UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period endedJune 30, 2017March 31, 2018.

or

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

For the transition period from __________to___________ to __________.

Commission File Number:001-33899

Digital Ally, Inc.

(Exact name of registrant as specified in its charter)

9705 Loiret Blvd, Lenexa, KS 66219

(Address of principal executive offices) (Zip Code)

(913) 814-7774

(Registrant’s telephone number, including area code)

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 [  ]

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

Yes [X] No [  ]

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes [  ] No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

FORM 10-Q

DIGITAL ALLY, INC.

JUNE 30, 2017MARCH 31, 2018

(Unaudited)

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

JUNE 30, 2017MARCH 31, 2018 AND DECEMBER 31, 20162017

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND SIX MONTHS ENDED

JUNE 30,MARCH 31, 2018 AND 2017 AND 2016

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

FOR THE SIXTHREE MONTHS ENDED JUNE 30, 2017MARCH 31, 2018
(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIXTHREE MONTHS ENDED JUNE 30,MARCH 31, 2018 AND 2017 AND 2016
(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business:

Digital Ally, Inc. and subsidiaries (collectively, “Digital Ally,” “Digital,” the “Company,” “we,” “ours” and “us”) produces digital video imaging and storage products for use in law enforcement, security and commercial applications. Its current products are an in-car digital video/audio recorder contained in a rear-view mirror for use in law enforcement and commercial fleets;fleets, a system that provides itsour law enforcement customers with audio/video surveillance from multiple vantage points and hands-free automatic activation of body-worn cameras and in-car video systems; a miniature digital video system designed to be worn on an individual’s body; a weather-resistant mobile digital video recording system for use on motorcycles, ATV’s and boats; a hand-held laser speed detection device that it is offering primarily to law enforcement agencies; and cloud storage solutions.solutions including cloud-based fleet management and driver monitoring/training applications. The Company has active research and development programs to adapt itsour technologies to other applications. It can integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxi cab and the military. The Company sells its products to law enforcement agencies and other security organizations, and consumer and commercial fleet operators through direct sales domestically and third-party distributors internationally. The Company has several new and derivative products in research and development that it anticipates will begin commercial production during 2018.

The Company was originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no operations until 2004. On November 30, 2004, Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally, Inc., at which time the merged entity was renamed Digital Ally, Inc.

Accounting Changes:

Except for the changes discussed below, the Company has consistently applied the accounting policies to all periods presented in these unaudited consolidated financial statements.

Effective January1, 2018 the Company adopted FASB ASC Topic 606,Revenue from Contracts with Customers, the Company changed certain characteristics of the revenue recognition accounting policy as described below. ASC 606 was applied using the modified retrospective approach, where the cumulative effect of the initial application is recognized as an adjustment to opening retained earnings at January 1, 2018. Therefore, comparative prior periods have not been adjusted and continue to be reported under FASB ASC Topic 605,Revenue Recognition, or ASC 605. The following table summarizes the impact of the adoption of ASC 606 on revenue, operating expenses and operating profit for the three months ended March 31, 2018 (in thousands):

The impact of the adoption of ASC 606 on net (loss) for the Company was not material and the impact of the adoption of ASC 606 on the unaudited consolidated financial statements at March 31, 2018 and the unaudited consolidated statements of operations, equity/(deficit) and cash flows for the three months ended March 31, 2018 was not material.

Upon adoption of ASC 606, the Company changed our accounting policy for the capitalization of costs to obtain contracts. Prior to the adoption of ASC 606, all commissions paid to the salesforce was recognized as commission expense including any commissions earned for future revenues. Under ASC 606, the Company is required to capitalize commissions paid to the salesforce for future revenues and recognize as commission expense as the respective revenues are earned. This change was the principal adjustment to the Company’s reported revenue and operating expenses included in the above table.

Management’s Liquidity Plan

The Company incurred substantial operating losses in the sixthree months ended June 30,March 31, 2018 and for the year ended December 31, 2017 and recent years primarily due to reduced revenues and gross margins caused by specific product quality issues resulting in the significant delays in customer orders and product rework expenditures.expenditures and introduction by competitors of newer products with more features than those of the Company. In addition, the Company’s revenues and gross margins have been significantly and negatively impacted by its competitors’ willful infringement of the Company’s patents, specifically the auto-activation of body-worn and in-car video systems, and its competitors’ significant price cutting of their products. The Company has incurred net losses of approximately $2.6 million during the three months ended March 31, 2018 and $12.3 million in the year ended December 31, 2017 and it had an accumulated deficit of $64.4 million as of March 31, 2018. In recent years the Company has accessed the public and private capital markets to raise approximately $700,000 on June 30, 2017,funding through the issuance of debt and equity. In that regard, the Company raised funding in the form of subordinated and secured debt totaling $1,608,500 and the issuance of common stock and warrants totaling $2,776,332 during the year ended December 31, 2017. During 2016, the Company raised $4.0 million of funding in December 2016the form of convertible debentures and $11.0 million in 2015common stock purchase warrants. These debt and equity raises were utilized to fund its operations and management expects to continue this pattern until it achieves positive cash flows from operations. As of June 30, 2017, theoperations, although it can offer no assurance in this regard.

The Company had an accumulated deficit of $54.0 million and has financed its recent operations primarily through debt and equity financings. During the six months ended June 30, 2017 and year ended December 31, 2016, the Company incurred net losses of approximately $4.4 and $12.7 million, respectively, and used cash in operating activities of $3.4 million and $5.9 million, respectively. The $700,000outstanding $1,008,500 principal amount of subordinated and secured notes payable (the “Notes”) matureswhich were to mature prior to or on September 30, 2017.March 31, 2018. Additionally, the $4.0$3,250,000 million principal amount of 8% Secured Convertible Debentures (the “Debentures”) matures inmatured on March 2018 unless the Debentures are converted by their holders ($5.00 per share conversion rate) before maturity.30, 2018. The Notesnotes and Debentures represent current liabilities as of June 30, 2017March 31, 2018 and will requirerequired the Company to negotiate extensions and/or raise substantial funds through the issuance of new debt and/or equity to liquidate if operating results do not improve before the maturity dates of such Notesnotes and Debentures. These conditions indicate that there is substantial doubt aboutAs part of the Company’s abilityoverall strategic alternatives process which commenced in November 2017, the Board of Directors approved a private placement (the “Private Placement”) of $6.05 million principal amount of 8% Senior Secured Convertible Notes (the “Notes”) and 806,667 warrants (the “Warrants”) exercisable to continue as a going concern within one year afterpurchase 806,667 shares of common stock of the dateCompany. This Private Placement closed on April 3, 2018 and is described in Subsequent Events Footnote 14. A portion of the proceeds were used to repay in full the Debentures and approximately $1,008,500 principal amount and accrued interest on the subordinated and secured notes that were due to mature. The balance of the financial statements are issued.net proceeds will be used for working capital and general corporate purposes. The Company believes that this financing has addressed its near-term liquidity needs.

The Company is also negotiating with the Web.com golf tournament officials to terminate its sponsorship fee commitment of $500,000 annually for 2018 and 2019 tournaments. There can be no assurance that it will be successful in negotiating the termination of this sponsorship agreement or that if successful in such negotiation on terms acceptable or favorable to the Company.

The Company will needhave to restore positive operating cash flows and profitability over the next twelve months and/or raise additional capital to fund operations, accommodate the potential liquidity needs to retire the Debentures at their maturity,its operational plans, meet its customary payment obligations and otherwise execute its business plan. There can be no assurance that it will be successful in restoring positive cash flows and profitability, or that it can raise additional financing if and when needed, and obtain it on terms acceptable or favorable to the Company.

ManagementThe Company has implemented aan enhanced quality control function which is tasked with the detectionprogram to detect and correction ofcorrect product issues before they result in significant rework expenditures affecting the Company’s gross margins. Themargins and has seen progress in that regard. In addition, the Company has undertaken a number of cost reduction initiatives, including a reduction of its workforce by approximately 40%, restructuring its direct sales force and cutting other selling, general and administrative costs. In 2017 the Company introduced a new full high definition in-car video system (DVM-800 HD), which is intended to help it regain market share and improve revenues in its law enforcement division. In late 2017 the Company entered into a three-year supply and distribution agreement with a competitor (“VieVu”) that includes minimum purchase requirements of $2.5 million in 2018 and $3.0 million in 2019 to maintain its exclusive status. The Company has increased its addressable market to non-law enforcement customers and has obtainedsignificant new non-law enforcement contracts in 2017 and early 2018, which contracts include recurring revenue over the 20172018 to 20192020 period. ManagementThe Company believes that its quality control, initiative,headcount reduction and cost cutting initiatives, introduction of the DVM-800 HD for law enforcement and expansion to non-law enforcement sales channels will restore positive operating cash flows and profitability during the next year, although it can offer no assurances in this regard.

The Company’s plan also includes raising additional capital, and is currently considering the issuance of debt, equity or a combination of both within the next 90 days. In addition to the initiatives described above, the Board of Directors is conducting a review of a full range of strategic alternatives to best position the Company is considering reducingfor the exercise price on outstanding common stock purchase warrants in orderfuture including, but not limited to, induce holders to exercise which would generate working capital.monetizing its patent portfolio and related patent infringement litigation against Axon Enterprise, Inc. (“Axon” formerly Taser International, Inc.) and Enforcement Video, LLC d/b/a WatchGuard Video (“WatchGuard”), the sale of all or certain assets, properties or groups of properties or individual businesses or merger or combination with another company. The result of this review may also include the continued implementation of the Company’s business plan. The Company has demonstrated its abilityretained Roth Capital Partners (“Roth”) to raise new debt or equity capital in recent years and if necessary, it believes that it could raise additional capital during the next 12 months if required, but again can offer no assurancesassist in this regard. process. The Private Placement completed on April 3, 2018 was a part of this strategic alternatives review. While the Private Placement addressed the Company’s near-term liquidity needs, it continues to consider strategic alternatives to address longer-term liquidity needs and operational issues. There can be no assurance that any additional transactions or financings will result from this process.

Based on the uncertainties described above, the Company believes its business plan does not alleviate the existence of substantial doubt about its ability to continue as a going concern within one year after the date thatof the consolidated condensed financial statements in this Report.

The following is a summary of the Company’s Significant Accounting Policies:

Basis of Consolidation:

The accompanying financial statements include the consolidated accounts of Digital Ally and its wholly-owned subsidiaries, Digital Ally International, Inc., MP Ally, LLC, Medical Devices Ally, LLC and Digitaldeck, LLC. All intercompany balances and transactions have been eliminated during consolidation.

The Company formed Digital Ally International, Inc. during August 2009 to facilitate the export sales of its products. In addition, it formed Medical Devices Ally, LLC was formed in July 2014, MP Ally, LLC was formed in July 2015, and Digitaldeck, LLC was formed in June 2017, all of which have been inactive since formation.

Fair Value of Financial Instruments:

The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accountssubordinated notes payable approximate fair value because of the short-term nature of these items. The Company accounts for its derivative liabilities and its secured convertible debentures on a fair value basis.

Revenue Recognition:

RevenuesThe Company applies the provisions of Accounting Standards Codification (ASC) 606-10,Revenue from Contracts with Customers, and all related appropriate guidance. The Company recognizes revenue under the salecore principle to depict the transfer of control to the Company’s customers in an amount reflecting the consideration the Company expects to be entitled. In order to achieve that core principle, the Company applies the following five-step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.

The Company considers customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with the customer. In situation where sales are to a distributor, the Company had concluded its contracts are with the distributor as the Company holds a contract bearing enforceable rights and obligations only with the distributor. As part of part of its consideration for the contract, the Company evaluates certain factors including the customers’ ability to pay (or credit risk). For each contract, the Company considers the promise to transfer products, each of which is distinct, to be the identified performance obligations. In determining the transaction price the Company evaluates whether the price is subject to refund or adjustment to determine the net consideration to which the Company expects to be entitled. As the Company’s standard payment terms are recordedless than one year, the Company has elected the practical expedient under ASC 606-10-32-18 to not assess whether a contract has a significant financing component. The Company allocates the transaction price to each distinct product based on their relative standalone selling price. The product price as specified on the purchase order is considered the standalone selling price as it is an observable input which depicts the price as if sold to a similar customer in similar circumstances. Revenue is recognized when control of the product is shipped, title and risk of loss have transferred to the purchaser,customer (i.e. when the Company’s performance obligations is satisfied), which typically occurs at shipment. Further in determining whether control has been transferred, the Company considers if there is a present right to payment terms are fixed or determinable and payment is reasonably assured.legal title, along with risks and rewards of ownership having transferred to the customer. Customers do not have a right to return the product other than for warranty reasons for which they would only receive repair services or replacement product.

The Company has also elected the practical expedient under ASC 340-40-25-4 to expense commissions when incurred as the amortization period of the commission asset the Company would have otherwise recognized is less than one year.

The Company sells its products and services to law enforcement and commercial customers in the following manner:

Sales taxes collected on products sold are excluded from revenues and are reported as an accrued expense in the accompanying balance sheets until payments are remitted.

Service and other revenue is comprised of revenues from extended warranties, repair services, cloud revenue and software revenue. Revenue is recognized upon shipment of the product and acceptance of the service or materials by the end customer for repair services. Revenue for extended warranty, cloud service or other software-based are treated as deferred revenue and recognizedproducts is over the term of the contractedcontract warranty or service periodperiod. A time-elapsed method is used to measure progress because the Company transfers control evenly over the contractual period. Accordingly, the fixed consideration related to these revenues is generally recognized on a straight-line method.basis over the contract term, as long as the other revenue recognition criteria have been met.

Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenue and recognized over the termContracts with some of the extended warrantyCompany’s customers contain multiple performance obligations that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a straight-line method.

relative standalone selling price (“SSP”). The Company determined SSP for all of the performance obligations using observable inputs, such as standalone sales and historical pricing. SSP is consistent with the Company’s overall pricing objectives, taking into consideration the type of service being provided. SSP also reflects the amount the Company would charge for the performance obligation if it were sold separately in a standalone sale. Multiple element arrangements consistingperformance obligations consist of product, software, cloud subscriptions and extended warranties are offered to our customers. Revenue arrangements with multiple deliverables are divided into separate units and revenue is allocated using the relative selling price method based upon vendor-specific objective evidence of selling price or third-party evidence of the selling prices if vendor-specific objective evidence of selling prices does not exist. If neither vendor-specific objective evidence nor third-party evidence exists, management uses its best estimate of selling price. The majority of the Company’s allocations of arrangement consideration under multiple element arrangements are performed using vendor-specific objective evidence by utilizing prices charged to customers for deliverables when sold separately. warranties.

The Company’s multiple element arrangementsperformance obligations may include future in-car or body-worn camera devices to be delivered at defined points within a multi-year contract, and in those arrangements, the Company allocates total arrangement consideration over the life of the multi-year contract to future deliverables using management’s best estimate of selling price. The Company has not utilized third-party evidence

Contract liabilities consist of selling price.deferred revenue and include payments received in advance of performance under the contract. Such amounts are generally recognized as revenue over the contractual period.

Sales returns and allowances aggregated $13,736$20,019 and $123,703$(41,321) for the three months ended June 30,March 31, 2018 and 2017, and 2016, respectively, and $(27,585) and $201,990 for the six months ended June 30, 2017 and 2016, respectively. Obligations for estimated sales returns and allowances are recognized at the time of sales on an accrual basis. The accrual is determined based upon historical return rates adjusted for known changes in key variables affecting these return rates. A customer paid under a sales transaction in March 2017 that had been accrued to be returned at December 31, 2016, which the caused the negative sales returns for the sixthree months ended June 30,March 31, 2017.

Revenues for first quarter 2018 and first quarter 2017 were derived from the following sources:

Use of Estimates:

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and cash equivalents:

Cash and cash equivalents include funds on hand, in bank and short-term investments with original maturities of ninety (90) days or less.

Cash and cash equivalents that are restricted as to withdrawal or use under the terms of the secured convertible debentures are presented as restricted cash separate from cash and cash equivalents on the accompanying balance sheet.

Accounts Receivable:

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a weekly basis. The Company determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.

A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more than thirty (30) days beyond terms. No interest is charged on overdue trade receivables.

Inventories:

Inventories consist of electronic parts, circuitry boards, camera parts and ancillary parts (collectively, “components”), work-in-process and finished goods, and are carried at the lower of cost (First-in, First-out Method) or market value. The Company determines the estimate for the reserve for slow moving or obsolete inventories by regularly evaluating individual inventory levels, projected sales and current economic conditions.

Furniture, fixtures and equipment:

Furniture, fixtures and equipment is stated at cost net of accumulated depreciation. Additions and improvements are capitalized while ordinary maintenance and repair expenditures are charged to expense as incurred. Depreciation is recorded by the straight-line method over the estimated useful life of the asset, which ranges from three to ten years. Amortization expense on capitalized leases is included with depreciation expense.

Intangible assets:

Intangible assets include deferred patent costs and license agreements. Legal expenses incurred in preparation of patent application have been deferred and will be amortized over the useful life of granted patents. Costs incurred in preparation of applications that are not granted will be charged to expense at that time. The Company has entered into several sublicense agreements under which it has been assigned the exclusive rights to certain licensed materials used in its products. These sublicense agreements generally require upfront payments to obtain the exclusive rights to such material. The Company capitalizes the upfront payments as intangible assets and amortizes such costs over their estimated useful life on a straight-line method.

Secured convertible debentures:

The Company has elected to record its Debentures at their fair value. Accordingly, the Debentures will be marked-to-market at each reporting date with the change in fair value reported as a gain (loss) in the statementCondensed Consolidated Statement of operations.Operations. All issuance costs related to the Debentures were expensed as incurred in the statement of operations.

Long-Lived Assets:

Long-lived assets such as property, plant and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques, including discounted cash flow models, quoted market values and third-party appraisals, as considered necessary.

Warranties:

The Company’s products carry explicit product warranties that extend up to two years from the date of shipment. The Company records a provision for estimated warranty costs based upon historical warranty loss experience and periodically adjusts these provisions to reflect actual experience. Accrued warranty costs are included in accrued expenses. Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenue and recognized over the term of the extended warranty.

Shipping and Handling Costs:

Shipping and handling costs for outbound sales orders totaled $19,661$13,967 and $21,650$20,430 for the three months ended June 30,March 31, 2018 and 2017, and 2016, respectively, and $40,091 and $46,219 for the six months ended June 30, 2017 and 2016, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

Advertising Costs:

Advertising expense includes costs related to trade shows and conventions, promotional material and supplies, and media costs. Advertising costs are expensed in the period in which they are incurred. The Company incurred total advertising expense of approximately $143,053$79,569 and $194,944$127,276 for the three months ended June 30,March 31, 2018 and 2017, and 2016, respectively, and $270,329 and $321,412 for the six months ended June 30, 2017 and 2016, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

Income Taxes:

Deferred taxes are provided for by the liability method in which deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

The Company applies the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) No. 740 - Income Taxes that provides a framework for accounting for uncertainty in income taxes and provided a comprehensive model to recognize, measure, present, and disclose in its financial statements uncertain tax positions taken or expected to be taken on a tax return. It initially recognizes tax positions in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application requires numerous estimates based on available information. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information, the Company may need to periodically adjust its recognized tax positions and tax benefits. These periodic adjustments may have a material impact on its consolidated statementsConsolidated Statements of operations.Operations.

The Company’s policy is to record estimated interest and penalties related to the underpayment of income taxes as income tax expense in the consolidated statements of operations. There was no interest expense related to the underpayment of estimated taxes during the sixthree months ended June 30, 2017March 31, 2018 and 2016.2017. There have been no penalties in the sixthree months ended June 30, 2017March 31, 2018 and 2016.2017.

The Company is subject to taxation in the United States and various states. As of June 30, 2017,March 31, 2018, the Company’s tax returns filed for 2013, 2014, 2015, and 20152016 and to be filed for 20162017 are subject to examination by the relevant taxing authorities. With few exceptions, as of June 30, 2017,March 31, 2018, the Company is no longer subject to Federal, state, or local examinations by tax authorities for years before 2013.2014.

Research and Development Expenses:

The Company expenses all research and development costs as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and software development costs were expensed as incurred during the sixthree months ended June 30, 2017March 31, 2018 and 2016.2017.

Common Stock Purchase Warrants:

The Company has common stock purchase warrants that are accounted for as liabilities under the caption of derivative liabilities on the consolidated balance sheet and recorded at fair value due to the warrant agreements containing anti-dilution provisions. The change in fair value is being recorded in the consolidated statementCondensed Consolidated Statement of operation.Operations.

The Company has common stock purchase warrants that are accounted for as equity based on their relative fair value and are not subject to remeasurement.re-measurement.

Stock-Based Compensation:

The Company grants stock-based compensation to its employees, board of directors and certain third party contractors. Share-based compensation arrangements may include the issuance of options to purchase common stock in the future or the issuance of restricted stock, which generally are subject to vesting requirements. The Company records stock-based compensation expense for all stock-based compensation granted based on the grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award.

The Company estimates the grant-date fair value of stock-based compensation using the Black-Scholes valuation model. Assumptions used to estimate compensation expense are determined as follows:

Segments of Business:

Management has determined that its operations are comprised of one reportable segment: the sale of digital audio and video recording and speed detection devices. For the three and six months ended June 30,March 31, 2018 and 2017, and 2016, sales by geographic area were as follows:

Sales to customers outside of the United States are denominated in U.S. dollars. All Company assets are physically located within the United States.

ReclassificationAdoption of Prior Year Presentation:

Certain prior year amounts have been reclassified for consistency with the current year presentation. These reclassifications had no effect on the reported results of operations.

RecentNew Accounting Pronouncements:

In May 2014, the FASB issued Accounting Standard Update (“ASU”) No. 2014-09,“Revenue from Contracts with Customers”(“ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The standard is effective for interim and annual periods beginning after December 15, 2017 and permits the use of either the retrospective or cumulative effect transition method. The Company has not yet selected a transition method and is currently evaluating the standard and the impact on its consolidated financial statements and footnote disclosures.

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330):Simplifying the Measurement of Inventory. The amendments in the ASU require entities that measure inventory using the first-in, first-out or average cost methods to measure inventory at the lower of cost and net realizable value. Net realizable value is defined as estimated selling price in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation. ASU 2015-11 is effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016 on a prospective basis. This ASU will be effective for the Company for fiscal years beginning after December 15, 2016 The Company adopted this new standard on January 1, 2017 and such adoption did not have any impact on its consolidated financial statements.

In November 2015, the FASB issued ASU 2015-17,Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This ASU simplifies the presentation of deferred income taxes by eliminating the requirement for entities to separate deferred tax liabilities and assets into current and noncurrent amounts in classified balance sheets. Instead, it requires deferred tax assets and liabilities be classified as noncurrent in the balance sheet. ASU 2015-17 is effective for financial statements issued for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company adopted this new standard on January 1, 2017 and such adoption did not have any impact on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02,Leases (Topic 842). The objective of ASU 2016-02 is to recognize lease assets and lease liabilities by lessees for those leases classfied as operating leases under previous U.S. GAAP. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption of ASU 2016-02 is permitted. The Company is evaluating the effects adoption of this guidance will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09,Compensation-Stock Compensation (Topic 718). The objective of ASU 2016-09 is to reduce the complexity of certain aspects of the accounting for employee share-based payment transactions. As a result of this ASU, there are changes to minimum statutory withholding requirements, accounting for forfeitures, and accounting for income taxes. The ASU is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company adopted this new standard on January 1, 2017 and elected to account for forfeitures as they occur and has resulted in a credit to stock-based compensation of $256,167 relative to forfeitures during the six months ended June 30, 2017.Pronouncement:

In August 2016, the FASB issued ASU 2016-15,Clarification on Classification of Certain Cash Receipts and Cash Payments on the Statement of Cash Flows, to create consistency in the classification of eight specific cash flow items. This standard is effective for calendar-year SEC registrants beginning in 2018. The Company is evaluating the effects adoption of this guidance will havehad no effect on itsour consolidated condensed financial statements.

In November 2016, the FASB issued ASU 2016-18,Statement of Cash Flows - Restricted Cash (Topic 230), which amends the existing guidance relating to the disclosure of restricted cash and restricted cash equivalents on the statement of cash flows. ASU 2016-18 is effective for the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, and early adoption is permitted. The Company is evaluating the impact of adoption of ASU 2016-18 had no effect on itsour Consolidated Condensed Statements of Cash Flows.

In May 2017, the FASB issued ASU 2017-09,Stock Compensation (Topic 718)-Scope of Modification Accounting, to provide guidance on determining which changes to terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. The Company is evaluating the effects adoption of this guidance will havehad no effect on itsour consolidated condensed financial statements.

NOTE 2. BASIS OF PRESENTATION

The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six-monththree-month period ended June 30, 2017March 31, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.2018.

The balance sheet at December 31, 20162017 has been derived from the audited financial statements at that date, but does not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements.

For further information, refer to the financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2016.2017.

NOTE 3. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject the Company to concentrations of credit risk consist of accounts receivable. Sales to domestic customers are typically made on credit and the Company generally does not require collateral while sales to international customers require payment before shipment or backing by an irrevocable letter or credit. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated losses. Accounts are written off when deemed uncollectible and accounts receivable are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts totaled $70,000 as of June 30, 2017March 31, 2018 and December 31, 2016.2017.

The Company uses primarily a network of unaffiliated distributors for international sales and employee-based direct sales force for domestic sales. No international distributor individually exceeded 10% of total revenues for the sixthree months ended June 30, 2017 or June 30, 2016. OneMarch 31, 2018 and 2017. No individual customer receivable balancesbalance exceeded 10% of total accounts receivable at June 30, 2017, and totaled $289,499. Twoas of March 31, 2018. One individual customer receivable balancesbalance exceeded 10% of total accounts receivable at June 30, 2016,as of March 31, 2017, and totaled $660,136.$878,006, or 26% of total accounts receivable.

The Company purchases finished circuit boards and other proprietary component parts from suppliers located in the United States and on a limited basis from Asia. Although the Company obtains certain of these components from single source suppliers, it generally owns all tooling and management has located alternative suppliers to reduce the risk in most cases to supplier problems that could result in significant production delays. The Company has not historically experienced significant supply disruptions from any of its principal vendors and does not anticipate future supply disruptions. The Company acquires most of its components on a purchase order basis and does not have long-term contracts with its suppliers.

NOTE 4. INVENTORIES

Inventories consisted of the following at June 30, 2017March 31, 2018 and December 31, 2016:2017:

Finished goods inventory includes units held by potential customers and sales agents for test and evaluation purposes. The cost of such units totaled $692,594$463,083 and $634,059$680,805 as of June 30, 2017March 31, 2018 and December 31, 2016,2017, respectively.

NOTE 5. FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment consisted of the following at June 30, 2017March 31, 2018 and December 31, 2016:2017:

Depreciation and amortization of furniture, fixtures and equipment aggregated $261,938$116,550 and $274,889$126,796 for the sixthree months ended June 30,March 31, 2018 and 2017, and 2016, respectively.

NOTE 6. SECURED CONVERTIBLE DEBENTURES SUBORDINATED NOTES PAYABLE, AND CAPITAL LEASE OBLIGATIONS

2016 Secured Convertible Debentures. Secured Convertible Debentures is comprised of the following:

On December 30, 2016, the Company completed a private placement (the “Private“2016 Private Placement”) of $4.0 million in principal amount of the Debentures and common stock warrants (the “Warrants”) to two institutional investors. The Debentures and Warrants were issued pursuant to a Securities Purchase Agreement (the “Purchase Agreement”) between the Company and the purchasers’ signatory thereto (the “Holders”). The 2016 Private Placement resulted in gross proceeds of $4.0 million before placement agent fees and other expenses associated with the transaction totaling $281,570, which was expensed as incurred.

The Company elected to account for the Debentures on the fair value basis. Therefore, the Company determined the fair value of the Debentures utilizing Monte Carlo simulation models which yielded an estimated fair value of $4.0 million for the Debentures including their embedded derivatives as of the origination date. No value was allocated to the detachable Warrants as of the origination date because of the relative fair value of the convertible note including its embedded derivative features approximated the gross proceeds of the financing transaction. The Company made principal payments of $750,000 on August 24, 2017 on the Debentures. The change in the fair value of the Debentures between December 31, 20162017 and June 30, 2017March 31, 2018 was $(73,742)$12,807 and was reflected as a chargechange in fair value of secured convertible debentures in the Condensed Consolidated Statement of Operations.

Prior to the maturity date, the Debentures bear interest at 8% per annum with interest payable in cash quarterly in arrears on the first business day of each calendar quarter following the issuance date. The Debentures rank senior to the Company’s existing and future indebtedness and are secured by substantially all tangible and certain intangible assets of the Company.

The Debentures are convertible at any time six months after their date of issue at the option of the holders into shares of the Company’s common stock at $5.00 per share (the “Conversion Price”). The Debentures maturematured on March 30, 2018. The Warrants are exercisable to purchase up to an aggregate of 800,000 shares of the Company’s common stock commencing on the date of issuance at an exercise price of $5.00 per share (the “Exercise Price”). The Warrants will expire on the fifth anniversary of their date of issuance. The Conversion Price and Exercise Price are subject to adjustment upon stock splits, reverse stock splits, and similar capital changes.

The Company has the right, subject to certain limitations, to redeem the DebentureDebentures with 30 days advance notice with the redemption amount determined as the sum of (a) 112% of the then outstanding principal amount of the Debenture,Debentures, (b) accrued but unpaid interest and (c) all liquidated damages and other amounts due in respect of the Debenture,Debentures, if any.

Additionally, if following the six-month anniversary of the Original Issue Date, the VWAP (volume weighted average price), for each of any ten (10) consecutive trading days exceeds $7.50 per share, the Company has the right, subject to certain limitations, to provide written notice to the Holders to cause them to convert all or part of the then outstanding principal amount of the Debenture plus accrued but unpaid interest.

Upon the occurrence of an event of default, the Debentures bear interest at 18% per annum and a Holder may require the Company to redeem all or a portion of its Debenture. The Company has agreed to maintain a cash balance of $500,000 while the Debentures are outstanding, which is reflected as restricted cash in the accompanying balance sheet.outstanding. The Holders have agreed to beneficial conversion limitation that effectively blocks either Holder from converting the DebentureDebentures or exercising the WarrantWarrants to the extent that such conversion or exercise would result in the Holder being the beneficial owner in excess of 4.99% (or, upon election of purchaser, 9.99%), which beneficial ownership limitation may be increased or decreased up to 9.99% upon notice to the Company, provided that any increase in such limitation will not be effective until 61 days following notice to the Company.

The Company paid the Debentures on April 3, 2018 as described in Note 14. Subsequent Events. The Company recorded accrued debt extinguishment costs of $500,000 as of March 31, 2018 related to the repayment and extinguishment of these Debentures.

Subordinated and Secured Notes Payable. Subordinated and secured notes payable is comprised of the following:

On June 30, 2017, the Company, in two separate transactions, borrowed an aggregate of $700,000 under two unsecured notes payable to private, third-party lenders. The loans were funded on June 30, 2017 and both arewere represented by promissory notes (the “Notes”“June Notes”) that bearbore interest at the rate of 8% per annum with principal and accrued interest payable on or before their maturity date of September 30, 2017. The June Notes arewere unsecured and subordinated to all existing and future senior indebtedness, as such term iswas defined in the June Notes.

The Company granted the lenders warrants (the “Warrants”) exercisable to purchase a total of 200,000 shares of its common stock at an exercise price of $3.65 per share until June 29, 2022.

The Company allocated $288,895 of the proceeds of the Notes to additional paid-in-capital, which represented the grant date relative fair value of the Warrants for 200,000 common shares issued to the lenders. The discount was amortized to interest expense ratably over the terms of the Note. On September 30, 2017, the Company obtained an extension of the maturity date of one of the June Notes to December 31, 2017 and then an extension to March 31, 2018. In connection with the initial extension, the Company issued warrants to purchase 100,000 shares of stock at $2.60 per share until November 15, 2022. On March 16, 2018, the Company issued warrants to purchase 60,000 shares of stock at $3.25 per share until March 15, 2029 for the subsequent extension. The Company treated the initial extension of this debt as an extinguishment for financial accounting purposes. Accordingly, the estimated fair value of the warrants granted totaled $180,148, which was recorded as additional paid-in-capital and a loss on extinguishment of subordinated notes payable. The Company allocated $32,370 of the proceeds of the Notes to additional paid-in-capital, which represented the grant date relative fair value of the Warrants for the subsequent extension. The discount was amortized to interest expense ratably over the terms of the Note. The Company paid the second June Note in full in August 2017.

On September 29, 2017, the Company borrowed $300,000 under an unsecured note payable with a private, third party lender. Such note bore interest at 8% per annum and was due and payable in full on November 30, 2017. The note was unsecured and subordinated to all existing and future senior indebtedness, as such term was defined in the note. The Company issued warrants to the lender exercisable to purchase 100,000 shares of common stock for $2.75 per share until September 30, 2022. The Company allocated $117,000 of the proceeds of the note to additional paid-in-capital, which represented the grant date relative fair value of the warrants issued to the lender. The discount was amortized to interest expense ratably over the terms of the note. On December 29, 2017 the Company borrowed an additional $350,000 with the same private, third party lender and combined the existing note payable plus accrued interest into a new note (the “Secured Note”) for $658,500 that was due and payable in full on March 1, 2018 and may be prepaid without penalty. The Secured Note is secured by the Company’s intellectual property portfolio, as such term is defined in the security agreement relating to the Secured Note. In connection with issuance of the Secured Note the Company issued warrants to the lender exercisable to purchase 120,000 shares of common stock for $3.25 per share until December 28, 2022. The Company treated the issuance and extension of this debt as an extinguishment for financial accounting purposes. Accordingly, the estimated fair value of the warrants granted totaled $244,379, which was recorded as additional paid-in-capital and a loss on extinguishment of subordinated notes payable.

The Company paid the Secured and subordinated notes with an aggregate principal balance of $1,008,500 on April 3, 2018 as described in Note 14, “Subsequent Events.”

On March 7, 2018 the Company borrowed $250,000 under a secured note payable with a private, third party lender (the “March Note”). The March Note bears interest at 12% per annum and is due and payable in full on June 7, 2018. The March Note is secured by the inventory of the Company and junior to senior liens held by the Holders of the Debentures and subordinated to all existing and future senior indebtedness, as such term was defined in the March Note. Such Note is convertible at any time after its date of issue at the option of the holder into shares of the Company’s common stock at $3.25 per share (the “Conversion Price”). The March Note matures on June 7, 2018. The Conversion Price and Exercise Price are subject to adjustment upon stock splits, reverse stock splits, and similar capital changes. The Company issued warrants to the lender exercisable to purchase 36,000 shares of common stock for $3.50 per share until March 7, 2019. The Company allocated $15,287 of the proceeds of the note to additional paid-in-capital, which represented the grant date relative fair value of the warrants issued to the lender. The discount will be amortized to interest expense ratably over the terms of the Note.

Capital Leases. Future minimum lease payments under non-cancelable capital leases having terms in excess of one year are as follows:note.

Assets under capital leases are included in furniture, fixturesThe discount amortized to interest expense totaled $36,192 and equipment as follows:$-0- for the three months ended March 31, 2018, and 2017, respectively.

NOTE 7. FAIR VALUE MEASUREMENT

In accordance with ASC Topic 820 —Fair Value Measurements and Disclosures (“ASC 820”), the Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets or liabilities, such as a business.

ASC 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

The following table represents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2017March 31, 2018 and December 31, 2016.2017.

The following table represents the change in levelLevel 3 tier value measurements:

NOTE 8. ACCRUED EXPENSES

Accrued expenses consisted of the following at June 30, 2017March 31, 2018 and December 31, 2016:2017:

Accrued warranty expense was comprised of the following for the sixthree months ended June 30, 2017:March 31, 2018:

NOTE 9. INCOME TAXES

The effective tax rate for the three and six months ended June 30,March 31, 2017 and 2016 varied from the expected statutory rate due to the Company continuing to provide a 100% valuation allowance on net deferred tax assets. The Company determined that it was appropriate to continue the full valuation allowance on net deferred tax assets as of June 30,March 31, 2017 primarily because of the current yearhistory of operating losses.

The valuation allowance on deferred tax assets totaled $24,130,000 and $22,455,000 as of June 30, 2017 and December 31, 2016, respectively.

The Company records the benefit it will derive in future accounting periods from tax losses and credits and deductible temporary differences as “deferred tax assets.” In accordance with Accounting Standards Codification (ASC) 740, “Income Taxes,” the Company records a valuation allowance to reduce the carrying value of its deferred tax assets if, based on all available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

At June 30, 2017, the Company had available approximately $44,200,000 of net operating loss carryforwards available to offset future taxable income generated. Such tax net operating loss carryforwards expire between 2023 and 2037. In addition, the Company had research and development tax credit carryforwards approximating $2,060,000 available as of June 30, 2017, which expire between 2023 and 2037.

The Internal Revenue Code contains provisions under Section 382 which limit a company’s ability to utilize net operating loss carry-forwards in the event that it has experienced a more than 50% change in ownership over a three-year period. Current estimates prepared by the Company indicate that due to ownership changes which have occurred, approximately $765,000 of its net operating loss and $175,000 of its research and development tax credit carryforwards are currently subject to an annual limitation of approximately $1,151,000, but may be further limited by additional ownership changes which may occur in the future. As stated above, the net operating loss and research and development credit carryforwards expire between 2023 and 2037, allowing the Company to potentially utilize all of the limited net operating loss carry-forwards during the carryforward period.

As discussed in Note 1, “Summary of Significant Accounting Policies,” tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold, it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Management has identified no tax positions taken that would meet or exceed these thresholds and therefore there are no gross interest, penalties and unrecognized tax expense/benefits that are not expected to ultimately result in payment or receipt of cash in the consolidated financial statements.

The Company’s federal and state income tax returns are closed for examination purposes by relevant statute and by examination for 2012 and all prior tax years.

NOTE 10. COMMITMENTS AND CONTINGENCIES

Operating Leases. The Company has severalWe have a non-cancelable long-term operating lease agreementsagreement for office space and warehouse space that expire at various dates throughexpires during April 2020. The Company hasWe have also entered into month-to-month leases for equipment.equipment and facilities. Rent expense was $99,431 and $99,431 for the three months ended June 30,March 31, 2018 and 2017 was $99,431 and 2016,$99,431, respectively, and $198,862 and $198,862, for the six months ended June 30, 2017 and 2016, respectively.related to these leases. Following are theour minimum lease payments for each year and in total.

License agreements.The Company has several license agreements wherebyunder which it has been assigned the rights to certain licensed materials used in its products. Certain of these agreements require the Company to pay ongoing royalties based on the number of products shipped containing the licensed material on a quarterly basis. Royalty expense related to these agreements aggregated $6,250$2,083 and $6,250$2,438 for the three months ended June 30,March 31, 2018 and 2017, and 2016, respectively, and $8,688 and $12,661 for the six months ended June 30, 2017 and 2016, respectively.

Litigation.

The Company is subject to various legal proceedings arising from normal business operations. Although there can be no assurances, based on the information currently available, management believes that it is probable that the ultimate outcome of each of the actions will not have a material adverse effect on the consolidated financial statementConsolidated Financial Statements of the Company. However, an adverse outcome in certain of the actions could have a material adverse effect on the financial results of the Company in the period in which it is recorded.

Axon Enterprise, Inc. – (Formerly Taser International, Inc.)

The Company owns U.S. Patent No. 8,781,2929,253,452 (the “ ‘292“452 Patent”), which is directed to a system that determines when a recording device, such as a law enforcement officer’s body camera or in-car video recorder, begins recording and automatically instructs other recording devices to begin recording. The technology described in the ‘292 Patent is incorporated in the Company’s VuLink product.

The Company received notice in April 2015 that Taser International, Inc., now known as Axon Enterprises, Inc. (“Axon”), had commenced an action in the U.S. Patent and Trademark Office (the “USPTO”) for a re-examination of the ‘292 patent. A re-examination is essentially a request that the USPTO review whether the patent should have issued in its present form in view of the “prior art,” e.g., other patents in the same technology field. The prior art used by Axon was from an unrelated third party and was not the result of any of Axon’s own research and development efforts.

On January 14, 2016 the USPTO ultimately rejected Axon’s efforts and confirmed the validity of the ‘292 Patent with 59 claims covering various aspects of the Company’s auto-activation technology. On February 2, 2016 the USPTO issued another patent relating to the Company’s auto-activation technology for law enforcement cameras. U.S. Patent No. 9,253,452 (the “ ‘452 Patent”) generally covers the automatic activation and coordination of multiple recording devices in response to a triggering event, such as a law enforcement officer activating the light bar on the vehicle.

The Company filed suit on January 15, 2016 in the U.S. District Court for the District of Kansas (Case No: 2:16-cv-02032) against Axon, alleging willful patent infringement against Axon’s body camera product line.line and Signal auto-activation product. The Company later added the ‘452 patent to the suit and is seeking both monetary damages and a permanent injunction against Axon for infringement of both the ‘452 and ‘292 Patents.Patent.

In addition to the infringement claims, the Company added a new set ofbrought claims to the lawsuit alleging that Axon conspired to keep the Company out of the marketplace by engaging in improper, unethical, and unfair competition. The amended lawsuit alleges Axon bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. The Company’s lawsuit also seeks monetary and injunctive relief, including treble damages, for these alleged violations.

Axon filed an answer, which denied the patent infringement allegations on April 1, 2016. In addition, Axon filed a motion to dismiss all allegations in the complaint on March 4, 2016 for which the Company filed an amended complaint on March 18, 2016 to address certain technical deficiencies in the pleadings. Axon amended and renewed its motion to seek dismissal of the allegations that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law on April 1, 2016. Formal discovery commenced on April 12, 2016 with respect to the patent related claims. In January 2017, the Court granted Axon’s motion to dismiss the portion of the lawsuit regarding claims that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. The Company has appealed this decision to the United States Court of Appeals for the Federal Circuit and is awaiting its decision.

In December 2016 and January 2017, Axon announced that it had commenced an action in the USPTOfiled two petitions forinter partes reviewInter Partes Review (“IPR”) of the Company’s ‘292 Patent. Previously Axon had attempted to invalidate the ‘292 Patent through a re-examination procedure at the USPTO. Axon is again attempting through its recently filed petition to convince the USPTO that Digital Ally’s patents lack patentability. Axon subsequently filed another action for an IPR against the ‘292 Patent and two more petitions against the ‘452 Patent. The USPTO rejected one of Axon’s requests on the ‘292United States Patent and instituted an investigation of the other petition. As for the ‘452 Patent, the courtTrademark Office (“USPTO”) rejected both of Axon’s requests on the petition challenging the claims at issue in the lawsuit.petitions. Axon is now statutorily precluded from filing any more IPR petitions against either the ‘292 or ‘452 Patents.Patent.

The District Court litigation in Kansas has beenwas temporarily stayed sincefollowing the filing of the petitions for IPR, TheIPR. However, on November 17, 2017, the Federal District Court however, requested an updateof Kansas rejected Axon’s request to maintain the stay. With this significant ruling, the parties will now proceed towards trial. Since litigation has resumed, aMarkman hearing was held on the status of the petitionsMarch 7, 2018 and the Company has provided such an update afterparties have continued to engage in discovery. All remaining significant deadlines will be set when the decision was rendered which denied the final ‘452 Patent petition. Because both of Axon’s petitions for an IPR on the ‘452 Patent that related to the claims in the lawsuit were denied, the Company is seeking to lift the stay and proceed with the lawsuit to a trial where the question of infringement and damages can be addressed.Court issues itsMarkmanorder.

Enforcement Video, LLC d/b/a WatchGuard Video

On May 27, 2016 the Company filed suit against Enforcement Video, LLC d/b/a WatchGuard, Video (“WatchGuard”), (Case No. 2:16-cv-02349-JTM-JPO) alleging patent infringement based on WatchGuard’s VISTA Wifi and 4RE In-Car product lines.

The USPTO has granted multiple patents to the Company with claims covering numerous features, such as automatically activating all deployed cameras in response to the activation of just one camera. Additionally, Digital Ally’s patent claims cover automatic coordination as well as digital synchronization between multiple recording devices. Digital AllyIt also has patent coverage directed to the coordination between a multi-camera system and an officer’s smartphone, which allows an officer to more readily assess an event on the scene while an event is taking place or immediately after it has occurred.

The Company’s lawsuit alleges that WatchGuard incorporated this patented technology into its VISTA Wifi and 4RE In-Car product lines without its permission. Specifically, Digital Ally is accusing WatchGuard of infringing three patents: the U.S Patent No. 8,781,292 (the “ ‘292 Patent”) and ‘452 Patents and U.S. Patent No. 9,325,950 the (“ ‘950 Patent”). The Company is aggressively challenging WatchGuard’s infringing conduct, seeking both monetary damages, as well as seeking a permanent injunction preventing WatchGuard from continuing to sell its VISTA Wifi and 4RE In-Car product lines using Digital Ally’s own technology to compete against it. On May 8, 2017, WatchguardWatchGuard filed a petition seeking IPR of the ‘950 Patent. The Company will vigorously oppose that petition. On December 4, 2017 The Patent Trial and Appeal Board (“PTAB”) will not issue a decision on whetherrejected the request of WatchGuard Video to institute until approximately November 2017.an IPR on the ‘950 Patent. The lawsuit also involves the ‘292 Patent and the ‘452 Patent, the same two patents asserted against Axon. The ‘292 Patent is in the IPR process with the USPTO, which is expected to be ruled on in June 2018, while WatchGuard is now statutorily barred from any further IPR’s challenges with respect to the ‘950 Patent. The lawsuit has been stayed pending a decision from the USPTO on whether to institute that petition.the ‘292 Patent IPR petition which is expected in June 2018.

Utility Associates, Inc.

On October 25, 2013, the Company filed a complaint in the United States District Court for the District of Kansas (2:13-cv-02550-SAC) to eliminate threats by a competitor, Utility Associates, Inc. (“Utility”), of alleged patent infringement regarding U.S. Patent No. 6,831,556 (the “ ‘556 Patent”). Specifically, the lawsuit seeks a declaration that the Company’s mobile video surveillance systems do not infringe any claim of the ‘556 Patent. The Company became aware that Utility had mailed letters to current and prospective purchasers of its mobile video surveillance systems threatening that the use of such systems purchased from third parties not licensed to the ‘556 Patent would create liability for them for patent infringement. The Company rejected Utility’s assertion and is vigorously defending the right of end-users to purchase such systems from providers other than Utility. The United States District Court for the District of Kansas dismissed the lawsuit because it decided that Kansas was not the proper jurisdictional forum for the dispute. The District Court’s decision was not a ruling on the merits of the case. The Company appealed the decision and the Federal Circuit affirmed the District Court’s previous decision.

In addition, the Company began proceedings to invalidate the ‘556 Patent through a request for IPR of the ‘556 patent at the USPTO. On July 27, 2015, the USPTO invalidated key claims in Utility’s ‘556 Patent. The Final Decision from the USPTO significantly curtailscurtailed Utility’s ability to threaten law enforcement agencies, municipalities, and others with infringement of the ‘556 Patent. Utility appealed this decision to the United States Court of Appeals for the Federal Circuit. The United States Court of Appeals for the Federal Circuit denied Utility’s appeal and therefore confirmedaffirmed the ruling of the USPTO. This denial of Utility’s appeal finalizedUSPTO summarily thus concluding the USPTO’s ruling in Digital’s favor and the matter is now concluded.matter.

On June 6, 2014 the Company filed ana separate Unfair Competition lawsuit against Utility in the United States District Court for the District of Kansas. In thethat lawsuit it contendscontended that Utility has defameddisparaged the Company and illegally interfered with its contracts, customer relationships and business expectancies by falsely asserting to its customers and others that its products violate the ‘556 Patent, of which Utility claims to be the holder.

The suit also includes claims against Utility for tortious interference with contracts and violation of the Kansas Uniform Trade Secrets Act (KUSTA), arising out of Utility’s employment of the Company’s employees, in violation of that employee’s Non-Competition and Confidentiality agreements with the Company. In addition to damages, the Company seeks temporary, preliminary, andsought permanent injunctive relief, prohibiting Utility from among other things, continuing to threatenthreated or otherwise interfere with the Company’s customers. On March 4, 2015, an initial hearing was held upon the Company’s request for injunctive relief.

Based upon facts revealed at thea March 4, 2015 injunction hearing, on March 16, 2015, the Company sought leave to amend its Complaint in the Kansasunfair competition suit to assert additional claims against Utility. Those new claims includeincluded claims of actual or attempted monopolization, in violation of § 2 of the Sherman Act, claims arising under a new Georgia statute that prohibits threats of patent infringement in “bad faith,” and additional claims of unfair competition/false advertising in violation of § 63(a) of the Lanham Act. As these statutes expressly provide, the Company will seek treble damages, punitive damages and attorneys’ fees as well as injunctive relief. The Court concluded its injunction hearing on April 22, 2015, and allowed the Company leave to amend its complaint,add these claims, but denied its preliminary injunction. TheSubsequent to the injunction hearing, Utility withdrew from the market the in-car video recording device that it had sold in competition with the Company’s own products of similar function and which Utility had attempted to market using threats of patent infringement. After discovery stage of the lawsuit expired in May 2016.closed, Utility filed a Motion for Summary Judgment and the Company filed a Motion for Partial Summary Judgment. On March 30, 2017, the Court entered its order granting Utility’s motion and denying the Company’s motion for summary judgment in their entireties.judgment. The Company believesbelieved the District Court had made several errors when ruling on the motions for summary judgment, in light of the USPTO’s final decision issued on July 27, 2015 and the various facts and admissions already presented to such Court and is filingfiled an appeal to the United States Court of Appeals for the Tenth Circuit.

On September 13, 2014,Circuit (10^th Circuit”). While the appeal was pending, Utility filed suita motion for the recovery from the Company of some $800,000 in alleged attorney’s fees as provided, purportedly, under the Lanham Patent and Uniform Trade Secrets Act. That motion was denied in its entirety by final judgement entered February 14, 2018. On February 16, 2018, the 10^th Circuit issued its decision affirming the decision of the District Court. The Company filed a petition for rehearing by the panel and en banc, which has also been denied. Utility has filed its own motion for the recovery of attorney fees, on appeal in the United States District Court for the Northern Districtalleged amount of Georgia against the Company alleging infringement of the ‘556 Patent. The suit was served on$125,000. That motion has not yet been fully briefed, but will be opposed by the Company on September 20, 2014. As alleged insubstantially the Company’s first filed lawsuit described above, the Company believes that the ‘556 Patent is both invalid and not infringed. Further, the USPTO has issued its final decision invalidating 23 of the 25 claims asserted in the ‘556 Patent, as noted above. The Company believes that the suit filed by Utility is without merit and is vigorously defending the claims asserted against the Company. An adverse resolution of the foregoing litigation or patent proceedings could have a material adverse effect on the Company’s business, prospects, results of operations, financial condition, and liquidity. The Court stayed all proceedings with respect to this lawsuit pending the outcome of the patent review performedsame grounds up which Utility’s prior motion for attorney’s fees was denied by the USPTO and the appellate court. Based on the USPTO’s final decision to invalidate substantially all claims contained in the ‘556 Patent and the United States Court of Appeals for the Federal Circuit full denial of Utility’s appeal, the Company intends to file for summary judgment in its favor if Utility does not request outright dismissal.

District Court.

The Company is also involved as a plaintiff and defendant in ordinary, routine litigation and administrative proceedings incidental to its business from time to time, including customer collections, vendor and employment-related matters. The Company believes the likely outcome of any other pending cases and proceedings will not be material to its business or its financial condition.

Sponsorship.On April 16, 2015 the Company entered into a Title Sponsorship Agreement (the “Agreement”) under which it became the title sponsor for a Web.com Tour golf tournament (the “Tournament”) held annually in the Kansas City Metropolitan area. The Agreement provides the Company with naming rights and other benefits for the 2015 through 2019 annual Tournament in exchange for the following sponsorship fee:

The Company has the right to sell and retain the proceeds from the sale of additional sponsorships, including but not limited to a presenting sponsorship, a concert sponsorship and founding partnerships for the Tournament. The Company recorded a net sponsorship expense of $6,595 and $-0-, respectively,$0 for the sixthree months ended June 30, 2017March 31, 2018 and 2016.2017. The Company is negotiating with the Web.com Tour golf tournament officials to terminate the Agreement and the sponsorship fee commitments for the 2018 and 2019 Tournaments. There can be no assurance that it will be successful in negotiating the termination of this sponsorship agreement or that if successful in such negotiations, on terms acceptable or favorable to the Company

401 (k) Plan.In July 2008, the Company amended and restated its 401(k) retirement savings plan. The amended plan requires the Company to provide 100% matching contributions for employees who elect to contribute up to 3% of their compensation to the plan and 50% matching contributions for employee’s elective deferrals on the next 2% of their contributions. The Company hashad made matching contributions totaling $47,055$29,375 and $47,453$47,273 for the three months ended June 30,March 31, 2018 and 2017, and 2016, respectively, and $94,326 and $88,711 for the six months ended June 30, 2017 and 2016, respectively. Each participant is 100% vested at all times in employee and employer matching contributions.

Consulting and Distributor Agreements.The Company entered into an agreement that requiresrequired it to make monthly payments whichthat will be applied to future commissions and/or consulting fees to be earned by the provider. The agreement is with a limited liability company (“LLC”) that is minority owned by a relative of the Company’s chief financial officer. Under the agreement, dated January 15, 2016 and as amended on February 13, 2017, the LLC provides consulting services for developing a new distribution channel outside of law enforcement for its body-worn camera and related cloud storage products to customers in the United States. The Company paidadvanced amounts to the LLC andas advance against commissions ranging from $5,000 to $6,000 per month plus necessary and reasonable expenses for athe period of one year beginning January 2016,through June 30, 2017, which can be automatically extended based on the LLC achieving minimum sales quotas. The agreement was renewed in January 2017 for a period of three years, subject to yearly minimum sales thresholds that would allow the Company to terminate the contract if such minimums are not met. As of June 30, 2017,March 31, 2018, the Company had advanced a total of $289,315$283,731 pursuant to this agreement.agreement and established an allowance reserve of $85,835 for a net advance of $197,896. The minimum sales threshold has not been met, and the Company has discontinued all advances, although the contract has not been formally terminated.

NOTE 11. STOCK-BASED COMPENSATION

The Company recorded pretax compensation expense related to the grant of stock options and restricted stock issued of $115,756$493,519 and $355,236,$387,033 for the three ended June 30, 2017 and 2016, and $502,789 and $781,066 for the six months ended June 30,March 31, 2018 and 2017, and 2016, respectively.

As of June 30, 2017,March 31, 2018, the Company had adopted seven separate stock option and restricted stock plans: (i) the 2005 Stock Option and Restricted Stock Plan (the “2005 Plan”), (ii) the 2006 Stock Option and Restricted Stock Plan (the “2006 Plan”), (iii) the 2007 Stock Option and Restricted Stock Plan (the “2007 Plan”), (iv) the 2008 Stock Option and Restricted Stock Plan (the “2008 Plan”), (v) the 2011 Stock Option and Restricted Stock Plan (the “2011 Plan”), (vi) the 2013 Stock Option and Restricted Stock Plan (the “2013 Plan”) and (vii) the 2015 Stock Option and Restricted Stock Plan (the “2015 Plan”). The 2005 Plan, 2006 Plan, 2007 Plan, 2008 Plan, 2011 Plan, 2013 Plan and 2015 Plan are referred to as the “Plans.”

These Plans permit the grant of stock options or restricted stock to its employees, non-employee directors and others for up to a total of 1,925,0002,425,000 shares of common stock. The 2005 Plan terminated during 2015 with 284,653 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2005 Plan that remain unexercised and outstanding as of June 30, 2017March 31, 2018 total 26,813.23,125. The 2006 Plan terminated during 2016 with 4,50520,587 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2006 Plan that remain unexercised and outstanding as of June 30, 2017March 31, 2018 total 62,080.46,387. The 2007 Plan terminated during 2017 with 48,50082,151 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2007 Plan that remain unexercised and outstanding as of June 30, 2017March 31, 2018 total 41,875.12,500.

The Company believes that such awards better align the interests of our employees with those of its stockholders. Option awards have been granted with an exercise price equal to the market price of its stock at the date of grant with such option awards generally vesting based on the completion of continuous service and having ten-year contractual terms. These option awards typically provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company has registered all shares of common stock that are issuable under its Plans with the SEC. A total of 8,363108,563 shares remained available for awards under the various Plans as of June 30, 2017.March 31, 2018.

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. There were no stock options issued during the sixthree months ended June 30, 2017.March 31, 2018.

Activity in the various Plans during the sixthree months ended June 30, 2017March 31, 2018 is reflected in the following table: