ORGANIZATION AND DESCRIPTION OF BUSINESS

6 Months Ended

Jun. 30, 2012

Notes to Financial Statements

Note 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS

Overview

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

Recent Developments

In March 2012, the Company entered into agreements with the holders of certain warrants acquired in connection with a financing consummated by the Company on December 21, 2011 (the “Qualified Financing”), which warrants are currently exercisable for 12,252,500 shares of the Company’s common stock at an exercise price of $0.50 per share.  The warrants contained certain settlement provisions that required, under specific circumstances, a net cash settlement upon the occurrence of a “Fundamental Transaction” as defined in the warrants.  These provisions effectively resulted in the characterization of the warrants as derivative liabilities.  The agreements amended the warrants to revise, among other provisions, the definition of “Fundamental Transaction”. As a result of the amendments, the warrants no longer qualify as derivative liabilities. The Company determined the change in fair value from the date of previous measurement (December 31, 2011) to the date of the amendment (March 21, 2012) for these warrants and recorded approximately $5,110,000 in expense. Such expense is included in the Company’s condensed consolidated statement of operations for the six months ended June 30, 2012 under the caption “Change in fair value of derivative liabilities”.

  Additionally, as a result of the agreements to amend the warrants and the warrants no longer qualifying for derivative liability treatment, the Company reclassified approximately $13,588,000 in derivative liability into a component of additional paid-in capital in the Company's financial statements for the period ended March 31, 2012. 

During the three months ended March 31, 2012, the Company paid approximately $178,000 in accumulated dividends to the holders of its Series B Convertible Preferred Stock. During the three months ended June 30, 2012, the Company paid $25,000 in accumulated dividends to the holders of its Series B Convertible Preferred Stock.

In June 2012, the Company entered into an asset purchase agreement with Vocel, Inc., a Delaware Corporation (“Vocel”), whereby the Company purchased from Vocel assets, consisting primarily of patents, software, trademarks and other intellectual property.  The Company evaluated this transaction under the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC’) No. 805, Business Combinations, and determined that this transaction constituted an asset purchase. As consideration for this asset purchase:

· the Company issued to Vocel a warrant to purchase 150,000 shares of the Company’s common stock (“Purchaser Warrant”).  The Purchaser Warrant is exercisable at $0.88 per share and vests 100% when the Company has derived $500,000 of gross revenue from the sale or license of the purchased intellectual property (“Warrant Vesting Date”).  The Purchaser Warrant is exercisable for a period of three years from the Warrant Vesting Date; and

· the Company agreed to pay Vocel a royalty of 7.5% of gross revenue received by the Company from any third party sale or license of the purchased intellectual property.

The Company recorded this asset purchase based on the fair value of the liabilities incurred and equity interests issued. The Company determined the aggregate fair value of the consideration to be approximately $159,000 and has allocated this amount to the relative fair value of the assets acquired.

Liquidity

At June 30, 2012, our principal sources of liquidity consisted of cash and cash equivalents of $3,648,000 and accounts receivable, net of $148,000. As of June 30, 2012, we had positive working capital of $507,000 which included $1,206,000 of deferred revenue.  Historically, our principal sources of cash have included customer payments from the sale of our products, proceeds from the issuance of common and preferred stock and proceeds from the issuance of debt. Our principal uses of cash have included cash used in operations, payments relating to purchases of property and equipment and repayments of borrowings. We expect that our principal uses of cash in the future will be for operations, working capital and capital expenditures. We expect that, as our revenues grow, our sales and marketing and research and development expenses will continue to grow and, as a result, we will need to generate significant net revenues to achieve profitability.

Management currently believes that the Company's current cash and cash equivalents, together with anticipated cash proceeds generated from the exercise of warrants expiring during the next 12 months, will be sufficient to meet working capital and capital expenditure requirements for the next 12 months from the date of the filing of this Quarterly Report. However results from operations are materially less than forecasted, the Company's current cash and cash equivalents may be insufficient to meet its working capital and capital expenditure requirements.  We may therefore be required to sell equity or debt securities, secure a bank line of credit, or consider strategic alliances to fully execute our business plan.  The sale of equity or equity–related securities could result in additional dilution to our shareholders.  There can be no assurance that additional financing, in any form, will be available at all or, if available, will be on terms acceptable to us.