bkyi_10k-123112.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2012
Commission File Number 1-13463
BIO-KEY INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
 
41-1741861
(State or other jurisdiction of
Incorporation or organization)
 
(IRS Employer
Identification Number)
3349 HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ 07719
(Address of Principal Executive Offices) (Zip Code)
(732) 359-1100
Issuer’s telephone number, including area code.
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Exchange on which Registered
 
 
Common Stock, $0.0001 par value per share
 
None
 
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes  o    No  x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   Yes  o    No  x
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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer  o
 
Accelerated filer  o
     
Non-accelerated filer  o
 
Smaller reporting company  x
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 aggregate market value of the registrant’s voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant’s most recently completed second fiscal quarter was $5,287,670.
As of March 15, 2013, the registrant had 87,182,348 shares of common stock outstanding.
Documents Incorporated by Reference: None


 
 

 
 
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PRIVATE SECURITIES LITIGATION REFORM ACT

All statements other than statements of historical facts contained in this Annual Report on Form 10-K, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “anticipate,” “believe,” “estimate,” “will,” “may,” “future,” “plan,” “intend” and “expect” and similar expressions generally identify forward-looking statements. Although we believe our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure they will be achieved. Actual results may differ materially from the forward-looking statements contained herein due to a number of factors. Many of these factors are set forth under the caption “Risk Factors” in Item 1A of this Annual Report and other filings with the Securities and Exchange Commission. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, may be significant, presently or in the future. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.
 
 
 

 
 
PART I

ITEM 1.
DESCRIPTION OF BUSINESS

BIO-key International, Inc., a Delaware corporation (the “Company,” “BIO-key,” “we,” or “us), was founded in 1993 to develop and market advanced fingerprint biometric technology and related security software solutions. First incorporated as BBG Engineering, the company was renamed SAC Technologies in 1994 and, again, renamed BIO-key International, Inc. in 2002.

We develop and market advanced fingerprint biometric identification and identity verification technologies, cryptographic authentication-transaction security technologies, as well as related Identity Management and Credentialing software solutions. We were pioneers in developing automated, finger identification technology that supplements or compliments other methods of identification and verification, such as personal inspection identification, passwords, tokens, smart cards, ID cards, PKI, credit card, passports, driver’s licenses, OTP or other form of possession or knowledge-based credentialing. Additionally, advanced BIO-key® technology has been and is used to improve both the accuracy and speed of competing finger-based biometrics.

We have developed what we believe is the most discriminating and effective commercially available finger-based biometric technology. Our primary focus is in marketing and selling this technology into commercial logical and physical Privilege Entitlement & Access Control markets. Example primary markets include Mobile Payments & Credentialing, Online Payments and Credentialing, and Healthcare record and payment data security, among other things. Our secondary focus includes government markets, primarily law enforcement forensic investigation and Homeland Security.  We continue to research and develop advancements in our capabilities, as well as exploring and developing potential strategic relationships, including potential business combinations and acquisitions, which could help us leverage our capability to deliver our solutions. We have built a direct sales force of professionals, and also team with resellers, integrators and partner networks with substantial experience in selling technology solutions to government and corporate customers.
 
Products

Finger-based Biometric Identification and Personal Identity Verification

BIO-key is a leader in finger-based biometric identification and personal identity verification, as well as authentication-transaction security. Stand-alone, or in partnerships with OEMs, integrators, and solution providers, we provide biometric software solutions and authentication-transaction security solutions to private and public sector customers. BIO-key helps customers reduce risk by providing the ability to control access to things and services, in either the logical or physical domain.  BIO-key capabilities positively identify individuals and verify, or confirm, their identity before granting access to valuable corporate resources, privileged or subscribed data and services, web portals, applications, physical locations or assets, among other things. BIO-key capabilities are software based and both hardware and operating-system agnostic.  We do not develop, manufacture or produce hardware components that are used in conjunction with our software.  However, we do sell third-party hardware components with our software in various configurations required by our customers, as do our partners.  Our products are interoperable with all major fingerprint reader and hardware manufacturers, enabling application developers, Value Added Resellers and channel partners to seamlessly integrate our fingerprint biometrics into virtually any application, while dramatically reducing maintenance, upgrade and life-cycle costs.  BIO-key’s core technology supports interoperability on over 60 different commercially available fingerprint readers.  The technology is also interoperable across Windows and Linux, as well as Apple iOS and Android mobile operating systems. This interoperability is unique in the industry and a key differentiator for BIO-key in the biometric market and, in our opinion, makes our technology more viable than competing technologies and expands the size of the overall market for our products.

The Company’s biometric identification technology improves both the accuracy and speed of screening individuals, for identification purposes or for personal identity verification, by extracting unique data from a fingerprint and comparing it to existing similar fingerprint data.  These comparisons are conducted to identify an individual, either in a forensic investigation or to screen the individual upon the application for a privilege, or to verify the individual’s identity upon the individuals request to access the previously entitled privilege.  The technology has been built to be completely scalable and can handle databases containing millions of fingerprints. BIO-key achieves the highest levels of discrimination without requiring any other identifying data (multi-factor) such as a userID, smart ID cards, or tokens, although our technology can be used in conjunction with such additional factors.

BIO-key supports industry standards, like BioAPI, and has received National Institute of Standards and Technology (“NIST”) independent laboratory certification of its ability to support Homeland Security Presidential Directive #12 (HSPD-12) and ANSI/INCITS-378 templates, as well as validation of our fingerprint match speed and accuracy in large database environments.

BIO-key’s finger identification algorithm—Vector Segment Technology (VST™) is the core intellectual property behind its full suite of biometric products that include:

 
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·
Vector Segment Technology SDK (VST) —BIO-key’s biometric software development kit (“SDK”) that provides developers the ability to incorporate our biometric capabilities into their respective product offerings or infrastructure. VST is available as a low level SDK for incorporation into any application architecture to increase security while not sacrificing convenience. VST runs on Windows and Linux as well as within WEB-key on iOS and Android systems.

 
·
Intelligent Image Indexing®—BIO-key’s biometric identification solution that offers both large-scale one-to-many user identification. This solution enables customers to perform false alias and fast entry checks, including preventing fraudulent access to systems and privileges.  Intelligent Image Indexing scales identification capabilities from thousands to millions of users.  The solution runs on commercially available hardware making it truly scalable for any size system.

 
·
Biometric Service Provider—BIO-key provides support for the BioAPI (a standards-based solution meeting worldwide needs) for a compliant interface to applications using biometrics for verification and identification. BIO-key enhances the traditional use of BioAPI by adding support 64-bit support and other advanced features, supporting identification calls and also providing a single user interface for multiple fingerprint readers.

 
·
ID Director™—BIO-key’s Single Sign On (SSO) is a suite of solutions for integration with CA Technologies SiteMinder, Oracle’s Fusion Middleware SSO, IBM Tivoli Access Manager and other solutions, utilizing the power and security of WEB-key. This solution provides a simple to implement, custom authentication scheme for companies looking to enhance authentication. ID Director can easily add a level of security and convenience to the transaction level of any application.

Authentication Transaction Security

     BIO-key’s authentication-transaction security technology, WEB-key®, provides the ability to conduct identification and identity verification transactions in potentially insecure environments, including the World Wide Web or in off-site Cloud environments.

 
·
WEB-key®— BIO-key’s authentication-transaction security platform for securing user authentication across unprotected networks, including the Internet. WEB-key makes Cloud-based biometric user-authentication viable and eliminates technology constraints on online service providers, who are otherwise held dependent on handset provider hardware and software platform decisions. It extends all features and functionalities of the VST algorithm to customers looking to add an enhanced level of security to their thin client and client/server applications. WEB-key currently is supported by both Windows and Linux operating systems. Clients are available on Windows, iOS and Android operating systems.

Intellectual Property Rights

We develop and own significant intellectual property and believe that our intellectual property is fundamental to our biometric operation:

 
·
Patents—we own patented technologies and trade secrets developed or acquired by us.

In May 2005, the U.S. Patent & Trademark Office issued us patent 6,895,104 for our Vector Segment fingerprint technology (VST), BIO-key’s core biometric analysis and identification technology.

On October 3rd, 2006, BIO-key announced that the Company’s patent for a biometric authentication security framework had been granted by the U.S. Patent & Trademark Office. The patent No. 7,117,356 was issued to BIO-key for a biometric authentication security framework that enhances commercial and civil biometric use.  BIO-key’s authentication security framework protects privacy and security of Cloud or network based authentications while also facilitates ease of use of biometric systems.  The technology that this patent is based on is the foundation for the authentication security incorporated in BIO-key’s WEB-key® product line.    WEB-key is a mature enterprise authentication solution that functions in a wide variety of application environments.  The solution supports a variety of implementation alternatives including card technologies for ‘two-factor’ authentication and also supports ‘single-factor’ authentication.  Partners and customers implementing BIO-key’s WEB-key software to provide convenient and secure user identity include a number of institutions including the Allscripts Healthcare Solutions, Computer Associates Site Minder, Oracle Access Manager and many other enterprise and solutions based systems.

On December 26th, 2006, BIO-key was issued US patent No. 7,155,040 covering BIO-key’s unique image processing technology, which is critical for enhancing information used in the extraction of biometric minutiae. The issued patent protects a critical part of an innovative four-phase image enhancement process developed by BIO-key, and represents the third U.S. patent granted to the company for its biometric technology.

 
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On April 15th, 2008, BIO-key was issued US patent No. 7,359,553 covering BIO-key’s image enhancement and data extraction core algorithm components. The solution protected under this recently issued patent provides the capability to quickly and accurately transform a fingerprint image into a computer image that can be analyzed to determine the critical data elements.

On August 19th, 2008 BIO-key was issued US patent No. 7,415,605 for the Company’s “Biometric Identification Network Security” method. The solution protected under this recently issued patent provides a defense against hackers and system attacks, while leveraging the industry standard Trusted Platform Module (TPM) specification for encryption key management.

On November 18th, 2008 BIO-key was issued US patent No. 7,454,624 for the Company’s “Match Template Protection within a Biometric Security System” method. The solution protected under this recently issued patent limits the scope of enrollment templates usage and also eliminates the need for revocation or encryption processes, which can be expensive and time consuming.

On March 10th, 2009 BIO-key was issued US patent No. 7,502,938 for the Company’s “Trusted Biometric Device” which covers a simple, yet secure method of protecting a user’s biometric information. It covers the transmission of information from the point the information is collected at the biometric reader until the data reaches the computer or device that is authenticating the user’s identity.

On May 26th, 2009 BIO-key was issued US patent No. 7,539,331 for the Company’s “Image Identification System” method for improving the performance and reliability of image analysis within an image identification system.

On November 8th, 2011 BIO-key was issued US Patent No 8,055,027 for the Company’s “Generation of Directional Information in the Context of Image Processing” method for image enhancement and processing.

On July 3rd, 2012 BIO-key was issued US Patent No 8,214,652 for the Company’s “Biometric Identification Network Security”, an expanded method of network and related network authentication security systems utilizing hardware based support for encryption and key management for authentication purposes.

BIO-key has also been granted parallel patents to the US Patent portfolio to certain of its patents in many foreign countries offering protection of the Company’s  intellectual property rights around the world.

 
·
Trademarks— We have registered our trademarks “BIO-key”, “True User Identification”, “Intelligent Image Indexing” and “WEB-key” with the U.S. Patent & Trademark Office, as well as many foreign countries, protecting our companies name and key technology offering names world-wide.

 
·
Copyrights and trade secrets—We take measures to ensure copyright and license protection for our software releases prior to distribution. When possible, the software is licensed in an attempt to ensure that only licensed and activated software functions to its full potential. We also take measures to protect the confidentiality of our trade secrets.
 
 
Markets

Identity Management, User Authentication, Privilege Entitlement and Access Control

BIO-key’s products reduce risk of theft, fraud, loss and attack by limiting access to valuable assets, privileges, data, services, networks and places, to only authorized individuals.  Conversely, BIO-key products enhance the monetary value and/or viability of privileged assets, places and services by ensuring only subscribers and otherwise entitled holders can enjoy full access to their privileges.  In effect, BIO-key products replace traditional credentialing systems, which utilize a physical or electronic credential document to represent the holder’s privilege entitlement, and access control systems that guard access to such privileges.   Examples of such privileges include, but are not limited to, international travel and immigration privileges, employment ID, campus ID and corporate ID privileges, healthcare service privileges, citizen Entitlement privileges like Medicare, Medicaid and Social Security, bank, credit account and financial transaction privileges like checking accounts, debit and credit cards, payments, online services and subscription privileges.  Examples of such choke-points include doorways, gates, computers, Point-of-Sale terminals, smart-phones or web-portals and automobiles. In our opinion, the market for advanced user authentication, including fingerprint biometrics, is conceptually enormous, represented by virtually any doorway, gate and computer network or internet end-point like smart-phones, desktop and laptop PC and tablets, compounded by the number of individuals privileged to access something guarded by those access points. In our opinion, the market opportunity for our products is effectively a massive upgrade cycle of global privilege entitlement and access control systems.

 
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Historically, our largest market has been access control within highly regulated industries like healthcare.  However, we believe the mass adoption of advanced smart-phone and hand-held wireless devices have caused commercial demand for advanced user authentication to emerge as viable.  The introduction of smart-phone capabilities, like Mobile Payments and Credentialing, could effectively require biometric user authentication on mobile devices to reduce risks of identity theft, payment fraud other forms of fraud in the mobile or cellular based World Wide Web. As more services and payment functionalities, like Mobile Wallets and Near Field Communication (NFC), migrate to smart-phones, the value and potential risk associated with such systems should grow substantially and drive demand and mass adoption of advanced user authentication technologies like fingerprint biometrics and BIO-key solutions.

BIO-key believes there is potential for significant market growth in three key areas:
 
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Corporate Network Access Control- Corporate campuses, computer networks and applications.
 
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Consumer Mobile Credentialing, including Mobile Payments- Credit and payment card programs, data and application access and commercial loyalty programs.
 
·
Government  Services and highly regulated industry- Medicare, Medicaid, Social Security, Drivers Licenses, Campus and School ID, Passports/Visas.

Business Model

We believe the most viable markets for our products involve various forms of computer network and Internet applications.  The emergences of Cloud computing and mobile computing are primary drivers of commercial and consumer adoption of advanced authentication applications, including biometric and BIO-key authentication capabilities.  As the value of assets, services and transactions increases on such networks, security and user authentication demand will rise proportionately.  We believe the nature of cloud and mobile computing requires technology interoperability across borders, jurisdictions and networks. Further, government and highly regulated service offerings must also interoperate across borders, jurisdictions and networks.  In many cases, government and highly regulated service-related technologies are required to be interoperable and standards compliant.  We have developed our technology and offerings to be software-based, standards compliant, universally interoperable, hardware and operating system agnostic and scalable.  Our technologies, products and platforms are designed to function on the Internet, in the Cloud or in a traditional network environment or stand-alone.  We believe our model provides the strongest opportunity to penetrate the global biometric authentication market, leverage partners potentially large and resource rich sales channels, as well as produce the highest margin revenue.

We have built a two-tier sales channel to deliver our solutions.  Channels include Direct Sales, Integrator Partners and Value Added Resellers (VAR).  We sell stand-alone software licenses for our products, as well as in packaged configurations with “commercial-off-the-shelf” (COTS) viable third-party hardware devices, like fingerprint readers and network technologies.  We do not develop or produce proprietary hardware products.  Our technologies also work with a variety of proprietary, sole-source technology offerings from third-party vendors.  We believe our technologies can work within the constraints of any customer or partner system design.  We are exploring a subscription or Software as a Service (SaaS) model for our software.

Direct Sales, Licensing, Integrator and Value Added Reseller (VAR) Partnerships

Our products are software based and we typically license our software to end users directly, or through integrator and Value-added Reseller (VAR) partners.  Our primary sales and marketing focus is to integrate our software into the platform offerings of large technology infrastructure producers.  We employ dedicated staff to develop relationships with end-users and integrator partners.  We further employ technical support staff who help customers integrate our technology into their applications  , as well as support new strategic development efforts.

BIO-key has formed strategic relationships with large Internet and network infrastructure providers, including IBM, Oracle, Microsoft, CA Technologies and Indigo, to provide enterprise-ready systems to large enterprise customers and stakeholders.  We have also established partnerships with leading technology integrators, like MorphoTrak, McKesson, LexisNexis, Allscripts, Epic, Caradigm, Identimetrics and HealthCast.

On February 27, 2013, BIO-key announced a strategic partnership with Interdigital Corporation to jointly develop and market biometric authentication solutions for the Mobile Credentialing & Payments markets.

 
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Competition

In addition to companies that provide existing commonplace methods of restricting access to facilities and logical access points such as pass cards, PIN numbers, passwords, locks and keys, there are numerous companies involved in the development, manufacturing and marketing of fingerprint biometrics products to commercial, government, law enforcement and prison markets. These companies include, but are not limited to, 3M (Cogent), NEC, and MorphoTrak.

The majority of sales for automated fingerprint identification products in the market to date have been deployed for government agencies, healthcare facilities and law enforcement applications. The consumer and commercial markets represent areas of significant growth potential for biometrics, led by the use of mobile devices.

The epidemic of security and data breaches reported over the past few years is one of the driving factors for identifying new methods of protecting valuable data.  After attempting to create a more sophisticated password or more efficient token or PIN, it’s become apparent that each of these methods is easily compromised and the downside risks are significant.

With respect to competing biometrics technologies, each has its strengths and weaknesses and none has emerged as a market leader:

 
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Fingerprint identification is generally viewed as very accurate, inexpensive and non-intrusive.

 
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Palmvein scanning is expensive, technique-sensitive and offers mobility challenges.

 
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Iris scanning is viewed as accurate, but the hardware is significantly more expensive.

 
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Facial recognition can have accuracy limitations and is typically highly dependent on ambient lighting conditions, angle of view and other factors.
 
 
Research and Development

Our research and development efforts are concentrated on enhancing the functionality, reliability and integration of our current products as well as developing new and innovative products for biometrics. Although BIO-key believes that its identification technology is one of the most advanced and discriminating fingerprint technologies available today, the markets in which BIO-key compete are characterized by rapid technological change and evolving standards. In order to maintain its position in the market, BIO-key will continue to upgrade and refine its existing technologies.
 
On February 26, 2013, the Company announced it had entered into an Research and Development Collaboration Agreement (the “R&D Collaboration”) with InterDigital Communications, Inc., a subsidiary of InterDigital, Inc. (“InterDigital”) (NASDAQ: IDCC), a wireless research and development company. The R&D Collaboration will target advanced cloud security and identity and access management solutions for the mobile market. The R&D Collaboration will bring together BIO-key’s innovative research and product development capabilities in fingerprint biometrics with InterDigital’s research efforts in developing identity and access management solutions for the mobile market.
 
During the fiscal years ended December 31, 2012 and 2011, BIO-key spent approximately $947,000 and $1,117,000 respectively, on its Biometric segment’s research, development and engineering. BIO-key’s limited customer base during that time did not directly bear these costs, which were principally funded through outside sources of equity and debt financing.


Government Regulations

BIO-key is not currently subject to direct regulation by any government agency, other than regulations generally applicable to businesses or related to specific project requirements. In the event of any international sales, the company would be subject to various domestic and foreign laws regulating such exports and export activities.


Environmental Regulations

As of the date of this report, BIO-key has not incurred any material expenses relating to our compliance with federal, state, or local environmental laws and does not expect to incur any material expenses in the foreseeable future.

 
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Employees and Consultants

As of March 15, 2013, BIO-key employed fifteen (15) individuals on a full-time basis as follows - five (5) in engineering, customer support, research and development; three (3) in finance and administration; and seven (7) in sales and marketing. BIO-key also uses the services of one (1) consultants (full-time), who provide engineering and technical services, one (1) part-time contracts administrator, and one (1) part-time sales support.
 
ITEM 1A. RISK FACTORS

Set forth below are the risks that we believe are material to our investors. This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements appearing just before our Description of Business section above.

Business and Financial Risks

Based on our lack of significant revenue since inception and recurring losses from operations, our auditors have included an explanatory paragraph in their opinion as to the substantial doubt about our ability to continue as a going concern.

Due to, among other factors, our history of losses and limited revenue, our independent auditors have included an explanatory paragraph in their opinion for the year ended December 31, 2012 as to the substantial doubt about our ability to continue as a going concern. Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States, which contemplate that we will continue to operate as a going concern. Our financial statements do not contain any adjustments that might result if we are unable to continue as a going concern.

Since our formation, we have historically generated minimal revenue and have sustained substantial operating losses.

As of December 31, 2012, we had a working deficit of approximately $1,447,000 and an accumulated deficit of approximately $52,288,000. Since our inception, we have focused almost exclusively on developing our core technologies and, until the fourth quarter of 2004 had not generated any significant revenue. In 2009, we sold our Law Enforcement division, losing the benefit of significant recurring revenue streams. In order to increase revenue, we have developed a direct sales force and anticipate the need to retain additional sales, marketing and technical support personnel and may need to incur substantial expenses. We cannot assure you that we will be able to secure these necessary resources, that a significant market for our technologies will develop or that we will be able to achieve our targeted revenue.

Our biometric technology has yet to gain widespread market acceptance and we do not know how large of a market will develop for our technology.

Biometric technology has received only limited market acceptance, particularly in the private sector. Our technology represents a novel security solution and we have not yet generated significant sales. Although recent security concerns relating to identification of individuals has increased interest in biometrics generally, it remains an undeveloped, evolving market. Biometric based solutions compete with more traditional security methods including keys, cards, personal identification numbers and security personnel. Acceptance of biometrics as an alternative to such traditional methods depends upon a number of factors including:

 
·
the reliability of biometric solutions

 
·
public perception regarding privacy concerns

 
·
costs involved in adopting and integrating biometric solutions

For these reasons, we are uncertain whether our biometric technology will gain widespread acceptance in any commercial markets or that demand will be sufficient to create a market large enough to produce significant revenue or earnings. Our future success depends, in part, upon business customers adopting biometrics generally, and our solution specifically.

Biometric technology is a new approach to Internet security which must be accepted in order for our WEB-key ® solution to generate significant revenue.

Our WEB-key ® authentication initiative represents a new approach to Internet security which has been adopted on a limited basis by companies which distribute goods, content or software applications over the Internet. The implementation of our WEB-key ® solution requires the distribution and use of a finger scanning device and integration of database and server side software. Although we believe our solutions provide a higher level of security for information transmitted over the Internet than existing traditional methods, unless business and consumer markets embrace the use of a scanning device and believe the benefits of increased accuracy outweigh implementation costs, our solution will not gain market acceptance.

 
6

 
 
Our software products may contain defects which will make it more difficult for us to establish and maintain customers.

Although we have completed the development of our core biometric technology, it has only been used by a limited number of business customers. Despite extensive testing during development, our software may contain undetected design faults and software errors, or “bugs” that are discovered only after it has been installed and used by a greater number of customers. Any such defect or error in new or existing software or applications could cause delays in delivering our technology or require design modifications. These could adversely affect our competitive position and cause us to lose potential customers or opportunities. Since our technologies are intended to be utilized to secure physical and electronic access, the effect of any such bugs or delays will likely have a detrimental impact on us. In addition, given that biometric technology generally, and our biometric technology specifically, has yet to gain widespread acceptance in the market, any delays would likely have a more detrimental impact on our business than if we were a more established company.

While we have commenced a significant sales and marketing effort, we have only begun to develop a significant distribution channel and may not have the resources or ability to sustain these efforts or generate any meaningful sales.

In order to generate revenue from our biometric products, we are dependent upon independent original equipment manufacturers, system integrators and application developers, which we do not control. As a result, it may be more difficult to generate sales.

We market our technology through licensing arrangements with:

 
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Original equipment manufacturers, system integrators and application developers which develop and market products and applications which can then be sold to end users

 
·
Companies which distribute goods, services or software applications over the Internet

As a technology licensing company, our success will depend upon the ability of these manufacturers and developers to effectively integrate our technology into products and services which they market and sell. We have no control over these licensees and cannot assure you that they have the financial, marketing or technical resources to successfully develop and distribute products or applications acceptable to end users or generate any meaningful revenue for us. These third parties may also offer the products of our competitors to end users.

We face intense competition and may not have the financial and human resources necessary to keep up with rapid technological changes, which may result in our technology becoming obsolete.

The Internet, facility access control and information security markets are subject to rapid technological change and intense competition. We compete with both established biometric companies and a significant number of startup enterprises as well as providers of more traditional methods of access control. Most of our competitors have substantially greater financial and marketing resources than we do and may independently develop superior technologies, which may result in our technology becoming less competitive or obsolete. We may not be able to keep pace with this change. If we are unable to develop new applications or enhance our existing technology in a timely manner in response to technological changes, we will be unable to compete in our chosen markets. In addition, if one or more other biometric technologies such as voice, face, iris, hand geometry or blood vessel recognition are widely adopted, it would significantly reduce the potential market for our fingerprint identification technology.

We depend on key employees and members of our management team, including our Chairman of the Board and Chief Executive Officer, in order to achieve our goals. We cannot assure you that we will be able to retain or attract such persons.

Our consulting contract with Thomas J. Colatosti, our Chairman of the Board, expired in December 2011. Mr. Colatosti continues, however, to assist the Company in the areas of strategic planning and corporate finance. In addition, our employment contract with Michael W. DePasquale, our Chief Executive Officer, expires in March each year, and renews automatically for successive one year periods unless notice of non-renewal is provided by the Company. Although the contract does not prevent him from resigning, it does contain confidentiality and non-compete clauses which are intended to prevent him from working for a competitor within one year after leaving our Company. Our success depends on our ability to attract, train and retain employees with expertise in developing, marketing and selling software solutions. In order to successfully market our technology, we will need to retain additional engineering, technical support and marketing personnel. The market for such persons remains highly competitive and our limited financial resources will make it more difficult for us to recruit and retain qualified persons.

 
7

 
 
We cannot assure you that the intellectual property protection for our core technology provides a sustainable competitive advantage or barrier to entry against our competitors.

Our success and ability to compete is dependent in part upon proprietary rights to our technology. We rely primarily on a combination of patent, copyright and trademark laws, trade secrets and technical measures to protect our propriety rights. We have filed a patent application relating to both the optic technology and biometrics solution components of our technology wherein several claims have been allowed. Over the last few years, the U.S. Patent Office has issued us a series of patents for our Vector Segment fingerprint technology (VST), and our other core biometric analysis and identification technologies. We cannot assure you that any additional patents will be issued or that we will have the resources to protect any patent from infringement. Although we believe our technology does not currently infringe upon patents held by others, we cannot assure you that such infringements do not exist or will not exist in the future.

We may need to obtain additional financing to execute our business plan, which may not be available. If we are unable to raise additional capital or generate significant revenue, we may not be able to continue operations.

Since our inception, we have not generated significant, recurring revenue (other than revenue from acquired businesses) and have experienced substantial losses.
 
In February 2013, we raised additional capital of approximately $500,000 from certain private and institutional investors and $925,000 from affiliates of InterDigital through a combination of debt, equity and research and development funding.
 
If we are unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. Therefore, we may need to obtain additional financing through the issuance of debt or equity securities, or to restructure our financial position through similar transactions to those consummated during the 2010 to 2011 period.

We cannot assure you that we will ever be able to secure any such additional financing on terms acceptable to us. If we cannot obtain such financing, we may not be able to execute our business plan or continue operations.
 
We may not achieve sustainable profitability with respect to the biometric component of our business if we are unable to maintain, improve and develop the wireless data services we offer.

We believe that our future business prospects depend in part on our ability to maintain and improve our current services and to develop new ones on a timely basis. Our services will have to achieve market acceptance, maintain technological competitiveness and meet an expanding range of customer requirements. As a result of the complexities inherent in our service offerings, major new wireless data services and service enhancements require long development and testing periods. We may experience difficulties that could delay or prevent the successful development, introduction or marketing of new services and service enhancements. Additionally, our new services and service enhancements may not achieve market acceptance. If we cannot effectively develop and improve services we may not be able to recover our fixed costs or otherwise become profitable.

If we fail to adequately manage our resources, it could have a severe negative impact on our financial results or stock price.

We could be subject to fluctuations in technology spending by existing and potential customers. Accordingly, we will have to actively manage expenses in a rapidly changing economic environment. This could require reducing costs during economic downturns and selectively growing in periods of economic expansion. If we do not properly manage our resources in response to these conditions, our results of operations could be negatively impacted.

We granted a blanket security interest in all of our assets to the holders of our secured debt.  If we are unable to make our required payments on such debt, or any other event of default occurs, it could have a material adverse effect on our business and operations, and the debt holders may foreclose on our assets.

As part of our secured debt financing transactions, we granted to the holders of such secured debt a blanket security interest in all of our assets, including assets of our subsidiary.  See the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this report.  In the event we default in payment on such debt, or any other event of default occurs under the relevant financing documents, and the default is not cured, 100% of the outstanding principal amount of the secured notes, plus accrued interest and fees will accelerate and be due and payable in full.

 
8

 
 
The cash required to pay such accelerated amounts on the secured notes following an event of default would most likely come out of our working capital.  As we rely on our working capital for our day to day operations, such a default could have a material adverse effect on our business, operating results, or financial condition to such extent that we are forced to restructure, file for bankruptcy, sell assets or cease operations.  In addition, upon an event of default, the holders of the secured debt could foreclose on our assets or exercise any other remedies available to them.  If our assets were foreclosed upon, we would most likely be forced to file for bankruptcy or cease operations; stockholders may not receive any proceeds from disposition of our assets and may lose their entire investment in our stock.

Our obligations to the holder of our outstanding Secured Notes may adversely affect our ability to enter into potential significant transactions with other parties.

We will need to obtain the consent of the holder of our Secured Notes before we can take certain actions, including the issuance of any loan or debt secured by the assets of the Company. Accordingly, unless we obtain such consent, we may not be able to enter into certain transactions.

Risks Related To Our Common Stock

We have issued a substantial number of securities that are convertible into shares of our common stock which could result in substantial dilution to the ownership interests of our existing shareholders.

As of December 31, 2012, approximately 12,750,000 shares of our common stock were reserved for issuance upon exercise or conversion of the following securities (at conversion prices applicable as at December 31, 2012):

 
·
11,512,000 shares upon exercise of outstanding stock options and warrants;

 
·
1,238,000 shares upon exercise of options available for future grant under our existing option plans; and

The exercise or conversion of these securities will result in a significant increase in the number of outstanding shares and substantially dilute the ownership interests of our existing shareholders.

Applicable SEC Rules governing the trading of “penny stocks” limits the trading and liquidity of our common stock, which may affect the trading price of our common stock.

Our common stock currently trades on the OTC Bulletin Board. Since our common stock continues to trade below $5.00 per share, our common stock is considered a “penny stock” and is subject to SEC rules and regulations, which impose limitations upon the manner in which our shares can be publicly traded. These regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the associated risks. Under these regulations, certain brokers who recommend such securities to persons other than established customers or certain accredited investors must make a special written suitability determination regarding such a purchaser and receive such purchaser’s written agreement to a transaction prior to sale. These regulations have the effect of limiting the trading activity of our common stock and reducing the liquidity of an investment in our common stock.

We do not intend to pay dividends in the foreseeable future.

We have never declared or paid a dividend on our common stock. We intend to retain earnings, if any, for use in the operation and expansion of our business and, therefore, do not anticipate paying any dividends on our common stock in the foreseeable future.

The trading price of our common stock may be volatile.

The trading price of our shares has from time to time fluctuated widely and in the future may be subject to similar fluctuations. The trading price may be affected by a number of factors including the risk factors set forth in this Report as well as our operating results, financial condition, announcements of innovations or new products by us or our competitors, general conditions in the biometrics and access control industries, and other events or factors. Although we believe that approximately 15 registered broker dealers currently make a market in our common stock, we cannot assure you that any of these firms will continue to serve as market makers or have the financial capability to stabilize or support our common stock. A reduction in the number of market makers or the financial capability of any of these market makers could also result in a decrease in the trading volume of and price of our shares. In recent years broad stock market indices, in general, and the securities of technology companies, in particular, have experienced substantial price fluctuations. Such broad market fluctuations may adversely affect the future-trading price of our common stock.

 
9

 

ITEM 2.
DESCRIPTION OF PROPERTY

We do not own any real estate. We conduct operations from leased premises in Eagan, Minnesota (5,544 square feet), Wall, New Jersey (4,179 square feet) and North Billerica, Massachusetts (shared services center). We believe our current facilities are adequate for the foreseeable future.


ITEM 3.
LEGAL PROCEEDINGS

In the normal course of business, the Company periodically becomes involved in litigation. As of December 31, 2012, in the opinion of management, the Company had no pending litigation that would have a material adverse effect on the Company’s financial position, results of operations or cash flows.

During August 2012, Blue Spike, LCC, filed suit against the Company in the United States District Court for the Eastern District of Texas alleging that the Company infringed one or more claims of U.S. Patents Nos. 7,346,472, 7,660,700, 7,949,494, and 8,214,175.  In December 2012, the Company reached an agreement to resolve litigation, which resulted in a dismissal of all claims asserted in this litigation (both against and by the Company) with prejudice.  Legal and settlement fees amounted to approximately $208,000.


ITEM 4.
MINE SAFETY DISCLOSURES

N/A
 
 
10

 

PART II

ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock currently trades on the OTC Bulletin Board under the symbol “BKYI”. The following table sets forth the range of high and low bid prices per share of our common stock for each of the calendar quarters identified below as reported by the OTC Bulletin Board. These quotations represent inter-dealer prices, without retail mark-up, markdown or commission, and may not represent actual transactions.

2012:
 
High
   
Low
 
             
Quarter ended December 31, 2012
  $ 0.09     $ 0.06  
Quarter ended September 30, 2012
    0.10       0.06  
Quarter ended June 30, 2012
    0.11       0.06  
Quarter ended March 31, 2012
    0.09       0.06  
 
2011:
 
High
   
Low
 
             
Quarter ended December 31, 2011
  $ 0.14     $ 0.06  
Quarter ended September 30, 2011
    0.14       0.10  
Quarter ended June 30, 2011
    0.16       0.13  
Quarter ended March 31, 2011
    0.19       0.14  

Holders

As of March 15, 2013, the number of stockholders of record of our common stock was 117.

Dividends

We have not paid any cash dividends on our common stock to date, and have no intention of paying any cash dividends on our common stock in the foreseeable future. The declaration and payment of dividends on our common stock is also subject to the discretion of our Board of Directors and certain limitations imposed under the Delaware General Corporation Law. The timing, amount and form of dividends, if any, will depend on, among other things, our results of operations, financial condition, cash requirements and other factors deemed relevant by our Board of Directors.

Equity Compensation Plan Information

For information regarding our equity compensation plans, see Item 12 included in this Annual Report on Form 10-K.

Recent Sales of Unregistered Securities; use of Proceeds from Registered Securities

None

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

None.


 
ITEM 6.
SELECTED FINANCIAL DATA

N/A

 
11

 
 
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion And Analysis Of Financial Condition And Results Of Operations, and other parts of this Report contain forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this Report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth in the section captioned “RISK FACTORS” in Item 1A and elsewhere in this Report. The following should be read in conjunction with our audited financial statements included elsewhere herein.

The following Management’s Discussion And Analysis Of Financial Condition And Results Of Operations (“MD&A”) is intended to help you understand BIO-key International (the “Company”, “we”, “us” or “our”). MD&A is provided as a supplement to and should be read in conjunction with our financial statements and the accompanying notes. Our MD&A includes the following sections:

OVERVIEW provides a description of our business, the major items that affected our business, and how we analyze our business. It then provides an analysis of our overall 2012 performance and a description of the significant events impacting 2012 and thereafter.

RESULTS OF OPERATIONS provides an analysis of the consolidated results of operations for 2012 compared to 2011.

LIQUIDITY AND CAPITAL RESOURCES provides an overview of our cash flows, financing, contractual obligations, and liquidity outlook.

CRITICAL ACCOUNTING POLICIES provides a discussion of our accounting policies that require critical judgment, assumptions and estimates.

 
RECENT ACCOUNTING STANDARDS provides a description of accounting standards which we have not yet been required to implement and may be applicable to our operations, as well as those significant accounting standards which were adopted during 2012 See Note A to the Consolidated Financial Statements included elsewhere in this Annual Report.


OVERVIEW

BIO-key develops and markets advanced fingerprint identification biometric technology and software solutions. We were among the initial pioneers in developing automated, finger identification technology that can be used without the aid of non-automated methods of identification such as a personal identification, password, token, smart card, ID card, credit card, passport, driver’s license or other form of possession or knowledge based identification. This advanced BIO-key™ identification technology improves both the accuracy and speed of finger-based biometrics.

Through partnerships with OEMs, integrators, and solution providers, we provide biometric software solutions to private and public sector customers.  BIO-key provides the ability to positively identify individuals in seconds before granting access to valuable corporate resources, web portals or applications.  Powered by our patented Vector Segment Technology™ our VST™, WEB-key® and BSP development kits are fingerprint biometric solutions that provide true interoperability with all major reader manufacturers, enabling application developers and integrators to seamlessly integrate fingerprint biometrics into virtually any application.

While our growth has been sluggish due to market acceptance, and lengthy processes involved with building relationships with large integrators, we believe that due to current market conditions, specifically identity theft, we are well-positioned for growth as solutions empower users to take control of their identities in a way that cannot be replicated, stolen or mistaken for unauthorized use. Organizations that employ BIO-key’s solutions to authenticate employees and protect company data also experience a measurable return on investment.

 
12

 
 
RESULTS OF OPERATIONS

Consolidated Results of Operations

Two Year % trend

   
Years ended December 31,
 
   
2012
   
2011
 
Revenues
           
Services
    29 %     24 %
License fees and other
    71 %     76 %
      100 %     100 %
Costs and other expenses
               
Cost of services
    6 %     5 %
Cost of license fees and other
    9 %     18 %
      15 %     23 %
Gross Profit
    85 %     77 %
                 
Operating expenses
               
Selling, general and administrative
    59 %     86 %
Research, development and engineering
    25 %     32 %
      84 %     118 %
Operating income (loss)
    1 %     -41 %
                 
Other income (deductions)
               
Total other income (deductions)
    -1 %     -13 %
Net income (loss)
    0 %     -54 %


Revenues and Costs of goods sold

                 2012 - 2011  
   
2012
   
2011
   
$ Chg
   
% Chg
 
                           
Revenues
                         
Service
  $ 1,094,731     $ 848,483     $ 246,248       29 %
License & other
    2,741,162       2,660,321       80,841       3 %
Total Revenue
  $ 3,835,893     $ 3,508,804     $ 327,089       9 %
                                 
Cost of goods sold
                               
Service
  $ 221,027     $ 159,223     $ 61,804       39 %
License & other
    350,706       651,236       (300,530 )     -46 %
Total COGS
  $ 571,733     $ 810,459     $ (238,726 )     -29 %

Revenues

For the years ended December 31, 2012 and 2011, service revenues included approximately $688,000 and $680,000, respectively, of recurring maintenance and support revenue, and approximately $407,000 and $168,000, respectively, of non-recurring custom services revenue.  Non-recurring service revenue increased 142% from 2011 to 2012 as the Company completed services for a large custom contract and continued to provide custom services deployed to different sites from a legacy customer.

For the year ended December 31, 2012, license and other revenue (comprised of third party hardware and royalty income) increased as a result of several contributing factors.  The Company realized an approximate $441,000 increase (27%) from 2011 to 2012 in its core software license revenue from both new and existing customers. The percentage of license and other revenue as a proportion of total revenue decreased from 76% to 71%, due to the relative increase in service revenue from 24% to 29% of total revenue. Third-party hardware sales decreased by approximately $381,000 (41%) from 2011 to 2012 primarily as a result of smaller deployments from new customers in the healthcare industry, who required initial start-up investments in hardware, in addition to expanding deployments from existing customers and other OEM requirements.  Depending on the size and the timing requirements of the customers’ software deployment roadmap, hardware purchases may be solely within the initial software order, or, as with our OEM partners in the healthcare industry, a recurring activity. McKesson continued their deployment of our identification technology in their AccuDose® product line, and our partners Allscripts, Medflow, ChoicePoint/LexisNexis, Educational Biometric Technology and Identimetrics all continued expansion of biometric ID deployments. The Company’s royalty income for the year ended December 31, 2012 was derived from a December 2009 OEM agreement, and resulted in a 22% increase in revenue of approximately $94,000 to $116,000 from 2011 to 2012. The Company expects this revenue stream to be recurring.

 
13

 

Costs of goods sold

For the year ended December 31, 2012, cost of services increased from 2011 due to costs associated with the increased non-recurring custom services, as well as customer support, as needed for the expanding customer base.  The Company expects these costs will increase in future periods as additional Biometric customers are added and non-recurring custom services increase with diversification of markets.

For the year ended December 31, 2012, cost of license and other decreased from 2011 due to the decrease in third party hardware costs commensurate with the decrease in hardware orders discussed in the “Revenues” section above. This was the main reason behind the increase in the Company’s gross margin to 85% from 77% over the two year period.


Selling, general and administrative

                 2012 - 2011  
   
2012
   
2011
   
$ Chg
   
% Chg
 
                           
Total
  $ 2,288,903     $ 3,036,299     $ (747,396 )     -25 %

Selling, general and administrative costs decreased 25% for the year ended December 31, 2012 as compared to the same period 2011.   Reductions included a reversal of a bad debt expense related to a contract whose payments were behind schedule for $377,000 in 2012, which was expensed in 2011, a decrease in personnel fees of approximately $233,000 and marketing related expenses of $50,000. The decreases were offset by an increase in legal and settlement fees for litigation filed by Blue Spike, LLC of approximately $208,000.


Research, development and engineering

 
                  2012 - 2011  
   
2012
   
2011
   
$ Chg
   
% Chg
 
                           
Total
  $ 947,371     $ 1,116,658     $ (169,287 )     -15 %

For the year ended December 31, 2012, R & D costs decreased as compared to 2011, primarily related to consultant expenses for the development of a new software application completed in 2011, and not continued into 2012. The Company expects to continue to devote similar funding to its R & D function as it further develops new features to its product suite.



Other income and expense
 
                 2012 - 2011  
   
2012
   
2011
   
$ Chg
   
% Chg
 
                           
Interest income
  $ 7     $ 95,033     $ (95,026 )     -100 %
Interest expense
    (24,626 )     (411,527 )     386,901       -94 %
Income tax
          (26,500 )     26,500       -100 %
Net discounts of notes payable and receivable
          (100,000 )     100,000       -100 %
                                 
    $ (24,619 )   $ (442,994 )   $ 418,375       -94 %

 
14

 
 
Interest income for the fiscal year ended 2011 was attributable to the note receivable received for the sale of the Law Division, which was fully paid in May 2011.

Series D Convertible Preferred Stock, accrued and unpaid dividends thereon and convertible debt issued in prior periods was converted to two notes payable, one note which was discounted as a result of the issuance of detachable warrants associated with the conversion. For 2011, the amortization of the discount, which was included in interest expense in the Statements of Operations, was attributable to the Note Payable.   Interest expense for the fiscal year ended 2011 was comprised of approximately $104,000 owing to the holders of the notes payable and approximately $308,000 in non-cash amortization of the discount attached to the Notes.

The interest expense for the fiscal year ended 2012 in the above table was attributable to the note payable, of which approximately $321,000 remained outstanding as of December 31, 2012.

For the year ended December 31, 2011, the net discounts of notes payable and receivable were non-cash items with respect to the value of the net early payment discount granted to the holder of the note receivable.

For the year ended December 31, 2011, income taxes were comprised of federal alternative minimum tax and minimum state taxes.  For the year ended December 31, 2012, the Company incurred a taxable loss.
 
LIQUIDITY AND CAPITAL RESOURCES

OPERATING ACTIVITIES OVERVIEW

Net cash provided by operations during the year ended December 31, 2012 was approximately $66,000. The cash provided by operating activities of continuing operations was primarily used to fund operations.  Other items of note were as follows:

 
·
Positive cash flows related to a decrease in accounts receivable of approximately $360,000, due to a large payment received in the third quarter of 2012, offset by a non-cash reduction in the allowance for doubtful accounts for this customer. During 2012, the Company also established a receivable balance of approximately $190,000 due from the Factor (See below), which was received in early 2013.

 
·
Positive cash flows from an increase of approximately $161,000 in accounts payable and accrued liabilities, comprising of obligations for third party hardware shipped, delayed vendor payments due to cash management strategies and unpaid accrued commissions.

 
·
The Company recorded approximately $50,000 of charges in 2012 for the expense of issuing options to employees for services.

INVESTING ACTIVITIES OVERVIEW

There were no cash flows under investing activities during the year.

FINANCING ACTIVITIES OVERVIEW

Net cash used for financing activities of $25,000 was due to a principal payment against the secured note.

Net working deficit at December 31, 2012 was approximately $1,447,000 as compared to a deficit of approximately $1,540,000 at December 31, 2011. The change was due to the steady improvement in the operations of the business.

Since January 7, 1993 (date of inception), our capital needs have been principally met through proceeds from the sale of equity and debt securities.

We do not expect any material capital expenditures during the next twelve months.

We do not currently maintain a line of credit or term loan with any commercial bank or other financial institution.

As of December 2011, the Company entered into a 24-month accounts receivable factoring arrangement with a financial institution (the “Factor”). Pursuant to the terms of this arrangement, BIO-key, from time to time shall sell to the Factor certain of its accounts receivable balances on a non-recourse basis for credit approved accounts. The Factor shall then remit 75% of the accounts receivable balance to BIO-key (the “Advance Amount”), with the remaining balance, less fees to be forwarded to the Company once the Factor collects the full accounts receivable balance from the customer. Factoring fees range from 2.75% to 15% of the face value of the invoice factored and are determined by the number of days required for collection of the invoice. BIO-key expects to use this factoring arrangement periodically to assist with its general working capital requirements.

 
15

 
 
Liquidity outlook

At December 31, 2012, our total of cash and cash equivalents was approximately $84,000, as compared to approximately $43,000 at December 31, 2011.

As discussed above, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, as well as convertible preferred stock and common stock. We currently require approximately $385,000 per month to conduct our operations. During 2012, we generated approximately $3,836,000 of revenue, which is below our average monthly requirements.
 
On February 26, 2013, the Company entered into a number of agreements with affiliates of InterDigital relating to the R&D Collaboration.  In connection with this arrangement, affiliates of InterDigital have invested an aggregate of $900,000 in return for approximately 4,027,000 newly issued shares of the Company’s common stock (the “InterDigital Equity Investment”) and the Company’s issuance of a senior secured promissory note in the amount of $497,307 that will mature December 31, 2015 (the “InterDigital Note”).  As part of these agreements, the balance of the Company’s Secured Notes of approximately $321,000 was paid to the holder together with all accumulated and unpaid interest in February 2013. See Note S – Subsequent Events, to the Consolidated Financial Statements included elsewhere in this Annual Report.  In addition, the Company raised $500,000 from certain private and institutional investors in return for 5,000,000 newly issued shares of the Company’s common stock.
 
If we are unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. See Note S – Subsequent Events, to the Consolidated Financial Statements included elsewhere in this Annual Report.

Due to several factors, including our history of losses and limited revenue, our independent auditors have included an explanatory paragraph in their opinion related to our annual financial statements as to the substantial doubt about our ability to continue as a going concern. Our long-term viability and growth will depend upon the successful commercialization of our technologies and our ability to obtain adequate financing. To the extent that we require such additional financing, no assurance can be given that any form of additional financing will be available on terms acceptable to us, that adequate financing will be obtained to meet our needs, or that such financing would not be dilutive to existing stockholders. If available financing is insufficient or unavailable or we fail to continue to generate meaningful revenue, we may be required to further reduce operating expenses, delay the expansion of operations, be  unable to pursue merger or acquisition candidates, or continue as a going concern.


OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements that have, or are in the opinion of management reasonably likely to have, a current or future effect on our financial condition or results of operations.


CRITICAL ACCOUNTING POLICIES

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates under different assumptions or conditions. There have been no material changes to these estimates for the periods presented in this Annual Report on Form 10-K.

We believe that of our significant accounting policies, which are described in Note A of the notes to our consolidated financial statements included in this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations.

 
16

 
 
1. Revenue Recognition

Revenues from software licensing are recognized in accordance with ASC 985-605, “Software Revenue Recognition. Accordingly, revenue from software licensing is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.

The Company intends to enter into arrangements with end users for items which may include software license fees, and services or various combinations thereof. For each arrangement, revenues will be recognized when evidence of an agreement has been documented, the fees are fixed or determinable, collection of fees is probable, delivery of the product has occurred and no other significant obligations remain.

Multiple-Element Arrangements: For multiple-element arrangements, the Company applies the residual method in accordance with ASC 985-605. The residual method requires that the portion of the total arrangement fee attributable to the undelivered elements be deferred based on its VSOE of fair value and subsequently recognized as the service is delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, which is generally the software license. VSOE of fair value for all elements in an arrangement is based upon the normal pricing for those products and services when sold separately. VSOE of fair value for support services is additionally determined by the renewal rate in customer contracts. The Company has established VSOE of fair value for support as well as consulting services.

License Revenues: Amounts allocated to license revenues are recognized at the time of delivery of the software and all other revenue recognition criteria discussed above have been met.

Revenue from licensing software, which requires significant customization and modification, is recognized using the percentage of completion method, based on the hours of effort incurred by the Company in relation to the total estimated hours to complete. In instances where third party hardware, software or services form a significant portion of a customer’s contract, the Company recognizes revenue for the element of software customization by the percentage of completion method described above. Otherwise, third party hardware, software, and services are recognized upon shipment or acceptance as appropriate. If the Company makes different judgments or utilizes different estimates of the total amount of work expected to be required to customize or modify the software, the timing and revenue recognition, from period to period, and the margins on the project in the reporting period, may differ materially from amounts reported. Anticipated contract losses are recognized as soon as they become known and are estimable.

Service Revenues: Revenues from services are comprised of maintenance and consulting and implementation services. Maintenance revenues include providing for unspecified when-and-if available product updates and customer telephone support services, and are recognized ratably over the term of the service period. Consulting services are generally sold on a time-and-materials basis and include a range of services including installation of software and assisting in the design of interfaces to allow the software to operate in customized environments. Services are generally separable from other elements under the arrangement since performance of the services are not essential to the functionality of any other element of the transaction and are described in the contract such that the total price of the arrangement would be expected to vary as the result of the inclusion or exclusion of the services. Revenues from services are generally recognized as the services are performed.

The Company provides customers, free of charge or at a minimal cost, testing kits which potential licensing customers may use to test compatibility/acceptance of the Company’s technology with the customer’s intended applications.

Costs and other expenses: Includes professional compensation and other direct contract expenses, as well as costs attributable to the support of client service professional staff, depreciation and amortization costs related to assets used in revenue-generating activities, and other costs attributable to serving the Company’s client base. Professional compensation consists of payroll costs and related benefits including stock-based compensation and bonuses. Other direct contract expenses include costs directly attributable to client engagements, such as out-of-pocket costs including travel and subsistence for client service professional staff, costs of hardware and software and costs of subcontractors. The allocation of lease and facilities charges for occupied offices is included in costs of service.

The Company accounts for its warranties under the FASB ASC 450 “Contingencies.” The Company generally warrants that its products are free from defects in material and workmanship for a period of one year from the date of initial delivery to our customers. The warranty does not cover any losses or damage that occurs as a result of improper installation, misuse or neglect or repair or modification by anyone other than the Company or its authorized repair agent. The Company’s policy is to accrue anticipated warranty costs based upon historical percentages of items returned for repair within one year of the initial sale. The Company’s repair rate of products under warranty has been minimal, and a historical percentage has not been established. The Company’s software license agreements generally include certain provisions for indemnifying customers against liabilities if the Company’s software products infringe upon a third party’s intellectual property rights. The Company has not provided for any reserves for warranty liabilities as it was determined to be immaterial.

 
17

 
 
2. Impairment or Disposal of Long Lived Assets, including Intangible Assets

We review our long-lived assets, including intangible assets subject to amortization, whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to the future undiscounted cash flows the assets are expected to generate. If such assets are considered impaired, the impairment to be recognized is equal to the amount by which the carrying value of the assets exceeds their fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. In assessing recoverability, we must make assumptions regarding estimated future cash flows and discount factors. If these estimates or related assumptions change in the future, we may be required to record impairment charges. Intangible assets with determinable lives are amortized over their estimated useful lives, based upon the pattern in which the expected benefits will be realized, or on a straight-line basis, whichever is greater. We did not record any impairment charges in any of the years presented.

3.Research and Development Expenditures

Research and development expenses include costs directly attributable to the conduct of research and development programs primarily related to the development of our software products and improving the efficiency and capabilities of our existing software. Such costs include salaries, payroll taxes, employee benefit costs, materials, supplies, depreciation on research equipment, services provided by outside contractors, and the allocable portions of facility costs, such as rent, utilities, insurance, repairs and maintenance, depreciation and general support services. All costs associated with research and development are expensed as incurred.

4. Income Taxes

The provision for, or benefit from, income taxes includes deferred taxes resulting from the temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from the differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carryback, carryforward period available under tax law. The Company evaluates, on a quarterly basis whether, based on all available evidence, if it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is more likely than not that the tax benefit of the deferred tax asset will not be realized. The evaluation, as prescribed by ASC 740-10, “Income Taxes,” includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carryforward from expiring unused. Because of the Companies historical performance and estimated future taxable income a full valuation allowance has been established.

5. Accounting for Stock-Based Compensation

The Company accounts for share based compensation in accordance with the provisions of ASC 718-10, “Compensation — Stock Compensation,” which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of our common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.

 
18

 

ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

N/A


ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See financial statements appearing at pages 39-67 of this report

 
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

N/A


ITEM 9A.
CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2012. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of December 31, 2012, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Management’s Annual Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation of our management, including our CEO and CFO, we have conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012, based upon the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that our internal control over financial reporting was effective as of December 31, 2012.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.

Changes in Internal Control Over Financial Reporting

No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 
19

 

ITEM 9B.
OTHER INFORMATION

None.

 
20

 

PART III

ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The following sets forth certain information about each director and executive officer of the Company.

NAME
 
AGE
 
POSITIONS HELD
Thomas J. Colatosti
  64  
Chairman of the Board of Directors
Michael W. DePasquale
  58  
Chief Executive Officer and Director
Jeffrey J. May (b)
  53  
Director
Charles P. Romeo (a) (c)
  71  
Director
John Schoenherr (b) (c)
  60  
Director
         
Cecilia Welch
  53  
Chief Financial Officer
Mira K. LaCous
  51  
Vice President of Technology & Development
Renat Zhdanov
  50  
Vice President, Chief Scientist
Scott Mahnken
  53  
Vice President of Marketing
 

 
(a)
From April 2004 to February 2005, Mr. Romeo was employed by the Company.

 
(b)
Audit Committee Member

 
(c)
Compensation Committee Member

The following is a brief summary of the business experience of each of the above-named individuals:

THOMAS J. COLATOSTI has served as a Director of the Company since September 2002, as Chairman of the Board since January 3, 2003, and as Chief Financial Officer from November 17, 2008 to December 21, 2009.  Mr. Colatosti also served as Co-Chief Executive Officer of the Company from July 2005 to August 2006. Mr. Colatosti also currently serves as the Chief Executive Officer of American Security Ventures, a Lexington, Massachusetts-based consulting firm he founded which specializes in providing strategic management consulting services to emerging and developing companies in the homeland security industry. Since November 2010, Mr. Colatosti has been serving as a President and CEO of Oasis Systems LLC, a privately held IT services company. From August 2009 to December 2012, Mr. Colatosti has served as Chairman of Commodore Advanced Sciences Corporation an environmental services and remediation company. From August 18, 2005 until August 18, 2008 Mr. Colatosti served as Director and President of Good Harbor Partners Acquisition Corp., a publicly-traded special purpose acquisition company formed to acquire businesses in the security sectors. From 1997 through June 2002, Mr. Colatosti served as the Chief Executive Officer of Viisage Technology, Inc., a publicly traded biometric technology company. Between 1995 and 1997, Mr. Colatosti served as President and Chief Executive Officer of CIS Corporation. Prior to CIS, Mr. Colatosti had a 21 year career with Digital Equipment Corporation (now HP Corporation). Among his executive positions he was Vice President and General Manager of the company’s $1.2 billion Government Systems Division. Mr. Colatosti is a seasoned technology executive with global experience in operating both private as public corporations in the technology sector.


MICHAEL W. DEPASQUALE has served as the Chief Executive Officer and a Director of the Company since January 3, 2003. He served as Co-Chief Executive Officer of the Company from July 2005 to August 2006. Mr. DePasquale brings more than 27 years of executive management, sales and marketing experience to the Company. Prior to joining BIO-key, Mr. DePasquale served as the President and Chief Executive Officer of Prism eSolutions, Inc., a Pennsylvania-based provider of professional consulting services and online solutions for ISO-9001/14000 certification for customers in manufacturing, healthcare and government markets, since February 2001. From December 1999 through December 2000, Mr. DePasquale served as Group Vice President for WRC Media, a New York-based distributor of supplemental education products and software. From January 1996 until December 1999, Mr. DePasquale served as Senior Vice President of Jostens Learning Corp., a California-based provider of multi media curriculum. Prior to Jostens, Mr. DePasquale held sales and marketing management positions with McGraw-Hill and Digital Equipment Corporation. Mr. DePasquale earned a Bachelor of Science degree from the New Jersey Institute of Technology. He serves on the Board of Directors and as Treasurer of the International Biometrics and Identification Industry Association.  . Mr. DePasquale has extensive General Management experience in the technology sector and has served on a number of non-profit as well as private company Boards.

 
21

 

JEFFREY J. MAY has served as a Director of the Company since October 29, 2001. Since 1997, Mr. May has served as the President of Gideons Point Capital, a Minnesota-based investment and consulting firm focusing on assisting start-up technology companies. Mr. May served as the CEO and Director of MagnaLynx, a semiconductor company specializing in high speed chip level communications from December 2006 until the company was sold in March 2010. In 1983, Mr. May co-found Advantek, Inc., a manufacturer of equipment and materials for the semiconductor industry, which was sold in 1993. Mr. May continued to serve as a director and Vice-President of Operations of Advantek until 1997, when it had over 600 employees and sales in excess of $100 million. Mr. May earned a Bachelor of Science degree in Electrical Engineering from the University of Minnesota in 1983. Mr. May is an entrepreneur who brings extensive International technical and general business management experience to BIO-key
 
 
CHARLES P. ROMEO has served as a director of the Company since February 28, 2005 and from January 29, 2003 to April 19, 2004. From April 2004 until February 2005, he served as Vice President of Sales, Public Safety Division of the Company. From November 2005 to November 2007, Mr. Romeo served as the Vice President of Sales and Marketing for UNICOM, a Rhode Island systems integrator. From September 2002 until April 2004 Mr. Romeo has served as the President and Chief Executive Officer of FreedomBridge Technologies, Inc., a Rhode Island-based consulting firm to technology companies in the homeland security industry specializing in implementing direct and channel selling programs, strategic alliances and partnerships in the law enforcement market. Prior to founding FreedomBridge, Mr. Romeo had a 33 year sales and marketing management career with Digital Equipment Corporation, Compaq Computer Corporation and Hewlett Packard. During his career, Mr. Romeo served as Vice President of Service Sales for a $500 million business unit, and Director of Public Sector Sales, a $275 million division of Hewlett Packard. Mr. Romeo authored The Sales Manager’s Troubleshooter, Prentice Hall 1998, which was named as one of the “top 10 must reads” by Sales and Marketing Magazine. Mr. Romeo earned a Bachelor of Science degree in Mathematics and Economics from the University of Massachusetts and an Executive MBA from Babson College. Mr. Romeo brings a wealth of Sales and Marketing Management experience in the infrastructure and computer hardware and software industries

JOHN SCHOENHERR has served as a Director of the Company since December 30, 2004. Mr. Schoenherr served as Vice President of Corporate Performance Management for Oracle Corporation from 1995 through 2006.  Prior to Oracle he served as Senior Vice President of Business Intelligence and Analytics at Information Resources, Inc.   Mr. Schoenherr has over 25 years of experience in the area of business intelligence and strategic planning.  His career includes a number of product development and management positions. Mr. Schoenherr brings significant product management and information services experience in both the large and small enterprise sectors.


CECILIA WELCH has served as Chief Financial Officer of the Company since December 21, 2009. Ms. Welch joined the Company in 2007 as the Company’s Corporate Controller. Prior to joining the Company, from January 2006 to December 2006 she was the Controller for Savaje Technologies (acquired by Sun Microsystems), a developer of advanced mobile telephone software. From October 2004 to January 2006, she was Controller for Crystal Systems, a manufacturer of sapphire crystals used for industrial, semiconductor, defense and medical applications.  From December 1988 to July 2004, she was the Controller for ATN Microwave (acquired by Agilent Technologies), a manufacturer of automated test equipment. Ms. Welch has a Bachelor’s degree in Accounting from Franklin Pierce University.

MIRA K. LACOUS has served as Vice President of Technology & Development of the Company since May 15, 2000. In 2012 Ms LaCous was promoted to Senior Vice President of Technology and Development.  Ms. LaCous has over 28 years of product / project management, solution architecture, software development, team leadership and customer relations experience with a background that includes successfully bringing numerous technologies to market, including automated voice response systems, automated building control systems, software piracy protection, intranet training materials and testing, page layout and design software, image scanning software and systems, biometric security, biometric algorithms and more. Ms. LaCous is also the author of six US Patented technologies, multiple international patents, and other patent pending solutions.  She has been an officer or director of two other companies; National Computer Systems (NCS), and TEL-Line Systems. Ms. LaCous has a Bachelor’s in Computer Science from North Dakota State University.  Ms. LaCous also served on the Board of Directors of the Minnesota Sinfonia, a not-for-profit  arts and education organization, as well as it’s chairperson for two years.

RENAT Z. ZHDANOV has served as Chief Scientist of the Company since November 2001. He has over fifteen years of academic experience in various fields of Mathematics and Physics; fifteen years of image processing, pattern recognition, and big data analysis algorithm development experience and more than ten years of software development experience ranging from database programming to statistical and analytical programming. Dr. Zhdanov is a recognized expert in Mathematical Physics and is the author of two books and more than 130 papers published in leading mathematics and physics journals. Before coming to BIO-key, he worked as Chief Mathematician and Visiting Scientist in universities in Ukraine, Germany, Great Britain, Sweden and Spain. Dr. Zhdanov has two PhD degrees in Mathematical Physics and Differential Equations from the Institute of Mathematics in Kiev, Ukraine. He serves as the member of the Editorial Board of the ‘Journal of Applied Mathematics’.

 
22

 
 
SCOTT MAHNKEN has served as Vice President of Marketing since February 2011. He brings over 20 years of marketing experience and success through strategic marketing and building dynamic relationships with channel partners. Prior to joining the Company, from August 2009 until February 2011 he was President of Edge Marketing, a leading marketing consulting firm in the dental and medical devices industries. From February 2008 until August 2009, Mr. Mahnken served as Director of Marketing at Milestone Scientific Inc, a manufacturer of computer controlled anesthetic delivery medical devices. From August 2002 until January 2008, he served as Director of Partnership Relations at ArcMesa Educators, an organization dedicated to providing accredited continuing education to medical and dental providers. Prior to ArcMesa, Mr. Mahnken held a number of marketing roles with the Lanmark Group a leading healthcare advertising agency. Mr. Mahnken is a graduate of the University of New Orleans, where he earned a Bachelors of Art degree in Marketing.

Directors’ Terms of Office

Mr. May was initially elected to serve as a director in 2001, and was re-elected in 2004. Mr. Colatosti was initially elected to serve as a director in 2002, and was re-elected in 2004. Mr. DePasquale was initially elected as a director in 2003, and was re-elected in 2004. Mr. Schoenherr was initially elected as a director in 2004. Mr. Romeo was initially elected as a director in 2005. Each such director was elected to serve until the Company’s next annual meeting or until his successor is duly elected and qualified in accordance with the By-laws of the Company.

Audit Committee

The Audit Committee is comprised of John Schoenherr and Jeffrey J. May, who may not qualify as “audit committee financial experts” under the applicable rules adopted by the Securities and Exchange Commission. However, the Board believes that each Audit Committee member has sufficient knowledge in financial and auditing matters to serve on the Audit Committee. Additionally, the Audit Committee has the ability on its own to retain independent accountants or consultants whenever it deems appropriate.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the U.S. Securities and Exchange Act of 1934, as amended (the “Exchange Act”), requires the Company’s officers and directors and persons who own more than ten percent (10%) of the Company’s Common Stock to file with the Securities and Exchange Commission (“SEC”) initial reports of ownership and reports of changes in ownership of the Company’s Common Stock. Such officers, directors and ten percent (10%) stockholders are also required by applicable SEC rules to furnish the Company with copies of all forms filed with the SEC pursuant to Section 16(a) of the Exchange Act. Based solely on its review of the copies of such forms received by it, or written representations from such persons that no other reports were required for such persons, the Company believes that during the fiscal year ended December 31, 2012, all Section 16(a) filing requirements applicable to the Company’s officers, directors and ten percent (10%) stockholders were satisfied in a timely fashion.

Code of Ethics

We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Ethics is designed to deter wrongdoing and promote: (i) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; (ii) full, fair, accurate, timely and understandable disclosure in reports and documents that we file with, or submit to, the SEC and in our other public communications; (iii) compliance with applicable governmental laws, rules, and regulations; (iv) the prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and (v) accountability for adherence to the code.  The Company intends to disclose amendments or waivers of the Code of Ethics on its website within four business days.  Any person may obtain a copy of our Code of Ethics free of charge by sending a written request for such to the attention of the Chief Financial Officer of the Company, 3349 Highway 138, Building D Suite B, Wall, NJ 07719.

Internet Address and SEC Reports

We maintain a website with the address www.BIO-key.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge through our website our Annual Reports on Form 10-K (and, where applicable, 10-KSB), Quarterly Reports on Form 10-Q (and, where applicable, 10-QSB) and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the SEC. Our SEC filings are also available over the Internet at the SEC’s website www.sec.gov. Members of the public may read and copy any materials the Company files with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the public reference room is available by calling the SEC on 1800-SEC-0330.

 
23

 
ITEM 11.
EXECUTIVE COMPENSATION

The following table sets forth a summary of the compensation paid to or accrued by our chief executive officer (principal executive officer) and the two most highly compensated executive officers other than the principal executive officer, who were serving as executive officers at the end of December 31, 2012, for the fiscal years ended December 31, 2012 and 2011:

SUMMARY COMPENSATION TABLE

Name
 
Fiscal
Year
 
Salary ($)
   
Bonus ($)
   
Stock
Awards
($)
   
Option
Awards
($)
     
Non-Equity
Incentive Plan
Compensation
($)
   
Nonqualified
Deferred
Compensation
Earnings
($)
   
All Other
Compensation
($)
   
Total
($)
 
                                                       
Michael W. DePasquale
 
2012
    259,324                                       739       260,063  
Chief Executive Officer
 
2011
    226,504                                       449       226,953  
                                                                       
Mira K. LaCous
 
2012
    142,092                                       545       142,637  
Vice President Technology & Development
 
2011
    134,018                   8,340 (1 )                 266       142,624  
                                                                       
Scott Mahnken
 
2012
    124,680                                       499       125,179  
Vice President Marketing
 
2011
    102,527                   11,120 (1 )                 154       113,801  
 

(1)
The aggregate grant date fair value of the option awards was estimated using the Black-Scholes option pricing model, with the assumptions listed in Note A to the Company’s financial statements. The amount shown in this column represents the grant date fair value calculated under ASC 718


Narrative Disclosure to Summary Compensation Table

Compensation for BIO-key’s executives is comprised of three main components: base salary, annual performance-based cash bonus and long-term equity awards. We do not target a specific weighting of these three components or use a prescribed formula to establish pay levels. Rather, the board of directors and compensation committee considers changes in the business, external market factors and our financial position each year when determining pay levels and allocating between long-term and current compensation for the named executive officers.

Cash compensation is comprised of base salary and an annual performance-based cash bonus opportunity. The committee generally seeks to set a named executive officer’s targeted total cash compensation opportunity within a range that is the average of the applicable peer company and/or general industry compensation survey data, adjusted as appropriate for individual performance and internal pay equity and labor market conditions.

In setting cash compensation levels, we favor a balance in which base salaries are generally targeted at slightly below the peer average and a bonus opportunity that is targeted at slightly above the average. The committee believes that this higher emphasis on performance-based cash bonuses places an appropriate linkage between a named executive officer’s pay, his or her individual performance and the achievement of specific business goals by placing a higher proportion of annual cash compensation at risk, thereby aligning executive opportunity with the interests of stockholders.

We include an equity component as part of our compensation package because we believe that equity-based compensation aligns the long-term interests of our named executive officers with those of stockholders.

These cash and equity compensation components of pay are supplemented by various benefit plans that provide health, life, accident, disability and severance benefits, most of which are the same as the benefits provided to all of our US based employees.

 
24

 
 
Employment Agreements

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March 24, 2011. The agreement automatically renews for subsequent one-year terms, unless the employment relationship is terminated by either party, or modified in accordance with the terms and conditions of the Agreement. Under the Agreement, Mr. DePasquale will be paid an annual base salary of $250,000, subject to adjustment by the Board or Compensation Committee. In addition to the Base Salary, a “Performance Bonus” may be awarded to Mr. DePasquale on the basis of the Company achieving certain corporate and strategic performance goals, as determined by the Board in its sole discretion. The employment agreement contains standard and customary confidentiality, non-solicitation and “work made for hire” provisions as well as a covenant not to compete which prohibits Mr. DePasquale from doing business with any current or prospective customer of the Company or engaging in a business competitive with that of the Company during the term of his employment and for the one year period thereafter. This agreement also contains a number of termination and change in control provisions as described in “Termination and Change in Control Arrangements” in this Item.

On November 20, 2012, the Company renewed its one-year employment agreement with Mira K. LaCous to serve as the Vice President of Technology & Development of the Company at an annual base salary of $147,420, subject to adjustment by the Board or Compensation Committee. The employment agreement contains standard and customary confidentiality, technical invention provisions, as well as a covenant not to compete which prohibits Ms. LaCous from doing business with any current or prospective customer of the Company or engaging in a business competitive with that of the Company during the term of her employment and for the one year period thereafter. This agreement also contains a number of termination provisions as described in “Termination and Change in Control Arrangements” in this Item.

Stock Option Grants

In the event of any change in the outstanding shares of our common stock by reason of a stock dividend, stock split, combination of shares, recapitalization, merger, consolidation, transfer of assets, reorganization, conversion or what the board deems to be similar circumstances, the number and kind of shares subject to outstanding options, and the exercise price of such options shall be appropriately adjusted in a manner to be determined in the sole discretion of the board. Furthermore, these option agreements contain a change of control provision as described in “Termination Arrangements” in this Item.


OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END
DECEMBER 31, 2012

The following table sets forth for each named executive officer, information regarding outstanding equity awards as at December 31, 2012:

   
Option Awards
 
Stock Awards
 
Name
 
Number of
securities
underlying
unexercised
options
exercisable
(#)
   
Number of
securities
underlying
unexercised
options
unexercisable
(#)
   
Equity
incentive
plan
awards:
Number of
securities
underlying
unexercised
unearned
options
(#)
   
Option
exercise
price
($)
 
Option
expiration
date
 
Number
of shares
or units of
stock that
have not
vested
(#)
   
Market
value of
shares or
units of
stock that
have not
vested
($)
   
Equity
incentive
plan
awards:
Number
of
unearned
shares or
units or
other
rights that
have not
vested
(#)
   
Equity
incentive
plan
awards:
Market or
payout
value of
unearned
shares,
units or
other
rights that
have not
vested
($)
 
                                                   
Michael W. DePasquale
    500,000                   0.087  
2/27/2016
                       
                                                                   
Mira LaCous
    75,000                   0.180  
8/13/2015
                       
      340,000                   0.460  
1/7/2017
                       
      25,000       50,000 (1 )         0.140  
5/11/2018
                       
                                                                   
Cecilia Welch
    20,000                   0.150  
8/10/2014
                       
      50,000       100,000 (1 )         0.140  
5/11/2018
                       
                                                                   
Renat Zhdanov
    50,000                   0.180  
8/13/2015
                       
      70,000                   0.400  
1/7/2017
                       
      16,666       33,334 (1 )         0.140  
5/11/2018
                       
                                                                   
Scott Mahnken
    33,333       66,667 (1 )         0.140  
5/11/2018
                       
                                                                   
 

(1)
The options vest equally in three annual installments commencing May 11, 2012

 
25

 
 
Narrative Disclosure to Outstanding Equity Awards at Fiscal Year End Table

The following are the material terms of each agreement, contract, plan or arrangement that provide for payments to one or more of our named executive officers at, following or pursuant to their resignation, retirement or termination, or in connection with a change in control of the Company.
 
Termination Arrangements

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March, 24, 2011. The agreement automatically renews for subsequent one-year terms, unless the employment relationship is terminated by either party, or modified in accordance with the terms and conditions of the Agreement. The Company may terminate the Agreement at any time with or without cause. In the event of termination by the Company without cause, Mr. DePasquale shall continue to be paid his then current base salary for the greater of nine months from the date of such termination or the number of months remaining until the end of the term of the Agreement.

On November 20, 2012, the Company renewed the annual agreement with Mira K. LaCous to serve as the Vice President of Technology & Development of the Company. The Company may terminate the agreement at any time with or without cause. In the event of termination by the Company without cause, Ms. LaCous shall continue to be paid her then current base salary for six months from the date of such termination.

Change in Control Provisions

The Company’s 1999 Stock Option Plan and 2004 Stock Incentive Plan (the “1999 Plan” and together with the 2004 Plan, the “Plans”) provide for the acceleration of the vesting of unvested options upon a “Change in Control” of the Company. A Change in Control is defined in the Plans to include (i) a sale or transfer of substantially all of the Company’s assets; (ii) the dissolution or liquidation of the Company; (iii) a merger or consolidation to which the Company is a party and after which the prior shareholders of the Company hold less than 50% of the combined voting power of the surviving corporation’s outstanding securities; (iv) the incumbent directors cease to constitute at least a majority of the Board of Directors; or (v) a change in control of the Company which would otherwise be reportable under Section 13 or 15(d) of the Exchange Act.

In the event of a “Change In Control” each Plan provides for the immediate vesting of all options issued thereunder. The 1999 Plan provides for the Company to deliver written notice to each optionee under the 1999 Plan fifteen (15) days prior to the occurrence of a Change in Control during which all options issued under the 1999 Plan may be exercised. Thereafter, all options issued under the 1999 Plan which are neither assumed or substituted in connection with such transaction, automatically expire unless otherwise determined by the Board. The 2004 Plan enables the Board to provide that all outstanding options be assumed, or equivalent options be substituted by the acquiring or succeeding corporation upon the occurrence of a “Reorganization Event” as defined. If such Reorganization Event also constitutes a Change In Control, then such assumed or substituted options shall be immediately exercisable in full. If the acquiring or succeeding corporation does not agree to assume, or substitute for such options, then the Board, upon written notice to the Participants, may provide that all unexercised options become exercisable in full as of a specified time prior to the Reorganization Event and terminate prior to the consummation of the Reorganization Event. Alternatively, if under the terms and conditions of the Reorganization Event, holders of common stock will receive a cash payment for their shares, then the Board may provide that all Participants receive a cash payment equal to the difference between the Acquisition Price and the Option Price multiplied by the number of options held by such Participants.

Options issued to executive officers outside of the Plans contain change in control provisions substantially similar to those contained in the 1999 Plan.

On March 26, 2010, the Company entered into an employment agreement, effective as of March 25, 2010, with Michael W. DePasquale to serve as the Chief Executive Officer of the Company until March, 24, 2011. There is a Change of Control provision that is triggered if Mr. Depasquale is not offered continued employment with the Company or any successor, or within five years following such Change of Control, the Company or any successor terminates Mr. Depasquale’s employment without Cause, then Mr. Depasquale is to be paid his Base Salary and benefits earned but unpaid through the date of termination, and any prorated bonus earned during the then current bonus year, plus two times his then current Base Salary.

 
26

 
 
DIRECTOR COMPENSATION FOR THE FISCAL YEAR ENDED
DECEMBER 31, 2012

The following table sets forth for each director, information regarding their compensation for the year ended December 31, 2012:

Name
 
Fees Earned or
Paid in Cash
($)
   
Stock
Awards
($)
   
Option
Awards
($) (3)
   
Non-Equity
Incentive Plan
Compensation
($)
   
Nonqualified
Deferred
Compensation
Earnings
($)
   
All Other
Compensation
($)
   
Total
($)
 
Thomas J. Colatosti (1)
                                         
Michael W. DePasquale (2)
                                         
Jeffrey J. May
                                         
Charles P. Romeo
                                         
John Schoenherr
                                         
 

(1)
Refer to Narrative Disclosure to Summary Compensation Table for information pertaining to Mr. DePasquale’s employment agreement.

(2)
The aggregate grant date fair value of the option awards was estimated using the Black-Scholes option pricing model, with the assumptions listed in Note A to the Company’s financial statements. The amount shown in this column represents the grant date fair value calculated under ASC 718


Narrative Disclosure to Director Compensation Table

The Company’s current policy is to issue options to purchase 50,000 shares of common stock to each non-employee director on an annual basis. The Chair of the Audit Committee receives options to purchase an additional 50,000 shares of common stock on an annual basis. No options were awarded to any of the Company’s directors during 2012, as the Company was still reviewing the overall financial performance.

We reimburse each of our non-employee directors for their reasonable expenses incurred in connection with attending meetings of the board of directors and related committees.

 
27

 
 
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
The following table sets forth, as of March 15, 2013 information with respect to the securities holdings of all persons which the Company, pursuant to filings with the Securities and Exchange Commission, has reason to believe may be deemed the beneficial owners of more than five percent (5%) of the Company’s outstanding common stock. The following table also sets forth, as of such date, the beneficial ownership of the Company’s common stock by all officers and directors, individually and as a group. Unless otherwise indicated, the address of each person listed below is c/o BIO-key International, Inc., 3349 Highway 138, Building D, Suite B, Wall, NJ 07719.

Name and Address of Beneficial Owner
 
Amount and Nature
of Beneficial
Ownership(1)
     
Percentage of
Class(1)
 
               
Thomas J. Colatosti
    500,241 (2 )     *  
Michael W. DePasquale
    550,000 (3 )     *  
Mira LaCous
    440,000 (4 )     *  
Jeffrey May
    305,481 (5 )     *  
John Schoenherr
    198,930 (5 )     *  
Renat Zhdanov
    136,666 (6 )     *  
Charles P. Romeo
    132,620 (5 )     *  
Cecilia Welch
    70,000 (7 )     *  
Scott Mahnken
    33,333 (8 )     *  
                   
All officers and directors as a group (9) persons
    2,367,271         2.7 %
 

*
Less than 1%

(1)
The securities “beneficially owned” by an individual are determined in accordance with the definition of “beneficial ownership” set forth in the regulations promulgated under the Securities Exchange Act of 1934 and, accordingly, may include securities owned by or for, among others, the spouse and/or minor children of an individual and any other relative who has the same home as such individual, as well as, other securities as to which the individual has or shares voting or investment power or which each person has the right to acquire within 60 days through the exercise of options or otherwise. Beneficial ownership may be disclaimed as to certain of the securities. This table has been prepared based on 87,182,348 shares of common stock outstanding as of March 15, 2013.

(2)
Includes 165,241 issuable on exercise of options and 335,000 shares of common stock.

(3)
Includes 500,000 issuable on exercise of options and 50,000 shares of common stock.

(4)
Consists of 440,000 shares issuable upon exercise of options. Does not include 50,000 shares issuable upon exercise of options subject to vesting.

(5)
Consists of shares issuable upon exercise of options.

(6)
Consists of 133,336 shares issuable upon exercise of options. Does not include 33,334 shares issuable upon exercise of options subject to vesting.

(7)
Consists of 70,000 shares issuable upon exercise of options. Does not include 100,000 shares issuable upon exercise of options subject to vesting.

(8)
Consists of 33,333 shares issuable upon exercise of options. Does not include 66,667 shares issuable upon exercise of options subject to vesting.


The following table sets forth, as of December 31, 2012, information with respect to securities authorized for issuance under equity compensation plans.

 
28

 
 
EQUITY COMPENSATION PLAN INFORMATION

 
Number of securities to be issued
upon exercise of outstanding
options, warrants and rights
(a)
 
Weighted-average
exercise price of outstanding
options, warrants and rights
(b)
 
Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a))
(c)
 
Equity compensation plans approved by security holders
 
 
 
Equity compensation plans not approved by security holders
3,262,272
 
$
0.16
 
1,237,728
 
Total
3,262,272
 
$
0.16
 
1,237,728
 


The Company’s 1999 Stock Option Plan (the “1999 Plan”) was adopted by the Board of Directors of the Company on or about August 31, 1999. The material terms of the 1999 Plan are summarized below.

The 1999 Plan is currently administered by the Board of Directors of the Company (the “Plan Administrator”). The Plan Administrator is authorized to construe the 1999 Plan and any option issued under the 1999 Plan, select the persons to whom options may be granted, and determine the number of shares to be covered by any option, the exercise price, vesting schedule and other material terms of such option. Under the 1999 Plan 2,000,000 shares of common stock were reserved for issuance to officers, employees, directors and consultants of the Company at exercise prices not less than 85% of the last sale price of the Company’s common stock as reported on the OTC Bulletin Board on the date of grant. Options have terms of not more than 10 years from the date of grant, are subject to vesting as determined by the Plan Administrator and are not transferable without the permission of the Company except by will or the laws of descent and distribution or pursuant to a domestic relations order. Options terminate three (3) months after termination of employment or other association with the Company or one (1) year after termination due to disability, death or retirement. In the event that termination of employment or association is for a cause, as that term is defined in the 1999 Plan, options terminate immediately upon such termination. The Plan Administrator has the discretion to extend options for up to three years from the date of termination or disassociation with the Company.

The 1999 Plan provides for the immediate vesting of all options in the event of a “Change In Control” of the Company. In the event of a Change In Control, the Company is required to deliver written notice to each optionee under the 1999 Plan fifteen (15) days prior to the occurrence of a Change in Control, during which time all options issued under 1999 Plan may be exercised. Thereafter, all options issued under the 1999 Plan which are neither assumed or substituted in connection with such transaction, automatically expire, unless otherwise determined by the Board. Under the 1999 Plan, a “Change In Control” is defined to include (i) a sale or transfer of substantially all of the Company’s assets; (ii) the dissolution or liquidation of the Company; (iii) a merger or consolidation to which the Company is a party and after which the prior shareholders of the Company hold less than 50% of the combined voting power of the surviving corporation’s outstanding securities; (iv) the incumbent directors cease to constitute at least a majority of the Board of Directors; or (v) a change in control of the Company which would otherwise be reportable under Section 13 or 15(d) of the Exchange Act. The 1999 Plan expired in August 2009.

As of December 31, 2012, there were outstanding options under the 1999 Plan to purchase 500,000 shares of common stock, and no shares were available for future grants.

On October 12, 2004, the Board of Directors of the Company approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan has not yet been presented to stockholders for approval and thus incentive stock options are not available under this plan. Under the terms of this plan, 4,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of stock options granted may not exceed ten years. Options issued under the 2004 Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 2004 Plan expires in October 2014.

As of December 31, 2012, there were outstanding options under the 2004 Plan to purchase 2,762,272 shares of common stock, and options to purchase an aggregate of 1,237,728 shares were available for future grants.

In addition to options issued under the 1999 and 2004 Plans, the Company has issued options to employees, officers, directors and consultants to purchase common stock under the non-plan. As of December 2012, there were no outstanding options under the non-plan to purchase shares of common stock. The terms of outstanding options under the non-plan are substantially similar to the provisions of the 1999 Plan and options issued thereunder.
 
 
29

 
 
ITEM 13. 
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Employment Arrangements

The Company has entered into employment agreements with Michael W. DePasquale, and Mira LaCous. See “EXECUTIVE COMPENSATION—Employment Agreements.”

Consulting Arrangement with Thomas J. Colatosti

In connection with his appointment to the Board of Directors in September 2002, and as acting Chief Financial Officer from November 2008 to December 2009, the Company had entered into a number of consulting arrangements with Thomas Colatosti. Under the most recent arrangement, which was entered into on January 12, 2010, Mr. Colatosti provided services to the Company and its subsidiaries and affiliates for the two-year term ended December 31, 2011 at a rate of $5,000 per month.

Director Independence

The Board applies the definition of independent director as set forth in NASDAQ Stock Market Rule 4200 (a)(15), as well as Rule 10A-3 under the Securities Exchange Act of 1934, as amended.

In accordance with this guidance, the Board considers Mr. May, Mr. Schoenherr, and Mr. Romeo to be independent. Mr. May and Mr. Schoenherr are the members of the Company’s Audit Committee, while Mr. Schoenherr and Mr. Romeo are the members of the Company’s Compensation Committee.

 
30

 

ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES

The following table shows fees for professional services and quarterly audit fees billed to us by Rotenberg Meril Solomon Bertiger & Guttilla, P.C. (“RMSBG”) for the audit of our annual consolidated financial statements for the years ended December 31, 2012 and 2011:

   
2012
   
2011
 
             
Audit Fees
  $ 72,000     $ 72,272  
Audit-Related Fees
    0       0  
Tax Fees
    20,000       22,782  
                 
Total Fees
  $ 92,000     $ 95,054  

Audit Fees consist of fees billed for professional services rendered for the audit of our financial statements and review of the interim financial statements included in quarterly reports and services that are normally provided by our auditors in connection with statutory and regulatory filings or engagements. Audit fees also include fees for services provided in connection with registration of securities, comfort letters, and review of documents filed with the SEC.

Audit-Related Fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements and which are not reported under audit fees. These services relate primarily to mergers and acquisitions due diligence as well as advisory services as it pertains to the Sarbanes-Oxley Act and related rules and regulations;

Tax Fees consist of fees billed for professional services for tax compliance assistance rendered during the fiscal year.

Audit Committee Pre-Approval Procedures

The Audit Committee of our Board of Directors consists of Jeffrey J. May and John Schoenherr. The Audit Committee approves the engagement of our independent auditors to render audit and non-audit services before they are engaged. All of the fees for 2012 and 2011 shown above were pre-approved by the Audit Committee.

The Audit Committee pre-approves all audit and other permitted non-audit services provided by our independent auditors. Pre-approval is generally provided for up to one year, is detailed as to the particular category of services and is subject to a monetary limit. Our independent auditors and senior management periodically report to the Audit Committee the extent of services provided by the independent auditors in accordance with the pre-approval, and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.

Our audit committee will not approve engagements of our independent registered public accounting firm to perform non-audit services for us if doing so will cause our independent registered public accounting firm to cease to be independent within the meaning of applicable SEC rules. In other circumstances, our audit committee considers, among other things, whether our independent registered public accounting firm is able to provide the required services in a more or less effective and efficient manner than other available service providers.

 
31

 

ITEM 15.
EXHIBITS

(a)      The following documents are filed as part of this Report. Portions of Item 15 are submitted as separate sections of this Report:

 
(1)
Financial statements filed as part of this Report:

 
Reports of Independent Registered Public Accounting Firm

 
Balance Sheets as at December 31, 2012 and 2011

 
Statements of Operations—Years ended December 31, 2012 and 2011

 
Statement of Stockholders’ (Deficit) Equity —Years ended December 31, 2012 and 2011

 
Statements of Cash Flows—Years ended December 31, 2012 and 2011

 
Notes to Financial Statements—December 31, 2012 and 2011

(2)      The exhibits listed in the Exhibits Index immediately preceding such exhibits are filed as part of this Report

ITEM 8—FINANCIAL STATEMENTS

The following financial statements of BIO-key International, Inc. are included herein at the indicated page numbers:

 
Report of Independent Registered Public Accounting Firm, RMSBG P.C.
33
Balance Sheets as at December 31, 2012 and 2011
34
Statements of Operations—Years ended December 31, 2012 and 2011
35
Statements of Stockholders’ (Deficit) Equity —Years ended December 31, 2012 and 2011
36
Statements of Cash Flows—Years ended December 31, 2012 and 2011
37
Notes to the Financial Statements—December 31, 2012 and 2011
38

 
32

 

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
BIO-key International, Inc.
North Billerica, MA

We have audited the accompanying consolidated balance sheets of BIO-key International, Inc. and Subsidiary (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, stockholders’ (deficit) equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BIO-key International, Inc. and Subsidiary as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As disclosed in the consolidated financial statements, the Company has suffered substantial net losses in recent years, and has an accumulated deficit at December 31, 2012, which raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding these matters are disclosed in Note A. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Rotenberg Meril Solomon Bertiger & Guttilla, P.C.
 
 
ROTENBERG MERIL SOLOMON BERTIGER & GUTTILLA, P.C.
Saddle Brook, New Jersey
 
April 1, 2013
 
 
 
33

 
 
BIO-key International, Inc. and Subsidiary
CONSOLIDATED BALANCE SHEETS

   
December 31,
 
   
2012
   
2011
 
ASSETS
           
Cash and cash equivalents
  $ 83,989     $ 43,437  
Accounts receivable, net of allowance for doubtful accounts of $20,526 at December 31, 2012 and $397,526 at December 31, 2011
    604,784       587,346  
Due from factor
    189,904       -  
Inventory
    4,186       8,238  
Prepaid expenses and other
    25,088       58,920  
Total current assets
    907,951       697,941  
Equipment and leasehold improvements, net
    24,267       52,870  
Deposits and other assets
    8,712       8,712  
Intangible assets—less accumulated amortization
    195,911       207,180  
Total non-current assets
    228,890       268,762  
TOTAL ASSETS
  $ 1,136,841     $ 966,703  
                 
LIABILITIES
               
Accounts payable
  $ 931,276     $ 687,441  
Accrued liabilities
    593,599       675,833  
Deferred revenue
    508,520       527,092  
Note payable – related party
    321,428       346,428  
Total current liabilities
    2,354,823       2,236,794  
Deferred revenue, net of current portion
    -       1,000  
Total non-current liabilities
    -       1,000  
TOTAL LIABILITIES
    2,354,823       2,237,794  
                 
Commitments and contingencies
               
                 
STOCKHOLDERS’ DEFICIT:
               
Common stock — authorized, 170,000,000 shares; issued and outstanding; 78,155,413 of $.0001 par value at December 31, 2012 and December 31, 2011
    7,815       7,815  
Additional paid-in capital
    51,062,624       51,012,782  
Accumulated deficit
    (52,288,421 )     (52,291,688 )
TOTAL STOCKHOLDERS’ DEFICIT
    (1,217,982 )     (1,271,091 )
TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT
  $ 1,136,841     $ 966,703  

The accompanying notes are an integral part of these statements.

 
34

 
 
BIO-key International, Inc. and Subsidiary
STATEMENTS OF OPERATIONS

   
Years ended December 31,
 
   
2012
   
2011
 
             
Revenues
           
Services
  $ 1,094,731     $ 848,483  
License fees and other
    2,741,162       2,660,321  
      3,835,893       3,508,804  
Costs and other expenses
               
Cost of services
    221,027       159,223  
Cost of license fees and other
    350,706       651,236  
      571,733       810,459  
Gross Profit
    3,264,160       2,698,345  
                 
Operating expenses
               
Selling, general and administrative
    2,288,903       3,036,299  
Research, development and engineering
    947,371       1,116,658  
      3,236,274       4,152,957  
Operating income (loss)
    27,886       (1,454,612 )
                 
Other income (deductions)
               
Interest income
    7       95,033  
Interest expense
    (24,626 )     (411,527 )
Income taxes
    -       (26,500 )
Net discounts of notes payable and note receivable
    -       (100,000 )
      (24,619 )     (442,994 )
Net income (loss)
  $ 3,267     $ (1,897,606 )
                 
Basic and Diluted Income (Loss) per Common Share:
  $ 0.00     $ (0.02 )
                 
Weighted Average Shares Outstanding:
               
Basic and Diluted
    78,155,413       78,155,413  

The accompanying notes are an integral part of these statements.

 
35

 

BIO-key International, Inc. and Subsidiary
STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY

               
Additional
             
   
Common Stock
   
Contributed
   
Accumulated
       
   
Shares
   
Amount
   
Capital
   
Deficit
   
Total
 
Balance as of December 31, 2010
    78,155,413     $ 7,815     $ 50,955,602     $ (50,394,082 )   $ 569,335  
                                         
Share-based compensation
                57,180             57,180  
Net loss
                        (1,897,606 )     (1,897,606 )
                                         
Balance as of December 31, 2011
    78,155,413     $ 7,815     $ 51,012,782     $ (52,291,688 )   $ (1,271,091 )
                                         
Share-based compensation
                49,842             49,842  
Net income
                      3,267       3,267  
                                         
Balance as of December 31, 2012
    78,155,413     $ 7,815     $ 51,062,624     $ (52,288,421 )   $ (1,217,982 )

The accompanying notes are an integral part of these statements.

 
36

 
 
BIO-key International, Inc. and Subsidiary
STATEMENTS OF CASH FLOWS

   
Years ended December 31,
 
   
2012
   
2011
 
             
CASH FLOW FROM OPERATING ACTIVITIES:
           
Net income (loss)
  $ 3,267     $ (1,897,606 )
Adjustments to reconcile net income (loss) to cash provided by (used for) operating activities:
               
Allowance for doubtful accounts
    (377,000 )     386,000  
Depreciation
    28,603       31,462  
Amortization
               
Intangible assets
    11,269       11,270  
Discount on secured debt
    -       307,932  
Net discounts of notes payable and note receivable
    -       100,000  
Share-based compensation
    49,842       57,180  
Change in assets and liabilities:
               
Accounts receivable trade
    359,562       (622,253 )
Due from factor
    (189,904 )        
Inventory
    4,051       1,538  
Prepaid expenses and other
    33,833       129,995  
Accounts payable
    243,835       507,028  
Accrued liabilities
    (82,234 )     221,925  
Deferred revenue
    (19,572 )     242,418  
Net cash provided by (used for) operating activities
    65,552       (523,111 )
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from payment of note receivable
    -       3,350,000  
Capital expenditures
    -       (56,204 )
Net cash provided by investing activities
    -       3,293,796  
CASH FLOW FROM FINANCING ACTIVITIES:
               
Repayment of notes payable
    (25,000 )     (3,612,135 )
Preferred stock dividend paid
    -       (125,209 )
Net cash used for financing activities
    (25,000 )     (3,737,344 )
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    40,552       (966,659 )
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    43,437       1,010,096  
CASH AND CASH EQUIVALENTS, END OF YEAR
  $ 83,989     $ 43,437  
 

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

   
Years ended December 31,
 
   
2012
   
2011
 
             
Cash paid for:
           
Interest
  $     $ 80,286  
Income taxes     41,169       12,393  
 
The accompanying notes are an integral part of these statements.
 
 
37

 

BIO-key International, Inc. and Subsidiary
NOTES TO THE FINANCIAL STATEMENTS
December 31, 2012 and 2011

NOTE A —THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

The Company, founded in 1993, develops and markets proprietary fingerprint identification biometric technology and software solutions. We also deliver advanced identification solutions and information services to law enforcement departments, public safety agencies and other government and private sector customers. Our mobile wireless technology provides first responders with critical, reliable, real-time data and images from local, state and national databases.

Basis of Presentation

We have incurred significant losses to date, and at December 31, 2012, we had an accumulated deficit of approximately $52 million. In addition, broad commercial acceptance of our technology is critical to the Company’s success and ability to generate future revenues. At December 31, 2012, our total cash and cash equivalents were approximately $84,000, as compared to approximately $43,000 at December 31, 2011.

As discussed below, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, convertible preferred stock,  common stock, and recently through factoring receivables. We currently require approximately $385,000 per month to conduct our operations, a monthly amount that we have been unable to achieve through revenue generation.

If the Company is unable to generate sufficient revenue to meet our goals, we will need to obtain additional third-party financing to (i) conduct the sales, marketing and technical support necessary to execute our plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital. No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained by the Company in order to meet its needs, or that such financing would not be dilutive to existing shareholders.

The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern, and assumes continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The matters described in the preceding paragraphs raise substantial doubt about the Company’s ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet is dependent upon the Company’s ability to meet its financing requirements on a continuing basis, and become profitable in its future operations. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

Summary of Significant Accounting Policies

A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows:

1.  Basis of Consolidation

The accompanying consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly-owned subsidiary (collectively, the “Company”). Intercompany accounts and transactions have been eliminated in consolidation.

2. Use of Estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) as set forth in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) and consider the various staff accounting bulletins and other applicable guidance issued by the U.S. Securities and Exchange Commission (SEC). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our consolidated financial statements will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result.

 
38

 
 
3. Revenue Recognition

Revenues from software licensing are recognized in accordance with ASC 985-605, “Software Revenue Recognition. Accordingly, revenue from software licensing is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.

The Company intends to enter into arrangements with end users for items which may include software license fees, and services or various combinations thereof. For each arrangement, revenues will be recognized when evidence of an agreement has been documented, the fees are fixed or determinable, collection of fees is probable, delivery of the product has occurred and no other significant obligations remain.

Multiple-Element Arrangements: For multiple-element arrangements, the Company applies the residual method in accordance with ASC 985-605. The residual method requires that the portion of the total arrangement fee attributable to the undelivered elements be deferred based on its VSOE of fair value and subsequently recognized as the service is delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, which is generally the software license. VSOE of fair value for all elements in an arrangement is based upon the normal pricing for those products and services when sold separately. VSOE of fair value for support services is additionally determined by the renewal rate in customer contracts. The Company has established VSOE of fair value for support as well as consulting services.

License Revenues: Amounts allocated to license revenues are recognized at the time of delivery of the software and all other revenue recognition criteria discussed above have been met.

Revenue from licensing software, which requires significant customization and modification, is recognized using the percentage of completion method, based on the hours of effort incurred by the Company in relation to the total estimated hours to complete. In instances where third party hardware, software or services form a significant portion of a customer’s contract, the Company recognizes revenue for the element of software customization by the percentage of completion method described above. Otherwise, third party hardware, software, and services are recognized upon shipment or acceptance as appropriate. If the Company makes different judgments or utilizes different estimates of the total amount of work expected to be required to customize or modify the software, the timing and revenue recognition, from period to period, and the margins on the project in the reporting period, may differ materially from amounts reported. Anticipated contract losses are recognized as soon as they become known and are estimable.

Service Revenues: Revenues from services are comprised of maintenance and consulting and implementation services. Maintenance revenues include providing for unspecified when-and-if available product updates and customer telephone support services, and are recognized ratably over the term of the service period. Consulting services are generally sold on a time-and-materials basis and include a range of services including installation of software and assisting in the design of interfaces to allow the software to operate in customized environments. Services are generally separable from other elements under the arrangement since performance of the services are not essential to the functionality of any other element of the transaction and are described in the contract such that the total price of the arrangement would be expected to vary as the result of the inclusion or exclusion of the services. Revenues from services are generally recognized as the services are performed.

The Company provides customers, free of charge or at a minimal cost, testing kits which potential licensing customers may use to test compatibility/acceptance of the Company’s technology with the customer’s intended applications.

Costs and other expenses: Includes professional compensation and other direct contract expenses, as well as costs attributable to the support of client service professional staff, depreciation and amortization costs related to assets used in revenue-generating activities, and other costs attributable to serving the Company’s client base. Professional compensation consists of payroll costs and related benefits including stock-based compensation and bonuses. Other direct contract expenses include costs directly attributable to client engagements, such as out-of-pocket costs including travel and subsistence for client service professional staff, costs of hardware and software and costs of subcontractors. The allocation of lease and facilities charges for occupied offices is included in costs of service.

 
39

 
 
The Company accounts for its warranties under the FASB ASC 450 “Contingencies.” The Company generally warrants that its products are free from defects in material and workmanship for a period of one year from the date of initial receipt by our customers. The warranty does not cover any losses or damage that occurs as a result of improper installation, misuse or neglect or repair or modification by anyone other than the Company or its authorized repair agent. The Company’s policy is to accrue anticipated warranty costs based upon historical percentages of items returned for repair within one year of the initial sale. The Company’s repair rate of products under warranty has been minimal, and a historical percentage has not been established. The Company’s software license agreements generally include certain provisions for indemnifying customers against liabilities if the Company’s software products infringe upon a third party’s intellectual property rights. The Company has not provided for any reserves for warranty liabilities as it was determined to be immaterial.

4.  Cash Equivalents

Cash equivalents consist of liquid investments with original maturities of three months or less.  At December 31, 2012 and 2011, cash equivalents consisted of a money market account.

5. Accounts Receivable

Accounts receivable billed and unbilled are carried at original amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful receivables by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Accounts receivable are written off when deemed uncollectible. Recoveries of accounts receivable previously written off are recorded when received. Accounts receivable at December 31, 2012 and 2011 consisted of the following:


   
December 31,
 
   
2012
   
2011
 
             
Accounts receivable
  $ 625,310     $ 984,872  
Allowance for doubtful accounts
    (20,526 )     (397,526 )
                 
Accounts receivable, net allowances for doubtful accounts
    604,784       587,346  

The allowance for doubtful accounts for the years ended December 31, 2012 and 2011 is as follows:


   
Balance at
Beginning of Year
   
Charged to Costs
and Expenses
   
Deductions From
Reserves
   
Balance at
End of Year
 
Year Ended December 31, 2012
                       
Allowance for Doubtful Accounts
  $ 397,526     $ -     $ 377,000     $ 20,526  
Year Ended December 31, 2011
                               
Allowance for Doubtful Accounts
  $ 11,526     $ 386,000     $ -     $ 397,526  
 
The allowance was set up primarily for one customer whose payments under a contract were behind schedule. $400,000 was collected from the customer in 2012, and subsequently, $150,000 was collected in 2013. The final payment for the balance due under the contract has been approved to be paid, although the funds have not been received as of the filing date.  As of the date of the filing, the customer owes approximately $313,000.
 
6. Property and Equipment, Intangible Assets and Depreciation and Amortization

Property and equipment are stated at cost.  Depreciation is provided for in amounts sufficient to relate the cost of depreciable assets to operations over the estimated service lives, principally using straight-line methods. Leasehold improvements are amortized over the shorter of the life of the improvement or the lease term, using the straight-line method.

The estimated useful lives used to compute depreciation and amortization for financial reporting purposes are as follows:

Equipment and leasehold improvements
     
Equipment (years)
  3 - 5  
Furniture and fixtures (years)
  3 - 5  
Software (years)
    3    
Leasehold improvements
 
life or lease term
 

 
40

 
 
Intangible assets consist of patents.  Patent costs are capitalized until patents are awarded. Upon award, such costs are amortized using the straight-line method over their respective economic lives. If a patent is denied, all costs are charged to operations in that year.

7. Impairment or Disposal of Long Lived Assets, including Intangible Assets

We review our long-lived assets, including intangible assets subject to amortization, whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to the future undiscounted cash flows the assets are expected to generate. If such assets are considered impaired, the impairment to be recognized is equal to the amount by which the carrying value of the assets exceeds their fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. In assessing recoverability, we must make assumptions regarding estimated future cash flows and discount factors. If these estimates or related assumptions change in the future, we may be required to record impairment charges. Intangible assets with determinable lives are amortized over their estimated useful lives, based upon the pattern in which the expected benefits will be realized, or on a straight-line basis, whichever is greater. We did not record any impairment charges in any of the years presented.

8. Advertising Expense

The Company expenses the costs of advertising as incurred. Advertising expenses for the years ended December 31, 2012 and 2011 were approximately $114,000 and $170,000, respectively.

9. Deferred Revenue

Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have not been recognized as revenue. The majority of these amounts are related to maintenance contracts for which the revenue is recognized ratably over the applicable term, which generally is 12 months from the date the customer accepts the products.

10. Research and Development Expenditures

Research and development expenses include costs directly attributable to the conduct of research and development programs primarily related to the development of our software products and improving the efficiency and capabilities of our existing software. Such costs include salaries, payroll taxes, employee benefit costs, materials, supplies, depreciation on research equipment, services provided by outside contractors, and the allocable portions of facility costs, such as rent, utilities, insurance, repairs and maintenance, depreciation and general support services. All costs associated with research and development are expensed as incurred.

11. Earnings Per Share of Common Stock (“EPS”)

The Company’s EPS is calculated by dividing net income (loss) applicable to common stockholders by the weighted-average number of common shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuances of common stock, such as stock issuable pursuant to the exercise of stock options and warrants and the assumed conversion of convertible notes, when the effect of their inclusion is dilutive. See Note R -  Earnings Per Share “EPS”, for additional information.

12. Accounting for Stock-Based Compensation

The Company accounts for share based compensation in accordance with the provisions of ASC 718-10, “Compensation — Stock Compensation,” which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of our common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.

 
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The compensation expense recognized under ASC 718 amounted to $49,842 and $57,180 for the years ended December 31, 2012 and 2011 respectively.

The following table presents share-based compensation expenses for continuing operations included in the Company’s consolidated statements of operations:

   
Year ended
December 31,
 
   
2012
   
2011
 
             
Selling, general and administrative
  $ 22,502     $ 12,054  
Research, development and engineering
    27,340       45,126  
    $ 49,842     $ 57,180  

Valuation Assumptions for Stock Options

For the years ended December 31, 2012 and 2011, 600,000 and 845,000 stock options were granted, respectively. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

   
Year ended
December 31,
 
   
2012
   
2011
 
Risk free interest rate
    0.80 %     1.64 %
Expected life of options (in years)
    4.48       4.52  
Expected dividends
    0 %     0 %
Volatility of stock price
    114 %     114 %

The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical daily price changes of the Company’s common stock over the expected option term. The expected term was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

13. Income Taxes

The provision for, or benefit from, income taxes includes deferred taxes resulting from the temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from the differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carryback, carryforward period available under tax law. The Company evaluates, on a quarterly basis whether, based on all available evidence, if it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is more likely than not that the tax benefit of the deferred tax asset will not be realized. The evaluation, as prescribed by ASC 740-10, “Income Taxes,” includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carryforward from expiring unused. Because of the Company’s historical performance and estimated future taxable income, a full valuation allowance has been established.

The Company accounts for uncertain tax provisions in accordance with ASC 740-10-05 “Accounting for Uncertainty in Income Taxes.” The ASC clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. The ASC prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The ASC provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

14. Recent Accounting Pronouncements

Management does not believe that any other recently issued, but not yet effective, accounting standard if currently adopted would have a material effect on the accompanying consolidated financial statements.

 
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NOTE B—FACTORING

Due from factor consisted of the following as of December 31:
   
Original Invoice
Value
   
Factored
Amount
   
Factored
Balance due
 
Year Ended December 31, 2012
                 
Factored accounts receivable
  $ 744,315     $ 554,411     $ 189,904  
Year Ended December 31, 2011
                       
Factored accounts receivable
  $ -     $ -     $ -  
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