-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Cc6GqKkp9zQFAroU4GdbP4846spGtKIOGmujp///rTxepcTXGT8iq1fw/6xfIdnR CUKGyohQ1rJlqBzEgMl7Mw== 0000914190-99-000123.txt : 19990331 0000914190-99-000123.hdr.sgml : 19990331 ACCESSION NUMBER: 0000914190-99-000123 CONFORMED SUBMISSION TYPE: 10KSB PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: DATAKEY INC CENTRAL INDEX KEY: 0000704914 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS ELECTRICAL MACHINERY, EQUIPMENT & SUPPLIES [3690] IRS NUMBER: 411291472 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10KSB SEC ACT: SEC FILE NUMBER: 000-11447 FILM NUMBER: 99578832 BUSINESS ADDRESS: STREET 1: 407 W TRAVELERS TRAIL CITY: BURNSVILLE STATE: MN ZIP: 55337 BUSINESS PHONE: 6128906850 MAIL ADDRESS: STREET 1: 407 WEST TRAVELERS TRAIL CITY: BURNSVILLE STATE: MN ZIP: 55337 10KSB 1 FORM 10-KSB FOR YEAR ENDED 12/31/98 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB ANNUAL REPORT ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 Commission file No. 0-11447 DATAKEY, INC. (Name of small business issuer in its charter) MINNESOTA 41-1291472 (State of incorporation or organization) (I.R.S. Employer Identification No.) 407 West Travelers Trail, Burnsville, Minnesota 55337 (Address of principal executive offices) Issuer's telephone number, including area code: (612) 890-6850 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.05 per share (Title of Class) Check whether the Issuer (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 Issuer was required to file such reports) and (2) has been subject to such filing requirements for the last 90 days. YES X NO ____ Check if there is no disclosure of delinquent filers pursuant to Item 405 of Regulation S-B contained herein and no disclosure will be contained, to the best of Issuer's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] Issuer's revenues for its most recent fiscal year: $5,870,250. The aggregate market value of the voting stock (Common Stock) held by non-affiliates was approximately $4,800,000 based upon the closing sale price of the Issuer's Common Stock on March 19, 1999. As of March 19, 1999, there were 3,103,259 shares of the Issuer's Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part II of this Annual Report on Form 10-KSB incorporates by reference information (to the extent specific sections are referred to herein) from the Issuer's Annual Report to Shareholders for the year ended December 31, 1998 (the "1998 Annual Report"). Portions of the Company's definitive Proxy Statement for its Annual Meeting of Shareholders to be held on May 26, 1999 are incorporated by reference pursuant to Rule 12b-23 into Items 9, 10 and 11 of Part III. Transitional Small Business Disclosure Format (check one) YES [ ] NO [ X ] PART I ITEM 1. DESCRIPTION OF BUSINESS General Datakey, Inc. (the "Company") was incorporated under the laws of the State of Minnesota in 1976 under the name "The Systems Group, Inc." In 1980, the Company changed its name to Datakey, Inc. The Company provides product, subsystem and system solutions to record, store and transmit electronic information. Datakey also manufactures and sells products and systems directed to the information security market which enable user identification and authentication, secure data exchange and information validation. It also provides OEM products, consisting of proprietary memory keys, cards and other custom-shaped tokens that serve as a convenient way to carry electronic information and are packaged to survive in portable environments. The Company's first portable memory products, consisting of an electronic key and support electronics, were introduced in 1981 for applications requiring convenient storage, transportation and management of information. The Company's current products utilize semiconductor technology to provide a storage device more versatile than conventional portable information products such as keys, badges and magnetic stripe cards. The Company's current product line of portable memory devices and associated interface products provide up to 16,384,000 bits of data storage which are used in a wide range of applications including communications security, computer security, facility security, vending and process control. Each of the Company's portable memory systems consist of one or more portable memory devices, access devices and, for certain models, interface modules containing microprocessors. These components, together with the user's processor-based equipment, function as an integrated system allowing instantaneous processing of personalized data carried within a portable data carrier. Through the incorporation of advanced semiconductor memory technology, the Company's portable memory device is able to store and carry substantial amounts of information. When the memory device is used in conjunction and with the other components of the Company's system, information can be selectively altered, added to or erased, as required, to effectively and reliably manage or control a particular activity or transaction. The Company has introduced end-user systems that utilize smart cards or smart keys and are designed to provide advanced information security utilizing digital signatures and encryption. These systems incorporate hardware and software to provide a higher level of security than is obtainable with current software only solutions. Current Products and Products Under Development Electronic Products (EP) Portable Memory Devices. Portable memory devices are electronic devices which store information. They have a plastic exterior, are in the forms of keys, cards, or custom shaped tokens and encapsulate semiconductor memory. Certain devices have been designed to store information which may be retrieved, altered, erased or updated; while other devices have been designed to store one-time programmable information which may be retrieved but not altered or updated. The storage capacities of the Company's portable memory devices range from 1,024 bits to 16,384,000 bits. The portable memory devices are priced generally between $2 and $100 per unit, depending on capacities and quantities purchased. Access Device. The access device is the element into which a portable memory device is inserted to provide the interconnection between the portable memory device and the electronic interface circuitry or the host processor-based equipment. It is through this physical interconnection that the data contained in the portable memory device is transmitted to the electronic interface or to the host interface. Several models of the access device have been developed to handle the Company's different portable memory devices. The access devices are priced generally between $15 and $120 per unit, depending on models and quantities purchased. Interface. The interface is the electronics control module between the access device and a customer's processor-based equipment. This module is used with the Company's serial communication key and contains all the necessary electronics to control information within the key and to coordinate the information requests of the host equipment. This communication process is managed by the system's firmware, which is a software program existing within the interface. For some applications, this firmware structures, secures and verifies the information within the portable device, and may allow separate groups or files of data to reside in a single portable device and be secure from access except by equipment authorized to manage a particular group or file of data. The interface is priced between $70 and $120 per unit, depending on models and quantities purchased. Integrated System Solutions (ISS) For the past three years, Datakey has been developing "token-based" (smart card or smart key) products that provide advanced information security solutions to the problems of organizations, worldwide. The first release of these token-based information security systems was introduced in September 1997 and additional versions were introduced in 1998. In addition to other versions, the Company expects to launch a new version of SignaSURE CIP in the second half of 1999. The launch and success of such products is dependent on further successful development efforts and market acceptance, along with other risks. See "Forward Looking Statements." SignaSURE CIP. Password-based software programs that implement public-key cryptography technology for information security offer easier operation and improved data integrity over older symmetric cryptography software. Password-based security, however, is insufficient for networks with connections, such as the Internet, outside of the organization. The Company's SignaSURE CIP (Cryptographic Interface Provider) is designed to solve this problem, allowing the Internet to be used safely for electronic commerce. SignaSURE CIP allows users and value-added resellers to upgrade their software-only systems to token-based information security and gain the benefit of secure Internet operation. Token-based information security implements a two-level security scheme--something that is owned (a hardware token) and something that is known (a password to activate the token)--for a much stronger level of security than password-based software solutions. SignaSURE CIP provides token add-ons to Cryptoki (PKCS-11) standard information security interface applications and for applications that incorporate Microsoft's CryptoAPI (API). These products offer "load, plug and play" convenience for strong information security. SignaSURE CIP products include a user-unique smart card or smart key that holds the critical information to perform the cryptographic functions necessary for information privacy and data integrity, a companion reader/writer that plugs into a computer's serial port, PCMCIA port or floppy disk drive, and software which is loaded into the workstation and interfaces to the application program. The Company introduced, in September 1997, a version of SignaSURE CIP that utilizes the standard PKCS #11 (Cryptoki) Interface and then in January 1998, it released a version that utilizes either the PKCS#11 interface or Microsoft's CryptoAPI. SignaSURE DTK. As public-key information security continues to grow, due to the technology's adoption by well-known software companies such as Microsoft and Netscape, software developers are implementing public-key information security into their specialized applications. Because no easy method was previously available for application developers to implement a token-based public key infrastructure (PKI), the Company developed its SignaSURE DTK (Developers Tool Kit) so that developers could easily and cost-effectively launch their applications with the much stronger, token-based information security. SignaSURE DTK is a turnkey package that the Company designed to allow software developers to integrate Datakey hardware tokens and a PKI into their applications. DTK includes up to three main components: hardware cryptographic tokens, interface and integration software and security infrastructure products. DTK is available in four configurations ranging from a token with a reader/writer and integration software, to the full PKI configuration that issues and manages hardware tokens and digital certificates. This product flexibility allows user-developers who utilize SignaSURE DTK to integrate just what is needed for their application. The Company began selling the SignaSURE DTK in mid-1997. SignaSURE ESS. Many organizations have made the transition from large mainframe systems to more flexible, but much less secure, client-server networks and intranets. Client-server networks and intranets allow digital information to reside on networks, rather than at the desktop so many authorized users can access the same information. Authorized users may include company employees, suppliers and customers who can be connected to the network, or located remotely from the enterprise. With the advent of the Internet, information transmission over any distance can be accomplished quickly and cost effectively, but not securely. Datakey believes its SignaSURE ESS (Enterprise Security Suite) offers a solution to manage a network, intranet and Internet computing structure to allow only authorized users access to information. Information can then be transmitted securely and stored safely on both private and public networks without privacy and data integrity concerns. SignaSURE ESS is an integrated "end-to-end" data security system that the Company believes will assure secure network access, confidential information exchange, integrity of data and transaction non-repudiation. Secure, personalized smart tokens are employed within a PKI to provide a higher level of information security than is provided by software-only solutions. Security functions are integrated into applications like Microsoft Office(TM), thereby providing seamless security operation to the user. SignaSURE ESS will operate over the Internet, and wide and local area networks enabling secure information exchange for all users, whether local or remote to the enterprise. SignaSURE ESS includes a user-personalized smart card or smart key and companion reader/writer for workstation or laptop that perform the functions necessary for information privacy and data integrity. It also incorporates client software that manages secure information and interfaces to applications, and server-based, enterprise infrastructure hardware and software that initialize SignaSURE ESS and continuously ensure that all users are authorized. ESS also includes an optional secure stand-alone workstation to initialize cards and provide backup of private keys for recovery purposes. The Company plans to release SignaSURE ESS in the second half of 1999. The following chart shows the Company's SignaSURE products: SignaSURE Product Attribute CIP DTK ESS - ------------- -------------------------- --- --- --- Customer Organizational End-User x x Software Developer x System Type Integrated Solution x Add-on Subsystem x Component x Application Information Security x x Token Integration x x Hardware Datakey Smart Token x x x Datakey Reader/Writer x x x Software Security Solution x Token Interface x x Year 2000 The Company's new products are designed to accept either two digits or four digits in designating the year. As a result, these products can distinguish the year 2000 from the year 1900; therefore, the Company does not believe the year 2000 will cause any material problems. See also "Management's Discussion & Analysis--Year 2000." Research and Development During 1997 and 1998, the Company continued the development of portable memory devices to expand its line of standard products as well as newly designed custom products. The Company also continued its development of token-based information security products. As the need for computer security products continues to grow, the Company has been expending significant effort into development and improvement of token-based computer information security systems. The Company's SignaSURE line of information security products, which were initially released for sale during 1997, are designed to provide encryption and digital signatures required for electronically generated documents on computer networks. The technology involved in information security systems is undergoing rapid expansion and advancement which could result in the development of new products and systems which may make the Company's present information security products obsolete. The initial development effort for the Company's information security products was completed in 1997 but the Company must continue to improve its present information security products in order to remain competitive. In 1998 and 1997, research and development expenses were $1,673,000 and $3,186,000, respectively. The Company expects that research and development expenses in 1999 will be greater than in 1998. Manufacturing The Company's in-house manufacturing capabilities include microelectronic assembly, plastic injection molding, automated surface mount assembly, and general electronic assembly. The Company also utilizes independent subcontractors from time to time to perform certain manufacturing functions. The Company provides a 90-day warranty on domestic sales, a 180-day warranty on sales to its international distributors to cover the longer shelf life of the Company's products, and a 180-day warranty on sales to the government. In an effort to more efficiently produce products, to reduce product costs, and to increase its manufacturing flexibility, the Company intends to continue to improve certain manufacturing processes and add capital equipment to its manufacturing operations. While the Company believes that these steps will provide a greater level of control over, and flexibility in, its manufacturing processes, there are no assurances that the Company's ability to produce products and to meet required delivery schedules will be sufficiently improved to meet the demands created by increased sales and more complex manufacturing processes. Sources of Supply The Company purchases a microprocessor, with its proprietary operating masked into the chip, from a single source supplier. The Company intends to continue purchasing microprocessors from this supplier during 1999 but will continue to evaluate alternative sources of supply. Due to the unique nature of these cryptographic microprocessors, there are currently a limited number of alternative sources of supply and, due to different operating systems and other characteristics, one supplier's microprocessors are not easily interchanged with another. Should the present source of supply become inadequate or inferior to other offerings in the future or should it experience unforeseen Year 2000 issues, the Company will be required to incur a significant cost and possibly experience a gap in supply to switch to a new supplier. The Company has several qualified sources from which to purchase printed circuit boards and electronic components for most of its standard portable memory devices. The components for the Company's products are, in general, available from multiple suppliers. Some of the plastic components are molded on the Company's in-house molding equipment or suppliers' molding equipment using Company-owned tooling. The Company purchases integrated circuits primarily through nationwide multivendor distributors. If, for any reason, the Company would have to cancel or reduce a particular integrated circuit order, it might thereafter have to pay a higher price for the integrated circuits. Since general economic conditions have an effect on the supply and cost of integrated circuits, there is no guarantee that the Company will be able to obtain adequate quantities of integrated circuits to meet all of its production needs during periods of short supply. Significant Customer The Company sells its electronic products to a number of commercial original equipment manufacturers and other customers, including governmental entities. At this time, the Company is not dependent on any one customer or few customers, the loss of which would have a material adverse effect on its business. Marketing General. While there appears to be a broad range of applications and potential customers for portable memory devices, no single application group has evidenced strong, long-term growth potential. The diversity of potential applications has made it difficult for the Company to focus its limited marketing resources. In 1997, sales to EP customers decreased to $5,868,000, and in 1998 they decreased to $5,241,000. As sales to new customers come on line, the Company believes that commercial EP sales may increase in 1999. ISS products for the information security marketplace were introduced in 1997 and resulted in revenue of $629,000 during 1998. In 1999, the Company expects revenue from these products to increase significantly as additional pilot programs are commenced and certain customers convert into production mode. As with any new product line, revenue will depend on customer acceptance, the extent of which is difficult to assess at this time. Market for EP Products. To date, most applications in the commercial and government market have used the Data Key for electronic security and equipment control applications. The Company is seeking to develop other long-term business in this market. The Company markets its products to domestic and international customers using the following channels: Domestic. The Company markets its portable memory devices domestically through a combination of direct and indirect sales personnel. In addition, it utilizes advertising, trade shows and direct mail to reach its buying audience. In 1998 and 1997, EP sales to domestic customers, and the corresponding percentage of total revenue, were approximately $3,650,000 (62%) and $4,068,000 (68%), respectively. International. The Company presently markets its portable memory devices internationally through an independent sales agent in the United Kingdom and agents and/or distributors in Australia, Belgium, the Netherlands, Germany, Ireland, Spain, Italy and Sweden. The Company has customers in other countries who are handled on a direct basis from the Company's headquarters in the United States. The Company intends to expand into other international market areas in the future. In 1998 and 1997, EP sales to international customers, and the corresponding percentage of total revenue, were approximately $1,591,000 (27%) and $1,800,000 (30%), respectively. Market for ISS Products. Datakey markets and sells its advanced information security products (the initial offerings in its ISS line) through a combination of direct sales and marketing personnel, dealers, distributors, value added resellers and system integrators/developers. The direct sales and marketing personnel concentrate primarily on relationships with large security-conscious organizations either through direct or indirect contact, establishing alliances with system integrators/developers and setting up dealer/distributor relationships for its products. The future revenue of Datakey ISS products is dependent on the success of a new and untested marketing and direct sales organization. Also, see "Outlook and Risks" in the Management's Discussion and Analysis contained in the Company's 1998 Annual Report, portions of which are included in Exhibit 13.1 of this Report. Backlog As of March 13, 1999, the Company had an order backlog, totaling approximately $2,053,000, including approximately $748,000 with no scheduled shipment date or with scheduled shipment dates after 1999. Although the orders generally contain scheduled shipment dates, they may be accelerated, delayed or canceled at the customer's request. The Company does not believe that the current backlog is necessarily indicative of future backlog levels. Competition Electronic Products. The Company's primary competition for electronic products sold to original equipment manufacturers is presently, and is expected to remain, conventional portable information systems, such as keys and cards, and more advanced portable information systems including those in the familiar credit card format, such as "smart cards," Personal Computer Memory Card Industry Association (PCMCIA) cards, magnetic stripe cards, bar-code cards and laser technology cards. The Company's products, when used as a portable data base, may also compete with centralized data base systems. Many of the manufacturers of these portable information devices and systems are large, well-established companies. A number of European and Japanese firms continue to develop and refine the smart card technologies. Some of these companies have established branch offices in the United States to explore the United States market. To date, the smart card has been used primarily in Europe, where it has been implemented extensively in prepaid telephone systems and more recently in loyalty programs and various cashless vending applications. In the United States, smart cards are currently being used mainly in field trial environments. Although the Company does not have complete information about the status of these trials, the Company believes that, in time, the smart card will be successfully developed and could become a competitor, especially in those markets which have a history of using a card or a preference for card-type devices. Memory cards, such as PCMCIA standard cards, are functionally equivalent to the Company's portable memory devices in that they utilize semiconductor memory in card-shaped devices made of plastic. Memory cards generally have larger memory capacities than the devices currently offered by the Company and historically incorporated volatile, battery-backed memory elements. More recently, nonvolatile (principally "Flash Memory") memory elements which do not require battery backup have become more prominent. They are used in such applications as laser printer fonts, instrumentation, electronic lettering machines and fax/modems, and are also used as replacements or "add ons" to diskettes and hard drives for data storage in certain desktop, notebook and smaller portable computers. Magnetic stripe cards are relatively inexpensive and are used extensively in the access control industry and in the banking and credit card industries. These markets are not priority markets for the Company's portable information devices. Magnetic stripe cards are not conveniently updated, have limited storage capacity and generally have a useful life of one or two years. As a result, the Company believes its products are technologically superior and may be more cost-effective for applications requiring more complex technologies. Other portable memory devices, including one in a "button" form and others in shapes similar to the Data Key, are becoming more common in the marketplace. Many of these competing devices utilize similar semiconductor components and electronic interfaces. The Company expects competition from these alternative devices to continue in the future. Another technology utilizes a strip of reflective material which is laminated into a card. Information is inscribed on this material through use of a laser beam. Since these cards can contain several million bits of information, the Company believes that this technology will be a competitor in portable information markets where very large information storage capacities are required and instantaneous management of information is not essential. The Company's ability to compete in the portable information market will depend primarily on its ability to demonstrate superior product performance at cost-effective prices and on the enhanced features of its system which make it more effective than competing systems. Integrated System Solutions. Datakey currently offers token-based (smart card, smart key) information security systems which are primarily utilized in encryption for electronic mail privacy, private and secure file transfer and digital signatures for electronic document authentication. The Company is continuing a significant product development effort to expand the applications and ease-of-use of its products and systems. See "Products--Integrated System Solutions." Competition in the information security business is varied with companies offering hardware solutions, software solutions and combinations of hardware and software solutions. As awareness for security on the Internet, company intranets and on other local area networks has increased over the past few years, many companies have introduced software and/or hardware based products to provide security. These products range from software-based password only systems to firewalls, which may be very sophisticated. Other applications are using hand held hardware devices, commonly referred to as tokens, to provide access to networks and, in some cases, use encryption and digital signatures to further secure networks. The Company's advanced information security products, some of which are released and some of which are currently in development, are based upon a smart card or smart key and utilize encryption and digital signatures. They also include extensive software to make the system user-friendly and seamless with common desktop software packages. The Company feels this will provide a unique combination of advanced security features at a reasonable selling price. There are several companies operating in this highly competitive and rapidly changing marketplace, however, and many of such companies have strong name recognition and vast financial resources. The Company believes it can compete on the basis of its unique design and ease of use. The initial reception to the Company's products in the marketplace, beginning in late 1997, has been encouraging and sales of evaluation units and units for pilot programs have been progressing very well. There are no assurances, however, that the existing and future products will, in the long term, be accepted in the marketplace. Patents and Trademarks The Company has been granted several patents by the United States Patent and Trademark Office relative to the Data Key, its key interface and its overall portable information device technology. The Company has sought and will, when appropriate, continue to seek patent protection in several foreign countries. The federal registration of the Datakey trademark was approved in 1985. In an industry characterized by rapid technological change, the Company believes that the knowledge, experience and creativity of its employees will prove to be more important than patent protection. Employees As of March 13, 1999, the Company employs 60 full-time employees, 15 of whom are involved in manufacturing, 3 in materials handling, 2 in quality assurance, 14 in engineering, 16 in marketing/sales and 10 in general and administrative areas. In addition, the Company uses contract labor during peak production times and for major projects. The Company's employees are not subject to a collective bargaining agreement, and the Company believes that its employee relations are good. Forward Looking Statements Certain statements made in this Form 10-KSB, which are summarized here, are forward-looking statements that involve risk and uncertainties, and actual results may be materially different. Factors that could cause actual results to differ include, but are not limited to, those identified: o The expectation that Datakey in the second half of 1999 will introduce SignaSURE ESS and a new version of SignaSURE CIP, is subject to the risk of unanticipated problems or delays in development and depends upon market acceptance and demand, as well as other general market conditions and competitive conditions within this market, including the introduction of products by competitors. o The expectation that the Company will continue to improve its manufacturing processes, leading to more efficient production, depends on the Company's ability to monitor such processes and to add capital equipment to its manufacturing operations. o The expectation that commercial EP sales may increase in 1999 depends on acceptance by new customers identified by the Company's sales representatives, as well as other general market conditions and competitive conditions. o The expectation that the Company will expand sales in international markets depends on the acceptance of its products in such markets, the quality and performance of the Company's products as compared to competitive products, the effectiveness of relatively new marketing and sales personnel, and other general market and competitive conditions within such markets. ITEM 2. DESCRIPTION OF PROPERTY The Company's corporate offices and manufacturing facility, located at 407 West Travelers Trail, Burnsville, Minnesota, consists of 18,488 square feet. Approximately one-half of the space is used for manufacturing and warehousing, and the balance for present and future office space. All of this space is rented under a lease which extends through June 1999. The Company also utilizes approximately 2,400 square feet in a nearby office under a sublease that expires in May 1999. The annualized rent expense for the space currently occupied is $160,000, plus a portion of the operating expenses and real estate taxes. The Company is currently negotiating with its present landlord to extend its lease for an additional five years and to add approximately 6,500 square feet of adjoining space to provide for relocation of personnel from the nearby office and also for future expansion. The Company is also evaluating proposals from two other parties for similar space in the nearby vicinity. The Company intends to make a decision on space by April 15, 1999. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings pending to which the Company is a party or of which any of its property is the subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year 1998. PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the Nasdaq National Market System under the symbol DKEY. The high and low sale prices for the common stock by quarter as reported by Nasdaq are set forth in the following table for 1998 and 1997. On March 12, 1999, the Company had approximately 1,100 shareholders, including approximately 800 beneficial owners. The Company has never paid dividends on its common stock and does not plan to in the foreseeable future. Sale Prices High Low 1998 1st Quarter................................. $4 $2 3/4 2nd Quarter................................. $7 1/2 $2 5/8 3rd Quarter................................. $6 7/8 $2 7/8 4th Quarter................................. $3 3/4 $1 15/16 1997 1st Quarter................................. $4 7/8 $2 1/4 2nd Quarter................................. $4 7/8 $1 7/8 3rd Quarter................................. $4 1/4 $3 4th Quarter................................. $4 1/4 $3 1/8 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The information required by Item 6 is incorporated by reference from the Company's 1998 Annual Report, a portion of which is included herewith in Exhibit 13.1 to this Report. ITEM 7. FINANCIAL STATEMENTS The following financial statements of the Company are included as part of Exhibit 13.1 to this Report: Independent Auditor's Report Consolidated Balance Sheets as of December 31, 1998 and 1997 Consolidated Statements of Operations for Years Ended December 31, 1998 and 1997 Consolidated Statements of Stockholders' Equity for Years Ended December 31, 1998 and 1997 Consolidated Statements of Cash Flows for Years Ended December 31, 1998 and 1997 Notes to Consolidated Financial Statements ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT The information required by Item 9 regarding the Company's directors and executive officers is incorporated by reference to the Company's proxy statement for its 1999 Annual Meeting of Shareholders under the captions "Determination of Number and Election of Directors" and "Executive Officers of the Company." The Company's proxy statement will be filed pursuant to Rule 14a-3 within 120 days after the close of the fiscal year for which this report is filed. The information relating to compliance with Section 16(a) of the Exchange Act is incorporated by reference to the Company's proxy statement for its 1999 Annual Meeting of Shareholders under the caption "Section 16(a) Beneficial Ownership Compliance." ITEM 10. EXECUTIVE COMPENSATION The information required by Item 10 is incorporated by reference to the Company's proxy statement for its 1999 Annual Meeting of Shareholders under the caption "Executive Compensation." ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 11 is incorporated by reference to the Company's proxy statement for its 1999 Annual Meeting of Shareholders under the caption "Security Ownership of Management and Certain Beneficial Owners." ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are included in this report: See "Exhibit Index" immediately following the financial statements following the signature page of this Form 10-KSB. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1998. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Issuer has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 30, 1999 DATAKEY, INC. BY: /s/ Carl P. Boecher Carl P. Boecher Chief Executive Officer and Director (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company, in the capacities, and on the dates, indicated: POWER OF ATTORNEY Each person whose signature appears below constitutes and appoints Carl P. Boecher and Alan G. Shuler as his true and lawful attorneys-in-fact and agents, each acting alone, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-KSB and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming said attorneys-in-fact and agents, acting alone, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof. SIGNATURES TITLES DATE /s/ Carl P. Boecher Chief Executive Officer and March 30, 1999 Carl P. Boecher Director (Principal Executive Officer) /s/ Alan G. Shuler Vice President and Chief March 30, 1999 Alan G. Shuler Financial Officer (Principal Financial and Accounting Officer) /s/ Thomas R. King Director and Secretary March 30, 1999 Thomas R. King /s/ Terrence W. Glarner Director March 30, 1999 Terrence W. Glarner /s/ Gary R. Holland Chairman of the Board of March 30, 1999 Gary R. Holland Directors /s/ Eugene W. Courtney Director March 30, 1999 Eugene W. Courtney /s/ John H. Underwood Director March 30, 1999 John H. Underwood DATAKEY, INC. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-KSB For the Fiscal Year Ended December 31, 1998 Exhibit No. Description 3.1 Restated Articles of Incorporation, as amended 3.2 Bylaws, as Amended (Incorporated by reference to Exhibit 3.2 to Form 10-K for fiscal year ended December 31, 1988) 10.1 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)* 10.2 Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.5 to Form 10-K for fiscal year ended December 31, 1991)* 10.3 Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to Exhibit 10.5 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.4 License Agreement between CTS Corporation and the Company dated March 9, 1988 (Incorporated by reference to Exhibit 10.8 to Form 10-K for fiscal year ended December 31, 1987) 10.5 Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987, as amended on February 10, 1988, December 23, 1988, February 13, 1992 and April 1, 1992 (Incorporated by reference to Exhibit 10.12 to Form 10-K for fiscal year ended December 31, 1991) 10.6 Manufacturing Agreement between Duncan Industries and the Company dated August 27, 1993 (Incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended December 31, 1993) 10.7 Employment Agreement between Alan G. Shuler and the Company dated January 1, 1995 (Incorporated by reference to Exhibit 10 to Form 10-QSB for fiscal year ended July 1, 1995)* 10.8 Consulting Agreement between Gary R. Holland and the Company dated November 1, 1995 (Incorporated by reference to Exhibit 10.19 to Form 10-KSB for fiscal year ended December 31, 1995)* 10.9 Amendment dated February 11, 1997 to Consulting Agreement between Gary R. Holland and the Company dated November 1, 1995 (Incorporated by reference to Exhibit 10.18 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.10 Employment Agreement between Carl P. Boecher and the Company dated January 1, 1997 (Incorporated by reference to Exhibit 10.19 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.11 Separation Agreement and Release between John H. Underwood and the Company dated January 1, 1997 (Incorporated by reference to Exhibit 10.20 to Form 10-KSB for fiscal year ended December 31, 1996)* 10.12 1997 Management Incentive Plan, as amended March 10, 1997 (Incorporated by reference to Exhibit 10 to Form 10-QSB for fiscal quarter ended June 28, 1997)* 10.13 Lease Amendment No. 5 dated December 17, 1996 to Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987 (Incorporated by reference to Exhibit 10.22 to Form 10-KSB for fiscal year ended December 31, 1996) 10.14 Employment Agreement between Michael L. Sorensen and the Company dated April 16, 1997 (Incorporated by reference to Exhibit 10.14 to Form 10-KSB for fiscal year ended December 31, 1997)* 10.15 1997 Stock Option Plan (Incorporated by reference to Exhibit 10.15 to Form 10-KSB for fiscal year ended December 31, 1997)* 10.16 Forms of Incentive and Nonqualified Stock Option Agreements under 1997 Stock Option Plan (Incorporated by reference to Exhibit 10.16 to Form 10-KSB for fiscal year ended December 31, 1997)* 13.1 Portions of 1998 Annual Report, including 1998 Financial Statements and Management's Discussion and Analysis 21.1 Subsidiaries of the Company (Incorporated by reference to Exhibit 21.1 to Form 10-KSB for fiscal year ended December 31, 1994) 23.1 Independent Accountant's Consent 24.1 Power of attorney for Carl P. Boecher, Alan G. Shuler, Thomas R. King, Terrence W. Glarner, Gary R. Holland, Eugene W. Courtney and John H. Underwood (included on the signature page of this Form 10-KSB) 27 Financial Data Schedule (filed with electronic version only) * Designates a management contract or compensatory plan or arrangement. EX-3.1 2 RESTATED ARTICLES OF INCORPORATION CERTIFICATE OF RESTATED ARTICLES OF INCORPORATION OF DATAKEY, INC. We the undersigned William P. Flies and Thomas R. King, respectively the president and secretary of Datakey, Inc., a corporation subject to the provisions of the Minnesota Business Corporations Act, do hereby certify that, pursuant to action taken by the directors of the Corporation at a regularly scheduled meeting thereof and a majority vote of the outstanding shares of the Corporation present in person or by proxy at an annual meeting thereof, the Corporation effective as of May 24, 1982 elected to become governed by Minnesota Statutes Ch. 302A and, in addition, approved and adopted the following Restated Articles of Incorporation to supercede and take place of the existing Articles of Incorporation. ARTICLE I The name of the Corporation is Datakey, Inc. ARTICLE II The registered office of this Corporation is located at 12281 Nicollet Avenue South, Burnsville, Minnesota, 55337. ARTICLE III 3.01 The aggregate number of shares of stock which this Corporation shall have the authority to issue is 5,000,000. All common stock issued by the Corporation shall have a par value of $.05 per share. 3.02. The board of directors may from time to time establish by resolution different classes or series of shares and may fix the rights and preferences of said shares in any class or series. 3.03. No shareholder of the Corporation shall have any preemptive rights. 3.04. No shareholder shall be entitled to any cumulative voting rights. 3.05. The shareholders shall take action by the affirmative vote of the holders of a majority of the voting power of all voting shares outstanding, except where a larger proportion is required by law, these articles or a shareholder control agreement. ARTICLE IV The name and address of the original incorporator of this Corporation is: William P. Flies, 12808 Woodview Lane, Burnsville, Minnesota, 55337. ARTICLE V The names and addresses of the present board of directors are: William P. Flies Richard A. Walter 12281 Nicollet Avenue 10101 E. Bren Road Burnsville, MN 55337 Minnetonka, MN 55343 Thomas R. King Timothy P. Stepanek 600 Midwest Plaza Bldg. 1730 Midwest Plaza Bldg. Minneapolis, MN 55402 Minneapolis, MN 55402 IN WITNESS WHEREOF, we have hereunto set our hands this 24th day of May, 1982. /s/ William P. Flies William P. Flies, President /s/ Thomas R. King Thomas R. King, Secretary STATE OF MINNESOTA ) ) ss. COUNTY OF HENNEPIN ) William P. Flies and Thomas R. King, being duly sworn on oath, depose and say that they are, respectively, the president and secretary of Datakey, Inc., the corporation named in the foregoing certificate; that said certificate contains a true statement of the action of the shareholders and board of directors of said corporation; that said certificate is executed on behalf of said corporation by its express authority; and that they further acknowledge the same to be their free act and deed and the free act, and deed of said corporation. /s/ William Flies /s/ Thomas R. King Subscribed and sworn to before me this 24th day of May, 1982. /s/ Elizabeth A. Forehand Notary Public - Minnesota Hennepin County My commission expires 3-13-87 OFFICERS' CERTIFICATE OF DATAKEY, INC. We, the undersigned, John H. Underwood and Thomas R. King, the respective President and Secretary of Datakey, Inc., a corporation subject to the provisions of Minnesota Statutes, Chapter 302A, do hereby certify that the Minutes of Action Without Meeting of the Board of Directors of the corporation dated December 23, 1985, a copy of which is attached hereto and incorporated herein by reference, in which the Board of Directors authorized the issuance of Preferred Stock, were unanimously adopted and approved by such Board of Directors. IN WITNESS WHEREOF, we have subscribed our names this 23rd day of December, 1985. /s/ John H. Underwood John H. Underwood President /s/ Thomas R. King Thomas R. King Secretary STATE OF MINNESOTA ) ) ss. COUNTY OF HENNEPIN ) On this 23rd day of December, 1985, before a Notary Public within and for said County, personally appeared John H. Underwood and Thomas R. King, to me personally known, being by me duly sworn, and did say that they are the President and Secretary, respectively, of the corporation named above and that the said instrument was signed on behalf of the corporation and the persons who signed said instrument acknowledged it to be the free act and deed of said corporation. /s/ Diane M. Dossetto Notary Public - Minnesota Ramsey County My commission expires 7-10-90 MINUTES OF ACTION WITHOUT MEETING OF THE BOARD OF DIRECTORS OF DATAKEY, INC. The undersigned, being all of the members of the Board of Directors of Datakey, Inc., hereby adopt, by action without meeting, the following resolutions to be effective as of December 23, 1985, to-wit: RESOLVED: That the Preferred Stock authorizing resolutions, which resolutions are attached hereto as Exhibit A and which resolutions establish a class of Convertible Preferred Stock be and they hereby are adopted. FURTHER RESOLVED: That the officers of the corporation be, and they hereby are, authorized and directed to take whatever action is necessary to effect the foregoing resolutions. /s/ John H. Underwood John H. Underwood /s/ William P. Flies William P. Flies /s/ Timothy A. Stepanek Timothy A. Stepanek /s/ Thomas R. King Thomas R. King EXHIBIT A MINUTES OF ACTION WITHOUT MEETING OF THE BOARD OF DIRECTORS OF DATAKEY, INC. The undersigned, being all of the members of the Board of Directors of Datakey, Inc., hereby adopt, by action without meeting, the following resolution to be effective as of December 23, 1985, to-wit: WHEREAS, the Articles of Incorporation of Datakey, Inc., a Minnesota corporation, authorize the corporation to issue an aggregate of 5,000,000 shares of capital stock and empower the corporation's Board of Directors to establish from time to time by resolution different classes or series of shares and to fix the rights and preferences of said shares in any class or series; and WHEREAS, there currently are outstanding 2,979,750 shares of Common Stock, the remaining 2,020,250 authorized shares of capital stock being undesignated; and WHEREAS, the corporation's Board of Directors deems it to be in the best interests of the corporation and its shareholders to establish a second class of capital stock, Convertible Preferred Stock, having certain rights and preferences; NOW, THEREFORE, BE IT RESOLVED, that the 5,000,000 shares of capital stock authorized by the Articles of Incorporation of this corporation be, and they hereby are, designated as belonging to the following classes having the relative rights and preferences set forth below: Section 1. Shares and Classes Authorized. Of the 5,000,000 shares which the corporation is authorized to issue, 4,000,000 shares shall be designated Common Stock, par value $.05, 400,000 shares shall be designated Convertible Preferred Stock and 600,000 shares shall be undesignated capital stock. Section 2. Right and Preferences of Convertible Preferred Stock. The rights and preferences of the 400,000 shares of Convertible Preferred Stock shall be as set forth in Exhibit 1 which is attached hereto and made a part hereof. /s/ William P. Flies William P. Flies /s/ John H. Underwood John H. Underwood /s/ Timothy A. Stepanek Timothy A. Stepanek /s/ Thomas R. King Thomas R. King EXHIBIT 1 CERTIFICATE OF RIGHTS AND PREFERENCES OF CONVERTIBLE PREFERRED STOCK OF DATAKEY, INC. (A). Classification of Undesignated Shares. Of the 1,000,000 undesignated shares which the corporation is authorized to issue under its Articles of Incorporation, 400,000 of such shares shall all be classified as shares of Convertible Preferred Stock of the corporation (the "Preferred Stock"). Such shares of Preferred Stock, together with the 4,000,000 authorized shares of Common Stock of the corporation (the "Common Stock") and the balance of the undesignated shares of the corporation, are sometimes hereinafter collectively referred to as the "capital stock". (B). Voting Privileges. (a) General. Each holder of Preferred Stock shall have that number of votes on all matters submitted to the stockholders that is equal to the number of shares of Common Stock into which such holder's shares of Preferred Stock are then convertible, as hereinafter provided. Except as otherwise provided in subparagraph (b) below, and except as otherwise required by agreement or law, the shares of capital stock of the corporation shall vote as a single class on all matters submitted to the stockholders. (b) Without the affirmative vote of the holders (acting together as a class) of at least a majority (with respect to (1) below) or at least 90% (with respect to (2) below) of the shares of Preferred Stock at the time outstanding, the corporation shall not: (1) authorize or issue any shares of stock having a priority over Preferred Stock or ranking on a parity therewith as to the payment or distribution of assets upon the liquidation or dissolution, voluntary or involuntary, of the corporation; or (2) amend the Articles of Incorporation of the corporation so as to alter any existing provision relating to Preferred Stock. (c) No Cumulative Voting. No holder of shares of capital stock shall have any cumulative voting rights. (C). No Preemptive Rights. No holder of shares of any class of capital stock shall be entitled as such, as a matter of right, to subscribe for, purchase or receive any part of any new or additional issue of stock of any class whatsoever, or of securities convertible into or exchangeable for any stock of any class whatsoever, whether now or hereafter authorized and whether issued for cash or other consideration or by way of dividend. (D). Cash Dividends. Any dividend declared must be payable with respect to all outstanding shares of capital stock of the corporation. In the event any dividend is declared with respect to the capital stock, each holder of Preferred Stock shall be paid such cash dividend on the basis of the number of shares of Common Stock into which such holder's shares of Preferred Stock are then convertible, as hereinafter provided. (E). Other Terms of the Preferred Stock. (a) Liquidation Preference. In the event of either an involuntary or a voluntary liquidation or dissolution of the corporation, the holders of shares of Preferred Stock shall be entitled to receive out of the assets of the corporation an amount equal to $2.50 per share. In the event of either an involuntary or voluntary liquidation or dissolution of the corporation, payment shall be made to the holders of the Preferred Stock in the amounts herein fixed before any payment shall be made or any assets distributed to the holders of the Common Stock or any other class of shares of the corporation ranking junior to the Preferred Stock with respect to payment of dividends or upon dissolution or liquidation of the corporation. If upon any such liquidation or dissolution of the corporation the assets available for distribution `shall be insufficient to pay the holders of all outstanding shares of Preferred Stock the full amounts to which they respectively shall be entitled, the holders of such shares shall share pro rata in any such distribution. The merger or consolidation of the corporation into or with another corporation or the merger or consolidation of any other corporation into or with the corporation (in which consolidation or merger the stockholders of the corporation receive distribution of cash or securities or other property as a result of such consolidation or merger), or the sale, transfer or other disposition of all or substantially all of the assets of the corporation, shall be deemed, for purposes of determining the amounts to be received by the holders of the Preferred Stock in such merger, consolidation, sale, transfer or other disposition, to be a liquidation or dissolution of the corporation for purposes of this subparagraph (a) if the holders of a majority of the outstanding shares of Preferred Stock so elect by giving written notice thereof to the corporation at least two days before the effective date of such event. If no such notice is given, the provisions of subparagraph (c)(7) hereof shall apply. Nothing hereinabove set forth shall affect in any way the right of each holder of shares of Preferred Stock to convert such shares at any time and from time to time in accordance with subparagraph (c) below. (b) Redemptions. Redemptions of shares of Preferred Stock by the corporation without the consent of the holders thereof are not permitted. Mandatory redemptions of shares of Preferred Stock by the corporation are not required. (c) Conversion Right; Mandatory Conversion. At the option of the holders thereof, the shares of Preferred Stock shall be convertible, at the office of the corporation (or at such other office or offices, if any, as the Board of Directors may designate), into fully paid and nonassessable shares (calculated as to each conversion to the nearest 1/100th of a share) of Common Stock of the corporation, at the conversion price, determined as hereinafter provided, in effect at the time of conversion, each share of the Preferred Stock being taken at $2.50 for the purpose of such conversion. The price at which shares of Common Stock shall be delivered upon conversion (herein called the "conversion price") shall be initially $2.50 per share of Common Stock (i.e., at an initial conversion rate of one share of Common Stock for each share of Preferred Stock), provided, however, that such initial conversion price shall be subject to adjustment from time to time in certain instances as hereinafter provided. The following provisions shall govern such right of conversion: (1) In order to convert shares of Preferred Stock into shares of Common Stock of the corporation, the holder thereof shall surrender at any office hereinabove mentioned the certificate or certificates therefor, duly endorsed to the corporation or in blank, and give written notice to the corporation at such office that such holder elects to convert such shares. Shares of Preferred Stock shall be deemed to have been converted immediately prior to the close of business on the day of the surrender of such shares for conversion as herein provided, and the person entitled to receive the shares of Common Stock of the corporation issuable upon such conversion shall be treated for all purposes as the record holder of such shares of Common Stock at such time. As promptly as practicable on or after the conversion date, the corporation shall issue and deliver or cause to be issued and delivered at such office a certificate or certificates for the number of shares of Common Stock of the corporation issuable upon such conversion. (2) The conversion price shall be subject to adjustment from time to time as hereinafter provided. Upon each adjustment of the conversion price each holder of shares of Preferred Stock shall thereafter be entitled to receive the number of shares of Common Stock of the corporation obtained by multiplying the conversion price in effect immediately prior to such adjustment by the number of shares issuable pursuant to conversion immediately prior to such adjustment and dividing the product thereof by the conversion price resulting from such adjustment. (3) Except for the issuance of Conversion Stock and Warrant Stock (as those terms are defined in the Preferred Stock Purchase Agreement dated December 16, 1985 among the corporation and the Purchasers named therein) (a) if and whenever on or prior to June 30, 1987 the corporation shall issue or sell any shares of its Common Stock for a consideration per share less than the conversion price in effect immediately prior to the time of such issue or sale, then forthwith upon such issue or sale the conversion price shall be reduced to such lesser price, and (b) if and whenever after June 30, 1987 the corporation shall issue or sell any shares of its Common Stock for a consideration per share less than the conversion price in effect immediately prior to the time of such issue or sale, and/or the corporation shall issue or sell any shares of Common Stock for a consideration per share less than the market price on the date of such issue or sale, then forthwith upon such issue or sale the conversion price shall be reduced to the price (calculated to the nearest cent) determined by dividing (1) an amount equal to the sum of (aa) the number of shares of Common Stock outstanding immediately prior to such issue or sale multiplied by the then existing conversion price, and (bb) the consideration, if any, received by the corporation upon such issue or sale, by (2) an amount equal to the sum of (aa) the number of shares of Common Stock outstanding immediately prior to such issue or sale and (bb) the number of shares of Common Stock thus issued or sold. For the purposes of this subparagraph (3), the following provisions (i) to (vii), inclusive, shall also be applicable: (i) In case at any time the corporation shall grant (whether directly or by assumption in a merger or otherwise) any rights to subscribe for or to purchase, or any options for the purchase of, (a) Common Stock or (b) any obligations or any shares of stock of the corporation which are convertible into, or exchangeable for, Common Stock (any of such obligations or shares of stock being hereinafter called "Convertible Securities") whether or not such rights or options or the right to convert or exchange any such Convertible Securities are immediately exercisable, and the price per share for which Common Stock is issuable upon the exercise of such rights or options or upon conversion or exchange of such Convertible Securities (determined by dividing (x) the total amount, if any, received or receivable by the corporation as consideration for the granting of such rights or options, plus the minimum aggregate amount of additional consideration payable to the, corporation upon the exercise of such rights or options, plus, in the case of such Convertible Securities, the minimum aggregate amount of additional consideration, if any, payable upon the issue of such Convertible Securities and upon the conversion or exchange thereof, by (y) the total maximum number of shares of Common Stock issuable upon the exercise of such rights or options or upon the conversion or exchange of all such Convertible Securities issuable upon the exercise of such rights or options) shall be less than the conversion price in effect immediately prior to the time of the granting of such rights or options, then the total maximum number of shares of Common Stock issuable upon the exercise of such rights or options or upon conversion or exchange of the total maximum amount of such Convertible Securities issuable upon the exercise of such rights or options shall (as of the date of granting of such rights or options) be deemed to have been issued for such price per share. Except as provided in subparagraph (6) below, no further adjustments of the conversion price shall be made upon the actual issue of such Common Stock or of such Convertible Securities upon exercise of such rights or options or upon the actual issue of such Common Stock upon conversion or exchange of such Convertible Securities. (ii) In case the corporation shall issue or sell (whether directly or by assumption in a merger or otherwise) any Convertible Securities, whether or not the rights to exchange or convert thereunder are immediately exercisable, and the price per share for which Common Stock is issuable upon such conversion or exchange (determined by dividing (x) the total amount received or receivable by the corporation as consideration for the issue or sale of such Convertible Securities, plus the minimum aggregate amount of additional consideration, if any, payable to the corporation upon the conversion or exchange thereof, by (y) the total maximum number of shares of Common Stock issuable upon the conversion or exchange of all such Convertible Securities) shall be less than the conversion price in effect immediately prior to the time of such issue or sale, then the total maximum number of shares of Common Stock issuable upon conversion or exchange of all such Convertible Securities shall (as of the date of the issue or sale of such Convertible Securities) be deemed to be outstanding and to have been issued for such price per share, provided that (a) except as provided in subparagraph (6) below, no further adjustments of the conversion price shall be made upon the actual issue of such Common Stock upon conversion or exchange of such Convertible Securities, and (b) if any such issue or sale of such Convertible Securities is made upon exercise of any rights to subscribe for or to purchase or any option to purchase any such Convertible Securities for which adjustments of the conversion price have been or are to be made pursuant to other provisions of this subparagraph (3), no further adjustment of the conversion price shall be made by reason of such issue or sale. (iii) In case the corporation shall, after June 30, 1987, declare a dividend or make any other distribution upon any capital stock of the corporation payable in Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities, any Common Stock or Convertible Securities, or any such rights or options, as the case may be, issuable in payment of such dividend or distribution shall be deemed to have been issued or sold without consideration. (iv) In case any shares of Common Stock or Convertible Securities or any rights or options to purchase any such Common Stock or Convertible Securities shall be issued or sold for cash, the consideration received therefor shall be deemed to be the amount received by the corporation therefor, without deducting therefrom any expenses incurred or any underwriting commissions or concessions paid or allowed by the corporation in connection therewith. In case any shares of Common Stock or Convertible Securities or any rights or options to purchase any such Common Stock or Convertible Securities shall be issued or sold for a consideration other than cash, the amount of the consideration other than cash received by the corporation shall be deemed to be the fair value of such consideration as determined by the Board of Directors of the corporation, without deducting therefrom any expenses incurred or any underwriting commissions or concessions paid or allowed by the corporation in connection therewith. In case any shares of Common Stock or Convertible Securities or any rights or options to purchase such Common Stock or Convertible Securities shall be issued in connection with any merger or consolidation in which the corporation is the surviving corporation, the amount of consideration therefor shall be deemed to be the fair value as determined by the Board of Directors of the corporation of such portion of the assets and business of the non-surviving corporation or corporations as such Board shall determine to be attributable to such Common Stock, Convertible Securities, rights or options, as the case may be. In the event of any consolidation or merger of the corporation in which the corporation is not the surviving corporation or in the event of any sale of all or substantially all of the assets of the corporation for stock or other securities of any other corporation, the corporation shall be deemed to have issued a number of shares of its Common Stock for stock or securities of the other corporation computed on the basis of the actual exchange ratio on which the transaction was predicated and for a consideration equal to the fair market value on the date of such transaction of such stock or securities of the other corporation, and if any such calculation results in adjustment of the conversion price, the determination of the number of shares of Common Stock issuable upon conversion immediately prior to such merger, conversion or sale, for purposes of subparagraph (7) below, shall be made after giving effect to such adjustment of the conversion price. (v) In case the corporation shall take a record of the holders of its Common Stock for the purpose of entitling them (a) to receive a dividend or other distribution payable in Common Stock or in Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities, or (b) to subscribe for or purchase Common Stock or Convertible Securities, then the date of such record shall be deemed to be the date of the issue or sale of the shares of Common Stock deemed to have been issued or sold upon the declaration of such dividend or the making of such other distribution or the date of the granting of such rights of subscription or purchase, as the case may be. (vi) The number of shares of Common Stock outstanding at any given time shall not include shares owned or held by or for the account of the corporation, and the disposition of any such shares shall be considered an issue or sale of Common Stock for the purpose of this subparagraph (3). (vii) "Market price" shall mean the average of the high and low prices of the Common Stock sales on all exchanges on which the Common Stock may at the time be listed, or, if there shall have been no sales on any such exchange on any such day, the average of the bid and asked prices at the end of such day, or, if the Common Stock shall not be so listed, the average of the bid and asked prices at the end of the day in the over-the-counter market, in each case averaged over a period of 20 consecutive business days prior to the date as of which "market price" is being determined. If at any time the Common Stock is not listed on any exchange or quoted in the over-the-counter market, the "market price" shall be deemed to be the higher of (i) the book value thereof as determined by any firm of independent public accountants of recognized standing selected by the Board of Directors of the corporation as of the last day of any month ending within 60 days preceding the date as of which the determination is to be made, or (ii) the fair value thereof determined in good faith by the Board of Directors of the corporation as of a date which is within 15 days of the date as of which the determination is to be made. (4) In case the corporation shall declare a dividend or make a distribution upon the Common Stock payable otherwise than out of earnings or earned surplus (including dividends or distributions in Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities), then thereafter each holder of shares of Preferred Stock upon the conversion thereof will be entitled to receive the number of shares of Common Stock into which such shares of Preferred Stock have been converted, and, in addition and without payment therefor, the cash, stock or other securities and other property which such holder would have received by way of dividends (otherwise than out of such earnings or surplus) if continuously since such holder became the record holder of such shares of Preferred Stock such holder (i) had been the record holder of the number of shares of Common Stock then received, and (ii) had retained all dividends or distributions in stock or securities (including Common Stock or Convertible Securities, or in any rights or options to purchase any Common Stock or Convertible Securities) payable in respect of such Common Stock or in respect of any stock or securities paid as dividends or distributions and originating directly or indirectly from such Common Stock. For the purposes of the foregoing a dividend or distribution other than in cash shall be considered payable out of earnings or earned surplus only to the extent that such earnings or surplus are charged an amount equal to the fair value of such dividend or distribution as determined by the Board of Directors of the corporation. (5) In case the corporation shall at any time subdivide its outstanding shares of Common Stock into a greater number of shares, the conversion price in effect immediately prior to such subdivision shall be proportionately reduced, and conversely, in case the outstanding shares of Common Stock of the corporation shall be combined into a smaller number of shares, the conversion price in effect immediately prior to such combination shall be proportionately increased. (6) If (i) the purchase price provided for in any right or option referred to in clause (i) of subparagraph (3), or (ii) the additional consideration, if any, payable upon the conversion or exchange of Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3), or (iii) the rate at which any Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3) are convertible into or exchangeable for Common Stock, shall change at any time (other than under or by reason of provisions designed to protect against dilution), the conversion price then in effect hereunder shall forthwith be increased or decreased to such conversion price as would have obtained had the adjustments made upon the issuance of such rights, options or Convertible Securities been made upon the basis of (a) the issuance of the number of shares of Common Stock theretofore actually delivered upon the exercise of such options or rights or upon the conversion or exchange of such Convertible Securities, and the total consideration received therefor, and (b) the issuance at the time of such change of any such options, rights, or Convertible Securities then still outstanding for the consideration, if any, received by the corporation therefor and to be received on the basis of such changed price; and on the expiration of any such option or right or the termination of any such right to convert or exchange such Convertible Securities, the conversion price then in effect hereunder shall forthwith be increased to such conversion price as would have obtained had the adjustments made upon the issuance of such rights or options or Convertible Securities been made upon the basis of the issuance o the shares of Common Stock theretofore actually delivered (and the total consideration received therefor) upon the exercise of such rights or options or upon the conversion or exchange of such Convertible Securities. If the purchase price provided for in any right or option referred to in clause (i) of subparagraph (3), or the rate at which any Convertible Securities referred to in clause (i) or clause (ii) of subparagraph (3) are convertible into or exchangeable for Common Stock, shall decrease at any time under or by reason of provisions with respect thereto designed to protect against dilution, then in case of the delivery of Common Stock upon the exercise of any such right or option or upon conversion or exchange of any such Convertible Security, the conversion price then in effect hereunder shall forthwith be decreased to such conversion price as would have obtained had the adjustments made upon the issuance of such right, option or Convertible Security been made upon the basis of the issuance of (and the total consideration received for) the shares of Common Stock delivered as aforesaid. (7) If any capital reorganization or reclassification of the capital stock of the corporation, or consolidation or merger of the corporation with another corporation, or the sale of all or substantially all of its assets to another corporation shall be effected in such a way that holders of Common Stock shall be entitled to receive stock, securities or assets with respect to or in exchange for Common Stock, then, as a condition of such reorganization, reclassification, consolidation, merger or sale, and subject to subparagraph (a) above, lawful and adequate provision shall be made whereby the holders of Preferred Stock shall thereafter have the right to receive upon the basis and upon the terms and conditions specified herein and in lieu of the shares of the Common Stock of the corporation immediately theretofore receivable upon the conversion of Preferred Stock, such shares of stock, securities or assets as may be issued or payable with respect to or in exchange for a number of outstanding shares of such Common Stock equal to the number of shares of such stock immediately theretofore receivable upon the conversion of Preferred Stock had such reorganization, reclassification, consolidation, merger or sale not taken place, plus all dividends unpaid and accumulated or accrued thereon to the date of such reorganization, reclassification, consolidation, merger or sale, and in any such case appropriate provision shall be made with respect to the rights and interests of the holders of Preferred Stock to the end that the provisions hereof (including without limitation provisions for adjustments of the conversion price and of the number of shares receivable upon the conversion of Preferred Stock) shall thereafter be applicable, as nearly as may be in relation to any shares of stock, securities or assets thereafter receivable upon the conversion of Preferred Stock. The corporation shall not effect any such consolidation, merger or sale, unless prior to the consummation thereof the successor corporation (if other than the corporation) resulting from such consolidation or merger or the corporation purchasing such assets shall assume by written instrument executed and mailed to the holders of Preferred Stock, at the last addresses of such holders appearing on the books of the corporation, the obligation to deliver to such holder such shares of stock, securities or assets as, in accordance with the foregoing provisions, such holder may be entitled to receive. (8) Upon any adjustment of the conversion price, then and in each case the corporation shall give written notice thereof, by first-class mail, postage prepaid, addressed to the holders of Preferred Stock, at the addresses of such holders as shown on the books of the corporation, which notice shall state the conversion price resulting from such adjustment and the increase or decrease, if any, in the number of shares receivable at such price upon the conversion of Preferred Stock, setting forth in reasonable detail the method of calculation and the facts upon which such calculation is based. (9) In case at any time: (i) the corporation shall declare any cash dividend on its Common Stock at a rate in excess of the rate of the last cash dividend theretofore paid; (ii) the corporation shall pay any dividend payable in stock upon its Common Stock or make any distribution (other than regular cash dividends) to the holders of its Common Stock; (iii) the corporation shall offer for subscription pro rata to the holders of its Common Stock any additional shares of stock of any class or other rights; (iv) there shall be any capital reorganization, or reclassification of the capital stock of the corporation, or consolidation or merger of the corporation with, or sales of all or substantially all of its assets to, another corporation; or (v) there shall be a voluntary or involuntary dissolution, liquidation or winding up of the corporation; then, in any one or more of said cases, the corporation shall give written notice, by first-class mail, postage prepaid, addressed to the holders of Preferred Stock at the addresses of such holders as shown on the books of the corporation, of the date on which (a) the books of the corporation shall close or a record shall be taken for such dividend, distribution or subscription rights, or (b) such reorganization, reclassification, consolidation, merger, sale, dissolution, liquidation or winding up shall take place, as the case may be. Such notice shall also specify the date as of which the holders of Common Stock of record shall participate in such dividend, distribution or subscription rights, or shall be entitled to exchange their Common Stock for securities or other property deliverable upon such reorganization, reclassification, consolidation, merger, sale, dissolution, liquidation, or winding up, as the case may be. Such written notice shall be given at least 20 days prior to the action in question and not less than 20 days prior to the record date or the date on which the corporation's transfer books are closed in respect thereto. (10) If any event occurs as to which in the opinion of the Board of Directors of the corporation the other provisions of this paragraph (c) are not strictly applicable or if strictly applicable would not fairly protect the rights of the holders of Preferred Stock in accordance with the essential intent and principles of such provisions, then the Board of Directors shall make an adjustment in the application of such provisions, in accordance with such essential intent and principles, so as to protect such rights as aforesaid. (11) As used in this paragraph (c) the term "Common Stock" shall mean and include the corporation's presently authorized Common Stock and shall also include any capital stock of any class of the corporation hereafter authorized which shall not be limited to a fixed sum or percentage in respect of the rights of the holders thereof to participate in dividends or in the distribution of assets upon the voluntary or involuntary liquidation, dissolution or winding up of the corporation; provided that the shares receivable pursuant to conversion of shares of Preferred Stock shall include shares designated as Common Stock of the corporation as of the date of issuance of such shares of Preferred Stock, or, in case of any reclassification of the outstanding shares thereof, the stock, securities or assets provided for in subparagraph (7) above. (12) No fractional shares of Common Stock shall be issued upon conversion, but, instead of any fraction of a share which would otherwise be issuable, the corporation shall pay a cash adjustment in respect of such fraction in an amount equal to the same fraction of the market price per share of Common Stock, determined pursuant to subparagraph (3)(vii) above, as of the close of business on the day of conversion. Mandatory Conversion. Preferred Stock shall automatically be converted into shares of Common Stock of the corporation, without any act by the corporation or the holders of Preferred Stock, concurrently with the closing of the first public offering by the corporation of shares of Common Stock of the corporation registered under the Securities Act of 1933, as amended, in which (1) the offering is underwritten on a firm commitment basis by an underwriter, or a group of underwriters represented by an underwriter or underwriters, and (2) the aggregate public offering price of the securities sold for cash by the corporation in the offering, net of expenses payable by the corporation in connection with such offering, is at least $5,000,000, and (3) the public offering price per share of Common Stock is at least $5 (as adjusted from time to time to reflect stock splits, dividends, recapitalizations, combinations or the like). As used herein, the term "closing" shall mean the delivery by the corporation to the underwriters of certificates representing the shares of Common Stock of the corporation offered to the public against delivery to the corporation by such underwriters of payment therefor. The term "firm commitment basis" with respect to the underwriting of such public offering shall mean a commitment pursuant to a written underwriting agreement under which the nature of the underwriters' commitment is such that all securities will be purchased by such underwriters if any securities are purchased by such underwriters. Each holder of a share of Preferred Stock so converted shall be entitled to receive the full number of shares of Common Stock into which such share of Preferred Stock held by such holder could be converted if such holder had exercised its conversion right at the time of closing of such public offering. Upon such conversion, each holder of a share of Preferred Stock shall immediately surrender such share in exchange for appropriate stock certificates representing a share or shares of Common Stock of the corporation. ARTICLES OF AMENDMENT OF ARTICLES OF INCORPORATION OF DATAKEY, INC. Pursuant to the provisions of Minnesota Statutes, Section 302A.135, the following Amendment of Section 3.01 of the Articles of Incorporation of Datakey, Inc. was adopted at a meeting of the shareholders of the corporation duly convened and held on the 6th day of May, 1986, by a vote of 84% of the voting power of all shares entitled to vote: "3.01 The aggregate number of shares of stock which this corporation shall have authority to issue is 12,500,000 shares, consisting of 10,000,000 shares of Common Stock, par value $.05, 400,000 shares of Preferred Stock and 2,100,000 undesignated shares." I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation. /s/ John H. Underwood John H. Underwood, President STATE OF MINNESOTA ) ) SS. COUNTY OF Dakota ) The foregoing instrument was acknowledged before me this 25th day of June, 1986, by John H. Underwood, President of Datakey, Inc., a Minnesota corporation, on behalf of the corporation. /s/ Bette F. Feahr Notary Public - Minnesota Dakota County My commission expires 8-20-91 (Notarial Seal) ARTICLES OF AMENDMENT OF ARTICLES OF INCORPORAT10N OF DATAKEY, INC. Pursuant to the provisions of Minnesota Statutes, Section 302A.135, the following Amendment of the Articles of Incorporation of Datakey, Inc., adding Article VI, was adopted at a meeting of the shareholders of the corporation duly convened and held on the May 12, 1987, by a majority vote of the voting power of all shares entitled to vote: "ARTICLE VI - LIMITATION OF DIRECTOR LIABILITY 6.1) To the fullest extent permitted by the Minnesota Business Corporation Act as the same exists or may hereafter be amended, a director of this corporation shall not be personally liable to the corporation or its shareholders for monetary damages for breach of fiduciary duty as a director." I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation. /s/ John H. Underwood John H. Underwood, President STATE OF MINNESOTA ) ) SS. COUNTY OF DAKOTA ) The foregoing instrument was acknowledged before me this 27 day of May, 1987, by John H. Underwood, President of Datakey, Inc., a Minnesota corporation, on behalf of the corporation. /s/ Bette F. Feahr Notary Public - Minnesota Dakota County My commission expires 8-20-91 (Notarial Seal) Notice of Change of Registered Office by DATAKEY, INC. Pursuant to Minnesota Statutes, Section 302A.123, the undersigned hereby certifies that the Board of Directors of the above named Minnesota Corporation has resolved to change the corporation's registered office or agent: FROM: Datakey, Inc. 12281 Nicollet Avenue South Burnsville, MN 55337 TO: Datakey, Inc. 407 West Travelers Trail Burnsville, MN 55337-2554 The new address may not be a post office box. It must be a street address, pursuant to Minnesota Statutes, Section 302A.011, Subd. 3. The effective date of the change will be the 1st day of July, 1987 or the day of filing of this certificate with the Secretary of State, whichever is later. I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation. /s/ George H. M. Rountree George H. M. Rountree Vice President Finance July 11, 1988 State of Minnesota ) ) ss. County of Dakota ) The foregoing instrument was acknowledged before me on this 11th day of July, 1988. /s/ Bette F. Feahr Notary Public - Minnesota Dakota County My commission expires 8-20-91 State of Minnesota Department of State Filed: August 10, 1988 STATEMENT OF DESIGNATION OF SHARES OF DATAKEY, INC. The undersigned hereby certifies that the resolutions set forth on Exhibit A attached hereto were duly adopted by the Board of Directors of Datakey, Inc. on May 11, 1998. I swear that the foregoing is true and accurate and that I have the authority to sign this document on behalf of the corporation. May 14, 1998 DATAKEY, INC. /s/ Alan G. Shuler Alan G. Shuler Vice President and Chief Financial Officer EXHIBIT A DESIGNATION OF SERIES A CONVERTIBLE CUMULATIVE PREFERRED STOCK WHEREAS, pursuant to the Articles of Incorporation of this corporation, the Board of Directors has authority to establish, from the 2,100,000 undesignated shares of capital stock, one or more classes or series of shares, to designate each such class or series, and to fix the relative rights and preferences of each such class or series; and WHEREAS, the Board of Directors deem it advisable to designate shares of Series A Convertible Cumulative Preferred Stock; NOW, THEREFORE, RESOLVED, that of the 2,100,000 undesignated shares currently authorized, 150,000 shares are hereby designated as shares of Series A Convertible Cumulative Preferred Stock, which shares shall have the terms as set forth on Exhibit A hereto. EXHIBIT A RIGHTS, PREFERENCES AND RESTRICTIONS OF PREFERRED STOCK The rights, preferences, restrictions and other matters relating to the Series A Convertible Cumulative Preferred Stock (the "Series A Preferred Stock") are as follows: 1. Dividend Provisions. Upon issuance, dividends shall accrue on each share of outstanding Series A Preferred Stock at an annual rate equal to $1.264 per share per annum (8% of the Original Issue Price, as defined herein). Such dividends shall be cumulative and shall be payable upon any conversion of the Series A Preferred Stock pursuant to Section 3 hereof. Such dividends shall only be paid out of legally available funds of the Company. Such dividends shall be payable by the Company, in its sole discretion, all in cash or all by the issuance of a number of shares of the Company's unrestricted, freely tradable common stock equal to the dividends owing on the Series A Preferred Stock; provided, however, that prior to the payment of any such dividend by the issuance of shares of the Company's common stock, the Company shall deliver to the Investors an opinion of its counsel stating that all such shares have been validly registered, and that they are duly authorized, validly issued and nonassessable. For the purposes hereof, the number of shares of the Company's common stock issuable in lieu of any cash dividend payment shall equal the total dividend payment then due divided by the per share price of such stock. The per share price of the Company's common stock shall be determined based on the average closing bid price of such stock quoted on The Nasdaq Stock Market for the ten consecutive trading days prior to the payment of such dividends. Dividends on shares of the Series A Preferred Stock shall accrue beginning on the date of issuance of the shares of Series A Preferred Stock, shall compound on an annual basis and shall be payable upon conversion of the Series A Preferred Stock (a "Payment Date"). All accrued and unpaid dividends on the Series A Preferred Stock must be paid before any dividends may be declared or paid on any other junior series of preferred or common stock issued by the Company. 2. Liquidation Preference. (a) In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary, the holders of the previously issued Convertible Preferred Stock (the "Convertible Preferred Stock") and the Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets of the Company to the holders of common stock by reason of their ownership thereof, an amount per share equal to $2.50 for the Convertible Preferred Stock, and for the Series A Preferred Stock the sum of (i) $15.80, as adjusted pursuant to Section 4(c) hereof (the "Original Issue Price"), and (ii) an amount equal to cumulative unpaid dividends on such shares (respectively, a "Liquidation Amount"). If upon the occurrence of such an event, the assets and funds thus distributed among the holders of the Convertible Preferred Stock and the Series A Preferred Stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then, the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the Convertible Preferred Stock and the Series A Preferred Stock in proportion to the amount of such stock owned by each such holder multiplied by the appropriate Liquidation Amount. (b) Upon the completion of the distribution required by subparagraph (a) of this Section 2, if assets remain in the Company, the remaining assets of the Company shall be distributed ratably among the holders of the Company's common stock and the Series A Preferred Stock in proportion to the number of shares of common stock held by each (assuming full conversion of all shares of Series A Preferred Stock). (c) (i) For purposes of this Section 2, a liquidation, dissolution or winding up of the Company shall be deemed to be occasioned by, or to include, (A) the acquisition of the Company by another entity by means of any transaction or series of related transactions (including any reorganization, merger or consolidation but excluding any merger effected exclusively for the purpose of changing the domicile of the Company); or (B) a sale of all or substantially all of the assets of the Company, unless the Company's shareholders as constituted immediately prior to such acquisition or sale will, immediately after such acquisition or sale (by virtue of securities issued as consideration for the Company's acquisition or sale or otherwise) hold at least 50% of the voting power of the surviving or acquiring entity. (ii) In any of such events, if the consideration received by the Company is other than cash, its value will be deemed its fair market value. (iii) In the event the requirements of this Section 2 are not complied with, the Company shall forthwith either: (A) cause such closing to be postponed until such time as the requirements of this Section 2 have been complied with, or (B) cancel such transaction, in which event the rights, preferences and privileges of the holders of the Convertible Preferred Stock and the Series A Preferred Stock shall revert to and be the same as such rights, preferences and privileges existing immediately prior to the date of the first notice referred to in subsection 2(c)(iv) hereof. (iv) The Company shall give each holder of record of Convertible Preferred Stock and the Series A Preferred Stock written notice of such impending transaction not later than 20 days prior to the shareholders' meeting called to approve such transaction, or 20 days prior to the closing of such transaction, whichever is earlier, and shall also notify such holders in writing of the final approval of such transaction; provided, however, that the holder of any shares of then outstanding Convertible Preferred Stock or Series A Preferred Stock shall have the right during such 20-day period to convert such shares pursuant to Section 3 hereof. The first of such notices shall describe the material terms and conditions of the impending transaction and the provisions of this Section 2, and the Company shall thereafter give such holders prompt notice of any material changes. The transaction shall in no event take place sooner than 20 days after the Company has given the first notice provided for herein or sooner than ten days after the Company has given notice of any material changes provided for herein; provided, however, that such periods may be shortened upon the written consent of the holders of the Convertible Preferred Stock and the Series A Preferred Stock that are entitled to such notice rights or similar notice rights and that represent at least a majority of the voting power of all then outstanding shares of each of the classes of preferred stock, voting separately as a class. 3. Conversion. (a) Conversion Right. At the option of the holder thereof, each share of Series A Preferred Stock shall be convertible at any time during the period commencing on the day on which the Series A Preferred Stock is issued and expiring on May 15, 2000 (the date which is the second anniversary of the date of issuance of the Series A Preferred Stock); provided, however, that such expiration date shall be extended for a number of days equal to the number of days beyond the 90th day following the date of issuance of the Series A Preferred Stock that the Registration Statement (as such term is defined in the Registration Rights Agreement, of even date herewith, entered into by and between the Company and the Investors set forth on Schedule A thereto) is not effective (such date, including any extension thereof pursuant to the foregoing proviso, being herein referred to as the "Second Anniversary"). The Series A Preferred Stock shall be convertible at the office of the Company or any transfer agent for such stock into such number of fully paid and nonassessable shares of the Company's common stock as is determined by dividing the Original Issue Price, subject to adjustment as provided in Section 4, by the Conversion Price applicable to such shares, determined as hereafter provided, in effect on the date the certificates representing such shares are surrendered for conversion (the "Conversion Date"). The Conversion Price shall be equal to the average closing bid price of one share of the Company's common stock as quoted by the Nasdaq SmallCap Market, the Nasdaq National Market or the principal exchange upon which shares of the Company's common stock may be listed, or, if the Company's common stock shall not then be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market or listed on a national securities exchange, but shall otherwise be traded in the over-the-counter market, on such over-the-counter market for the ten-day period ending on the day prior to the Conversion Date (the "Trading Period") multiplied by .8 (the "Conversion Price"); provided, however, that in no event shall the Conversion Price exceed $5.00 per share or be less than $2.75 (the "Maximum Price" and "Minimum Price," respectively) per share; and provided, further, that appropriate adjustments shall be made in determining the average closing bid price if a recapitalization or other event affecting the Company's common stock shall occur during the Trading Period. (b) Dividend Payment. Should the Company, pursuant to Section 1 hereof, not elect to pay all outstanding, cumulative, accrued and unpaid dividends on the Series A Preferred Stock in shares of its common stock, the Company shall pay, in immediately available funds, to the holder of any shares of Series A Preferred Stock being converted, within two days, all such dividends on the date that it receives notice of such holder's intent to convert such shares pursuant to (d) below. Separately, should the Company elect to pay all outstanding, cumulative, accrued and unpaid dividends on the Series A Preferred Stock in shares of its common stock, it shall, within two business days of receiving a holder's notice of intent to convert, deliver certificates representing such shares to the holder of the Series A Preferred Stock. (c) Automatic Conversion. Any shares of Series A Preferred Stock remaining outstanding on the Second Anniversary shall be automatically converted pursuant to the conversion terms of Section 3(a) above. The Conversion Date with respect to such automatic conversion shall be the Second Anniversary. In any event, the Company shall, within two business days after automatic conversion of the Series A Preferred Stock, issue and deliver a certificate or certificates for the number of shares of the Company's common stock to which each former holder of Series A Preferred Stock is entitled. Notwithstanding the foregoing, no automatic conversion of the Series A Preferred Stock shall occur pursuant to this Section unless (i) all shares of the Company's common stock underlying the shares of Series A Preferred Stock may be sold pursuant to an effective registration statement under the Securities Act of 1933, as amended, (ii) the Company's common stock is listed and trading on The Nasdaq Stock Market, and (iii) the Company has reserved and available for issuance a number of shares of its common stock sufficient to cover conversion of all outstanding shares of Series A Preferred Stock. (d) Mechanics of Conversion. Before any holder of Series A Preferred Stock shall be entitled to convert the same into shares of the Company's common stock, he, she or it shall surrender the certificate or certificates therefor, duly endorsed, at the office of the Company or of any transfer agent for the Series A Preferred Stock, and shall give written notice, via facsimile, to the Company, at its principal corporate office, of the election to convert the same and shall state therein the name or names in which the certificate or certificates for shares of the Company's common stock are to be issued. The Company shall, immediately thereafter (and in any event no more than two business days thereafter), issue and deliver to such holder of Series A Preferred Stock at the address shown on the Company's records or at such other address as such party may designate by written notice to the Company, or to the nominee or nominees of such holder, a certificate or certificates for the number of shares of the Company's common stock to which such holder shall be entitled pursuant to Section 3(a) and a certificate representing shares of Series A Preferred Stock not so converted by the holder. Such conversion shall be deemed to have been made immediately prior to the close of business on the Conversion Date, and the person or persons entitled to receive the shares of the Company's common stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of the Company's common stock as of such date. (e) Mechanics of Automatic Conversion. On the Conversion Date with respect to the automatic conversion pursuant to subsection 3(c) above, the certificates representing shares of Series A Preferred Stock shall immediately represent that number of shares of the Company's common stock into which such shares are convertible. Holders of Series A Preferred Stock shall deliver their certificates, duly endorsed in blank, to the principal office of the Company, together with a notice setting out the name or names (with addresses) and denominations in which the certificates representing such shares of common stock issuable upon conversion are to be issued and including instructions for delivery thereof. The person entitled to receive the shares of the Company's common stock issuable upon such conversion shall be treated for all purposes as the record holder of such shares of common stock at and on the Conversion Date, and the rights of such person as a holder of shares of Series A Preferred Stock shall cease and terminate at and on the Conversion Date, in any case without regard to any failure by such holder to deliver the certificates or the notice required by this subsection 3(e). On the Conversion Date with respect to automatic conversion, the Company shall pay all outstanding, cumulative, accrued and unpaid dividends, either by the issuance of shares of its common stock or in cash, pursuant to the provisions set forth in (a) above; provided, however, that should the Company elect to pay such dividends by the issuance of additional shares of its common stock, the person entitled to receive such shares of the Company's common stock issuable upon such conversion shall be treated for all purposes as the record holder of such additional shares on the Conversion Date (f) No Impairment. The Company will not, by amendment of its Articles of Incorporation or through any reorganization, recapitalization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Company, but will at all times in good faith assist in the carrying out of all the provisions of this Section 3 and in the taking of all such action as may be necessary or appropriate in order to protect the conversion rights of the holders of the Series A Preferred Stock against impairment. (g) No Fractional Shares. No fractional shares shall be issued upon the conversion of any share or shares of the Series A Preferred Stock, and the number of shares of the Company's common stock to be issued shall be rounded to the nearest whole share. Whether or not fractional shares are issuable upon such conversion shall be determined on the basis of the total number of shares of Series A Preferred Stock the holder is at the time converting into shares of the Company's common stock and the number of shares of such common stock issuable upon such aggregate conversion. (h) Notices of Record Date. In the event of any taking by the Company of a record of the holders of any class of securities for the purpose of determining the holders thereof who are entitled to receive any dividend or other distribution, any right to subscribe for, purchase or otherwise acquire any shares of stock of any class or any other securities or property, or to receive any other right, the Company shall mail to each holder of Series A Preferred Stock, at least 20 days prior to the date specified therein, a notice specifying the date on which any such record is to be taken for the purpose of such dividend, distribution or right, and the amount and character of such dividend, distribution or right. (i) Reservation of Stock Issuable Upon Conversion. The Company shall at all times reserve and keep available out of its authorized but unissued shares of common stock, solely for the purpose of effecting the conversion of the shares of the Series A Preferred Stock, such number of its shares of its common stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Series A Preferred Stock; and if at any time the number of authorized but unissued shares of the Company's common stock shall not be sufficient to effect the conversion of all then outstanding shares of the Series A Preferred Stock, in addition to such other remedies as shall be available to the holder of such Series A Preferred Stock, the Company will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of common stock to such number of shares as shall be sufficient for such purposes, including engaging in best efforts to obtain the requisite shareholder approval of any necessary amendment to the Company's Articles of Incorporation. (j) Notices. Any notice required by the provisions of this Section 3 to be given to the holders of shares of Series A Preferred Stock shall be deemed given if deposited in the United States mail, postage prepaid, and addressed to each holder of record at his, her or its address appearing on the books of the Company. 4. Anti-Dilution Provisions. The Original Issue Price shall be subject to adjustment from time to time upon the happening of any of the following events: (a) In the event the Company shall issue or sell any shares of its common stock (except as provided in paragraph (e) hereof) for a consideration per share less than the greater of (A) $5.00, or (B) 80% of the Market Price (as defined below) on the date of such issue or sale, then the Original Issue Price shall be increased to such greater price (calculated to the nearest cent) as shall be determined by multiplying the Original Issue Price by a fraction, the numerator of which shall be the number of shares of the Company's common stock outstanding immediately after the issuance or sale of such additional shares, and the denominator of which shall be the sum of (i) the number of shares of the Company's common stock outstanding immediately prior to the issuance or sale of such additional shares, and (ii) the number of shares of the Company's common stock which the aggregate consideration received for the issuance or sale of such additional shares would purchase at the greater of $5.00, or if such shares of the Company's common stock shall have been issued for a consideration per share less than 80% of the Market Price on the date of issuance or sale, the current Market Price. For purposes of this paragraph, all shares of the Company's common stock issuable upon exercise of outstanding options and warrants shall be deemed to be outstanding. (b) For the purposes of paragraph 4(a) above, the following subparagraphs (i) to (vii), inclusive, shall be applicable: (i) If at any time the Company shall issue or sell any rights to subscribe for, or any rights or options to purchase, shares of its common stock or any stock or other securities convertible into or exchangeable for such common stock (such convertible or exchangeable stock or securities being hereinafter called "Convertible Securities"), whether or not such rights or options or the right to convert or exchange any such Convertible Securities shall be immediately exercisable, and the price per share for which shares of the Company's common stock shall be issuable upon the exercise of such rights or options or upon conversion or exchange of such Convertible Securities (determined by dividing (1) the total amount, if any, received or receivable by the Company as consideration for the granting of such rights or options, plus the minimum aggregate amount of additional consideration payable to the Company upon the exercise of such rights or options, plus, in the case of any such rights or options which shall relate to Convertible Securities, the minimum aggregate amount of additional consideration, if any, payable upon the issue or sale of such Convertible Securities and upon the conversion or exchange thereof, by (2) the total number of shares of the Company's common stock issuable upon the exercise of such rights or options or upon the conversion or exchange of all such Convertible Securities issuable upon the exercise of such rights or options) shall be less than the greater of (x) the $5.00, or (y) 80% of the Market Price at the time of such issue or sale, then the total number of shares of the Company's common stock issuable upon the exercise of such rights or options or upon conversion or exchange of the total amount of such Convertible Securities issuable upon the exercise of such rights or options shall (as of the date of granting of such rights or options) be deemed to be outstanding and to have been issued for such price per share, and except as provided in paragraph 4(d), no further adjustments of the Original Issue Price shall be made upon the actual issue of such shares of common stock or of such Convertible Securities, upon the exercise of such rights or options or upon the actual issue of such common stock upon conversion or exchange of such Convertible Securities. (ii) If at any time the Company shall issue or sell any Convertible Securities, whether or not the rights to exchange or convert thereunder shall be immediately exercisable, and the price per share for which shares of the Company's common stock shall be issuable upon such conversion or exchange (determined by dividing (1) the total amount received or receivable by the Company as consideration for the issue or sale of such Convertible Securities, plus the minimum aggregate amount of additional consideration, if any, payable to the Company upon the conversion or exchange thereof, by (2) the total number of shares of the Company's common stock issuable upon the conversion or exchange of all such Convertible Securities) shall be less than the greater of (x) $5.00, or (y) 80% of the Market Price at the time of such issue or sale, then the total number of shares of the Company's common stock issuable upon conversion or exchange of all such Convertible Securities shall (as of the date of the issue or sale of such Convertible Securities) be deemed to be outstanding and to have been issued for such price per share, and, except as provided in paragraph 4(d), no further adjustments of the Original Issue Price shall be made upon the actual issue of such shares of common stock upon conversion or exchange of such Convertible Securities. In addition, if any issue or sale of such Convertible Securities shall be made upon exercise of any rights to subscribe for or to purchase or any option to purchase any such Convertible Securities for which adjustments of the Original Issue Price shall have been or shall be made pursuant to other provisions of this paragraph 4(b)(ii), no further adjustment of the Original Issue Price shall be made by reason of such issue or sale. (iii) If at any time the Company shall declare and pay a dividend or make any other distribution upon the shares of its common stock payable in such stock or Convertible Securities, any such stock or Convertible Securities, as the case may be, issuable in payment of such dividend or distribution shall be deemed to have been issued or sold without consideration. (iv) If at any time any shares of the Company's common stock or Convertible Securities or any rights or options to purchase shares of any such stock or Convertible Securities shall be issued or sold for cash, the consideration received therefor shall be deemed to be the amount received by the Company therefor, without deduction therefrom of any expenses incurred or any underwriting commissions or concessions or discounts paid or allowed by the Company in connection therewith. In case any shares of the Company's common stock or Convertible Securities or any rights or options to purchase any such common stock or Convertible Securities shall be issued or sold for a consideration other than cash, the amount of the consideration other than cash received by the Company shall be deemed to be the fair value of such consideration as determined by the Company's Board of Directors, without deduction therefrom of any expenses incurred or any underwriting commissions or concessions or discounts paid or allowed by the Company in connection therewith. In case any shares of the Company's common stock or Convertible Securities or any rights or options to purchase any such common stock or Convertible Securities shall be issued in connection with any merger of another corporation into the Company, the amount of consideration therefor shall be deemed to be the fair value of the net assets of such merged corporation as determined by the Company's Board of Directors after deducting therefrom all cash and other consideration (if any) paid by the Company in connection with such merger. (v) If at any time the Company shall take a record of the holders of its common stock for the purpose of entitling them (1) to receive a dividend or other distribution payable in shares of the Company's common stock or in Convertible Securities, or (2) to subscribe for or purchase shares of the Company's common stock or Convertible Securities, then such record date shall be deemed to be the date of the issue or sale of the shares of the Company's common stock deemed to have been issued or sold upon the declaration of such dividend or the making of such other distribution or the date of the granting of such right of subscription or purchase, as the case may be. (vi) The number of shares of the Company's common stock outstanding at any given time shall not include shares owned or held by or for the account of the Company, provided that such shares are neither issued, sold or otherwise distributed by the Company. (vii) For purposes hereof, the "Market Price" shall mean the average closing bid price of the Company's common stock on the Nasdaq SmallCap Market, the Nasdaq National Market or the principal exchange upon which shares of the Company's common stock may be listed, or, if the Company's common stock shall not then be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market or listed on a national securities exchange, but shall otherwise be traded in the over-the-counter market, on such over-the-counter market, in each case for the ten day period immediately preceding any determination of such "Market Price" (subject to appropriate adjustments which shall be made in determining the average closing bid price if a recapitalization or other event affecting the Company's common stock shall occur during such 10-day period). If at any time shares of the Company's common stock shall not be quoted on the Nasdaq SmallCap Market or the Nasdaq National Market, listed on a national securities exchange, or otherwise traded in the over-the-counter market, the "Market Price" of a share of the Company's common stock shall be deemed to be the higher of (x) the book value thereof (as determined by any firm of independent public accountants of nationally recognized standing selected by the Company's Board of Directors) as of the last day of any month ending within 60 days preceding the date of determination, or (y) the fair value thereof (as determined in good faith by the Company's Board of Directors) as of a date which shall be within 15 days of the date of determination. (c) In case at any time the Company shall subdivide its outstanding shares of common stock into a greater number of shares, the Original Issue Price in effect immediately prior to such subdivision, the Maximum Price and the Minimum Price shall be proportionately reduced, and the Company shall subdivide the Series A Preferred Stock in the same proportion. In case at any time the outstanding shares of the Company's common stock shall be combined into a smaller number of shares, the Original Issue Price in effect immediately prior to such combination, the Maximum Price and the Minimum Price shall be proportionately increased, and the Company shall combine the Series A Preferred Stock in the same proportion. Any adjustment under this paragraph 4(c) shall become effective at the close of business on the date the subdivision or combination shall become effective. The Company will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of Series A Preferred Stock to such number of shares as shall be sufficient for any such purposes, including engaging in best efforts to obtain the requisite shareholder approval of any necessary amendment to the Company's Articles of Incorporation. (d) If the purchase or exercise price provided for in any right or option referred to in paragraph 4(b)(i), or the rate at which any Convertible Securities referred to in paragraph 4(b)(i) or (ii) shall be convertible into or exchangeable for shares of the Company's common stock, shall change or a different purchase or exercise price or rate shall become effective at any time or from time to time (including any change resulting from termination of such right, option or convertible security), then, upon such change becoming effective, the Original Issue Price then in effect hereunder shall forthwith be increased or decreased to such Original Issue Price as would have been obtained had the adjustments made upon the granting or issuance of such rights or options or Convertible Securities been made upon the basis of (A) the issuance of the number of shares of the Company's common stock theretofore actually delivered upon the exercise of such options or rights or upon the conversion or exchange of such Convertible Securities, and (B) the granting or issuance at the time of such change of any such options, rights or Convertible Securities then still outstanding for the consideration, if any, received by the Company therefor and to be received on the basis of such changed price. (e) The Company shall not be required to make any adjustment to the Original Issue Price in the case of: (i) the granting, after the date hereof, by the Company of stock options under the Company's 1997 Stock Option Plan, so long as the shares of the Company's common stock underlying such options are covered by the 800,000 shares currently reserved for issuance under such plan as of the date hereof, assuming approval by the Company's shareholders of the 300,000 share increase at the Company's 1998 Annual Meeting of Shareholders; (ii) the issuance of shares of the Company's common stock, pursuant to the exercise of the options referred to in paragraph 4(e)(i) above or the exercise of any other options or warrants outstanding as of the date hereof; or (iii) the issuance of shares of the Series A Preferred Stock hereunder or of shares of the Company's common stock upon the conversion of any shares of the Series A Preferred Stock or upon the exercise of the Warrant or the Warrant issued to Miller, Johnson & Kuehn, Incorporated on the same date as the Preferred Stock Purchase Agreement to which this certificate of Designation is an Exhibit. 5. Voting Rights. The holder of each share of Series A Preferred Stock shall have the right to the number of votes on all matters submitted to the Company's shareholders that shall be equal to the number of shares of the Company's common stock into which such holder's shares of Series A Preferred Stock shall then be convertible (assuming a conversion as of the record date set for the vote). 6. Status of Converted Stock. In the event any shares of Series A Preferred Stock shall be converted pursuant to Section 3 hereof, the shares of Series A Preferred Stock so converted shall be canceled and shall not be issuable by the Company. The Articles of Incorporation of the Company shall be appropriately amended to effect the corresponding reduction in the Company's authorized capital stock. 7. Notice of Adjustment. The Company shall provide all holders of shares of Series A Preferred Stock five business days prior written notice of any adjustments in the Original Issue Price, the Maximum Price, the Minimum Price or any other adjustments made pursuant to the provisions hereof. EX-13.1 3 PORTIONS OF ANNUAL REPORT INDEPENDENT AUDITOR'S REPORT To the Stockholders Datakey, Inc. Burnsville, Minnesota We have audited the accompanying consolidated balance sheets of Datakey, Inc. and Subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Datakey, Inc. and Subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. /s/ McGLADREY & PULLEN, LLP Minneapolis, Minnesota February 5, 1999 DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, 1998 and 1997
ASSETS (Note 3) 1998 1997 - -------------------------------------------------------------------------------------------------------------------- Current Assets Cash and cash equivalents $ 853,827 $ 1,305,392 Trade receivables, less allowance for doubtful accounts of $30,000 (Note 7) 859,636 634,267 Inventories (Note 2) 1,007,948 1,082,737 Prepaid expenses and other 56,237 53,360 ------------------------------------- Total current assets 2,777,648 3,075,756 ------------------------------------- Other Assets Licenses and patents, less amortization--1998 $229,523; 1997 $181,801 (Note 8) 674,481 1,104,302 ------------------------------------- Equipment and Leasehold Improvements, at cost Production tooling 1,251,857 1,215,012 Equipment 3,012,184 2,956,269 Furniture and fixtures 304,853 298,771 Leasehold improvements 286,916 281,956 ------------------------------------- 4,855,810 4,752,008 Less accumulated depreciation 3,771,659 3,278,760 ------------------------------------- 1,084,151 1,473,248 ------------------------------------- Total Assets $ 4,536,280 $ 5,653,306 =====================================
See Notes to Consolidated Financial Statements.
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1997 - -------------------------------------------------------------------------------------------------------------------- Current Liabilities Accounts payable $ 435,873 $ 184,103 Accrued expenses: Compensation 162,509 410,055 Other 66,364 91,774 License obligation (Note 8) - 439,000 Accrued dividends (Note 5) 67,023 - ------------------------------------- Total current liabilities 731,769 1,124,932 ------------------------------------- Commitments and Contingencies (Notes 5, 8, and 9) Stockholders' Equity (Notes 5 and 6) Convertible preferred stock, voting, liquidation value $2.50 per share; authorized 400,000 shares; issued and outstanding 150,000 shares 375,000 375,000 Series A convertible cumulative preferred stock, voting, 8% cumulative, liquidation value $15.80 per share plus accrued dividends; authorized 150,000 shares; issued and outstanding 83,957 shares in 1998 1,326,519 - Common stock, par value $0.05 per share; authorized 10,000,000 shares; issued and outstanding 3,045,704 shares in 1998 and 2,887,235 shares in 1997 152,285 144,361 Additional paid-in capital 4,793,665 4,089,283 Accumulated deficit (2,842,958) (80,270) ------------------------------------- 3,804,511 4,528,374 ------------------------------------- $ 4,536,280 $ 5,653,306 =====================================
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1998 and 1997
1998 1997 - -------------------------------------------------------------------------------------------------------------------- Net sales (Note 7) $ 5,870,250 $ 5,977,464 ------------------------------------- Costs and expenses: Cost of goods sold 3,681,124 4,389,367 Research and development 1,672,837 3,185,894 Marketing and sales 2,069,288 1,716,343 General and administrative 793,948 713,308 ------------------------------------- Total costs and expenses 8,217,197 10,004,912 ------------------------------------- Operating loss (2,346,947) (4,027,448) Interest income 57,572 169,569 ------------------------------------- Loss before income taxes (2,289,375) (3,857,879) Income tax expense (Note 4) - 325,000 ------------------------------------- Net loss $ (2,289,375) $ (4,182,879) ===================================== Net loss attributable to common stockholders: Net loss $ (2,289,375) $ (4,182,879) Preferred stock beneficial conversion feature (Note 5) (395,000) - Preferred stock dividends (Note 5) (78,313) - ------------------------------------- Net loss attributable to common stockholders $ (2,762,688) $ (4,182,879) ===================================== Basic and diluted loss per share (0.94) (1.45) Weighted average shares: Basic and diluted 2,931,465 2,886,641
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1998 and 1997
Series A Cumulative Convertible Preferred Stock Preferred Stock ------------------------------------------------------------ Shares Amount Shares Amount - --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1996 150,000 $ 375,000 - $ - Issuance of common stock under stock options (Note 6) - - - - Net loss - - - - ------------------------------------------------------------ Balance, December 31, 1997 150,000 375,000 - - Issuance of common stock under stock options (Note 6) - - - - Issuance of Series A preferred stock (net of offering expenses) (Note 5) - - 100,000 1,580,000 Preferred stock beneficial conversion feature (Note 5) - - - - Preferred stock dividends (Note 5) - - - - Conversion of Series A preferred stock, including accrued dividends, to common stock (Note 5) - - (16,043) (253,481) Net loss - - - - ------------------------------------------------------------ Balance, December 31, 1998 150,000 $ 375,000 83,957 $ 1,326,519 ============================================================
See Notes to Consolidated Financial Statements.
Additional Common Stock Paid-In Accumulated ----------------------- Shares Amount Capital Deficit Total - --------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1996 2,882,069 $ 144,103 $ 4,070,815 $ 4,102,609 $ 8,692,527 Issuance of common stock under stock options (Note 6) 5,166 258 18,468 - 18,726 Net loss - - - (4,182,879) (4,182,879) ------------------------------------------------------------------ Balance, December 31, 1997 2,887,235 144,361 4,089,283 (80,270) 4,528,374 Issuance of common stock under stock options (Note 6) 62,500 3,125 230,105 - 233,230 Issuance of Series A preferred stock (net of offering expenses) (Note 5) - - (180,695) - 1,399,305 Preferred stock beneficial conversion feature (Note 5) - - 395,000 (395,000) - Preferred stock dividends (Note 5) - - - (67,023) (67,023) Conversion of Series A preferred stock, including accrued dividends, to common stock (Note 5) 95,969 4,799 259,972 (11,290) - Net loss - - - (2,289,375) (2,289,375) ------------------------------------------------------------------ Balance, December 31, 1998 3,045,704 $ 152,285 $ 4,793,665 $(2,842,958) $ 3,804,511 ==================================================================
DATAKEY, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1998 and 1997
1998 1997 - --------------------------------------------------------------------------------------------------------------------------- Cash Flows From Operating Activities Net loss $ (2,289,375) $ (4,182,879) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 515,391 515,593 Amortization 47,722 127,723 Interest on investment securities - 163,287 Deferred taxes - 325,000 Changes in assets and liabilities: Trade receivables (225,369) 271 Inventories 74,789 46,170 Accounts payable 251,770 (375,177) Other (275,833) (152,118) --------------------------------- Net cash used in operating activities (1,900,905) (3,532,130) --------------------------------- Cash Flows From Investing Activities Purchase of equipment (126,294) (587,136) Proceeds from maturity of held-to-maturity securities - 5,829,941 License and patent costs (56,901) (234,789) --------------------------------- Net cash provided by (used in) investing activities (183,195) 5,008,016 --------------------------------- Cash Flows From Financing Activities Net proceeds from issuance of common stock 233,230 18,726 Net proceeds from issuance of preferred stock 1,399,305 - Payment on license obligation - (329,250) --------------------------------- Net cash provided by (used in) financing activities 1,632,535 (310,524) --------------------------------- Increase (decrease) in cash and cash equivalents (451,565) 1,165,362 Cash and Cash Equivalents Beginning 1,305,392 140,030 --------------------------------- Ending $ 853,827 $ 1,305,392 ================================= Supplemental Schedule of Noncash Investing and Financing Activities Increase (decrease) in liability for license obligation (Note 8) $ (439,000) $ 768,250 Beneficial conversion feature (Note 5) 395,000 - Accrued dividends (Note 5) 67,023 - Preferred stock dividend converted to common stock 11,290 - =================================
See Notes to Consolidated Financial Statements. DATAKEY, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------ Note 1. Nature of Business and Significant Accounting Policies Nature of business: Datakey, Inc. is an international supplier of electronic products and services. The Company provides product, subsystem, and system solutions to record, store, and transmit electronic information. The Company also provides products and systems directed to the information security market which enables user identification and authentication, secure data exchange, and information validation. The Company also provides electronic products, consisting of proprietary memory keys, cards, and other custom-shaped tokens, that serve as a convenient way to carry electronic information and are packaged to survive in portable environments. Liquidity: The Company believes its working capital and cash equivalents together with its bank line of credit will be sufficient to fund its planned operations and continued development and promotional activities during 1999, provided that revenues from new products materialize as expected. The Company is, however, exploring its options to arrange additional equity financing to provide working capital. In addition, the Company expects the bank line of credit, which expires in May 1999, will be renewed for another year. A summary of significant accounting policies follows: Principles of consolidation: The consolidated financial statements include the accounts of Datakey, Inc. and its wholly-owned subsidiary. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and cash equivalents: For purposes of reporting in the statements of cash flows, the Company includes all cash accounts and all highly liquid debt instruments purchased with an original maturity of three months or less as cash and cash equivalents on the accompanying consolidated balance sheets. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market. Licenses and patents: Licenses and patents are stated at cost. Patents are being amortized using the straight-line method over their economic useful lives which have been estimated to be five years. The costs of the license agreements are amortized to cost of goods sold as the products incorporating the licensed units are sold. Accounting for long-lived assets: The Company periodically reviews the utilization of its licenses, patents, and other long-lived assets for impairment. To date, management has determined that no impairment in the value of these assets has occurred. Certain licenses with a carrying value totaling approximately $439,000 will expire in December 2000. If the Company's sales do not meet anticipated levels, an impairment charge relating to these licenses could be recognized in 1999 or 2000. Note 1. Nature of Business and Significant Accounting Policies (Continued) Depreciation: Depreciation of equipment and leasehold improvements is computed on the straight-line and accelerated methods over the following estimated useful lives: Years Production tooling 2-5 Equipment 3-7 Furniture and fixtures 7 Leasehold improvements Life of lease Warranty costs: The Company provides for estimated normal warranty costs at the time of product sales to customers and for other costs associated with specific items at the time their existence and amounts are determinable. Income taxes: Deferred taxes are provided on an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss or tax credit carryforwards, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the amounts of assets and liabilities recorded for income tax and financial reporting purposes. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Revenue recognition: The Company records sales revenue upon shipment of product or providing services to the customer. The Company's practice is to grant credit on an unsecured basis to customers who meet certain financial criteria. Research and development: Research and development costs are charged to expense as incurred. Advertising: Expenditures for advertising costs are expensed as incurred. Fair value of financial instruments: The Company's financial instruments consist of cash and cash equivalents and short-term trade receivables and payables for which current carrying amounts approximate fair value. Loss per share: The Company computes basic and diluted net loss per share based upon the weighted- average number of common shares outstanding during each year. Preferred stock dividends and the beneficial conversion feature related to the Series A preferred stock (Note 5) are included in the net loss attributable to stockholders in calculating basic and diluted loss per share. Potential common shares such as options, warrants, and convertible preferred stock (as discussed in Note 6) were not included in the computation of diluted loss per common share as their effect is antidilutive. Due to the losses in 1998 and 1997, basic and diluted loss per share were the same for each of these years. Note 2. Inventories Inventories consist of the following components as of December 31, 1998 and 1997: 1998 1997 -------------------------- Raw materials $ 638,671 $ 766,955 Work in process 73,181 63,007 Finished goods 296,096 252,775 -------------------------- $1,007,948 $1,082,737 ========================== Note 3. Line of Credit The Company has available a $1,000,000 line of credit from a bank which bears interest at 1.25 percent above the prime rate (9 percent at December 31, 1998) and is secured by substantially all assets of the Company. The line of credit expires in May 1999 and is subject to annual renewal. There were no balances outstanding as of December 31, 1998 or 1997. Note 4. Income Taxes Income tax expense consists of the following: December 31 1998 1997 -------------------- Currently payable $ -- $ -- Deferred -- 325,000 -------------------- $ -- $ 325,000 ==================== The income tax benefit is different from that which would be computed by applying the U.S. federal income tax rate (35 percent) to pretax loss as follows:
December 31 1998 1997 ----------------------------- Computed "expected" federal tax benefit at statutory rates $ (801,000) $(1,350,000) Effect of net operating loss, with no current benefit 801,000 1,350,000 Change in valuation allowance -- 325,000 ----------------------------- Actual tax expense $ -- $ 325,000 =============================
Note 4. Income Taxes (Continued) Deferred taxes consist of the following components as of December 31, 1998 and 1997: 1998 1997 ----------------------------- Deferred tax assets: Allowance for doubtful accounts $ 11,000 $ 11,000 Inventory 159,000 239,000 Warranty reserve 11,000 18,000 Compensation and benefits 26,000 89,000 Net operating loss carryforward 2,981,000 1,940,000 Research and development tax credit 172,000 68,000 ----------------------------- Total gross deferred tax assets 3,360,000 2,365,000 Valuation allowance (3,244,000) (2,206,000) ----------------------------- Net deferred tax assets 116,000 159,000 Deferred tax liability: Depreciation (116,000) (159,000) ----------------------------- Net deferred taxes $ -- $ -- ============================= Realization of deferred tax assets is dependent upon the generation of sufficient future taxable income. At December 31, 1996, the Company had established a valuation allowance against a portion of the net deferred tax assets in recognition of the risk that part of the loss carryforward may not be realized. During 1997 and 1998, management determined that sufficient uncertainty existed regarding the realizability of the balance of the net deferred tax assets, and accordingly, the Company increased the valuation allowance to entirely reserve the net deferred tax assets of the Company. At December 31, 1998, the Company's net operating loss and tax credit carryforwards expire as follows: Research and Development Operating Loss Tax Credit Carryforward Carryforward -------------- ------------- 2011 $1,850,000 $ -- 2012 3,540,000 113,000 2018 2,560,000 59,000 -------------- ------------- $7,950,000 $ 172,000 ============== ============= The future use of federal net operating losses can be subject to annual limits in the event of ownership changes. Note 5. Stockholders' Equity Convertible preferred stock: The preferred stock is convertible at the rate of one share of common stock for each share of preferred stock, subject to certain antidilution adjustments. Conversion is mandatory in the event of certain future public offerings of corporate stock. The holders of the preferred stock have certain piggyback and demand registration rights, have a liquidation preference of $2.50 per share, and share in dividends paid on common stock. Series A convertible cumulative preferred stock: In May 1998, the Company completed a $1.58 million convertible preferred stock offering which entitles the preferred stockholders, for a two-year period, to convert their investment into common shares at 80 percent of the average closing price (for a ten-day period prior to conversion) of the Company's common stock, with a maximum conversion price of $5.00 per share and a minimum conversion price of $2.75 per share. On the second anniversary of the stock offering, any remaining preferred stock is automatically converted to common stock using the same conversion terms. Because the preferred stock can be converted to common stock at a 20 percent discount to average market value, a "beneficial conversion feature," which was valued at $395,000, was recorded by the Company. The beneficial conversion feature did not require the Company to disburse any cash and was recorded by increasing both additional paid-in capital and accumulated deficit, with no effect on overall stockholders' equity. The holders of the Series A convertible preferred stock are also entitled to receive dividends at the rate of 8 percent annually, which are payable at the option of the Company in cash or shares of the Company's common stock. Dividends are fully cumulative and are payable upon conversion of the Series A convertible preferred stock. The Company is accruing the dividends on a monthly basis. At December 31, 1998, accrued but unpaid dividends totaled $67,023. The holders of the Series A convertible preferred stock have a liquidation preference of $15.80 per share plus unpaid dividends. Undesignated stock: The Company has 1,950,000 shares of undesignated capital stock. Note 6. Stock Options and Warrants Stock options: The Company has reserved 800,000 common shares for issuance under qualified and nonqualified stock options for its key employees and directors. The Company has also reserved 50,000 common shares for issuance under nonqualified options to various distributors, dealers, and consultants. Option prices are the fair market value of the stock at the time the option was granted. Options become exercisable as determined at the date of grant by a committee of the Board of Directors. Options expire ten years after the date of grant unless an earlier expiration date is set at the time of grant. Note 6. Stock Options and Warrants (Continued) The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. Accordingly, no compensation cost has been recognized for the stock option plans. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards in 1998 and 1997, consistent with the provisions of SFAS No. 123, the Company's net loss attributable to common stockholders and basic and diluted loss per share would have changed to the pro forma amounts indicated below:
Years Ended December 31 1998 1997 ----------------------------- Net loss attributable to common stockholders, as reported $(2,762,688) $(4,182,879) Net loss attributable to common stockholders, pro forma (3,080,178) (4,391,620) Basic and diluted loss per share, as reported (0.94) (1.45) Basic and diluted loss per share, pro forma (1.05) (1.52)
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998 and 1997:
Years Ended December 31 1998 1997 ----------------------------- Expected dividend yield -- -- Expected stock price volatility 65.79% 53.26% Risk-free interest rate 5.22% 6.17% Expected life of options 3.6 years 3.6 years Weighted-average fair value of options granted during the year $ 0.92 $ 1.39
The pro forma effect on net loss attributable to common stockholders in 1998 and 1997 is not representative of the pro forma effect in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995. Additional information relating to all outstanding options as of December 31, 1998 and 1997, is as follows:
1998 1997 ------------------------------------------------ Weighted- Weighted- Average Average Exercise Exercise Shares Price Shares Price ------------------------------------------------ Options outstanding at beginning of year 701,333 $ 3.84 517,167 $ 4.37 Options exercised (62,500) 3.73 (5,166) 3.62 Options forfeited (41,000) 3.12 (80,668) 4.81 Options granted 354,500 4.13 270,000 3.12 ------------------------------------------------ Options outstanding at end of year 952,333 $ 3.97 701,333 $ 3.84 ================================================ Options exercisable at end of year 395,668 $ 4.30 379,333 $ 4.33 ================================================
Note 6. Stock Options and Warrants (Continued) The following table summarizes information about stock options outstanding at December 31, 1998:
Options Outstanding Options Exercisable ------------------------- ------------------------------ Weighted- Average Number Remaining Weighted- Number Weighted- Range of Outstanding Contractual Average Exercisable Average Exercise at December 31, Life Exercise at December 31, Exercise Prices 1998 (Years) Price 1998 Price - ----------------------------------------------------------------------------------------------------- $2.25 - $3.38 247,000 8.1 $ 2.73 62,834 $ 2.83 $3.50 - $4.875 412,833 7.4 3.71 190,334 3.67 $5.00 - $8.00 292,500 6.5 5.38 142,500 5.79 - -------------- ---------------------------------------------------------------------------- $2.25 - $8.00 952,333 7.3 $ 3.97 395,668 $ 4.30 ============== ============================================================================
In May 1998, warrants to purchase 225,983 shares of the Company's common stock were issued. The exercise price of the warrants ranges from $6.00 to $6.60 per common share. The warrants are currently exercisable and expire as follows: 2003, 188,093 and 2008, 37,890. As of December 31, 1998, none of the warrants had been exercised. Note 7. Major Customers and International Sales Major customers: Net sales for 1998 and 1997 and trade receivable balances as of December 31, 1998, include the following amounts with major customers: Trade Receivables Amount of Net Sales Balance -------------------------- ----------- 1998 1997 1998 ------------------------------------------- U.S. government agencies $ 536,000 $1,198,000 $ 30,000 Customer A 482,000 616,000 18,000 Customer B 583,000 638,000 140,000 ------------------------------------------- $1,601,000 $2,452,000 $ 188,000 =========================================== International sales: Export sales to international customers for 1998 and 1997 were $1,591,000 and $1,800,000, respectively. Accounts receivable from international customers were approximately $288,000 at December 31, 1998. Note 8. Commitments and Contingencies License agreement: In December 1996, the Company entered into a license agreement with a software company to allow the Company to bundle the licensed products into certain of the Company's products. Under the agreement, payments to the software company for the licensed products are based upon the number of units sold and the nature of the software bundled. In addition, the Company agreed to purchase a minimum quantity of software units over a specified period of time. The value of the minimum purchase is included in the initial license agreement. Note 8. Commitments and Contingencies (Continued) At December 31, 1996, the Company had paid $109,750 as the first payment for the license agreement, with an additional $768,250 to be paid in seven quarterly installments pending the successful delivery of a beta version of the licensed product from the software company in 1997. Upon delivery of the product in 1997, the Company recorded an additional liability of $768,250 and a corresponding asset for prepaid license fees. In 1997, the software company announced that certain of the licensed software would be available at no cost to the general public. As a result of this announcement, the Company amended the license agreement in 1998 and fixed the total license fee obligation at $439,000, the amount that had already been paid, rather than the $878,000 in the original agreement. Accordingly, the remaining license fee obligation of $439,000 was reduced to zero and the prepaid license fees were also reduced by $439,000. The remaining prepaid license fee will be amortized as the licensed products are sold. Leases: The Company leases its office and warehouse facilities under noncancelable operating leases which expire in May and June 1999. The remaining lease commitment is approximately $75,000 in 1999. Total rent expense under these leases totaled $160,000 and $136,000 in 1998 and 1997, respectively. Note 9. Operating Segments The Company adopted SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, for the year ended December 31, 1998. This statement requires public enterprises to report selected information about operating segments in annual and interim reports issued to shareholders. The adoption of this statement had no impact on the Company's financial condition or results of operations. The Company's reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. The Company has two reportable segments: Electronic Products (EP) and Integrated Systems Solutions (ISS). The Electronic Products segment produces and markets proprietary memory keys, cards, and other custom-shaped tokens that serve as a convenient way to carry electronic information. The Integrated Systems Solutions segment produces and markets products for the information security market which enable user identification and authentication, secure data exchange, and information validation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. There are no intersegment transactions. The Company evaluates performance based on operating earnings of the respective segments. Note 9. Operating Segments (Continued)
December 31, 1998 ---------------------------------------------------------------- EP ISS Unallocated Total ---------------------------------------------------------------- Revenue $ 5,241,000 $ 629,200 $ -- $ 5,870,200 Interest income -- -- 57,600 57,600 Depreciation and amortization 423,300 139,800 -- 563,100 Segment profit (loss) 573,100 (2,917,300) 54,800 (2,289,400) December 31, 1997 ---------------------------------------------------------------- EP ISS Unallocated Total ---------------------------------------------------------------- Revenue $ 5,868,400 $ 109,100 $ -- $ 5,977,500 Interest income -- -- 169,600 169,600 Depreciation and amortization 456,300 187,000 -- 643,300 Segment profit (loss) 349,100 (4,373,600) (158,400) (4,182,900)
The Company does not segregate total assets between its two segments. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS Results of Operations The table below summarizes changes in selected operating indicators, showing certain income, cost and expense items as a percentage of total revenue for each of the past three years. Inflation has not been a significant factor in Datakey's operations to date. Percentage of Total Revenue --------------------------- Year Ended December 31, 1998 1997 ---- ---- Revenue 100% 100% Cost and Expenses Cost of goods sold 63 73 Research and development 29 53 Marketing and sales 35 29 General and administrative 13 12 ---- ---- Total cost and expenses 140 167 Interest income 1 2 Loss before income taxes (39) (65) Income taxes - 5 ---- ---- Net loss (39)% (70)% ==== ==== Comparison of 1998 with 1997 Total revenue: Total revenue was $5,870,000 in 1998, a decrease of 2 percent from $5,977,000 in 1997. The revenue decrease was primarily due to a reduction in orders from a few key Electronic Products (EP) customers, offset, in part, by an increase in orders in the Information Systems Solutions (ISS) business segment. Gross margins: The gross profit margin increased to 37 percent in 1998 from 27 percent in 1997. This improvement was principally due to improved materials and labor costs in relation to selling prices and a reduction in scrap and yield loss. Research and development: Research and development (R&D) expense decreased by 47 percent to $1,673,000 in 1998 from $3,186,000 in 1997. R&D expense declined substantially because the initial new product development phase was completed in 1997, and the Company was able to concentrate on product enhancements and upgrades during 1998. Marketing and sales, General and administrative: Marketing and sales expense increased 21 percent to $2,069,000 in 1998 from $1,716,000 in 1997. The increase in 1998 expense resulted from increases in sales salaries, advertising and promotional activities to promote the Company's information security products. General and administrative expenses increased 11 percent to $794,000 in 1998 from $713,000 in 1997 primarily as a result of increases in office rental, real estate tax, and corporate insurance expense. Interest income: Interest income decreased to $58,000 in 1998 from $170,000 in 1997 due to a decline in the Company's interest bearing cash equivalent accounts. Income tax expense: As a result of the net cumulative operating losses of approximately $8,000,000 at December 31, 1998, the Company recorded no income tax expense in 1998 compared to a tax expense of $325,000 in 1997. Comparison of 1997 with 1996 Total revenue: Total revenue was $5,977,000 in 1997, a decrease of 9 percent from $6,558,000 in 1996. The revenue decrease was primarily due to customer requested delays in shipments to major electronic products customers during the second half of 1997, resulting from delays, cancellation, or non-renewal of orders from their customers. Gross margins: The gross profit margin decreased to 27 percent in 1997 from 35 percent in 1996, primarily as a result of lower revenue, product costs associated with zero charge evaluation units delivered to customers, and increases in reserves for inventory obsolescence. Research and development: Research and development expenses increased 41 percent to $3,186,000 in 1997 from $2,263,000 in 1996 due to the Company's significant increase in product development activities for token-based information security systems. Marketing and sales, General and administrative: Marketing and sales expense in 1997 increased 31 percent to $1,716,000 from $1,312,000 in 1996 due to a planned increase in product promotion expense to achieve market introduction of the new token-based information security systems. General and administrative expenses decreased 38 percent to $713,000 in 1997 from $1,156,000 in 1996 primarily due to an accrual in 1996 for severance pay and benefits due the Company's former chief executive officer. Interest income: Interest income decreased 53 percent to $170,000 in 1997 from $361,000 in 1996 due to a decline in the Company's investment in interest bearing investments. Income tax expense (benefit): The Company recorded an income tax expense of $325,000 in 1997 as compared to an income tax benefit of $388,000 in 1996. As a result of the net operating loss carryover in excess of $5,000,000 at December 31, 1997, the Company determined that the realization of the future tax benefit of the operating losses for tax purpose was uncertain and, accordingly, the deferred tax asset of $325,000 recorded at December 31, 1996, was entirely reserved and charged to expense in 1997. Liquidity and Capital Resources The Company had a reduction of $452,000 in cash and cash equivalents in 1998 compared to a reduction of $4,828,000 in cash, cash equivalents, and held-to-maturity securities in 1997. The 1998 reduction resulted from the net loss of $2,289,000 due in part to significant expenditures, totaling $3,742,000, in research and development and marketing expenses principally related to the Company's new product development activities. The decrease was offset, in part, by $1,633,000 in proceeds from the sale of securities. The Company invested $183,000 in the purchase of equipment and maintenance of licenses and patents in 1998 compared to $1,151,000 in 1997. The 1997 amount is primarily attributable to prepaid license fees related to licensed software that the Company intends to bundle with the Company's information security systems, and purchases of automated equipment to improve factory efficiency. Cash and cash equivalents as of December 31, 1998, were $854,000 as compared to $1,305,000 as of December 31, 1997. See "Outlook & Risks". Datakey's balance sheet reflects $2,046,000 in working capital and a current assets to current liabilities ratio of 3.8 to 1 as of December 31, 1998. Outlook & Risks Certain statements in the following section and in other parts of this Annual Report are forward looking, are based upon current expectations and actual results may differ materially due to risks and uncertainties, including those set forth below. Revenue: Revenue from the EP segment is expected to increase gradually during 1999 as shipments to new customers come on line, which will likely result in an increase in total revenue from this segment in 1999 compared to 1998. Revenue from the ISS segment is expected to increase significantly as more pilot programs move into a deployment phase and additional pilot programs are commenced. If this revenue meets the Company's current expectations, the ISS segment may contribute 50% of the total quarterly revenue by the end of 1999. Revenue increases from both the EP and ISS segments depend on customer acceptance, competition, and the effectiveness of the Company's marketing and sales organization. There is no assurance that the Company will achieve it revenue plan. Gross margins: A gradual improvement in gross profit margins during 1999 is expected through effective material purchasing, an increase in revenue without an attendant increase in factory overhead, an increase in the revenue contribution from ISS products that, generally, carry higher margins, and improvements in manufacturing efficiency. Such an increase in gross margin depends on achievement of the expected purchasing prices, realization of the revenue increases, and a continuation of improvement in factory processes. Research and development: The Company intends to increase funding for new product development activities in 1999 by about 10 percent compared to 1998. The ability to increase such funding depends on the Company's capital resources. Marketing and sales, General and administrative: Marketing and sales expenses are expected to increase about 15 percent in 1999 to support new product introductions and the expected increase in revenue. General and administrative expenses in 1999 are expected to increase slightly from the 1998 level. Interest income (expense): Interest income is expected to decline materially in 1999 as the Company intends to use cash and cash equivalents to fund continuing product development and marketing activities to support the Company's entry into advanced information security products. Beginning in the second or third quarter, the Company expects to borrow money and begin incurring interest expense under the $1 million bank line of credit. Income taxes: As a result of a net operating loss carry-forward the Company does not expect to record an income tax benefit or expense during 1999. Expected loss: The Company expects to report a loss in the first half of 1999. The Company's ability to attain profitability in the second half of 1999 and thereafter will depend primarily on it ability to significantly increase the revenue contribution from its ISS segment. There is no assurance that this revenue increase will occur. Liquidity and capital resources: In 1999, the Company plans to increase new product development, marketing activities and inventory levels. Based on its current plan, which assumes significantly increased revenues from its ISS segment, the Company believes its working capital together with its bank line of credit will be sufficient to fund its planned operations and product development and promotional activities in 1999. Because there can be no assurance that the revenue goals of its 1999 plan will be met, however, the Company is in the process of seeking additional capital through a private equity placement. There is no assurance that such a private placement will be successful or that its bank line of credit, which expires in May 1999, will be extended. In the event that the Company's revenues in 1999 are significantly less than projected, the Company's inability to extend its current bank credit line or successfully complete a private equity placement could jeopardize the Company's ability to maintain its current business operations. Year 2000 The Company began addressing the Year 2000 issue in 1997 using a multi-step approach, including inventory and assessment, remediation and testing, and contingency planning. The Company, with the assistance of outside consultants, began by analyzing and testing its major internal software programs to determine the level of compliance with the changeover in Year 2000. At this point the Company believes all "mission critical" systems are either materially compliant or will be materially compliant by June 30, 1999, with minor software upgrades. The Company is currently seeking assurances from key suppliers and customers regarding their Year 2000 readiness. The Company has not yet completed this part of the assessment phase and cannot predict the outcomes of other companies' remediation efforts. The Company currently plans to substantially complete its Year 2000 compliance efforts by September 1999. The Company has also formed a team to develop contingency plans by September 30, 1999, in the event certain suppliers are unable to deliver critical parts and components in early 2000. At this time, the Company believes that its most reasonably likely worst case scenario is that the Company could experience delays in delivery of critical parts and supplies and/or key customers could experience a delay in delivery of needed Datakey parts. In the event that either of these scenarios occur, the Company expects that it would have a material adverse effect on the Company's financial condition and results of operations. The Company estimates that the total cost of efforts, in 1999, to make hardware and software Year 2000 compliant, will be approximately $20,000. EX-23.1 4 INDEPENDENT ACCOUNTANT'S CONSENT Consent of Independent Accountants We consent to the incorporation by reference in the Rgistration Statements on Forms S-8 No. 33-14144, No. 33-47068, No. 33-67280, No. 333-11405, No. 33-80894, and No. 333-43937 of our report dated February 5, 1999, with respect to the financial statements of Datakey, Inc., which appear in Item 7 of the annual report on Form 10-KSB for the year ended December 31, 1998. /s/ McGladrey & Pullen, LLP McGladrey & Pullen, LLP Minneapolis, Minnesota March 29, 1999 EX-27 5 ART 5 FDS FOR YEAR ENDED 12/31/98
5 1 U.S. Dollars YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 1 853,827 0 889,636 30,000 1,007,948 2,777,648 4,855,810 3,771,659 4,536,280 731,769 0 1,326,519 375,000 152,285 1,950,707 4,536,280 5,870,250 5,870,250 3,681,124 3,681,124 4,536,073 0 0 (2,289,375) 0 (2,289,375) 0 0 0 (2,289,375) (0.94) (0.94)
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