U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

Commission file number 1-13463

 

BIO-KEY INTERNATIONAL, INC.

(Exact Name of registrant as specified in its charter)

 

 

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

(Address of Principal Executive Offices)

 

(732) 359-1100

(Registrant’s telephone number, including area code)

 

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

Yes  x   No  o

 

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

Yes  o  No  x

 

Number of shares of Common Stock outstanding as of May 13, 2008 were 62,842,726, par value $.0001 per share

 

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

 

 

 

BIO-KEY INTERNATIONAL, INC.

 

INDEX

 

PART I. FINANCIAL INFORMATION
Item 1	—	Condensed Consolidated Financial Statements:
		Balance Sheets as of March 31, 2008 and December 31, 2007	3
		Statements of Operations for the three months ended March 31, 2008, and 2007	4
		Statements of Cash Flows for the three months ended March 31, 2008, and 2007	5
		Notes to Condensed Consolidated Financial Statements	7
Item 2	—	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 4	—	Controls and Procedures	29
PART II. OTHER INFORMATION
Item 6	—	Exhibits	30
Signatures			31

 

2

 

BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS

 

		March 31,			December 31,
		2008			2007
		(Unaudited)
ASSETS
Cash and cash equivalents		$	639,110		$	964,774
Restricted cash		153,994			153,094
Accounts receivable, net of allowance for doubtful accounts of $113,771 at March 31, 2008 and December 31, 2007		1,386,899			2,129,797
Costs and earnings in excess of billings on uncompleted contracts		260,087			233,805
Inventory		4,004			4,879
Investments		391,760			—
Prepaid expenses		116,030			119,068
Total current assets		2,951,884			3,605,417
Equipment and leasehold improvements, net		145,119			177,282
Deposits and other assets		487,815			487,815
Intangible assets—less accumulated amortization		1,139,936			1,324,269
Goodwill		7,836,986			7,836,986
Total non-current assets		9,609,856			9,826,352
TOTAL ASSETS		$	12,561,740		$	13,431,769
LIABILITIES
Accounts payable		$	3,191,061		$	1,162,690
Accrued liabilities		1,222,800			3,401,749
Deferred rent		233,412			367,986
Deferred revenue		4,175,113			4,468,748
Total current liabilities		8,822,386			9,401,173
Warrants		59,677			64,520
Redeemable preferred stock derivatives		15,397			41,295
Deferred revenue		31,134			34,518
Total non-current liabilities		106,208			140,333
TOTAL LIABILITIES		8,928,594			9,541,506
Commitments and contingencies
Series B redeemable convertible preferred stock: authorized, 1,000,000 shares (liquidation preference of $1 per share); issued and outstanding 970,612 shares of $.0001 par value at March 31, 2008 and December 31, 2007		912,960			881,340
Series C redeemable convertible preferred stock: authorized, 600,000 shares (liquidation preference of $10 per share); issued and outstanding 592,032 shares of $.0001 par value at March 31, 2008 and December 31, 2007		5,991,195			5,776,231
		6,904,155			6,657,571
STOCKHOLDERS’ EQUITY/(DEFICIT):
Series A convertible preferred stock: authorized, 100,000 shares (liquidation preference of $100 per share); issued and outstanding 30,557 shares of $.0001 par value, at March 31, 2008 and December 31, 2007		3			3
Common stock — authorized, 170,000,000 shares; issued and outstanding; 62,511,172 and 61,153,202 of $.0001 par value at March 31, 2008 and December 31, 2007, respectively		6,251			6,115
Additional paid-in capital		52,146,668			52,126,595
Accumulated other comprehensive income		391,760			—
Accumulated deficit		(55,815,691		)	(54,900,021		)
TOTAL STOCKHOLDERS’ DEFICIT		(3,271,009		)	(2,767,308		)
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY/(DEFICIT)		$	12,561,740		$	13,431,769

 

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

 

3

 

BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

 

		Three months ended  March 31,
		2008			2007
Revenues
Services		$	1,717,270		$	1,875,176
License fees and other		823,148			840,064
		2,540,418			2,715,240
Costs and other expenses
Cost of services		347,585			447,889
Cost of license fees and other		93,896			30,910
		441,481			478,799
Gross Profit		2,098,937			2,236,441
Operating Expenses
Selling, general and administrative		1,789,092			2,551,295
Research, development and engineering		1,247,031			1,356,958
		3,036,123			3,908,253
Operating loss		(937,186		)	(1,671,812		)
Other income (expenses)
Derivative and warrant fair value adjustments		30,741			829,369
Interest income		899			—
Interest expense		(10,124		)	(538,517		)
Other		—			(5,902		)
		21,516			284,950
Loss from continuing operations		(915,670		)	(1,386,862		)
Income from discontinued operations		—			474,489
Net Loss		$	(915,670	)	$	(912,373	)
Basic and Diluted Earnings(Loss) per Common Share:
Loss from continuing operations		$	(0.02	)	$	(0.03	)
Income from discontinued operations					0.01
Net loss per Common Share		$	(0.02	)	$	(0.02	)
Weighted Average Shares Outstanding:
Basic and diluted		61,786,732			56,634,523

 

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

 

4

 

BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

		Three Months Ended March 31,
		2008			2007
CASH FLOW FROM OPERATING ACTIVITIES:
Net Loss		$	(915,670	)	$	(912,373	)
Less:
Income from discontinued operations		—			(474,489		)
Loss from continuing operations		(915,670		)	(1,386,862		)
Adjustments to reconcile net loss to cash used in operating activities:
Derivative and warrant fair value adjustments		(30,741		)	(829,369		)
Depreciation		36,555			65,543
Amortization
Intangible assets		184,333			182,512
Deferred financing costs		—			56,871
Discounts on convertible debt related to warrants and beneficial conversion features		—			229,853
Allowance for doubtful receivables		—			13,413
Deferred rent		(134,574		)	(119,429		)
Fair market value adjustment on equity issuance and warrant modification		—			91,182
Share-based compensation		266,793			223,719
Change in assets and liabilities:
Accounts receivable trade		742,898			1,382,783
Costs and earnings in excess of billings on uncompleted contracts		(26,282		)	—
Inventory		875			(7,179		)
Prepaid expenses and other		3,038			2,079
Accounts payable		2,028,371			441,046
Accrued liabilities		(2,178,949		)	(128,559		)
Deferred revenue		(297,019		)	(496,744		)
Net cash used for continuing operations		(320,372		)	(279,141		)
Net cash provided by discontinued operations		—			823,914
Net cash used for operating activities		(320,372		)	544,773
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(4,392		)	(9,115		)
Deposits		—			43,336
Interest on Restricted cash		(900		)	—
Patent costs		—			(9,997		)
Net cash provided (used) by continuing operations		(5,292		)	24,224
Net cash used for discontinued operations		—			(7,615		)
Net cash provided (used) by investing activities		(5,292		)	16,609
CASH FLOW FROM FINANCING ACTIVITIES:
Repayment of long term obligations		—			(362,758		)
Net cash used for financing activities		—			(362,758		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(325,664		)	198,624
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		964,774			627,167
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	639,110		$	825,791

 

5

 

BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

 

		Three Months Ended March 31,
		2008			2007
Cash paid for:
Interest		$	—		$	129,651
Noncash Investing and Financing Activities:
Conversion of convertible notes and related obligations, net of discount, and accrued interest into common stock		—			150,000
Issuance of common stock in exchange for Series A, B and C preferred stock and cumulative dividends in arrears, thereon		170,644			575,466
Unrealized gain on investment		391,760			—

 

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

 

6

 

BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

March 31, 2008 (Unaudited)

 

1.             BASIS OF PRESENTATION

 

The accompanying unaudited interim consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly owned subsidiary (collectively, the “Company”) and are stated in conformity with accounting principles generally accepted in the United States, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  The operating results for interim periods are not necessarily indicative of results that may be expected for any other interim period or for the full year. Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. Significant intercompany accounts and transactions have been eliminated in consolidation.

 

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

 

Recently Issued Accounting Pronouncements

 

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

 

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

 

Reclassifications

 

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

 

2.             LIQUIDITY AND CAPITAL RESOURCE MATTERS

 

We have only recently begun to generate significant revenues and have incurred significant losses to date, and at March 31, 2008, we had an accumulated deficit of approximately $56 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues.

 

7

 

If the Company is unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained by the Company in order to meet its needs, or that such financing would not be dilutive to existing shareholders

 

The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which contemplate continuation of the Company as a going concern, and assumes continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The matters described in the preceding paragraphs raise substantial doubt about the Company’s ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance 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 condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

 

3.             DISCONTINUED OPERATIONS

 

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

 

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

 

During the quarter ended September 30, 2007, $250,000 of the escrow balance was released to ZOLL. It is expected the remaining escrow balance, less applicable adjustments (if approved) shall be remitted to the Company over the next three months.

 

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

 

Revenues and net income (loss) for the Fire Segment for the three month period ended March 31, 2007 were as follows:

 

		2007
Revenues		$	1,156,256
Net income		474,489

 

8

 

4.             SHARE BASED COMPENSATION

 

The Company accounts for share based compensation in accordance with the provisions of SFAS 123R, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of our common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.

 

The compensation expense recognized under SFAS 123R increased the Company’s loss from continuing operations by $266,793 and $223,719 with no effect per share (basic and diluted) for the three months ended March 31, 2008 and 2007, respectively.

 

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

 

		Three Months Ended March 31,
		2008			2007
Cost of services		$	10,973		$	7,174
Selling, general and administrative		185,185			167,565
Research, development and engineering		70,635			48,980
		$	266,793		$	223,719

 

Valuation Assumptions for Stock Options

 

For the three months ended 2007, 89,000 stock options were granted. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

		Three Months Ended March 31,
		2007
Risk free interest rate		4.57	%
Expected life of options (in years)		4.5
Expected dividends		0	%
Volatility of stock price		114	%

 

9

 

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

 

EQUITY COMPENSATION PLAN INFORMATION

 

1996 Stock Option Plan

 

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

 

1999 Stock Option Plan

 

During 1999, the Board of Directors of the Company adopted the 1999 Stock Option Plan (the “1999 Plan”). The 1999 Plan was not presented to stockholders for approval and thus incentive stock options are not available under the plan. Under the 1999 Plan, 2,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of nonstatutory stock options granted may not exceed ten years. Options issued under the 1999 Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 1999 Plan expires in August 2009.

 

2004 Stock Option Plan

 

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

 

Non-Plan Stock Options

 

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

 

Stock Option Activity

 

The following table summarizes stock option activity for the three months ended March 31, 2008:

 

10

 

		Number of Options										Weighted  average  exercise			Weighted  average  remaining life		Aggregate intrinsic
		1996 Plan		1999 Plan		2004 Plan		Non Plan		Total		price			(in years)		value
Outstanding, as of December 31, 2007		80,000		805,000		2,221,415		3,943,000		7,049,415		$	0.85
Granted		—		—		—		—		—		—
Exercised		—		—		—		—		—		—
Forfeited		—		—		(82,414	)			(82,414	)	0.78
Expired		—		—		—		(48,000	)	(48,000	)	6.42
Outstanding, as of March 31, 2008		80,000		805,000		2,139,001		3,895,000		6,919,001		$	0.81		3.41		$	—
Vested or expected to vest at March 31, 2008										6,800,257		$	0.82		3.37		$	—
Exercisable at March 31, 2008										6,480,462		$	0.84		3.29		$	—

 

The options outstanding and exercisable at March 31, 2008 were in the following exercise price ranges:

 

		Options Outstanding							Options Exercisable
Range of exercise prices		Number of  shares		Weighted  average  exercise  price			Weighted  average  remaining life  (in years)		Number  exercisable		Weighted  average  exercise  price
$  0.15-0.21		67,000		$	0.18		6.24		4,333		$	0.21
0.22-0.40		876,666		0.33			1.69		819,329		0.33
0.41-0.68		2,095,666		0.56			3.17		1,777,131		0.55
0.69-1.11		2,208,169		0.90			4.41		2,208,169		0.90
1.12-6.42		1,671,500		1.30			3.23		1,671,500		1.30
$   0.15-6.42		6,919,001							6,480,462

 

The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Company’s closing stock price of $0.11 as of March 31, 2008, which would have been received by the option holders had all option holders exercised their options as of that date. There are no in-the-money options exercisable as of March 31, 2008.

 

The weighted average fair value of options, as determined under SFAS No. 123R, granted during the three months ended March 31, 2008 and 2007 was $0 and $0.29 per share, respectively.

 

As of March 31, 2008 future compensation cost related to nonvested stock options is approximately $160,712 and will be recognized over an estimated weighted average period of approximately 1.14 years.

 

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

 

The Company’s basic EPS is calculated using net income (loss) available to common shareholders and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuance of common stock, such as stock issuable pursuant to the exercise of stock options and warrants and the assumed conversion of convertible notes and preferred stock. For the three months ended March 31, 2008 and 2007, diluted per share computations are not presented since this effect would be antidilutive.

 

11

 

The reconciliation of the numerator of the basic and diluted EPS calculations, due to the inclusion of preferred stock dividends and accretion was as follows for the following three month period ended March 31:

 

		Three Months ended  March 31,
		2008			2007
Numerator:
Loss from continuing operations		$	(915,670	)	$	(1,386,862	)
Convertible preferred stock dividends and accretion		(470,893		)	(471,390		)
Loss available to common stockholders (basic and diluted EPS)		$	(1,386,563	)	$	(1,858,252	)

 

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

 

		Three Months Ended  March 31,
		2008		2007
Preferred Stock		33,155,440		19,952,040
Convertible Debt		—		8,819,771
Stock Options		—		20,000
Potentially dilutive securities		33,155,440		28,791,811

 

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

 

		Three Months Ended  March 31,
		2008		2007
Stock options		6,919,001		8,026,085
Warrants		10,566,375		10,566,375
Total		17,485,376		18,592,460

 

12

 

6.             EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

Equipment and leasehold improvements consisted of the following:

 

		March 31,			December 31,
		2008			2007
Equipment		$	522,051		$	517,658
Furniture and fixtures		187,984			187,984
Software		136,355			136,355
Leasehold improvements		198,889			198,889
		1,045,279			1,040,886
Less accumulated depreciation and amortization		(900,160		)	(863,604		)
Total		$	145,119		$	177,282

 

7.             GOODWILL AND OTHER INTANGIBLE ASSETS

 

The Company’s goodwill resulted from the acquisition of Public Safety Group, Inc. and certain assets and assumed liabilities of the Mobile Government Division of Aether Systems, Inc. in 2004. As provided by SFAS No. 142, the Company has elected to perform the annual assessment of the carrying value of all goodwill as of September 30^th each year using a number of criteria, including the value of the overall enterprise. Impairment charges from existing operations or other acquisitions, if any, are reflected as an operating expense in the statement of operations. As of March 31, 2008 goodwill totaled $7,836,986.

 

Other intangible assets as of March 31, 2008 consisted of the following:

 

		March 31, 2008									December 31, 2007
		Gross  Carrying  Amount			Accumulated  Amortization			Net Carrying Amount			Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount
Copyrighted software		$	1,181,429		$	(945,143	)	$	236,286		$	1,181,429		$	(886,071	)	$	295,358
Customer relationships		617,271			(432,089		)	185,182			617,271			(401,225		)	216,046
Trademarks		807,872			(603,491		)	204,381			807,872			(563,099		)	244,773
Developed technology		434,353			(304,047		)	130,306			434,353			(282,330		)	152,023
Marketing agreements		605,340			(484,273		)	121,067			605,340			(454,005		)	151,335
Patents and patents pending		298,059			(35,345		)	262,714			298,059			(33,325		)	264,734
Total		$	3,944,324		$	(2,804,388	)	$	1,139,936		$	3,944,324		$	(2,620,055	)	$	1,324,269

 

Aggregate amortization expense for the three months ended March 31, 2008 and 2007, was $184,333 and $182,512 respectively.

 

8.             INVESTMENTS

 

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

 

In February 2008, the above mentioned private company consummated a reverse merger with a publicly traded US company. As a result of the merger, BIO-key’s investment was converted into shares of the

 

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public company. This change in circumstances enabled the fair value of the investment to be “readily determinable” under the provisions of FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Accordingly, BIO-key now classifies its investment as an “available-for-sale” security, and accounts for it at its market value as specified on a securities exchange.

 

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

 

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

 

		March 31, 2008						December 31, 2007
		Cost			Fair Value			Cost			Fair Value
Available-for-sale security		$	—		$	391,760		$	—		$	—
Balance as of March 31, 2008		$	—		$	391,760		$	—		$	—

 

Unrealized gain on the available-for-sale security was $391,760 at March 31, 2008.

 

9.             CONVERTIBLE DEBT FINANCING / WARRANTS

 

Long-term obligations consisted of the following as of:

 

		March 31,			December 31,
		2008			2007
2004
FMV of warrants		$	10,334		$	11,663
2005
FMV of warrants		31,772			34,644
2006
FMV of warrants		17,571			18,213
Total		$	59,677		$	64,520

 

Senior Convertible Term Notes

 

On September 29, 2004, we entered into a Securities Purchase Agreement (the “2004 Senior Purchase Agreement”) with Laurus Master Fund, Ltd. (“Laurus”) to issue secured convertible term notes in the aggregate principal amount of $5,050,000.  On June 8, 2005, we entered into a second Securities Purchase Agreement (the “2005 Senior Purchase Agreement”) with Laurus to issue secured convertible term notes in the aggregate principal amount of $2,000,000.

 

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

 

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The account balance shown represents the fair market value of warrants issued in conjunction with debt offerings undertaken from the 2004 to 2006 fiscal years. The Warrants are classified as liabilities and were valued as of March 31, 2008, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 88% to 98% and risk-free interest rate of 1.6% to 1.8%.

 

2004 and 2005 Senior Note Derivatives and Discounts

 

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

 

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

 

10.           ACCRUED LIABILITIES

 

Accrued liabilities at consisted of the following:

 

		March 31,			December 31,
		2008			2007
Contract costs not yet invoiced by vendors		$	90,296		$	2,185,610
Compensation		109,196			140,314
Compensated absences		388,273			367,731
Royalties		366,470			371,158
Interest		176,083			176,083
Other		92,482			160,853
Total		$	1,222,800		$	3,401,749

 

11.           REDEEMABLE PREFERRED STOCK

 

Series B Convertible Preferred Stock

 

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

 

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Original Purchase Price still outstanding, payable quarterly. In any liquidation of the Company, each share of Preferred Stock is entitled to a liquidation preference on a pari passu basis with the Series A and Series C Preferred Stock before any distribution may be made on the Company’s common stock.

 

As of March 31, 2008, 1,000,000 shares of Series B Preferred Stock were authorized, 970,612 of which were issued and outstanding, at a par value of $0.0001 and a liquidation preference of $1.00 with accumulated dividends in arrears of $36,802, which have been accreted to the principal balance of the Series B Preferred Stock.

 

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

 

As of March 31, 2008, the derivatives were valued at $2,359.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 48%; and risk free annual interest rate of 1.53% as well as probability analysis related to trading volume restrictions.

 

An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock.  The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the Preferred Stock.  At March 31, 2008, the unamortized discount on the Preferred Stock was $94,860.

 

Series C Convertible Preferred Stock

 

The Company issued 592,032 shares of redeemable Series C Convertible Preferred Stock on August 10, 2006, upon the exchange of certain convertible term notes. Each share of Series C Preferred Stock has an Original Issue Price of $10.00 per share. The holder has the option to redeem the shares of Series C Preferred Stock at any time for a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.30 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series C Preferred Stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series C shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.20. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.20 the Company shall mandatorily redeem all remaining outstanding Series C Preferred Stock by paying cash equal to $10.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem any or all of the remaining outstanding Series C shares in cash at a conversion price equal to $12.00 per share, together with all accrued and unpaid dividends upon giving 30 days’ notice. Holders of the Series C Preferred Stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly. In any liquidation of the Company, each share of Preferred Stock is entitled to a liquidation preference on a pari passu basis with the Series A and Series B Preferred Stock before any distribution may be made on the Company’s common stock.

 

As of March 31, 2008, 600,000 Shares of Series C Preferred Stock were authorized, 592,032 of which were issued and outstanding, at a par value of $0.0001 and a liquidation preference of $10.00 with accumulated dividends in arrears of $442,643, which have been accreted to the principal balance of the Series C Preferred Stock.

 

The Preferred Stock contains features that are considered embedded derivative financial instruments: 

 

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

 

As of March 31, 2008, the derivatives were valued at $13,038.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 48%; and risk free annual interest rate of 1.53% as well as probability analysis related to trading volume restrictions.

 

An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock.   The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the Preferred Stock.  At March 31, 2008, the unamortized discount on the Preferred Stock was $337,083.

 

Together with the above transaction, the terms of certain warrants held by the Company’s investment bankers and their associates were modified. The incremental value of the modification was calculated to be $110,453, and was allocated against the proceeds of the Series C Preferred Stock as a cost of financing, and is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock.  At March 31, 2008, the net amount remaining to be accreted was $34,685.

 

12.           STOCKHOLDERS EQUITY

 

Common Stock

 

The Company is authorized to issue 170,000,000 shares of common stock, $.0001 par value per share, of which 62,511,172 were outstanding as of March 31, 2008.

 

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

 

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

 

During the three months ended March 31, 2008, preferred stockholders converted accumulated dividends of $170,644 into 1,357,970 shares of the Company’s common stock.

 

Series A Convertible Preferred Stock

 

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

 

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In March 2004, we designated 100,000 shares of preferred stock as Series C Convertible Preferred Stock. In connection with the Company’s reincorporation in Delaware on January 1, 2005, each share of Series C Convertible Preferred Stock was automatically converted into one share of Series A Convertible Preferred Stock (the “Series A Shares”), of which 30,557 were issued and outstanding as at March 31, 2008.

 

The Series A Shares accrue a cumulative annual dividend of 7% on the $100 face amount of such shares payable June 15 and December 15 each year in shares of common stock. In the event of a liquidation, dissolution or winding up of the Company, the Series A Shares have a liquidation preference of $100 per share (plus all accrued and unpaid dividends thereon) prior to any payment or distribution to holders of our common stock. The Series A Shares are convertible into common stock at a conversion price of $0.30 per share. The conversion price is subject to proportional adjustment in the event of stock splits, stock dividends or reclassifications. Subject to certain exceptions, in the event we issue additional shares of common stock at a purchase price less than the conversion price of the Series A Shares, the conversion price shall be lowered to such lesser price. In the event that the average closing bid price of our common stock is less than $1.00 per share for thirty (30) consecutive trading days at any time after November 17, 2008, we will be required to redeem the Series A Shares by payment of $100 per share plus all accrued and unpaid dividends due thereon.

 

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

 

As of March 31, 2008, cumulative dividends in arrears related to the Series A Preferred Stock were approximately $298,022, which have been accreted to the principal balance of the Series A Preferred Stock.

 

Warrants

 

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

 

		Total Warrants		Weighted average exercise price			Weighted average remaining life (in years)		Aggregate intrinsic value
Outstanding, as of December 31, 2007		10,566,375		$	0.95
Granted		—		—
Exercised		—		—
Expired		—		—
Outstanding, as of March 31, 2008		10,566,375		0.95			2.02		$	—
Vested or expected to vest at March 31, 2008		10,566,375		0.95			2.02		—
Exercisable at March 31, 2008		10,566,375		0.95			2.02		—

 

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The warrants outstanding and exercisable at March 31, 2008 were in the following exercise price ranges:

 

			Warrants outstanding and Exercisable
Range of exercise prices			Number of warrants		Weighted average remaining life (in years)
$	0.30		2,798,014		2.86
0.75			533,333		3.36
0.97			150,000		1.29
1.00			2,655,552		1.62
1.35			4,429,476		1.00
			10,566,375

 

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

 

13.           COMPREHENSIVE LOSS

 

The component of accumulated other comprehensive income was as follows:

 

		March 31,
		2008
Unrealized gain on available-for-sale securities, net of tax		$	391,760
Total accumulated other comprehensive income		$	391,760

 

The components of comprehensive loss for the three months ended March 31, 2008 and 2007 were as follows:

 

		March 31,			March 31,
		2008			2007
Net loss		$	(915,670	)	$	(912,373	)
Unrealized gain on securities, net of tax		391,760			—
Total comprehensive loss		$	(523,910	)	$	(912,373	)

 

14.           SEGMENT INFORMATION

 

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

 

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Prior to the sale of the Fire business in May 2007, Fire had been reported as a separate segment. Prior periods presented have been recast accordingly to reflect these operations as discontinued. Geographically, North American sales accounted for approximately 96% and 100% of the Company’s total sales for the three months ended March 31, 2008 and 2007.

 

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

 

		Three Months Ended March 31,
		2008			2007
Revenue:
Law		$	2,187,799		$	2,597,672
Biometrics		352,619			117,568
Consolidated Revenue		$	2,540,418		$	2,715,240
Segment operating loss
Law		(698,802		)	(1,047,276		)
Biometrics		(238,384		)	(624,536		)
Total Segment Operating Loss		(937,186		)	(1,671,812		)
Reconciliation to net loss
Derivative and warrant fair value adjustments		30,741			829,369
Interest income		899			—
Interest expense		(10,124		)	(538,517		)
Other expense		—			(5,902		)
Net loss from continuing operations		(915,670		)	(1,386,862		)
Income from discontinued operations		—			474,489
Net loss		$	(915,670	)	$	(912,373	)

 

15.           INCOME TAXES

 

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

 

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

 

The Company has not been audited by the Internal Revenue Service (“IRS”) or any states in connection with income taxes. The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The periods from 2004-2007 remain open to examination by the IRS and state jurisdictions. The Company believes it is not subject to any tax risk beyond the preceding discussion. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of

 

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