10QSB/A 1 a2041958z10qsba.txt 10QSB/A AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON APRIL 2, 2001 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------------------- FORM 10QSB/A AMENDMENT 1 -------------------------------- (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2000 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from _____________________ to _______________________ Commission file number 333-93131 IMAGEWARE SYSTEMS, INC. (Name of small business issuer as specified in its charter) CALIFORNIA 33-0224167 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 10883 THORNMINT ROAD SAN DIEGO, CA 92127 (Address of principal executive officers) (858) 673-8600 (Issuer's telephone number) NOT APPLICABLE (Former name, former address and former fiscal year, if changed since last report) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 --- --- State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: As of August 10, 2000 the number of outstanding shares of the Registrant's common stock, par value $.01, was 3,311,348. IMAGEWARE SYSTEMS, INC. INDEX
Page No. -------- RESTATEMENT 3 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) 3 Condensed Consolidated Balance Sheets as of June 30, 2000 and December 31, 1999 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2000 and 1999 4 Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 2000 and 1999 5 Notes to Condensed Consolidated Financial Statements 6 ITEM 2. Management's Discussion and Analysis of Financial 8 Condition and Results of Operations PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 14 ITEM 2. CHANGES IN SECURITIES 14 ITEM 3. DEFAULTS ON SENIOR SECURITIES 14 ITEM 4. SUBMISSION OF MATTERS TO A VOTE 14 OF SECURITY HOLDERS ITEM 5. OTHER INFORMATION 14 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 14
2 RESTATEMENT The undersigned registrant hereby amends its Quarterly Report on Form 10-QSB for the quarter ended June 30, 2000 to amend Items 1 and 2 of Part 1 in its entirety. The Company is restating the financial statements filed with the Company's Form 10-QSB for the three month period ending June 30, 2000 to revise the accounting for a loan issued in November of 1999. The loan contained a beneficial conversion feature, which required that a portion of the loan proceeds be allocated to equity. Subsequent to issuance, the amount of the beneficial conversion feature should have been recognized as interest expense through the loan conversion date. As a result of the restatement, interest expense and net loss increased by $889,000 in the 3 months ended March 31, 2000. During the second quarter ending June 30, 2000, the Company extinguished the debt. The difference between the debt payment of $1,250,000 and the carrying amount of $628,000 was recorded as an extraordinary gain of $622,000. This change has no impact on the Company's revenues, gross margins, operating expenses, working capital or cash flows in those periods. The Company is restating the financial statements filed with the Company's Form 10-QSB for the three month period ending June 30, 2000 to reflect additional stock-based compensation relative to a warrant issued for consulting services. The restatement will reduce net income in the quarter ended June 30, 2000 by $79,000. This change has no impact on the Company's revenues, gross margins, working capital or cash flows in that period. These items are further explained in Note 2 and Note 5 to these Condensed Consolidated Financial Statements. PART I FINANCIAL INFORMATION - ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) IMAGEWARE SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) ASSETS
6/30/00 12/31/99 ----------- -------- (UNAUDITED) Current Assets: Cash 7,665 156 Accounts receivable, net 3,871 2,920 Inventory 8 112 Other Assets 320 183 ----------- -------- Total Current Assets 11,864 3,371 Property and Equipment, net 202 192 Intangible assets, net 1,413 2,347 ----------- -------- TOTAL ASSETS 13,479 5,910 =========== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts Payable 438 1,625 Deferred Revenue 677 853 Accrued expenses 1,344 2,227 Deferred compensation - 294 Accrued interest 170 437 Notes payable to bank - 500 Notes payable to related parties 56 1,719 ----------- -------- Total Current liabilities 2,685 7,655 Notes Payable to Related Parties, Net of current portion - 36 ----------- -------- Total Liabilities 2,685 7,691 Stockholders' equity (deficit): Common Stock at par value 33 12 Preferred Stock 4 4 Additional paid in capital 31,536 17,489 Treasury Stock (64) - Accumulated Deficit (20,715) (19,286) ----------- -------- Total stockholders' equity 10,794 (1,781) ----------- -------- TOTAL EQUITY AND LIABILITIES 13,479 5,910 =========== ========
See accompanying notes to condensed consolidated financial statements 3 IMAGEWARE SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, 2000 1999 2000 1999 --------- --------- --------- --------- REVENUES: Product 1,688 664 3,115 1,417 Maintenance 356 385 627 742 License and other 24 43 58 81 --------- --------- --------- --------- 2,068 1,092 3,800 2,240 Cost of revenue Product 312 317 868 554 Maintenance 310 222 617 430 --------- --------- --------- --------- Gross profit 1,446 553 2,315 1,256 --------- --------- --------- --------- Operating, Gen & Admin. 752 791 1,391 1,167 Sales and marketing 301 281 702 495 Research & Development 302 265 624 569 Depreciation and amortization 252 262 496 533 --------- --------- --------- --------- 1,607 1,599 3,213 2,764 Loss from Operations (161) (1,046) (898) (1,508) Interest (income) expense, net (87) 104 973 192 Income (loss) before income taxes (74) (1,150) (1,871) (1,700) Tax provision - - - - Extraordinary item: Gain on debt extinguishment net of income taxes of $0 622 - 622 - --------- --------- --------- --------- Net income (loss) 548 (1,150) (1,249) (1,700) ========= ========= ========= ========= Basic earnings (loss) per share - see note 2 Earnings (loss) before extraordinary item $ (0.03) $ (1.23) $ (0.87) $ (1.88) Extraordinary item 0.19 - 0.28 - Earnings (loss) per share 0.16 (1.23) (0.59) (1.88) Weighted average shares (basic) 3,220,989 949,135 2,198,346 924,108
See accompanying notes to condensed consolidated financial statements 4 IMAGEWARE SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW (IN THOUSANDS; UNAUDITED)
Six Months Six Months Ended June 30, Ended June 30, 2000 1999 CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (1,249) $ (1,700) Adjustments to reconcile net loss to net cash used by operating activities Depreciation and amortization 496 543 Noncash compensation and fees 129 348 Deferred revenue - - Change in assets and liabilities Accounts receivable, net (951) (476) Inventory 104 (24) Other current assets (137) 13 Other long-term assets (332) (6) Accounts payable (1,187) 148 Accrued expenses (808) 532 Deferred compensation (294) - Accrued interest 62 70 Deferred revenue (176) 93 ---------- ---------- Total adjustments (3,094) 1,241 ---------- ---------- Net cash used by operating activities (4,343) (459) ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of property and equipment (65) (8) ---------- ---------- Net cash used by investing activities (65) (8) ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of notes payable 56 500 Repayment of loans (3,473) (10) Proceeds from issuance of stock, net of issuance costs 15,579 - Repurchase of common stock (64) - Dividends paid (181) - ---------- ---------- Net cash (used)/provided by financing activities 11,917 490 ---------- ---------- Net (decrease) increase) in cash 7,509 23 Cash at beginning of period 156 46 ---------- ---------- Cash at end of period $ 7,665 $ 69 ========== ========== NON-CASH TRANSACTIONS Value allocated to warrants for services 82 Issuance of stock for loan guarantee 348 SUPPLEMENTAL CASH FLOWS INFORMATION Cash paid for interest 377 66
See accompanying notes to condensed consolidated financial statements 5 IMAGEWARE SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The accompanying condensed consolidated unaudited financial statements of ImageWare Systems, Inc. ("ImageWare" or the "Company") have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with consolidated financial statements for the year ended December 31, 1999 and notes thereto included in the Company's SB-2 registration statement dated March 30, 2000. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments, consisting of only normal recurring items, necessary for a fair presentation of the Company's financial position as of June 30, 2000 and its results of operations for the six months ended June 30, 2000 and 1999, respectively. These condensed consolidated unaudited financial statements are not necessarily indicative of the results to be expected for the entire year. NOTE 2. RESTATEMENT The second quarter balance sheet has been restated as follows:
December 31, 1999 As reported As restated ----------- ----------- Note payable to related parties, net of current portion(2) 925 36 Total Liabilities 8,580 7,691 Additional paid-in capital(2) 16,600 17,489 Total stockholders' equity(2) (2,670) (1,781)
The second quarter results have been restated as follows (in thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED June 30, 2000 June 30, 2000 AS AS AS AS REPORTED RESTATED REPORTED RESTATED ------------ ------------ -------------- -------------- General & Administrative expense(1) $ 673 $ 752 $ 1,312 $ 1,391 Loss from Operations $ (82) $ (161) $ (819) $ (898) Interest expense, net(2) $ (87) $ (87) $ 84 $ 973 Income (loss) before income taxes $ 5 $ (74) $ (903) $(1,871) Extraordinary item: Gain on extinguishment of debt, net of income tax of $0(2) $ - $ 622 $ - $ 622 Net income (loss) $ 5 $ 548 $ (903) $(1,249) Basic earnings (loss) per share: Earnings (loss) before extraordinary item $ - $ (0.03) $ (0.43) $ (0.87) Extraordinary item $ - $ 0.19 $ - $ 0.28 Earnings (loss) per share $ - $ (0.16) $ (0.43) $ (0.59)
(1) The Company recorded an expense of $79,000 to properly record the issuance of common stock purchase warrants for consulting services. (2) During the quarter ended March 31, 2000, the Company recorded interest expense of $889,000 due to the convertibility feature embedded in a debt instrument. The value of this beneficial conversion feature was measured using its intrinsic value, i.e. the excess of the aggregrate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The intrinsic value of the beneficial conversion feature of approximately $10 million exceeded the proceeds allocated to the debt of approximately $899,000; therefore the Company limited recognition of the beneficial conversion feature to approximately $899,000 of proceeds allocated to the debt. The beneficial conversion feature was treated as a discount on the Note, as such, a portion of the loan proceeds were allocated to additional paid-in capital. The Company accreted the entire amount of the beneficial conversion feature as interest expense over the period beginning on the date of issuance, November 10, 1999 and ending on the date the note became immediately convertible, April 1, 2000, using the effective interest rate method. During the second quarter ending June 30, 2000, the Company extinguished the debt. The difference between the debt payment of $1,250,000 and the carrying amount of $628,000 was recorded as an extraordinary gain of $622,000. NOTE 3. EARNINGS PER COMMON SHARE Effective November 29, 1999, the Company declared a 5.275-for-1 reverse stock split of common stock. All references to the number of shares, per share amounts, conversion amounts and stock option data of the Company's common stock have been restated to reflect this reverse stock split for all periods presented. Basic earnings per common share is calculated by dividing net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, increased to include, if dilutive, the number of additional common shares that would have been outstanding if the potential common shares had been issued. The dilutive effect of outstanding stock options is included in the calculation of diluted earnings per common share using the treasury stock method. During the period ended June 30, 1999 and 2000, the Company has excluded all convertible preferred stock and outstanding stock options from the calculation of diluted loss per share, as their effect would have been antidilutive. The following table sets forth the computation of basic and diluted loss per share for the periods ended June 30, 1999 and 2000: 6
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, 2000 1999 2000 1999 ------------ ------------ ------------ ------------ Numerator (Loss) before income taxes and extraordinary item $ (74) $ (1,150) $ (1,871) $ (1,700) Less Series B preferred dividends (21) (21) (41) (41) ------------ ------------ ------------ ------------ Loss available to common shareholders before extraordinary item (95) (1,171) (1,912) (1,741) ------------ ------------ ------------ ------------ Extraordinary item - see note 5 622 - 622 - ------------ ------------ ------------ ------------ Net income (loss) available to common shareholders 527 (1,171) (1,290) (1,741) ============ ============ ============ ============ Denominator Weighted-average shares outstanding 3,220,989 949,135 2,198,346 924,108 ============ ============ ============ ============ Basic and diluted earnings per share before extraordinary item $ (0.03) $ (1.23) $ (0.87) $ (1.88) Extraordinary item $ 0.19 $ - $ 0.28 $ - Net income (loss) per share $ 0.16 $ (1.23) $ (0.59) $ (1.88)
NOTE 4. RELATED PARTY TRANSACTIONS. On March 30, 2000, two officers of the Company loaned ImageWare $58,000 pursuant to short-term promissory notes. This debt was incurred to meet working capital needs. The entire amount of the notes was due on the date the Company closed its Initial Public Offering. The loan was paid in full on April 5, 2000. On June 15, 2000, the Company paid in full two short-term promissory notes due an officer of the Company and member of the Board of Directors in accordance with the maturity date of these notes. NOTE 5. INITIAL PUBLIC OFFERING On March 31, 2000, the Company completed an IPO of 1,875,000 units, (units consists of one share of common stock and a warrant to purchase one share of common stock) at $8.00 per unit. Net proceeds to ImageWare aggregated approximately $13.5 million. The IPO proceeds were received by the Company on April 5, 2000. On May 2, 2000 the Company received approximately $2.0 million in additional net proceeds from the exercise the of the over allotment option by the underwriter to sell an additional 281,250 units. The Company utilized approximately $3.5 million of the proceeds to reduce notes payable in the second quarter of 2000. NOTE 6. NOTES PAYABLE AND EXTRAORDINARY ITEM In November 1999, the Company issued a convertible promissory note for $1,250,000 at an interest rate of 10%, due the earlier of February 10, 2001 or five days following the closing of an IPO, to an individual affiliated with Atlus Co. (which beneficially owns approximately 31% of the Company's common shares outstanding). Under the terms of the note, the principal amount is fixed in Japanese yen and shall be repaid in U.S. dollars at a fixed (104.55 Japanese yen per U.S. dollar) conversion rate established on the date of issuance. If the principal and interest has not been paid prior to April 1, 2000, the note becomes convertible to common stock at $1.00 per share. In conjunction with the note, the Company issued the individual a warrant to purchase 125,000 shares of common stock for $6.00 per share. The Company has recorded the note net of a discount equal to the fair value allocated to the warrants issued of approximately $361,000. The Company recorded a charge of $889,000 for the beneficial conversion feature embedded in this debt instrument during the first quarter 2000. The value of the beneficial conversion feature was measured using its intrinsic value, i.e., the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The intrinsic value of the beneficial conversion feature of approximately $10 million exceeded the proceeds allocated to the debt of approximately $889,000; therefore, the Company limited recognition of the beneficial conversion feature to the approximately $889,000 of proceeds allocated to the debt. The Company accreted the entire amount of the beneficial conversion feature as interest expense over the period from the date of issuance, November 10, 1999, to the date the note becomes immediately convertible, April 1, 2000, using the effective interest method. On April 5, 2000, the Company used a portion of the proceeds from its initial public offering to extinguish this outstanding debt. The difference between the debt payment amount of $1,250,000 and the carrying amount of the debt of approximately $628,000 was recorded as an extraordinary gain of $622,000. 7 NOTE 7. LETTER OF CREDIT As collateral for performance on the Company's operating lease for its office and research and development facilities, the Company is contingently liable under an irrevocable standby letter of credit in the amount of $120,000. The letter of credit expires July 31, 2003 and will automatically reduce to $90,000 on August 1, 2000, $60,000 on August 1, 2001, and $30,000 on August 1, 2002 provided there are no drawings against the outstanding balance. As a condition, the bank required the Company to invest $120,000 in the form of a one year certificate of deposit which matures in June 2001. NOTE 8. SUBSEQUENT EVENTS On July 7, 2000 ImageWare announced that it had signed a definitive agreement to acquire Imaging Technology Corporation ("ITC") of Hudson, MA in a stock transaction. Founded in 1994, ITC develops digital imaging software for photo identification cards and documents. ITC's software is used for driver's licenses, voter registration programs, national ID programs, passport programs and for public and private security applications. ITC sells its ID software worldwide through OEMs, agents, resellers and system integrators such as Sensormatic/Software House, Polaroid, and Cardkey/Johnson Control. ITC has powered solutions ranging from a Polaroid branded ID card product, ID Cardmaker-TM-, to full identification solutions for Massachusetts Institute of Technology, the U.S. Bureau of Engraving and Printing, JFK International Airport and for the countries such as Nigeria and Peru. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risk and uncertainties. ImageWare Systems, Inc.'s ("ImageWare" or "the Company") future results could differ materially from those discussed here. Factors that could cause or contribute to such differences include but are not limited to: fluctuations in the Company's operating results, continued new product introductions by the Company, market acceptance of the Company's new product introductions, new product introductions by competitors, technological changes in the digital imaging industry, uncertainties regarding intellectual property rights and the other factors referred to herein including, but not limited to, the items discussed under "Risk Factors" in the Company's SB-2 registration statement dated March 30, 2000. The following discussion should be read in conjunction with the consolidated financial statements included elsewhere within this quarterly report. Fluctuations in annual and quarterly results may occur as a result of factors affecting demand for the Company's products such as the timing of the Company's and competitors' new product introductions and the Company's customers' political and budgetary constraints. Due to such fluctuations, historical results and percentage relationships are not necessarily indicative of the operating results for any future period. 8 OVERVIEW ImageWare Systems, Inc. develops, sells and supports a suite of modular software products used by law enforcement and public safety agencies to manage criminal history records and to investigate crime. Its software systems and associated hardware enable its customers to quickly capture, archive, search, retrieve and share digital photographs and criminal history records. RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2000 AND 1999 REVENUES. Product revenues increased 154% from $0.7 million for the three months ended June 30, 1999 to $1.7 million for the corresponding period in 2000. The increase reflected the further purchases of the Crime Capture System by new and existing customers. The backlog of product orders as of June 30, 2000 was approximately $1.1 million. Customer service revenues decreased 8% from $385,000 for the three months ended June 30, 1999 to $356,000 for the corresponding period in 2000. In 1999, the Company offered its UNIX-based customers incentives to upgrade to the Windows-based Crime Capture System. As part of the upgrade incentives, the customers received reduced maintenance fees in 1999, a portion of which carried over into 2000 due primarily to the timing of the installations late in 1999 with maintenance commencing 90 days after final system acceptance. These price reductions were justified based upon the need to consolidate the number of versions of systems the Company would have to support and to avoid the cost of bringing the older installations into Y2K compliance. The Company does not expect to offer similar price reductions in the future and expects customer service revenues to increase along with its expanded installed base. COST OF REVENUES. Cost of products and maintenance increased 15% from $0.5 million, or 49% of revenue, for the three months ended June 30, 1999 to $0.6 million, or 30% of revenue for the corresponding period in 2000. Cost of product revenues was unchanged from $0.3 million in 1999 to $0.3 million for the corresponding period in 2000. Cost of product revenues as a percentage of product sales decreased from 48% for the three months ended June 30, 1999 to 18% for the corresponding period in 2000. This reduction was due to a higher than normal concentration of software only product mix during the three months ended June 30, 2000. Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and the hardware content included in systems installed during a given period. Costs of maintenance revenue increased $0.1 million as the Company increased staffing levels to maintain optimal service to its expanding installed base. GROSS MARGINS. Total gross margins increased from $0.6 million, or 51% of revenues, for the three month period ended June 30, 1999 to $1.4 million, or 70% of revenues for the corresponding period in 2000. Gross margins related to product sales increased from $0.3 million, or 52% of revenues, to $1.4 million or 82% of revenues for the corresponding period in 2000 due to an uncharacteristically high product mix of software only components. Gross margins related to maintenance revenues decreased from $163,000 for the three months ended June 30, 1999 to $46,000 for the corresponding period in 2000 due to increased staffing levels and the impact of the upgrades of the Company's UNIX based customers on maintenance revenue. OPERATING, GENERAL AND ADMINISTRATIVE EXPENSES. Operating, general and administrative expenses are comprised primarily of salaries for administrative personnel, legal and professional services, occupancy and communication costs. Such expenses decreased 4% from $0.8 million for the three months ended June 30, 1999 to $0.7 million for the corresponding period in 2000 due primarily to a one-time charge for costs associated with loan guarantees by certain officers and directors of the Company in 1999. SALES AND MARKETING. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of the Company's sales force. Such expenses increased 7% from $281,000 for the three months ended June 30, 1999 to $301,000 for the corresponding period in 2000 due primarily to increased salaries as the Company enlarged and restructured its sales force to better capture market opportunities. 9 RESEARCH AND DEVELOPMENT. Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased 14% for the three months ended June 30, 1999 from $265,000 in 1999 to $302,000 for the corresponding period in 2000. The Company expects to continue to invest in the development of products for which it believes there is a need in the market, however, there can be no assurance that research and development programs invested in by the Company will be successful or that products resulting from such programs will achieve market acceptance. INTEREST EXPENSE, NET. For the three months ended June 30, 1999, the Company recognized interest income of $2,000 and interest expense of $106,000. For the three months ended June 30, 2000, the Company recognized interest income of $102,000 and interest expense of $15,000. Interest income increased substantially due to higher cash and cash equivalents held in interest bearing accounts, resulting from the proceeds of the Company's initial public offering. Interest expense decreased substantially due to the paydown of interest bearing obligations. EXTRAORDINARY ITEM. In November 1999, the Company issued a convertible promissory note for $1,250,000 at an interest rate of 10%, due the earlier of February 10, 2001 or five days following the closing of an IPO, to an individual affiliated with Atlus Co. (which beneficially owned approximately 31% of the Company's common shares outstanding at the date of note issuance). Under the terms of the note, the principal amount is fixed in Japanese yen and shall be repaid in U.S. dollars at a fixed (104.55 Japanese yen per U.S. dollar) conversion rate established on the date of issuance. If the principal and interest has not been paid prior to April 1, 2000, the note becomes convertible to common stock at $1.00 per share. In conjunction with the note, the Company issued the individual a warrant to purchase 125,000 shares of common stock for $6.00 per share. The Company has recorded the note net of a discount equal to the fair value allocated to the warrants issued of approximately $361,000. The Company recorded a charge of $889,000 for the beneficial conversion feature embedded in this debt instrument. The value of the beneficial conversion feature was measured using its intrinsic value, i.e., the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The intrinsic value of the beneficial conversion feature of approximately $10 million exceeded the proceeds allocated to the debt of approximately $889,000; therefore, the Company limited recognition of the beneficial conversion feature to the approximately $889,000 of proceeds allocated to the debt. The Company accreted the entire amount of the beneficial conversion feature as interest expense over the period from the date of issuance, November 10, 1999, to date the note becomes immediately convertible, April 1, 2000, using the effective interest method. On April 5, 2000, the Company used a portion of the proceeds from its initial public offering to extinguish this outstanding debt. The difference between the debt payment amount of $1,250,000 and the carrying amount of the debt of approximately $628,000 was recorded as an extraordinary gain of $622,000. SIX MONTHS ENDED JUNE 30, 1999 AND 2000 REVENUES. Product revenues increased 120% from $1.4 million for the six months ended June 30, 1999 to $3.1 million for the corresponding period in 2000. The increase reflected the further purchases of the Crime Capture System by new and existing customers. Customer service revenues decreased 15% from $0.7 million for the six months ended June 30, 1999 to $0.6 million for the corresponding period in 2000. In 10 1999, the Company offered its UNIX-based customers incentives to upgrade to the Windows-based Crime Capture System. As part of the upgrade incentives, the customers received reduced maintenance fees in 1999, a portion of which carried over into 2000 due primarily to the timing of the installations late in 1999 with 90 day warranties and maintenance commencing 90 days after final system acceptance. These price reductions were justified based upon the need to consolidate the number of versions of systems the Company would have to support and to avoid the cost of bringing the older installations into Y2K compliance. The Company does not expect to offer similar price reductions in the future and expects customer service revenues to increase along with its expanded installed base. COST OF REVENUES. Cost of products and maintenance increased 51% from $1.0 million, or 44% of revenue, for the six months ended June 30, 1999 to $1.5 million, or 39% of revenue for the corresponding period in 2000. Cost of product revenues increased 57% from $0.6 million, or 39% of revenue in 1999 to $0.9 million, or 28% of revenue for the corresponding period in 2000. The decrease in product revenues as a percentage of product sales from 39% for the six months ended June 30, 1999 to 28% for the corresponding period in 2000 was due to a higher than normal concentration of software only product mix during the six months ended June 30, 2000. Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and the hardware content included in systems installed during a given period. Costs of maintenance revenue increased $0.2 million as the Company increased staffing levels to maintain optimal service to its expanding installed base. GROSS MARGINS. Total gross margins increased from $1.3 million, or 56% of revenues, for the six month period ended June 30, 1999 to $2.3 million, or 61% of revenues for the corresponding period in 2000. Gross margins related to product sales increased from $0.9 million, or 61% of revenues, to $2.2 million or 72% of revenues for the corresponding period in 2000. Gross margins related to maintenance revenues decreased from $312,000 for the six months ended June 30, 1999 to $10,000 for the corresponding period in 2000 due to increased staffing levels and the impact of the upgrades of the Company's UNIX based customers on maintenance revenue. OPERATING, GENERAL AND ADMINISTRATIVE EXPENSES. Operating, general and administrative expenses are comprised primarily of salaries for administrative personnel, legal and professional services, occupancy and communication costs. Such expenses increased 19% from $1.2 million for the six months ended June 30, 1999 to $1.4 million for the corresponding period in 2000. SALES AND MARKETING. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of the Company's sales force. Such expenses 11 increased 42% from $0.5 million for the six months ended June 30, 1999 to $0.7 million for the corresponding period in 2000 due primarily to increased salaries and commissions as the Company enlarged and restructured its sales force to better capture market opportunities. RESEARCH AND DEVELOPMENT. Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased 10% from $569,000 in 1999 to $624,000 for the corresponding period in 2000. The Company expects to continue to invest in the development of products for which it believes there is a need in the market; however, there can be no assurance that research and development programs invested in by the Company will be successful or that products resulting from such programs will achieve market acceptance. INTEREST EXPENSE, NET. The Company recorded total interest expense of $1,078,000, net of interest income of $105,000 for the six months ended June 30, 2000 of which $889,000 relates to the accretion of a beneficial conversion feature embedded in the Company's convertible promissory note issued in November 1999, as more fully explained in Note 5 to these Condensed Consolidated Financial Statements. Exclusive of this charge, for the six months ended June 30, 1999, the Company recognized interest income of $3,000 and interest expense of $195,000. For the six months ended June 30, 2000, the Company recognized interest income of $105,000 and interest expense of $189,000. Interest income increased substantially due to higher cash and cash equivalents held in interest bearing accounts, resulting from the proceeds of the Company's IPO, such proceeds received by the Company on April 5, 2000. EXTRAORDINARY ITEM. In November 1999, the Company issued a convertible promissory note for $1,250,000 at an interest rate of 10%, due the earlier of February 10, 2001 or five days following the closing of an IPO, to an individual affiliated with Atlus Co. (which beneficially owned approximately 31% of the Company's common shares outstanding at the date of note issuance). Under the terms of the note, the principal amount is fixed in Japanese yen and shall be repaid in U.S. dollars at a fixed (104.55 Japanese yen per U.S. dollar) conversion rate established on the date of issuance. If the principal and interest has not been paid prior to April 1, 2000, the note becomes convertible to common stock at $1.00 per share. In conjunction with the note, the Company issued the individual a warrant to purchase 125,000 shares of common stock for $6.00 per share. The Company has recorded the note net of a discount equal to the fair value allocated to the warrants issued of approximately $361,000. The Company recorded a charge of $889,000 for the beneficial conversion feature embedded in this debt instrument. The value of the beneficial conversion feature was measured using its intrinsic value, i.e., the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security. The intrinsic value of the beneficial conversion feature of approximately $10 million exceeded the proceeds allocated to the debt of approximately $889,000; therefore, the Company limited recognition of the beneficial conversion feature to the approximately $889,000 of proceeds allocated to the debt. The Company accreted the entire amount of the beneficial conversion feature as interest expense over the period from the date of issuance, November 10, 1999, to date the note becomes immediately convertible, April 1, 2000. On April 5, 2000, the Company used a portion of the proceeds from its initial public offering to extinguish this outstanding debt. The difference between the debt payment amount of $1,250,000 and the carrying amount of the debt of approximately $628,000 was recorded as an extraordinary gain of $622,000. LIQUIDITY AND CAPITAL RESOURCES. Since inception, the Company has funded operations primarily from proceeds from the sale of stock and borrowings from 12 individuals and financial institutions. On March 31, 2000, the Company completed an IPO of 1,875,000 units, (units consist of one share of commons stock and a warrant to purchase one share of common stock) at $8.00 per unit. Net proceeds to ImageWare aggregated approximately $13.5 million. The IPO proceeds were received by the Company on April 5, 2000. On May 2, 2000 the Company received approximately $2.0 million in additional net proceeds from the exercise of the over allotment option by the underwriter to sell an additional 281,250 units. As of June 30, 2000, ImageWare had total current assets of $11.9 million and total current liabilities of $2.7 million, or working capital of $9.2 million. Net cash used in operating activities was $0.5 million for the six months ending June 30, 1999 as compared to $4.3 million for the six months ending June 30, 2000. The Company used cash to fund net losses of $1.7 million for the six months ended June 30, 1999 and $1.2 million for the corresponding period in 2000. In 1999, the Company used cash of $0.5 million to fund increases in current assets offset by increases in current liabilities of $0.8 million (excluding debt) and $0.9 from non cash expenses (depreciation, amortization and non cash compensation). In 2000, the Company used cash of $1.3 million to fund increases in current assets and other long-term assets, $2.6 million from decreases in current liabilities and deferred revenues (excluding debt) offset by $0.6 million from non cash expenses (depreciation, amortization and non-cash compensation). Net cash generated by financing activities was $0.5 million for the six months ending June 30, 1999 as compared to $12.0 million for the corresponding period of 2000. Net cash generated for the six months ending June 30, 2000 was primarily from net proceeds of $15.6 million from the company's IPO, completed March 31, 2000, offset by repayment of loans of $3.4 million, dividends paid on the Company's Series B preferred stock of $181,000 and the repurchase of the Company's common stock of $64,000. The Company believes that the funds held in cash and cash equivalents and funds provided by operations will be sufficient to finance its working capital requirements for at least the next twelve months. The Company is currently considering strategic transactions and alternatives with the goal of maximizing stockholder value. These transactions may include a variety of different business arrangements, including acquisitions, strategic partnerships, joint ventures and business combinations. Such transactions create a number of risks for the Company, including the risk that such transactions may not be consummated on favorable terms or at all, the risk that such transactions may not enhance stockholder value and may adversely affect the business or the trading price of the Company's stock and the risk that any such transaction may require the Company to incur non-recurring or other charges and may pose significant integration challenges and/or management and business disruptions. 13 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is currently not a party to any material legal proceedings. ITEM 2. CHANGES IN SECURITIES On March 30, 2000, the Securities and Exchange Commission declared the Company's Amendment No. 2 of the Registration Statement on Form SB-2 (333-93131) effective under the Securities Act of 1933, as amended. The registered securities were offered to the public on March 31, 2000, and the offering terminated on the same day, with the sale of all of the registered securities. The managing underwriters of the offering were Paulson Investment Company, Inc. and I-Bankers Securities, Inc. As of March 31, 2000, the Company sold 1,875,000 of the 2,156,250 units registered for an aggregate offering price for the amount sold of $15,000,000. The aggregate price of the offering amount registered was $17,250,000. Each unit consists of one share of common stock and one public warrant to purchase an additional share of common stock. The common stock and public warrants traded only as a unit until May 1, 2000, when the units separated and the common stock and warrants began trading separately. On April 18, 2000, the Company repurchased 6,704 shares of common stock for an aggregate price of $63,688. On May 2, 2000, the Company sold the remaining 281,250 units registered for an aggregate offering price of $2,250,000. ITEM 3. DEFAULTS ON SENIOR SECURITIES Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. ITEM 5. OTHER INFORMATION Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K Not Applicable. 14 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. IMAGEWARE SYSTEMS, INC. By: /s/ Wayne Wetherell ---------------------------------------- Wayne Wetherell, Chief Financial Officer Date: April 2, 2001 15