IMAGEWARE SYSTEMS INC - Annual Report: 2010 (Form 10-K)

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Washington, D.C. 20549

o	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Delaware		33-0224167
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
10815 Rancho Bernardo Road, Suite 310, San Diego, CA		92127
(Address of principal executive offices)		(Zip Code)

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes o No o

Large accelerated filer	o	Accelerated filer	o
Non-accelerated filer (Do not check if smaller reporting company)	o	Smaller Reporting Company	x

			Page
PART I
Item 1.		Business	3
Item 1A.		Risk Factors	16
Item 1B.		Unresolved Staff Comments	23
Item 2.		Properties	23
Item 3.		Legal Proceedings	23
Item 4.		Submission of Matters to a Vote of Security Holders	23
PART II
Item 5.		Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	24
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 7A.		Quantitative and Qualitative Disclosures About Market Risk	63
Item 8.		Financial Statements and Supplementary Data	63
Item 9.		Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	63
Item 9A.		Controls and Procedures	63
Item 9B.		Other Information	64
PART III
Item 10.		Directors, Executive Officers and Corporate Governance	65
Item 11.		Executive Compensation	69
Item 12.		Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	75
Item 13.		Certain Relationships and Related Transactions, and Director Independence	78
Item 14.		Principal Accountant Fees and Services	79
PART IV
Item 15.		Exhibits and Financial Statement Schedules	80
SIGNATURES			84
EXHIBIT INDEX			F-43

 

●

Unaudited consolidated financial information for each of the quarters of fiscal years 2010 and 2009, not including balance sheets, cash flow statements and separate financial statement footnotes; and

●

Management’s discussion and analysis of our operating results for each of the first, second and third interim periods in the years 2010 and 2009.

 As described in our Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on August 16, 2010, management determined that our financial statements for the three and six months ended March 31 and June 30, 2009, respectively, which were included in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009 and June 30, 2009, should no longer be relied upon due to an error in such financial statements with respect to the accounting for certain derivative features of our Series C and D Preferred Stock (the “Preferred Shares”) and certain warrants (the “Warrants”) which were previously recorded as equity instruments in accordance with generally accepted accounting principles in effect through December 31, 2008.

	●	a derivative liability has been recorded as of January 1, 2009 through a charge to Accumulated Deficit for the effect of the cumulative adjustment of the fair value of the derivatives as of that date;
	●	the fair value of derivatives as of March 31, 2009 has been amended to reflect a non-cash charge to expense; and

●

the fair value of derivatives as of June 30, 2009 has been amended to record a non-cash charge to expense.

ITEM 1.

BUSINESS

Our law enforcement solutions enable agencies to quickly capture, archive, search, retrieve, and share digital images, fingerprints and other biometrics as well as criminal history records on a stand-alone, networked, wireless or Web-based platform. We develop, sell and support a suite of modular software products used by law enforcement and public safety agencies to create and manage criminal history records and to investigate crime. Our IWS Law Enforcement solution consists of five software modules: Capture and Investigative modules, which provide a criminal booking system with related databases as well as the ability to create and print mug photo/SMT image lineups and electronic mugbooks; a Facial Recognition module, which uses biometric facial recognition to identify suspects; a Web module, which provides access to centrally stored records over the Internet in a connected or wireless fashion; and a LiveScan module, which incorporates LiveScan capabilities into IWS Law Enforcement providing integrated fingerprint and palm print biometric management for civil and law enforcement use.  The IWS Biometric Engine is also available to our law enforcement clients and allows them to capture and search using other biometrics such as iris or DNA.

We believe the biometric identity management market will continue to grow as the role of biometrics becomes more widely adopted for enhancing security and complying with government regulations and initiatives and as biometric capture devices become increasingly mobile, robust and cost effective. Our biometric and secure credentialing solutions are meeting the requirements and standards for true multi-modal biometric identity management systems, as well as providing scalability to support evolving functionality.

Our identity management solutions are primarily focused around biometrics and secure credentials providing complete, cross-functional and interoperable systems. Our biometric and secure credentialing products provide complete and interoperable solutions with features and functions required throughout the entire identity management life cycle, enabling users the flexibility to make use of any desired options, such as identity proofing and enrollment, card issuance, maintenance and access control. Our solutions offer a significant benefit that one vendor’s solution is used throughout the various stages, from establishing an applicant’s verified identity, to issuance of smart card based credentials, to the usage and integration to physical and logical access control systems.

	●	HSPD-12 Personal Identity Verification (PIV)
	●	Border Management
	●	ePassport & eVisa
	●	Applicant Identity Vetting
	●	Mobile Acquisition
	●	Physical Access Control
	●	Single-Sign-On and Logical Access Control

 

●

Support for multiple authentication tools including Public Key Infrastructure (PKI) within a uniformed platform and privilege Management Infrastructure (PMI) technology to provide more advanced access control services and assure authentication and data integrity;

●

Integration with IWS Biometric Engine for searching and match capabilities (1:1, 1:N and X:N);

●

Integration with IWS EPI Builder for the production and management of secure credentials;

●

Support for both BioAPI and BAPI standards;

●

Supports a single sign-on feature that securely manages Internet Explorer and Windows application ID and password information;

●

Supports file and folder encryption features; and

●

Supports various operating systems, including Microsoft Windows 2000, Windows XP, and Windows Server 2003.

 

●

Biometric enrollment and identity proofing with Smart Card encoding of biometrics;

●

Flexible models of central or distributed issuance of credentials;

●

Customizable card life-cycle workflow managed by the CMS; and

●

Integration of the CMS data with other enterprise solutions, such as physical access control and logical access control (i.e. Single-Sign-On – SSO).

IWS PIV Encoder.  PIV smart cards must be programmed with specific mandatory data, digital signatures and programs in order to maintain the interoperability as well as the security features specified for the cards. The IWS PIV Encoder could be considered to be a complex device driver that properly programs the PIV smart cards.  The Encoder interacts with the Card Management System for data payload elements. It interacts with the Certificate Authority to encrypt or sign the PIV smart card data with trusted certificates. Finally, it acts as the application-level device driver to make the specific PIV smart card encoding system properly program the smart card, regardless if the system is a standalone encoding system or one integrated into a card printer.

Investigative.  This software module allows users to search the database created with IWS Law Enforcement. Officers can conduct text searches in many fields, including file number, name, alias, distinctive features, and other information such as gang membership and criminal history. The Investigative module creates a catalogue of possible matches, allowing officers or witnesses to save time by looking only at mug shots that closely resemble the description of the suspect. This module can also be used to create a line-up of similar facial images from which a witness may identify the suspect.

Our strategy is to provide patented open-architected identity management solutions including multi-biometric, secure credential and law enforcement technologies that are stand alone, integrated and/or bundled with key partners including channel relationships and large systems integrators such as, United Technology Security, SAIC, GCR, Unisys, HP, IBM and Safran, among others. Key elements of our strategy for growth include the following:

With the advent of cloud based computing, the proliferation of mobile devices which allow for mobile transactions across wide geographical areas, the emergence of inexpensive and reliable biometric capture devices and the need to secure access to data, product and services, the Company believes that the market for multi-biometric solutions will expand to encompass significant deployments of biometric systems in the commercial and consumer markets.  The Company therefore intends to leverage the strength of its existing government clients who have deployed the Company’s products for large populations, as well as its foundational patent portfolio in the field of multi-modal biometrics and the fusion of multiple biometric algorithms, to address the commercial and consumer market. As part of its marketing plan, the Company will offer new versions of its product suite on a Software as a Service (“SaaS”) model during 2012.  This new business model, which is intended to supplement the Company’s existing business model, will allow new commercial and consumer clients to verify identity in order to access data, products or services from mobile and desktop devices.

 
 

We have a wide variety of domestic and international customers. Most of our IWS Law Enforcement customers are government agencies at the federal, state and local levels in the United States. Our secure credential  products are also being used in Australia, Canada, the United Arab Emirates, Kuwait, Mexico, Colombia, Costa Rica, Venezuela, Singapore, Indonesia and the Philippines. In 2009, two customers accounted for approximately 23%, or $1,412,000 of our revenues.  In 2010, one customer accounted for approximately 31%, or $1,803,000 of our revenues.

●

the unique ability to integrate our modular products into a complete biometric, LiveScan, imaging and investigative system;

●

our reputation as a reliable systems supplier;

●

the usability and functionality of our products; and

●

the responsiveness, availability and reliability of our customer support.

●

our strong brand reputation with a customer base which includes small and medium-sized businesses, Fortune 500 corporations and large government agencies;

●

the ease of integrating our technology into other complex applications; and

●

the leveraged strength that comes from offering customers software tools, packaged solutions and Web-based service applications that support a wide range of hardware peripherals.

●

our ability to provide a system which enables the enrollment, management and authentication of multiple biometrics managing population databases of unlimited sizes;

●

searches can be 1:1 (verification), 1:N (identification) and X:N (investigative); and N:N (database integrity);

	●	the system is technology and biometric agnostic, enabling the use of biometric devices and algorithms from any vendor, and the support of the following biometric types: finger, face, iris, hand geometry, palm, DNA, signature, voice, and 3D face and retina; and
	●	we hold five patents covering our core multi-modal biometric and fusion  technology, which we believe will give us a competitive advantage over our direct competitors who have little or no patent protection.

 

 

ITEM 1A.

RISK FACTORS

·	varying demand for and market acceptance of our technology and products;

·	changes in our product or customer mix;

·	the gain or loss of one or more key customers or their key customers, or significant changes in the financial condition of one or more of our key customers or their key customers;

·	our ability to introduce, certify and deliver new products and technologies on a timely basis;

·	the announcement or introduction of products and technologies by our competitors;

·	competitive pressures on selling prices;

·	costs associated with acquisitions and the integration of acquired companies, products and technologies;

·	our ability to successfully integrate acquired companies, products and technologies;

·	our accounting and legal expenses; and

·	general economic conditions.

 

 

We occasionally rely on systems integrators to manage our large projects, and if these companies do not perform adequately, we may lose business.

 

·	increase the cost of our products;

·	be expensive and time consuming to defend;

·	result in us being required to pay significant damages to third parties;

·	force us to cease making or selling products that incorporate the challenged intellectual property;

·	require us to redesign, reengineer or rebrand our products;

·	require us to enter into royalty or licensing agreements in order to obtain the right to use a third party’s intellectual property, the terms of which may not be acceptable to us;

·	require us to indemnify third parties pursuant to contracts in which we have agreed to provide indemnification to such parties for intellectual property infringement claims;

·	divert the attention of our management; and

·	result in our customers or potential customers deferring or limiting their purchase or use of the affected products until the litigation is resolved.

Our success will depend to a significant extent upon the efforts and abilities of our executive officers and other key personnel. The loss of the services of one or more of these key employees and any negative market or industry perception arising from the loss of such services could have a material adverse effect on us and the trading price of our common stock.  Our business will also be dependent upon our ability to attract and retain qualified personnel. Acquiring and keeping these personnel could prove more difficult or cost substantially more than estimated and we cannot be certain that we will be able to retain such personnel or attract a high caliber of personnel in the future.

Our Board of Directors (“Board”) has the authority to issue a total of up to four million shares of preferred stock and to fix the rights, preferences, privileges, and restrictions, including voting rights, of the preferred stock, which typically are senior to the rights of the common stockholders, without any further vote or action by the common stockholders. The rights of our common stockholders will be subject to, and may be adversely affected by, the rights of the holders of the preferred stock that have been issued, or might be issued in the future. Preferred stock also could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. This could delay, defer, or prevent a change in control. Furthermore, holders of preferred stock may have other rights, including economic rights, senior to the common stock. As a result, their existence and issuance could have a material adverse effect on the market value of the common stock. We have in the past issued and may from time to time in the future issue, preferred stock for financing or other purposes with rights, preferences, or privileges senior to the common stock. As of December 31, 2010, we had three series of preferred stock outstanding, Series B Preferred Stock (“Series B Preferred”), Series C 8% Convertible Preferred Stock (“Series C Preferred”) and Series D 8% Convertible Preferred Stock (“Series D Preferred”).   As a result of the consummation of the Qualified Financing, on December 20, 2011, our Series C Preferred and Series D Preferred automatically converted into shares of our common stock.

●

changes in stock market analyst recommendations or earnings estimates regarding our common stock, other comparable companies or our industry generally.

 

ITEM IB.

UNRESOLVED STAFF COMMENTS

 

ITEM 2.

PROPERTIES

ITEM 3.

LEGAL PROCEEDINGS

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

ITEM  5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

2010 Fiscal Quarters		High				Low
First Quarter		$	0.99			$	0.73
Second Quarter		$	0.92			$	0.46
Third Quarter		$	0.60			$	0.27
Fourth Quarter		$	0.98			$	0.30

2009 Fiscal Quarters		High				Low
First Quarter		$	0.30			$	0.14
Second Quarter		$	0.69			$	0.20
Third Quarter		$	0.95			$	0.45
Fourth Quarter		$	0.88			$	0.60

We did not repurchase any shares of our common stock during fiscal 2010 or 2009.

 

ITEM  7.

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

Our law enforcement solutions enable agencies to quickly capture, archive, search, retrieve, and share digital images, fingerprints and other biometrics as well as criminal history records on a stand-alone, networked, wireless or Web-based platform. We develop, sell and support a suite of modular software products used by law enforcement and public safety agencies to create and manage criminal history records and to investigate crime. Our IWS Law Enforcement solution consists of five software modules: Capture and Investigative modules, which provide a criminal booking system with related databases as well as the ability to create and print mug photo/SMT image lineups and electronic mugbooks; a Facial Recognition module, which uses biometric facial recognition to identify suspects; a Web module, which provides access to centrally stored records over the Internet in a connected or wireless fashion; and a LiveScan module, which incorporates LiveScan capabilities into IWS Law Enforcement providing integrated fingerprint and palm print biometric management for civil and law enforcement use.  The IWS Biometric Engine is also available to our law enforcement clients and allows them to capture and search using other biometrics such as iris or DNA.

 

Valuation of Goodwill, Other Intangible and Long-Lived Assets.  The Company accounts for its intangible assets under the provisions of ASC 350, “Intangibles - Goodwill and Other”. In accordance with ASC 350, intangible assets with a definite life are analyzed for impairment under ASC 360-10-05 and intangible assets with an indefinite life are analyzed for impairment under ASC 360. In accordance with ASC 350, goodwill, or the excess of cost over fair value of net assets acquired, is no longer amortized but is tested for impairment using a fair value approach at the “reporting unit” level. A reporting unit is the operating segment, or a business one level below that operating segment (referred to as a component) if discrete financial information is prepared and regularly reviewed by management at the component level. The Company’s reporting unit is at the entity level. The Company recognizes an impairment charge for any amount by which the carrying amount of a reporting unit’s goodwill exceeds its fair value. The Company uses fair value methodologies to establish fair values.

 

 

 

Level 1

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2

Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.

Level 3

Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).

 

 

 

 

 

Product Revenues.

 

		Years Ended December 31,
Net Product Revenues		2010				2009				$ Change			% Change
(dollars in thousands)
Software and royalties		$	1,882			$	2,307			$	(425)		(18)	%
Percentage of total net product revenue			59	%			67	%
Hardware and consumables		$	381			$	230			$	151		66	%
Percentage of total net product revenue			12	%			7	%
Services		$	929			$	893			$	36		4	%
Percentage of total net product revenue			29	%			26	%
Total net product revenues		$	3,192			$	3,430			$	(238)		(7)	%

 

 

 

		Years Ended December 31,
Net Maintenance Revenues		2010				2009				$ Change				% Change
(dollars in thousands)
Maintenance Revenues		$	2,619			$	2,599			$	20				1	%

 

 

 

 

		Years Ended December 31,
Cost of Product Revenues		2010				2009				$ Change				% Change
(dollars in thousands)
Software and royalties		$	266			$	310			$	(44)				(14)	%
Percentage of software and royalty product revenue			14	%			13	%
Hardware and consumables		$	289			$	228			$	61				27	%
Percentage of hardware and consumables product revenue			76	%			99	%
Services		$	504			$	627			$	(123)				(20)	%
Percentage of services product revenue			54	%			70	%
Total cost of product revenues		$	1,059			$	1,165			$	(106)				(9)	%
Percentage of total product revenues			33	%			34	%

		Years Ended December 31,
Cost of Maintenance Revenues		2010				2009				$ Change				% Change
(dollars in thousands)
Total maintenance cost of revenues		$	938			$	814			$	124				15	%
Percentage of total maintenance revenues			36	%			31	%

 

		Years Ended December 31,
Product Gross Profit		2010				2009				$ Change				% Change
(dollars in thousands)
Software and royalties		$	1,616			$	1,997			$	(381)				(19)	%
Percentage of software and royalty product revenue			86	%			87	%
Hardware and consumables		$	92			$	2			$	90				4,500	%
Percentage of hardware and consumables product revenue			24	%			1	%
Services		$	425			$	266			$	159				60	%
Percentage of services product revenue			46	%			30	%
Total product gross profit		$	2,133			$	2,265			$	(132)				(6)	%
Percentage of total product revenues			67	%			66	%

		Years Ended December 31,
Maintenance Gross Profit		2010				2009				$ Change				% Change
(dollars in thousands)
Total maintenance gross profit		$	1,681			$	1,785			$	(104)				(6)	%
Percentage of total maintenance revenues			64	%			69	%

Gross margins related to maintenance revenues decreased despite higher maintenance revenues of approximately $20,000 due to higher maintenance cost of revenues of approximately $124,000.  This increase in costs is due primarily to higher labor costs incurred to perform maintenance requirements on completed large-scale identity management projects.

		Years Ended December 31,
Operating Expenses		2010				2009				$ Change				% Change
(dollars in thousands)
General and administrative		$	2,546			$	2,433			$	113				5	%
Percentage of total net revenue			44	%			40	%
Sales and marketing		$	1,528			$	1,705			$	(177)				(10)	%
Percentage of total net revenue			26	%			28	%
Research and development		$	2,531			$	2,367			$	164				7	%
Percentage of total net revenue			44	%			39	%
Depreciation and amortization		$	50			$	98			$	(48)				(49)	%
Percentage of total net revenue			1	%			2	%

·	Increase in stock-based compensation expense of approximately $14,000 due to an increase in the issuance of stock options and restricted stock grants in 2010.

·	Increase in professional services of approximately $317,000.

·	Decrease in occupancy and insurance related expenses of approximately $61,000.

·	Decrease in compensation and related fringe benefits of approximately $197,000 due to lower headcounts and the implementation of mandatory furlough days to reduce costs.

·	Increase in licenses, dues, miscellaneous financing charges and travel of approximately $40,000.

·

Decrease in salaries and personnel costs of approximately $48,000 due to reductions in headcount and the implementation of mandatory furlough days to reduce costs.

·

Decrease in professional services of approximately $157,000.

 

 

 

 

 

·	Coupon interest on secured notes payable and convertible notes payable of approximately $370,000.

 

·	Accretion of note discount and debt issuance costs to interest expense of approximately $674,000.

 

·	Other interest expense of approximately $79,000.

 

 

·	Coupon interest on secured notes payable and convertible notes payable of approximately $115,000.

 

·	Accretion of note discount and debt issuance costs to interest expense of approximately $363,000.

 

·	Amortization of deferred financing fees to interest expense of approximately $26,000.

 

·	Interest expense of approximately $175,000 related to liquidated damages accrued pursuant to a registration payment arrangement.

 

·	Fair value of warrants issued to related party convertible note holders in consideration for wavier of default of approximately $51,000.

 

·	Other interest expense of approximately $12,000

 

 

 

During the first three quarters of fiscal 2011, we were faced with limited funds for operations. As a result, we took measures to reduce our operating costs. As a result of the consummation of the Qualified Financing in December 2011 we believe that our current cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months from the date of the filing of this Annual Report and that we will have sufficient liquidity to fund our business and meet our contractual obligations over a period beyond the next 12 months. However, we may be required to obtain additional financing in order to fund our continued operations. Due to the tightening of the credit markets, general economic conditions, our SEC filing delinquencies and other economic and business factors, this financing may not be available to us on acceptable terms or at all. Although we cannot accurately anticipate the effect of inflation or foreign exchange markets on our operations, we do not believe these external economic forces have had, or are likely in the foreseeable future to have, a material impact on our results of operations.

 

		Quarter Ended
		March 31				June 30				Sept. 30				March 31				June 30				Sept. 30
		2009				2009				2009				2010				2010				2010
Revenues:
Product		$	675			$	999			$	241			$	1,360			$	511			$	769
Maintenance			638				646				659				668				640				653
			1,313				1,645				900				2,028				1,151				1,422
Cost of revenues:
Product			284				317				167				528				144				249
Maintenance			209				199				201				247				254				198
Gross profit			820				1,129				532				1,253				753				975
Operating expenses:
General and administrative			609				595				555				697				680				512
Sales and marketing			429				451				376				392				381				385
Research and development			587				553				582				697				666				576
Depreciation and amortization			33				30				19				14				12				13
			1,658				1,629				1,532				1,800				1,739				1,486
Loss from operations			(838	)			(500	)			(1,000	)			(547	)			(986	)			(511	)
Interest expense, net			102				180				212				242				334				60
Change in fair value of financing obligation			152				450				438				229				(744	)			(38	)
Change in fair value of derivative liabilities			(748	)			5,179				756				477				(4,154	)			(506	)
Loss on debt modification			-				750				-				-				-				1,100
Financing expense			-				-				1,371				-				-				-
Other income, net			(11	)			(11	)			(124	)			(17	)			(284	)			(12	)
Income (loss) from operations before income taxes			(333	)			(7,048	)			(3,653	)			(1,478	)			3,862				(1,115	)
Income tax expense			-				-				-				-				197				2
Income (loss) from operations			(333	)			(7,048	)			(3,653	)			(1,478	)			3,665				(1,117	)
Net income (loss)		$	(333	)		$	(7,048	)		$	(3,653	)		$	(1,478	)		$	3,665			$	(1,117	)
Preferred dividends			(99	)			(100	)			(101	)			(99				(98	)			(99	)
Net income (loss) available to common shareholders		$	(432	)		$	(7,148	)		$	(3,754	)		$	(1,577	)		$	3,567			$	(1,216	)
Basic and diluted income (loss) per common share - see note 2
Income (loss) from operations		$	(0.02	)		$	(0.39	)		$	(0.18	)		$	(0.07	)		$	0.16			$	(0.05	)
Preferred dividends			-				(0.01	)			(0.01	)			-				-				-
Basic and diluted income (loss) per common shareavailable to common shareholders		$	(0.02	)		$	(0.40	)		$	(0.19	)		$	(0.07	)		$	0.16	(1)		$	(0.05	)