IMAGEWARE SYSTEMS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those items discussed under "Risk Factors" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2011, and in Item 1A of Part II of this Quarterly Report on Form 10-Q.

The following discussion of the financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements included elsewhere within this Quarterly Report. Fluctuations in annual and quarterly results may occur as a result of factors affecting demand for our products such as the timing of new product introductions by us and by our competitors and our customers' political and budgetary constraints. Due to such fluctuations, historical results and percentage relationships are not necessarily indicative of the operating results for any future period.

Overview ImageWare Systems, Inc. (the "Company"), a Delaware corporation, is a pioneer and leader in the emerging market for biometrically enabled software-based identity management solutions. Using those human characteristics that are unique to us all, the Company creates software that provides a highly reliable indication of a person's identity, including the Company's "flagship" product- the patented IWS Biometric Engine®. Our products are used to manage and issue secure credentials including national IDs, passports, driver's licenses and access control credentials. Our products also provide law enforcement with integrated mug shot, LiveScan fingerprint and investigative capabilities. We also provide comprehensive authentication security software using biometrics to secure physical and logistical access to facilities, computer networks and Internet sites. Biometric technology is now an integral part of all markets we address, and all of our products are integrated into the IWS Biometric Engine.

Recent Developments On August 20, 2012, the Company and Fujitsu Frontech North America Inc.

("Fujitsu") executed an original equipment manufacturer, or OEM, licensing agreement. Subsequently, on September 6, 2012, the Company received certification to run its patented Biometric Engine® across Fujitsu's NuVola Private Cloud Platform. Utilization of the NuVola Cloud Platform will allow the Biometric Engine to rapidly and securely deploy biometric security information to users.

Critical Accounting Policies and Estimates The discussion and analysis of our condensed consolidated financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these consolidated condensed financial statements in accordance with GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company's financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application.

Significant estimates include the allowance for doubtful accounts receivable, calculation of the Company's tax provision, inventory obsolescence reserve, deferred tax asset valuation allowances, accounting for loss contingencies, recoverability of goodwill and acquired intangible assets and amortization periods, assumptions used in the Black-Scholes model to calculate the fair value of share based payments, assumptions used in the application of fair value methodologies to calculate the fair value of derivative liabilities and revenue and cost of revenues recognized under the percentage of completion method.

Actual results could differ from estimates.

Critical accounting policies are those that, in management's view, are most important in the portrayal of our financial condition and results of operations.

Management believes there have been no material changes during the three and nine months ended September 30, 2012 to the critical accounting policies discussed in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2011.

-17--------------------------------------------------------------------------------- Table of Contents Results of Operations This management's discussion and analysis of financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes contained elsewhere in this Quarterly Report.

Comparison of the Three Months Ended September 30, 2012 to the Three Months Ended September 30, 2011.

Product Revenue Three Months Ended September 30, Net Product Revenue 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 224 $ 275 $ (51 ) (19) % Percentage of total net product revenue 87 % 89 % Hardware and consumables $ 12 $ 23 $ (11 ) (48) % Percentage of total net product revenue 5 % 7 % Services $ 21 $ 12 $ 9 75 % Percentage of total net product revenue 8 % 4 % Total net product revenue $ 257 $ 310 $ (53 ) (17) % Software and royalty revenue decreased 19% or approximately $51,000 during the three months ended September 30, 2012 as compared to the corresponding period in 2011. This decrease is due to lower law enforcement project related revenues of approximately $11,000 and lower identification software royalties and license revenue of approximately $55,000. These decreases were offset by an increase in our sales of boxed identity management software through our distribution channel of approximately $8,000 and higher project-oriented revenues of our identification management software sold into project solutions of approximately $7,000.

Revenue from the sale of hardware and consumables decreased 48% or approximately $11,000 during the three months ended September 30, 2012 as compared to the corresponding period in 2011. The decrease resulted from lower revenues from project solutions containing hardware and consumable components.

Services revenue is comprised primarily of software integration services, system installation services and customer training. Such revenue increased 75% or approximately $9,000 during the three months ended September 30, 2012 as compared to the corresponding period in 2011 due primarily to the timing of completion of the service element in certain contracts.

We believe our third quarter product revenue was negatively impacted by the later than expected release of our newest version of the Biometric Engine released in late April 2012, approximately six months later than originally planned. A number of sales initiatives were dependent upon the release of this newest version. Additionally, several significant international projects, forecast to begin in the first and second quarter of 2012, were delayed into 2013. We currently have the new version of our Biometric Engine being evaluated in test installations by four major integrators and two major commercial entities. In August 2012, we signed an OEM Software License Agreement with Fujitsu Frontech North America Inc. and received certification on the Fijitsu's NuVola Private Cloud Platform. We are in ongoing discussions with several additional integrators and commercial entities that have shown an interest in the latest version of the Biometric Engine. We anticipate announcing partnerships and licensing arrangements with one or more of these entities in the next few months.

We believe that the period-to-period fluctuations of identity management software revenue in project-oriented solutions are largely due to the timing of government procurement with respect to the various programs we are pursuing. Based on management's current visibility into the timing of potential government procurements, we believe that we will see a significant increase in government procurement and implementations with respect to identity management initiatives; however, we cannot predict the timing of such initiatives. During the quarter ended September 30, 2012 we accelerated our efforts to move the Biometric Engine into cloud and mobile markets and expanding our end-user market into non-government sectors including commercial, consumer and healthcare applications. Such efforts resulted in the consummation, in August 2012, of an OEM Software License Agreement with Fujitsu Frontech North America Inc. and certification on the Fijitsu's NuVola Private Cloud Platform. We anticipate positive results from these efforts in the next few months, which should help us to begin to smooth out our period-to-period fluctuations in revenue and enable us to provide better visibility into the timing of future revenues.

-18--------------------------------------------------------------------------------- Table of Contents Maintenance Revenue Three Months Ended September 30, Maintenance Revenue 2012 2011 $ Change % Change (dollars in thousands) Maintenance revenue $ 681 $ 750 $ (69 ) (9) % Maintenance revenue was $681,000 for the three months ended September 30, 2012 as compared to $750,000 for the corresponding period in 2011. Identity management maintenance revenue generated from identification software solutions were $220,000 for the three months ended September 30, 2012 as compared to $263,000 during the comparable period in 2011. The decrease of $43,000 is primarily due to the expiration of certain maintenance contracts. Law enforcement maintenance revenue decreased $26,000 for the three months ended September 30, 2012 as compared to the corresponding period in 2011 due to the expiration of certain maintenance contracts.

We anticipate growth of our maintenance revenue through the retention of existing customers combined with the expansion of our installed base resulting from the completion of project-oriented work, however, we cannot predict the timing of this anticipated growth.

Cost of Product Revenue Three Months Ended September 30, Cost of Product Revenue: 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 23 $ 32 $ (9 ) (28) % Percentage of software and royalty product revenue 10 % 12 % Hardware and consumables $ 10 $ 18 $ (8 ) (44) % Percentage of hardware and consumables product revenue 83 % 78 % Services $ 16 $ 15 $ 1 7 % Percentage of services product revenue 76 % 125 % Total product cost of revenue $ 49 $ 65 $ (16 ) (25) % Percentage of total product revenue 19 % 21 % The cost of software and royalty product revenue decreased 28% or approximately $9,000 for the three months ended September 30, 2012 as compared to the corresponding period of 2011. The decrease in software and royalty cost of product revenue of approximately $9,000 is due to lower software product sales. The decrease in the percentage of software and royalty cost of product revenue as a percentage of software and royalty product revenue from 12% for the three months ended September 30, 2011 to 10% for the three months ended September 30, 2012 is due to lower fixed costs. In addition to changes in costs of software and royalty product revenue caused by revenue level fluctuations, costs of products can vary as a percentage of product revenue from period to period depending upon level of software customization and third party software license content included in product sales during a given period.

The decrease in the cost of product revenue for our hardware and consumable sales of $8,000 or 44% for the three months ended September 30, 2012 as compared to the corresponding period in 2011 reflects the decrease in hardware and consumable revenue for the three months ended September 30, 2012 as compared to the corresponding period in 2011 combined with higher costs incurred on hardware and consumable procurements.

Cost of Maintenance Revenue Three Months Ended September 30, Maintenance cost of revenue 2012 2011 $ Change % Change (dollars in thousands) Total maintenance cost of revenue $ 207 $ 227 $ (20 ) (9) % Percentage of total maintenance revenue 30 % 30 % -19--------------------------------------------------------------------------------- Table of Contents Cost of maintenance revenue decreased approximately $20,000 during the three months ended September 30, 2012 from $227,000 for the corresponding period in 2011, due primarily to lower maintenance revenues on certain large-scale identification projects combined with lower costs incurred due to the movement of certain technical support functions from our Canadian office to our San Diego office.

Product Gross Profit Three Months Ended September 30, Product gross profit 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 201 $ 243 $ (42 ) (17) % Percentage of software and royalty product revenue 90 % 88 % Hardware and consumables $ 2 $ 5 $ (3 ) (60) % Percentage of hardware and consumables product revenue 17 % 22 % Services $ 5 $ (3) $ 8 267 % Percentage of services product revenue 24 % (25) % Total product gross profit $ 208 $ 245 $ (37 ) 15 % Percentage of total product revenue 81 % 79 % Software and royalty gross profit decreased 17% or approximately $42,000 for the three months ended September 30, 2012 from the corresponding period in 2011 due primarily to lower software and royalty product revenues of approximately $51,000. Costs of software products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.

Hardware and consumables gross profit decreased 60% or approximately $3,000 for the three month period ended September 30, 2012 as compared to the corresponding period in 2011. This decrease was primarily due to lower hardware and consumables revenue of approximately $11,000 in the three month period ended September 30, 2012 as compared to the corresponding period in the 2011 year.

Services gross profit decreased $8,000 due to lower professional services revenue of approximately $9,000 during the three months ended September 30, 2012 to the corresponding period in 2011.

Maintenance Gross Profit Three Months Ended September 30, Maintenance gross profit 2012 2011 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 474 $ 523 $ (49 ) (9) % Percentage of total maintenance revenue 70 % 70 % Gross profit related to maintenance revenue decreased $49,000 for the three months ended September 30, 2012 as compared to the corresponding period in 2011 due to lower maintenance revenues during this period of approximately $69,000 offset by lower costs of approximately $20,000. The decrease in maintenance revenues is reflective of the expiration of certain maintenance contracts. The decrease in maintenance cost of revenues is reflective of the movement of certain technical support functions to San Diego from Canada.

-20--------------------------------------------------------------------------------- Table of Contents Operating Expense Three Months Ended September 30, Operating expenses 2012 2011 $ Change % Change (dollars in thousands) General & administrative $ 749 $ 617 $ 132 21 % Percentage of total net revenue 80 % 58 % Sales and marketing $ 461 $ 343 $ 118 34 % Percentage of total net revenue 49 % 32 % Research & development $ 798 $ 683 $ 115 17 % Percentage of total net revenue 85 % 64 % Depreciation and amortization $ 17 $ 7 $ 10 143 % Percentage of total net revenue 2 % 1 % General and Administrative Expense General and administrative expense is comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expense. The increase in general and administrative expense, in both dollars and as a percentage of total net revenues, during the three months ended September 30, 2012 as compared to the corresponding period in 2011 is reflective of the curtailment of certain cost cutting measures commencing during the second half of 2010 and continuing through September 30, 2011. The dollar increase of $132,000 is primarily comprised of the following major components: Increase in professional fees $33,000 due primarily to higher patent related expenses.

Increase in travel expense of approximately $30,000.

Increase in stock-based compensation of approximately $36,000.

Increase in rent and office related expenses and other of approximately $33,000.

Sales and Marketing Sales and marketing expense consists primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing, business development and product management functions. The dollar increase of $118,000 during the three months ended September 30, 2012 as compared to the corresponding period in 2011 is primarily comprised of the following major components: Increase in personnel related expense of approximately $43,000.

Increase in stock-based compensation expense of approximately $19,000.

Increase in professional services of approximately $52,000.

Increase in contract services, travel and trade show expenses office related expenses and other of approximately $35,000.

Decrease in our Canadian and Mexico sales offices expenses of approximately $31,000.

Research and Development Research and development expense consists primarily of salaries, employee benefits and outside contractors for new product development, product enhancements, custom integration work and related facility costs. Such expense increased approximately $115,000 for the three months ended September 30, 2012 as compared to the corresponding period in 2011 due primarily to the following major components: Increase in personnel expenditures of approximately $70,000 due to headcount increases combined with increases in contractor and contract services of $13,000.

Increase in rent, office related costs and travel and trade show expenses of approximately $15,000.

Increase in stock-based compensation of approximately $17,000.

-21--------------------------------------------------------------------------------- Table of Contents Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software development as well as continue to enhance existing products.

Depreciation and Amortization During the three months ended September 30, 2012, depreciation and amortization expense increased 143% or $10,000 as compared to the corresponding period in 2011. The relatively small amount of depreciation and amortization is a reflection of our relatively small property and equipment carrying value.

Interest Expense For the three months ended September 30, 2012, we recognized interest income of $1,000 and interest expense of $6,000. For the three months ended September 30, 2011, we recognized interest income of $0 and interest expense of $686,000. Interest expense for the three months ended September 30, 2011 contains the following components: Coupon interest of approximately $93,000 related to our 6% secured convertible notes and 7% convertible notes.

Accretion of note discount and beneficial conversion feature classified as interest expense of approximately $431,000 and $155,000, respectively.

Other interest expense of approximately $7,000.

Change in Fair Value of Derivative Liabilities For the three months ended September 30, 2012, we recognized non-cash expense of $1,378,000 compared to non-cash income of $6,955,000 for the corresponding period of 2011. This non-cash income or expense is related to the change in fair value of the Company's derivative liabilities associated with the anti-dilution provisions in certain warrants to purchase shares of our common stock. The Derivative Liabilities were revalued using available market information and commonly accepted valuation methodologies.

Other Income, Net For the three months ended September 30, 2012, we recognized other income of $17,000 and other expense of $15,000. For the three months ended September 30, 2011, we recognized other income of $10,000 and other expense of $0. Other income for the three months ended September 30, 2012 is comprised of approximately $12,000 from the write-off of certain accounts payable due and the expiration of the legal statute of limitation on such payables combined with $5,000 in miscellaneous other income. Other expense for the three months ended September 30, 2012 related to the write-off of certain deferred financing fees.

Comparison of the Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011.

Product Revenue Nine Months Ended September 30, Net Product Revenue 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 715 $ 1,925 $ (1,210 ) (63) % Percentage of total net product revenue 80 % 81 % Hardware and consumables $ 132 $ 183 $ (51 ) (28) % Percentage of total net product revenue 15 % 8 % Services $ 51 $ 259 $ (208 ) (80) % Percentage of total net product revenue 5 % 11 % Total net product revenue $ 898 $ 2,367 $ (1,469 ) (62) % Software and royalty revenue decreased 63% or $1,210,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011. This decrease is due to lower project-oriented revenues of our identity management software into project solutions of approximately $1,197,000 and lower identification software royalties and license revenues of approximately $51,000, offset by slightly higher sales of boxed identity management software through our distribution channel of approximately $24,000 and slightly higher sales of our law enforcement project related revenues of approximately $14,000.

-22--------------------------------------------------------------------------------- Table of Contents Revenue from the sale of hardware and consumables decreased 28% or $51,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011. The decrease reflects lower revenues from project solutions containing hardware and consumable components.

Services revenue is comprised primarily of software integration services, system installation services and customer training. Such revenues decreased approximately $208,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011 due primarily to lower service revenues being generated from software integration of our biometric engine and Personal Identity Verification ("PIV") products into project solutions combined with a reduction in our installation of hardware products.

We believe our year-to-date product revenue was negatively impacted by the later than expected release of our newest version of the Biometric Engine released in late April 2012, approximately six months later than originally planned. A number of sales initiatives were dependent upon the release of this newest version. Additionally, several significant international projects forecasted to begin in the first and second quarters of 2012 were delayed into 2013. We currently have the new version of our Biometric Engine being evaluated in test installations by four major integrators and two major commercial entities. In August 2012, we signed an OEM Software License Agreement with Fujitsu Frontech North America Inc. and received certification on the Fijitsu's NuVola Private Cloud Platform. We are in ongoing discussions with several additional integrators and commercial entities that have shown an interest in the latest version of the Biometric Engine. We anticipate announcing partnerships and licensing arrangements with one or more of these entities in the next few months.

We believe that the period-to-period fluctuations of identity management software revenue in project-oriented solutions are largely due to the timing of government procurement with respect to the various programs we are pursuing. Based on management's current visibility into the timing of potential government procurements, we believe that we will see a significant increase in government procurement and implementations with respect to identity management initiatives; however we cannot predict the timing of such initiatives. During the quarter ended September 30, 2012 we accelerated our efforts to move the Biometric Engine into cloud and mobile markets and expanding our end-user market into non-government sectors including commercial, consumer and healthcare applications. Such efforts resulted in the consummation, in August 2012, of an OEM Software License Agreement with Fujitsu Frontech North America Inc. and certification on the Fijitsu's NuVola Private Cloud Platform. We anticipate that we will see positive results from these efforts in the next few months which should help smooth out our period-to-period fluctuations in revenue and enable us to provide better visibility into the timing of future revenues.

Maintenance Revenue Nine Months Ended September 30, Maintenance Revenue 2012 2011 $ Change % Change (dollars in thousands) Maintenance revenue $ 2,127 $ 2,113 $ 14 1 % Maintenance revenue for the nine months ended September 30, 2012 increased $14,000 over the corresponding period in the 2011. Identity management maintenance revenues generated from identification software solutions were $679,000 for the nine months ended September 30, 2012 as compared to $635,000 during the comparable period in 2011. The increase of $44,000 is primarily due to the increase in the identity management installed base. Law enforcement maintenance revenues decreased approximately $30,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011 due to the expiration of certain maintenance contracts.

We anticipate growth of our maintenance revenue through the retention of existing customers combined with the expansion of our installed base resulting from the completion of project-oriented work, however we cannot predict the timing of this anticipated growth.

-23--------------------------------------------------------------------------------- Table of Contents Cost of Product Revenue Nine Months Ended September 30, Cost of Product Revenue: 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 88 $ 101 $ (13 ) (13) % Percentage of software and royalty product revenue 12 % 5 % Hardware and consumables $ 62 $ 112 $ (50 ) (45) % Percentage of hardware and consumables product revenue 47 % 61 % Services $ 34 $ 158 $ (124 ) (78) % Percentage of services product revenue 67 % 61 % Total product cost of revenue $ 184 $ 371 $ (187 ) (50) % Percentage of total product revenue 20 % 16 % The cost of software and royalty product revenue decreased 13% or $13,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011. The increase in software and royalty cost of product revenues as a percentage of software and royalty product revenue was primarily driven by higher content of third-party software in project solutions and higher levels of software customization during the nine months ended September 30, 2012 as compared to the corresponding period of 2011.

The decrease in the cost of product revenue for our hardware and consumable sales of $50,000 for the nine months ended September 30, 2012 as compared to the corresponding period in 2011 reflects the decrease in hardware and consumable revenues for the nine months ended September 30, 2012 as compared to the same period in 2011 combined with lower costs incurred on hardware and consumable procurements.

Cost of service revenue decreased 124,000 or 78% during the nine months ended September 30, 2012 as compared to the corresponding period in 2011. The 78% decrease in cost of services product revenue is reasonably similar to the 80% decrease in services revenue.

Cost of Maintenance Revenue Nine Months Ended September 30, Maintenance cost of revenue 2012 2011 $ Change % Change (dollars in thousands) Total maintenance cost of revenue $ 748 $ 674 $ 74 11 % Percentage of total maintenance revenue 35 % 32 % Cost of maintenance revenue increased 11% or $74,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011 due to a combination of higher maintenance revenues of $14,000 combined with higher maintenance costs incurred on certain large-scale identification projects and higher costs incurred during the first half of 2012 due to the movement of certain technical support functions from our Canadian office to our San Diego office.

Product Gross Profit Nine Months Ended September 30, Product gross profit 2012 2011 $ Change % Change (dollars in thousands) Software and royalties $ 627 $ 1,824 $ (1,197 ) (66) % Percentage of software and royalty product revenue 88 % 95 % Hardware and consumables $ 70 $ 71 $ (1 ) (1) % Percentage of hardware and consumables product revenue 53 % 39 % Services $ 17 $ 101 $ (84 ) (83) % Percentage of services product revenue 33 % 39 % Total product gross profit $ 714 $ 1,996 $ (1,282 ) (64) % Percentage of total product revenue 80 % 84 % -24--------------------------------------------------------------------------------- Table of Contents Software and royalty gross profit decreased 66% or $1,197,000 for the nine months ended September 30, 2012 as compared to the corresponding period in 2011 due primarily to a 63% or $1,210,000 decrease in software and royalty revenue.

Hardware and consumables gross profit decreased $1,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011. This decrease reflects lower hardware and consumables revenues of $51,000 and lower cost of hardware and consumables revenues of $50,000 due to lower costs incurred on hardware and consumables procurements in the 2012 period. Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

Services gross profit decreased approximately $84,000 for the nine months ended September 30, 2012 as compared to the corresponding period of 2011 due to lower services revenue of $208,000.

Maintenance Gross Profit Nine Months Ended September 30, Maintenance gross profit 2012 2011 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 1,379 $ 1,439 $ (60 ) (4) % Percentage of total maintenance revenue 65 % 68 % Gross margins related to maintenance revenue decreased to 65% for the nine months ended September 30, 2012 from 68% for the corresponding period in the prior year due to a combination of a $74,000 increase in maintenance costs offset by a $14,000 increase in maintenance revenues. The increase in maintenance cost of revenue is due primarily to a higher maintenance costs incurred on certain large-scale identification projects combined with higher costs incurred in the first half of 2012 due to the movement of certain technical support functions from our Canadian office to our San Diego office.

Operating Expense Nine Months Ended September 30, Operating expense 2012 2011 $ Change % Change (dollars in thousands) General & administrative $ 2,580 $ 1,610 $ 970 60 % Percentage of total net revenue 85 % 36 % Sales and marketing $ 1,277 $ 1,076 $ 201 19 % Percentage of total net revenue 42 % 24 % Research & development $ 2,291 $ 1,995 $ 296 15 % Percentage of total net revenue 76 % 45 % Depreciation and amortization $ 44 $ 21 $ 23 110 % Percentage of total net revenue 1 % 0 % General and Administrative Expense General and administrative expense is comprised primarily of salaries and other employee-related costs for executive, financial and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The dollar increase of $970,000 is comprised of the following major components: Increase in professional fees including consulting services and contract services of approximately $747,000 due primarily to increases in audit related fees of $176,000, increases in legal fees of approximately $136,000, increases in patent expenses of approximately $163,000, increases in investor relations and contract services of approximately $76,000 and increases in contractor fees and corporate expenses of approximately $196,0000.

Increase in personnel related expense of approximately $38,000.

Increase in stock-based compensation expense of approximately $130,000.

Increase in travel, insurances, licenses, dues, rent, and office related costs of approximately $80,000.

Decrease in financing fees of approximately $25,000.

-25--------------------------------------------------------------------------------- Table of Contents Sales and Marketing Sales and marketing expense consists primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing, business development and product management functions. The dollar increase of $201,000 during the nine months ended September 30, 2012 as compared to the corresponding period in 2011 is primarily comprised of the following major components: Increase in personnel related expense of approximately $73,000.

Increase in professional services of approximately $90,000.

Increase in travel and trade show expenses of approximately $58,000.

Increase in stock-based compensation of approximately $31,000.

Increase in rent, office related expenses, contract services and other expenses of approximately $25,000.

Decreases in our Canada and Mexico office expenses of approximately $76,000.

Research and Development Research and development expense consists primarily of salaries, employee benefits and outside contractors for new product development, product enhancements, custom integration work and related facility costs. Such expense increased approximately $296,000 for the nine months ended September 30, 2012 as compared to the corresponding period in 2011 due primarily to the following major components: Increase in personnel expenditures of approximately $214,000 due to headcount increases combined with increases in contractor and contract services of approximately $10,000.

Increase in travel, rent and office related costs of approximately $23,000.

Increase in stock-based compensation of approximately $49,000.

Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software as well as continue to enhance existing products.

Depreciation and Amortization During the nine months ended September 30, 2012, depreciation and amortization expense increased $23,000 as compared to the corresponding period in 2011. The increase in depreciation and amortization expense reflects additions to fixed assets during the nine months ended September 30, 2012, primarily for the replacement of obsolete computer equipment. The Company's amortization expense consists of amortization expense incurred on the Company's EPI trademark and trade name intangible asset of approximately $12,000 and approximately $3,000 related to the amortization of acquired patents.

Interest Expense (Income), Net For the nine months ended September 30, 2012, we recognized interest income of $3,000 and interest expense of $17,000. For the nine months ended September 30, 2011, we recognized interest income of $0 and interest expense of $1,955,000. Interest expense for the nine months ended September 30, 2012 contains the following components: Coupon interest of approximately $4,000 related to our 7% convertible notes.

Other interest expense of approximately $13,000.

Interest expense for the nine months ended September 30, 2011 contains the following components: Coupon interest of approximately $261,000 related to our 6% secured convertible notes and 7% convertible notes.

Accretion of note discount and beneficial conversion feature classified as interest expense of approximately $1,252,000 and $424,000, respectively Other interest expense of approximately $18,000.

-26--------------------------------------------------------------------------------- Table of Contents Change in Fair Value of Derivative Liabilities For the nine months ended September 30, 2012, we recognized a non-cash expense of $6,473,000 compared to a non-cash income of $4,268,000 for the corresponding period of 2011. The 2012 expense is related to the change in fair value of the Company's derivative liabilities associated with the anti-dilution provisions and cash settlement provisions in certain warrants to purchase shares of our common stock. The 2011 expense is related to the change in fair value of the Company's Derivative Liabilities associated with the embedded conversion feature in our Series C and Series D Preferred Stock and the anti-dilution provisions in certain warrants to purchase shares of our common stock. The Derivative Liabilities were revalued using available market information and commonly accepted valuation methodologies.

Other Income, Net For the nine months ended September 30, 2012, we recognized other income of $342,000 and other expense of $15,000. For the nine months ended September 30, 2011, we recognized other income of $19,000 and other expense of $0. Other income for the nine months ended September 30, 2012 is comprised of approximately $328,000 from the write off of certain accounts payable due the expiration of the legal statute of limitations on such accounts payable and $14,000 in miscellaneous other income. Other expense for the nine month ended September 30, 2012 is comprised of approximately $15,000 from the write off of certain deferred financing fees. Other income for the nine months ended September 30, 2011 contains approximately $16,000 in miscellaneous receipts at our German sales office and $3,000 from the negotiated settlement of certain trade accounts payable at amounts less than their carrying value.

LIQUIDITY AND CAPITAL RESOURCES On December 20, 2011, we consummated an equity financing resulting in gross proceeds of $10.0 million ("Qualified Financing"), including the $750,000 of promissory notes converted into the Qualified Financing. In connection with the Qualified Financing, we issued 20,000,000 shares of our common stock (the "Shares"), and warrants to purchase 12,207,500 shares of common stock exercisable for $0.50 per share ("Warrants"), which number includes 2,207,500 shares issuable upon exchange of warrants issued to MDB Capital Group in consideration for acting as placement agent in connection with the Qualified Financing. We also issued 90,000 shares of common stock and a warrant exercisable for 45,000 shares of common stock in lieu of cash in payment for legal fees related to the Qualified Financing. We also issued a warrant to purchase 250,000 shares of the Company's common stock at an exercise price of $0.50, which expires two years from the date of grant, to a significant investor to cover certain expenses related to and in anticipation of the Qualified Financing. The net proceeds from the Qualified Financing were approximately $8,544,000, of which, $1,500,000 was then used to repay certain convertible notes payable. As of September 30, 2012, all debt other than the $65,000 in related party notes payable had been converted to common stock or repaid. Additionally, in connection with the Qualified Financing, (i) the anti-dilution provision contained in certain existing warrants were amended, resulting in such warrants no longer qualifying as derivative liabilities; and (ii) a significant investor ("Investor") exchanged $4.5 million principal amount of convertible promissory notes issued by the Company ("Exchanged Notes") and accrued but unpaid interest on the Exchanged Notes and an additional $2.25 million in promissory notes, into 9,774,559 shares of our common stock ("Exchange Shares"). The Investor also agreed to convert $750,000 principal amount of additional promissory notes held by the Investor and invest the proceeds into the Qualified Financing.

During the three months ended September 30, 2012, the Company issued 7,003,947 shares of common stock pursuant to the exercise of 7,003,947 warrants for cash proceeds of approximately $3,502,000.

At September 30, 2012, our principal sources of liquidity consisted of cash and cash equivalents of $5,316,000 and accounts receivable, net of $1,038,000.

As of September 30, 2012, we had positive working capital of $2,815,000 which included $1,880,000 of deferred revenue. Historically, our principal sources of cash have included customer payments from the sale of our products, proceeds from the issuance of common and preferred stock and proceeds from the issuance of debt. Our principal uses of cash have included cash used in operations, payments relating to purchases of property and equipment and repayments of borrowings. We expect that our principal uses of cash in the future will be for operations, working capital and capital expenditures. We expect that, as our revenues grow, our sales, marketing and research and development expenses will continue to grow and, as a result, we will need to generate significant net revenues to achieve profitability.

Management currently believes that the Company's current cash and cash equivalents will be sufficient to meet working capital and capital expenditure requirements for the next 12 months from the date of the filing of this Quarterly Report. However, in the event results from operations are materially less than forecasted, the Company's current cash and cash equivalents may be insufficient to meet its working capital and capital expenditure requirements.

We may therefore be required to sell equity or debt securities, secure a bank line of credit, or consider strategic alliances to fully execute our business plan. The sale of equity or equity-related securities could result in additional dilution to our shareholders. There can be no assurance that additional financing, in any form, will be available at all or, if available, will be on terms acceptable to us.

-27--------------------------------------------------------------------------------- Table of Contents Operating Activities We used net cash of $4,517,000 in operating activities for the nine months ended September 30, 2012 as compared to net cash used of $968,000 during the comparable period in 2011. During the nine months ended September 30, 2012, net cash used in operating activities consisted of net loss of $10,265,000 and an increase in working capital and other assets and liabilities of $938,000. Those amounts were offset by $6,686,000, net of non-cash costs including a $6,473,000 unrealized loss related to the change in value of our derivative liabilities, $479,000 in stock based compensation and $47,000 in depreciation and amortization, $15,000 in deferred financing fee expense offset by $328,000 of non-cash income from the write-off of certain accounts payable due to the expiration of the statute of limitations. During the nine months ended September 30, 2012, we used cash of $912,000 from increases in current assets and used cash of $26,000 through decreases in current liabilities and deferred revenues, excluding debt.

During the nine months ended September 30, 2011, we used net cash of $968,000 in operating activities. During this period, net cash used in operating activities primarily consisted of a net income of $1,059,000 and a net decrease in working capital and other assets and liabilities of $291,000. Those amounts were offset by $2,318,000 of non-cash costs including a $4,268,000 unrealized gain related to the change in value of our derivative liabilities, $1,676,000 in amortization of debt related costs, and $240,000 in stock based compensation. The decrease in working capital and other assets of $291,000 was primarily driven by an increase of $399,000 in deferred revenue, a $261,000 increase in accrued expenses and a $241,000 decrease in billings in excess of costs and estimated earnings on uncompleted contracts.

Investing Activities Net cash used in investing activities was $159,000 for the nine months ended September 30, 2012. There was relatively no cash used in investing activities for the nine months ended September 30, 2011. For the nine months ended September 30, 2012, we used cash to fund capital expenditures of computer equipment, software and furniture and fixtures of approximately $159,000. This level of equipment purchases resulted primarily from the replacement of older equipment. For the nine months ended September 30, 2011, we used relatively no cash to fund capital expenditures of computer equipment, software and furniture and fixtures.

Financing Activities We generated cash of $3,261,000 from financing activities for the nine months ended September 30, 2012 as compared to the generation of $1,159,000 for the same period in 2011. We generated cash of $3,502,000 from the exercise of 7,003,947 common stock warrants and $7,000 from the exercise of 24,924 common stock options. We used cash of $203,000 for the payment of dividends on our Series B Convertible Redeemable Preferred Stock and $45,000 for the repayment of notes payable. During the nine months ended September 30, 2011, we generated cash of $655,000 from the exercise of 1,310,000 common stock warrants, generated $500,000 from the issuance of secured notes payable and generated $4,000 from the exercise of common stock options.

Debt At September 30, 2012, we had approximately $65,000 in outstanding debt, exclusive of any debt discounts, and another $28,000 in related accrued interest.

7% Convertible Promissory Notes to Related Parties On November 14, 2008, we entered into a series of convertible promissory notes (the "Related-Party Convertible Notes"), aggregating $110,000, with certain officers and members of the Company's Board of Directors. The Related-Party Convertible Notes bear interest at 7.0% per annum and were due February 14, 2009. The principal amount of the Related-Party Convertible Notes plus accrued but unpaid interest is convertible at the option of the holder into common stock of the Company. The number of shares into which the Related-Party Convertible Notes are convertible shall be calculated by dividing the outstanding principal and accrued but unpaid interest by $0.50 (the "Conversion Price").

In conjunction with the issuance of the Related-Party Convertible Notes, we issued an aggregate of 149,996 warrants to the note holders to purchase common stock of the Company. The warrants have an exercise price of $0.50 per share and may be exercised at any time from November 14, 2008 until November 14, 2013.

In 2008, we initially recorded the Related-Party Convertible Notes net of a discount equal to the fair value allocated to the warrants of approximately $13,000. We estimated the fair value of the warrants using the Black-Scholes option pricing model using the following assumptions: term of 5 years, a risk free interest rate of 2.53%, a dividend yield of 0%, and volatility of 96%. The Related-Party Convertible Notes also contained a beneficial conversion feature, which resulted in an additional debt discount of $12,000. The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. We have accreted the beneficial conversion feature over the life of the Related-Party Convertible Notes.

-28--------------------------------------------------------------------------------- Table of Contents We did not repay the Related-Party Convertible Notes on the due date. In August 2009, we received from the Related-Party Convertible Note holders a waiver of default and extension of the Maturity Date to January 31, 2010. As consideration for the waiver and note extension, we issued to the Related-Party Convertible Note holders an aggregate of 150,000 warrants to purchase shares of the Company's common stock. The warrants have an exercise price of $0.50 per share and expire on August 25, 2014.

We did not repay the notes on January 31, 2010. During the nine months ended September 30, 2012, we repaid $45,000 in principal to certain holders of the Related-Party Convertible Notes. We are currently seeking an additional waiver of default from the holders of the Related-Party Convertible Notes.

Contractual Obligations Total contractual obligations and commercial commitments as of September 30, 2012 are summarized in the following table (in thousands): Payment Due by Year 2012 Total (3 months) 2013 2014 2015 2016 Thereafter 7% related party promissory notes* 65 65 - - - - - Operating lease obligations 977 132 434 287 124 - - Total $ 1,042 $ 197 $ 434 $ 287 $ 124 $ - $ - * Notes had a maturity date of January, 2010. We did not repay the notes on January 31, 2010 and we are currently seeking an additional waiver of default from the holders of the Related-Party Convertible Notes.

Real Property Leases In December 2010, we entered into a new lease agreement and relocated our corporate headquarters to Rancho Bernardo Road in San Diego, California. The lease term commenced in December 2010 and ends on December 31, 2013. In April 2012, we extended the term of this lease to October 31, 2014. We are obligated under the lease to pay base rent and certain operating costs and taxes for the building. Future minimum rent payments will be approximately $28,000 in 2012, $105,000 in 2013 and $98,000 in 2014.. Our rent was abated at a rate of 50% for the first 12 months of the lease. Under the lease, we were required to provide a security deposit in the amount of approximately $9,500.

In April 2012, we entered into an amendment of our corporate headquarters lease whereby we leased an additional 2,560 square feet of space. The lease term commenced in May 2012 and ends on October 31, 2014. Future minimum rent payments will be approximately $10,000 in 2012, $50,000 in 2013 and $43,000 in 2014.

In April 2012, we entered into a lease extension of our Portland, Oregon offices whereby we extended the lease term for a period of 36 months commencing November 1, 2012 until October 31, 2015. Future minimum rent payments will be approximately $35,000 in 2012, $141,000 in 2013, $146,000 in 2014 and $124,000 in 2015.

In addition to the corporate headquarters lease in San Diego, California, we also lease space in Ottawa, Province of Ontario, Canada; and Mexico City, Mexico. Those contractual lease obligations, as well as the San Diego lease, are included in the "contractual obligations" summary table above.

-29--------------------------------------------------------------------------------- Table of Contents Stock-based Compensation Stock-based compensation has been classified as follows in the accompanying condensed consolidated statements of operations (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 Cost of revenues $ 3 $ 1 $ 8 $ 4 General and administrative 84 38 248 141 Sales and marketing 35 16 103 50 Research and development 33 15 95 45 Total $ 155 $ 70 $ 454 $ 240 Recently Issued Accounting Standards Please refer to the section "Recently Issued Accounting Standards" in Note 2 of our Notes to Condensed Consolidated Financial Statements.

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