Identiphi (IDPIQ) 10-Q 2003 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

COMMISSION FILE NUMBER 0-20270

SAFLINK CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	95-4346070
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

777 108th Ave NE, Suite 2100, Bellevue, Washington 98004

(Address of principal executive offices and zip code)

(425) 278-1100

(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 is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes  ¨  No  x

There were 27,036,767 shares of SAFLINK Corporation’s common stock outstanding as of November 4, 2003.

SAFLINK Corporation

FORM 10-Q

For the Quarter Ended September 30, 2003

INDEX

Part I.	Financial Information
	Item 1.	Financial Statements (Unaudited)
	a.	Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002	3
	b.	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002	4
	c.	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002	5
	d.	Notes to Condensed Consolidated Financial Statements	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	22
	Item 4.	Controls and Procedures	22
Part II.	Other Information
	Item 1.	Legal Proceedings	23
	Item 2.	Changes in Securities	23
	Item 6.	Exhibits and Reports on Form 8-K	23
Signatures			24

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PART I –FINANCIAL INFORMATION

ITEM 1.FINANCIAL STATEMENTS

SAFLINK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)

	September 30, 2003			December 31, 2002
ASSETS
Current assets:
Cash and cash equivalents	$	9,939		$	7,447
Accounts receivable, net		727			143
Inventory		146			39
Other current assets		543			790
Total current assets		11,355			8,419
Furniture and equipment, net		594			199
	$	11,949		$	8,618
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	349		$	758
Accrued expenses		746			467
Deferred revenue		39			130
Total current liabilities		1,134			1,355
Stockholders’ equity:
Preferred stock		—			—
Common stock		270			196
Additional paid-in capital		103,659			92,316
Accumulated deficit		(93,114	)		(85,249	)
Total stockholders’ equity		10,815			7,263
	$	11,949		$	8,618

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share and per share data)

	Three months ended September 30,						Nine months ended September 30,
	2003			2002			2003			2002
Revenue:
Product	$	331		$	79		$	688		$	336
Service		432			287			839			590
Total revenue		763			366			1,527			926
Cost of revenue:
Product		125			39			216			318
Service		175			55			338			178
Total cost of revenue		300			94			554			496
Gross profit		463			272			973			430
Operating expenses:
Product development		687			447			1,873			1,255
Sales and marketing		1,317			415			3,802			1,143
General and administrative		956			880			3,203			2,783
Total operating expenses		2,960			1,742			8,878			5,181
Operating loss		(2,497	)		(1,470	)		(7,905	)		(4,751	)
Interest expense		(6	)		(5	)		(11	)		(43	)
Other income (expense), net		20			8			51			12
Net loss		(2,483	)		(1,467	)		(7,865	)		(4,782	)
Preferred stock dividend		—			—			—			4,731
Net loss attributable to common stockholders	$	(2,483	)	$	(1,467	)	$	(7,865	)	$	(9,513	)
Basic and diluted loss per common share:
Net loss	$	(0.09	)	$	(0.08	)	$	(0.31	)	$	(0.35	)
Preferred stock dividend		—			—			—			(0.34	)
Net loss attributable to common stockholders	$	(0.09	)	$	(0.08	)	$	(0.31	)	$	(0.69	)
Weighted average number of common shares outstanding		26,936			17,701			24,980			13,820

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Nine months ended September 30,
	2003			2002
Cash flows from operating activities:
Net loss	$	(7,865	)	$	(4,782	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock-based compensation		661			324
Depreciation and amortization		151			186
Changes in operating assets and liabilities:
Accounts receivable		(584	)		(336	)
Inventory		(107	)		(30	)
Other current assets		(370	)		(158	)
Accounts payable		(409	)		(479	)
Accrued expenses		279			(476	)
Deferred revenue		(91	)		(21	)
Net cash used in operating activities		(8,335	)		(5,772	)
Cash flows from investing activities:
Purchases of property and equipment		(546	)		(50	)
Cash used in investing activities		(546	)		(50	)
Cash flows from financing activities:
Payments on notes payable		—			(1,435	)
Proceeds from exercises of stock options		1,487			103
Proceeds from warrant exercises and issuance of common stock, net of issuance costs		9,886			11,439
Net cash provided by financing activities		11,373			10,107
Net increase in cash and cash equivalents		2,492			4,285
Cash and cash equivalents at beginning of period		7,447			64
Cash and cash equivalents at end of period	$	9,939		$	4,349
Non-cash financing and investing activities:
Preferred stock dividend	$	—		$	4,731
Conversion of note payable to common stock		—			1,506
Conversion of Series E preferred stock		12			23
Cashless exercises of warrants		3			—
Issuance of common stock and warrants for prepaid services		—			175

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Basis of Presentation

The accompanying condensed consolidated financial statements present unaudited interim financial information and therefore do not contain certain information included in the annual consolidated financial statements of SAFLINK Corporation and its wholly-owned subsidiary, SAFLINK International, Inc., (the “Company” or “SAFLINK”). The balance sheet at December 31, 2002, has been derived from the Company’s audited financial statements as of that date. In the opinion of management, all adjustments (consisting only of normally recurring items) it considers necessary for a fair presentation have been included in the accompanying condensed consolidated financial statements. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002, as filed with the Securities and Exchange Commission (the “SEC”) on March 28, 2003.

Certain balances have been reclassified to conform to current period presentation. Such reclassifications had no impact on the results of operations or stockholders’ equity for any period presented. All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s condensed consolidated interim financial statements are not necessarily indicative of results to be expected for a full fiscal year.

2. Stock Based Compensation

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to account for its stock options. Under this method, compensation expense is recognized only if the current market price of the underlying stock exceeded the exercise price on the date of grant. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net loss if the fair-value-based method had been applied to all outstanding and unvested awards in each period.

	Three months ended September 30,						Nine months ended September 30,
	2003			2002			2003			2002
	(In thousands, except per share data)						(In thousands, except per share data)
Net loss attributable to common stockholders	$	(2,483	)	$	(1,467	)	$	(7,865	)	$	(9,513	)
Add stock-based employee compensation expense included in reported net loss		—			14			15			30
Deduct total stock-based employee compensation expense determined under fair-value-based method for all awards		(1,502	)		(928	)		(3,886	)		(3,146	)
Pro forma net loss attributable to common stockholders		(3,985	)		(2,381	)		(11,736	)		(12,629	)
Basic and diluted loss per common share, as reported		(0.09	)		(0.08	)		(0.31	)		(0.69	)
Basic and diluted loss per common share, pro forma		(0.15	)		(0.13	)		(0.47	)		(0.91	)

The Company accounts for non-employee stock-based compensation in accordance with SFAS No. 123 and EITF No. 96-18.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

3. Stockholders’ Equity

During January 2003, in accordance with anti-dilution provisions contained in certain warrants to purchase shares of the Company’s common stock, the number of shares of common stock issuable upon exercise of Series A warrants increased by approximately 200,000 shares and the exercise price per share decreased from $3.50 to either $2.83 or $3.12, dependent upon the warrant holders’ contractual rights. In addition, the number of shares of the Company’s common stock issuable upon exercise of Series C warrants increased by approximately 247,000 shares and the exercise price per share decreased from $2.25 to $2.14. The number of shares of the Company’s common stock issuable upon exercise of other warrants increased by an aggregate of approximately 42,000 shares with corresponding exercise price reductions.

On February 20, 2003, an aggregate of 1,054,000 shares of common stock were issued to SDS Merchant Fund, LP upon conversion of 7,378 shares of Series E preferred stock. Also, during the three months ended March 31, 2003, 36,429 shares of common stock were issued to other various investors upon conversion of 255 shares of Series E preferred stock.

During the three months ended June 30, 2003, an aggregate of 75,715 shares of common stock were issued to two investors upon conversion of 530 shares of Series E preferred stock.

There were no conversions of Series E preferred stock during the three months ended September 30, 2003.

In January and February 2003, the Company received approximately $9.4 million in net proceeds upon the exercise of warrants to purchase approximately 4.9 million shares of common stock. Approximately 4.1 million shares of common stock were issued upon exercise of Series C warrants, 11,133 shares of common stock were issued upon exercise of Series A warrants, and 355,500 shares of common stock were issued upon exercise of warrants associated with the June 2002 financing. In addition, 300,824 shares of common stock were issued upon exercise, and 185,133 shares of common stock were surrendered in connection with the exercise of warrants issued to placement agents and net exercises related to previous financings.

During the three months ended June 30, 2003, the Company received approximately $141,000 in net proceeds upon the exercise of warrants to purchase approximately 57,000 shares of common stock. Exercises during this period were related to placement agents warrants issued for previous financings and warrants that were issued for services to financial advisory consultants.

On July 10, 2003, the Company issued redemption notices, pursuant to the terms of SAFLINK Corporation Series A warrants, to certain qualifying Series A warrant holders. The subsequent exercise of these warrants resulted in net proceeds to the Company of approximately $345,000 and the issuance of approximately 122,000 shares of common stock. Also, during the three months ended September 30, 2003, the Company received an additional $49,000 in net proceeds upon the exercise of warrants to purchase approximately 23,000 shares of common stock related to placement agent and financial advisory warrant issuances.

In January 2002, the Company received funds totaling approximately $5.5 million, net of issuance costs, in connection with the issuance of common stock to certain holders of its Series E preferred stock and the exercise of a portion of its outstanding Series A and Series B warrants to purchase common stock.

Holders of the Company’s Series A and Series B warrants exercised warrants to purchase approximately 4,835,000 shares of the Company’s common stock at a price of $1.00 per share. The exercise price of the warrants was reduced from $1.75 to $1.00, subject to receipt by the Company of the payment in full of such warrant holders’ special exercise price by the close of business on January 8, 2002. In connection with the exercise, each exercising warrant holder received a Series C warrant to purchase that number of shares of the Company’s common stock issued to such holder upon the exercise of the original Series A and Series B warrants.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Due to a restriction in the Series A and Series B warrants held by SAC Capital Associates, LLC and SDS Merchant Fund, LP which precluded each of them from exercising their respective Series A and Series B warrants in excess of 4.9% of the Company’s outstanding common stock, SAC and SDS were unable to exercise their warrants in full but agreed to exercise a portion of their Series A and all of their Series B warrants at a reduced price of $1.00 per share and to purchase approximately 1,200,000 shares of common stock without exercising their warrants. Each of SAC and SDS agreed to purchase at $1.00 per share that number of shares of common stock that the Company would have issued to SAC and SDS above 4.9% if these entities were to fully exercise their respective Series A and Series B warrants. In connection with their warrant exercise, SAC and SDS received a Series C warrant to purchase that number of shares of common stock issued to such purchaser upon the exercise of the original Series A and Series B warrants.

During January of 2002, the Company accounted for the value allocated to the inducement noted above through the issuance of the shares and Series C warrants and the modifications made to the Series A and B warrants as an in-substance dividend in the amount of $4.7 million. The in-substance dividend increased the net loss applicable to common stockholders. The value allocated to the inducement related to the common shares issued, Series C warrants and modifications of the Series A and B warrants, was calculated as the difference between the fair value of modified equity instruments at the modification date and the fair value of the original equity instruments immediately before the terms were amended. The value allocated to the Series C warrants was calculated to be $3.8 million using an option pricing model.

In connection with the exercise of the Series A and B warrants, the anti-dilution provisions of the Series E preferred stock were waived by the requisite majority of the holders of Series E preferred stock. The exercise price of the warrants held by those holders of Series E preferred stock that did not elect to purchase the shares underlying their warrants or otherwise grant a waiver of the anti-dilution provisions were adjusted in January 2003 in accordance with the anti-dilution provisions applicable to such warrants. In connection with the issuance of common stock to SAC and SDS, the Company received a waiver of the anti-dilution provisions of the Series E preferred stock and Series A and B warrants not exercised.

4. Guarantees

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. The Company adopted FIN No. 45 during the quarter ended December 31, 2002. In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FIN No. 45 except for standard indemnification and warranty provisions that are contained within many of its customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN No. 45.

Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in its industry. The duration of the Company’s product warranties generally does not exceed 90 days following delivery of its products. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically and does not expect to incur significant obligations in the near future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

5. Concentration of Credit Risk and Significant Customers

Two customers accounted for 29% and 11% of the Company’s revenue for the nine months ended September 30, 2003, while two customers accounted for 49% and 11% of the Company’s revenue for the three months ended September 30, 2003. Two customers accounted for 58% and 13% of accounts receivable as of September 30, 2003. For the nine months ended September 30, 2002, two customers accounted for 40% and 23% of the Company’s revenue. Two customers accounted for 44% and 38% of the Company’s revenue for the three months ended September 30, 2002, while one customer accounted for 74% of accounts receivable as of December 31, 2002.

6. Comprehensive Loss

For the three and nine months ended September 30, 2003, and 2002, the Company had no components of other comprehensive loss; accordingly, total comprehensive loss equaled the net loss for the respective periods.

7. Net Loss Per Share

In accordance with SFAS No. 128, “Earnings Per Share,” the Company has reported both basic and diluted net loss per common share for each period presented. Basic net loss per common share is computed on the basis of the weighted-average number of common shares outstanding for the period. Diluted net loss per common share is computed on the basis of the weighted-average number of common shares plus dilutive potential common shares outstanding. Dilutive potential common shares are calculated under the treasury stock method. Securities that could potentially dilute basic income per share consist of outstanding stock options and warrants and convertible preferred stock. Net loss attributable to common stockholders includes net loss and preferred stock dividends. As the Company had a net loss attributable to common stockholders in each of the periods presented, basic and diluted net loss per common share are the same. All outstanding warrants and options to purchase shares of common stock were excluded because their effect was anti-dilutive.

Potential common shares consisted of options and warrants to purchase approximately 11.2 million and 15.5 million shares of common stock at September 30, 2003, and 2002, respectively, and approximately 2.2 million and 3.4 million shares of common stock issuable upon conversion of Series E preferred stock as of September 30, 2003, and 2002, respectively.

8. Segment Information

Operating segments are revenue-producing components of the enterprise for which separate financial information is produced internally for the Company’s management. Under this definition, the Company operated, for all periods presented, as a single segment.

9. Legal Proceedings

On March 13, 2003, the receiver for Alex Jones, Ltd., an alleged creditor of Jotter Technologies, Inc., filed a civil complaint in United States District Court of Utah against Jotter Technologies and SAFLINK. The complaint alleges breach of contract and judgment on a promissory note against Jotter in connection with a promissory note executed by Jotter and delivered to Alex Jones, Ltd., and unjust enrichment, fraudulent conveyance and declaratory judgment against all parties in connection with SAFLINK’s purchase of substantially all of the intellectual property and fixed assets of Jotter in December 2000. The complaint seeks relief from Jotter in the amount of $800,000 in principal and approximately $163,333 in interest on the promissory note, including attorneys’ fees and costs. The complaint also seeks unspecified monetary and equitable relief against SAFLINK and Jotter. SAFLINK tendered defense of the lawsuit to Jotter and Jotter accepted that tender. Jotter has retained Utah counsel to defend both Jotter and SAFLINK in the lawsuit, at Jotter’s expense. Jotter has informed the Company that it intends to vigorously defend the suit.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Litigation is subject to significant uncertainty and any final result could be greater or less than current management expectations. However, the Company currently believes that the outcome of these matters will not have a material adverse effect on its results of operations or financial condition.

10. Recently Issued Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21 (“EITF 00-21”),Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 became effective for periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position and results of operations.

In May 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 150 (SFAS 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. The adoption of SFAS 150 did not have a significant impact on the Company’s financial position or results of operations.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in FIN 46. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. As amended by FASB Staff Position (“FSP”) No. FIN 46-6, FIN 46 is effective for variable interests in a variable interest entity created before February 1, 2003 at the end of the first interim or annual period ending after December 15, 2003. The Company does not expect the adoption of FIN 46 to have a material impact on our financial position or results of operations.

In July 2003, the EITF reached a consensus on Issue 03-5, “Applicability of AICPA Statement of Position 97-2 “Software Revenue Recognition” (SOP 97-2) to Non-Software Deliverables” (EITF 03-5). The consensus was reached that non-software deliverables are included within the scope of SOP 97-2 if they are included in an arrangement that contains software that is essential to the non-software deliverables’ functionality. This consensus is effective at the beginning of the first interim period beginning after August 13, 2003. The Company does not expect the adoption of EITF 03-5 to have a material impact on our financial position or results of operations.

11. Subsequent Events

On October 31, 2003, the Company signed a 5-year lease for 6,083 square feet in Reston, Virginia that will become the new offices for the Company’s Government sales team, integrated solutions group, and support staff. The lease period is to commence on or about February 1, 2004. Contractual commitments associated with this lease are approximately $121,000, $136,000, $140,000, $144,000, $154,000, and $161,000 for 2004, 2005, 2006, 2007, and 2008 and beyond, respectively.

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

This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes included in this document and the 2002 audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 28, 2003.

This quarterly report on Form 10-Q contains statements and information about management’s view of the Company’s future expectations, plans and prospects that constitute forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. These forward-looking statements include without limitation statements regarding our expectations and beliefs about the market and industry, our goals, plans, and expectations regarding our products and services and product development, our intentions and strategies regarding customers and customer relationships, our relationships with the software development community, our intent to continue to invest resources in research and development, our intent to develop relationships and strategic alliances, our beliefs regarding the future success of our products and services, our expectations and beliefs regarding competition, competitors, the basis of competition and our ability to compete, our expectations regarding future growth and financial performance, our expectations regarding licensing arrangements and our revenues, our expectations and beliefs regarding revenue and revenue growth, our expectations regarding our strategies and long-term strategic relationships, and our beliefs and expectations regarding our results of operations and financial position. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those anticipated, including the factors described in the sections of this quarterly report on Form 10-Q, entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors That May Affect Future Results.” We undertake no obligation to publicly release the result of any revisions to these forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, conditions or circumstances.

The following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with management’s discussion and analysis of financial condition and results of operations included in our annual report on Form 10-K for the year ended December 31, 2002.

As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “we,” “us,” “our,” “the Company,” and “SAFLINK” refer to SAFLINK Corporation, a Delaware corporation, and its subsidiaries.

Overview

We provide cost-effective network security software solutions to protect the safety of information assets and track network access by authorized personnel. We develop biometric authentication software and resell hardware from leading manufacturers of biometric hardware devices. Our products can be used to protect business and personal information by replacing passwords and personal identification numbers (PINs) with biometric identifiers in order to safeguard and simplify access to electronic systems. Biometric technologies identify computer users by electronically capturing a specific biological or behavioral characteristic of that individual, such as a fingerprint or voice or facial feature, and creating a unique digital identifier from that characteristic. Because this process relies on largely unalterable human characteristics, it is both highly secure and highly convenient for the individual seeking access.

The process of identity authentication typically requires that a person present for comparison one or more of the following factors:

• something known such as a password, PIN, or mother’s maiden name;

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• something carried such as a token, card, or key; or

• something physical such as fingerprint, iris or voice pattern, signature motion, facial shape or other biological or behavioral characteristic.

Comparison of biological and behavioral characteristics has historically been the most reliable and accurate of the three factors, but has also been the most difficult and costly to implement given the complex nature of enterprise computer systems. However, recent advances in the development of integrated biometric software solutions, reduced cost of biometric devices, and the emergence of recognized industry standards to connect biometric components to applications have reduced the cost of implementing biometrics in commercial environments. We believe that government and private sector organizations will increasingly use this method of identity authentication because of the higher level of security and greater user convenience it provides and the reduced cost of password administration associated with such a security system.

Our software products are designed for large-scale and complex computer networks and allow computer users to be identified from various biometric technologies. Our products comply with recognized industry standards, which allows us to integrate a large variety of biometric technologies within a common application environment without costly development related to the integration of each technology. Our products also provide our customers with the flexibility to deploy a mixture of different biometric technologies within their network to meet specific user needs and environmental requirements while providing protection against technology obsolescence since new devices can be added to, or upgraded within, the system without replacing or modifying the underlying biometric network support infrastructure.

In September 2003, we were awarded U.S. Patent No. 6,618,806 entitled “System and Method for Authenticating Users in a Computer Network,” which describes what we consider to be a fundamental process for controlling access to a computer network using biometric authentication. The patent primarily governs what we believe is a critical step in biometric authentication – the policy system, which provides administrators the flexibility to tailor biometric security for users within their organization.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of commitments and contingencies. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe our most critical accounting policy is revenue recognition and it affects the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. We derive revenue from license fees for software products, reselling of hardware and fees for services relating to the software products including maintenance services, technology and programming consulting services.

We recognize revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9 and related interpretations, including technical practice aids, which provide specific guidance and stipulate that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post contract customer support, installation or training. The application of SOP 97-2 requires judgment, including whether a software

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arrangement includes multiple elements, and if so, whether vendor-specific objective evidence of fair value exists for these elements. In multiple element arrangements in which fair value exists only for undelivered elements, the fair value of the undelivered elements is deferred and the residual arrangement fee is assigned to the delivered elements. If evidence of fair value for any of the undelivered elements does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered.

Revenue from software license fees is recognized upon delivery, net of an allowance for estimated returns, provided persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If customers receive pilot or test versions of products, revenue from these arrangements is recognized upon customer acceptance of permanent license rights. If our software is sold through a reseller, revenue is recognized when the reseller delivers its product to the end-user or if there are non-refundable minimum guaranteed fees upon delivery to the reseller. We also act as a reseller of hardware. Such revenue is recognized upon delivery of the hardware, provided that all other conditions of the sale have been met and evidence of fair value for any undelivered elements exists.

Service and other revenue includes payments under support and upgrade contracts and fees from consulting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Consulting revenue is primarily related to installation, integration and training services performed on a time-and-materials basis under separate service arrangements. Fees from consulting are recognized as services are performed.

Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter.

Results of Operations

We believe that period-to-period comparisons of our operating results may not be a meaningful basis to predict our future performance. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets. We may not be able to successfully address these risks and difficulties.

We incurred net losses of approximately $2.5 million and $7.9 million for the three and nine months ended September 30, 2003, respectively. This compared to net losses of $1.5 million and $4.8 million for the three and nine months ended September 30, 2002, respectively. The net loss attributable to common stockholders of $9.5 million for the nine months ended September 30, 2002 included an in-substance dividend of approximately $4.7 million resulting from the modification of our Series A and B warrants, sale of common stock, and issuance of our Series C warrants during January 2002.

The following discussion presents certain changes in our revenue and operating expenses that have occurred during the three and nine months ended September 30, 2003, respectively, as compared to the three and nine months ended September 30, 2002, respectively.

Revenue and Cost of Revenue

We recorded revenue primarily from three sources during the three and nine months ended September 30, 2003, and 2002: software, hardware and services. Product revenue consists of revenue from sales of licenses to use software produced by us and from the re-sale of hardware purchased from third parties. Service revenue consists of revenue from post-contract customer support, consulting services and training. During the three months ended September 30, 2003, software license sales were approximately $169,000, while sales of hardware and services were approximately $162,000 and $432,000, respectively. During the same period in 2002, software

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license sales were approximately $43,000, while sales of hardware and services were approximately $36,000 and $287,000, respectively. Total revenue of approximately $763,000 for the three months ended September 30, 2003, increased approximately $397,000, or 108%, from revenue of approximately $366,000 for the three months ended September 30, 2002. This increase was primarily due to the utilization of our more extensive and experienced direct sales team and reseller channel to pursue sales opportunities. Revenue of approximately $1.5 million for the nine months ended September 30, 2003, increased approximately $601,000, or 65%, from revenue of approximately $926,000 for the nine months ended September 30, 2002.

Total cost of revenue includes product cost of revenue and service cost of revenue. Product cost of revenue consists of packaging and production costs for software license sales and cost of hardware purchased from third parties for hardware sales. Service cost of revenue consists of labor and expenses for post-contract customer support, consulting services and training. During the three months ended September 30, 2003, cost of revenue from software, hardware and services were approximately $2,000, $123,000, and $175,000, respectively. During the same period in 2002, cost of revenue from software, hardware and services were approximately $11,000, $28,000 and $55,000, respectively. Total cost of revenue for the three months ended September 30, 2003, of approximately $300,000 increased $206,000 from cost of revenue of $94,000 for the same period in 2002. This increase was primarily due to higher revenue in this period when compared to the same period in 2002. Total cost of revenue of approximately $554,000 for the nine months ended September 30, 2003, increased $58,000, or 12%, from $496,000 during the same period in 2002. Even with a 65% increase in revenue during the nine month period ending September 30, 2003, cost of revenue increased only slightly primarily because we incurred significant software royalty fees during the first three months of 2002, which we are no longer obligated to pay in 2003 and beyond.

Our gross margins for the three months ended September 30, 2003, and 2002 were approximately 61% and 74%, respectively. This decrease was mainly due to a favorable settlement related to a customer account during the prior-year period, whereby we recorded revenue of $160,000 with no direct costs from which we realized unusually high gross margins on that revenue. Gross margins for the nine months ended September 30, 2003, were approximately 64% and 46%, respectively. This increase from 2002 to 2003 was primarily due to a higher mix of software license sales to hardware sales compared to 2002, the lack of software royalty fees in 2003 and the recognition of approximately $110,000 in the first three months of 2003 for a service contract that expired for which there were no direct costs of revenue.

Operating Expenses

Total operating expenses for the three months ended September 30, 2003, increased approximately $1.2 million, or 70%, to approximately $3.0 million from approximately $1.8 million for the comparable period in 2002. This increase was primarily due to increased compensation and related benefits ($913,000), increased travel and entertainment expenses ($121,000), and higher advertising and promotion expenses ($74,000) associated with increased spending on trade shows and public relations. These costs were largely driven by the expansion of our direct sales team. Other functional categories, including occupancy and telephone and internet, had moderate increases in the three months ended September 30, 2003, as compared to the same period in 2002, due to the 75%, or 30 employee, increase in headcount from September 30, 2002, to September 30, 2003.

The following table provides a breakdown of the dollar and percentage changes in operating expenses for the three and nine months ended September 30, 2003, as compared to the same periods in 2002:

	Three Months				Nine Months
(Dollars in thousands)	Increase		Increase		Increase		Increase
Product development	$	240	54	%	$	618	49	%
Sales and marketing		902	217			2,659	233
General and administrative		76	9			420	15
	$	1,218	70	%	$	3,697	71	%

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Product Development – Product development expenses consist primarily of salaries, benefits and equipment for software developers and quality assurance personnel. Product development expenses increased during the three and nine months ended September 30, 2003, compared to the same periods in 2002, primarily due to increased headcount and related compensation and benefits, as well as recruiting fees, and legal fees associated with our intellectual property. We currently believe that staffing is adequate to meet our short-term development objectives.

Sales and Marketing – Sales and marketing expenses consist primarily of salaries and commissions earned by sales and marketing personnel, advertising and promotional expenses and travel and entertainment costs. Sales and marketing expenses increased substantially during the three and nine months ended September 30, 2003, compared to the same periods in 2002. These increases were primarily due to increased headcount, which included fifteen new employees hired in the first nine months of 2003, and associated recruiting costs, travel and lodging, consulting fees and marketing activities, such as trade shows and public relations. We currently believe that staffing is adequate to cover potential sales opportunities and meet our short-term sales objectives. Sales and marketing expenses are a function of revenue, due to commissions being paid as percentage of sales, and will increase if revenue increases in future quarters.

General and Administrative – General and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, human resource and administrative personnel, professional services fees and allowances for bad debt. General and administrative expenses increased modestly during the three and nine months ended September 30, 2003, primarily due to non-cash amortization associated with the issuance of common stock and grants of options and warrants to purchase shares of common stock to third-party providers of financial advisory services. This non-cash amortization ended in September 2003. We currently believe that staffing remains adequate to meet our short-term objectives in this area.

Interest and Other income (expense)

Interest expense for the three and nine months ended September 30, 2003, was approximately $6,000 and $11,000, compared to approximately $5,000 and $43,000, respectively, for the same periods in 2002. Interest expense during 2003 consists of interest accrued from the financing of certain insurance policies over a nine month period. Interest expense of $43,000 during the nine months ended September 30, 2002, related to interest in connection with bridge loans and the financing of certain insurance policies.

Other income (expense) for the three and nine months ended September 30, 2003, was approximately $20,000 and $51,000, respectively, compared to approximately $8,000 and $12,000, respectively, for the same periods in 2002. Other income primarily consisted of interest earned on cash and money market balances, and the increase was due to higher cash balances during the first nine months of 2003 compared to the same period in 2002.

Liquidity and Capital Resources

We financed our operations during the nine months ended September 30, 2003, primarily from our working capital. As of September 30, 2003, our principal source of liquidity largely consisted of approximately $9.9 million of cash. We do not have a bank line of credit of other credit facility available to finance our operations.

We expended $8.3 million in operating activities during the first nine months of 2003, compared to $5.8 million for the same period in 2002. The net loss of $7.9 million for the nine months ended September 30, 2003, represents the majority of the cash used in operations. Significant adjustments to the net loss were increases of $584,000 and $370,000 in accounts receivable and other current assets, respectively, and a decrease of $409,000 in accounts payable, offset by a $661,000 in non-cash, stock-based compensation.

We used approximately $546,000 in investing activities during the nine months ended September 30, 2003, related to the purchases of equipment and software to support our increased headcount and to increase operating efficiency, compared to approximately $50,000 for the same period in 2002.

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Net cash provided from financing activities was $11.4 million in the first nine months of 2003, compared to $10.1 million during the same period in 2002. During the first nine months of 2003, we received $9.9 million in net proceeds for various warrant exercises and $1.5 million from stock option exercises. The $10.1 million provided by financing activities during the first nine months of 2002 primarily came from the issuance of common stock to certain holders of our Series E preferred stock and exercises of Series A and Series B warrants to purchase common stock in January 2002 for net proceeds of $5.5 million. In addition, we had a financing in June 2002 which provided $4.9 million in net proceeds and we also received $103,000 from the exercise of stock options. These proceeds from financing activities in the first nine months of 2002 were offset by payments made on notes payable of approximately $1.4 million.

Cash and working capital as of September 30, 2003, were approximately $9.9 million and $10.2 million, compared to approximately $7.4 million and $7.1 million, respectively, as of December 31, 2002. The increase in our cash and working capital as of September 30, 2003, compared to December 31, 2002, was primarily due to the net proceeds of approximately $9.9 million from warrant exercises of our Series A warrants, Series C warrants and warrants associated with our September 2002 financing as well as proceeds from stock option exercises totaling approximately $1.5 million during the first nine months of 2003. The cash provided by financing activities during this period was used to expand our existing sales and product development teams, purchase equipment and supplies, market and promote our products, and for general corporate purposes.

We have incurred significant costs to develop our technology, products and services and to hire employees in our sales, marketing and administration departments, in addition to incurring non-cash compensation costs. To date, we have not generated significant revenue from the sale of our products and services when compared to our operating expenses. As a result, we have incurred significant net losses since inception, significant negative cash flows from operations in the periods from inception through September 30, 2003, and as of September 30, 2003, we had an accumulated deficit of approximately $93.1 million. These losses have been funded primarily through the issuance of convertible preferred stock, common stock and warrants to purchase common stock.

We anticipate that our current cash and working capital will be sufficient to satisfy our working capital and capital requirements for the next 9 months. However, if our expenses increase, we will likely require additional funds prior to such time, and we would then seek to sell additional equity or debt securities through public or private financings, or seek alternative sources of financing. We cannot assure you that additional funding will be available on favorable terms, when needed, if at all. If we are successful in raising additional financing, we may not be able to do so on terms that are not excessively dilutive to existing stockholders or less costly than existing sources of financing. If we are unable to obtain any necessary additional financing, we may be required to reduce the scope of our planned sales and marketing and product development efforts and curtail certain aspects of our other operations, which could materially adversely affect our business, financial condition and operating results. In addition, we may require additional funds in order to fund more rapid expansion, to develop new or enhanced services or products or to invest in complementary businesses, technologies, services or products.

The following table reflects our contractual commitments as of September 30, 2003 (in thousands):

	2003		2004 to 2005		2006 to 2007		Total
Operating Leases	$	73	$	533	$	159	$	765
License Agreement		42		78		—		120
	$	115	$	611	$	159	$	885

On October 31, 2003, we signed a 5-year lease for 6,083 square feet in Reston, Virginia that will become the new offices for our Government sales team, integrated solutions group, and support staff. The lease period is to commence on or about February 1, 2004. Contractual commitments associated with this lease are approximately $121,000, $136,000, $140,000, $144,000, $154,000, and $161,000 for 2004, 2005, 2006, 2007, and 2008 and beyond, respectively.

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Factors That May Affect Future Results

This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our business, operating results, financial performance, and share price may be materially adversely affected by a number of factors, including but not limited to the following risk factors, any one of which could cause actual results to vary materially from anticipated results or from those expressed in any forward-looking statements made by us in this quarterly report on Form 10-Q or in other reports, press releases or other statements issued from time to time. Additional factors that may cause such a difference are set forth elsewhere in this quarterly report on Form 10-Q and in our annual report on Form 10-K.

In addition to other information contained in this quarterly report on Form 10-Q, the following factors, among others, sometimes have affected, and in the future could affect our actual results and could cause future results to differ materially from those in any forward looking statements made by us or on our behalf. Factors that could cause future results to differ from expectations include, but are not limited to the following:

We have accumulated significant losses since we started doing business and may not be able to generate significant revenue or any net income in the future, which would negatively impact our ability to run our business.

We have accumulated net losses of approximately $93.1 million from our inception through September 30, 2003. We have continued to accumulate losses after September 30, 2003, to date and we may be unable to generate significant revenue or any net income in the future. We have funded our operations primarily through the issuance of equity securities to investors and may not be able to generate a positive cash flow in the future. If we are unable to generate sufficient cash flow from operations, we will need to seek additional funds through the issuance of additional equity securities or other sources of financing. We may not be able to secure such additional financing on favorable terms, or at all. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of or cease our operations.

Our success depends on significant growth in the biometrics market and on broad acceptance of products in this market.

Our product revenue and a portion of our service revenue is derived from the sale of biometric products and services. Biometric solutions have not gained widespread commercial acceptance. We cannot accurately predict the future growth rate, if any, or the ultimate size of the biometric technology market. The expansion of the market for our products and services depends on a number of factors including without limitation:

• the cost, performance and reliability of our products and services and the products and services of competitors;

• customers’ perception of the perceived benefit of biometric solutions;

• public perceptions of the intrusiveness of these solutions and the manner in which firms are using the fingerprint information collected;

• public perceptions regarding the confidentiality of private information;

• customers’ satisfaction with our products and services; and

• marketing efforts and publicity regarding these products and services.

Even if biometric solutions gain wide market acceptance, our products and services may not adequately address the market requirements and may not gain wide market acceptance. If biometric solutions or our products and services do not gain wide market acceptance our business and our financial results will suffer.

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Because they own approximately 48% of our company, two investors could significantly influence our affairs which may preclude other stockholders from being able to influence stockholder votes.

Given that two investors, combined, own in excess of 48% of our currently outstanding common stock, they would be able to significantly influence the vote on those corporate matters to be decided by our stockholders if they decided to act together. In addition, as of November 4, 2003, these investors beneficially own warrants to purchase an additional 430,442 shares of our common stock. If these investors exercised their warrants in full, they would own approximately 49% of our outstanding common stock. Such concentrated ownership may decrease the value of our common stock and could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes.

If we are unable to maintain our Nasdaq SmallCap Market listing, our common stock may be subject to delisting from the SmallCap Market and your ability to trade shares of our common stock could suffer.

In April 2003, our common stock was approved for relisting on the Nasdaq SmallCap Market and began trading on April 25, 2003. For our common stock to remain listed on the Nasdaq SmallCap Market, we must meet the minimum listing requirements for continued listing, including, among other requirements, minimum bid price and market value of public float requirements. If we fail to continue to meet the minimum listing requirements, we may be delisted from the Nasdaq SmallCap Market. If our common stock is delisted from the Nasdaq SmallCap Market, sales of our common stock would likely be conducted only in the over-the counter market or potentially on regional exchanges. This may have a negative impact on the liquidity and the price of our common stock, and investors may find it more difficult to purchase or dispose of, or to obtain accurate quotations as to the market value of, our common stock. In addition, if our common stock is not listed on the Nasdaq National Market or the Nasdaq SmallCap Market and the trading price of our common stock fell below $1.00 per share, trading in our common stock would also be subject to the requirements of certain rules which require additional disclosures by broker-dealers in connection with any trades involving a stock defined as a “penny stock.” In such event, the additional burdens imposed upon broker-dealers to effect transactions in our common stock could further limit the market liquidity of our common stock and the ability of investors to trade our common stock.

The issuance of common stock reserved for our stock option plans and the exercise of warrants could dilute the value of our stock and may create a negative public perception of the value of our stock.

We have issued options and warrants to acquire shares of common stock to our employees and certain other persons at various prices, some of which have exercise prices below the current market price for our common stock. Of these options and warrants, approximately 10.9 million have exercise prices below the recent market price of $4.55 (as of November 4, 2003). In addition, our existing stock option plan currently has approximately 2.9 million shares available for issuance as of November 4, 2003.

Our issuance of a large number of additional shares of our common stock upon the exercise of outstanding stock options or warrants could cause substantial dilution to existing stockholders and could decrease the market price of our common stock. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur. If we issue our common stock to option and warrant holders, it will dilute our investors’ interest. In addition, if a large number of option or warrant holders sell their shares of our common stock, it could create a negative public perception of the value of our stock.

We are partly dependent on third parties for our product distribution and if these parties do not promote our products, it may limit our ability to generate revenue.

We utilize third parties such as resellers, distributors and makers of complementary technology to complement our full-time sales staff in promoting sales of our products. If these third parties do not actively promote our products, our ability to generate revenue may be limited. We cannot control the amount and timing

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of resources that these third parties devote to marketing activities on our behalf. Some of these business relationships are formalized in agreements which can be terminated with little or no notice and may be subject to amendment. We also may not be able to negotiate acceptable distribution relationships in the future and cannot predict whether current or future distribution relationships will be successful.

Since a large percentage of our historic revenue has been derived from a limited number of customers, our sales have experienced wide fluctuations.

Two customers accounted for 29% and 11% of our revenue for the nine months ended September 30, 2003. Three customers accounted for approximately 46% (Freddie Mac), 24% (BearingPoint—for the Department of Defense’s CAC program), and 11% (Kaiser Permanente) of our entire 2002 revenue, respectively. As a result of this concentration of sales to a limited number of customers, our sales have experienced wide fluctuations, and may continue to experience wide fluctuations in the future.

In order to succeed, we will have to keep up with rapid technological change in the software industry and various factors could impact our ability to keep pace with these changes.

Software design and the biometric technology industry are characterized by rapid development and technological improvements. Because of these changes, our success will depend on our ability to keep pace with a changing marketplace and integrate new technology into our software and introduce new products and product enhancements to address the changing needs of the marketplace. Various technical problems and resource constraints may impede the development, production, distribution and marketing of our products and services. In addition, laws, rules, regulations or industry standards may be adopted in response to these technological changes, which in turn, could materially adversely affect how we do business.

Our future success will depend upon our ability to develop and introduce a variety of new products and services and enhancements to these new products and services in order to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometric industry require assessments to be made of the future directions of technology and technology markets generally, which are inherently risky and difficult to predict. Delays in introducing new products, services and enhancements, the failure to choose correctly among technical alternatives or the failure to offer innovative products and services at competitive prices may cause customers to forego purchases of our products and services and purchase those of our competitors.

Continued participation by us in the market for governmental agencies may require the investment of our resources in upgrading our products and technology for us to compete and to meet regulatory and statutory standards. We may not have adequate resources available to us or may not adequately keep pace with appropriate requirements in order to effectively compete in the marketplace.

Provisions in our Certificate of Incorporation and our Certificate of Designation, Preferences and Rights of the Series E preferred stock may prevent or impact the value of a takeover of our company even if a takeover is beneficial to stockholders.

Our Certificate of Incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, which may adversely affect our common stockholders. We may issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as the board of directors determines. Specifically, the issuance of preferred stock may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, voting control of our company even if the acquisition would benefit stockholders. In addition, the issuance of the Series E preferred stock may impact the value of a takeover to common stockholders because the holders of the Series E preferred stock are entitled to demand that we redeem their stock for cash equal to 125% of the price paid for this stock by the holders in connection with certain acquisitions in which more than 40% of our stock is issued.

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A significant number of shares of our common stock eligible for future sale could drive down the market price for our common stock and the availability of a large number of our shares on the open market could make it difficult for us to raise capital.

As of November 4, 2003, 27,036,767 shares of our common stock were outstanding. In addition, there are approximately 8.3 million shares of common stock issuable upon exercise or conversion of outstanding warrants and preferred stock. Sales of shares of common stock in the public market or the perception that sales of large numbers of our shares may occur could adversely affect the market price of our common stock. These sales or the perception of possible sales could also impair our ability to raise capital in the future. It is possible that this scenario will have an adverse effect on the market price of the common stock.

Our financial and operating results often vary significantly from quarter to quarter and may be negatively affected by a number of factors.

Our financial and operating results may fluctuate from quarter to quarter because of the following reasons:

• reduced demand for products and services caused by competitors;

• price reductions, new competitors, or the introduction of enhanced products or services from new or existing competitors;

• changes in the mix of products and services we or our distributors sell;

• cancellations, delays or contract amendments by government agency customers;

• the lack of availability of government funds;

• unforeseen legal expenses, including litigation costs;

• expenses related to acquisitions;

• other one-time financial charges;

• the lack of availability or increase in cost of key components and subassemblies; and

• the inability to successfully manufacture in volume certain of our products that may contain complex designs and components.

Particularly important is our need to invest in planned technical development programs to maintain and enhance our competitiveness, and to develop and launch new products and services. Improving the manageability and likelihood of success of such programs requires the development of budgets, plans and schedules for the execution of these programs and the adherence to such budgets, plans and schedules. The majority of such program costs are payroll and related staff expenses, and secondarily materials, subcontractors and promotional expenses. These costs are very difficult to adjust in response to short-term fluctuations in our revenue, compounding the difficulty of achieving profitability.

Our lengthy and variable sales cycle will make it difficult to predict operating results.

Certain of our products often have a lengthy sales cycle while the customer evaluates and receives approvals for purchase. If, after expending significant funds and effort pursuing a sales opportunity, we fail to receive an order, a negative impact on our financial results and stock price could result.

We derive a substantial portion of our revenue from government contracts, which are often non-standard, involve competitive bidding, may be subject to cancellation without penalty and may produce volatility in earnings and revenue.

Our performance in any one reporting period is not necessarily indicative of sales trends or future operating or earnings performance because of our reliance on a small number of large customers, a substantial portion of

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which are government agencies. Government contracts frequently include provisions that are not standard in private commercial transactions. For example, government contracts may include bonding requirements and provisions permitting the purchasing agency to cancel the contract without penalty in certain circumstances. As public agencies, our prospective customers are also subject to public agency contract requirements that vary from jurisdiction to jurisdiction. Some of these requirements may be onerous or impossible to satisfy.

Failure by us to maintain the proprietary nature of our technology and intellectual property could have a material adverse effect on our business, operating results, financial condition and stock price and on our ability to compete effectively.

We principally rely upon patent, trademark, copyright, trade secret and contract law to establish and protect our proprietary rights. There is a risk that claims allowed on any patents or trademarks we hold may not be broad enough to protect our technology. In addition, our patents or trademarks may be challenged, invalidated or circumvented and we cannot be certain that the rights granted thereunder will provide competitive advantages to us. Moreover, any current or future issued or licensed patents, or trademarks, or currently existing or future developed trade secrets or know-how may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of our already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others. In addition, there is a risk that others may independently develop proprietary technologies and processes, which are the same as, substantially equivalent or superior to ours, or become available in the market at a lower price. There is a risk that we have infringed or in the future will infringe patents or trademarks owned by others, that we will need to acquire licenses under patents or trademarks belonging to others for technology potentially useful or necessary to us, and that licenses will not be available to us on acceptable terms, if at all.

We may have to litigate to enforce our patents or trademarks or to determine the scope and validity of other parties’ proprietary rights. Litigation could be very costly and divert management’s attention. An adverse outcome in any litigation may have a severe negative impact on our financial results and stock price. We also rely on trade secrets and proprietary know-how, which we seek to protect by confidentiality agreements with our employees, consultants, service providers and third parties. There is a risk that these agreements may be breached, and that the remedies available to us may not be adequate. In addition, our trade secrets and proprietary know-how may otherwise become known to or be independently discovered by others.

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

Our management believes that in order to be successful, we must appropriately manage the size of our business. This may mean reducing costs and overhead in certain economic periods, and selectively growing in periods of economic expansion. In addition, we will be required to implement operational, financial and management information procedures and controls that are efficient and appropriate for the size and scope of our operations. The management skills and systems currently in place may not be adequate and we may not be able to manage any significant reductions or growth effectively.

If we fail to attract and retain qualified senior executive and key technical personnel, our business will not be able to expand.

We are dependent on the continued availability of the services of our employees, many of whom are individually key to our future success, and the availability of new employees to implement our business plans. The market for skilled employees is highly competitive, especially for employees in technical fields. Although our compensation programs are intended to attract and retain the employees required for us to be successful, there can be no assurance that we will be able to retain the services of all of the key employees or a sufficient number to execute our plans, nor can there be any assurances that we will be able to continue to attract new employees as required.

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Our personnel may voluntarily terminate their relationship with us at any time, and competition for qualified personnel, especially engineers, is intense. The process of locating additional personnel with the combination of skills and attributes required to carry out our strategy could be lengthy, costly and disruptive.

If we lose the services of key personnel, or fail to replace the services of key personnel who depart, we could experience a severe negative impact on our financial results and stock price. In addition, there is intense competition for highly qualified engineering and marketing personnel in the locations where we principally operate. The loss of the services of any key engineering, marketing or other personnel or our failure to attract, integrate, motivate and retain additional key employees could have a material adverse effect on our business, operating and financial results and stock price.

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market rate risk for changes in interest rates relates primarily to money market funds included in our cash and cash equivalents portfolio. Investments in fixed rate earning instruments carry a degree of interest rate risk as their fair market value may be adversely impacted due to a rise in interest rates. As a result, our future investment income may fall short of expectations due to changes in interest rates. We do not use any hedging transactions or any financial instruments for trading purposes and we are not a party to any leveraged derivatives.

We have certain foreign operations whose expenses are incurred in its local currency. As exchange rates vary, transaction gains or losses will be incurred and may vary from expectations and adversely impact overall profitability. If, in the remainder of fiscal 2003, the US dollar uniformly changes in strength by 10% relative to the currency of the foreign operations, our operating results would likely not be significantly affected.

ITEM 4.CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

Changes in internal controls

There were no significant changes in our internal controls that have materially affected, or are reasonably likely to materially affect our internal controls subsequent to the end of the period covered by this quarterly report.

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PART II –OTHER INFORMATION

ITEM 1.LEGAL PROCEEDINGS

On March 13, 2003, the receiver for Alex Jones, Ltd., an alleged creditor of Jotter Technologies, Inc., filed a civil complaint in United States District Court of Utah against Jotter Technologies and SAFLINK. The complaint alleges breach of contract and judgment on a promissory note against Jotter in connection with a promissory note executed by Jotter and delivered to Alex Jones, Ltd., and unjust enrichment, fraudulent conveyance and declaratory judgment against all parties in connection with our purchase of substantially all of the intellectual property and fixed assets of Jotter in December 2000. The complaint seeks relief from Jotter in the amount of $800,000 in principal and approximately $163,333 in interest on the promissory note, including attorneys’ fees and costs. The complaint also seeks unspecified monetary and equitable relief against us and Jotter. We tendered defense of the lawsuit to Jotter and Jotter accepted that tender. Jotter has retained Utah counsel to defend both Jotter and SAFLINK in the lawsuit, at Jotter’s expense. Jotter has informed us that it intends to vigorously defend the suit.

Litigation is subject to significant uncertainty and any final result could be greater or less than current management expectations. However, we believe that the outcome of these matters will not have a material adverse effect on our results of operations or financial condition.

ITEM 2.CHANGES IN SECURITIES

During the three months ended September 30, 2003, we issued an aggregate of approximately 147,000 shares of common stock upon the exercise of Series A warrants, placement agent warrants associated with previous financings and warrants associated with financial advisory agreements.

Options to purchase shares of common stock exercised by employees and consultants during the three months ended September 30, 2003 resulted in the issuance of approximately 109,000 shares of common stock.

ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K.

On August 14, 2003, we furnished a current report on Form 8-K regarding our press release announcing our financial results for the quarter ended June 30, 2003.

On August 27, 2003, we filed a current report on Form 8-K announcing our appointment of Gordon Fornell to our Board of Directors.

On September 10, 2003, we filed a current report on Form 8-K announcing that we had been awarded U.S. Patent No. 6,618,806 from the United States Patent and Trademark Office for a system for authenticating users in a computer network.

On November 3, 2003, we furnished a current report on Form 8-K regarding our press release announcing our financial results for the quarter ended September 30, 2003.

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SIGNATURES

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

	SAFLINK CORPORATION
DATE:  November 14, 2003	By:	/s/    JON C. ENGMAN
		Jon C. Engman Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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Exhibit Index

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002