named executive officers with those of stockholders.

These cash and equity compensation components of pay are supplemented by various benefit plans that provide health, life, accident, disability and severance benefits, most of which are the same as the benefits provided to all of our US based employees.

Employment Agreements

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March 24, 2011. The agreement automatically renews for subsequent one-year terms, unless the employment relationship is terminated by either party, or modified in accordance with the terms and conditions of the Agreement. Under the Agreement, Mr. DePasquale will be paid an annual base salary of $250,000, subject to adjustment by the Board or Compensation Committee. In addition to the Base Salary, a “Performance Bonus” may be awarded to Mr. DePasquale on the basis of the Company achieving certain corporate and strategic performance goals, as determined by the Board in its sole discretion. 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. This agreement also contains a number of termination and change in control provisions as described in “Termination and Change in Control Arrangements” in this Item.
 
 
25

 
 
On November 20, 2011, the Company renewed its one-year employment agreement with Mira K. LaCous to serve as the Vice President of Technology & Development of the Company at an annual base salary of $147,420, subject to adjustment by the Board or Compensation Committee. The employment agreement contains standard and customary confidentiality, technical invention provisions, as well as a covenant not to compete which prohibits Ms. LaCous 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 her employment and for the one year period thereafter. This agreement also contains a number of termination provisions as described in “Termination and Change in Control Arrangements” in this Item.
 
Stock Option Grants

In the event of any change in the outstanding shares of our common stock by reason of a stock dividend, stock split, combination of shares, recapitalization, merger, consolidation, transfer of assets, reorganization, conversion or what the board deems to be similar circumstances, the number and kind of shares subject to outstanding options, and the exercise price of such options shall be appropriately adjusted in a manner to be determined in the sole discretion of the board. Furthermore, these option agreements contain a change of control provision as described in “Termination Arrangements” in this Item.


OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END
DECEMBER 31, 2011

The following table sets forth for each named executive officer, information regarding outstanding equity awards as at December 31, 2011:

   
Option Awards
 
Stock Awards
 
Name
 
Number of
securities
underlying
unexercised
options
exercisable
(#)
   
Number of
securities
underlying
unexercised
options
unexercisable
(#)
   
Equity
incentive
plan
awards:
Number of
securities
underlying
unexercised
unearned
options
(#)
   
Option
exercise
price
($)
 
Option
expiration
date
 
Number
of shares
or units of
stock that
have not
vested
(#)
   
Market
value of
shares or
units of
stock that
have not
vested
($)
   
Equity
incentive
plan
awards:
Number
of
unearned
shares or
units or
other
rights that
have not
vested
(#)
   
Equity
incentive
plan
awards:
Market or
payout
value of
unearned
shares,
units or
other
rights that
have not
vested
($)
 
                                                   
Michael W. DePasquale
    601,938                   0.300  
11/2/2012
                       
      500,000                   0.087  
2/27/2016
                       
                                                                   
Mira LaCous
    75,000                   0.180  
8/13/2015
                       
      170,000 (1)     170,000 (1)           0.460  
1/7/2017
                       
            75,000 (2)           0.140  
5/11/2018
                       
                                                                   
Cecilia Welch
    20,000                   0.150  
8/10/2014
                       
            150,000 (2)           0.140  
5/11/2018
                       
                                                                   
Scott Mahnken
          100,000 (2)           0.140  
5/11/2018
                       
 

(1)
The options vest equally in two annual installments commencing January 7, 2011
(2)
The options vest equally in two annual installments commencing May 11, 2012

Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End Table

The following are the material terms of each agreement, contract, plan or arrangement that provide for payments to one or more of our named executive officers at, following or pursuant to their resignation, retirement or termination, or in connection with a change in control of the Company.

Termination Arrangements

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March, 24, 2011. The agreement automatically renews for subsequent one-year terms, unless the employment relationship is terminated by either party, or modified in accordance with the terms and conditions of the Agreement. The Company may terminate the Agreement at any time with or without cause. In the event of termination by the Company without cause, Mr. DePasquale shall continue to be paid his then current base salary for the greater of nine months from the date of such termination or the number of months remaining until the end of the term of the Agreement.
 
 
26

 

On November 20, 2011, the Company renewed the annual agreement with Mira K. LaCous to serve as the Vice President of Technology & Development of the Company. The Company may terminate the agreement at any time with or without cause. In the event of termination by the Company without cause, Ms. LaCous shall continue to be paid her then current base salary for six months from the date of such termination.

Change in Control Provisions

The Company’s 1999 Stock Option Plan and 2004 Stock Incentive Plan (the “1999 Plan” and together with the 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 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.

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March, 24, 2011. There is a Change of Control provision that is triggered if Mr. Depasquale is not offered continued employment with the Company or any successor, or within five years following such Change of Control, the Company or any successor terminates Mr. Depasquale’s employment without Cause, then Mr. Depasquale is to be paid his Base Salary and benefits earned but unpaid through the date of termination, and any prorated bonus earned during the then current bonus year, plus two times his then current Base Salary.


DIRECTOR COMPENSATION FOR THE FISCAL YEAR ENDED
DECEMBER 31, 2011

The following table sets forth for each director, information regarding their compensation for the year ended December 31, 2011:

Name
 
Fees Earned or
Paid in Cash
($)
   
Stock
Awards
($)
   
Option
Awards
($) (3)
   
Non-Equity
Incentive Plan
Compensation
($)
   
Nonqualified
Deferred
Compensation
Earnings
($)
   
All Other
Compensation
($)
   
Total
($)
 
Thomas J. Colatosti (1)
                                         
Michael W. DePasquale (2)
                                         
Jeffrey J. May
                                         
Charles P. Romeo
                                         
John Schoenherr
                                         
 

(1)
Refer to Narrative Disclosure to Director Compensation Table for information pertaining to Mr. Colatosti’s consulting agreement.

(2)
Refer to Narrative Disclosure to Summary Compensation Table for information pertaining to Mr. DePasquale’s employment agreement.
 
 
27

 
 
Narrative Disclosure to Director Compensation Table

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. The Chair of the Audit Committee receives options to purchase an additional 50,000 shares of common stock on an annual basis. No options were awarded to any of the Company’s directors during 2011.

In connection with his appointment to the Board of Directors in September 2002, and as acting Chief Financial Officer from November 2008 to December 2009, the Company has entered into a number of consulting arrangements with Colatosti. Under the most recent arrangement, which was entered into on January 12, 2010, Mr. Colatosti provided services to the Company and its subsidiary for the two-year term ended December 31, 2011 at a rate of $5,000 per month.

We reimburse each of our non-employee directors for their reasonable expenses incurred in connection with attending meetings of the board of directors and related committees.
 
 
28

 
 
ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
The following table sets forth, as of April 4, 2012, 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)
 
Michael W. DePasquale
 
1,151,938
(2)
1.5
%
Thomas J. Colatosti
 
1,134,405
(3)
1.5
%
Jeffrey May
 
316,845
(4)
*
 
Mira LaCous
 
245,000
(5)
*
 
Charles P. Romeo
 
233,558
(4)
*
 
John Schoenherr
 
209,721
(4)
*
 
Cecilia Welch
 
20,000
(6)
*
 
Scott Mahnken
 
(7)
*
 
           
All officers and directors as a group (9) persons
 
3,311,467
 
4.2
%


*
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 78,155,413 shares of common stock outstanding as of February 29, 2012.

(2)
Consists of 1,101,938 shares issuable upon exercise of options and 50,000 shares of common stock.

(3)
Consists of 549,405 shares issuable upon exercise of options and 585,000 shares of common stock.

(4)
Consists of shares issuable upon exercise of options.

(5)
Consists of 245,000 shares issuable upon exercise of options. Does not include 245,000 shares issuable upon options subject to vesting.

(6)
Consists of 20,000 shares issuable upon exercise of options. Does not include 150,000 shares issuable upon options subject to vesting.

(7)
Does not include 100,000 shares issuable upon options subject to vesting.
 
 
29

 

 
The following table sets forth, as of December 31, 2011, 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
 
 
Equity compensation plans not approved by security holders
4,404,412
 
$
0.22
 
1,168,164
Total
4,404,412
 
$
0.22
 
1,168,164
 
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. Under the 1999 Plan 2,000,000 shares of common stock were reserved for issuance 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 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. The 1999 Plan expired in August 2009.

As of December 31, 2011, there were outstanding options under the 1999 Plan to purchase 500,000 shares of common stock, and no 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 expires in October 2014.

As of December 31, 2011, there were outstanding options under the 2004 Plan to purchase 2,831,836 shares of common stock, and options to purchase an aggregate of 1,168,164 shares were available for future grants.

In addition to options issued under the 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 2011, there were outstanding options under the non plan to purchase 1,072,576 shares of common stock. The terms of these options are substantially similar to the provisions of the 1999 Plan and options issued thereunder.

 
30

 
 
ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
Employment Arrangements

The Company has entered into employment agreements with Michael W. DePasquale, and Mira LaCous. See “EXECUTIVE COMPENSATION—Employment Agreements.”

Consulting Arrangement with Thomas J. Colatosti

In connection with his appointment to the Board of Directors in September 2002, and as acting Chief Financial Officer from November 2008 to December 2009, the Company has entered into a number of consulting arrangements with Thomas Colatosti. Under the most recent arrangement, which was entered into on January 12, 2010, Mr. Colatosti provided services to the Company and its subsidiaries and affiliates for the two year term ended December 31, 2011 at a rate of $5,000 per month.

Director Independence

The Board applies the definition of independent director as set forth in NASDAQ Stock Market Rule 4200 (a)(15), as well as Rule 10A-3 under the Securities Exchange Act of 1934, as amended.

In accordance with this guidance, the Board considers Mr. May, Mr. Schoenherr, and Mr. Romeo to be independent. Mr. May and Mr. Schoenherr are the members of the Company’s Audit Committee, while Mr. Schoenherr and Mr. Romeo are the members of the Company’s Compensation Committee.
 
 
31

 

ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
The following table shows fees for professional services and quarterly audit fees billed to us by CCR LLP (“CCR”) for services during 2010, and for professional audit services billed to us by Rotenberg Meril Solomon Bertiger & Guttilla, P.C. (“RMSBG”) for the audit of our annual consolidated financial statements for the years ended December 31, 2011 and 2010, and fees billed to us by RMSBG for other services during 2011 and 2010:

   
2011
   
2010
 
Audit Fees:
           
CCR
  $ -     $ 20,000  
RMSBG
    72,695       74,621  
                 
Audit-Related Fees
               
CCR
    -       47,150  
RMSBG
    195       3,048  
                 
Tax Fees:
               
CCR
    -       28,700  
RMSBG
    26,154        
                 
Total Fees
  $ 99,044     $ 173,519  
 
Audit Fees consist of fees billed for professional services rendered for the audit of our financial statements and review of the interim financial statements included in quarterly reports and services that are normally provided by our auditors in connection with statutory and regulatory filings or engagements. Audit fees also include fees for services provided in connection with registration of securities, comfort letters, and review of documents filed with the SEC.

Audit-Related Fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements and which are not reported under audit fees. These services relate primarily to mergers and acquisitions due diligence as well as advisory services as it pertains to the Sarbanes-Oxley Act and related rules and regulations;

Tax Fees consist of fees billed for professional services for tax compliance assistance rendered during the fiscal year.

Audit Committee Pre-Approval Procedures

The Audit Committee of our Board of Directors consists of Jeffrey J. May and John Schoenherr. The Audit Committee approves the engagement of our independent auditors to render audit and non-audit services before they are engaged. All of the fees for 2011 and 2010 shown above were pre-approved by the Audit Committee.

The Audit Committee pre-approves all audit and other permitted non-audit services provided by our independent auditors. Pre-approval is generally provided for up to one year, is detailed as to the particular category of services and is subject to a monetary limit. Our independent auditors and senior management periodically report to the Audit Committee the extent of services provided by the independent auditors in accordance with the pre-approval, and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.

Our audit committee will not approve engagements of our independent registered public accounting firm to perform non-audit services for us if doing so will cause our independent registered public accounting firm to cease to be independent within the meaning of applicable SEC rules. In other circumstances, our audit committee considers, among other things, whether our independent registered public accounting firm is able to provide the required services in a more or less effective and efficient manner than other available service providers.

 
32

 
 
ITEM 15.    EXHIBITS
 
(a)      The following documents are filed as part of this Report. Portions of Item 15 are submitted as separate sections of this Report:

 
(1)
Financial statements filed as part of this Report:

 
Reports of Independent Registered Public Accounting Firm

 
Balance Sheets as at December 31, 2011 and 2010

 
Statements of Operations—Years ended December 31, 2011 and 2010

 
Statement of Stockholders’ Equity (Deficit)—Years ended December 31, 2011 and 2010

 
Statements of Cash Flows—Years ended December 31, 2011 and 2010

 
Notes to Financial Statements—December 31, 2011 and 2010

(2)      The exhibits listed in the Exhibits Index immediately preceding such exhibits are filed as part of this Report

ITEM 8—FINANCIAL STATEMENTS

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

Report of Independent Registered Public Accounting Firm, RMSBG P.C.
40
Balance Sheets as at December 31, 2011 and 2010
42
Statements of Operations—Years ended December 31, 2011 and 2010
43
Statements of Stockholders’ (Deficit) Equity —Years ended December 31, 2011 and 2010
44
Statements of Cash Flows—Years ended December 31, 2011 and 2010
45
Notes to the Financial Statements—December 31, 2011 and 2010
46

 
33

 

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
BIO-key International, Inc.
North Billerica, MA

We have audited the accompanying consolidated balance sheets of BIO-key International, Inc. and Subsidiary (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ (deficit) equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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 audits to obtain reasonable assurance about whether the consolidated 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 audits 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 also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated 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, 2011 and 2010, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As disclosed in the consolidated financial statements, the Company has suffered substantial net losses in recent years, and has an accumulated deficit at December 31, 2011, which raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding these matters are disclosed in Note A. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Rotenberg Meril Solomon Bertiger & Guttilla, P.C.
 
 
ROTENBERG MERIL SOLOMON BERTIGER & GUTTILLA, P.C.
Saddle Brook, New Jersey
 
April 16, 2012
 
 
 
34

 
 
BIO-key International, Inc and Subsidiary
CONSOLIDATED BALANCE SHEETS

   
December 31,
 
   
2011
   
2010
 
ASSETS
           
Cash and cash equivalents
  $ 43,437     $ 1,010,096  
Accounts receivable, net of allowance for doubtful accounts of $397,526 at December 31, 2011 and $11,526 at December 31, 2010
    587,346       351,093  
Note receivable, current portion
    -       2,167,000  
Inventory
    8,238       9,775  
Prepaid expenses and other
    58,920       188,916  
Total current assets
    697,941       3,726,880  
Equipment and leasehold improvements, net
    52,870       28,128  
Deposits and other assets
    8,712       8,712  
Note receivable, net of current portion
    -       1,333,000  
Intangible assets—less accumulated amortization
    207,180       218,450  
Total non-current assets
    268,762       1,588,290  
TOTAL ASSETS
  $ 966,703     $ 5,315,170  
                 
LIABILITIES
               
Accounts payable
  $ 687,441     $ 180,413  
Accrued liabilities
    675,833       1,079,117  
Deferred revenue
    527,092       281,393  
Current portion of notes payable
    346,428       2,098,139  
Total current liabilities
    2,236,794       3,639,062  
Long term portion of notes payable
    -       1,102,492  
Deferred revenue, net of current portion
    1,000       4,281  
Total non-current liabilities
    1,000       1,106,773  
TOTAL LIABILITIES
    2,237,794       4,745,835  
                 
Commitments and contingencies
               
                 
STOCKHOLDERS’ (DEFICIT) EQUITY:
               
Common stock — authorized, 170,000,000 shares; issued and outstanding; 78,155,413 of $.0001 par value at December 31, 2011 and December 31, 2010
    7,815       7,815  
Additional paid-in capital
    51,012,782       50,955,602  
Accumulated deficit
    (52,291,688 )     (50,394,082 )
TOTAL STOCKHOLDERS’ (DEFICIT) EQUITY
    (1,271,091 )     569,335  
TOTAL LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY
  $ 966,703     $ 5,315,170  
 
The accompanying notes are an integral part of these statements.

 
35

 
 
BIO-key International, Inc. and Subsidiary
STATEMENTS OF OPERATIONS

   
Years ended December 31,
 
   
2011
   
2010
 
             
Revenues
           
Services
  $ 848,483     $ 439,759  
License fees and other
    2,660,321       3,080,649  
      3,508,804       3,520,408  
Costs and other expenses
               
Cost of services
    159,223       102,661  
Cost of license fees and other
    651,236       456,480  
      810,459       559,141  
Gross Profit
    2,698,345       2,961,267  
                 
Operating expenses
               
Selling, general and administrative
    3,036,299       3,105,291  
Research, development and engineering
    1,116,658       1,055,980  
      4,152,957       4,161,271  
Operating loss
    (1,454,612 )     (1,200,004 )
                 
Other income (deductions)
               
Interest income
    95,033       241,416  
Interest expense
    (411,527 )     (711,348 )
Income taxes
    (26,500 )     -  
Derivative and warrant fair value adjustments
    -       1,020,164  
Net discounts of notes payable and note receivable
    (100,000 )     -  
      (442,994 )     550,232  
Loss from continuing operations
    (1,897,606 )     (649,772 )
Income from discontinued operations
    -       342,983  
Net loss
  $ (1,897,606 )   $ (306,789 )
                 
Basic and Diluted Earnings per Common Share:
               
Loss from continuing operations
  $ (0.02 )   $ (0.02 )
Income from discontinued operations
    -       0.01  
Net loss
  $ (0.02 )   $ (0.01 )
                 
Weighted Average Shares Outstanding:
               
Basic and Diluted
    78,155,413       77,901,103  
 
The accompanying notes are an integral part of these statements.

 
36

 

BIO-key International, Inc. and Subsidiary
STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY

   
Series D 7%
                               
   
Convertible
               
Additional
             
   
Preferred Stock
   
Common Stock
   
Contributed
   
Accumulated
       
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Deficit
   
Total
 
Balance as of January 1, 2010
    30,557     $ 2,630,593       77,713,398     $ 7,771     $ 51,187,754     $ (50,087,293 )   $ 1,108,232  
                                                         
Accretion of preferred stock discount
          426,889                   (426,889 )           (426,889 )
Accretion of preferred stock dividends
          216,870                   (216,870 )           (216,870 )
Conversion of Series D Preferred Stock to Secured Notes
    (30,557 )     (3,055,700 )                              
Conversion of preferred stock dividends in arrears into Secured notes
          (218,652 )                              
Conversion of convertible notes and accrued interest into common stock
                442,015       44       55,650             55,694  
Issuance of warrants
                            307,932             307,932  
Share-based compensation
                            48,025             48,025  
Net loss
                                    (306,789 )     (306,789 )
                                                         
Balance as of December 31, 2010
        $       78,155,413     $ 7,815     $ 50,955,602     $ (50,394,082 )   $ 569,335  
                                                         
Share-based compensation
                            57,180             57,180  
Net loss
                                    (1,897,606 )     (1,897,606 )
                                                         
Balance as of December 31, 2011
        $       78,155,413     $ 7,815     $ 51,012,782     $ (52,291,688 )   $ (1,271,091 )
 
The accompanying notes are an integral part of these statements.

 
37

 
 
BIO-key International, Inc. and Subsidiary
STATEMENTS OF CASH FLOWS

   
Years ended December 31,
 
   
2011
   
2010
 
             
CASH FLOW FROM OPERATING ACTIVITIES:
           
Net (Loss) Income
  $ (1,897,606 )   $ (306,789 )
Less:
               
Income from discontinued operations
    -       (342,983 )
Loss from continuing operations
    (1,897,606 )     (649,772 )
Adjustments to reconcile net loss to cash used in operating activities:
               
Derivative and warrant fair value adjustments
    -       (1,020,164 )
Allowance for doubtful accounts
    386,000        
Depreciation
    31,462       21,015  
Amortization
               
Intangible assets
    11,270       11,809  
Discount on convertible debt related to derivatives
    -       659,138  
Discount on secured debt
    307,932        
Net discounts of notes payable and note receivable
    100,000        
Share-based compensation
    57,180       46,385  
Change in assets and liabilities:
               
Accounts receivable trade
    (622,253 )     496,122  
Inventory
    1,538       5,160  
Prepaid expenses and other
    129,995       (65,005 )
Accounts payable
    507,028       (159,828 )
Accrued liabilities
    221,925       (77,701 )
Deferred revenue
    242,418       75,287  
Net cash used for continuing operations
    (523,111 )     (657,554 )
Net cash provided by discontinued operations
    -       344,624  
Net cash used for operating activities
    (523,111 )     (312,930 )
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from payment of note receivable
    3,350,000       500,000  
Capital expenditures
    (56,204 )     (9,900 )
Transfer of funds from restricted cash
    -       40,500  
Net cash provided by continuing operations
    3,293,796       530,600  
Net cash provided by investing activities
    3,293,796       530,600  
CASH FLOW FROM FINANCING ACTIVITIES:
               
Repayment of notes payable
    (3,612,135 )      
Preferred stock dividend paid
    (125,209 )      
Net cash used for continuing operations
    (3,737,344 )      
Net cash used for financing activities
    (3,737,344 )      
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
    (966,659 )     217,670  
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    1,010,096       792,426  
CASH AND CASH EQUIVALENTS, END OF YEAR
  $ 43,437     $ 1,010,096  
 
The accompanying notes are an integral part of these statements.

 
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BIO-key International, Inc. and Subsidiary
NOTES TO THE FINANCIAL STATEMENTS
December 31, 2011 and 2010

NOTE A —THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

The Company, founded in 1993, develops and markets 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.

Basis of Presentation

We have incurred significant losses to date, and at December 31, 2011, we had an accumulated deficit of approximately $52 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues. At December 31, 2011, our total cash and cash equivalents were approximately $43,400, as compared to approximately $1,010,000 at December 31, 2010.

As discussed below, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, convertible preferred stock,  common stock, and recently through factoring receivables. We currently require approximately $385,000 per month to conduct our operations, a monthly amount that we have been unable to achieve through revenue generation.

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 of America, 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 sheet 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 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.

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”). Intercompany accounts and transactions have been eliminated in consolidation.
 
 
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2. Use of Estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) as set forth in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) and consider the various staff accounting bulletins and other applicable guidance issued by the U.S. Securities and Exchange Commission (SEC). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our consolidated financial statements will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result.

3. Revenue Recognition

Revenues from software licensing are recognized in accordance with ASC 985-605, “Software Revenue Recognition. 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, 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, the Company applies the residual method in accordance with ASC 985-605. The residual method requires that the portion of the total arrangement fee attributable to the undelivered elements be deferred based on its VSOE of fair value and subsequently recognized as the service is delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, which is generally the software license. VSOE of fair value for all elements in an arrangement is based upon the normal pricing for those products and services when sold separately. VSOE of fair value for support services is additionally determined by the renewal rate in customer contracts. The Company has established VSOE of fair value for support as well as consulting services.

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. Otherwise, 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. 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 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.

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.

Costs and other expenses: Includes professional compensation and other direct contract expenses, as well as costs attributable to the support of client service professional staff, depreciation and amortization costs related to assets used in revenue-generating activities, and other costs attributable to serving the Company’s client base. Professional compensation consists of payroll costs and related benefits including stock-based compensation and bonuses. Other direct contract expenses include costs directly attributable to client engagements, such as out-of-pocket costs including travel and subsistence for client service professional staff, costs of hardware and software and costs of subcontractors. The allocation of lease and facilities charges for occupied offices is included in costs of service.
 
 
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The Company accounts for its warranties under the FASB ASC 450 “Contingencies.” The Company generally warrants that its products are free from defects in material and workmanship for a period of one year from the date of initial receipt by our customers. The warranty does not cover any losses or damage that occurs as a result of improper installation, misuse or neglect or repair or modification by anyone other than the Company or its authorized repair agent. The Company’s policy is to accrue anticipated warranty costs based upon historical percentages of items returned for repair within one year of the initial sale. The Company’s repair rate of products under warranty has been minimal, and a historical percentage has not been established. The Company’s software license agreements generally include certain provisions for indemnifying customers against liabilities if the Company’s software products infringe upon a third party’s intellectual property rights. The Company has not provided for any reserves for warranty liabilities as it was determined to be immaterial.

4. Cash and Cash Equivalents

Cash equivalents consist of certificates of deposit and all other liquid investments with original maturities of three months or less.

5. Accounts Receivable an