Identiphi (IDPIQ) 10-Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 ended June 30, 2006

OR

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

For the transition period from            to            

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.)

12413 Willows Road NE, Suite 300, Kirkland, WA 98034

(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 a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

There were 88,908,229 shares of Saflink Corporation’s common stock outstanding as of August 1, 2006.

Saflink Corporation

FORM 10-Q

For the Quarter Ended June 30, 2006

INDEX

			Page
Part I.	Financial Information
	Item 1.	Financial Statements (Unaudited)	3
	a.	Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005	3
	b.	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005	4
	c.	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005	5
	d.	Notes to Condensed Consolidated Financial Statements	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	23
	Item 4.	Controls and Procedures	24
Part II.	Other Information
	Item 1.	Legal Proceedings	25
	Item 1A.	Risk Factors	25
	Item 5.	Other Information	32
	Item 6.	Exhibits	33
Signatures			34

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PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SAFLINK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)

	June 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	10,492		$	15,217
Accounts receivable, net		494			692
Inventory		589			563
Prepaid expenses and other current assets		1,179			841
Total current assets		12,754			17,313
Furniture and equipment, net of accumulated depreciation of $3,005 and $2,706 as of June 30, 2006, and December 31, 2005, respectively		1,523			1,018
Debt issuance costs, net		906			—
Intangible assets, net of accumulated amortization of $5,554 and $4,162 as of June 30, 2006, and December 31, 2005, respectively		18,456			19,848
Goodwill		15,523			75,923
Total assets	$	49,162		$	114,102
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,125		$	1,204
Accrued expenses		2,968			2,150
Current portion of convertible debt, net of discount		2,323			1,250
Other current obligation		569			765
Deferred revenue		133			174
Total current liabilities		7,118			5,543
Deferred tax liability		166			140
Long-term convertible debt, net of current portion and discount		2,672			—
Total liabilities		9,956			5,683
Stockholders’ equity:
Common stock		889			889
Additional paid-in capital		273,980			269,256
Deferred stock-based compensation		—			(541	)
Accumulated deficit		(235,663	)		(161,185	)
Total stockholders’ equity		39,206			108,419
Total liabilities and stockholders’ equity	$	49,162		$	114,102

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

	Three months ended June 30,						Six months ended June 30,
	2006			2005			2006			2005
Revenue:
Product	$	786		$	1,099		$	1,542		$	2,277
Service		158			707			259			1,713
Total revenue		944			1,806			1,801			3,990
Cost of revenue:
Product		366			470			693			876
Service		130			403			256			1,021
Amortization of intangible assets		671			671			1,342			1,342
Total cost of revenue		1,167			1,544			2,291			3,239
Gross profit (loss)		(223	)		262			(490	)		751
Operating expenses:
Product development		2,423			2,320			4,842			4,632
Sales and marketing		2,053			2,399			3,931			4,711
General and administrative		1,956			2,129			4,013			4,430
Impairment loss on goodwill		30,700			—			60,400			—
Impairment loss on intangible assets		—			—			—			900
Total operating expenses		37,132			6,848			73,186			14,673
Operating loss		(37,355	)		(6,586	)		(73,676	)		(13,922	)
Interest expense		(323	)		(28	)		(362	)		(66	)
Other income, net		59			74			171			161
Change in fair value of outstanding warrants		—			27			—			172
Loss before income taxes		(37,619	)		(6,513	)		(73,867	)		(13,655	)
Income tax provision (benefit)		13			13			26			(298	)
Net loss		(37,632	)		(6,526	)		(73,893	)		(13,357	)
Modification of outstanding warrants		(76	)		(59	)		(585	)		(59	)
Net loss attributable to common stockholders	$	(37,708	)	$	(6,585	)	$	(74,478	)	$	(13,416	)
Basic and diluted net loss per common share attributable to common stockholders	$	(0.43	)	$	(0.08	)	$	(0.85	)	$	(0.17	)
Weighted average number of common shares outstanding		88,106			81,286			88,101			80,116

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Six months ended June 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(73,893	)	$	(13,357	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock-based compensation		518			867
Depreciation and amortization		1,730			1,673
Non-cash interest expense		228			—
Impairment loss on goodwill		60,400			—
Impairment loss on intangible assets		—			900
Loss on disposal of fixed assets		5			—
Change in fair value of outstanding warrants		—			(172	)
Deferred taxes		26			(298	)
Changes in operating assets and liabilities:
Accounts receivable, net		198			215
Inventory		(26	)		57
Prepaid expenses and other current assets		(338	)		404
Accounts payable		(87	)		(444	)
Accrued expenses		383			91
Deferred revenue		(41	)		(130	)
Net cash used in operating activities		(10,897	)		(10,194	)
Cash flows from investing activities:
Purchases of furniture and equipment		(475	)		(117	)
Proceeds from sale of furniture and equipment		6			—
Net cash used in investing activities		(469	)		(117	)
Cash flows from financing activities:
Proceeds from exercises of stock options		17			436
Proceeds from the issuance of common stock and warrants, net of issuance costs		—			13,965
Proceeds from issuance of convertible debt, net of issuance costs		7,479			—
Warrant redemptions		(855	)		—
Net cash provided by financing activities		6,641			14,401
Net increase/(decrease) in cash and cash equivalents		(4,725	)		4,090
Cash and cash equivalents at beginning of period		15,217			22,217
Cash and cash equivalents at end of period	$	10,492		$	26,307
Supplemental disclosure of cash flow information:
Cash paid for interest	$	31		$	62
Modification of outstanding warrants	$	585		$	59
Issuance of stock options for services	$	—		$	27
Reclassification of warrants from liability to equity	$	196		$	—
Debt issuance costs included in accounts payable and accrued liabilities	$	93		$	—
Beneficial conversion feature related to convertible debentures	$	1,655		$	—
Warrants issued in connection with convertible debenture financing	$	2,812		$	—
Placement agent warrant issued in connection with convertible debenture financing	$	337		$	—
Non-cash additions to furniture and equipment	$	350		$	—

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Description of Business and Basis of Presentation

Description of the Company

Saflink Corporation offers biometric security, smart card, and public key infrastructure (PKI) solutions that protect intellectual property, secure information assets, and eliminate passwords. Saflink software provides Identity Assurance Management^™, allowing administrators to verify identity and control access to computer networks, physical facilities, applications, and time and attendance systems.

Saflink Corporation was incorporated in the State of Delaware on October 23, 1991, and maintains its headquarters in Kirkland, Washington.

Condensed Consolidated Financial Statements

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 subsidiaries, Saflink International, Inc. and Litronic, Inc. (together, the “Company” or “Saflink”). The balance sheet at December 31, 2005, has been derived from the Saflink 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 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Saflink Annual Report on Form 10-K for the fiscal year ended December 31, 2005, as filed with the Securities and Exchange Commission (the “SEC”) on March 17, 2006.

2. Summary of Significant Accounting Policies

Basis of Financial Statement Presentation and Principles of Consolidation

The capital structure presented in these condensed consolidated financial statements is that of Saflink. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. Preparation of the condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods. Actual results could differ from those estimates.

Revenue Recognition

The Company derives revenue from license fees for software products, selling hardware manufactured by the Company, reselling third party hardware and software applications, and fees for services related to these software and hardware products including maintenance services, installation and integration consulting services.

The Company recognizes revenue in accordance with the provisions of Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions,” and related interpretations, including Technical Practice Aids, which provides specific guidance and stipulates 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, integration and/or training. Under this guidance, the determination of fair value is based on objective evidence that is specific to the vendor. In multiple element arrangements in which fair value exists 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 biometric software and data security 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

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determinable, and vendor-specific objective evidence exists to allocate the total fee to the undelivered 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 the Company’s software is sold through a reseller, revenue is recognized when the reseller delivers its product to the end-user. Certain software delivered under a license requires a separate annual maintenance contract that governs the conditions of post-contract customer support. Post-contract customer support services can be purchased under a separate contract on the same terms and at the same pricing, whether purchased at the time of sale or at a later date. Revenue from these separate maintenance support contracts is recognized ratably over the maintenance period. If software maintenance is included under the terms of the software license agreement, then the value of such maintenance is deferred and recognized ratably over the initial license period. The value of such deferred maintenance revenue is established by the price at which the customer may purchase a renewal maintenance contract.

Revenue from hardware manufactured by the Company is generally recognized upon shipment, unless contract terms call for a later date, 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. Revenue from some data security hardware products contains embedded software. However, the embedded software is considered incidental to the hardware product sale. The Company also acts as a reseller of third party hardware and software applications. Such revenue is also generally recognized upon shipment of the hardware, unless contract terms call for a later date, provided that all other conditions above have been met.

Service revenue includes payments under support and upgrade contracts and consulting fees. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Consulting revenue primarily relates to installation, integration and training services performed on a time-and-materials or fixed-fee basis under separate service arrangements. Fees from consulting are recognized as services are performed. If a transaction includes both license and service elements, license fees are recognized separately upon delivery of the licensed software, provided services do not include significant customization or modification of the software product, the licenses are not subject to acceptance criteria, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If the services do include significant customization or modification of the software product, the revenue is recognized in accordance with the relevant guidance from the American Institute of Certified Public Accountants Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1).

The Company recognizes revenue for these types of arrangements as services are rendered using the percentage-of-completion method with progress-to-complete usually measured using labor hour or labor cost inputs. The Company believes that these input measures more accurately reflect its progress on projects accounted for under SOP 81-1, as opposed to output measures, which are generally difficult to establish for the projects in which the Company is engaged. The Company periodically reviews cost estimates on percentage-of-completion contracts and records adjustments in the period in which the revisions are made. Any anticipated losses on contracts are charged to operations as soon as they are determinable. The complexity of the estimation process and factors relating to the assumptions, risks and uncertainties inherent with the application of the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in the Company’s consolidated financial statements. A number of internal and external factors can affect the Company’s estimates, including labor rates, availability of qualified personnel and project requirement and/or scope changes. Billings on uncompleted contracts may be less than or greater than the revenues recognized and are recorded as either unbilled receivable (an asset) or deferred revenue (a liability) in the consolidated financial statements.

Goodwill and Other Intangible Assets with Indefinite Useful Lives

Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized.

The Company assesses the impairment of goodwill, in accordance with guidance provided by SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors the Company considers important that could trigger an impairment review include the following:

• poor economic performance relative to historical or projected future operating results;

• significant negative industry, economic or company specific trends;

• changes in the manner of its use of the assets or the plans for its business; and

• loss of key personnel.

If the Company were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, the Company

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would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, the Company would record an impairment charge for the difference.

The Company also assesses the impairment of intangible assets with indefinite useful lives on at least an annual basis, or more frequently if any of the above factors exist that might cause impairment to the carrying value. The Company compares the fair value of each intangible asset group, which is determined based on a discounted cash flow valuation method, with the carrying value of the intangible asset group. If the Company were to determine that the fair value of an intangible asset was less than its carrying value, based upon the discounted cash flow valuation, the Company would recognize impairment loss in the amount of the difference between fair value and the carrying value of the asset.

The Company has significant goodwill on its balance sheet related to previous business combinations. The assessment of goodwill includes using a discounted cash flow approach that requires estimates of future revenue, costs and discount rates, as well as analysis of the Company’s market capitalization. Factors the Company uses to determine appropriate estimates for revenue include, but are not limited to, historical trends, potential market size and market share, and competitor pricing and gross margins, while using reasonable estimates of headcount, operating expenses and capital expenditures to support the revenue forecasts. These estimates have a significant effect on the Company’s financial statements and changes to these estimates could significantly affect the amount of goodwill on the Company’s balance sheet.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), 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. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its undiscounted estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

The Company has significant purchased intangible assets subject to amortization on its balance sheet related to developed technology. These intangible asset values were estimated using a discounted cash flow approach that used estimated future revenues, costs and discount rates. The useful lives of these assets were estimated using the Company’s own historical experience, as well as analyzing other companies in the same or related industries. Factors the Company used to determine appropriate estimates of useful lives include, but are not limited to, the expected use of the assets, any legal regulatory, or contractual provisions that may affect the useful lives, the effects of competition and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the assets. These estimates have a significant effect on the Company’s financial statements. Changes to these estimates could significantly affect the asset values on the Company’s balance sheet and the amount of amortization that is recognized in the statement of operations.

Valuation of Outstanding Warrants

In accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150), the Company classified certain warrants to purchase shares of its common stock as a liability because they contain characteristics of debt. The Company valued the outstanding warrants using a Black-Scholes-Merton (“BSM”) option valuation model and used estimates for an expected dividend yield, a risk-free interest rate, and price volatility of its common stock. Each interim period and year end, while the warrants were outstanding and contained characteristics of debt, the warrants were revalued, but not below their cash redemption value, and any difference from the previous valuation date was recognized as a change in fair value of outstanding warrants in the Company’s statement of operations. On June 5, 2006, the warrants classified as a liability expired, and, accordingly, were no longer classified as a liability.

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Reclassifications

Certain reclassifications, including stock-based compensation expense, were made to the 2005 condensed consolidated financial statements to conform to the 2006 presentation. The Company’s condensed consolidated interim financial statements are not necessarily indicative of results to be expected for a full fiscal year.

3. Stock-Based Compensation

The Company maintains the Saflink Corporation 2000 Stock Incentive Plan (the “2000 Plan”) under which it may grant stock options and restricted stock awards to employees, non-employee directors and consultants. Generally, these awards vest monthly over a 36 month term and expire ten years from the date of grant. There were 15,000,000 shares authorized and 1,862,118 shares reserved for future issuance under the 2000 Plan as of June 30, 2006. On August 25, 2005, the Company’s stockholders approved the Saflink Employee Stock Purchase Plan (the “Plan”). The Plan authorizes the issuance of up to 300,000 shares of the Company’s common stock, subject to appropriate adjustment in the event of any stock dividend, stock split, reverse stock split, recapitalization or similar change in the capital structure of the Company, or in the event of any merger, sale of assets or other reorganization. Generally, each purchase period under the Plan will be for a period of six months, with the purchase date being the last day of the purchase period and the purchase price will be no less than 95% of the fair value of the Company’s common stock on the purchase date. The Company has not yet commenced the initial purchase period under the Plan.

Prior to the January 1, 2006 adoption of the Financial Accounting Standards Board (“FASB”) Statement No. 123 (Revised 2004), “Share-Based Payment” (SFAS 123R), the Company accounted for stock-based compensation to employees using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, when the stock option grant price equaled the market price on the date of grant, no compensation expense was recognized by the Company for stock-based compensation. As permitted by SFAS 123, “Accounting for Stock-Based Compensation” (SFAS 123), stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, and applied the provision of Staff Accounting Bulletin No. 107, “Share-Based Payment,” using the modified-prospective transition method. Under this transition method, stock-based compensation expense is recognized in the consolidated financial statements for grants of stock options. Compensation expense recognized includes the estimated expense for stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Further, as required under SFAS 123R, forfeitures are estimated for share-based awards that are not expected to vest. Results for prior periods have not been restated, as provided for under the modified-prospective transition method. Prior to the adoption of SFAS 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis. This amount would be shown as “Excess tax benefit from exercise of stock options” on the consolidated statement of cash flows. There were no realized excess tax benefits in the three and six months ended June 30, 2006.

Determining Fair Value Under SFAS 123R

Valuation and Amortization Method. The Company estimates the fair value of stock-based awards granted using the BSM option valuation model. Generally, these awards have an exercise price that is equal to the fair value of the Company’s common stock at the date of grant with monthly vesting over a 36 month term, no post-vesting restrictions and expire ten years from the date of grant. The Company amortizes the fair value of all stock option awards using the single option valuation approach over the requisite service periods, which are generally the vesting periods.

Expected Life. The expected life of awards granted represents the period of time that they are expected to be outstanding. The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise behavior and post-vesting cancellations.

Expected Volatility. The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of its common stock. The volatility factor the Company uses in the BSM option valuation model is based on the Company’s historical stock prices over the most recent period commensurate with the estimated expected life of the award. Certain historical periods that have characteristics that the Company does not expect in the future have been given less weight when calculating expected volatility.

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Risk-Free Interest Rate. The Company bases the risk-free interest rate used in the BSM option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.

Expected Dividend Yield. The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the BSM option valuation model.

Expected Forfeitures. Due to the monthly vesting schedules associated with the Company’s stock option grants, the Company is using actual forfeitures in determining stock-based compensation expense as the Company asserts that the difference between using actual forfeitures versus using an estimated forfeiture rate that is trued up at every vesting date would be insignificant.

The fair value for each option grant was estimated at the date of the grant using a BSM option valuation model based on the following weighted average assumptions:

	Three months ended June 30,						Six months ended June 30,
	2006			2005			2006			2005
Expected dividend yield		0	%		0	%		0	%		0	%
Risk-free interest rate		5.00	%		4.00	%		4.60	%		4.00	%
Volatility		95	%		129	%		96	%		129	%
Expected life (years)		6.1			6.6			6.1			6.3
Fair value of options granted per share	$	0.48		$	1.85		$	0.63		$	1.85

Stock-based compensation Under SFAS 123R

The following table summarizes stock-based compensation expense related to stock-based awards under SFAS 123R for the three and six months ended June 30, 2006, which was incurred as follows (in thousands):

	Three months ended June 30, 2006		Six months ended June 30, 2006
Stock-based compensation:
Product development	$	30	$	58
Sales and marketing		23		42
General and administrative		163		418
Total stock-based compensation	$	216	$	518

No compensation cost was capitalized as part of an asset during the three and six months ended June 30, 2006.

At June 30, 2006, the Company had 1.5 million non-vested stock options that had a weighted average grant date fair value of $0.65. At December 31, 2005, the Company had 223,337 non-vested stock options that had a weighted average grant date fair value of $1.04. As of June 30, 2006, the Company had $1.4 million of total unrecognized compensation cost related to non-vested stock-based awards granted under the 2000 Plan. The Company expects to recognize this cost over a weighted average period of 1.2 years.

The following table presents the impact of the Company’s adoption of SFAS 123R on selected line items from its condensed consolidated financial statements for the three and six months ended June 30, 2006 (in thousands, except per share amounts):

	Three months ended June 30, 2006						Six months ended June 30, 2006
	As Reported Following SFAS 123R			If Reported Following APB 25			As Reported Following SFAS 123R			If Reported Following APB 25
Condensed consolidated statement of operations
Operating loss	$	(37,355	)	$	(37,272	)	$	(73,676	)	$	(73,423	)
Loss before income taxes		(37,619	)		(37,536	)		(73,867	)		(73,614	)
Net loss attributable to common stockholders		(37,708	)		(37,625	)		(74,478	)		(74,225	)
Basic and diluted net loss per share attributable to common stockholders	$	(0.43	)	$	(0.43	)	$	(0.85	)	$	(0.84	)

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The Company’s statement of cash flows was not affected by the adoption of SFAS 123R.

The following table shows the effect on net loss and net loss per share for the three and six months ended June 30, 2005, had compensation cost been recognized based upon the estimated fair value on the grant date of stock options, in accordance with SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”

	Three months ended June 30, 2005			Six months ended June 30, 2005
Net loss attributable to common stockholders	$	(6,585	)	$	(13,416	)
Add: Stock-based employee compensation expense included in reported net loss		398			863
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all rewards and modifications		(1,662	)		(3,642	)
Pro forma net loss attributable to common stockholders		(7,849	)		(16,195	)
Basic and diluted net loss per common share attributable to common stockholders, as reported	$	(0.08	)	$	(0.17	)
Basic and diluted net loss per common share attributable to common stockholders, pro forma	$	(0.10	)	$	(0.20	)

Stock Option Activity

The following table summarizes stock option activity:

	Options Outstanding (in thousands)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (years)	Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2005	8,507		$	1.12
Granted	1,706			0.79
Exercised	(21	)		0.79
Expired or Canceled	(733	)		2.01
Outstanding at June 30, 2006	9,459		$	0.99	6.7	$	—
Exercisable at June 30, 2006	7,958		$	1.03	6.2	$	—

The Company received $17,000 in cash from the exercises of stock options during the six months ended June 30, 2006. As of June 30, 2006, the aggregate intrinsic value of options outstanding and exercisable was zero as there were no options granted with an exercise price less than the $0.37 closing market price of the Company’s common stock at June 30, 2006. The total intrinsic value of options exercised during the three months ended June 30, 2006 and 2005, was $0 and $187,000, respectively, determined as of the date of each exercise.

The following table summarizes information about employee stock options outstanding at June 30, 2006:

	Options outstanding				Options exercisable
Range of exercise prices	Number of shares (in thousands)	Weighted average remaining contractual life (in years)	Weighted average exercise price per share		Number of shares (in thousands)	Weighted average exercise price per share
$0.01 – $1.50	8,648	6.8	$	0.81	7,147	$	0.81
1.51 –   3.00	522	6.6		2.42	522		2.42
3.01 –   4.50	197	2.2		3.51	197		3.51
$4.51 – $5.64	92	7.0		5.28	92		5.28
Total	9,459	6.7	$	0.99	7,958	$	1.03

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Non-vested Restricted Stock Awards

The Company has two outstanding non-vested, restricted stock awards as of June 30, 2006. Kris Shah, a member of the Company’s board of directors and President of Litronic Inc., a wholly-owned subsidiary of the Company, holds 500,000 non-vested, restricted shares of the Company’s common stock and Glenn Argenbright, the Company’s President and Chief Executive Officer, holds 301,928 non-vested, restricted shares of the Company’s common stock. Mr. Shah’s shares are scheduled to vest on August 9, 2006, while Mr. Argenbright’s shares are scheduled to vest on June 23, 2007. The compensation cost related to these awards was calculated based on the market price of the Company’s common stock on the exercise date of the stock purchase rights. The remaining compensation expense of $277,000 at June 30, 2006 is being recorded equally over the respective remaining vesting periods. Compensation expense related to non-vested, restricted stock awards was $132,000 and $263,000 for the three and six months ended June 30, 2006, respectively.

4. Goodwill

The Company tests goodwill as of November 30^th annually. However, the Company concluded that certain factors, such as the lack of significant revenue and the continued decline of the price of its common stock as reported on the Nasdaq Capital Market, constituted triggering events under SFAS 142 during the first and second quarters of 2006. During the process of finalizing its goodwill valuation as of March 31, 2006, the Company reduced its $29.7 million goodwill impairment loss by $2.3 million, which is a component of the Company’s impairment loss recorded in its statement of operations for the three and six months ended June 30, 2006. The nature of this adjustment was related to the finalization of the estimated in-process research and development amount as of March 31, 2006. As a result of the Company’s preliminary testing as of June 30, 2006, the Company believed that an impairment loss was probable and that it could reasonably estimate a goodwill impairment charge of $33.0 million for the three months ended June 30, 2006. Given the volatility in the Company’s historical revenue trends, the significant decline in the Company’s market capitalization, and other indicators of fair value, the Company determined that the best estimate of fair value as of June 30, 2006 for the goodwill impairment test was the Company’s market capitalization. The Company is still in the process of finalizing its goodwill assessment as of June 30, 2006, but expects to complete the valuation of the impairment charge during the third quarter of 2006. Any significant adjustments to the Company’s preliminary estimate will be disclosed in the Company’s quarterly report on Form 10-Q for the quarter ended September 30, 2006.

The changes in the carrying value of goodwill for the six months ended June 30, 2006, are as follows (in thousands):

Balance as of December 31, 2005	$	75,923
First quarter impairment loss		29,700
First quarter impairment adjustment		(2,300	)
Second quarter impairment loss		33,000
Balance as of June 30, 2006	$	15,523

5. Intangible Assets

In connection with the preliminary testing of goodwill under SFAS 142 as of June 30, 2006, the Company also tested its intangible assets for impairment under SFAS 144 and determined that no impairment existed. In the first quarter of 2005, the Company assessed the marketing strategy for its product offerings and decided to discontinue use of two tradenames that were acquired in connection with the Litronic acquisition. Management estimated the fair value of these two tradenames to be zero because no future use was anticipated and the Company did not believe that a market existed for these tradenames. As a result, the Company recorded a $900,000 impairment loss on intangible assets during the first quarter of 2005.

6. Inventory

The following is a summary of inventory as of June 30, 2006, and December 31, 2005 (in thousands):

	June 30, 2006		December 31, 2005
Raw materials	$	166	$	83
Work-in-process		2		49
Finished goods		421		431
	$	589	$	563

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7. Stockholders’ Equity

June 2006 Convertible Debenture and Warrant Issuance

On June 12, 2006, the Company raised $8.0 million in gross proceeds through a private placement of 8% convertible debentures and warrants to purchase up to 8,889,002 shares of the Company’s common stock. The warrants have an exercise price of $0.48 per share and are exercisable for a period of five years beginning December 10, 2006. The Company also issued a warrant to purchase 1,066,680 shares of its common stock, exercisable at $0.48 per share, to the placement agent for services rendered in connection with this financing.

The debentures bear interest at 8% per annum and are due December 12, 2007. The debentures are convertible into shares of the Company’s common stock at any time at a conversion rate of $0.45 per share; however, the initial conversion price is subject to adjustment in the event the Company issues common stock or common stock equivalents at a price per share of common stock below the conversion price of the debentures. Under the terms of the purchase agreement, unless the Company obtains stockholder approval of the financing, the Company may not issue shares of its common stock upon the conversion of the debentures or upon exercise of the warrants if the number of shares of common stock so issued, when aggregated with any shares of common stock issued after June 12, 2006, upon conversion of the debentures or upon exercise of warrants issued in the financing would exceed 19.999% of the number of shares of the Company’s common stock outstanding on the date of the financing. The Company agreed to hold a stockholders meeting for the purpose of seeking stockholder approval of the financing because the common stock issuable upon conversion of the debentures and exercise of the warrants issued in the financing exceeded 15% of the Company’s common stock outstanding on the date of the financing. The principal amount of the debentures is redeemable at the rate of 1/12 of the original principal amount per month plus accrued but unpaid interest on the debentures commencing December 1, 2006. The Company may, in its discretion, elect to pay the monthly redemption amount in cash or in shares of its common stock, subject to certain conditions related to the market for shares of the Company’s common stock and the registration of the shares issuable upon conversion of the debentures under the Securities Act of 1933. Pursuant to the terms of the debentures, if a registration statement covering the resale of the conversion shares has not been declared effective by the SEC on or prior to March 9, 2007, the Company would be deemed in default and the outstanding principal amount of the debentures, plus accrued but unpaid interest, would become, at the debenture holder’s election, immediately due and payable in cash. The Company filed a registration statement on Form S-3 related to this financing with the SEC on July 7, 2006, but the registration statement has not yet been declared effective.

The Company applied the guidance of Emerging Issue Task Force (EITF) No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios and EITF No. 00-27, Application of Issue No. 98-5 Certain Convertible Instruments and concluded that the convertible debentures included a beneficial conversion feature, which was valued at $1,655,000. This amount was determined by first allocating the cash proceeds received in the financing transaction to the convertible debentures and warrants on a relative fair value basis. Second, an effective conversion price on the convertible debentures was calculated based on this allocation and used to measure the intrinsic value of the embedded conversion option. The warrants were valued at $2,812,000, using the BSM option valuation model with the following assumptions: an expected dividend yield of 0%, risk-free interest rate of approximately 5%, expected volatility of 95% and contractual life of five and half years. The beneficial conversion feature and warrants were recorded as a debt discount that are being amortized to interest expense over the term of the convertible debentures using the effective interest method.

The debt issuance costs associated with this financing are recorded as a long-term asset and are being amortized over the term of the debentures to interest expense using the effective interest method. The components of the debt issuance costs include cash costs of $614,000 for legal, banking and other fees and a warrant issued to the placement agent to purchase 1,066,680 shares of the Company’s common stock valued at $337,000, using the BSM option valuation model with the same assumptions used to value the investor warrants. As of June 30, 2006, $93,000 of the total cash transaction costs were unpaid and classified in accounts payable and accrued liabilities.

The following table summarizes the activity related to the Company’s convertible debentures issued in June 2006:

Face value of convertible debentures	$	8,000
Less: unamortized debt discounts		(4,255	)
Total carrying value, net of debt discount June 30, 2006	$	3,745
Current portion of debt, net of debt discount	$	1,073
Long term portion of debt, net of debt discount	$	2,672

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Modification of Outstanding Warrants

On June 12, 2006, the Company amended certain warrants to purchase 2,250,000 shares of its common stock issued in connection with its June 2005 private placement. The amendment required that the Company call one hundred percent of the warrants (“called warrant shares”) if it completed a debt or equity financing for a minimum of $8.0 million in gross proceeds prior to the expiration of the warrants. In addition, the rights and privileges granted pursuant to the warrants would expire on the tenth day after the holders receive a call notice if the warrants were not exercised. In the event the warrants were not exercised with respect to the called warrant shares, the Company agreed to remit to the warrant holders $0.38 per called warrant share. The amendment did not otherwise change any terms of the warrants, including the exercise price or the number of shares issuable upon exercise of the warrants.

As a result of the $8.0 million raised in the convertible debenture and warrant issuance on June 12, 2006, and pursuant to the warrant amendments, the Company issued call notices to the holders of the called warrant shares. The warrant holders waived their right to the ten day exercise period and, accordingly, the Company remitted $0.38 per called warrant share, an aggregate of $855,000, to the warrant holders during June 2006. Due to the warrant amendments, the Company reclassified the warrants as a liability because the amended warrants then contained characteristics of debt instruments. The Company estimated the fair value of the warrants to be $0.38 per called warrant share, an aggregate of $855,000, which was the amount to be remitted to the warrant holders if the warrants were not exercised after being called and was reclassified to a liability from equity in June 2006.

As a result of the Company’s convertible debenture issuance on June 12, 2006, anti-dilution provisions contained in certain outstanding warrants issued by the Company were triggered. Accordingly, the Company recorded adjustments to the exercise price and, in certain cases, to the number of common shares issuable upon exercise of these warrants. The total number of shares of the Company’s common stock issuable upon exercise of these warrants increased by approximately 253,000 shares and the exercise price reductions varied depending upon the type of warrant.

The fair value of the modification of these warrants was determined by using a BSM option valuation model immediately before and after the effective date of June 12, 2006, with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of approximately 5%, expected volatility between 71% and 75%, and estimated lives between 6 months and 4 years, the remaining contractual lives of these warrants. The fair value of the modification was estimated to be $76,000 and was recorded as a modification of outstanding warrants. This charge increased net loss attributable to common stockholders.

On January 1, 2006, anti-dilution provisions were triggered in certain outstanding warrants issued by the Company as a result of the modification to the Company’s convertible note payable to a related party on December 31, 2005. Accordingly, the Company recorded adjustments to the exercise price and, in certain cases, to the number of common shares issuable upon exercise of these warrants. The total number of shares of the Company’s common stock issuable upon exercise of these warrants increased by approximately 5,000 shares and the exercise price of the warrants issued in connection with the Company’s June 2005 financing was reduced from $2.50 to $0.71 per common share as of that date. The exercise price of these warrants was subsequently reduced to $0.45 per common share as a result of the June 2006 convertible debenture financing.

The fair value of the modification of these warrants was determined by using a BSM option valuation model immediately before and after the effective date of January 1, 2006, with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate between 4% and 5%, expected volatility between 71% and 98%, and estimated lives between 2 and 5 years, the remaining contractual lives of these warrants. The fair value of the modification was estimated to be $509,000 and was recorded as a modification of outstanding warrants. This charge increased net loss attributable to common stockholders.

Series A Warrant Expiration and Redemption Notices

The SSP-Litronic acquisition in August 2004 triggered certain redemption provisions in connection with the Company’s Series A warrants. The cash redemption value was estimated to be $765,000 as of August 2, 2004, the date the Company notified the warrant holders of the merger, and was fixed as long as the warrants were outstanding or until expiration in June 2006. On August 6, 2004, the closing date of the merger, these warrants were reclassified as a liability because the warrants then contained characteristics of a debt instrument.

During the second quarter of 2006 and prior to the expiration of these warrants on June 5, 2006, the Company received notices from certain warrant holders exercising the redemption provision. Based on the redemption notices received and the cash redemption calculation contained in the warrant, the Company has reduced the current obligation from $765,000 to $569,000 during the three months ended June 30, 2006, reclassifying $196,000 into stockholders’ equity.

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8. Concentration of Credit Risk and Significant Customers

Four customers accounted for 12%, 12%, 11% and 10% of the Company’s revenue for the three months ended June 30, 2006, while three customers accounted for 24%, 12% and 12% of accounts receivable as of June 30, 2006. Two customers accounted for 11% and 10% of the Company’s revenue for the six months ended June 30, 2006.

Three customers accounted for 19%, 18% and 12% of the Company’s revenue for the three months ended June 30, 2005, while two of the same customers accounted for 20% and 17% of the Company’s revenue for the six months ended June 30, 2005.

Sales to the U.S. government and state and local government agencies, either directly or indirectly, accounted for 64% and 56% of the Company’s revenue for the three and six months ended June 30, 2006, respectively, while these sales accounted for 85% and 87% of the Company’s revenue for the three and six months ended June 30, 2005. In addition, accounts receivable related to direct and indirect sales to the U.S. government and state and local government agencies accounted for 79% and 71% of the Company’s total accounts receivable balance as of June 30, 2006, and December 31, 2005, respectively.

9. Comprehensive Loss

For the three moths ended June 30, 2006, and 2005, the Company had no components of other comprehensive loss; accordingly, total comprehensive loss equaled the net loss for the respective periods.

10. Net Loss Per Share

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, warrants, convertible debentures and a convertible promissory note. As the Company had a net loss in each of the periods presented, basic and diluted net loss per common share are the same. All potentially dilutive securities were excluded from the calculation of dilutive net loss per share as their effect was anti-dilutive.

Potential common shares outstanding consisted of options, warrants, convertible debentures and a convertible note to purchase or acquire 43,644,186 and 16,493,649 shares of common stock at June 30, 2006, and 2005, respectively. There were 801,928 unvested shares of restricted common stock outstanding as of June 30, 2006, and 2005.

11. Segment Information

In accordance with SFAS No. 131, “Disclosure About Segments of an Enterprise and Related Information,” operating segments are defined as revenue-producing components of an enterprise for which discrete financial information is available and whose operating results are regularly reviewed by the Company’s chief operating decision maker. Saflink management and chief operating decision maker review financial information on a consolidated basis and, therefore, the Company operated as single segment for all periods presented.

12. Related-party Transactions

KRDS Real Property Lease

As a result of the merger with SSP-Litronic in August 2004, the Company assumed the building lease for SSP-Litronic’s corporate offices in Irvine, California. The lessor is KRDS, Inc., which is majority-owned by three employees of Saflink’s subsidiary, Litronic, one of whom is Kris Shah, the president of Litronic and a member of the Company’s board of directors. Saflink recognized rent expense of approximately $129,000 and $260,000 for the three and six months ended June 30, 2006. The lease expires in 2012.

13. Contingencies

The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

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14. Liquidity and Capital Resources

The Company had working capital of $5.6 million and $11.8 million at June 30, 2006, and December 31, 2005, respectively. As of June 30, 2006, the Company’s balance of cash and cash equivalents totaled $10.5 million. The Company received proceeds, net of issuance costs paid through June 30, 2006, of $7.5 million in connection with its June 2006 financing (see Note 7). However, the Company incurred losses from operations for both the year ended December 31, 2005, and the six months ended June 30, 2006. The Company also expects to incur additional losses for the remainder of 2006.

As a result of the capital raised during 2006, the Company believes that it will have sufficient funds to continue its operations at current levels through December 31, 2006. The Company does not have a credit line or other borrowing facility to fund its operations. To continue the current level of operations beyond December 31, 2006, the Company expects that it will need to seek additional funds through the issuance of additional equity or debt securities or other sources of financing. The Company may not be able to secure additional financing on favorable terms, or at all. If the Company is unable to obtain the necessary additional financing, it would be required to reduce the scope of its operations, primarily through the reduction of discretionary expenses, which include personnel, benefits, marketing and other costs.

If the Company is unable to generate sufficient revenue from customer contracts, or to further reduce costs sufficiently to generate positive cash flow from operations, the Company will need to consider alternative financing sources. Alternative financing sources may not be available when and if needed by the Company and will depend on many factors including, but not limited to:

• the ability to extend terms received from vendors;

• the market acceptance of products and services;

• the levels of promotion and advertising that will be required to launch new products and services and attain a competitive position in the marketplace;

• research and development plans;

• levels of inventory and accounts receivable;

• technological advances;

• competitors’ responses to the Company’s products and services;

• relationships with partners, suppliers and customers;

• projected capital expenditures; and

• a downturn in the economy.

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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 our 2005 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 17, 2006.

This quarterly report on Form 10-Q contains statements and information about management’s view of our 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 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 section of this quarterly report on Form 10-Q entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and identified in Item 1A of Part II entitled “Risk Factors.” We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that 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, 2005.

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

Our primary source of revenue is the sale of our software and hardware products and consulting services combined with the resale of software applications and hardware products sourced or assembled from third parties. For logical access control needs, we develop biometric and smart card application software, and resell biometric and smart card hardware and device control software from leading manufacturers. Biometric technologies automatically identify individuals by electronically capturing a specific biological or behavioral characteristic of that individual, such as a fingerprint, iris pattern, voiceprint or facial feature, creating a unique digital identifier from that characteristic and then comparing it against a previously created and stored digital identifier. Because this process relies on largely unalterable human characteristics, it is both highly secure and highly convenient for the individual seeking access. Smart card solutions operate similarly for identity verification and authentication but typically are used in conjunction with a Public Key Infrastructure (PKI) deployment. Smart cards employing PKI technology can be used for logical access decisions as well as securing electronic communications.

Our software products are designed for large-scale and complex computer networks, facilities, and manufacturing automation systems, and allow users seeking access or performing transactions to be identified using various biometric technologies. Our products comply with recognized industry standards, which allow us to integrate a large variety of biometric technologies within a common application environment without costly development related to 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 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.

Our financial focus continues to be the growth of our top-line revenue while maintaining acceptable gross margins. We believe that our products and services are best sold through a consultative sales approach that requires experienced enterprise sales personnel, either from our resellers or direct sales staff, to pursue and manage sales opportunities over several months, and possibly beyond a year in length.

The primary challenge for management is to convert our sales pipeline into revenue. We believe that we have been successful in building and managing our sales pipeline of opportunities. However, we have not been successful in converting this pipeline into significant revenue. Some of the primary challenges that can impact our success in this area include government appropriations, general market factors influencing purchasing of computer network and security solutions, a relatively long sales cycle associated with our types of solutions and services, and the relative immaturity of the biometrics market.

Our ability to translate the value proposition of our products and services into revenue will be a key factor in our ability to achieve financial and operational success. The biometrics market is relatively immature and new to numerous potential

17

customers in the commercial or governmental sectors. This makes it even more important, compared to a more mature or established market, that we successfully identify the positive attributes of our solutions, and then translate those to the customers, so that they are motivated to purchase our products and services.

Among the key challenges to our business is whether we can establish sales and profitability success prior to the emergence of a dominant competitor in our targeted markets. Our goal has been to grow our market share while the biometric market matures. We believe that sales of large enterprise deployments, in the public or private sector, will be the first signs that we are beginning to achieve our goal of growth in market share.

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. 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. We believe our most critical accounting policies and estimates include revenue recognition, goodwill and other intangible assets with indefinite useful lives, impairment of long-lived assets, stock-based compensation and the valuation of outstanding warrants. Actual results may differ from these estimates under different assumptions or conditions.

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. Consideration should be given to our prospects in light of the risks and difficulties described in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2005. We may not be able to successfully address these risks and difficulties.

We incurred net losses attributable to common stockholders of $37.7 million and $74.5 million for the three and six months ended June 30, 2006, respectively. These results included impairment losses on goodwill of $30.7 million and $60.4 million for the three and six months ended June 30, 2006, respectively. The results for the three and six months ended June 30, 2006, are compared to net losses attributable to common stockholders of $6.6 million and $13.4 million for the three and six months ended June 30, 2005, respectively. The net loss attributable to common stockholders for the six months ended June 30, 2005, included a $900,000 impairment loss on intangible assets. There were no impairment losses on intangible assets during the six months ended June 30, 2006.

The following discussion presents certain changes in our revenue and expenses that have occurred during the three and six months ended June 30, 2006, as compared to the three and six months ended June 30, 2005.

Revenue and Cost of Revenue

We recorded revenue primarily from four sources during the three and six months ended June 30, 2006, and 2005: software licenses, manufactured hardware, third party hardware and software, and services. Product revenue consisted of license fees for our software products, sales of our manufactured hardware and the reselling of third party hardware and software products and applications. Service revenue consisted of payments for maintenance and support contracts, as well as labor fees related to government and commercial projects and programs. During the three months ended June 30, 2006, software license sales were $89,000; sales of manufactured hardware were $481,000; and sales of third party software and hardware were $216,000, while service revenue was $158,000, which was entirely related to customer support and product maintenance. During the same period in 2005, software license sales were $77,000; sales of manufactured hardware were $809,000; and sales of third party software and hardware were $213,000, while service revenue was $707,000, which was comprised of $587,000 related to fees for consulting, integration and project labor and $120,000 related to customer support and product maintenance. Total revenue of $1.8 million for the six months ended June 30, 2005 decreased $2.2 million, or 55%, from revenue of $4.0 million for the six months ended June 30, 2005. Product and service revenue for the six months ended June 30, 2006 were $1.5 million and $259,000, respectively, compared to $2.3 million and $1.7 million, respectively, for the six months ended June 30, 2005. The decreases in total revenue for the three and six months ended June 30, 2006 can be primarily attributed to declining service revenue related to projects and a reduction in manufactured hardware revenue during these periods. We have de-emphasized our participation in custom integration services over the last year in favor of the development of new product offerings for the commercial and government sectors, which has resulted in lower service revenue during 2006. We believe the reduction in manufactured hardware sales, primarily related to our legacy Litronic-branded readers, was caused by decreased spending on communications infrastructure by the U.S. Government’s Department of Defense due to the diversion of funds for military needs abroad.

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Total cost of revenue included product cost of revenue, service cost of revenue and the amortization of intangible assets. Product cost of revenue consisted of raw materials, packaging and production costs for our software and manufactured hardware sales, and cost of hardware and software applications purchased from third parties. Service cost of revenue consisted of labor and expenses for post-contract customer support, consulting and integration services, and training. During the three months ended June 30, 2006, cost of revenue from software and manufactured hardware were $1,000 and $205,000, respectively, cost of third party software and hardware was $160,000, while cost of service revenue was $130,000. Total cost of revenue also included amortization of intangible assets of $671,000 for the three months ended June 30, 2006, which was primarily related to intangible assets acquired in the acquisition of SSP-Litronic in August 2004. During the same period in 2005, cost of revenue from software and manufactured hardware was $1,000 and $314,000, respectively, cost of revenue from third party software and hardware was $155,000, while cost of service revenue was $403,000. There also was $671,000 in amortization of intangible assets included in cost of revenue for three months ended June 30, 2005. Total cost of revenue of $1.2 million for the three months ended June 30, 2006 decreased $377,000, or 24%, from cost of revenue of $1.5 million for the same period in 2005, primarily attributable to the decrease in total revenue. Total cost of revenue of $2.3 million for the six months ended June 30, 2006 decreased $948,000, or 29%, from cost of revenue of $3.2 million for the same period in 2005. Product and service cost of revenue for the six months ended June 30, 2006 were $693,000 and $256,000, respectively, compared to $876,000 and $1.0 million, respectively, for the six months ended June 30, 2005. Amortization of intangible assets recorded in cost of revenue was $1.3 million for the first six months of 2006 and 2005. The overall decrease in total cost of revenue can primarily be attributed to lower revenue during the first six months of 2006 when compared to the same period in 2005. However, our gross margin on hardware and third party hardware revenue decreased slightly during the six months ended June 30, 2006, which increased cost of revenue as a percentage of sales.

Our gross loss for the three months ended June 30, 2006 was $223,000, or negative 24%, compared to a gross profit of $262,000, or 15%, for the same period in 2005. Our gross loss for the six months ended June 30, 2006, was $490,000, or negative 27%, compared to a gross profit of $751,000, or 19%, for the same period in 2005.

Operating Expenses

Total operating expenses for the three months ended June 30, 2006 increased approximately $30.3 million, or 442%, to $37.1 million from $6.8 million for the same period in 2005. The overall increase was primarily due to a net impairment loss on goodwill of $30.7 million that was recorded during the three months ended June 30, 2006. The net impairment loss on goodwill for the three months ended June 30, 2006 included a $2.3 million reduction in the goodwill impairment loss for the first quarter of 2006, which was recognized upon finalization of the goodwill valuation as of March 31, 2006. Excluding the net impairment loss on goodwill, operating expenses for the three months ended June 30, 2006 decreased $416,000, when compared to the same period in 2005. From a functional operating expense perspective, excluding the impairment losses on goodwill and intangible assets, the decrease was primarily due to a $571,000 decrease in compensation and related benefits driven by headcount being reduced to 112 employees at June 30, 2006, compared to 149 employees at June 30, 2005. This decrease, however, was partially offset by a $196,000 increase is legal and professional services which was primarily related to increased fees for legal and consulting services.

Total operating expenses for the six months ended June 30, 2006 increased approximately $58.5 million, or 399%, to $73.2 million from $14.7 million for the comparable period in 2005. This increase was directly attributable to the impairment losses on goodwill of $60.4 million during the first six months of 2006. During the first six months of 2005, we recorded a $900,000 impairment loss on intangible assets, but did not incur any impairment losses related to goodwill.

The following table provides a breakdown of the dollar and percentage changes in operating expenses for the three and six months ended June 30, 2006, as compared to the same period in 2005 (in thousands):

	Three months					Six Months
	$ Change			% Change		$ Change			% Change
Product development	$	103		4	%	$	210		5	%
Sales and marketing		(346	)	(14	)		(780	)	(17	)
General and administrative		(173	)	(8	)		(417	)	(9	)
Impairment loss on goodwill		30,700		—			60,400		—
Impairment loss on intangible assets		—		—			(900	)	(100	)
	$	30,284		442	%	$	58,513		399	%

Product Development—Product development expenses consist primarily of salaries, benefits, supplies and materials for software developers, hardware engineers, product architects and quality assurance personnel, fees paid for outsourced software development and hardware design. Product development expenses increased $103,000, or 4%, during the three

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months ended June 30, 2006, to $2.4 million from $2.3 million for the same period in 2005. From a functional operating expense perspective, this increase was primarily due to a $49,000 increase related to outsourced hardware design costs, a $27,000 increase in occupancy costs, and a $26,000 increase in other expenses, which is primarily comprised of research and development materials, education and training, license fees, and dues and subscriptions. Despite a headcount decrease of 18 employees, or 26%, from June 30, 2005 to June 30, 2006, compensation and related benefits only decreased $17,000, because the decreased wages were offset by the fact that we had fewer revenue projects for product development personnel to work on and, therefore, less salary and wages to be allocated to cost of revenue from operating expense.

For the six months ended June 30, 2006, total product development expenses increased $210,000 compared to the same period in 2005. This increase can be primarily attributed to a $159,000 increase in other expenses related to purchases of research and development materials for the development of new product and service offerings.

Sales and Marketing—Sales and marketing expenses consist primarily of salaries and commissions earned by sales and marketing personnel, trade shows, advertising and promotional expenses, fees for consultants, and travel and entertainment costs. Sales and marketing expenses decreased $346,000, or 14%, during the three months ended June 30, 2006, compared to the same period in 2005. From a functional operating expense perspective, this decrease was primarily due to a $325,000 decrease in compensation and related benefits and a $57,000 decrease in other expenses, which is primarily comprised of software license fees and maintenance, dues and subscriptions and education and training. The decrease in compensation and related benefits was primarily due to a reduction in sales and marketing headcount of 14 employees, or 29%, from June 30, 2005 to June 30, 2006, while the decrease in other expenses was driven by reduced software license fees during the quarter. These decreases were offset by a $41,000 increase in legal and professional services, primarily related to an increase in market research consulting fees for product lines currently in development.

For the six months ended June 30, 2006, total sales and marketing expenses decreased $780,000 compared to the same period in 2005. This decrease can be primarily attributed to a $748,000 decrease in compensation and related benefits due to the 29% headcount reduction from June 30, 2005 to June 30, 2006.

General and Administrative—General and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, legal, human resource, information technology and administrative personnel, professional services fees and allowances for bad debts. General and administrative expenses decreased $173,000 during the three months ended June 30, 2006, compared to the same period in 2005. From a functional operating expense perspective, this decrease was primarily due to a $230,000 decrease in compensation and related benefits and a decrease of $38,000 in other expenses, which was primarily comprised of insurance expense, education and training, bank and license fees, and taxes. The decrease in compensation and benefits was primarily driven by a reduction in general and administrative headcount of five employees, or 19%, from June 30, 2005 to June 30, 2006. The decrease in other expenses was primarily due to lower corporate taxes as a result of the amendment to decrease the number of common shares authorized for issuance from 500,000,000 to 200,000,000 in August 2005. These decreases were offset by an increase in legal and professional services of $106,000, which was primarily driven by increased corporate legal fees.

For the six months ended June 30, 2006, total general and administrative expenses decreased $417,000 compared to the same period in 2005. This decrease can be primarily attributed to a $517,000 decrease in compensation and related benefits due to the headcount reduction from June 30, 2005 to June 30, 2006, and decrease of $226,000 in other expenses, primarily the result of a patent infringement settlement gain of $100,000 during the first quarter of 2006. These decreases were offset by a $362,000 increase in legal and professional services primarily due to increased general corporate legal fees and legal fees related to the enforcement of our intellectual property rights in connection with our settlement agreement.

Impairment Loss on Goodwill—We test goodwill as of November 30^th annually. However, we concluded that certain factors, such as the lack of significant revenue and the continued decline of the price of our common stock as reported on the Nasdaq Capital Market, constituted triggering events under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) for the first and second quarters of 2006. During the process of finalizing our goodwill valuation as of March 31, 2006, we reduced the $29.7 million goodwill impairment loss by $2.3 million, which is a component of the Company’s impairment loss recorded in its statement of operations for the three and six months ended June 30, 2006. The nature of this adjustment was related to the finalization of the estimated in-process research and development amount as of March 31, 2006. As a result of our preliminary testing as of June 30, 2006, we believed that an impairment loss was probable and that we could reasonably estimate a goodwill impairment charge of $33.0 million for the three months ended June 30, 2006. This resulted in a net impairment loss on goodwill of $30.7 million and $60.4 million for the three and six months ended June 30, 2006, respectively. Given the volatility in our historical revenue trends, the significant decline in our market capitalization, and other indicators of fair value, we determined that the best estimate of fair value as of June 30, 2006 for the goodwill impairment test was our market capitalization. We are still in the process of finalizing our goodwill assessment but expect to complete the valuation of the impairment charge during the third quarter of 2006. Any significant adjustments to our preliminary estimate will be disclosed in our quarterly report on Form 10-Q for the quarter ended September 30, 2006.

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Impairment Loss on Intangible Assets—There was no impairment loss on intangible assets during the three and six months ended June 30, 2006. During the first quarter of 2005, we decided to discontinue use of two tradenames that we acquired in connection with the SSP-Litronic acquisition. We estimated the fair value of these two tradenames to be zero, and as such, recorded a $900,000 impairment loss on intangible assets during that period.

Interest expense

Interest expense for the three and six months ended June 30, 2006 was $323,000 and $362,000, respectively, compared to $28,000 and $66,000 for the three and six months ended June 30, 2005, respectively. Interest expense for the three and six months ended June 30, 2006 and 2005 consisted of interest expense from the financing of certain insurance policies over a three month period and interest related to a convertible note payable to a related party that we assumed in the SSP-Litronic acquisition. Due to the convertible debenture and warrant financing in June 2006, interest expense for the three and six months ended June 30, 2006 also included interest expense on the principal of $8.0 million, amortization of the debt issuance costs, which includes the fair value of the placement agent warrant, and amortization of the debt discounts related to the investor warrants and the beneficial conversion feature.

Other income, net

Other income for the three and six months ended June 30, 2006 was $59,000 and $171,000, respectively. This is compared to $74,000 and $161,000 for the three and six months ended June 30, 2005, respectively. Other income primarily consisted of interest earned on cash and money market balances.

Change in fair value of outstanding warrants

Change in fair value of outstanding warrants for the three and six months ended June 30, 2005 resulted in gains of $27,000 and $172,000, respectively. The SSP-Litronic acquisition in August 2004 triggered certain redemption provisions in connection with our Series A warrants. The cash redemption value was estimated to be $765,000 as of August 2, 2004, the date we notified the warrant holders of the merger, and was fixed as long as the warrants were outstanding or until expiration in June 2006. On August 6, 2004, the closing date of the merger, these warrants were reclassified as a liability because the warrants then contained characteristics of a debt instrument. The gains during the three and six months ended June 30, 2005, represented the change in valuation from March 31, 2005 and December 31, 2004, respectively, and the estimated value of $765,000, as of June 30, 2005. There were no changes in the fair value of these warrants for the three and six months ended June 30, 2006.

During the second quarter of 2006 and prior to the expiration of these warrants on June 5, 2006, we received notices from certain warrant holders exercising the redemption provision. Based on the redemption notices received and the cash redemption calculation contained in the warrant, we have reduced the current obligation from $765,000 to $569,000 during the three months ended June 30, 2006, reclassifying $196,000 into stockholders’ equity.

Income tax provision

We recorded income tax expense of $13,000 and $26,000 for the three and six months ended June 30, 2006, respectively, while we recorded an income tax expense of $13,000 for the three months ended June 30, 2005, and an income tax benefit of $298,000 for the six months ended June 30, 2005. Income tax expense of $13,000 was recorded during the first and second quarters of 2006 and 2005, which represented the income tax effect of goodwill amortization created by our asset purchase from BSG in December 2003. For tax purposes the goodwill is amortized over 15 years whereas for book purposes the goodwill is not amortized, but instead tested at least annually for impairment. The effective tax rate applied to the tradenames intangible asset and goodwill amortization deductible for tax purposes was 36%. In addition, during the first quarter of 2005, we recorded a $324,000 non-cash tax benefit related to the $900,000 impairment charge related to tradenames. Tradenames have no basis for tax purposes, but do have book carrying value. To the extent that we cannot reasonably estimate the amount of deferred tax liabilities related to tradenames that will reverse during the net operating loss carry forward period, the deferred tax liabilities cannot be offset against deferred tax assets for purposes of determining the valuation allowance.

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Modification of Outstanding Warrants

As a result of our convertible debenture issuance on June 12, 2006, anti-dilution provisions contained in certain outstanding warrants issued by us were triggered. Accordingly, we recorded adjustments to the exercise price and, in certain cases, to the number of common shares issuable upon exercise of these warrants. The total number of shares of our common stock issuable upon exercise of these warrants increased by approximately 253,000 shares and the exercise price reductions varied depending upon the type of warrant.

The fair value of the modification of these warrants was determined by using a Black-Scholes-Merton (“BSM”) option valuation model immediately before and after the effective date of June 12, 2006, with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of approximately 5%, expected volatility between 71% and 75%, and estimated lives between 6 months and 4 years, the remaining contractual lives of these warrants. The fair value of the modification was estimated to be $76,000 and was recorded as a modification of outstanding warrants. This charge increased net loss attributable to common stockholders.

On January 1, 2006, anti-dilution provisions were triggered in certain outstanding warrants issued by us as a result of the modification to our convertible note payable to a related party on December 31, 2005. Accordingly, we recorded adjustments to the exercise price and, in certain cases, to the number of common shares issuable upon exercise of these warrants. The total number of shares of our common stock issuable upon exercise of these warrants increased by approximately 5,000 shares and the exercise price of the warrants issued in connection with our June 2005 financing was reduced from $2.50 to $0.71 per common share. The exercise price of these warrants was subsequently reduced to $0.45 per common share as a result of the June 2006 convertible debenture financing.

The fair value of the modification of these warrants was determined by using a BSM option valuation model immediately before and after the effective date of January 1, 2006, with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate between 4% and 5%, volatility between 71% and 98%, and estimated lives between 2 and 5 years, the remaining contractual lives of these warrants. The fair value of the modification was estimated to be $509,000 and was recorded as a modification of outstanding warrants. This charge increased net loss attributable to common stockholders.

Liquidity and Capital Resources

We financed our operations during the six months ended June 30, 2006, primarily from our existing working capital, and bolstered our cash position as a result of our June 2006 convertible debenture and warrant issuance. As of June 30, 2006, our principal source of liquidity consisted of $5.6 million of working capital, which included $10.5 million of cash and cash equivalents. This is compared to working capital of $11.8 million at December 31, 2005, which included cash of $15.2 million.

As a result of the capital raised during 2006, we believe that we have sufficient funds to continue our operations at current levels through December 31, 2006. We do not have a credit line or other borrowing facility to fund our operations. To continue our current level of operations beyond December 31, 2006, we expect that we will need to seek additional funds through the issuance of additional equity or debt securities or other sources of financing. We may not be able to secure additional financing on favorable terms, or at all. If we are unable to obtain the necessary additional financing, we would be required to reduce the scope of our operations, primarily through the reduction of discretionary expenses, which include personnel, benefits, marketing and other costs.

We expended $10.9 million in operating activities during the first six months of 2006, compared to $10.2 million for the same period in 2005. The net loss of $73.9 million for the six months ended June 30, 2006 was significantly impacted by $60.4 million in losses related to the impairment of goodwill. Other significant adjustments to the net loss were depreciation and amortization of $1.7 million, stock-based compensation of $518,000, a decrease in accounts receivable of $198,000, and an increase in accrued expenses of $383,000. These adjustments were offset by an increase in prepaid expenses and other current assets of $338,000.

Net cash used in investing activities was $469,000 during the six months ended June 30, 2006, primarily related to purchases of equipment and leasehold improvements for our new executive offices in Kirkland, Washington, which we began to occupy in May 2006. This is compared to $117,000 used for purchases of furniture and equipment for the same period in 2005.

Net cash provided from financing activities was $6.6 million during the six months ended June 30, 2006, compared to $14.4 million during the same period in 2005. In June 2006, we received gross proceeds of $8.0 million, net of $521,000 in debt issuance costs paid during the quarter, through the issuance of 8% convertible debentures and warrants to purchase

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8,889,002 shares of our common stock. These proceeds were offset by $855,000 in payments as a result of the amendments of certain warrants issued in connection with our June 2005 financing. For further discussion related to the June 2006 convertible debenture and warrant issuance and the amendments to certain warrants in connection with our June 2005 financing, seeNote 7. Stockholders’ Equityin the notes to the consolidated financial statements included in this quarterly report on Form 10-Q.

In May 2006, we moved our principle executive offices from Bellevue, Washington to Kirkland, Washington. We now lease our current principal executive offices, consisting of approximately 19,456 square feet, in Kirkland, Washington, under a lease that expires in August 31, 2011. We also lease approximately 8,100 square feet of office space, under a lease expiring in March 2007, in Edmonton, Alberta, Canada. In Reston, Virginia, we lease 6,083 square feet of office space under a lease that expires in April 2009. In connection with our asset purchase on December 29, 2003, we assumed a lease from Information Systems Support, Inc., consisting of 4,484 square feet in Charleston, South Carolina, which expired in February 2006. On March 1, 2006, we signed a new one-year lease for the same property in Charleston, South Carolina, that will expire in February 2007.

In connection with our acquisition of SSP-Litronic on August 6, 2004, we assumed the leases for properties in Irvine, California and Reston, Virginia. In Irvine, we lease 20,702 square feet of office space that serves as the principal office for Litronic. This lease expires in February 2012 and the lessor is KRDS, Inc., an entity that is majority-owned by three employees of Litronic, one of whom is Kris Shah, the president of Litronic, and a member of our board of directors. In Reston, we lease 5,130 square feet of office space under a lease that expires in March 2009. On April 21, 2006, we entered into an agreement to sublet this office space. The term of the sublease is April 24, 2006, through March 31, 2009. The initial base rent is $117,990 per year, subject to 5% annual adjustments throughout the term of the sublease. We believe that our facilities are adequate to satisfy our projected requirements for the foreseeable future, and that additional space will be available if needed. The following is a summary of our current property leases:

Property Description	Location	Square Feet	Lease Expiration Date
Saflink executive offices (beginning May 1, 2006)	Kirkland, Washington	19,456	8/31/2011
Edmonton development office	Edmonton, Alberta, Canada	8,100	3/31/2007
Charleston development office	Charleston, South Carolina	4,484	2/25/2007
Saflink Reston sales office (Campus Commons)	Reston, Virginia	6,083	4/30/2009
Litronic headquarters	Irvine, California	20,702	2/29/2012
Litronic Reston sales office	Reston, Virginia	5,130	3/31/2009

Our significant fixed commitments with respect to our convertible note obligation and our operating leases as of June 30, 2006, were as follows (in thousands):

	Payments For The Year Ended December 31,
	Total		Remainder 2006		2007 & 2008		2009 & 2010		2011 & After
Operating leases	$	5,254	$	526	$	2,103	$	1,745	$	880
Series A warrant redemptions		569		569		—		—		—
Convertible note payable to related party		1,250		1,250		—		—		—
Convertible note interest		125		125		—		—		—
Convertible debentures		8,000		667		7,333		—		—
Convertible debentures interest		592		299		293		—		—
Total Contractual Cash Obligations	$	15,790	$	3,436	$	9,729	$	1,745	$	880

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 investment 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. Due to the nature of our investment portfolio, we believe that we are not subject to any material market risk exposure.

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

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ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation 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 that 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.

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PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are involved in various claims and legal actions arising in the ordinary course of business. We do not believe, the ultimate disposition of these matters will have a material adverse effect on our consolidated financial position, results of operations or liquidity.

ITEM 1A. RISK FACTORS

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 annual report on Form 10-K 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.

We have accumulated significant losses 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 $235.7 million from our inception through June 30, 2006. We have continued to accumulate losses after June 30, 2006, to date and we may be unable to generate significant revenue or 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 or debt securities or other sources of financing. We may not be able to secure such additional financing on favorable terms, or at all. Any additional financings will likely cause substantial dilution to existing stockholders. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of, or cease, our operations.

We have not generated any significant sales of our products within the competitive commercial market, nor have we demonstrated sales techniques or promotional activities that have proven to be successful on a consistent basis, which makes it difficult to evaluate our business performance or our future prospects.

We are in an emerging, complex and competitive commercial market for digital commerce and communications security solutions. Potential customers in our target markets are becoming increasingly aware of the need for security products and services in the digital economy to conduct their business. Historically, only enterprises that had substantial resources developed or purchased security solutions for delivery of digital content over the Internet or through other means. Also, there is a perception that security in delivering digital content is costly and difficult to implement. Therefore, we will not succeed unless we can educate our target markets about the need for security in delivering digital content and convince potential customers of our ability to provide this security in a cost-effective and easy-to-use manner. Even if we convince our target markets about the importance of and need for such security, there can be no assurance that it will result in the sale of our products. We may be unable to establish sales and marketing operations at levels necessary for us to grow this portion of our business, especially if we are unsuccessful at selling our products into vertical markets. We may not be able to support the promotional programs required by selling simultaneously into several markets. If we are unable to develop an efficient sales system, or if our products or components do not achieve wide market acceptance, then our operating results will suffer and our earnings per share will be adversely affected.

A significant number of shares of our common stock are or will be eligible for sale in the open market, which could reduce the market price for our common stock and make it difficult for us to raise capital.

As of August 1, 2006, 88,908,229 shares of our common stock were outstanding. In addition, there were a total of 43,477,458 shares of our common stock issuable upon exercise or conversion of outstanding options, warrants, and convertible debt. These convertible securities to acquire shares of common stock are held by our employees and certain other persons at various exercise or conversion prices, 53,000 of which have exercise or conversion prices below the market price for our common stock of $0.448 as of August 1, 2006. Options to acquire 9,291,982 shares of our common stock were outstanding as of August 1, 2006, and our existing stock incentive plan had 2,028,846 shares available for future issuance as of that date.

The issuance of a large number of additional shares of our common stock upon the exercise or conversion of outstanding options, warrants or convertible promissory notes would cause substantial dilution to existing stockholders and

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could decrease the market price of our common stock due to the sale of a large number of shares of common stock in the market, or the perception that these sales could occur. These sales, or the perception of possible sales, could also impair our ability to raise capital in the future.

If we do not generate significant revenue from our participation in large government security initiatives or increase the level of our participation in these initiatives, our business performance and future prospects may suffer.

We play various roles in certain large government security initiatives, which includes being a part of alliance of companies, known as the Fast Lane Option (FLO) Alliance that is pursuing various opportunities in connection with the Transportation Security Administration’s (TSA) Registered Traveler program. In addition, we have participated on the TSA’s Transportation Worker Identification Credential (TWIC) program, where our credentialing solutions accounted for a significant portion of the technology deployment for the prototype or limited deployment phase of the initiative. We have invested a substantial amount of time and resources in our efforts to participate in these and other government security initiatives, but we have not generated significant revenue from our participation in these security initiatives to date. If we are not able to generate significant revenue from our participation in these or other government programs, or if we incur substantial additional expenses related to government programs before we earn associated revenue, we may not have adequate resources to continue to operate or to compete effectively in the government or the commercial marketplace.

If our common stock is delisted from the Nasdaq Capital Market, our stock price may suffer and you may not be able to sell your shares quickly at the market price or at all.

On December 16, 2005, we received a Nasdaq staff deficiency letter indicating that we were not in compliance with the $1.00 per share minimum closing bid price requirement for continued listing on the Nasdaq Capital Market as set forth in Marketplace Rule 4310(c)(4). We received the letter because the bid price of our common stock closed below $1.00 per share for 30 consecutive business days. The deficiency letter also stated that, in accordance with Marketplace Rule 4310(c)(8)(D), we would be provided 180 calendar days, or until June 14, 2006, to regain compliance with the bid price requirement. On June 15, 2006, we received written notification from Nasdaq indicating that we will receive an additional 180 calendar days, or until December 11, 2006, to regain compliance with the minimum bid price requirement as set forth in Marketplace Rule 4310(c)(4). The letter also stated that if, at anytime prior to December 11, 2006, the bid price of our common stock closes at $1.00 per share or more for a minimum of ten consecutive business days, then we will receive notification that we are in compliance with the rule.

If we cannot demonstrate compliance by December 11, 2006, we will be provided written notice that our securities will be delisted. At that time, we would have the right to appeal Nasdaq’s determination to delist our securities to a listing qualifications panel, which would postpone the effect of the delisting pending a hearing on the matter before the panel.

If our common stock is delisted from the Nasdaq Capital Market, it may trade on the over-the-counter market, which may be a less liquid market. In such case, your ability to trade, or obtain quotations of the market value of, shares of our common stock could be severely limited because of lower trading volumes and transaction delays. These factors could contribute to lower prices and larger spreads in the bid and ask prices for our common stock. In addition, the delisting of our common stock from the Nasdaq Capital Market would significantly impair our ability to raise capital in the public markets in the future.

If the market for our products and services does not experience significant growth or if our biometric, token and smart card products do not achieve broad acceptance in this market, our ability to generate significant revenue in the future would be limited and our business would suffer.

A substantial portion of our product revenue and a portion of our service revenue are derived from the sale of biometric, token and smart card products and services. Biometric, token and smart card solutions have not gained widespread acceptance. It is difficult to predict the future growth rate of this market, if any, or the ultimate size of the biometric, token and smart card technology market. The expansion of the market for our products and services depends on a number of factors such as:

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

• customers’ perception of the benefits of biometric, token and smart card solutions;

• public perceptions of the intrusiveness of these solutions and the manner in which organizations use the biometric information collected;

• public perceptions regarding the confidentiality of private information;

• customers’ satisfaction with our products and services; and

• marketing efforts and publicity regarding our products and services.

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

Five stockholders could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes or corporate actions.

Five of our stockholders (together with their affiliates) beneficially own approximately 31% of our outstanding common stock as of August 1, 2006. Given this substantial ownership, if they decided to act together, they would be able to significantly influence the vote on those corporate matters to be decided by our stockholders. In addition, these stockholders hold options, warrants and convertible debt representing the right to acquire an additional 6,009,647 shares of our common stock. If these stockholders exercised their options and warrants and converted the promissory note in full, they would own approximately 36% 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.

Any acquisition we make in the future could disrupt our business and harm our financial condition.

To date, most of our revenue growth has been created by acquisitions. In any future acquisitions or business combinations, we are subject to numerous risks and uncertainties, including:

• dilution of our current stockholders’ percentage ownership as a result of the issuance of stock;

• incurrence or assumption of debt;

• assumption of unknown liabilities; or

• incurrence of expenses related to the future impairment of goodwill and the amortization of other intangible assets.

We may not be able to successfully complete the integration of the businesses, products or technologies or personnel in the businesses or assets that we might acquire in the future, and any failure to do so could disrupt our business and seriously harm our financial condition.

We have depended on a limited number of customers for a substantial percentage of our revenue, and due to the non-recurring nature of these sales, our revenue in any quarter may not be indicative of future revenue.

Four customers accounted for 12%, 12%, 11% and 10% of our revenue for the three months ended June 30, 2006, while two customers accounted for 11% and 10% of the Company’s revenue for the six months ended June 30, 2006. Two customers accounted for 16% and 10% of our revenue for the twelve months ended December 31, 2005. A substantial reduction in revenue from any of our significant customers would adversely affect our business unless we were able to replace the revenue received from those customers. As a result of this concentration of revenue from a limited number of customers, our revenue has experienced wide fluctuations, and we may continue to experience wide fluctuations in the future. Many of our sales are not recurring sales, and quarterly and annual sales levels could fluctuate and sales in any period may not be indicative of sales in future periods.

Doing business with the United States government entails many risks that could adversely affect us by decreasing the profitability of government contracts we are able to obtain and interfering with our ability to obtain future government contracts.

Sales to the U.S. government and state and local government agencies, either directly or indirectly, accounted for 64% and 56% of our revenue for the three and six months ended June 30, 2006, respectively. Our sales to the U.S. government are subject to risks that include:

• early termination of contracts;

• disallowance of costs upon audit; and

• the need to participate in competitive bidding and proposal processes, which are costly and time consuming and may result in unprofitable contracts.

In addition, the government may be in a position to obtain greater rights with respect to our intellectual property than we would grant to other entities. Government agencies also have the power, based on financial difficulties or investigations of their contractors, to deem contractors unsuitable for new contract awards. Because we will engage in the government

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contracting business, we will be subject to audits and may be subject to investigation by governmental entities. Failure to comply with the terms of any government contracts could result in substantial civil and criminal fines and penalties, as well as suspension from future government contracts for a significant period of time, any of which could adversely affect our business by requiring us to spend money to pay the fines and penalties and prohibiting us from earning revenues from government contracts during the suspension period.

Furthermore, government programs can experience delays or cancellation of funding, which can be unpredictable. For example, the U.S. military’s involvement in Iraq has caused the diversion of some Department of Defense funding away from certain projects in which we participate, thereby delaying orders under certain of our government contracts. This makes it difficult to forecast our revenues on a quarter-by-quarter basis.

Our efforts to expand our international operations are subject to a number of risks, including our potential inability to obtain government authorization regarding exports of our products, any of which could adversely affect our future international sales.

We must comply with U.S. laws regulating the export of our products in order to ship internationally. In some cases, authorization from the U.S. government may be needed in order to export our products. The export regimes applicable to our business are subject to frequent changes, as are the governing policies. Although we have obtained approvals to export certain of our products, we cannot assure you that such authorizations to export will be available to us or for our products in the future. If we cannot obtain the required government approvals under these regulations, we may not be able to sell products abroad or make products available for sale internationally.

Additionally, our international operations could be subject to a number of risks, any of which could adversely affect our future international sales, including:

• increased collection risks;

• trade restrictions;

• export duties and tariffs;

• uncertain political, regulatory and economic developments; and

• inability to protect our intellectual property rights.

If third parties, on whom we partly depend for our product distribution, do not promote our products, our ability to generate revenue may be limited and our business and financial condition could suffer.

We utilize third parties such as resellers, distributors and other technology manufacturers to augment 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 of resources that these third parties devote to marketing activities on our behalf. Some of these business relationships are formalized in agreements that can be terminated with little or no notice, which may further decrease the willingness of such third parties to act on our behalf. 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.

The lengthy and variable sales cycle of some of our products makes it difficult to predict operating results.

Certain of our products have lengthy sales cycles while customers complete in-depth evaluations of the products and receive approvals for purchase. In addition, new product introduction often centers on key trade shows and failure to deliver a product prior to such an event can seriously delay introduction of a product. As a result of the lengthy sales cycles, we may incur substantial expenses before we earn associated revenues because a significant portion of our operating expenses is relatively fixed and based on expected revenues. The lengthy sales cycles make forecasting the volume and timing of orders difficult. In addition, the delays inherent in lengthy sales cycles raise additional risks that customers may cancel or change their minds. If customer cancellations or product delays occur, we could lose anticipated sales.

Our failure to maintain the proprietary nature of our technology and intellectual property could adversely affect our business, operating results, financial condition and stock price and 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. Further, because we do business with the government, we may already have granted, or we may in the future have to grant, greater rights with respect to our

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intellectual property than we would grant to other entities. Moreover, any current or future issued or licensed patents, or trademarks, or existing or future 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 that are the same as, or 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 could adversely affect 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.

We may be unable to keep pace with rapid technological change in network operating environments, which could lead to an increase in our costs, a loss of customers or a delay in market acceptance of our products.

Network operating environments are characterized by rapid development and technological improvements. Because of these changes, our success will depend in part on our ability to keep pace with a changing marketplace, integrate new technology into our core software and hardware and introduce new products and product enhancements that build off of our existing technologies 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 and adversely affect how we will do business.

Our future success will also depend upon our ability to develop and introduce a variety of new products and services, and enhancements to these new products and services, to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometric and smart card 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.

Our continued participation 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 to compete effectively in the marketplace.

Our reliance on third party technologies for some specific technology elements of our products and our reliance on third parties for manufacturing may delay product launch, impair our ability to develop and deliver products or hurt our ability to compete in the market.

Our ability to license new technologies from third parties will be critical to our ability to offer a complete suite of products that meets customer needs and technological requirements. Some of our licenses do not run for the full duration of the third party’s patent for the licensed technology. We may not be able to renew our existing licenses on favorable terms, or at all. If we lose the rights to a patented technology, we may need to stop selling or may need to redesign our products that incorporate that technology, and we may lose a competitive advantage. In addition, competitors could obtain licenses for technologies for which we are unable to obtain licenses, and third parties may develop or enable others to develop a similar solution to digital communication security issues, either of which events could erode our market share. Also, dependence on the patent protection of third parties may not afford us any control over the protection of the technologies upon which we rely. If the patent protection of any of these third parties were compromised, our ability to compete in the market also would be impaired.

We face intense competition and pricing pressures from a number of sources, which may reduce our average selling prices and gross margins.

The markets where we offer our products and services are intensely competitive. As a result, we face significant competition from a number of sources. We may be unable to compete successfully because many of our competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than we have. In addition, there are several smaller and start-up companies with which we compete from time to time. We expect competition to increase as a result of consolidation in the information security technology industry.

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The average selling prices for our products may decline as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. The pricing of products depends on the specific features and functions of the products, purchase volumes and the level of sales and service support required. As we experience pricing pressure, the average selling prices and gross margins for our products may decrease over product lifecycles. These same competitive pressures may require us to write down the carrying value of any inventory on hand, which would adversely affect our operating results and adversely affect our earnings per share.

A security breach of our internal systems or those of our customers due to computer hackers or cyber terrorists could harm our business by adversely affecting the market’s perception of our products and services.

Since we provide security for Internet and other digital communication networks, we may become a target for attacks by computer hackers. The ripple effects throughout the economy of terrorist threats and attacks and military activities may have a prolonged effect on our potential commercial customers, or on their ability to purchase our products and services. Additionally, because we provide security products to the United States government, we may be targeted by cyber terrorist groups for activities threatened against United States-based targets.

We will not succeed unless the marketplace is confident that we provide effective security protection for Internet and other digital communication networks. Networks protected by our products may be vulnerable to electronic break-ins. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. Although we have never experienced any act of sabotage or unauthorized access by a third party of our internal network to date, if an actual or perceived breach of security for Internet and other digital communication networks occurs in our internal systems or those of our end-user customers, it could adversely affect the market’s perception of our products and services. This could cause us to lose customers, resellers, alliance partners or other business partners.

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

Our financial and operating results have fluctuated in the past and our financial and operating results could fluctuate in the future from quarter to quarter for the following reasons:

• reduced demand for our products and services;

• 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;

• contract cancellations, delays or amendments by customers;

• the lack of government demand for our products and services or the lack of government funds appropriated to purchase our products and services;

• unforeseen legal expenses, including litigation costs;

• expenses related to acquisitions;

• impairments of goodwill and intangible assets;

• other financial charges;

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

• the inability to successfully manufacture in volume, and reduce the price of, 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 will be very difficult to adjust in response to short-term fluctuations in our revenue, compounding the difficulty of achieving profitability.

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We may be exposed to significant liability for actual or perceived failure to provide required products or services.

Products as complex as those we offer may contain undetected errors or may fail when first introduced or when new versions are released. Despite our product testing efforts and testing by current and potential customers, it is possible that errors will be found in new products or enhancements after commencement of commercial shipments. The occurrence of product defects or errors could result in adverse publicity, delay in product introduction, diversion of resources to remedy defects, loss of or a delay in market acceptance, or claims by customers against us, or could cause us to incur additional costs, any of which could adversely affect our business. Because our customers rely on our products for critical security applications, we may be exposed to claims for damages allegedly caused to an enterprise as a result of an actual or perceived failure of our products. An actual or perceived breach of enterprise network or information security systems of one of our customers, regardless of whether the breach is attributable to our products or solutions, could adversely affect our business reputation. Furthermore, our failure or inability to meet a customer’s expectations in the performance of our services, or to do so in the time frame required by the customer, regardless of our responsibility for the failure, could result in a claim for substantial damages against us by the customer, discourage customers from engaging us for these services, and damage our business reputation.

Delays in deliveries from suppliers or defects in goods or components supplied by vendors could cause our revenues and gross margins to decline.

We rely on a limited number of vendors for certain components for certain hardware products we are developing. Any undetected flaws in components supplied by our vendors could lead to unanticipated costs to repair or replace these parts. We currently purchase some of our components from a single supplier, which presents a risk that the components may not be available in the future on commercially reasonable terms, or at all. For example, Atmel Corporation has completed the masks for production of specially designed Forté and jForté microprocessors for which we developed the Forté and jForté operating systems. Commercial acceptance of the Forté and jForté microprocessors will depend on continued development of applications to service customer requirements. Any inability to receive or any delay in receiving adequate supplies of the Forté and jForté microprocessors, whether as a result of delays in development of applications or otherwise, would adversely affect our ability to sell the Forté and jForté PKI cards.

We do not anticipate maintaining a supply agreement with Atmel Corporation for the Forté and jForté microprocessors. If Atmel Corporation were unable to deliver the Forté and jForté microprocessors for a lengthy period of time or were to terminate its relationship with us, we would be unable to produce the Forté and jForté PKI cards until we could design a replacement computer chip for the Forté and jForté microprocessors. This could take substantial time and resources to complete, resulting in delays or reductions in product shipments that could adversely affect our business by requiring us to expend resources while preventing us from selling the Forté and jForté PKI cards.

Government regulations affecting security of Internet and other digital communication networks could limit the market for our products and services.

The United States government and foreign governments have imposed controls, export license requirements and restrictions on the import or export of some technologies, including encryption technology. Any additional governmental regulation of imports or exports or failure to obtain required export approval of encryption technologies could delay or prevent the acceptance and use of encryption products and public networks for secure communications and could limit the market for our products and services. In addition, some foreign competitors are subject to less rigorous controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than us in the United States and in international security markets for Internet and other digital communication networks. In addition, governmental agencies such as the Federal Communications Commission periodically issue regulations governing the conduct of business in telecommunications markets that may adversely affect the telecommunications industry and us.

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

We will be dependent on the continued availability of the services of our employees, many of whom are individually keys to our future success, and the availability of new employees to implement our business plans. Although our compensation program is 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 our key employees or a sufficient number to execute our plans, nor can there be any assurance that we will be able to continue to attract new employees as required.

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.

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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 will 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 adversely affect on our business and financial results and stock price.

Provisions in our certificate of incorporation may prevent or adversely affect the value of a takeover of our company even if a takeover would be beneficial to stockholders.

Our certificate of incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, the issuance of which could adversely affect our common stockholders. We can issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as our board of directors determines. Specifically, the potential 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.

ITEM 5. OTHER INFORMATION

Material Impairment

We test goodwill as of November 30^th annually. However, we concluded that certain factors, such as the lack of significant revenue and the continued decline of the price of our common stock as reported on the Nasdaq Capital Market, constituted triggering events under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) as of June 30, 2006. During the process of finalizing our goodwill valuation as of March 31, 2006, we reduced the $29.7 million goodwill impairment loss by $2.3 million, which is a component of the Company’s impairment loss recorded in its statement of operations for the three and six months ended June 30, 2006. The nature of this adjustment was related to the finalization of the estimated in-process research and development amount as of March 31, 2006. As a result of our preliminary testing as of June 30, 2006, we believed that an impairment loss was probable and that we could reasonably estimate a goodwill impairment charge of $33.0 million for the three months ended June 30, 2006. This resulted in a net impairment loss on goodwill of $30.7 million and $60.4 million for the three and six months ended June 30, 2006, respectively. Given the volatility in our historical revenue trends, the significant decline in our market capitalization, and other indicators of fair value, we determined that the best estimate of fair value as of June 30, 2006, for the goodwill impairment test was our market capitalization. We are still in the process of finalizing our goodwill assessment but expect to complete the valuation of the impairment charge during the third quarter of 2006. Any significant adjustments to our preliminary estimate will be disclosed in our quarterly report on Form 10-Q for the quarter ended September 30, 2006.

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ITEM 6. EXHIBITS

The following exhibits are filed as part of this quarterly report:

			Incorporated by Reference
Exhibit No.	Description	Filed Herewith	Form	Exhibit No.	File No.	Filing Date
4.1	Form of 8% Convertible Debenture		8-K	4.1	000-20270	6/15/06
4.2	Form of Warrant		8-K	4.2	000-20270	6/15/06
10.1	Agreement of Sublease dated April 21, 2006, by and between Saflink Corporation and Concept Solutions, LLC		8-K	10.1	000-20270	4/27/06
10.2	Amended and Restated Retention Agreement dated April 27, 2006, by and between Saflink Corporation and Jon C. Engman*		10-Q	10.3	000-20270	5/10/06
10.3	Securities Purchase Agreement, dated as of June 12, 2006, by and among Saflink Corporation and the Purchasers		8-K	10.1	000-20270	6/15/06
10.4	Registration Rights Agreement, dated as of June 12, 2006, by and among Saflink Corporation and the Purchasers		8-K	10.2	000-20270	6/15/06
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	X
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	X

* Management contract or compensatory plan or arrangement

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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: August 9, 2006	By:	/s/ JON C. ENGMAN
		Jon C. Engman Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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Exhibit Index

			Incorporated by Reference
Exhibit No.	Description	Filed Herewith	Form	Exhibit No.	File No.	Filing Date
4.1	Form of 8% Convertible Debenture		8-K	4.1	000-20270	6/15/06
4.2	Form of Warrant		8-K	4.2	000-20270	6/15/06
10.1	Agreement of Sublease dated April 21, 2006, by and between Saflink Corporation and Concept Solutions, LLC		8-K	10.1	000-20270	4/27/06
10.2	Amended and Restated Retention Agreement dated April 27, 2006, by and between Saflink Corporation and Jon C. Engman*		10-Q	10.3	000-20270	5/10/06
10.3	Securities Purchase Agreement, dated as of June 12, 2006, by and among Saflink Corporation and the Purchasers		8-K	10.1	000-20270	6/15/06
10.4	Registration Rights Agreement, dated as of June 12, 2006, by and among Saflink Corporation and the Purchasers		8-K	10.2	000-20270	6/15/06
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	X
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	X

* Management contract or compensatory plan or arrangement

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