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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 March 31, 2010

 

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

(Registrant’s telephone number, including area code)

 

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 May 12, 2010 were 77,713,398

 

 

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BIO-KEY INTERNATIONAL, INC.

 

INDEX

 

PART I. FINANCIAL INFORMATION
	Item 1	—	Condensed Consolidated Financial Statements:
			Balance Sheets as of March 31, 2010 (unaudited) and December 31, 2009		3
			Statements of Operations for the three months ended March 31, 2010 and 2009 (unaudited)		4
			Statements of Cash Flows for the three months ended March 31, 2010 and 2009 (unaudited)		5
			Notes to Condensed Consolidated Financial Statements (unaudited)		7
	Item 2	—	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
	Item 4	—	Controls and Procedures		22
PART II. OTHER INFORMATION
	Item 6	—	Exhibits		23
Signatures					24

 

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PART I — FINANCIAL INFORMATION

 

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

 

		March 31,			December 31,
		2010			2009
		(Unaudited)			(Audited)
ASSETS
Cash and cash equivalents		$	487,971		$	792,426
Restricted cash		40,500			40,500
Accounts receivable, net of allowance for doubtful accounts of $11,526 at March 31, 2010 and December 31, 2009		1,397,005			847,215
Note receivable, current portion		1,334,000			1,334,000
Inventory		11,858			14,935
Prepaid expenses and other		148,875			123,911
Total current assets		3,420,209			3,152,987
Equipment and leasehold improvements, net		34,355			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		227,280			230,259
Total non-current assets		2,936,347			2,944,214
TOTAL ASSETS		$	6,356,556		$	6,097,201
LIABILITIES
Accounts payable		$	269,660		$	340,241
Accrued liabilities		549,641			708,765
Deferred revenue		304,972			200,996
Convertible notes, derivatives and warrants		381,650			471,483
Redeemable preferred stock derivatives		93,211			563,599
Total current liabilities		1,599,134			2,285,084
Warrants		—			63,901
Deferred revenue		5,939			9,391
Total non-current liabilities		5,939			73,292
TOTAL LIABILITIES		$	1,605,073		$	2,258,376
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 March 31, 2010 and December 31, 2009		2,789,328			2,630,593
		2,789,328			2,630,593
STOCKHOLDERS’ EQUITY:
Common stock — authorized, 170,000,000 shares; issued and outstanding; 77,713,398 of $.0001 par value at March 31, 2010 and December 31, 2009		7,771			7,771
Additional paid-in capital		51,041,119			51,187,754
Accumulated deficit		(49,086,735		)	(50,087,293		)
TOTAL STOCKHOLDERS’ EQUITY		1,962,155			1,108,232
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	6,356,556		$	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 March 31,
		2010			2009
Revenues
Services		$	92,043		$	131,350
License fees and other		884,132			406,844
		976,175			538,194
Costs and other expenses
Cost of services		30,429			17,417
Cost of license fees and other		79,671			119,662
		110,100			137,079
Gross Profit		866,075			401,115
Operating Expenses
Selling, general and administrative		700,021			878,462
Research, development and engineering		284,788			250,267
		984,809			1,128,729
Operating loss		(118,734		)	(727,614		)
Other income (expenses)
Derivative and warrant fair value adjustments		786,710			(35,330		)
Interest income		60,000			—
Interest expense		(162,736		)	(23,494		)
Other		—			(3,375		)
		683,974			(62,199		)
Income (loss) from continuing operations		565,240			(789,813		)
Income from discontinued operations		435,318			1,011,862
Net Income		$	1,000,558		$	222,049
Basic Earnings(Loss) per Common Share:
Income (loss) from continuing operations		0.005			(0.02		)
Income from discontinued operations		0.006			0.02
Net earnings per Common Share		$	0.011		$	0.00
Diluted Earnings(Loss) per Common Share:
Income (loss) from continuing operations		(0.002		)	(0.02		)
Income from discontinued operations		0.006			0.02
Net earnings per Common Share		$	0.004		$	0.00
Weighted Average Shares Outstanding:
Basic		77,713,398			68,477,547
Diluted		91,207,492			68,477,547

 

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)

 

		Three Months Ended March 31,
		2010			2009
CASH FLOW FROM OPERATING ACTIVITIES:
Net income		$	1,000,558		$	222,049
Less:
Income from discontinued operations		(435,318		)	(1,011,862		)
Income (loss) from continuing operations		$	565,240		$	(789,813	)
Adjustments to reconcile net income (loss) to cash used for operating activities:
Derivative and warrant fair value adjustments		(786,710		)	35,330
Depreciation		7,962			5,809
Amortization
Intangible assets		2,979			2,812
Discounts on convertible debt related to derivatives		162,588			—
Share-based compensation		11,490			49,590
Change in assets and liabilities:
Accounts receivable trade		(549,790		)	(238,692		)
Inventory		3,077			955
Prepaid expenses and other		(24,964		)	(19,639		)
Accounts payable		(70,581		)	17,049
Accrued liabilities		(159,124		)	135,206
Deferred revenue		100,524			(310,116		)
Net cash used for continuing operations		(737,309		)	(1,111,509		)
Net cash provided by discontinued operations		435,928			765,542
Net cash used for operating activities		(301,381		)	(345,967		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(3,074		)	(2,872		)
Deposits		—			(300		)
Net cash used for continuing operations		(3,074		)	(3,172		)
Net cash used for discontinued operations		—			(1,899		)
Net cash used for investing activities		(3,074		)	(5,071		)
CASH FLOW FROM FINANCING ACTIVITIES:
Dividends		—			(37,207		)
Net cash used for continuing operations		—			(37,207		)
Net cash used for financing activities		—			(37,207		)
NET DECREASE IN CASH AND CASH EQUIVALENTS		(304,455		)	(388,245		)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		792,426			1,712,912
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	487,971		$	1,324,667

 

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

 

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

 

		Three Months Ended March 31,
		2010			2009
Cash paid for:
Interest		$	—		$	22,793
Noncash Investing and Financing Activities:
Issuance of common stock in exchange for Series A, B and C preferred stock and cumulative dividends in arrears, thereon		—			149,566

 

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

 

March 31, 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 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 March 31, 2010, we had an accumulated deficit of approximately $49 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues. If the Company is unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained by the Company in order to meet its needs, or that such financing would not be dilutive to existing shareholders.

 

The accompanying 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

 

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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 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 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 period ended March 31, 2010, the Company recorded income of approximately $483,000 from a contract delivered under our arrangement with Buyer which was reduced by expenses for professional fees, resulting in net income from discontinued operations of approximately $435,000.  The Company does not expect any additional income from discontinued operations in the future.  The Company and Buyer have agreed to extend the period that Buyer can assert potential post closing purchase price adjustments to May 31, 2010.

 

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

 

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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 operating loss by $11,490 and $49,590 with no effect per share (basic and diluted) for the three months ended March 31, 2010 and 2009, 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,
		2010			2009
Cost of services		$	—		$	—
Selling, general and administrative		5,348			40,577
Research, development and engineering		6,142			9,013
		$	11,490		$	49,590

 

Valuation Assumptions for Stock Options

 

For the three months ended March 31, 2010 and 2009, 410,000 and 775,000 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 March 31,
		2010		2009
Risk free interest rate		2.36	%	1.83	%
Expected life of options (in years)		4.25		2.5-3.5
Expected dividends		0	%	0	%
Volatility of stock price		115	%	87.41	%

 

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, a total of 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 vested 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.

 

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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, a total of 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 nonstatutory stock options granted could not exceed ten years. Options issued under the 1999 Plan vested 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, a total of 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 in the 2004 Plan, 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 a change in control, as defined in the relevant agreements with the receipients, 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, 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		—		—		410,000		—		410,000		0.45
Exercised		—		—		—		—		—		—
Forfeited		—		—		—		—		—		—
Expired		—		—		(2,500	)	—		(2,500	)	0.67
Outstanding, as of March 31, 2010		45,000		500,000		2,480,689		1,329,841		4,355,530		$	0.26		4.34		$	151,676
Vested or expected to vest at March 31, 2010										4,153,717		$	0.25		4.24		$	146,337
Exercisable at March 31, 2010										3,559,362		$	0.26		3.96		$	119,560

 

The options outstanding and exercisable at March 31, 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		1,596,272		$	0.11		5.41		1,210,104		$	0.11
	0.22-0.40		2,299,258		0.30			3.32		2,229,258		0.30
	0.41-0.68		385,000		0.46			0.30		45,000		0.47
	0.69-0.94		75,000		0.94			1.59		75,000		0.94
$	0.07-0.94		4,355,530							3,559,362

 

The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Company’s closing stock price of $0.20 as of March 31, 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 March 31, 2010 was 1,185,771.

 

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The weighted average fair value of options granted during the three months ended March 31, 2010 and 2009 was $0.162 and $0.056 per share, respectively.  The total fair value of shares vested during the three months ended March 31, 2010 and 2009 was $8,030 and $81,534, respectively.

 

As of March 31, 2010, future compensation cost related to nonvested stock options is approximately $83,413 and will be recognized over an estimated weighted average period of approximately 1.48 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.

 

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 periods ended March 31:

 

		Three Months ended March 31,
		2010			2009
Basic Numerator:
Net income (loss) from continuing operations		$	565,240		$	(789,813	)
Convertible preferred stock dividends and accretion		(158,735		)	(361,618		)
Loss available to common stockholders		$	406,505		$	(1,151,431	)
Basic Denominator:		77,713,398			68,477,547
Per Share Amount		$	0.005		$	(0.02	)

 

The following table summarizes the potential weighted average shares of common stock that were included in the diluted per share calculation for three months ended March 31, 2010 and excluded from the three months ended March 31, 2009 because the effect of including these potential shares was antidilutive.

 

		Three Months Ended March 31,
		2010		2009
Preferred Stock		10,185,667		33,155,440
Convertible Debt		2,459,857		—
Stock Options		848,570		—
Warrants		—		—
Potentially dilutive securities		13,494,094		33,155,440

 

		Three Months ended March 31,
		2010			2009
Dilutive Numerator:
Net income (loss) from continuing operations		$	565,240		$	(789,813	)
Convertible preferred stock dividends and accretion		(158,735		)	(361,618		)
Convertible debt interest recognized		162,588			—
Reversed derivative change in fair market value		(698,884		)	—
Loss available to common stockholders		$	(129,791	)	$	(1,151,431	)
Dilutive Denominator:		91,207,492			68,477,547
Per Share Amount		$	0.00		$	(0.02	)

 

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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,
		2010		2009
Stock options		2,759,258		7,353,933
Warrants		16,775,791		6,136,899
Total		19,535,049		13,490,832

 

6.                                       NOTE RECEIVABLE

 

Notes receivable consisted of the following:

 

		March 31,			December 31,
		2010			2009
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 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 of the Law Enforcement division that were sold  to Buyer.

 

7.                                       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

Equipment and leasehold improvements consisted of the following:

 

		March 31,			December 31,
		2010			2009
Equipment		$	239,022		$	235,948
Furniture and fixtures		99,199			99,199
Software		28,624			28,624
Leasehold improvements		39,975			39,975
		406,820			403,746
Less accumulated depreciation and amortization		(372,465		)	(364,503		)
Total		$	34,355		$	39,243

 

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8.                                       OTHER INTANGIBLE ASSETS

 

Other intangible assets consisted of the following:

 

		March 31, 2010									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			(59,968		)	227,280			287,248			(56,989		)	230,259
Total		$	287,248		$	(59,968	)	$	227,280		$	287,248		$	(56,989	)	$	230,259

 

Aggregate amortization expense for the three months ended March 31, 2010 and 2009, was $2,979 and $2,796 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 is in the process of assigning its obligations under the lease to Buyer. Accordingly, the balance is recorded as the current asset, “Restricted cash” as at March 31, 2010.

 

10.                                 NOTES PAYABLE, CONVERTIBLE DEBT FINANCING / WARRANTS

 

Convertible Promissory Notes

 

Convertible note financing and warrants consisted of the following:

 

		March 31,			December 31,
		2010			2009
Current Portion
2005
FMV of warrants		$	2,604		$	47,773
2006
FMV of warrants		21,244			—
2009
Convertible promissory notes		737,957			737,957
Discount		(496,550		)	(659,138		)
FMV of embedded derivatives		116,395			344,891
Total		$	381,650		$	471,483
Long-Term Portion
2006
FMV of warrants		—			63,901
Total		$	—		$	63,901

 

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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:

 

		March 31,		December 31,
		2010		2009
Dividend Yield		0	%	0	%
Annual volatility		67-96	%	107-156	%
Risk-free interest rate		0.16-0.34	%	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 notes are valued using the Binomial Option model with the following assumptions:

 

		March 31,		December 31,
		2010		2009
Dividend Yield		0	%	0	%
Annual volatility		93	%	148	%
Risk-free interest rate		0.33	%	0.47	%

 

11.                               ACCRUED LIABILITIES

 

Accrued liabilities consisted of the following:

 

		March 31,			December 31,
		2010			2009
Compensation		$	75,845		$	92,860
Compensated absences		154,776			143,387
Royalties		58,905			—
Dividends Payable		128,644			128,644
Tax payable		5,000			188,000
Other		126,471			155,874
Total		$	549,641		$	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

 

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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 March 31, 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 $55,257, 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 March 31, 2010, these embedded derivatives were valued at $93,211.

 

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 March 31, 2010, the unamortized discount on the Series D Preferred Stock was $321,629.

 

13.                               STOCKHOLDERS EQUITY

 

Common Stock

 

The Company is authorized to issue 170,000,000 shares of common stock, $.0001 par value per share, of which 77,713,398 shares were outstanding as of March 31, 2010.

 

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 therefore. 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.

 

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, 2009		16,775,791		$	0.33		4.09
Granted		—		—
Exercised		—		—
Expired		—		—
Outstanding at March 31, 2010		16,775,791		0.33			3.84		$	—
Vested or expected to vest at March 31, 2010		16,775,791		0.33			3.84		—
Exercisable at March 31, 2010		16,775,791		0.33			3.84		—

 

The warrants outstanding and exercisable at March 31, 2010 were in the following exercise price ranges:

 

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				Warrants outstanding and Exercisable
Range of exercise prices				Number of warrants		Weighted average remaining life (in years)
	$	0.30		15,798,014		4.03
		0.75		533,333		1.36
		1.00		444,444		0.19
				16,775,791

 

14.                               COMPREHENSIVE INCOME/(LOSS)

 

Comprehensive income (loss) consists of net income (loss) and other gains and losses affecting shareholders’ equity (deficit) that, under generally accepted accounting principles, are excluded from net income (loss) in accordance with ASC 220. The Company, however, does not have any components of other comprehensive income (loss) as defined by ASC 220 and therefore, for the three months ended March 31, 2010 and 2009, comprehensive income (loss) is equivalent to the Company’s reported net income (loss). Accordingly, a separate statement of comprehensive income (loss) is not presented.

 

15.                               SEGMENT INFORMATION

 

The Company has determined that its continuing operations are one discrete segment consisting of Biometric products. Prior to the sale of the Law Enforcement division in December 2009, that division had been reported as a separate segment. Geographically, North American sales accounted for approximately 96% and 98% of the Company’s total sales for the three months ended March 31, 2010 and 2009, respectively.

 

16.                               INCOME TAXES

 

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.

 

The Company has reduced its deferred tax assets and the associated valuation allowance for gross unrecognized tax affected benefits by approximately $4,100,000. 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 2007-2009 remain open to examination by the IRS and state jurisdictions. The Company believes it is not subject to any tax risk beyond the preceding discussion. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. The Company does not have any accrued interest or penalty associated with any unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2010 and 2009.

 

For the three months ended March 31, 2010, $5,000 has been accrued for state and federal tax liabilities.

 

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