Identiphi (IDPIQ) 10-Q 2006 Q3 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 September 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 November 1, 2006.

Saflink Corporation

FORM 10-Q

For the Quarter Ended September 30, 2006

INDEX

			Page
Part I.	Financial Information
	Item 1.	Financial Statements (Unaudited)	3
	a.	Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005	3
	b.	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005	4
	c.	Condensed Consolidated Statements of Cash Flows for the nine months ended September 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	18
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	26
	Item 4.	Controls and Procedures	26
Part II.	Other Information
	Item 1.	Legal Proceedings	27
	Item 1A.	Risk Factors	27
	Item 4.	Submission of Matters to a Vote of Security Holders	34
	Item 6.	Exhibits	35
Signatures			36

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PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SAFLINK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)

	September, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	5,228		$	15,217
Accounts receivable, net		1,148			692
Inventory		514			563
Prepaid expenses and other current assets		822			841
Total current assets		7,712			17,313
Furniture and equipment, net of accumulated depreciation of $2,029 and $2,706 as of September 30, 2006, and December 31, 2005, respectively		689			1,018
Debt issuance costs, net		769			—
Intangible assets, net of accumulated amortization of $6,350 and $4,262 as of September 30, 2006, and December 31, 2005, respectively		3,903			19,848
Goodwill		15,523			75,923
Total assets	$	28,596		$	114,102
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,077		$	1,204
Accrued expenses		3,023			2,150
Current portion of convertible debt, net of discount		4,419			1,250
Other current obligation		372			765
Deferred revenue		231			174
Total current liabilities		9,122			5,543
Deferred tax liability		179			140
Long-term convertible debt, net of current portion and discount		1,222			—
Total liabilities		10,523			5,683
Stockholders’ equity:
Common stock		889			889
Additional paid-in capital		274,334			269,256
Deferred stock-based compensation		—			(541	)
Accumulated deficit		(257,150	)		(161,185	)
Total stockholders’ equity		18,073			108,419
Total liabilities and stockholders’ equity	$	28,596		$	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 September,						Nine months ended September 30,
	2006			2005			2006			2005
Revenue:
Product	$	1,414		$	2,032		$	2,956		$	4,309
Service		244			326			503			2,039
Total revenue		1,658			2,358			3,459			6,348
Cost of revenue:
Product		608			966			1,301			1,842
Service		134			221			390			1,242
Impairment loss on intangible assets		13,857			—			13,857			—
Amortization of intangible assets		670			670			2,012			2,012
Total cost of revenue		15,269			1,857			17,560			5,096
Gross profit (loss)		(13,611	)		501			(14,101	)		1,252
Operating expenses:
Product development		2,067			2,320			6,909			6,952
Sales and marketing		1,705			2,417			5,636			7,128
General and administrative		2,471			2,252			6,484			6,682
Impairment loss on goodwill		—			19,300			60,400			19,300
Impairment loss on intangible assets		—			600			—			1,500
Impairment loss on furniture and equipment		716			—			716			—
Total operating expenses		6,959			26,889			80,145			41,562
Operating loss		(20,570	)		(26,388	)		(94,246	)		(40,310	)
Interest expense		(983	)		(37	)		(1,345	)		(103	)
Other income, net		79			135			250			296
Change in fair value of outstanding warrants		—			—			—			172
Loss before income taxes		(21,474	)		(26,290	)		(95,341	)		(39,945	)
Income tax provision (benefit)		13			(203	)		39			(501	)
Net loss		(21,487	)		(26,087	)		(95,380	)		(39,444	)
Modification of outstanding warrants		—			—			(585	)		(59	)
Net loss attributable to common stockholders	$	(21,487	)	$	(26,087	)	$	(95,965	)	$	(39,503	)
Basic and diluted net loss per common share attributable to common stockholders	$	(0.24	)	$	(0.30	)	$	(1.09	)	$	(0.48	)
Weighted average number of common shares outstanding		88,405			88,057			88,203			82,792

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Nine months ended September 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(95,380	)	$	(39,444	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock-based compensation		872			1,162
Depreciation and amortization		2,552			2,518
Non-cash interest expense		1,040			—
Impairment loss on goodwill		60,400			19,300
Impairment loss on intangible assets		13,857			1,500
Impairment loss on furniture and equipment		716			—
Loss on disposal of fixed assets		5			—
Change in fair value of outstanding warrants		—			(172	)
Deferred taxes		39			(501	)
Changes in operating assets and liabilities:
Accounts receivable, net		(456	)		(81	)
Inventory		49			175
Prepaid expenses and other current assets		19			316
Accounts payable		(127	)		(62	)
Accrued expenses		523			280
Deferred revenue		57			(127	)
Net cash used in operating activities		(15,834	)		(15,136	)
Cash flows from investing activities:
Purchases of furniture and equipment		(512	)		(262	)
Proceeds from sale of furniture and equipment		6			—
Net cash used in investing activities		(506	)		(262	)
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		—			13,946
Proceeds from issuance of convertible debt, net of issuance costs		7,386			—
Warrant redemptions		(1,052	)		—
Net cash provided by financing activities		6,351			14,382
Net decrease in cash and cash equivalents		(9,989	)		(1,016	)
Cash and cash equivalents at beginning of period		15,217			22,217
Cash and cash equivalents at end of period	$	5,228		$	21,201
Supplemental disclosure of cash flow information:
Cash paid for interest	$	62		$	93
Modification of outstanding warrants		585			59
Issuance of stock options for services		—			6
Reclassification of warrants from liability to equity		196			—
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.

Management Changes

On September 28, 2006, Saflink’s board of directors approved the terms of an executive consulting agreement with Capital Placement Holdings, Inc. under which Steven Oyer, the president and principal of Capital Placement Holdings and a member of the board of directors of Saflink, agreed to serve as Saflink’s interim chief executive officer, replacing Glenn Argenbright. Mr. Argenbright was reassigned and will no longer serve as Saflink’s president and chief executive officer. Mr. Argenbright will continue to serve as a member of Saflink’s board of directors and has been named chairman of the board of directors and president and general manager of Saflink’s registered traveler solutions group. The reassignment of Mr. Argenbright may have triggered certain severance provisions contained in Mr. Argenbright’s employment agreement. As a result, Saflink determined that it had an obligation of $240,000, or twelve months’ base salary, to Mr. Argenbright, which Saflink accrued as of September 30, 2006. As compensation for Mr. Oyer’s services as interim chief executive officer, Saflink agreed to pay Capital Placement Holdings a fee of $25,000 per month for the length of the agreement and granted him options to purchase up to 1,050,000 shares of Saflink common stock, which are discussed further in Note 3 – Stock-Based Compensation. In addition, on September 25, 2006, Jon Engman submitted his resignation as Saflink’s chief financial officer, effective November 24, 2006, for personal reasons and to pursue other interests. Per the terms of Mr. Engman’s retention agreement, Saflink accrued $190,000, or twelve months’ salary, as of September 30, 2006.

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 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.

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The Company recognizes revenue in accordance with the provisions of Statement of Position 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 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.

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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 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.

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Reclassifications

Certain reclassifications 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 1,316,236 shares reserved for future issuance under the 2000 Plan as of September 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 nine months ended September 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 Black-Scholes-Merton (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. 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 pricing model based on the following weighted average assumptions:

	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Expected dividend yield		0	%		0	%		0	%		0	%
Risk-free interest rate		4.70	%		4.10	%		4.60	%		4.00	%
Volatility		132	%		127	%		104	%		128	%
Expected life (years)		9.3			6.3			6.8			6.3
Fair value of options granted	$	0.36		$	1.12		$	0.58		$	1.49

Stock-based Compensation Expense

The following table summarizes all stock-based compensation expense related to stock-based awards, which was incurred as follows (in thousands):

	Three months ended September 30, 2006		Nine months ended September 30, 2006
Stock-based compensation:
Product development	$	27	$	85
Sales and marketing		22		64
General and administrative		305		723
Total stock-based compensation	$	354	$	872

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

Non-employee Awards

On September 29, 2006, in connection with the Company’s agreement with Capital Placement Holdings, Inc. for Steven Oyer to provide services as the Company’s interim chief executive officer, the Company granted Mr. Oyer a fully-vested and exercisable non-statutory option to purchase 350,000 shares of its common stock. The fair value of this grant was determined by using a BSM option valuation model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 4.64%, expected volatility of 139%, and an estimated life of 10 years, the contractual term of the option. The fair value of this grant was estimated to be $127,000 and was expensed in the statement of operations during the third quarter of 2006. In addition, the Company granted Mr. Oyer a non-statutory option to purchase 700,000 shares of its common stock that becomes exercisable upon the achievement of specified performance objectives. The Company will not measure or recognize compensation expense related to this grant until completion of the specified performance objectives has been determined to be probable. The Company has not recognized any compensation expense related to this grant as of September 30, 2006, as none of the performance objectives had been determined to be probable. Both option grants have an exercise price of $0.37 per share, which is equal to the last sale price per share of the Company’s common stock as reported on the Nasdaq Capital Market on the last trading day prior to the date of grant.

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At September 30, 2006, the Company had 1,267,881 non-vested stock options outstanding that had a weighted average grant date fair value of $0.61, which excludes Mr. Oyer’s performance option grant to purchase 700,000 shares of the Company’s common stock described above. As of September 30, 2006, the Company had $933,000 of total unrecognized compensation cost related to non-vested stock-based awards granted under the 2000 Plan and expects to recognize this cost over a weighted average period of 1.1 years. This unrecognized compensation cost does not include any compensation cost related to the vesting of Mr. Oyer’s option grant when or if certain specified performance objectives are determined to be probable.

The following table presents the impact of the Company’s adoption of SFAS 123R on selected line items from its condensed consolidated financial statements (in thousands, except per share amounts):

	Three months ended September 30, 2006						Nine months ended September 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	$	(20,570	)	$	(20,439	)	$	(94,246	)	$	(93,862	)
Loss before income taxes		(21,474	)		(21,343	)		(95,341	)		(94,957	)
Net loss attributable to common stockholders		(21,487	)		(21,356	)		(95,965	)		(95,581	)
Basic and diluted net loss per share attributable to common stockholders	$	(0.24	)	$	(0.24	)	$	(1.09	)	$	(1.08	)

The following table shows the effect on net loss and net loss per share, 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 September 30, 2005			Nine months ended September 30, 2005
Net loss	$	(26,087	)	$	(39,444	)
Add: Stock-based employee compensation expense included in reported net loss		295			1,162
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all rewards and modifications		(1,400	)		(5,042	)
Pro forma net loss	$	(27,192	)	$	(43,324	)
Basic and diluted net loss per common share, as reported	$	(0.30	)	$	(0.48	)
Basic and diluted net loss per common share, pro forma	$	(0.31	)	$	(0.52	)

Stock Option Activity

The following table summarizes stock option activity for the nine months ended September 30, 2006:

	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	2,152			0.71
Exercised	(21	)		0.79
Expired or Canceled	(1,333	)		1.46
Outstanding at September 30, 2006	9,305		$	0.98	5.6	$	3
Exercisable at September 30, 2006	8,037		$	1.01	5.2	$	1

The Company received $0 and $17,000 in cash from the exercises of stock options during the three and nine months ended September 30, 2006, respectively. The aggregate intrinsic value of options outstanding at September 30, 2006 is calculated as the difference between the market price of the underlying common stock and the exercise price of the options for the 20,000 options that had exercise prices below the $0.37 closing market price of the Company’s common stock at September 29, 2006. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $0 and $4,000, respectively, determined as of the date of each exercise. The total intrinsic value of options exercised during the three and nine months ended September 30, 2005 was $0 and $333,000, respectively, determined as of the date of each exercise.

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The following table summarizes information about employee stock options outstanding at September 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	8,494	5.6	$	0.78	7,226	$	0.79
1.51 –    3.00	522	6.3		2.42	522		2.42
3.01 –    4.50	197	1.9		3.51	197		3.51
4.51 –    6.00	92	6.8		5.28	92		5.28
Total	9,305	5.6	$	0.98	8,037	$	1.01

Non-vested Restricted Stock Awards

The Company has one outstanding non-vested, restricted common stock grant as of September 30, 2006, held by Glenn Argenbright, president of the Company’s registered traveler solutions group and chairman of the Company’s board of directors. Mr. Argenbright holds 301,928 non-vested, restricted shares of the Company’s common stock, which are scheduled to vest in total on June 23, 2007. The remaining compensation expense of $185,000 at September 30, 2006, is being recorded equally over the remaining vesting period.

Kris Shah, a former member of the Company’s board of directors and former president of Litronic Inc., a wholly-owned subsidiary of the Company, held 500,000 restricted shares of the Company’s common stock, which vested in total on August 9, 2006, prior to his departure from the Company in October 2006. 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.

Compensation expense related to non-vested, restricted stock awards was $93,000 and $356,000 for the three and nine months ended September 30, 2006, respectively. Compensation expense for the three and nine months ended September 30, 2005, was $220,000 and $894,000, 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 first quarter of 2006, the Company recorded a $29.7 million impairment charge on goodwill. During the process of finalizing its goodwill valuation as of March 31, 2006, the Company reduced this $29.7 million goodwill impairment loss by $2.3 million during the second quarter of 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. In addition, as a result of the Company’s testing of goodwill as of June 30, 2006, the Company recorded another goodwill impairment charge of $33.0 million during the second quarter of 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 did not record an impairment loss on goodwill during the third quarter of 2006 because the Company’s September 30, 2006 fair market value (market capitalization) exceeded its net book value as of that date.

The changes in the carrying value of goodwill for the nine months ended September 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 September 30, 2006	$	15,523

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5. Intangible and Other Long-lived Assets

The Company periodically reviews the carrying values of its long-lived assets to determine whether such assets have been impaired. An impairment loss must be recorded pursuant to SFAS No. 144 when the undiscounted net cash flows expected to be realized from the use of such assets are less than their carrying value. The Company believed that its decision in the third quarter of 2006 to refocus its resources toward specific product offerings and revenue opportunities constituted a triggering event under SFAS 144. In addition, the Company continued to incur losses from operations and actual sales and growth rates during the third quarter of 2006 were significantly lower than expected. In reviewing the Company’s long-lived assets for impairment during the third quarter of 2006, the Company compared the carrying value of its primary long-lived assets – amortizable intangible assets and furniture and equipment to undiscounted cash flows expected from this asset group. As a result of the Company’s decision to refocus its resources toward specific products, continuing operating losses and lower sales and growth rates in the first nine months of 2006 compared to forecasts, the carrying value of the asset group exceeded undiscounted cash flows expected from this asset group. Consequently, the Company measured the fair value of its long-lived assets as of September 30, 2006, based on a discounted cash flow model and the orderly liquidation method, and concluded that an impairment charge of $14.6 million should be allocated to the asset group on a pro rata basis, which was recognized during the third quarter of 2006. The pro rata allocation resulted in a $13.9 million impairment charge of intangible assets and a $716,000 impairment charge related to furniture and equipment, which were recorded in the Company’s statement of operations.

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. In the third quarter of 2005, the Company estimated the fair value of its indefinite-lived intangible asset tradenames to be $100,000 and accordingly, recorded an additional $600,000 impairment loss on intangible assets during the three months ended September 30, 2005.

The changes in the carrying value of intangible assets for the nine months ended September 30, 2006, are as follows (in thousands):

Balance as of December 31, 2005, net of $4,262 accumulated amortization	$	19,848
Amortization of intangible assets		(2,088	)
Third quarter impairment loss		(13,857	)
Balance as of September 30, 2006	$	3,903

6. Inventory

The following is a summary of inventory (in thousands):

	September 30, 2006		December 31, 2005
Raw materials	$	146	$	83
Work-in-process		2		49
Finished goods		366		431
	$	514	$	563

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 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. 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

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December 1, 2006. The Company may, in its discretion, elect to pay the interest due of the debentures and 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. The Company filed a registration statement on Form S-3 related to this financing with the SEC on July 7, 2006, which became effective on October 6, 2006. The Company provided notice to the holders of the debentures of its election to pay interest on the debentures in shares of common stock beginning with the payment due in December 2006, and for future interest payment dates until revised by subsequent notice. The Company also provided notice to the holders of the debentures of its election to pay the monthly redemption payment due in December 2006 in shares of common stock.

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 to 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.

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

Face value of convertible debentures	$	8,000
Less: unamortized debt discounts		(3,609	)
Total carrying value, net of debt discount September 30, 2006	$	4,391
Current portion of debt, net of debt discount	$	3,169
Long term portion of debt, net of debt discount	$	1,222

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 such warrants 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 share underlying the called warrants. 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 these warrants. The warrant holders waived their right to the ten day exercise period and, accordingly, the Company remitted $0.38 per share underlying the called warrants, an aggregate of $855,000, to the warrant holders during June 2006. The Company reclassified these warrants as a liability because, due to the warrant amendments, the warrants then contained characteristics of debt instruments. The Company estimated the fair value of the warrants to be $0.38 per share underlying the called warrants, an aggregate of $855,000, which amount was reclassified from equity to a liability 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.

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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 from equity to 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 reduced the current obligation from $765,000 to $569,000 during the three months ended June 30, 2006, reclassifying $196,000 into stockholders’ equity. The Company made payments to warrant holders of $197,000 during the three and nine months ended September 30, 2006.

8. Concentration of Credit Risk and Significant Customers

Three customers accounted for 29%, 11% and 10% of the Company’s revenue for the three months ended September 30, 2006, while three customers accounted for 23%, 13% and 13% of accounts receivable as of September 30, 2006. One customer accounted for 14% of the Company’s revenue for the nine months ended September 30, 2006.

Four customers accounted for 15%, 13%, 10% and 10% of the Company’s revenue for the three months ended September 30, 2005. In addition, one of the aforementioned customers and another customer accounted for 17% and 11%, respectively, of the Company’s revenue for the nine months ended September 30, 2005.

Sales to the U.S. government and state and local government agencies, either directly or indirectly, accounted for 90% and 72% of the Company’s revenue for the three and nine months ended September 30, 2006, respectively, while these sales accounted for 85% and 87% of the Company’s revenue for the three and nine months ended September 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 93% and 71% of the Company’s total accounts receivable balance as of September 30, 2006, and December 31, 2005, respectively.

9. Comprehensive Loss

For the three and nine months ended September 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.

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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 44,190,068 and 16,329,714 shares of common stock at September 30, 2006, and 2005, respectively. There were 301,928 and 801,928 unvested shares of restricted common stock outstanding as of September 30, 2006 and 2005, respectively.

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 individuals who, as of September 30, 2006, were employees of Saflink’s subsidiary, Litronic, Inc. One of the individuals, Kris Shah, was the president of Litronic and a member of the Company’s board of directors as of September 30, 2006. Mr. Shah resigned as a member of the Company’s board of directors on October 13, 2006, and no longer serves as the president of Litronic. None of the three individuals are employees of the Company or Litronic. Saflink recognized rent expense of approximately $130,000 and $390,000 for the three and nine months ended September 30, 2006. The lease expires in 2012.

Convertible Promissory Note

As part of the Litronic acquisition, the Company assumed a convertible promissory note with a face value of $1,250,000 held by the Company’s chairman of the board of directors, Richard P. Kiphart. As of September 30, 2006, the note was still outstanding and matures on December 31, 2006. The note bears interest at a rate of 10% per annum and is also convertible, in whole or in part, at the option of the holder into shares of the Company’s common stock at any time prior to maturity, at a conversion price of $0.71 per share, subject to adjustment under certain conditions. For the three and nine months ended September 30, 2006 and 2005, interest expense related to this note was $32,000 and $93,000, respectively.

Interim Chief Executive Officer

On September 28, 2006, the Company’s board of directors approved the terms of an executive consulting agreement with Capital Placement Holdings, Inc. under which Steven Oyer, the president and principal of Capital Placement Holdings, Inc. and a member of the Company’s board of directors, agreed to serve as the Company’s interim chief executive officer until such time as the Company can find a qualified successor to Glenn L. Argenbright, the Company’s former president and chief executive officer. The agreement provides that Mr. Oyer will provide services as the Company’s interim chief executive officer, and as such, the Company has agreed to pay Capital Placement Holdings a fee of $25,000 per month for the length of the agreement. In connection with the agreement, the Company granted Mr. Oyer a fully-vested and exercisable non-statutory option to purchase 350,000 shares of its common stock under the Company’s 2000 stock incentive plan. The grant date fair value of this grant was estimated to be $127,000 and was recorded in the statement of operations during the three months ended September 30, 2006. In addition, the Company granted Mr. Oyer a non-statutory option to purchase 700,000 shares of its common stock that become exercisable upon the achievement of specified performance objectives. The Company has not recognized any compensation expense related to this grant as of September 30, 2006, as none of the performance objectives had been determined to be probable. The grants have an exercise price of $0.37 per share, which is equal to the last sale price per share of the Company’s common stock as reported on the Nasdaq Capital Market on the last trading day prior to the date of grant. No compensation expense was recognized for the performance grant as none of the performance objectives had been met as of September 30, 2006. The agreement commenced as of September 29, 2006 and continues until either party terminates the agreement upon 30 days advance written notice.

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On October 11, 2006, the Company received written notification from Nasdaq stating that it was not in compliance with the Nasdaq audit committee requirements as set forth in Marketplace Rule 4350. Mr. Oyer was serving as the chairman of the Company’s audit committee and due to his appointment as interim chief executive officer the Company is no longer in compliance with Marketplace Rule 4350 because he is no longer independent. However, the notice provided that the Company will be subject to a cure period in order to regain compliance as follows:

• until the earlier of the Company’s next annual shareholders’ meeting or September 28, 2007; or

• if the next annual shareholders’ meeting is held before March 27, 2007, then the Company must evidence compliance no later than March 27, 2007.

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.

14. Liquidity and Capital Resources

The Company had working capital of negative $1.4 million and $11.8 million at September 30, 2006, and December 31, 2005, respectively. As of September 30, 2006, the Company’s balance of cash and cash equivalents totaled $5.2 million. The Company received proceeds, net of issuance costs, of $7.4 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 nine months ended September 30, 2006. The Company also expects to incur additional losses for the remainder of 2006.

In October 2006, the Company significantly reduced its operating expenses by reducing its workforce by over 50%. The Company estimates restructuring costs to be approximately $800,000, which is primarily comprised of severance payments for the effected employees. The Company expects to pay out the $800,000 in restructuring costs, in addition to employee accrued paid-time off balances totaling approximately $525,000, during the fourth quarter of 2006.

After these restructuring activities and excluding severance expense to be recognized in the fourth quarter, the Company expects to use approximately $2.5 million in operations during the fourth quarter of 2006 and approximately $2.0 million per quarter after that. As a result of the restructuring and the capital raised during June 2006, the Company believes that it will have sufficient funds to continue its operations at current levels into the first quarter of 2007. The Company does not have a credit line or other borrowing facility to fund its operations. To continue current level of operations through September 30, 2007, the Company expects that it will need an additional $5.0 million of cash flow from operations and through the issuance of equity or debt securities or other sources of financing. Currently, the Company does not have any arrangements in place for any future financings, and may not be able to secure additional financing on favorable terms, or at all. Any additional financings will likely cause substantial dilution to existing stockholders. 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, and the Company may be required to cease its operations.

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

• the state of 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.

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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 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.

On September 28, 2006, our board of directors approved the terms of an executive consulting agreement with Capital Placement Holdings, Inc. under which Steven Oyer, the president and principal of Capital Placement Holdings, Inc. and a member of our board of directors, agreed to serve as our interim chief executive officer, replacing Glenn Argenbright. Mr. Argenbright was reassigned and will no longer serve as our president and chief executive officer. Mr. Argenbright will continue to serve as a member our board of directors and has been named chairman of the board of directors and president and general manager of our registered traveler solutions group. As compensation for Mr. Oyer’s services as interim chief executive officer, we agreed to pay Capital Placement Holdings, Inc. a fee of $25,000 per month for the length of the agreement. In connection with the agreement, we also granted Mr. Oyer a fully-vested and exercisable non-statutory option to purchase 350,000 shares of our common stock. In addition, we granted Mr. Oyer a non-statutory option to purchase 700,000 shares of our common stock that become exercisable upon the achievement of specified performance objectives. The grants have an exercise price of $0.37 per share, which is equal to the last sale price per share of our common stock as reported on the Nasdaq Capital Market on the last trading day prior to the date of grant. In addition, on September 25, 2006, Jon Engman submitted his resignation as our chief financial officer, effective November 24, 2006, for personal reasons and to pursue other interests.

In October 2006, we significantly reduced our operating expenses by reducing our workforce by over 50%. We estimate restructuring costs will be approximately $800,000, which is primarily comprised of severance payments for the effected employees. We expect to pay out the $800,000 in restructuring costs, in addition to employee accrued paid-time off balances totaling approximately $525,000, during the fourth quarter of 2006.

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, and stock-based compensation. 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 $21.5 million and $96.0 million for the three and nine months ended September 30, 2006, respectively. These results included impairment losses on goodwill, intangible assets and furniture and equipment of $14.6 million and $75.0 million for the three and nine months ended September 30, 2006, respectively. The results for the three and nine months ended September 30, 2006, are compared to net losses attributable to common stockholders of $26.1 million and $39.5 million for the three and nine months ended September 30, 2005, respectively. The net loss attributable to common stockholders for the nine months ended September 30, 2005, included a $19.3 million impairment loss on goodwill and a $1.5 million impairment loss on intangible assets. The following discussion presents certain changes in our revenue and expenses that have occurred during the three and nine months ended September 30, 2006, as compared to the three and nine months ended September 30, 2005.

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Revenue and Cost of Revenue

We recorded revenue primarily from four sources during the three and nine months ended September 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. Total revenue of $1.7 million for the three months ended September 30, 2006 decreased $700,000, or 30%, from revenue of $2.4 million for the three months ended September 30, 2005. During the three months ended September 30, 2006, software license sales were $64,000; sales of manufactured hardware were approximately $1.3 million; and sales of third party software and hardware were $69,000, while service revenue was $244,000, which was primarily related to customer support and product maintenance. During the same period in 2005, software license sales were $361,000; sales of manufactured hardware were approximately $1.3 million; and sales of third party software and hardware were $330,000, while service revenue was $326,000, which was comprised of $200,000 related to fees for consulting, integration and project labor and $126,000 related to customer support and product maintenance. Total revenue of $3.5 million for the nine months ended September 30, 2006 decreased approximately $2.9 million, or 46%, from revenue of $6.3 million for the nine months ended September 30, 2005. Product and service revenue for the nine months ended September 30, 2006 were $3.0 million and $503,000, respectively, compared to $4.3 million and $2.0 million, respectively, for the nine months ended September 30, 2005. The decreases in total revenue for the three and nine months ended September 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 affected 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.

Total cost of revenue included product cost of revenue, service cost of revenue and the amortization and impairment 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 September 30, 2006, cost of revenue from software and manufactured hardware were $1,000 and $558,000, respectively, cost of third party software and hardware was $50,000, while cost of service revenue was $133,000. Total cost of revenue for the three months ended September 30, 2006 also included amortization of intangible assets of $670,000 and an impairment loss on intangible assets of $13.9 million, both of which were 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 $2,000 and $676,000, respectively, cost of revenue from third party software and hardware was $288,000, while cost of service revenue was $221,000. There also was $670,000 in amortization of intangible assets included in cost of revenue for three months ended September 30, 2005. Total cost of revenue of $15.3 million for the three months ended September 30, 2006 increased $13.4 million, from cost of revenue of $1.9 million for the same period in 2005, primarily attributable to the $13.9 million impairment loss on intangible assets recorded during the third quarter of 2006. Total cost of revenue of $17.6 million for the nine months ended September 30, 2006 increased $12.5 million, from cost of revenue of $5.1 million for the same period in 2005, primarily attributable to the $13.9 million impairment loss on intangible assets recorded during the third quarter of 2006. Product and service cost of revenue for the nine months ended September 30, 2006 were $1.3 million and $390,000, respectively, compared to $1.8 million and $1.2 million, respectively, for the nine months ended September 30, 2005. Amortization of intangible assets recorded in cost of revenue was $2.0 million for the first nine months of 2006 and 2005. The overall decrease in total cost of revenue can primarily be attributed to lower revenue during the first nine months of 2006 when compared to the same period in 2005.

Our gross loss for the three months ended September 30, 2006 was negative $13.6 million, compared to a gross profit of $501,000 for the same period in 2005. Our gross loss for the nine months ended September 30, 2006, was $14.1 million, compared to a gross profit of $1.3 million for the same period in 2005.

Operating Expenses

Total operating expenses for the three months ended September 30, 2006 decreased approximately $19.9 million, or 74%, to $7.0 million from $26.9 million for the same period in 2005. The overall decrease was primarily because we recorded a $19.3 million impairment loss on goodwill and a $600,000 impairment loss on intangible assets for the three months ended September 30, 2005, while we recorded a $716,000 impairment loss on furniture and equipment and no impairment loss on goodwill or intangible assets for the three months ended September 30, 2006. Excluding the change in impairment loss on goodwill, intangible assets and furniture and equipment, operating expenses for the three months ended

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September 30, 2006 decreased $746,000, when compared to the same period in 2005. This decrease, excluding the impairment losses on goodwill, intangible assets and furniture and equipment, was primarily due to a $929,000 decrease in salaries and wages driven by headcount being reduced to 81 employees at September 30, 2006, compared to 138 employees at September 30, 2005, partially offset by a $592,000 increase in severance expense for the three months ended September 30, 2006 when compared to the same period in 2005. In addition, the overall decrease in operating expenses was related to a $151,000 decrease in legal and professional services for the three months ended September 30, 2006 when compared to the same period in 2005.

Total operating expenses for the nine months ended September 30, 2006 increased approximately $38.6 million, or 93%, to $80.1 million from $41.6 million for the comparable period in 2005. This increase was primarily because we recorded an impairment loss on goodwill of $60.4 million and an impairment loss on furniture and fixtures of $716,000 for the first nine months of 2006, while we recorded a $19.3 million impairment loss on goodwill and a $1.5 million impairment loss on intangible assets for the same period in 2005.

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

	Three months					Nine Months
	$ Change			% Change		$ Change			% Change
Product development	$	(252	)	(11	)%	$	(43	)	(1	)%
Sales and marketing		(711	)	(29	)		(1,492	)	(21	)
General and administrative		218		10			(199	)	(3	)
Impairment loss on goodwill		(19,300	)	(100	)		41,100		213
Impairment loss on intangible assets		(600	)	(100	)		(1,500	)	(100	)
Impairment loss on furniture and equipment		716		—			716		—
	$	(19,929	)	(74	)%	$	38,582		93	%

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 decreased $252,000, or 11%, during the three months ended September 30, 2006, to $2.1 million from $2.3 million for the same period in 2005. From a functional operating expense perspective, this decrease was primarily due to a $317,000 decrease in compensation and related benefits and a $42,000 decrease in occupancy cost. These decreases were offset by a $105,000 increase in legal and professional services and a $21,000 increase in other expense. Despite a headcount decrease of 36 employees, or 49%, from September 30, 2005 to September 30, 2006, compensation and related benefits only decreased $317,000, because we incurred $138,000 of additional severance expense during the three months ended September 30, 2006 compared to the same period in 2005 and 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. The decrease in occupancy cost was a result of lower rent expense for our Kirkland corporate office. The increase in legal and professional services was primarily related to an increase in outsourced hardware design costs increase in other expense was related to higher research and development materials and software license fees.

For the nine months ended September 30, 2006, total product development expenses decreased $43,000 compared to the same period in 2005. This decrease can be primarily attributed to a $382,000 decrease in compensation and related benefits offset by a $180,000 increase in other expenses primarily related to research and development materials, and a $134,000 increase in legal and professional services primarily related to outsourced hardware design costs.

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 $711,000, or 29%, during the three months ended September 30, 2006, compared to the same period in 2005. From a functional operating expense perspective, this decrease was primarily due to a $370,000 decrease in compensation and related benefits, a $140,000 decrease in legal and professional services, and an $82,000 decrease in advertising and promotion. The decrease in compensation and related benefits was primarily due to a reduction in sales and marketing headcount of 13 employees, or 31%, from September 30, 2005 to September 30, 2006, while the decrease in legal and professional services was driven by reduced expense for consulting and the decrease in advertising and promotion was the result of lower general advertising costs, although we did have higher public relations expense for the three months ended September 30, 2006, compared to the same period in 2005.

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For the nine months ended September 30, 2006, total sales and marketing expenses decreased $1.5 million compared to the same period in 2005. This decrease can be primarily attributed to a $1.1 million decrease in compensation and related benefits due to the 31% headcount reduction from September 30, 2005 to September 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, stock-based compensation and allowances for bad debts. General and administrative expenses increased $218,000, or 10% during the three months ended September 30, 2006, compared to the same period in 2005. From a functional operating expense perspective, this increase was primarily due to a $452,000 increase in compensation and related benefits. This increase was offset by a decrease of $117,000 in legal and professional services, a $71,000 decrease in other expense and a $40,000 decrease in occupancy expense. The increase in compensation and benefits was driven by increased severance expense related to corporate restructuring and increased stock-based compensation expense primarily related to the fully-vested stock option award granted to interim chief executive officer Steven Oyer, which represented $127,000 in expense. However, salaries and wages decreased $136,000 for the three months ending September 30, 2006 when compared to the same period in 2005, due to a headcount reduction of 8 employees, or 36%, from September 30, 2005. The decrease in legal and professional services was related to lower legal and consulting expense offset by higher shareholder expense related to strategic initiatives. 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 and insurance expense when compared to the same period in 2005. The decrease in occupancy expense was due to lower rent expense for our new corporate office in Kirkland, which we began to occupy in May, 2006.

For the nine months ended September 30, 2006, total general and administrative expenses decreased $199,000 compared to the same period in 2005. This decrease can be primarily attributed to a $297,000 decrease in other expense, primarily the result of a patent infringement settlement gain of $100,000 during the first quarter of 2006 and lower taxes and license fees for the nine months ending September 30, 2006. In addition, compensation and related benefits decreased $65,000 due to lower headcount and occupancy decreased $57,000 due to lower rent expense for the Kirkland office. These decreases were offset by a $246,000 increase in legal and professional services primarily due to increased legal and shareholder expense offset by lower consulting expense for the nine months ended September 30, 2006.

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 SFAS 142 during the first and second quarters of 2006. During the first quarter of 2006, we recorded a $29.7 million impairment charge on goodwill. 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, and recorded the adjustment during the second quarter of 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. In addition, as a result of our testing as of goodwill as of June 30, 2006, we recorded another goodwill impairment charge of $33.0 million during the second quarter of 2006. 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 did not record an impairment loss on goodwill during the third quarter of 2006 because our fair market value as of September 30, 2006 exceeded our net book value as of that date.

Impairment Loss on Intangible and Other Long-Lived Assets—We periodically review the carrying values of our long-lived assets to determine whether such assets have been impaired. An impairment loss must be recorded pursuant to SFAS No. 144 when the undiscounted net cash flows expected to be realized from the use of such assets are less than their carrying value. Due to our decision to refocus our resources toward specific product offerings and revenue opportunities during the third quarter, we believed that this constituted a triggering event under SFAS 144. In addition, we continued to incur losses from operations and actual sales and growth rates for the first nine months of 2006 were significantly lower than expected. In reviewing our long-lived assets for impairment for the three months ended September 30, 2006, we compared the carrying value of our primary long-lived assets – amortizable intangible assets and furniture and equipment to undiscounted cash flows expected from the use of the asset group. As a result of our decision to refocus our resources toward specific products, continuing operating losses and lower sales and growth rates in the first nine months of 2006 compared to forecasts, the carrying value of the group of assets exceeded undiscounted cash flows expected from the use of this asset group. Consequently, we measured the value of our long-lived assets as of September 30, 2006, based on a discounted cash flow model and the orderly liquidation method, and concluded that an impairment charge of $14.6 million should be allocated to the asset group on a pro rata basis, which we recognized during the third quarter of 2006. The pro rata allocation resulted in a $13.9 million impairment charge of intangible assets and a $716,000 impairment charge related to furniture and equipment, which were recorded in our statement of operations

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In the first quarter of 2005, we assessed the marketing strategy for our product offerings and decided to discontinue use of two tradenames that were acquired in connection with the Litronic acquisition. We estimated the fair value of these two tradenames to be zero because no future use was anticipated and we did not believe that a market existed for these tradenames. As a result, we recorded a $900,000 impairment loss on intangible assets for the first quarter of 2005. In the third quarter of 2005, we estimated the fair value of the indefinite-lived intangible asset tradenames to be $100,000 and accordingly, recorded an additional $600,000 impairment loss on intangible assets for the three months ended September 30, 2005.

Interest expense

Interest expense for the three and nine months ended September 30, 2006 was $983,000 and $1.3 million, respectively, compared to $37,000 and $103,000 for the three and nine months ended September 30, 2005, respectively. Interest expense for the three and nine months ended September 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 nine months ended September 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 nine months ended September 30, 2006 was $79,000 and $250,000, respectively. This is compared to $135,000 and $296,000 for the three and nine months ended September 30, 2005, respectively. Other income primarily consisted of interest earned on cash and money market balances.

Change in fair value of outstanding warrants

The SSP-Litronic acquisition in August 2004 triggered certain redemption provisions in connection with our Series A warrants. We estimated the cash redemption value was to be $765,000 as of August 2, 2004, the date we notified the warrant holders of the merger, and the value 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, we reclassified these warrants from equity to a liability because the warrants then contained characteristics of a debt instrument. The $172,000 gain during the nine months ended September 30, 2005, represented the change in valuation between September 30, 2005 and December 31, 2004. There were no changes in the fair value of these warrants during the period from December 31, 2005 to their expiration on June 6, 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 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 $39,000 for the three and nine months ended September 30, 2006, respectively. We recorded income tax benefits of $203,000 and $501,000 for the three and nine months ended September 30, 2005. We recorded income tax expense of $13,000 was recorded during the first three quarters of 2006 and 2005, which represented the income tax effect of goodwill amortization created by our asset purchase from Biometric Solutions Group 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, we cannot offset the deferred tax liabilities against deferred tax assets for purposes of determining the valuation allowance.

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.

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We determined the fair value of the modification of these warrants by using a Black-Scholes-Merton 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. We estimated the fair value of the modification to be $76,000 and we recorded this amount 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.

We determined the fair value of the modification of these warrants by using a Black-Scholes-Merton 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. We estimated the fair value of the modification to be $509,000 and we recorded this amounts 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 nine months ended September 30, 2006, primarily from our existing working capital, and bolstered our cash position with our June 2006 convertible debenture and warrant issuance. As of September 30, 2006, our working capital was negative $1.4 million, which included $5.2 million of cash and cash equivalents. This is compared to working capital of $11.8 million at December 31, 2005, which included cash and cash equivalents of $15.2 million.

In October 2006, we significantly reduced our operating expenses by reducing our workforce by over 50%. We estimate restructuring costs to be approximately $800,000, which is primarily comprised of severance payments for the effected employees. We expect to pay out the $800,000 in restructuring costs, in addition to employee accrued paid-time off balances totaling approximately $525,000, during the fourth quarter of 2006.

After these restructuring activities and excluding severance expense we expect to recognize in the fourth quarter, we expect to use approximately $2.5 million in the fourth quarter of 2006 and approximately $2.0 per quarter in operations after that. As a result of the restructuring and the capital raised during June 2006, we believe that we have sufficient funds to continue our operations at current levels into the first quarter of 2007. We do not have a credit line or other borrowing facility to fund our operations. To continue our current level of operations through September 30, 2007, we expect that we will need an additional $5.0 million of cash flow from operations and through the issuance of equity or debt securities or other sources of financing. Currently, we do not have any arrangements in place for any future financings, and we may not be able to secure 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 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, and we may be required to cease our operations.

The $8.0 million aggregate principal amount of our 8% convertible debentures we issued in June 2006 is subject to mandatory monthly redemption at the rate of 1/12 of the original principal amount plus accrued but unpaid interest on the debentures commencing December 1, 2006. We have elected to pay interest on the debentures in shares of our common stock beginning with the payment due in December 2006, and for future interest payment dates until we notify the holders of the debentures that we elect otherwise. We have also elected to pay the monthly redemption payment due in December 2006 in shares of common stock.

We expended $15.8 million in operating activities during the first nine months of 2006, compared to $15.1 million for the same period in 2005. The net loss of $96.0 million for the nine months ended September 30, 2006 was significantly impacted by $60.4 million in losses related to the impairment of goodwill and $14.6 million impairment to intangible assets and furniture and equipment. Other significant adjustments to the net loss were depreciation and amortization of $2.6 million, non-cash interest expense of $923,000, stock-based compensation of $872,000 and an increase in accrued expenses of $523,000. These adjustments were offset by an increase in accounts receivable of $456,000 and a decrease in accounts payable of $127,000.

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Net cash used in investing activities was $506,000 during the nine months ended September 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 $262,000 used for purchases of furniture and equipment for the same period in 2005.

Net cash provided from financing activities was $6.4 million during the nine months ended September 30, 2006, compared to $14.4 million during the same period in 2005. During the nine months ended September 30, 2006, we received gross proceeds of $8.0 million, net of $614,000 in debt issuance costs paid, through the issuance of 8% convertible debentures and warrants to purchase 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.

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 under a lease that expires in February 2012. 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	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 September 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	$	5,031	$	303	$	2,103	$	1,745	$	880
Series A warrant redemptions		372		160		212		—		—
Convertible note payable to related party		1,250		1,250		—		—		—
Convertible note interest		63		63		—		—		—
Convertible debentures		8,000		667		7,333		—		—
Convertible debentures interest		592		299		293		—		—
Total Contractual Cash Obligations	$	15,308	$	2,742	$	9,941	$	1,745	$	880

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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.

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.

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 $257.2 million from our inception through September 30, 2006. We have continued to accumulate losses after September 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 November 1, 2006, 88,908,229 shares of our common stock were outstanding. In addition, there were a total of 43,525,113 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, none of which have exercise or conversion prices below the market price for our common stock of $0.19 as of November 1, 2006. Options to acquire 9,339,637 shares of our common stock were outstanding as of November 1, 2006, and our existing stock incentive plan had 1,981,191 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 would 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.

On October 11, 2006, we received a Nasdaq staff deficiency letter indicating that we were not in compliance with the Nasdaq audit committee requirements as set forth in Marketplace Rule 4350. We received the letter because Mr. Oyer, who was serving as the chairman of the audit committee of our board of directors, no longer met the independence requirements of an audit committee member due to his appointment as interim chief executive officer. The notice stated that we would be provide a cure period in order to regain compliance with this rule as follows:

• until the earlier of our next annual shareholders’ meeting or September 28, 2007; or

• if the next annual shareholders’ meeting is held before March 27, 2007, then no later than March 27, 2007.

If we cannot demonstrate compliance within this period, we will be provided written notice that our securities will be delisted.

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.

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.

Three customers accounted for 29%, 11% and 10% of our revenue for the three months ended September 30, 2006, while one customer accounted for 14% of the Company’s revenue for the nine months ended September 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 90% and 72% of our revenue for the three and nine months ended September 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 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.

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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 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.

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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.

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.

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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.

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.

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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.

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

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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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Our annual meeting of stockholders was held on October 27, 2006. Our stockholders considered four proposals. The first proposal was to elect eight directors to hold office until our annual meeting of stockholders in 2007 and until their successors are elected and qualified, and each candidate received the following votes:

	For	Withheld
Glenn L. Argenbright	58,922,943	4,911,985
Frank J. Cilluffo	58,931,113	4,900,815
Lincoln D. Faurer	59,143,719	4,688,209
Gordon E. Fornell	58,994,529	4,837,399
Asa Hutchinson	58,498,808	5,333,120
Richard P. Kiphart	59,071,211	4,760,717
Trevor Nielson	58,645,257	5,186,671
Steven M. Oyer	53,863,554	1,367,855

All of the foregoing candidates were elected. On October 13, 2006, Kris Shah resigned as a member of our board of directors and declined to stand for reelection. As a result, a vacancy on the board of directors occurred prior to the annual meeting and we did not designate a substitute nominee.

The second proposal was to approve the issuance of more than 19.999% of our common stock in connection with our June 12, 2006 financing. This proposal received the following votes:

For	Against	Abstain	Broker Non-Votes
16,000,876	6,912,279	106,893	—

The foregoing proposal was approved. Approval of this proposal required the affirmative vote of a majority of the votes cast affirmatively or negatively on the proposal. Abstentions and broker non-votes were each counted as present for purposes of determining the presence of a quorum but did not have any effect on the outcome of the proposal.

The third proposal was to approve an amendment to our 2000 Stock Incentive Plan to increase by 8,000,000 the maximum number of shares of our common stock that may be issued under that plan. This proposal received the following votes:

For	Against	Abstain	Broker Non-Votes
8,921,030	13,985,568	113,450	—

The foregoing proposal was not approved. Approval of this proposal required the affirmative vote of a majority of the votes cast affirmatively or negatively on the proposal. Abstention and broker non-votes were each counted as present for purposes of determining the presence of a quorum but did not have any effect on the outcome of the proposal.

The fourth proposal was to ratify the appointment of KPMG LLP as our independent auditors for the fiscal year ending December 31, 2006. This proposal received the following votes:

For	Against	Abstain	Broker Non-Votes
59,550,241	5,263,405	18,282	—

The foregoing proposal was approved. Approval of this proposal required the affirmative vote of a majority of the votes cast affirmatively or negatively on the proposal. Abstentions and broker non-votes were each counted as present for purposes of determining the presence of a quorum but did not have any effect on the outcome of the proposal.

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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	Executive Consulting Agreement, dated as of September 28, 2006, by and between Saflink Corporation and Capital Placement Holdings, Inc.	X
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: November 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	Executive Consulting Agreement, dated as of September 28, 2006, by and between Saflink Corporation and Capital Placement Holdings, Inc.	X
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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