BIO KEY INTERNATIONAL INC - Quarter Report: 2010 September (Form 10-Q)

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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2010

 

or

 

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

 

For the Transition Period from              to            

 

Commission file number 1-13463

 

BIO-KEY INTERNATIONAL, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

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

(Address of Principal Executive Offices)

 

(732) 359-1100

(Issuer’s Telephone Number)

 

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 o   No  o

 

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

 

 

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, $.0001 par value per share, outstanding as of November 12, 2010 were 78,155,413.

 

 

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BIO-KEY INTERNATIONAL, INC.

 

INDEX

 

PART I. FINANCIAL INFORMATION
	Item 1	—	Condensed Consolidated Financial Statements
			Balance sheets as of September 30, 2010 (unaudited) and December 31, 2009	3
			Statements of operations for the three and nine months ended September 30, 2010 and 2009 (unaudited)	4
			Statements of cash flows for the nine months ended September 30, 2010 and 2009 (unaudited)	5
			Notes to condensed consolidated financial statements	7
	Item 2	—	Management’s Discussion and Analysis of Financial Conditions and Results of Operations	20
	Item 4	—	Controls and Procedures	28
PART II. OTHER INFORMATION
	Item 6	—	Exhibits	28
Signatures				29

 

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PART I — FINANCIAL INFORMATION

 

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

 

		September 30,			December 31,
		2010			2009
		(Unaudited)
ASSETS
Cash and cash equivalents		$	662,519		$	792,426
Restricted cash		—			40,500
Accounts receivable, net of allowance for doubtful accounts of $11,526 at September 30, 2010 and December 31, 2009		908,398			847,215
Note receivable, current portion		1,334,000			1,334,000
Inventory		13,482			14,935
Prepaid expenses and other		129,325			123,911
Total current assets		3,047,724			3,152,987
Equipment and leasehold improvements, net		32,238			39,243
Deposits and other assets		8,712			8,712
Note receivable, net of current portion		2,666,000			2,666,000
Intangible assets—less accumulated amortization		221,321			230,259
Total non-current assets		2,928,271			2,944,214
TOTAL ASSETS		$	5,975,995		$	6,097,201
LIABILITIES
Accounts payable		$	254,017		$	340,241
Accrued liabilities		621,142			708,765
Deferred revenue		337,871			200,996
Convertible notes, derivatives and warrants		610,078			471,483
Redeemable preferred stock derivatives		21,327			563,599
Total current liabilities		1,844,435			2,285,084
Warrants		—			63,901
Deferred revenue		5,268			9,391
Total non-current liabilities		5,268			73,292
TOTAL LIABILITIES		1,849,703			2,358,376
Commitments and contingencies
Series D redeemable convertible preferred stock: authorized, 100,000 shares (liquidation preference of $100 per share); issued and outstanding 30,557 shares of $.0001 par value at September 30, 2010 and December 31, 2009		3,112,090			2,630,593
		3,112,090			2,630,593
STOCKHOLDERS’ EQUITY:
Common stock — authorized, 170,000,000 shares; issued and outstanding; 78,155,413 and 77,713,398 of $.0001 par value at September 30, 2010 and December 31, 2009		7,815			7,771
Additional paid-in capital		50,802,147			51,187,754
Accumulated deficit		(49,795,760		)	(50,087,293		)
TOTAL STOCKHOLDERS’ EQUITY		1,014,202			1,108,232
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	5,975,995		$	6,097,201

 

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

 

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

 

		Three months ended September 30,						Nine months ended September 30,
		2010			2009			2010			2009
Revenues
Services		$	112,090		$	88,479		$	316,478		$	303,983
License fees and other		434,286			435,872			2,639,124			1,039,247
		546,376			524,351			2,955,602			1,343,230
Costs and other expenses
Cost of services		30,203			15,499			80,391			48,208
Cost of license fees and other		175,967			179,286			339,720			352,088
		206,170			194,785			420,111			400,296
Gross Profit		340,206			329,566			2,535,491			942,934
Operating Expenses
Selling, general and administrative		817,348			749,771			2,414,810			2,474,986
Research, development and engineering		265,682			245,318			825,607			719,095
		1,083,030			995,089			3,240,417			3,194,081
Operating loss		(742,824		)	(665,523		)	(704,926		)	(2,251,147		)
Other income (expenses)
Derivative and warrant fair value adjustments		(44,768		)	(102,193		)	932,520			(157,170		)
Interest income		61,343			405			182,295			405
Interest expense		(205,448		)	—			(532,531		)	—
Other		—			(3,774		)	—			(7,148		)
		(188,873		)	(105,562		)	582,284			(163,913		)
Loss from continuing operations		(931,697		)	(771,085		)	(122,642		)	(2,415,060		)
Income (loss) from discontinued operations		(12,093		)	701,674			414,176			2,707,468
Net income (loss)		$	(943,790	)	$	(69,411	)	$	291,534		$	292,408
Basic and Diluted Earnings per Common Share (See Note 5):
Loss from continuing operations		$	(0.01	)	$	(0.01	)	$	(0.01	)	$	(0.05	)
Income (loss) from discontinued operations		0.00			0.01			0.01			0.04
Net income (loss)		$	(0.01	)	$	0.00		$	0.00		$	(0.01	)
Weighted Average Shares Outstanding:
Basic and Diluted		78,016,082			73,521,550			77,815,401			71,115,231

 

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

 

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

 

		Nine Months Ended September 30,
		2010			2009
CASH FLOW FROM OPERATING ACTIVITIES:
Net income		$	291,534		$	292,408
Less:
Income from discontinued operations		414,176			2,707,468
Income (loss) from continuing operations		(122,642		)	(2,415,060		)
Adjustments to reconcile net income (loss) to cash used in operating activities:
Derivative and warrant fair value adjustments		(932,520		)	157,170
Depreciation		16,905			17,875
Amortization
Intangible assets		8,938			18,540
Discount on convertible debt related to derivatives		532,531			33,701
Share-based compensation		38,597			69,419
Change in assets and liabilities:
Accounts receivable trade		(61,183		)	(112,487		)
Inventory		1,453			(9,118		)
Prepaid expenses and other		(5,414		)	(1,284		)
Accounts payable		(86,224		)	163,999
Accrued liabilities		(99,519		)	185,355
Deferred revenue		132,752			(466,656		)
Net cash used for continuing operations		(576,326		)	(2,358,546		)
Net provided by discontinued operations		415,819			1,720,306
Net cash used for operating activities		(160,507		)	(638,240		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(9,900		)	(25,085		)
Deposits		—			(899		)
Transfer of funds from restricted cash		40,500			—
Net cash provided by (used for) continuing operations		30,600			(25,984		)
Net cash used for discontinued operations		—			(24,423		)
Net cash provided by (used for) investing activities		30,600			(50,407		)
CASH FLOW FROM FINANCING ACTIVITIES:
Issuance of short-term obligations		—			1,000,000
Repayment of long term obligations		—			(1,082,460		)
Dividends		—			(37,207		)
Net cash provided by (used for) financing activities		—			(119,667		)
NET DECREASE IN CASH AND CASH EQUIVALENTS		(129,907		)	(808,314		)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		792,426			1,712,912
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	662,519		$	904,598

 

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

 

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

 

		Nine Months Ended September 30,
		2010			2009
Noncash Investing and Financing Activities:
Issuance of Debt in exchange of discounted Series B redeemable preferred Stock		$	—		$	398,387
Discount on Series B redeemable preferred Stock		—			130,153
Issuance of Debt in exchange of discounted Series C redeemable preferred Stock		—			1,810,495
Discount on Series C redeemable preferred Stock		—			591,487
Issuance of common stock through conversion of principal, interest and dividends outstanding on preferred stock		—				767,916
Issuance of common stock through conversion of principal and interest on convertible promissory note			55,694		—

 

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

 

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BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

September 30, 2010 (Unaudited)

 

1.                                       BASIS OF PRESENTATION

 

The accompanying unaudited interim condensed 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 of America, 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, 2009 was derived from the audited financial statements, but does not include all of the disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed 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-K for the fiscal year ended December 31, 2009 (the “Form 10-K”), filed on March 26, 2010.

 

Recently Issued Accounting Pronouncements

 

In April 2010, the FASB issued Accounting Standards Update 2010-17 (ASU 2010-17), Revenue Recognition-Milestone Method (Topic 605): Milestone Method of Revenue Recognition. The amendments in this Update are effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Early adoption is permitted. If a vendor elects early adoption and the period of adoption is not the beginning of the entity’s fiscal year, the entity should apply the amendments retrospectively from the beginning of the year of adoption. The Company does not expect the provisions of ASU 2010-17 to have a material effect on its financial position or results of operations.

 

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures about Fair Value Measurements, amending ASC 820. ASU 2010-06 requires entities to provide new disclosures and clarify existing disclosures relating to fair value measurements.  The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The Company is currently evaluating the impact of ASU 2010-06, but does not expect its adoption to have a material impact on the Company’s financial position or results of operations.

 

In September 2009, the FASB issued ASU 2009-13, Multiple Element Arrangements. ASU 2009-13 addresses the determination of when the individual deliverables included in a multiple arrangement may be treated as separate units of accounting. ASU 2009-13 also modifies the manner in which the transaction consideration is allocated across separately identified deliverables and establishes definitions for determining fair value of elements in an arrangement. This standard must be adopted by the Company no later than January 1, 2011 with earlier adoption permitted. The Company is currently evaluating the impact, if any, that this standard update will have on its consolidated financial statements.

 

2.                                       LIQUIDITY AND CAPITAL RESOURCE MATTERS

 

We have incurred significant losses to date, and at September 30, 2010, we had an accumulated deficit of approximately $50 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues. If the Company is unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-

 

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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 condensed consolidated 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 paragraph raise substantial doubt about the Company’s ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheets is dependent upon the Company’s ability to meet its financing requirements on a continuing basis, and maintain profitability 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 as a going concern.

 

3.                                       DISCONTINUED OPERATIONS

 

On December 8, 2009, the Company consummated the sale (the “Asset Sale”) of its Law Enforcement division (the “Business”) to InterAct911 Mobile Systems, Inc. (“Buyer”), a wholly-owned subsidiary of InterAct911 Corporation (the “Parent”), pursuant to the Asset Purchase Agreement dated as of August 13, 2009 by and between the Company and Buyer (the “Purchase Agreement”).

 

Pursuant to the Purchase Agreement, Buyer acquired substantially all of the assets relating to the Business, including the Company’s customer contracts, intellectual property, accounts receivable, equipment, inventories, software, technologies, communication systems and goodwill relating to the Business.  Buyer also assumed certain specified liabilities as set forth in the Purchase Agreement.  The Company and InterAct Public Safety Systems, an affiliate of Buyer, had collaborated on many projects in the past, including partnership arrangements in which products used in the Business (including elements of the MobileCop®, PocketCop®, MobileRescue™, MobileOffice™, and InfoServer™ product lines) had been integrated with those of InterAct Public Safety Systems and sold to law enforcement agencies and other emergency response customers.  Outside of those commercial dealings, at the time of the Asset Sale there were no material relationships among the Company and Buyer or any of their respective affiliates other than in respect of the Purchase Agreement and the related ancillary agreements.

 

As consideration for the Asset Sale, Buyer paid the Company an aggregate purchase price of approximately $11.3 million. Of that amount, approximately $7.0 million was paid in cash at the closing of the Asset Sale, and approximately $300,000 was paid pursuant to the working capital adjustment provided for in the Purchase Agreement.  Buyer also issued a promissory note (the “Note”) in the original principal amount of $4.0 million in favor of the Company.  The Note is to be paid in three equal annual installments beginning on December 8, 2010 and bears interest, payable on a quarterly basis, at a rate per annum equal to six percent (6%) compounded annually on the principal sum from time to time outstanding.  The Note is guaranteed by SilkRoad Equity, LLC (“SilkRoad”), a private investment firm and a principal owner of Buyer, and is secured by all of the intellectual property assets of the Business transferred to Buyer as part of the Asset Sale.  In addition, at the closing of the Asset Sale, the Company issued to SilkRoad a warrant to purchase up to 8 million shares of the Company’s common stock at an exercise price of $0.30 per share.  This warrant will expire if not exercised prior to the fifth anniversary of the closing.

 

Prior to the sale, the Business had been reported as a separate segment. The Business has been reported as a discontinued operation and all periods presented have been recast accordingly to reflect these operations as discontinued.

 

During the nine month period ended September 30, 2010, the Company recorded income of approximately $483,000 from a contract delivered under our arrangement with Buyer which was reduced by cost of sales and expenses for professional fees, resulting in net income from discontinued operations of approximately $414,000.  The Company does not expect any additional income from discontinued operations in the future.  The Company and Buyer concluded the post-closing purchase price adjustments on August 3, 2010, which resulted in Buyer paying an additional $76,313 to the Company, and whereby Buyer returned approximately $263,000 of accounts receivable in lieu of a cash payment for the same amount.  The Company has collected approximately $132,000 and is still pursuing payment for the balance due.

 

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4.                                       SHARE 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.

 

The compensation expense recognized under ASC 718 increased the Company’s loss from continuing operations by $12,850 and $9,651, and $38,597 and $69,419 for the three and nine months ended September 30, 2010 and 2009, respectively, with no effect per share (basic and diluted).

 

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

 

		Three Months Ended September 30,			Three Months Ended September 30,
		2010			2009
Cost of services		$	—		$	—
Selling, general and administrative		1,468			2,526
Research, development and engineering		11,382			7,125
		$	12,850		$	9,651

 

		Nine Months Ended September 30,			Nine Months Ended September 30,
		2010			2009
Cost of services		$	—		$	—
Selling, general and administrative		12,278			51,427
Research, development and engineering		26,319			17,992
		$	38,597		$	69,419

 

Valuation Assumptions for Stock Options

 

For the three months ended September 30, 2010 and 2009, 100,000 and 0 stock options were granted, respectively. For the nine months ended September 30, 2010 and 2009, 510,000 and 790,000 stock options were granted, respectively. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

		Three Months Ended September 30,
		2010		2009
Risk free interest rate		1.63	%	N/A
Expected life of options (in years)		4.5		N/A
Expected dividends		0	%	N/A
Volatility of stock price		114	%	N/A

 

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		Nine Months Ended September 30,
		2010		2009
Risk free interest rate		2.1-2.22	%	1.83-1.85	%
Expected life of options (in years)		4.30		4.5
Expected dividends		0	%	0	%
Volatility of stock price		115	%	87	%

 

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

 

EQUITY COMPENSATION PLAN INFORMATION

 

1996 Stock Option Plan

 

During 1996, the Board of Directors and stockholders of the Company adopted the 1996 Stock Option Plan (the “1996 Plan”). Under the 1996 Plan, 750,000 shares of common stock were reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which could not be below 100% of fair market value for incentive stock options and 50% for all other options. The term of stock options granted could 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 in the 1996 Plan, 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 were not available under the plan. Under the 1999 Plan, 2,000,000 shares of common stock were reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which could not be below 85% of fair market value. The term of non-statutory stock options granted could 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 in the 1999 Plan, all options outstanding vest immediately. The 1999 Plan expired 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 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 in the relevant agreements with receipients, certain of the non-plan options outstanding vest immediately.

 

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Stock Option Activity

 

The following table summarizes stock option activity for the nine months ended September 30, 2010:

 

		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, 2009		45,000		500,000		2,073,189		1,329,841		3,948,030		$	0.24
Granted		—		—		510,000		—		510,000		0.40
Exercised		—		—		—		—		—		—
Forfeited		(45,000	)	—		—		—		(45,000	)	0.47
Expired		—		—		(2,500	)	—		(2,500	)	0.67
Outstanding, as of September 30, 2010		—		500,000		2,580,689		1,329,841		4,410,530		0.25			4.02		$	98,806
Vested or expected to vest at September 30, 2010										4,250,224		0.25			3.90		$	97,076
Exercisable at September 30, 2010										3,759,862		0.24			3.57		$	87,255

 

The options outstanding and exercisable at September 30, 2010 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
$	0.07-0.21			1,696,272		$	0.12		5.17		1,455,604		$	0.11
0.22-0.40				2,299,258		0.30			2.92		2,229,258		0.30
0.41-0.68				340,000		0.46			6.28		—		—
0.69-0.94				75,000		0.94			1.09		75,000		0.94
$	0.07-0.94			4,410,530							3,759,862

 

The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Company’s closing stock price of $0.18 as of September 30, 2010, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of September 30, 2010 was 1,425,604.

 

The weighted average fair value of options granted during the three months ended September 30, 2010 was $0.133 per share, and during the nine months ended September 30, 2010 and September 30, 2009 was $0.188 and $0.087 per share, respectively.

 

As of September 30, 2010, future compensation cost related to nonvested stock options is $83,481 and will be recognized over an estimated weighted average period of approximately 1.39 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 give effect to dilutive convertible securities, options, warrants, preferred stock and other potential common stock outstanding during the period, only in periods in which such effect is dilutive.

 

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The reconciliation of the numerators of the basic and diluted EPS calculation was as follows for both of the following three and nine month periods ended September 30:

 

		Three Months ended September 30,						Nine Months ended  September 30,
		2010			2009			2010			2009
Basic Numerator:
Loss from continuing operations		$	(931,697	)	$	(771,085	)	$	(122,642	)	$	(2,415,060	)
Convertible preferred stock dividends and accretion		(162,263		)	(244,249		)	(481,497		)	(971,502		)
Loss available to common stockholders (basic EPS)		$	(1,093,960	)	$	(1,015,334	)	$	(604,139	)	$	(3,386,562	)
Basic Denominator		78,016,082			73,521,550			77,815,401			71,115,231
Per Share Amount		$	(0.01	)	$	(0.01	)	$	(0.01	)	$	(0.05	)

 

The following table summarizes the securities that were excluded from the diluted per share calculation because the effect of including these potential shares was antidilutive.

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2010		2009		2010		2009
Preferred Stock		10,185,667		23,533,567		10,185,667		23,533,567
Convertible Debt		2,366,260		—		2,366,260		—
Stock Options		557,272		1,371,272		674,641		1,371,272
Potentially dilutive securities		13,109,199		24,904,839		13,226,568		24,904,839

 

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 September 30,				Nine Months Ended September 30,
		2010		2009		2010		2009
Stock options		3,039,258		5,404,169		2,844,258		5,458,169
Warrants		15,369,948		3,775,791		15,369,948		3,775,791
Total		18,409,206		9,179,960		18,314,206		9,233,960

 

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6.                                       NOTE RECEIVABLE

 

Notes receivable consisted of the following:

 

		September 30,			December 31,
		2010			2009
		(Unaudited)
Note Receivable — Current		$	1,334,000		$	1,334,000
Note Receivable — Non-Current		2,666,000			2,666,000
Total		$	4,000,000		$	4,000,000

 

As consideration for the Asset Sale (see “Note 3 — Discontinued Operations”), Buyer paid the Company an aggregate purchase price of approximately $11.3 million. Of that amount, approximately $7.0 million was paid in cash at the closing of the Asset Sale, and approximately $300,000 was paid pursuant to the working capital adjustment provided for in the Purchase Agreement.  Buyer also issued a promissory note (the “Note”) in the original principal amount of $4.0 million in favor of the Company.  The Note is to be paid in three equal annual installments beginning on the first anniversary of the closing and will bear interest, payable on a quarterly basis, at a rate per annum equal to six percent (6%) compounded annually on the principal sum from time to time outstanding.  The Note is guaranteed by SilkRoad, a private investment firm and a principal owner of Buyer, and is secured by all of the intellectual property assets that were sold to Buyer.

 

7.                                       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

Equipment and leasehold improvements consisted of the following:

 

		September 30,			December 31,
		2010			2009
		(Unaudited)
Equipment		$	245,848		$	235,948
Furniture and fixtures		99,199			99,199
Software		28,624			28,624
Leasehold improvements		39,975			39,975
		413,646			403,746
Less accumulated depreciation and amortization		(381,408		)	(364,503		)
Total		$	32,238		$	39,243

 

8.                                       OTHER INTANGIBLE ASSETS

 

Other intangible assets as of September 30, 2010 consisted of the following:

 

		September 30, 2010 (Unaudited)									December 31, 2009
		Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount			Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount
Patents and patents pending		287,248			(65,927		)	221,321			287,248			(56,989		)	230,259
Total		$	287,248		$	(65,927	)	$	221,321		$	287,248		$	(56,989	)	$	230,259

 

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Aggregate amortization expense for the three months ended September 30, 2010 and 2009, was $2,979 and $2,946 respectively, and was $8,938 and $8,528 for the nine months ended September 30, 2010 and 2009 respectively.

 

9.                                       RESTRICTED CASH

 

During 2008, the Company extended its property lease at the Marlborough, MA location. Pursuant to the agreement BIO-key was to maintain a security deposit in the form of an irrevocable letter of credit in the amount of $40,500. However, BIO-key and the landlord for the property subsequently agreed to have BIO-key place the funds in a third party escrow account, to be returned at the conclusion of the lease term, in August 2011. Pursuant to the sale of the Company’s Law Enforcement Business to Buyer in December 2009 (see “Note 3 — Discontinued Operations”), the Company is no longer situated at this location, and in June 2010 assigned its obligations under the lease to Buyer.

 

10.                                 NOTES PAYABLE, CONVERTIBLE DEBT FINANCING / WARRANTS

 

Effective as of July 2, 2009, the Company entered into a Settlement and Mutual Release Agreement (the “Settlement Agreement”) with Longview Special Finance, Inc. and Longview Fund, L.P. (collectively, the “Longview Entities”) in order to resolve all matters relating to the litigation initiated by the Longview Entities, in which they were seeking $2,886,563 in damages and an unspecified amount of interest and attorney’s fees from the Company as a result of the Company’s alleged improper failure to redeem their outstanding shares of the Company’s Convertible Preferred Stock (collectively, the “Shares”) in accordance with the terms and conditions of such preferred stock.  Pursuant to the Settlement Agreement, without admission of any liability or fault, the parties agreed to a payment schedule under which the Company was required to pay a total cash settlement amount of $2,164,922, fifty percent (50%) of which was paid on July 7, 2009.  The remaining portion of the settlement amount at interest rate of seventeen percent (17%) per annum was required to be paid in full on or before October 30, 2009.  In return, the Longview Entities agreed to a full and complete release of the Company from all claims that were or could have been alleged in the lawsuit and agreed to relinquish all of the Shares upon receiving final payment of the settlement amount.  From October 30, 2009 until November 12, 2009, interest on the remaining portion of the settlement amount accrued at twenty percent (20%) per annum.  On November 12, 2009, the Company paid in full the entire outstanding portion of the settlement amount, together with all accrued and unpaid interest, and satisfied all of its obligations to the Longview Entities under the Settlement Agreement.

 

On July 7, 2009, the Company issued an unsecured promissory note (the “Note”) in the aggregate principal amount of $1,000,000 to the Shaar Fund, Ltd (“Shaar”).  The Note had an interest rate at eight percent (8%) per annum and was originally due and payable on November 4, 2009. Shaar extended the due date of the Note to the earlier to occur of (i) the fifth business day after the closing of the Asset Sale and (ii) January 31, 2010 pursuant to a Note Amendment and Extension Agreement dated as of November 3, 2009 between the Company and Shaar. Shaar had also made a bridge loan to the Company in the principal amount of $750,000, evidenced by the Company’s unsecured Six Percent (6%) Promissory Note dated as of November 12, 2009.

 

Shaar and the Company also entered into a Securities Exchange Agreement dated as of November 12, 2009 (the “Exchange Agreement”) as the Company had not paid the dividends that had accrued on its Series A Convertible Preferred Stock (the “Series A Preferred Stock”).  Pursuant to the Exchange Agreement, the Company and the holders of the outstanding shares of the Series A Preferred Stock, such holders being Shaar (27,932 shares) and Thomas J. Colatosti (2,625 shares), agreed to the following:

 

(a) to exchange their shares of Series A Preferred Stock for an equal number of shares of the Company’s Series D Convertible Preferred Stock (the “Series D Preferred Stock”) and

 

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(b) to issue Seven Percent (7%) Convertible Promissory Notes (the “Convertible Notes”) and Warrants to purchase up to an aggregate of 5,000,000 shares of the Company’s Common Stock, including up to 4,750,000 shares to Shaar and up to 250,000 shares to Mr. Colatosti, at an exercise price of $0.30 per share, for the payment of all dividends accrued and unpaid on their shares of Series A Preferred Stock. See below for a discussion of the accounting treatment of the warrants.

 

The Convertible Notes may be converted in whole or in part at any time at the option of the holder into shares of the Company’s Common Stock at a price equal to the lower of (i) the average closing price of the Common Stock as quoted by Bloomberg for the ten (10) trading days prior to the date that the notice of conversion is transmitted to the Company, and (ii) $0.30, subject to certain adjustments

 

On July 27, 2010, one of the Noteholders converted $27,615 of interest and $28,079 of principal into 442,015 shares of common stock, reducing the principal balance to $709,878  One of the Noteholders is Thomas J. Colatosti, the Company’s Chairman of the Board.  At September 30, 2010, the Company owed him $68,360 in principal and interest.

 

The Convertible Notes contain features that are considered embedded derivative financial instruments: Principal’s and Accrued Interest conversion option: All or a portion of the principal and all or a portion of the accrued interest of the Convertible Notes may be converted into common stock at the Holder’s option at any time at lower of i) the average 10 days trading price prior to conversion, or ii) $0.30 per share. These features have been bifurcated and recorded on the Company’s balance sheet at their fair value.

 

The accounting treatment of the warrants and derivatives requires that the Company record the warrants and derivatives at their relative fair value and fair value, respectively as of the inception date of the agreement. As the warrants were classified as equity instruments, no further accounting adjustment is required. With respect to the derivatives, which were classified as liabilities, in subsequent periods the derivatives are “marked-to-market” at fair value. Any change in fair value will be recorded as non-operating, non-cash income or expense at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income.

 

As of September 30, 2010, the derivatives were valued at $62,079. Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 0%; annual volatility of 74%; and risk free annual interest rate of 0.22% as well as probability analysis related to trading volume restrictions.

 

The initial fair values of the warrants and derivatives were recorded as discounts to the Convertible Notes and are being amortized to interest expense over the expected term of the debt, using the effective interest method. At September 30, 2010, the unamortized discount on the Convertible Notes was $166,118.

 

Convertible note financing and warrants consisted of the following:

 

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		September 30,			December 31,
		2010			2009
		(Unaudited)
Current Portion
2005
FMV of warrants		$	—		$	47,773
2006
FMV of warrants		4,239			—
2009
Convertible promissory notes		709,878			737,957
Discount		(166,118		)	(659,138		)
FMV of embedded derivatives		62,079			344,891
Total		$	610,078		$	471,483
Long-Term Portion
2006
FMV of warrants		—			63,901
Total		$	—		$	63,901

 

2005 and 2006 Warrants

 

The account balance shown represents the fair market value of warrants issued in conjunction with debt offerings undertaken from the 2005 to 2006 fiscal years. The warrants are classified as liabilities and were valued using the Black Scholes Option Pricing model with the following assumptions:

 

		September 30,		December 31,
		2010		2009
		(Unaudited)
Dividend Yield		0	%	0	%
Annual volatility		116	%	107-156	%
Risk-free interest rate		0.16	%	0.20-0.47	%

 

2009 Convertible Promissory Notes

 

The account balance shown represents the fair market value of convertible promissory notes issued in 2009. The fair market value of the embedded derivatives attached to the notes are classified as liabilities and were valued using the Binomial Option model with the following assumptions:

 

		September 30,		December 31,
		2010		2009
		(Unaudited)
Dividend Yield		0	%	0	%
Annual volatility		119	%	148	%
Risk-free interest rate		0.16	%	0.47	%

 

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11.                                 ACCRUED LIABILITIES

 

Accrued liabilities consisted of the following:

 

		September 30,			December 31,
		2010			2009
		(Unaudited)
Compensation		$	83,224		$	92,860
Compensated absences		155,552			143,387
Dividends Payable		128,644			128,644
Interest Payable		11,633			—
Tax payable		5,000			188,000
Other		237,089			155,874
Total		$	621,142		$	708,765

 

12.                                 REDEEMABLE PREFERRED STOCK

 

Series D Convertible Preferred Stock

 

The Company issued 30,557 shares of its redeemable Series D Convertible Preferred Stock to The Shaar Fund, Ltd. and Thomas Colatosti on December 28, 2009, in exchange for 30,557 shares of Series A Convertible Preferred Stock held by those shareholders. Each share of Series D Preferred Stock has an Original Issue Price of $100.00 per share. Each holder has the option to convert its shares of Series D Preferred Stock at any time into a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the conversion price of $0.30 per share. This conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series D Preferred Stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price per share less than the conversion price. Mandatory redemption of all of the Series D Preferred Stock shares is scheduled to occur on December 31, 2010 by the Company paying cash equal to $100.00 per share together with all accrued and unpaid dividends.  In any liquidation of the Company, each share of Series D Preferred Stock is entitled to a liquidation preference before any distribution may be made on the Company’s common stock.

 

As of September 30, 2010, 100,000 Series D Preferred Stock shares were authorized, 30,557 of which were issued and outstanding, at a par value of $0.0001 and a liquidation preference of $100.00 with accumulated dividends in arrears of $163,989, which have been accreted to the principal balance of the Series D Preferred Stock.

 

The Series D 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; Semi Annual Dividends Conversion Option:  Holders have the option to convert the Preferred Stock’s semi-annual dividend payment at any time at the fixed conversion price of $0.30 per share.  These features have been bifurcated and recorded on the Company’s balance sheet as liabilities, at their fair value. As of September 30, 2010, these embedded derivatives were valued at $21,327.  An amount equal to the original value of the derivatives was recorded as a discount to the Series D Preferred Stock.  The discount is being accreted to the principal balance of the Series D Preferred Stock, using the effective interest method, over the expected term of the Series D Preferred Stock.  At September 30, 2010, the unamortized discount on the Series D Preferred Stock was $107,600.

 

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