10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2014

OR

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

For the transition period from            to           

Commission File Number  0-20191

INTRUSION INC.

(Exact name of registrant as specified in its charter)

Delaware	75-1911917
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1101 East Arapaho Road, Suite 200, Richardson, Texas 75081

(Address of principal executive offices)

(Zip Code)

(972) 234-6400

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

* * * * * * * * * *

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x  No o

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

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o  No x

The number of shares outstanding of the Registrant’s Common Stock, $0.01 par value, on November 1, 2014 was 12,426,002.

INTRUSION INC.

INDEX

PART I — FINANCIAL INFORMATION		2
Item 1. Financial Statements		2
	Unaudited Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013	2
	Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2014 and 2013	3
	Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 and 2013	4
	Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		9
Item 4. Controls and Procedures		13
PART II — OTHER INFORMATION		13
Item 1. Legal Proceedings		13
Item 1A. Risk Factors		13
Item 6. Exhibits		15
Signature Page		16

1

PART I — FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

INTRUSION INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

	September 30, 2014			December 31, 2013
ASSETS
Current Assets:
Cash and cash equivalents	$	1,376		$	1,139
Accounts receivable	1,015			816
Inventories, net	12			19
Prepaid expenses	142			95
Total current assets	2,545			2,069
Property and equipment, net	396			297
Other assets	63			51
TOTAL ASSETS	$	3,004		$	2,417
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current Liabilities:
Accounts payable and accrued expenses	$	966		$	998
Dividends payable	32			437
Obligations under capital lease, current portion	145			106
Deferred revenue	966			139
Loan payable to officer	1,530			—
Total current liabilities	3,639			1,680
Loan payable to officer	—			1,530
Obligations under capital lease, noncurrent portion	126			67
Commitments and contingencies
Stockholders’ deficit:
Preferred stock, $0.01 par value: Authorized shares — 5,000
Series 1 shares issued and outstanding — 200 as of September 30, 2014 and 220 as of December 31, 2013
Liquidation preference of $1,025 as of September 30, 2014	708			778
Series 2 shares issued and outstanding — 460 as of September 30, 2014 and December 31, 2013
Liquidation preference of $1,155 as of September 30, 2014	724			724
Series 3 shares issued and outstanding — 289 as of September 30, 2014 and 354 as of December 31, 2013
Liquidation preference of $633 as of September 30, 2014	411			504
Common stock, $0.01 par value:
Authorized shares — 80,000
Issued shares — 12,436 as of September 30, 2014 and 12,182 as of December 31, 2013 Outstanding shares — 12,426 as of September 30, 2014 and 12,172 as of December 31, 2013	124			122
Common stock held in treasury, at cost — 10 shares	(362		)	(362		)
Additional paid-in capital	56,310			55,905
Accumulated deficit	(58,569		)	(58,424		)
Accumulated other comprehensive loss	(107		)	(107		)
Total stockholders’ deficit	(761		)	(860		)
TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT	$	3,004		$	2,417

See accompanying notes.

2

INTRUSION INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

	Three Months Ended						Nine Months Ended
	September 30, 2014			September 30, 2013			September 30, 2014			September 30, 2013
Net product revenue	$	2,011		$	1,954		$	5,375		$	5,760
Net customer support and maintenance revenue	19			21			54			65
Total revenue	2,030			1,975			5,429			5,825
Cost of product revenue	704			785			1,891			2,135
Cost of customer support and maintenance revenue	3			5			8			16
Total cost of revenue	707			790			1,899			2,151
Gross profit	1,323			1,185			3,530			3,674
Operating expenses:
Sales and marketing	470			336			1,245			1,083
Research and development	443			361			1,442			1,138
General and administrative	293			281			959			921
Operating income (loss)	117			207			(116		)	532
Interest expense, net	(24		)	(34		)	(83		)	(97		)
Other income	54			—			54			—
Income (loss) before income tax provision	147			173			(145		)	435
Income tax provision	—			—			—			—
Net income (loss)	$	147		$	173		$	(145	)	$	435
Preferred stock dividends accrued	(35		)	(38		)	(106		)	(113		)
Net income (loss) attributable to common stockholders	$	112		$	135		$	(251	)	$	322
Net income (loss) per share attributable to common stockholders: Basic	$	0.01		$	0.01		$	(0.02	)	$	0.03
Diluted	$	0.01		$	0.01		$	(0.02	)	$	0.02
Weighted average common shares outstanding: Basic	12,426			12,172			12,379			12,172
Diluted	15,485			14,532			12,379			14,532

See accompanying notes.

3

INTRUSION INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

	Nine Months Ended
	September 30, 2014			September 30, 2013
Operating Activities:
Net income (loss)	$	(145	)	$	435
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	175			110
Stock-based compensation	284			148
Penalties and waived penalties on dividends	6			22
Changes in operating assets and liabilities:
Accounts receivable	(199		)	(819		)
Inventories	7			(14		)
Prepaid expenses and other assets	(62		)	7
Accounts payable and accrued expenses	(32		)	407
Deferred revenue	827			382
Net cash provided by operating activities	861			678
Investing Activities:
Purchases of property and equipment	(49		)	(60		)
Financing Activities:
Proceeds from line of credit	453			508
Payments on line of credit	(453		)	(638		)
Proceeds from stock options exercised	61			—
Payments of dividends	(512		)	—
Principal payments on capital leases	(124		)	(82		)
Net cash used by financing activities	(575		)	(212		)
Net increase in cash and cash equivalents	237			406
Cash and cash equivalents at beginning of period	1,139			52
Cash and cash equivalents at end of period	$	1,376		$	458
Cash paid during the year for interest	$	95		$	144
SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING ACTIVITIES:
Preferred stock dividends accrued	$	107		$	113
Purchase of leased equipment under capital lease	$	222		$	34
Conversion of preferred shares to common stock	$	163		$	—

See accompanying notes.

4

INTRUSION INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.Description of Business

We develop, market and support a family of entity identification, high speed data mining, advanced persistent threat detection, regulated information compliance, data privacy protection and network intrusion prevention/detection products.  Our product families include:

·TraceCop™ for identity discovery and disclosure,

·Savant™ for network data mining and advanced persistent threat detection,

·Compliance Commander™ for regulated information and data privacy protection, and

·SecureNet™ for network intrusion prevention and detection.

We market and distribute our products through a direct sales force to:

·end-users,

·value-added resellers,

·system integrators,

·managed service providers, and

·distributors.

Our end-user customers include:

·U.S. federal government entities,

·local government entities,

·banks,

·credit unions,

·other financial institutions,

·hospitals and other healthcare providers, and

·other customers.

Essentially, our end-users can be defined as any end-users requiring network security solutions for protecting their mission critical data.

We were organized in Texas in September 1983 and reincorporated in Delaware in October 1995.  Our principal executive offices are located at 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to the “Company”, “we”, “us”, “our”, “Intrusion” or “Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.  Compliance Commander, SecureNet, TraceCop and Savant are trademarks of Intrusion Inc.

On March 29, 2006, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to establish a $1.0 million line of credit (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amended and Restated Loan and Security Agreement with SVB to, among other things, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008 Credit Line”).  On June 24, 2014, we entered into the Sixth Amendment to the Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with SVB to replace our expiring line with a $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement are secured by substantially all of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’s Chairman, President and Chief Executive Officer, has established a Guaranty Agreement with SVB securing all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Credit are based on advances (each an “Advance”) against certain of our accounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eighty percent (80%) of each Eligible Account, or such other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance charge calculated as a daily rate that is based on a 360-day annual rate of the greater of the prime rate plus 2.0% or 7.0%.  Finance charges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateral handling fee of 0.5% of all outstanding Advances, depending on certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliest of (a) the date that the Eligible Account related to the Advance is paid, (b) the date the Eligible Account is no longer eligible under the Loan Agreement, or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) is asserted to the Eligible Account.  We have certain non-financial and financial covenants, including a liquidity coverage ratio and a rolling EBITDA computation, as defined in the Loan Agreement.  On June 23, 2015, the Loan Agreement terminates and all outstanding Advances, accrued but unpaid finance charges, outstanding collateral handing fees, and other amounts become due

5

under the Loan Agreement and related documents.  As of September 30, 2014 we had no borrowings outstanding under the Current Line of Credit and are within limits of all debt covenants.

As of September 30, 2014, we had cash and cash equivalents of approximately $1,376,000, up from approximately $1,139,000 as of December 31, 2013.  We generated a net loss of $145,000 for the nine month period ended September 30, 2014 compared to net income of $435,000 for the nine month period ended September 30, 2013.  As of September 30, 2014, in addition to cash and cash equivalents of $1,376,000, we had $500,000 in funding available under our $0.625 million line of credit at Silicon Valley Bank (“SVB”) and $670,000 funding available from a promissory note to borrow up to $2.2 million from G. Ward Paxton, the Company’s Chief Executive Officer.  We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources.  Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months.  We expect to fund our operations through Company profits, our line of credit, borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.

2.Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Item 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  The December 31, 2013 balance sheet was derived from audited financial statements, but does not include all the disclosures required by accounting principles generally accepted in the United States.  However, we believe that the disclosures are adequate to make the information presented not misleading.  In our opinion, all the adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included.  The results of operations for the three and nine month periods ended September 30, 2014 are not necessarily indicative of the results that may be achieved for the full fiscal year or for any future period.  The unaudited condensed consolidated financial statements included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2013, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 28, 2014.

The Company calculates the fair value of its assets and liabilities which qualify as financial instruments and includes this additional information in the notes to consolidated financial statements when the fair value is different from the carrying value of these financial instruments. The estimated fair value of accounts receivable, accounts payable and accrued expenses, and dividends payable approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of the line of credit payable approximates fair value since this instrument bears market interest rates.  Loans payable to officer are with a related party and as a result do not bear market rates of interest.  Management believes based on its current financial position that it could not obtain comparable amounts of third party financing, and as such cannot estimate the fair value of the loans payable to officer.  None of these instruments are held for trading purposes.

3.Inventories (In thousands)

	September 30, 2014		December 31, 2013
Inventories consist of:
Finished products	12		19
Net inventory	$	12	19

4.Loan Payable to Officer

On February 7, 2013, the Company entered into an unsecured revolving promissory note to borrow up to $2,200,000 from G. Ward Paxton, the Company’s Chief Executive Officer.  Under the terms of the note, the Company may borrow, repay and reborrow on the loan as needed up to an outstanding principal balance due of $2,200,000 at any given time through March 2014.

On February 6, 2014, the Company entered into an unsecured revolving promissory note to borrow up to $2,200,000 from G. Ward Paxton, which replaced the February 7, 2013 unsecured promissory note which was previously entered into between the Company and G. Ward Paxton.  Under the terms of the note, the Company may borrow, repay and reborrow on the loan as needed up to an outstanding principal balance due of $2,200,000 at any given time through March 2015.

6

Amounts borrowed from this officer accrue interest at a floating rate per annum equal to SVB’s prime rate plus 1% (5% at September 30, 2014).  All outstanding borrowings and accrued but unpaid interest is due on March 31, 2015.  As of September 30, 2014, the borrowings outstanding totaled $1,530,000 and accrued interest totaled $57,000.

5.Line of Credit

On March 29, 2006, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to establish a $1.0 million line of credit (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amended and Restated Loan and Security Agreement with SVB to, among other things, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008 Credit Line”).  On June 24, 2014, we entered into the Sixth Amendment to the Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with SVB to replace our expiring line with a $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement are secured by substantially all of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’s Chairman, President and Chief Executive Officer, has established a Guaranty Agreement with SVB securing all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Credit are based on advances (each an “Advance”) against certain of our accounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eighty percent (80%) of each Eligible Account, or such other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance charge calculated as a daily rate that is based on a 360-day annual rate of the greater of the prime rate plus 2.0% or 7.0%.  Finance charges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateral handling fee of 0.5% of all outstanding Advances, depending on certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliest of (a) the date that the Eligible Account related to the Advance is paid, (b) the date the Eligible Account is no longer eligible under the Loan Agreement, or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) is asserted to the Eligible Account.  We have certain non-financial and financial covenants, including a liquidity coverage ratio and a rolling EBITDA computation, as defined in the Loan Agreement.  On June 23, 2015, the Loan Agreement terminates and all outstanding Advances, accrued but unpaid finance charges, outstanding collateral handing fees, and other amounts become due under the Loan Agreement and related documents.  As of September 30, 2014 we had no borrowings outstanding under the Current Line of Credit and are within limits of all debt covenants.

6.Accounting for Stock-Based Compensation

During the three month periods ended September 30, 2014 and 2013, the Company granted 0 and 3,000, respectively, of stock options to employees or directors.  The Company recognized $97,000 and $39,000, respectively, of stock-based compensation expense for the three month periods ended September 30, 2014 and 2013.  During the nine month periods ended September 30, 2014 and 2013, the Company granted 295,000 and 286,000, respectively, of stock options to employees and directors.  The Company recognized $284,000 and $148,000, respectively, of stock-based compensation expense for the nine month periods ended September 30, 2014 and 2013.

During the three month periods ended September 30, 2014 and 2013, 0 options were exercised under the 2005 Plan, respectively.  During the nine month periods ended September 30, 2014 and 2013, 157,500 and 0 options were exercised under the 2005 Plan, respectively.

Valuation Assumptions

The fair values of employee and director option awards were estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:

	For Three Months Ended September 30, 2014	For Three Months Ended September 30, 2013			For Nine Months Ended September 30, 2014			For Nine Months Ended September 30, 2013
Weighted average grant date fair value	—	$	0.91		$	1.79		$	0.48
Weighted average assumptions used:
Expected dividend yield	—	0.0		%	0.0		%	0.0		%
Risk-free interest rate	—	1.34		%	1.46		%	0.75		%
Expected volatility	—	227.0		%	228.0		%	225.2		%
Expected life (in years)	—	5.0			4.9			4.9

Expected volatility is based on historical volatility and in part on implied volatility.  The expected term considers the contractual term of the option as well as historical exercise and forfeiture behavior.  The risk-free interest rate is based on the rates in effect on the grant date for U.S. Treasury instruments with maturities matching the relevant expected term of the award. Options granted to non-employees are valued using the fair market value on each measurement date of the option.

7

7.Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing net income (loss) attributable to common stockholders for the period by the weighted average number of common shares outstanding for the period.  Diluted net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted average number of common shares and dilutive common stock equivalents outstanding for the period.  Our common stock equivalents include all common stock issuable upon conversion of preferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stock equivalents excluded from the diluted income (loss) per share calculation for the three month periods ended September 30, 2014 and 2013 are 609,452 and 379,822 as they are antidilutive.  The aggregate number of common stock equivalents excluded from the diluted income (loss) per share calculation for the nine month periods ended September 30, 2014 and 2013 are 4,208,910 and 1,082,117 as they are antidilutive.

8.Concentrations

Our operations are concentrated in one area—security software/entity identification.  Sales to the U.S. Government through direct and indirect channels totaled 52.8% of total revenues for the third quarter of 2014 compared to 45.8% of total revenues for the third quarter of 2013.  During the third quarter of 2014, approximately 38.6% of total revenues were attributable to three government customers compared to approximately 30.9% of total revenues attributable to two government customers in the third quarter of 2013.  Sales to commercial customers totaled 47.2% of total revenue for the third quarter of 2014 compared to 54.2% of total revenue for the third quarter of 2013.  During the third quarter of 2014, approximately 42.0% of total revenue was attributable to two commercial customers compared to approximately 53.2% to two commercial customers in the third quarter of 2013.  Our similar product and service offerings are not viewed as individual segments, as our management analyzes the business as a whole and expenses are not allocated to each product offering.

9.Commitments and Contingencies

We are subject from time to time to various legal proceedings and claims that arise during the ordinary course of our business.  We do not believe that the outcome of those “routine” legal matters should have a material adverse affect on our consolidated financial position, operating results or cash flows; however, we can provide no assurances that legal claims that may arise in the future will not have such a material impact on the Company.

10.Dividends Payable

During the quarter ended September 30, 2014, we accrued $13,000 in dividends payable to the holders of our 5% Preferred Stock, $14,000 in dividends payable to the holders of our Series 2 5% Preferred Stock and $8,000 in dividends payable to the holders of our Series 3 5% Preferred Stock.  As of September 30, 2014, we have $32,000 in accrued and unpaid dividends.

Delaware law provides that we may only pay dividends out of our capital surplus or, if no surplus is available, out of our net profits for the fiscal year the dividend is declared and/or the preceding fiscal year.  These dividends continue to accrue on all our outstanding shares of preferred stock, regardless of whether we are legally able to pay them.  If we are unable to pay dividends on our preferred stock, we will be required to accrue an additional late fee penalty of 18% per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3 Preferred Stock.  Our CEO, CFO and one outside board member who are holders of our Series 2 and Series 3 Preferred Stock have waived any possible late fee penalties.  In addition to this late penalty, the holders of our Series 2 Preferred Stock and Series 3 Preferred Stock could elect to present us with written notice of our failure to pay dividends as scheduled, in which case we would have 45 days to cure such a breach.  In the event that we failed to cure the breach, the holders of these shares of preferred stock would then have the right to require us to redeem their shares of preferred stock for a cash amount calculated in accordance with their respective certificates of designation.  If we were required to redeem all shares of Series 2 Preferred Stock and Series 3 Preferred Stock as of November 1, 2014, the aggregate redemption price we would owe would be $1.9 million.

11.Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services.  The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein.  We are currently evaluating the impact of our pending adoption of ASU 2014-09.

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Item 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

This Quarterly Report on Form 10-Q, including, without limitation, the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Such forward-looking statements are generally accompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or other words that convey uncertainty of future events or outcomes.  These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail elsewhere in this Quarterly Report on Form 10-Q in Part II Item 1A “Risk Factors”, and in our 2013 Annual Report on Form 10-K in Item 1A “Risk Factors” include, but are not limited to:

·insufficient cash to operate our business and inability to meet our liquidity requirements;

·loss of revenues due to the failure of our newer products to achieve market acceptance;

·our need to increase current revenue levels in order to achieve sustainable profitability;

·concentration of our revenues from U.S. government entities or commercial customers and the possibility of loss of one of these customers and the unique risks associated with government customers;

·our dependence on sales made through indirect channels;

·our dependence on equity or debt financing provided primarily by our Chief Executive Officer in order to meet our cash flow requirements;

·the adverse effect that payment of accrued dividends on our preferred stock would have on our cash resources and the substantial dilution upon the conversion or redemption of our preferred stock;

·the consequences of our inability to pay scheduled dividends on shares of our preferred stock;

·the potentially detrimental impact that the conversion of preferred stock would have on the price of our common stock;

·the ability of our preferred stockholders and lenders to hinder additional financing; and

·the influence that our management and larger stockholders have over actions taken by the Company.

If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected. These forward-looking statements and other statements made elsewhere in this report are made in reliance on the Private Securities Litigation Reform Act of 1995.  Any forward-looking statement you read in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-K reflects our current views with respect to future events and is subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.  The section below entitled “Factors That May Affect Future Results of Operations” sets forth and incorporates by reference certain factors that could cause actual future results of the Company to differ materially from these statements.

9

Results of Operations

The following table sets forth, for the periods indicated, certain financial data as a percentage of net revenues. The period-to-period comparison of financial results is not necessarily indicative of future results.

	Three Months Ended				Nine Months Ended
	September 30, 2014		September 30, 2013		September 30, 2014		September 30, 2013
Net product revenue	99.1	%	98.9	%	99.0	%	98.9	%
Net customer support and maintenance revenue	0.9		1.1		1.0		1.1
Total revenue	100.0		100.0		100.0		100.0
Cost of product revenue	34.7		39.7		34.8		36.6
Cost of customer support and maintenance revenue	0.1		0.3		0.2		0.3
Total cost of revenue	34.8		40.0		35.0		36.9
Gross profit	65.2		60.0		65.0		63.1
Operating expenses:
Sales and marketing	23.2		17.0		22.9		18.5
Research and development	21.8		18.3		26.6		19.6
General and administrative	14.4		14.2		17.7		15.8
Operating income (loss)	5.8		10.5		(2.2	)	9.2
Interest expense	(1.3	)	(1.7	)	(1.5	)	(1.7	)
Other income	2.7		—		1.0		—
Income (loss) before income tax provision	7.2		8.8		(2.7	)	7.5
Income tax provision	—		—		—		—
Net income (loss)	7.2	%	8.8	%	(2.7	)%	7.5	%
Preferred stock dividends accrued	(1.7	)	(2.0	)	(1.9	)	(2.0	)
Net income (loss) attributable to common stockholders	5.5	%	6.8	%	(4.6	)%	5.5	%

	Three Months Ended				Nine Months Ended
	September 30, 2014		September 30, 2013		September 30, 2014		September 30, 2013
Domestic revenues	100.0	%	100.0	%	100.0	%	100.0	%
Export revenues to:	—		—		—		—
Net revenues	100.0	%	100.0	%	100.0	%	100.0	%

Net Revenues.  Net revenues for the quarter and nine months ended September 30, 2014 were $2.0 million and $5.4 million, respectively, compared to $2.0 million and $5.8 million for the same periods in 2013.  Product revenues increased $57 thousand for the quarter ended September 30, 2014, and decreased $0.4 million for the nine months ended September 30, 2014 compared to the same periods in 2013.  Decreased product revenues were primarily due to an unexpected lack of growth in sales of our Savant product line.  TraceCop sales for the quarters ended September 30, 2014 and 2013 were $1.5 million and $1.6 million, respectively.  Savant sales were $0.5 million for the quarter ended September 30, 2014 and were $0.4 million for the quarter ended September 30, 2013.  Customer support and maintenance revenue decreased $2 thousand for the quarter ended September 30, 2014, compared to $11 thousand for the nine months ended September 30, 2014.  This decrease was due to the current sales mix with a high concentration of sales not requiring a maintenance contract.

Concentration of Revenues.  Revenues from sales to various U.S. government entities totaled $1.1 million, or 52.8% of revenues, for the quarter ended September 30, 2014 compared to $0.9 million, or 45.8% of revenues, for the same period in 2013.  Revenues from sales to various U.S. government entities totaled $2.5 million, or 45.6% of revenues, for the nine months ended September 30, 2014 compared to $3.0 million, or 51.9% of revenues, for the same period in 2013.  Sales to commercial customers totaled 47.2% of total revenue for the third quarter of 2014 compared to 54.2% of total revenue for the third quarter of 2013.  During the third quarter of 2014, approximately 42.0% of total revenue was attributable to two commercial customers compared to approximately 53.2% to two commercial customers in the third quarter of 2013.  Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain sales, we anticipate that sales to government customers will continue to account for a significant portion of our revenues in future periods.  Sales to the government present risks in addition to

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those involved in sales to commercial customers which could adversely affect our revenues, including, without limitation, potential disruption to appropriation and spending patterns and the government’s reservation of the right to cancel contracts and purchase orders for its convenience.  Although we do not anticipate that any of our revenues with government customers will be renegotiated, a large number of cancelled or renegotiated government orders could have a material adverse effect on our financial results.  Currently, we are not aware of any proposed cancellation or renegotiation of any of our existing arrangements with government entities and, historically, government entities have not cancelled or renegotiated orders which had a material adverse effect on our business.

Gross Profit.  Gross profit was $1.3 million or 65.2% of net revenues for the quarter ended September 30, 2014, compared to $1.2 million or 60.0% of net revenues for the quarter ended September 30, 2013.  Gross profit was $3.5 million or 65.0% of net revenues for the nine months ended September 30, 2014 compared to $3.7 million or 63.1% of net revenues for the nine months ended September 30, 2013.  Gross profit on product revenues for the quarter and nine months ended September 30, trended from 59.8% and 62.9%, respectively, in 2013 to 65.0% and 64.8%, respectively, in 2014 mainly due to a change in product mix and slightly higher labor cost associated with TraceCop sales.  Gross profit on customer support and maintenance revenues for the quarter and nine months ended September 30, trended from 76.2% and 74.4%, respectively, in 2013 to 84.2% and 85.2%, respectively, in 2014.  Gross profit as a percentage of net revenues is impacted by several factors, including shifts in product mix, changes in channels of distribution, revenue volume, pricing strategies, and fluctuations in revenues of integrated third-party products.

Sales and Marketing.  Sales and marketing expenses increased to $0.5 million for the quarter ended September 30, 2014 compared to $0.3 million for the same period in 2013.  Sales and marketing expenses increased to $1.2 million for the nine months ended September 30, 2014 compared to $1.1 million for the same period in 2013.  Increased sales and marketing expense was due to increases in sales efforts to commercial customers.  Sales and marketing expenses may vary in the future.  We believe that these costs will increase through the end of 2014, with increases in revenue.

Research and Development.  Research and development expenses remained constant at $0.4 million for the quarter ended September 30, 2014 compared to the same period in 2013.  Research and development expenses increased to $1.4 million for the nine months ended September 30, 2014 compared to $1.1 million for the same period in 2013.  Research and development costs are expensed in the period incurred.  Research and development expenses may vary in the future; however, we believe that these costs will remain relatively constant through the end of 2014, although expenses may be increased relative to increases in revenue.

General and Administrative.  General and administrative expenses remained constant at $0.3 million for the quarters ended September 30, 2014 and 2013.  General and administrative expenses increased to $1.0 million for the nine months ended September 30, 2014 compared to the same period in 2013.  It is expected that general and administrative expenses will remain relatively constant throughout the remainder of 2013, although expenses may be increased relative to increases in revenue.

Interest.  Net interest expense decreased to $24 thousand for the quarter ended September 30, 2014 compared to $34 thousand for the same period in 2013.  Net interest expense decreased to $83 thousand for the nine months ended September 30, 2014 compared to $97 thousand for the same period in 2013.  The decrease in interest expense was primarily due to a decrease in interest expense related capital leased equipment as the payment schedules near expiration. Net interest expense may vary in the future based on our level of borrowing, which will be affected by our cash flow, operating income and capital expenditures.

Liquidity and Capital Resources

Our principal source of liquidity at September 30, 2014, was approximately $1.4 million of cash and cash equivalents.  At September 30, 2014, we had a working capital deficiency of $1.1 million compared to a $1.3 million deficiency at September 30, 2013.

Net cash provided by operations for the nine months ended September 30, 2014, was $861 thousand due to the following sources of cash and non-cash items: $827 thousand increase in deferred revenue, $7 thousand decrease in inventories, $126 thousand in amortization expense of capital leases, $284 thousand in stock-based compensation, $49 thousand in depreciation expense, and $6 thousand in penalties and waived penalties on dividends.  This was partially offset by the to a net loss of $145 thousand and the following uses of cash: $199 thousand increase in accounts receivable, $62 thousand increase in prepaid expenses and other assets, and $32 thousand decrease in accounts payable and accrued expenses. Net cash provided by operations for the nine months ended September 30, 2013, was $678 thousand due to net income of $435 thousand and the following sources of cash and non-cash items: $407 thousand increase in accounts payable and accrued expenses, $382 thousand increase in deferred revenue, $7 thousand decrease in prepaid expenses and other assets, $88 thousand in amortization expense of capital leases, $148 thousand in stock-based compensation, $22 thousand in depreciation expense, and $22 thousand in penalties and waived penalties on dividends. This was partially offset by the following uses of cash: $819 thousand increase in accounts receivable and $14 thousand increase in inventory. Future fluctuations in inventory balances, accounts receivable and accounts payable will be dependent upon several factors, including, but not limited to, quarterly sales volumes and timing of invoicing, and the accuracy of our forecasts of product demand and component requirements.

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Net cash used in investing activities for the nine months ended September 30, 2014, was $49 thousand for net purchases of property and equipment, compared to the nine months ended September 30, 2013, net cash used in investing activities for was $60 thousand for net purchases of property.

Net cash used by financing activities for the nine months ended September 30, 2014, was $575 thousand primarily due to $512 thousand payment of dividends and $124 thousand payment on principal of capital leases. This was offset by the following provisions of cash: $61 thousand in proceeds from the exercise of stock options. Net cash used in financing activities for the nine months ended September 30, 2013, was $212 thousand primarily due to $638 thousand payment to line of credit and $82 thousand payment on principal on capital leases. This was offset by the following provisions of cash: $508 thousand from the line of credit.

At September 30, 2014, the Company did not have any material commitments for capital expenditures.

During the nine months ended September 30, 2014, the Company funded its operations through the use of cash and cash equivalents, borrowing against our line of credit and advances on the loan from our Chief Executive Officer.

On March 29, 2006, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to establish a $1.0 million line of credit (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amended and Restated Loan and Security Agreement with SVB to, among other things, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008 Credit Line”).  On June 24, 2014, we entered into the Sixth Amendment to the Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with SVB to replace our expiring line with a $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement are secured by substantially all of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’s Chairman, President and Chief Executive Officer, has established a Guaranty Agreement with SVB securing all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Credit are based on advances (each an “Advance”) against certain of our accounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eighty percent (80%) of each Eligible Account, or such other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance charge calculated as a daily rate that is based on a 360-day annual rate of the greater of the prime rate plus 2.0% or 7.0%.  Finance charges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateral handling fee of 0.5% of all outstanding Advances, depending on certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliest of (a) the date that the Eligible Account related to the Advance is paid, (b) the date the Eligible Account is no longer eligible under the Loan Agreement, or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) is asserted to the Eligible Account.  We have certain non-financial and financial covenants, including a liquidity coverage ratio and a rolling EBITDA computation, as defined in the Loan Agreement.  On June 23, 2015, the Loan Agreement terminates and all outstanding Advances, accrued but unpaid finance charges, outstanding collateral handing fees, and other amounts become due under the Loan Agreement and related documents.  As of September 30, 2014 we had no borrowings outstanding under the Current Line of Credit and are within limits of all debt covenants.

As of September 30, 2014, we had cash and cash equivalents of approximately $1,376,000, up from approximately $1,139,000 as of December 31, 2013.  We generated a net income of $147,000 for the three month period ended September 30, 2014 compared to net income of $173,000 for the three month period ended September 30, 2013.  As of September 30, 2014, in addition to cash and cash equivalents of $1,376,000, we had $500,000 in funding available under our $0.625 million line of credit at Silicon Valley Bank (“SVB”) and $670,000 funding available from a promissory note to borrow up to $2.2 million from G. Ward Paxton, the Company’s Chief Executive Officer.  We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources.  Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months.  We expect to fund our operations through Company profits, our line of credit, borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.

We may explore the possible acquisitions of businesses, products and technologies that are complementary to our existing business.  We are continuing to identify and prioritize additional security technologies, which we may wish to develop, either internally or through the licensing, or acquisition of products from third parties.  While we may engage from time to time in discussions with respect to potential acquisitions, there can be no assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business.  In order to finance such acquisitions and working capital it may be necessary for us to raise additional funds through public or private financings.  Any equity or debt financings, if available at all, may be on terms, which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders.

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Item 4.CONTROLS AND PROCEDURES

We maintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance of achieving the desired control objectives, and we necessarily are required to apply our judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures.

Our management, including our principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2014, and concluded that the disclosure controls and procedures were effective.

Our management, with the participation of our principal executive officer and principal financial officer, evaluated our “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) as of December 31, 2013, and concluded that there have not been any changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1.LEGAL PROCEEDINGS

We are subject from time to time to various legal proceedings and claims that arise during the ordinary course of our business.  We do not believe that the outcome of those “routine” legal matters should have a material adverse effect on our consolidated financial position, operating results or cash flows; however, we can provide no assurances that legal claims that may arise will not have such a material impact in the future.

Item 1A.RISK FACTORS

Factors That May Affect Future Results of Operations

We are providing the following information regarding changes that have occurred to previously disclosed risk factors from our Annual Report on Form 10-K for the year ended December 31, 2013.  In addition to the other information set forth below and elsewhere in this report, you should consider the factors discussed under the heading “Risk Factors” in our Form 10-K for the year ended December 31, 2013.  The risks described in our Quarterly Reports on Form 10-Q are not the only risks facing our Company.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

We may not have sufficient cash to operate our business and may not be able to maintain certain liquidity requirements under our existing debt instruments.  Additional debt and equity offerings to fund future operations may not be available and, if available, may significantly dilute the value of our currently outstanding common stock.

As of September 30, 2014, we had cash and cash equivalents of approximately $1,376,000, up from approximately $1,139,000 as of December 31, 2013.  We generated a net income of $147,000 for the three month period ended September 30, 2014 compared to net income of $173,000 for the three month period ended September 30, 2013.  As of September 30, 2014, in addition to cash and cash equivalents of $1,376,000, we had $500,000 in funding available under our $0.625 million line of credit at Silicon Valley Bank (“SVB”) and $670,000 funding available from a promissory note to borrow up to $2.2 million from G. Ward Paxton, the Company’s Chief Executive Officer.  We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources.  Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months.  We expect to fund our operations through Company profits, our line of credit, borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in

13

dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.

We had a net income of $147 thousand for the quarter ended September 30, 2014, and have an accumulated deficit of $58.6 million as of September 30, 2014.  To continue annual profitability, we must generate increased revenue levels.

For the quarter ended September 30, 2014, we generated a net income of $147 thousand and had an accumulated deficit of approximately $58.6 million as of September 30, 2014, compared to a net income of $173 thousand for the quarter ended September 30, 2013 and an accumulated deficit of approximately $58.6 million at September 30, 2013.  We need to sustain greater revenue levels from the sales of our products if we are to achieve annual profitability.  If we are unable to achieve these revenue levels, losses could happen for the near term and possibly longer, and we may not sustain profitability or generate positive cash flow from operations.

A large percentage of our revenues are received from U.S. government entities/resellers, and the loss of any one of these customers could reduce our revenues and materially harm our business and prospects.

A large percentage of our revenues result from sales to U.S. government entities/resellers.  If we were to lose one or more of these key relationships, our revenues could decline and our business and prospects may be materially harmed. We expect that even if we are successful in developing relationships with non-governmental customers, our revenues will continue to be concentrated among government entities.  For the quarter ended September 30, 2014, sales to U.S. government entities/resellers collectively accounted for 52.8% of our revenues, compared to 45.8% for the comparable period in 2013.  The loss of any of these key relationships may send a negative message to other U.S. government entities or non-governmental customers concerning our product offering.  We cannot assure you that U.S. government entities will be customers of ours in future periods or that we will be able to diversify our customer portfolio to adequately mitigate the risk of loss of any of these customers.

A large percentage of our revenues are from one product line with a limited number of customers, and the decrease of revenue from sales of this product line could materially harm our business and prospects.

A large percentage of our revenues result from sales of our security product line.  Savant revenues were $0.5 million for the quarter ended September 30, 2014 compared to $0.4 million for the same period in 2013. TraceCop revenues were $1.5 million for the quarter ended September 30, 2014, compared to $1.6 million for the same quarter in 2013.  There were two individual commercial customers in the third quarter of 2014 attributable for 42.0% of total revenue compared to two customers at 53.2% for the same period in 2013 that exceeded 10% of total revenues for that quarter. If sales of this key product line were to decrease, our revenues could decline and our business and prospects may be materially harmed.

We are highly dependent on sales made through indirect channels, the loss of which would materially adversely affect our operations.

We derived 57.4% of revenue in the third quarter of 2014 through indirect channels of mainly government resellers, compared to 25.4% of our revenues in the quarter ended September 30, 2013.  We must continue to expand our sales through these indirect channels in order to increase our revenues.  We cannot assure you that our products will gain market acceptance in these indirect sales channels or that sales through these indirect sales channels will increase our revenues.  Further, many of our competitors are also trying to sell their products through these indirect sales channels, which could result in lower prices and reduced profit margins for sales of our products.

You will experience substantial dilution upon the conversion or redemption of the shares of preferred stock that we issued in our private placements or in the event we raise additional funds through the issuance of new shares of our common stock or securities convertible or exercisable into shares of common stock.

On October 31, 2014, we had 12,426,002 shares of common stock outstanding.  Upon conversion of all outstanding shares of preferred stock, we will have 13,493,444 shares of common stock outstanding, approximately an 8.6% increase in the number of shares of our common stock outstanding.

In addition, management may issue additional shares of common stock or securities exercisable or convertible into shares of common stock in order to finance our continuing operations.  Any future issuances of such securities would have additional dilutive effects on the existing holders of our Common Stock.

Further, the occurrence of certain events could entitle holders of our Series 2 Preferred Stock and Series 3 Preferred Stock to require us to redeem their shares for a certain number of shares of our common stock.  Assuming (i) we have paid all liquidated damages and other amounts to the holders, (ii) paid all outstanding dividends, (iii) a volume weighted average price of $2.77, which was the ten-day volume weighted average closing price of our common stock on October 31, 2014, and (iv) our 12,426,002 shares of common stock outstanding on October 31, 2014, upon exercise of their redemption right by the holders of the Series 3 Preferred Stock and the Series 2 Preferred Stock, we would be obligated to issue approximately 1,125,000 shares of our common stock.  This would represent an increase of approximately 9.1% in the number of shares of our common stock as of October 31, 2014.

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The conversion of preferred stock we issued in the private placements may cause the price of our common stock to decline.

The holders of the shares of our 5% Preferred Stock we issued in connection with the sale of our 5% Preferred Stock may freely convert their shares of preferred stock and sell the underlying shares of common stock pursuant to Rule 144 of the Securities and Exchange Commission.  As of November 1, 2014, 800,000 shares of our 5% Preferred Stock had converted into 1,272,263 shares of common stock and 200,000 shares of our 5% preferred stock remain outstanding.

The holders of the shares of Series 2 5% Preferred Stock we issued in connection with the sale of our Series 2 Preferred Stock may freely convert their shares of preferred stock and sell the underlying shares of common stock pursuant to Rule 144 of the Securities and Exchange Commission.  As of October 31, 2014, 605,200 shares of Series 2 Preferred Stock had converted into 605,200 shares of common stock and 460,000 shares of Series 2 5% preferred stock remain outstanding.

The holders of the shares of Series 3 5% Preferred Stock we issued in connection with the sale of our Series 3 Preferred Stock, may freely convert their shares of Series 3 Preferred Stock and sell the underlying shares of common stock pursuant to Rule 144 of the Securities and Exchange Commission.  As of October 31, 2014, 275,230 shares of Series 3 Preferred Stock had converted into 275,230 shares of common stock and 289,377 shares of Series 3 5% preferred stock remain outstanding.

For the four weeks ended on October 31, 2014, the average daily trading volume of our common stock on the OTCQB was 12,000 shares.  Consequently, if holders of preferred stock elect to convert their remaining shares and sell a material amount of their underlying shares of common stock on the open market, the increase in selling activity could cause a decline in the market price of our common stock.  Furthermore, these sales, or the potential for these sales, could encourage short sales, causing additional downward pressure on the market price of our common stock.

You will experience substantial dilution upon the exercise of stock options currently outstanding.

On October 31, 2014, we had 12,426,002 shares of common stock outstanding.  Upon the exercising of current options exercisable at or below the exercise price of $2.50, we will have approximately 14,654,000 shares of common stock outstanding, an 18.0% increase in the number of shares of our common stock outstanding.

Our management and larger stockholders exercise significant control over our company and have the ability to approve or take actions that may be adverse to your interests.

As of October 31, 2014, our executive officers, directors and preferred stockholders beneficially own approximately 27% of our voting power.  In addition, other related parties control approximately 30% of voting power.  As a result, these stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, which could delay or prevent someone from acquiring or merging with us.  These stockholders may use their influence to approve or take actions that may be adverse to the interests of holders of our Common Stock.  Further, we contemplate the possible issuance of shares of our Common Stock or of securities exercisable or convertible into shares of our Common Stock in the future to our Chief Executive Officer and Chief Financial Officer.  Any such issuance will increase the percentage of stock our Chief Executive Officer, Chief Financial Officer and our management group beneficially holds.

Item 6.Exhibits

The following Exhibits are filed with this report form 10-Q:

31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.
31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.
32.1	Certification Pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document

15

S I G N A T U R E S

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	INTRUSION INC.
Date: November 13, 2014	/s/ G. Ward Paxton
	G. Ward Paxton
	Chairman, President & Chief Executive Officer
	(Principal Executive Officer)
Date: November 13, 2014	/s/ Michael L. Paxton
	Michael L. Paxton
	Vice President, Chief Financial Officer, Treasurer & Secretary
	(Principal Financial & Accounting Officer)

16

EX-31.1

EXHIBIT 31.1

I, G. Ward Paxton, Chief Executive Officer of Intrusion Inc., certify that:

(1)I have reviewed this quarterly report on Form 10-Q of Intrusion Inc.;

(2)Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

(3)Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

(4)The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

(5)The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 13, 2014	/s/ G. Ward Paxton
	G. Ward Paxton
	Chief Executive Officer

EX-31.2

EXHIBIT 31.2

I, Michael L. Paxton, Chief Financial Officer of Intrusion Inc., certify that:

(1)I have reviewed this quarterly report on Form 10-Q of Intrusion Inc.;

(2)Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

(3)Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

(4)The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

(5)The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 13, 2014	/s/ Michael L. Paxton
	Michael L. Paxton
	Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO RULE 13a-14(b) OF THE EXCHANGE ACT AND 18 U.S.C. SECTION 1350, AS ENACTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Intrusion Inc. (the “Company”) on Form 10-Q, for the quarter ended September 30, 2014 (the “Report”) as filed with the Securities and Exchange Commission on the date hereof, each of the undersigned Officers of the Company does hereby certify, pursuant to 18 U.S.C. Section 1350, as enacted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

(2)The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

November 13, 2014	/s/ G. Ward Paxton
	G. Ward Paxton
	Chief Executive Officer

November 13, 2014	/s/ Michael L. Paxton
	Michael L. Paxton
	Chief Financial Officer

The foregoing certification is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and is not being filed as part of the Report or as a separate disclosure document.

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Accounting for Stock-Based Compensation (Details) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014	Sep. 30, 2013
Accounting for Stock-Based Compensation
Stock-based compensation expense	$ 97,000	$ 39,000	$ 284,000	$ 148,000
Options exercised (in shares)	0	0	157,500	0
Valuation Assumptions
Weighted average grant date fair value (in dollars per share)		$ 0.91	$ 1.79	$ 0.48
Weighted average assumptions used:
Expected dividend yield (as a percent)		0.00%	0.00%	0.00%
Risk-free interest rate (as a percent)		1.34%	1.46%	0.75%
Expected volatility (as a percent)		227.00%	228.00%	225.20%
Expected life	0 years	5 years	4 years 10 months 24 days	4 years 10 months 24 days
Employees and Directors [Member]
Accounting for Stock-Based Compensation
Stock options granted (in shares)	0	3,000	295,000	286,000

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Loan Payable to Officer

9 Months Ended

Sep. 30, 2014

Loan Payable to Officer

Loan Payable to Officer

4.Loan Payable to Officer

On February 7, 2013, the Company entered into an unsecured revolving promissory note to borrow up to $2,200,000 from G. Ward Paxton, the Company’s Chief Executive Officer.  Under the terms of the note, the Company may borrow, repay and reborrow on the loan as needed up to an outstanding principal balance due of $2,200,000 at any given time through March 2014.

On February 6, 2014, the Company entered into an unsecured revolving promissory note to borrow up to $2,200,000 from G. Ward Paxton, which replaced the February 7, 2013 unsecured promissory note which was previously entered into between the Company and G. Ward Paxton.  Under the terms of the note, the Company may borrow, repay and reborrow on the loan as needed up to an outstanding principal balance due of $2,200,000 at any given time through March 2015.

Amounts borrowed from this officer accrue interest at a floating rate per annum equal to SVB’s prime rate plus 1% (5% at September 30, 2014).  All outstanding borrowings and accrued but unpaid interest is due on March 31, 2015.  As of September 30, 2014, the borrowings outstanding totaled $1,530,000 and accrued interest totaled $57,000.

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Dividends Payable (Details) (USD $)	3 Months Ended		9 Months Ended			3 Months Ended	9 Months Ended			3 Months Ended	9 Months Ended	3 Months Ended	9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014	Sep. 30, 2013	Dec. 31, 2013	Sep. 30, 2014 Series A Preferred Stock [Member]	Sep. 30, 2014 Series A Preferred Stock [Member]	Sep. 30, 2014 Series B and Series C Preferred Stock [Member] item	Aug. 01, 2014 Series B and Series C Preferred Stock [Member]	Sep. 30, 2014 Series B Preferred Stock [Member]	Sep. 30, 2014 Series B Preferred Stock [Member]	Sep. 30, 2014 Series C Preferred Stock [Member]	Sep. 30, 2014 Series C Preferred Stock [Member]
Dividends Payable
Preferred stock dividends accrued during the period	$ 35,000	$ 38,000	$ 106,000	$ 113,000		$ 13,000				$ 14,000		$ 8,000
Accrued and unpaid dividends	32,000		32,000		437,000
Dividend rate (as a percent)							5.00%				5.00%		5.00%
Percentage of additional late fee penalty payable on unpaid dividends								18.00%
Number of outside board members invested in preferred stock								1
Period within which entity must cure breach								45 days
Redemption price									$ 1,900,000

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Inventories

9 Months Ended

Sep. 30, 2014

Inventories

Inventories

3.Inventories (In thousands)

	September 30, 2014		December 31, 2013
Inventories consist of:
Finished products	12		19
Net inventory	$	12	19

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CONDENSED CONSOLIDATED BALANCE SHEETS (USD $)	Sep. 30, 2014	Dec. 31, 2013
Current Assets:
Cash and cash equivalents	$ 1,376,000	$ 1,139,000
Accounts receivable	1,015,000	816,000
Inventories, net	12,000	19,000
Prepaid expenses	142,000	95,000
Total current assets	2,545,000	2,069,000
Property and equipment, net	396,000	297,000
Other assets	63,000	51,000
TOTAL ASSETS	3,004,000	2,417,000
Current Liabilities:
Accounts payable and accrued expenses	966,000	998,000
Dividends payable	32,000	437,000
Obligations under capital lease, current portion	145,000	106,000
Deferred revenue	966,000	139,000
Loan payable to officer	1,530,000
Total current liabilities	3,639,000	1,680,000
Loan payable to officer		1,530,000
Obligations under capital lease, noncurrent portion	126,000	67,000
Commitments and contingencies
Stockholders' deficit:
Common Stock $0.01 par value: Authorized shares - 80,000 Issued shares - 12,436 as of September 30, 2014 and 12,182 as of December 31, 2013 Outstanding shares - 12,426 as of September 30, 2014 and 12,172 as of December 31, 2013	124,000	122,000
Common stock held in treasury, at cost - 10 shares	(362,000)	(362,000)
Additional paid-in capital	56,310,000	55,905,000
Accumulated deficit	(58,569,000)	(58,424,000)
Accumulated other comprehensive loss	(107,000)	(107,000)
Total stockholders' deficit	(761,000)	(860,000)
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT	3,004,000	2,417,000
Series A Preferred Stock [Member]
Stockholders' deficit:
Preferred stock	708,000	778,000
Series B Preferred Stock [Member]
Stockholders' deficit:
Preferred stock	724,000	724,000
Series C Preferred Stock [Member]
Stockholders' deficit:
Preferred stock	$ 411,000	$ 504,000

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Description of Business

9 Months Ended

Sep. 30, 2014

Description of Business

Description of Business

1.Description of Business

We develop, market and support a family of entity identification, high speed data mining, advanced persistent threat detection, regulated information compliance, data privacy protection and network intrusion prevention/detection products.  Our product families include:

TraceCop™ for identity discovery and disclosure,

Savant™ for network data mining and advanced persistent threat detection,

Compliance Commander™ for regulated information and data privacy protection, and

SecureNet™ for network intrusion prevention and detection.

We market and distribute our products through a direct sales force to:

end-users,

value-added resellers,

system integrators,

managed service providers, and

distributors.

Our end-user customers include:

U.S. federal government entities,

local government entities,

banks,

credit unions,

other financial institutions,

hospitals and other healthcare providers, and

other customers.

Essentially, our end-users can be defined as any end-users requiring network security solutions for protecting their mission critical data.

We were organized in Texas in September 1983 and reincorporated in Delaware in October 1995.  Our principal executive offices are located at 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to the “Company”, “we”, “us”, “our”, “Intrusion” or “Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.  Compliance Commander, SecureNet, TraceCop and Savant are trademarks of Intrusion Inc.

On March 29, 2006, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to establish a $1.0 million line of credit (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amended and Restated Loan and Security Agreement with SVB to, among other things, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008 Credit Line”).  On June 24, 2014, we entered into the Sixth Amendment to the Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with SVB to replace our expiring line with a $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement are secured by substantially all of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’s Chairman, President and Chief Executive Officer, has established a Guaranty Agreement with SVB securing all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Credit are based on advances (each an “Advance”) against certain of our accounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eighty percent (80%) of each Eligible Account, or such other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance charge calculated as a daily rate that is based on a 360-day annual rate of the greater of the prime rate plus 2.0% or 7.0%.  Finance charges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateral handling fee of 0.5% of all outstanding Advances, depending on certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliest of (a) the date that the Eligible Account related to the Advance is paid, (b) the date the Eligible Account is no longer eligible under the Loan Agreement, or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) is asserted to the Eligible Account.  We have certain non-financial and financial covenants, including a liquidity coverage ratio and a rolling EBITDA computation, as defined in the Loan Agreement.  On June 23, 2015, the Loan Agreement terminates and all outstanding Advances, accrued but unpaid finance charges, outstanding collateral handing fees, and other amounts become due under the Loan Agreement and related documents.  As of September 30, 2014 we had no borrowings outstanding under the Current Line of Credit and are within limits of all debt covenants.

As of September 30, 2014, we had cash and cash equivalents of approximately $1,376,000, up from approximately $1,139,000 as of December 31, 2013.  We generated a net loss of $145,000 for the nine month period ended September 30, 2014 compared to net income of $435,000 for the nine month period ended September 30, 2013.  As of September 30, 2014, in addition to cash and cash equivalents of $1,376,000, we had $500,000 in funding available under our $0.625 million line of credit at Silicon Valley Bank (“SVB”) and $670,000 funding available from a promissory note to borrow up to $2.2 million from G. Ward Paxton, the Company’s Chief Executive Officer.  We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources.  Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months.  We expect to fund our operations through Company profits, our line of credit, borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.

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Inventories (Details) (USD $) In Thousands, unless otherwise specified	Sep. 30, 2014	Dec. 31, 2013
Inventories consist of:
Finished products	$ 12	$ 19
Net inventory	$ 12	$ 19

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Line of Credit (Details) (USD $)			9 Months Ended		9 Months Ended
	Mar. 29, 2006 Credit Line 2006 [Member]	Jun. 30, 2008 Credit Line 2008 [Member]	Sep. 30, 2014 Line of Credit [Member]	Jun. 24, 2014 Line of Credit [Member]	Sep. 30, 2014 Line of Credit [Member] Maximum [Member]
Line of Credit
Maximum borrowing capacity	$ 1,000,000	$ 2,500,000	$ 625,000	$ 625,000
Contingent advances as a percentage of each Eligible Account					80.00%
Period of annual rate for calculating daily rate of finance charge on each advance			360 days
Finance charge basis			prime rate
Percentage points added in daily rate of finance charge			2.00%
Minimum interest rate (as a percent)			7.00%
Monthly collateral handling fee (as a percent)			0.50%
Borrowings outstanding			$ 0

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Basis of Presentation

9 Months Ended

Sep. 30, 2014

Basis of Presentation

Basis of Presentation

2.Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Item 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  The December 31, 2013 balance sheet was derived from audited financial statements, but does not include all the disclosures required by accounting principles generally accepted in the United States.  However, we believe that the disclosures are adequate to make the information presented not misleading.  In our opinion, all the adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included.  The results of operations for the three and nine month periods ended September 30, 2014 are not necessarily indicative of the results that may be achieved for the full fiscal year or for any future period.  The unaudited condensed consolidated financial statements included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2013, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 28, 2014.

The Company calculates the fair value of its assets and liabilities which qualify as financial instruments and includes this additional information in the notes to consolidated financial statements when the fair value is different from the carrying value of these financial instruments. The estimated fair value of accounts receivable, accounts payable and accrued expenses, and dividends payable approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of the line of credit payable approximates fair value since this instrument bears market interest rates.  Loans payable to officer are with a related party and as a result do not bear market rates of interest.  Management believes based on its current financial position that it could not obtain comparable amounts of third party financing, and as such cannot estimate the fair value of the loans payable to officer.  None of these instruments are held for trading purposes.

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CONDENSED CONSOLIDATED BALANCE SHEETS (Parenthetical) (USD $)	Sep. 30, 2014	Dec. 31, 2013
Preferred stock, par value (in dollars per share)	$ 0.01	$ 0.01
Preferred stock, Authorized shares	5,000,000	5,000,000
Common stock, par value (in dollars per share)	$ 0.01	$ 0.01
Common stock, Authorized shares	80,000,000	80,000,000
Common stock, Issued shares	12,436,000	12,182,000
Common stock, Outstanding shares	12,426,000	12,172,000
Common stock held in treasury, shares	10,000	10,000
Series A Preferred Stock [Member]
Preferred stock, shares issued	200,000	220,000
Preferred stock, shares outstanding	200,000	220,000
Preferred stock, Liquidation preference (in dollars per share)	$ 1,025
Series B Preferred Stock [Member]
Preferred stock, shares issued	460,000	460,000
Preferred stock, shares outstanding	460,000	460,000
Preferred stock, Liquidation preference (in dollars per share)	$ 1,155
Series C Preferred Stock [Member]
Preferred stock, shares issued	289,000	354,000
Preferred stock, shares outstanding	289,000	354,000
Preferred stock, Liquidation preference (in dollars per share)	$ 633

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Inventories (Tables)

9 Months Ended

Sep. 30, 2014

Inventories

Schedule of inventories

Inventories (In thousands)

	September 30, 2014		December 31, 2013
Inventories consist of:
Finished products	12		19
Net inventory	$	12	19

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Document and Entity Information	9 Months Ended
	Sep. 30, 2014	Nov. 01, 2014
Document and Entity Information
Entity Registrant Name	INTRUSION INC
Entity Central Index Key	0000736012
Document Type	10-Q
Document Period End Date	Sep. 30, 2014
Amendment Flag	false
Current Fiscal Year End Date	--12-31
Entity Well-known Seasoned Issuer	No
Entity Voluntary Filers	No
Entity Current Reporting Status	Yes
Entity Filer Category	Smaller Reporting Company
Entity Common Stock, Shares Outstanding		12,426,002
Document Fiscal Year Focus	2014
Document Fiscal Period Focus	Q3

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Accounting for Stock-Based Compensation (Tables)

9 Months Ended

Sep. 30, 2014

Accounting for Stock-Based Compensation

Schedule of assumptions used to estimate the fair values of employee and director options awards at the date of grant using a Black-Scholes option-pricing model

	For Three Months Ended September 30, 2014	For Three Months Ended September 30, 2013			For Nine Months Ended September 30, 2014			For Nine Months Ended September 30, 2013
Weighted average grant date fair value	—	$	0.91		$	1.79		$	0.48
Weighted average assumptions used:
Expected dividend yield	—	0.0		%	0.0		%	0.0		%
Risk-free interest rate	—	1.34		%	1.46		%	0.75		%
Expected volatility	—	227.0		%	228.0		%	225.2		%
Expected life (in years)	—	5.0			4.9			4.9

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (USD $) In Thousands, except Per Share data, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014	Sep. 30, 2013
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Net product revenue	$ 2,011	$ 1,954	$ 5,375	$ 5,760
Net customer support and maintenance revenue	19	21	54	65
Total revenue	2,030	1,975	5,429	5,825
Cost of product revenue	704	785	1,891	2,135
Cost of customer support and maintenance revenue	3	5	8	16
Total cost of revenue	707	790	1,899	2,151
Gross profit	1,323	1,185	3,530	3,674
Operating expenses:
Sales and marketing	470	336	1,245	1,083
Research and development	443	361	1,442	1,138
General and administrative	293	281	959	921
Operating income (loss)	117	207	(116)	532
Interest expense, net	(24)	(34)	(83)	(97)
Other Income	54		54
Income (loss) before income tax provision	147	173	(145)	435
Net income (loss)	147	173	(145)	435
Preferred stock dividends accrued	(35)	(38)	(106)	(113)
Net income (loss) attributable to common stockholders	$ 112	$ 135	$ (251)	$ 322
Net income (loss) per share attributable to common stockholders:
Basic (in dollars per share)	$ 0.01	$ 0.01	$ (0.02)	$ 0.03
Diluted (in dollars per share)	$ 0.01	$ 0.01	$ (0.02)	$ 0.02
Weighted average common shares outstanding:
Basic (in shares)	12,426	12,172	12,379	12,172
Diluted (in shares)	15,485	14,532	12,379	14,532

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Net Income (Loss) Per Share

9 Months Ended

Sep. 30, 2014

Net Income (Loss) Per Share

Net Income (Loss) Per Share

7.Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing net income (loss) attributable to common stockholders for the period by the weighted average number of common shares outstanding for the period.  Diluted net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted average number of common shares and dilutive common stock equivalents outstanding for the period.  Our common stock equivalents include all common stock issuable upon conversion of preferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stock equivalents excluded from the diluted income (loss) per share calculation for the three month periods ended September 30, 2014 and 2013 are 609,452 and 379,822 as they are antidilutive.  The aggregate number of common stock equivalents excluded from the diluted income (loss) per share calculation for the nine month periods ended September 30, 2014 and 2013 are 4,208,910 and 1,082,117 as they are antidilutive.

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Accounting for Stock-Based Compensation

9 Months Ended

Sep. 30, 2014

Accounting for Stock-Based Compensation

Accounting for Stock-Based Compensation

6.Accounting for Stock-Based Compensation

During the three month periods ended September 30, 2014 and 2013, the Company granted 0 and 3,000, respectively, of stock options to employees or directors.  The Company recognized $97,000 and $39,000, respectively, of stock-based compensation expense for the three month periods ended September 30, 2014 and 2013.  During the nine month periods ended September 30, 2014 and 2013, the Company granted 295,000 and 286,000, respectively, of stock options to employees and directors.  The Company recognized $284,000 and $148,000, respectively, of stock-based compensation expense for the nine month periods ended September 30, 2014 and 2013.

During the three month periods ended September 30, 2014 and 2013, 0 options were exercised under the 2005 Plan, respectively.  During the nine month periods ended September 30, 2014 and 2013, 157,500 and 0 options were exercised under the 2005 Plan, respectively.

Valuation Assumptions

The fair values of employee and director option awards were estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:

	For Three Months Ended September 30, 2014	For Three Months Ended September 30, 2013			For Nine Months Ended September 30, 2014			For Nine Months Ended September 30, 2013
Weighted average grant date fair value	—	$	0.91		$	1.79		$	0.48
Weighted average assumptions used:
Expected dividend yield	—	0.0		%	0.0		%	0.0		%
Risk-free interest rate	—	1.34		%	1.46		%	0.75		%
Expected volatility	—	227.0		%	228.0		%	225.2		%
Expected life (in years)	—	5.0			4.9			4.9

Expected volatility is based on historical volatility and in part on implied volatility.  The expected term considers the contractual term of the option as well as historical exercise and forfeiture behavior.  The risk-free interest rate is based on the rates in effect on the grant date for U.S. Treasury instruments with maturities matching the relevant expected term of the award. Options granted to non-employees are valued using the fair market value on each measurement date of the option.

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Loan Payable to Officer (Details) (USD $)	9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014 Chief Executive Officer [Member] Revolving Credit Facility [Member]	Feb. 06, 2014 Chief Executive Officer [Member] Revolving Credit Facility [Member]	Feb. 07, 2013 Chief Executive Officer [Member] Revolving Credit Facility [Member]
Borrowing from Officer
Maximum borrowing capacity			$ 2,200,000	$ 2,200,000	$ 2,200,000
Floating rate base			prime rate
Percentage points added in interest rate			1.00%
Interest rate (as a percent)			5.00%
Loan payable to officer	1,530,000		1,530,000
Accrued interest			57,000
Proceeds from line of credit	$ 453,000	$ 508,000

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Description of Business (Details) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014	Sep. 30, 2013	Dec. 31, 2013	Dec. 31, 2012	Sep. 30, 2014 Line of Credit [Member]	Jun. 24, 2014 Line of Credit [Member]	Sep. 30, 2014 Revolving Credit Facility [Member] Chief Executive Officer [Member]	Feb. 06, 2014 Revolving Credit Facility [Member] Chief Executive Officer [Member]	Feb. 07, 2013 Revolving Credit Facility [Member] Chief Executive Officer [Member]
Description of Business
Funding available							$ 500,000		$ 670,000
Maximum borrowing capacity							625,000	625,000	2,200,000	2,200,000	2,200,000
Cash and cash equivalents	1,376,000	458,000	1,376,000	458,000	1,139,000	52,000
Net income	$ 147,000	$ 173,000	$ (145,000)	$ 435,000
Period during which the entity expects to have sufficient cash resources to finance its operations and capital expenditures			12 months

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Dividends Payable

9 Months Ended

Sep. 30, 2014

Dividends Payable

Dividends Payable

10.Dividends Payable

During the quarter ended September 30, 2014, we accrued $13,000 in dividends payable to the holders of our 5% Preferred Stock, $14,000 in dividends payable to the holders of our Series 2 5% Preferred Stock and $8,000 in dividends payable to the holders of our Series 3 5% Preferred Stock.  As of September 30, 2014, we have $32,000 in accrued and unpaid dividends.

Delaware law provides that we may only pay dividends out of our capital surplus or, if no surplus is available, out of our net profits for the fiscal year the dividend is declared and/or the preceding fiscal year.  These dividends continue to accrue on all our outstanding shares of preferred stock, regardless of whether we are legally able to pay them.  If we are unable to pay dividends on our preferred stock, we will be required to accrue an additional late fee penalty of 18% per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3 Preferred Stock.  Our CEO, CFO and one outside board member who are holders of our Series 2 and Series 3 Preferred Stock have waived any possible late fee penalties.  In addition to this late penalty, the holders of our Series 2 Preferred Stock and Series 3 Preferred Stock could elect to present us with written notice of our failure to pay dividends as scheduled, in which case we would have 45 days to cure such a breach.  In the event that we failed to cure the breach, the holders of these shares of preferred stock would then have the right to require us to redeem their shares of preferred stock for a cash amount calculated in accordance with their respective certificates of designation.  If we were required to redeem all shares of Series 2 Preferred Stock and Series 3 Preferred Stock as of November 1, 2014, the aggregate redemption price we would owe would be $1.9 million.

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Concentrations

9 Months Ended

Sep. 30, 2014

Concentrations

Concentrations

8.Concentrations

Our operations are concentrated in one area—security software/entity identification.  Sales to the U.S. Government through direct and indirect channels totaled 52.8% of total revenues for the third quarter of 2014 compared to 45.8% of total revenues for the third quarter of 2013.  During the third quarter of 2014, approximately 38.6% of total revenues were attributable to three government customers compared to approximately 30.9% of total revenues attributable to two government customers in the third quarter of 2013.  Sales to commercial customers totaled 47.2% of total revenue for the third quarter of 2014 compared to 54.2% of total revenue for the third quarter of 2013.  During the third quarter of 2014, approximately 42.0% of total revenue was attributable to two commercial customers compared to approximately 53.2% to two commercial customers in the third quarter of 2013.  Our similar product and service offerings are not viewed as individual segments, as our management analyzes the business as a whole and expenses are not allocated to each product offering.

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Commitments and Contingencies

9 Months Ended

Sep. 30, 2014

Commitments and Contingencies

Commitments and Contingencies

9.Commitments and Contingencies

We are subject from time to time to various legal proceedings and claims that arise during the ordinary course of our business.  We do not believe that the outcome of those “routine” legal matters should have a material adverse affect on our consolidated financial position, operating results or cash flows; however, we can provide no assurances that legal claims that may arise in the future will not have such a material impact on the Company.

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Recent Accounting Pronouncements

9 Months Ended

Sep. 30, 2014

Recent Accounting Pronouncements

Recent Accounting Pronouncements

11.Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services.  The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein.  We are currently evaluating the impact of our pending adoption of ASU 2014-09.

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Basis of Presentation (Details)	9 Months Ended
	Sep. 30, 2014
Basis of Presentation
Number of instruments held for trading purposes	0

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Net Income (Loss) Per Share (Details)	3 Months Ended		9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013	Sep. 30, 2014	Sep. 30, 2013
Net Income (Loss) Per Share
Number of common stock equivalents excluded from the diluted income (loss) per share calculation (in shares)	609,452	379,822	4,208,910	1,082,117

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (USD $) In Thousands, unless otherwise specified	9 Months Ended
	Sep. 30, 2014	Sep. 30, 2013
Operating Activities:
Net income (loss)	$ (145)	$ 435
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	175	110
Stock-based compensation	284	148
Penalties and waived penalties on dividends	6	22
Changes in operating assets and liabilities:
Accounts receivable	(199)	(819)
Inventories	7	(14)
Prepaid expenses and other assets	(62)	7
Accounts payable and accrued expenses	(32)	407
Deferred revenue	827	382
Net cash provided by operating activities	861	678
Investing Activities:
Purchases of property and equipment	(49)	(60)
Financing Activities:
Proceeds from line of credit	453	508
Payments on line of credit	(453)	(638)
Proceeds from stock options exercised	61
Proceeds from warrants exercised	(512)
Principal payments on capital leases	(124)	(82)
Net cash used in financing activities	(575)	(212)
Net increase in cash and cash equivalents	237	406
Cash and cash equivalents at beginning of period	1,139	52
Cash and cash equivalents at end of period	1,376	458
Cash paid during the year for interest	95	144
SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING ACTIVITIES:
Preferred stock dividends accrued	107	113
Purchase of leased equipment under capital lease	222	34
Conversion of preferred shares to common stock	$ 163

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Line of Credit

9 Months Ended

Sep. 30, 2014

Line of Credit

Line of Credit

5.Line of Credit

On March 29, 2006, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to establish a $1.0 million line of credit (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amended and Restated Loan and Security Agreement with SVB to, among other things, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008 Credit Line”).  On June 24, 2014, we entered into the Sixth Amendment to the Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with SVB to replace our expiring line with a $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement are secured by substantially all of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’s Chairman, President and Chief Executive Officer, has established a Guaranty Agreement with SVB securing all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Credit are based on advances (each an “Advance”) against certain of our accounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eighty percent (80%) of each Eligible Account, or such other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance charge calculated as a daily rate that is based on a 360-day annual rate of the greater of the prime rate plus 2.0% or 7.0%.  Finance charges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateral handling fee of 0.5% of all outstanding Advances, depending on certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliest of (a) the date that the Eligible Account related to the Advance is paid, (b) the date the Eligible Account is no longer eligible under the Loan Agreement, or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) is asserted to the Eligible Account.  We have certain non-financial and financial covenants, including a liquidity coverage ratio and a rolling EBITDA computation, as defined in the Loan Agreement.  On June 23, 2015, the Loan Agreement terminates and all outstanding Advances, accrued but unpaid finance charges, outstanding collateral handing fees, and other amounts become due under the Loan Agreement and related documents.  As of September 30, 2014 we had no borrowings outstanding under the Current Line of Credit and are within limits of all debt covenants.

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Concentrations (Details) (Revenues Net [Member], Customer Concentration Risk [Member])	3 Months Ended
	Sep. 30, 2014	Sep. 30, 2013
Concentrations
Percentage of revenue	47.20%	54.20%
United States Government [Member]
Concentrations
Percentage of revenue	52.80%	45.80%
Two Government Customer [Member]
Concentrations
Percentage of revenue		30.90%
Number of customers		2
Three Government Customer [Member]
Concentrations
Percentage of revenue	38.60%
Number of customers	3
Two Commercial Customer [Member]
Concentrations
Percentage of revenue	42.00%	53.20%
Number of customers	2	2

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Description of Business (Details 1) (USD $)			9 Months Ended		9 Months Ended
	Mar. 29, 2006 Credit Line 2006 [Member]	Jun. 30, 2008 Credit Line 2008 [Member]	Sep. 30, 2014 Line of Credit [Member]	Jun. 24, 2014 Line of Credit [Member]	Sep. 30, 2014 Line of Credit [Member] Maximum [Member]
Line of Credit
Maximum borrowing capacity	$ 1,000,000	$ 2,500,000	$ 625,000	$ 625,000
Contingent advances as a percentage of each Eligible Account					80.00%
Period of annual rate for calculating daily rate of finance charge on each advance			360 days
Finance charge basis			prime rate
Percentage points added in daily rate of finance charge			2.00%
Minimum interest rate (as a percent)			7.00%
Monthly collateral handling fee (as a percent)			0.50%
Borrowings outstanding			$ 0