IMAGEWARE SYSTEMS INC MANAGEMENT REPORT AND ANALYSIS OF FINANCIAL POSITION AND RESULTS OF OPERATIONS (Form 10-K)

The following discussion should be read in conjunction with our consolidated
financial statements and the related notes and other financial information
appearing elsewhere in this Annual Report on Form 10-K. Readers are also urged
to carefully review and consider the various disclosures made by us, which
attempt to advise interested parties of the factors which affect our business,
including (without limitation) the disclosures made under the captions
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Risk Factors", and in the audited consolidated financial
statements and related notes included in this Annual Report on Form 10-K.



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  Table of Contents



Overview



Imageware Systems, Inc. ("Imageware," the "Company," "we," "our") provides
biometric solutions to identify, verify, and authenticate people based on their
true identity, rather than on what keys and codes they have. A pioneer in the
field, Imageware was the first multimodal biometric solution provider in history
and holds dozens of patents, including some of the most cited patents in the
industry. Our Cloud-based and on-premises solutions provide faster, more
accurate identification to better secure communities, data, and assets. In fact,
governments, law enforcement agencies, and public and private enterprises
worldwide trust Imageware with critical identity solutions which manage millions
of identities every day.



Our patented Imageware Biometric Engine® is one of the most accurate and fastest
biometrics matching engines in the industry, capable of our patented biometrics
fusion. We are a "biometrics first" company, leveraging unique human
characteristics to provide unparalleled accuracy for identification while
protecting your identity.



Our product portfolio, called the Imageware Identity Platform, is built around
three key areas: Enroll & Identify, Badge & Credential, and Authenticate. All of
these areas are built on top of the Imageware Biometric Engine. The Platform is
a fully-modular, customizable, and pre-integrated portfolio of capabilities to
support state and local law enforcement, Federal agencies, and enterprises
alike.



Enroll & Identify


The Register and Identify area includes four key modules: Imageware Proof, Imageware Capture, Imageware Identify, and Imageware Investigate.



Imageware Proof enables an entity to prove someone's identity from their
biometrics, government issued ID, and 3rd party databases (such as credit bureau
data). Imageware Capture enables the fastest capture of biographic and biometric
detail (such as face, fingerprint, palm print, iris, and SMT's) in the industry.
Imageware Identify enables a user to identify someone from their biometrics in
seconds. Imageware Investigate enables an officer to create digital lineups very
quickly.



Badge & Credential


The Badge & Credential area includes two key modules: Imageware Credential (formerly EPI Suite) and Imageware Digital ID. Imageware Credential allows a user to design, create and print badges for access control systems. This includes tickets, smart badges, wristbands, personal identity verification (“PIV”) cards, and more. Imageware Digital ID is a decentralized identity service that enables self-sovereign identity backed by biometrics-related blockchain technology.


Authenticate



The Authenticate area includes Imageware Authenticate, which enables users to
leverage multimodal biometrics hosted in a central server or cloud to log in to
services and applications from any device. Imageware Authenticate is easily
integrated into existing solutions leveraging OpenID Connect ("OIDC"), Security
Assertion Mark-up Language ("SAML"), or OAuth2 protocols, and includes a
software development kit ("SDK") for partners and customers to easily embed into
their existing applications.



Imageware Biometric Engine



The Imageware Biometric Engine® is a patented biometric identity and
authentication database built for multi-biometric enrollment, management and
authentication. It is hardware agnostic and can utilize different types of
biometric algorithms from any vendor. It allows different types of biometrics to
be operated at the same time on a seamlessly integrated platform. It is also
offered as an SDK, enabling developers and system integrators to implement
biometric solutions or integrate biometric capabilities, into existing
applications.



Imageware Law Enforcement



Our modules are leveraged across many industries and use cases with minimal
customization needed. One of the key areas includes our Law Enforcement 2.0
solution which enables state, local and Federal agencies to quickly capture,
archive, search, retrieve, and share digital images, fingerprints and other
biometrics, as well as criminal history records on a stand-alone, networked,
wireless or browser-based platform. Our Imageware Law Enforcement 2.0 solution
includes Imageware Capture, Imageware Identify, Imageware Investigate, Imageware
Credential, and Imageware Authenticate. Other modules can also be easily
leveraged as needed.



Recent Market Conditions


During March 2020a global pandemic has been declared by the World Health Organization related to the rapidly growing epidemic of a new strain of coronavirus (“COVID-19”).



The pandemic has significantly impacted the economic conditions both in the
United States and worldwide, with accelerated effects in February 2020 through
the date of this Annual Report, as federal, state and local governments react to
the public health crisis, creating significant uncertainties in both the
worldwide and the United States economies. The situation is rapidly changing and
additional impacts to our business may arise that we are not aware of currently.
We cannot predict whether, when or the manner in which the conditions
surrounding COVID-19 will change including the timing of lifting any
restrictions or office closure requirements.



The full extent of COVID-19's impact on our operations and financial performance
depends on future developments that are uncertain and unpredictable, including
the duration and spread of the pandemic, its impact on capital and financial
markets and any new information that may emerge concerning the severity of the
virus, its spread to other regions as well as the actions taken to contain it,
among others.



In addition to the impact resulting from COVID-19, recent geopolitical
conflicts, specifically the war in Ukraine, may have an additional impact on
purchasing decisions both in the United States and worldwide, which creates
additional uncertainties in both the worldwide and the United States economies.
These factors could affect our ability to obtain additional financing or
consummate a strategic transaction, although no assurances can be given.



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Contents

Critical accounting estimates



The discussion and analysis of our consolidated financial condition and results
of operations are based on our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States of America ("GAAP"). The preparation of these consolidated
financial statements in accordance with GAAP requires us to utilize accounting
policies and make certain estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingencies as of the
date of the consolidated financial statements and the reported amounts of
revenue and expense during a fiscal period. The SEC considers an accounting
policy to be critical if it is important to a company's financial condition and
results of operations, and if it requires significant judgment and estimates on
the part of management in its application.



Significant estimates include the evaluation of our ability to continue as a
going concern, the allowance for doubtful accounts receivable, assumptions used
in the Black-Scholes model to calculate the fair value of share-based payments,
fair value of Series D Preferred and financial instruments issued with and
affected by the Series D Preferred Financing (defined below), fair value of
financial instruments with and affected by the Series C Preferred (defined
below), fair value of Series A Preferred (defined below), fair value of Series
A-1 Preferred (defined below), assumptions used in the application of revenue
recognition policies, assumptions used in the derivation of the Company's
incremental borrowing rate used in the computation of the Company's operating
lease liabilities and assumptions used in the application of fair value
methodologies to calculate the fair value of pension assets and obligations.
Actual results could differ from estimates.



The following are our critical accounting policies because we believe they are
both important to the portrayal of our financial condition and results of
operations and require critical management judgments and estimates about matters
that are uncertain. If actual results or events differ materially from those
contemplated by us in making these estimates, our reported financial condition
and results of operations for future periods could be materially affected.



Revenue Recognition. Effective January 1, 2018, we adopted Accounting Standards
Codification ("ASC"), Topic 606, Revenue from Contracts with Customers ("ASC
606"), using the modified retrospective transition method.



In accordance with ASC 606, revenue is recognized when control of the promised
goods or services is transferred to our customers, in an amount that reflects
the consideration we expect to be entitled to in exchange for those goods or
services.



The core principle of the standard is that we should recognize revenue to depict
the transfer of promised goods or services to customers in an amount that
reflects the consideration to which we expect to be entitled in exchange for
those goods or services. To achieve that core principle, we apply the following
five step model:



  1. Identify the contract with the customer;




  2. Identify the performance obligation in the contract;




  3. Determine the transaction price;




  4. Allocate the transaction price to the performance obligations in the
     contract; and



5. Recognize revenue when (or as) each performance obligation is satisfied.




At contract inception, we assess the goods and services promised in a contract
with a customer and identify as a performance obligation each promise to
transfer to the customer either: (i) a good or service (or a bundle of goods or
services) that is distinct or (ii) a series of distinct goods or services that
are substantially the same and that have the same pattern of transfer to the
customer. We recognize revenue only when we satisfy a performance obligation by
transferring a promised good or service to a customer.



Determining the timing of satisfaction of performance obligations as well as the transaction price and amounts allocated to performance obligations requires judgment.



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Contents

We disclose the breakdown of our customers’ revenues by categories of similar products and services as follows:


  ? Software licensing and royalties;




  ? Sales of computer hardware and identification media;




  ? Services; and




  ? Post-contract customer support.



Software licenses and royalties



Software licenses consist of revenue from the sale of software for identity
management applications. Our software licenses are functional intellectual
property and typically provide customers with the right to use our software in
perpetuity as it exists when made available to the customer. We recognize
revenue from software licensing at a point in time upon delivery, provided all
other revenue recognition criteria are met.



Royalties consist of revenue from usage-based arrangements and guaranteed minimum arrangements. We recognize revenue from royalty arrangements no later than (i) when the related sales occur or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied.

IT equipment and identification media



We generate revenue from the sale of computer hardware and identification media.
Revenue for these items is recognized upon delivery of these products to the
customer, provided all other revenue recognition criteria are met.



Services


Services revenue mainly includes software customization services, software integration services, system installation services and customer training. Revenue is generally recognized upon completion of services and customer acceptance, provided all other criteria for revenue recognition are met.

Post-Contract (“PCS”) Customer Support



PCS consists of maintenance on software and hardware for our identity management
solutions. We recognize PCS revenue from periodic maintenance agreements.
Revenue is generally recognized ratably over the respective maintenance periods
provided no significant obligations remain. Costs related to such contracts are
expensed as incurred.


Agreements with multiple performance obligations



A performance obligation is a promise in a contract to transfer a distinct good
or service to the customer. In addition to selling software licenses, hardware
and identification media, services and post-contract customer support on a
standalone basis, certain contracts include multiple performance obligations.
For such arrangements, we allocate revenue to each performance obligation based
on our best estimate of the relative standalone selling price. The standalone
selling price for a performance obligation is the price at which we would sell a
promised good or service separately to a customer. The primary methods used to
estimate standalone selling price are as follows: (i) the expected cost-plus
margin approach, under which we forecast our expected costs of satisfying a
performance obligation and then add an appropriate margin for that distinct good
or service and (ii) the percent discount off of list price approach.



Contract costs



We recognize an asset for the incremental costs of obtaining a contract with a
customer if we expect the benefit of those costs to be longer than one year. We
apply a practical expedient to expense costs as incurred for costs to obtain a
contract when the amortization period is one year or less.



Other items


We do not offer return rights for our products and services in the normal course of business.

Sales tax collected from customers is excluded from revenue.

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Impairment of Goodwill, Other Intangible and Long-Lived Assets.  The Company
accounts for its intangible assets under the provisions of ASC Topic 350,
Intangibles - Goodwill and Other ("ASC 350"). In accordance with ASC 350,
intangible assets with a definite life are analyzed for impairment under ASC
360-10-05 "Property, Plant and Equipment" and intangible assets with an
indefinite life are analyzed for impairment under ASC 360 annually, or more
often if circumstances dictate. The Company performs its annual simplified
impairment test in the fourth quarter of each year. In December 2018, the
Company adopted the provisions of ASU 2017-04, "Intangibles - Goodwill and Other
(Topic 350): Simplifying the Test for Goodwill Impairment". The provisions of
ASU 2017-04 eliminate the requirement to calculate the implied fair value of
goodwill to measure a goodwill impairment charge. Instead, entities will record
an impairment charge based on the excess of a reporting unit's carrying amount
over its fair value. Entities that have reporting units with zero or negative
carrying amounts will no longer be required to perform a qualitative assessment
assuming they pass the simplified impairment test.



The Company has not recorded any goodwill impairment charge for the years ended
December 31, 2021 or 2020.



The Company evaluates long-lived assets for impairment whenever events or
changes in circumstances indicate their net book value may not be recoverable.
When such factors and circumstances exist, the Company compares the projected
undiscounted future cash flows associated with the related asset or group of
assets over their estimated useful lives against their respective carrying
amount. Impairment, if any, is based on the excess of the carrying amount over
the fair value, based on market value when available, or discounted expected
cash flows, of those assets and is recorded in the period in which the
determination is made. The Company's management currently believes there is no
impairment of its long-lived assets. There can be no assurance, however, that
market conditions will not change or demand for the Company's products under
development will continue. Either of these could result in future impairment of
long-lived assets.



There are many management assumptions and estimates underlying the determination
of an impairment loss, and estimates using different, but reasonable,
assumptions could produce significantly different results. Significant
assumptions include estimates of future levels of revenue and operating expense.
Therefore, the timing and recognition of impairment losses by us in the future,
if any, may be highly dependent upon our estimates and assumptions. There can be
no assurance that goodwill impairment will not occur in the future.



Stock-Based Compensation. At December 31, 2021 and 2020, the Company had one
stock-based compensation plan for employees and nonemployee directors, which
authorizes the granting of various equity-based incentives including stock
options and restricted stock.



The Company estimates the fair value of its stock options using a Black-Scholes
option-pricing model, consistent with the provisions of ASC Topic 718,
Compensation - Stock Compensation ("ASC 718"). The fair value of stock options
granted is recognized to expense over the requisite service period. Stock-based
compensation expense for all share-based payment awards is recognized using the
straight-line single-option method. Stock-based compensation expense is reported
in general and administrative, sales and marketing, engineering and customer
service expense based upon the departments to which substantially all of the
associated employees report and credited to additional paid-in capital.



ASC 718 requires the use of a valuation model to calculate the fair value of
stock-based awards. For the years ended December 31, 2021 and 2020, the Company
has elected to use the Black-Scholes option-pricing model, which incorporates
various assumptions including volatility, expected life, and interest rates. The
Company is required to make various assumptions in the application of the
Black-Scholes option-pricing model. The Company has determined that the best
measure of expected volatility is based on the historical weekly volatility of
the Company's Common Stock. Historical volatility factors utilized in the
Company's Black-Scholes computations for options granted during the years ended
December 31, 2021 and 2020 ranged from 57% and 99%. The Company has elected to
estimate the expected life of an award based upon the SEC approved "simplified
method" noted under the provisions of Staff Accounting Bulletin Topic 14. The
expected term used by the Company to value the grants issued in 2021 and 2020 as
computed by this method ranged from 3.33 to 5.17 years. The effect of the
difference between the actual historical expected life and the simplified method
was immaterial. The interest rate used is the risk-free interest rate and is
based upon U.S. Treasury rates appropriate for the expected term. Interest rates
used in the Company's Black-Scholes calculations ranged from 1.37% to 2.58%% for
the years ended December 31, 2021 and 2020. Dividend yield is zero, as the
Company does not expect to declare any dividends on the Company's common shares
in the foreseeable future.



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Contents



In addition to the key assumptions used in the Black-Scholes model, the
estimated forfeiture rate at the time of valuation is a critical assumption. The
Company has utilized an estimated annualized forfeiture rate ranging from
approximately 5.0% to 10% for corporate officers, 4.1% to 10% for members of the
Board of Directors and 15.0% to 25% for all other employees for options granted
during the years ended December 31, 2021 and 2020. The Company reviews the
expected forfeiture rate annually to determine if that percent is still
reasonable based on historical experience.



Income Taxes. The Company accounts for income taxes in accordance with ASC Topic
740, Accounting for Income Taxes ("ASC 740"). Deferred income taxes are
recognized for the tax consequences related to temporary differences between the
carrying amount of assets and liabilities for financial reporting purposes and
the amounts used for tax purposes at each year-end, based on enacted tax laws
and statutory tax rates applicable to the periods in which the differences are
expected to affect taxable income. A valuation allowance is established when
necessary, based on the weight of available evidence, if it is considered more
likely than not that all or some portion of the deferred tax assets will not be
realized. Income tax expense is the sum of current income tax plus the change in
deferred tax assets and liabilities.



ASC 740-10 requires a company to first determine whether it is
more-likely-than-not (defined as a likelihood of more than fifty percent) that a
tax position will be sustained based on its technical merits as of the reporting
date, assuming that taxing authorities will examine the position and have full
knowledge of all relevant information. A tax position that meets this
more-likely-than-not threshold is then measured and recognized at the largest
amount of benefit that is greater than fifty percent likely to be realized upon
effective settlement with a taxing authority.



We recognize and measure uncertain tax positions in accordance with GAAP,
pursuant to which we only recognize the tax benefit from an uncertain tax
position if it is more likely than not that the tax position will be sustained
on examination by the taxing authorities, based on the technical merits of the
position. Any tax benefits recognized in the consolidated financial statements
from such positions are then measured based on the largest benefit that has a
greater than fifty percent likelihood of being realized upon ultimate
settlement. We report a liability for unrecognized tax benefits resulting from
uncertain tax positions taken or expected to be taken in a tax return. GAAP
further requires that a change in judgment related to the expected ultimate
resolution of uncertain tax positions be recognized in earnings in the quarter
of such change. We recognize interest and penalties, if any, related to
unrecognized tax benefits in income tax expense.



We file annual income tax returns in multiple taxing jurisdictions around the
world. A number of years may elapse before an uncertain tax position is audited
and finally resolved. While it is often difficult to predict the final outcome
or the timing of resolution of any particular uncertain tax position, we believe
that our analysis of income tax reserves reflects the most likely outcome. We
adjust these reserves, if any, as well as the related interest, in light of
changing facts and circumstances. Settlement of any particular position could
require the use of cash.



Significant judgment is required in evaluating the Company's uncertain tax
positions and determining the Company's provision for income taxes. No assurance
can be given that the final tax outcome of these matters will not be different
from that which is reflected in the Company's historical income tax provisions
and accruals. The Company adjusts these items in light of changing facts and
circumstances. To the extent that the final tax outcome of these matters is
different than the amounts recorded, such differences will impact the provision
for income taxes in the period in which such determination is made.



The Internal Revenue Code (the "Revenue Code") limits the availability of
certain tax credits and net operating losses that arose prior to certain
cumulative changes in a corporation's ownership resulting in a change of control
of the Company. The Company's use of its net operating loss carryforwards and
tax credit carryforwards will be significantly limited because the Company
believes it underwent "ownership changes", as defined under Section 382 of the
Revenue Code, in 1991, 1995, 2000, 2003, 2004, 2011, 2012, 2018 and 2020, though
the Company has not performed a study to determine the limitation. The Company
has reduced its deferred tax assets to zero relating to its federal and state
research credits because of such limitations. The Company continues to disclose
the tax effect of the net operating loss carryforwards at their original amount
as the actual limitation has not yet been quantified. The Company has also
established a full valuation allowance for substantially all deferred tax assets
due to uncertainties surrounding its ability to generate future taxable income
to realize these assets. Since substantially all deferred tax assets are fully
reserved, future changes in tax benefits will not impact the effective tax rate.
Management periodically evaluates the recoverability of the deferred tax assets.
If it is determined at some time in the future that it is more likely than not
that deferred tax assets will be realized, the valuation allowance would be
reduced accordingly at that time.



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Fair-Value Measurements. The Company accounts for fair value measurements in
accordance with ASC Topic 820, Fair Value Measurements and Disclosures ("ASC
820"), which defines fair value, establishes a framework for measuring fair
value in generally accepted accounting principles, and expands disclosures about
fair value measurements.



ASC 820 establishes a fair value hierarchy that prioritizes the inputs to
valuation techniques used to measure fair value. The hierarchy gives the highest
priority to unadjusted quoted prices in active markets for identical assets or
liabilities (Level 1 measurements) and the lowest priority to unobservable
inputs (Level 3 measurements). The three levels of the fair value hierarchy
under ASC 820 are described below:



Level 1 – Unadjusted quoted prices in active, accessible markets on the measurement date for identical assets or liabilities without restriction.



Level 2- Applies to assets or liabilities for which there are inputs other than
quoted prices included within Level 1 that are observable for the asset or
liability such as quoted prices for similar assets or liabilities in active
markets; quoted prices for identical assets or liabilities in markets with
insufficient volume or infrequent transactions (less active markets); or
model-derived valuations in which significant inputs are observable or can be
derived principally from, or corroborated by, observable market data.



Level 3- Pricing or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).



Assessing the significance of a particular input to the fair value measurement
requires judgment, considering factors specific to the asset or
liability. Determining whether a fair value measurement is based on Level 1,
Level 2, or Level 3 inputs is important because certain disclosures are
applicable only to those fair value measurements that use Level 3 inputs. The
use of Level 3 inputs may include information derived through extrapolation or
interpolation which involves management assumptions as well as valuation
techniques employing Monte Carlo simulation methodologies.



Lease liabilities and assets under the right of use of operating leases



The Company is a party to certain contractual arrangements for office space
which meet the definition of leases under  ASC Topic 842 - Leases ("ASC 842").
In accordance with ASC 842, the Company has determined that such arrangements
are operating leases and accordingly the Company has, as of January 1, 2019,
recorded operating lease right-of-use assets and related lease liability for the
present value of the lease payments over the lease terms using the Company's
estimated weighted-average incremental borrowing rate of approximately 14.5%.
The Company has utilized the practical expedient regarding lease and nonlease
components and has combined such items into a single combined component. The
Company has also utilized the practical expedient regarding leases of twelve
months or less and has excluded such leases from its computation of lease
liability and related right-of-use assets. The Company has also elected the
optional transition package of practical expedients which include:



A practical expedient package not to be questioned:

? If a contract is or contains a lease



  ? Lease classification




  ? Initial direct costs




The company evaluates its operating lease right-of-use assets for impairment. As
of December 31, 2021, and through the date of this report, management's review
indicated that there was an impairment of an operating lease right-of-use asset
and the Company recorded an impairment loss of approximately $333,000.
Impairment is based on the excess of the carrying amount over the fair value,
based on market value when available, or expected future economic benefits to
the company from the operating lease right-of-use asset and is recorded in the
period in which the determination is made. Such amount is included in the
Company's Consolidated Statement of Operations for the year ended December31,
2021 under the caption "General and administrative" expense.



For a detailed analysis of the application of these and other accounting methods, see note 2 of the notes to the consolidated financial statements for the year ended December 31, 2021.

Comparison of results for the years ended December 31, 2021 and 2020


Product Revenue



                                               Twelve Months Ended
                                                   December 31,
Net Product Revenue                           2021             2020          $ Change       % Change
(dollars in thousands)
Software and royalties                     $      383       $       872     $     (489 )          (56 )%
Percentage of total net product revenue            45 %              39 %
Hardware and consumables                   $      290       $        84     $      206            245 %
Percentage of total net product revenue            34 %               4 %
Services                                   $      181       $     1,275     $   (1,094 )          (86 )%
Percentage of total net product revenue            21 %              57 %
Total net product revenue                  $      854       $     2,231     $   (1,377 )          (62 )%




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Software and royalty revenue decreased 56% or approximately $489,000 during the
year ended December 31, 2021 as compared to the corresponding period in 2020.
This decrease is attributable to lower identification project related revenue of
approximately $442,000 and lower royalty revenue of approximately $110,000
offset by higher law enforcement project related revenue of approximately
$33,000 and higher sales of boxed identity management software sold through our
distribution channel of approximately $30,000. The decrease in identification
project related revenue is reflective of lower software licenses sold into
identification projects during the year ended December 31, 2021 and the decrease
in royalty revenue results primarily from lower reported usage from certain
customers. The increase in boxed identity management software sold through our
distribution channel reflects higher procurement from certain international
customers and the increase in law enforcement software reflects the expansion of
our installed base among existing customers.



Revenue from the sale of equipment and consumables increased by approximately
$206,000 during the year ended December 31, 2021 compared to the corresponding period of 2020 due to an increase in project-related solutions containing hardware and consumables sales primarily to law enforcement customers.



Services revenue consists primarily of software integration services, system
installation services and customer training. Such revenue decreased $1,094,000
during the year ended December 31, 2021 as compared to the corresponding period
in 2020, due to a decrease in the service element of project related work
completed during the year ended December 31, 2021.



We believe that the period-to-period fluctuations of identity management
software revenue in project-oriented solutions are largely due to the timing of
government procurement with respect to the various programs we are
pursuing. Although no assurances can be given, based on management's current
visibility into the timing of potential government procurements and potential
partnerships and current pilot programs, we believe that we will see an increase
in government procurement and implementations with respect to identity
management initiatives; however, government procurement initiatives,
implementations and pilots are frequently delayed and extended and we cannot
predict the timing of such initiatives.



As discussed more fully elsewhere in this Annual Report, the full extent of
COVID-19's impact on our operations and financial performance depends on future
developments that are uncertain and unpredictable, including the duration and
spread of the pandemic, its impact on our ability to close sales transactions
and on capital and financial markets and any new information that may emerge
concerning the severity of the virus, its spread to other regions as well as the
actions taken to contain it, among others.



During the year ended December 31, 2021, we have focused on strategically
modernizing our modules within the Imageware Identity Platform, prioritized by
market opportunities. We relaunched Imageware Authenticate (formerly GoVerify
ID®) in February 2021. This relaunch includes a new container and
microservices-based architecture along with refreshed mobile and desktop
clients. We believe these updates will result in additional customers
implementing our Imageware Authenticate solution. Additionally, we launched
Imageware Capture, our first module of the Law Enforcement 2.0 solution in
October 2021 and Imageware Investigate in December 2021. These are the first of
many modules that we plan to build and modernize throughout 2022 and beyond.
Prior to releasing Imageware Investigate, we closed our largest
software-as-a-service (SaaS) deal in company history with Imageware Investigate.
Management believes that these initiatives will result in the expansion of our
solutions into state & local law enforcement, federal government, and
enterprises alike.



Maintenance Revenue



                              Twelve Months Ended
                                  December 31,
Maintenance Revenue            2021           2020        $ Change      % Change
(dollars in thousands)
Total maintenance revenue   $    2,618       $ 2,554     $       64             3 %




Maintenance revenue was approximately $2,618,000 for the year ended December 31,
2021, as compared to approximately $2,554,000 for the corresponding periods in
2020. For the year ended December 31, 2021, identity management maintenance
revenue was approximately $1,385,000 as compared to $1,264,000 for the
comparable period in 2020. The increase of $121,000 in identification software
maintenance revenue for the year ended December 31, 2021 as compared to the
corresponding period of 2020 is reflective of certain additional maintenance
services provided by the Company during the year ended December 31, 2021. For
the year ended December 31, 2021, law enforcement maintenance revenue was
approximately $1,233,000 as compared to $1,290,000 for the comparable period in
2020. The decrease of $57,000 in law enforcement maintenance revenue for the
year ended December 31, 2021 as compared to the corresponding period of 2020
reflects the expiration of certain maintenance contracts.



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We anticipate growth of our maintenance revenue through the retention of
existing customers combined with the expansion of our installed base resulting
from the completion of project-oriented work; however, we cannot predict the
timing of this anticipated growth.



Cost of Product Revenue



                                               Twelve Months Ended
                                                  December 31,
Cost of Product Revenue:                      2021             2020         $ Change       % Change
(dollars in thousands)
Software and royalties                     $       28       $       54     $      (26 )          (48 )%
Percentage of software and royalty
product revenue                                     7 %              6 %
Hardware and consumables                   $      200       $       52     $      148            285 %
Percentage of hardware and consumables
product revenue                                    69 %             62 %
Services                                   $       94       $      694     $     (600 )          (86 )%
Percentage of services product revenue             52 %             54 %
Total product cost of revenue              $      322       $      800     $     (478 )           60 %
Percentage of total product revenue                38 %             36 %




The cost of software and royalty product revenue decreased approximately $26,000
due to lower software and royalty revenue for the year ended December 31, 2021
of approximately $489,000. In addition to changes in costs of software and
royalty product revenue caused by revenue level fluctuations, costs of products
can vary as a percentage of product revenue from period to period depending upon
level of software customization and third-party software license content
included in product sales during a given period.



The cost of product revenue for our hardware and consumable sales during the
year ended December 31, 2021 increased approximately $148,000 as compared to the
corresponding period in 2020 due primarily to higher hardware and consumable
product revenue of approximately $206,000 during the 2021 period.



The cost of services revenue decreased approximately $600,000 during the year
ended December 31, 2021 as compared to the corresponding period in 2020 due to
lower service revenue of approximately $1,094,000. Although changes in costs of
services product revenue are sometimes caused by revenue level fluctuations,
costs of services can also vary as a percentage of service revenue from period
to period depending upon both the level and complexity of professional service
resources utilized in the completion of the service element.



Cost of Maintenance Revenue



                                               Twelve Months Ended
Maintenance cost of revenue                       December 31,
(dollars in thousands)                        2021             2020         $ Change       % Change
Total maintenance cost of revenue          $      346       $      448     $     (102 )          (23 )%
Percentage of total maintenance revenue            13 %             18 %




Cost of maintenance revenue decreased approximately $102,000 during the year
ended December 31, 2021 as compared to the corresponding period in 2020 despite
higher maintenance revenue of approximately $64,000. This decrease is reflective
of lower maintenance labor costs incurred during the year ended December 31,
2021 as compared to the corresponding period in 2020 due primarily to the
headcount reductions in our customer support department and a reduction in fixed
maintenance costs.



Product Gross Profit



                                               Twelve Months Ended
                                                   December 31,
Product gross profit                          2021             2020          $ Change       % Change
(dollars in thousands)
Software and royalties                     $      355       $       818     $     (463 )          (57 )%
Percentage of software and royalty
product revenue                                    93 %              94 %
Hardware and consumables                   $       90       $        32     $       58            181 %
Percentage of hardware and consumables
product revenue                                    31 %              38 %
Services                                   $       87       $       581     $     (494 )          (85 )%
Percentage of services product revenue             48 %              46 %
Total product gross profit                 $      532       $     1,431     $     (899 )          (63 )%
Percentage of total product revenue                62 %              64 %




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Software and royalty gross profit decreased 57% or approximately $463,000 for
the year ended December 31, 2021 as compared to the corresponding period in
2020, due primarily to lower software and royalty revenue of approximately
$489,000 combined with lower software and royalty cost of revenue of $26,000 for
the same period. This revenue decrease with only a minimal decrease in software
and royalty cost of revenue reflects low third-party software costs. In addition
to changes in costs of software and royalty product revenue caused by revenue
level fluctuations, costs of products can vary as a percentage of product
revenue from period to period depending upon level of software customization and
third-party software license content included in product sales during a given
period.



Hardware and consumables gross profit increased approximately $58,000 for the
year ended December 31, 2021, as compared to the 2020 period, due primarily to
higher hardware and consumable revenue of approximately $206,000 combined with
higher cost of hardware and consumable revenue of approximately $148,000. These
increases result from an increase in project related solutions containing
hardware and consumable components.



Services gross profit decreased approximately $494,000 for the year ended
December 31, 2021 as compared to the corresponding period in 2020 due to lower
service revenue of approximately $1,094,000 combined with lower service cost of
revenue of $600,000 for the year ended December 31, 2021 as compared to the
corresponding period in 2020. Although changes in costs of services product
revenue are sometimes caused by revenue level fluctuations, costs of services
can also vary as a percentage of service revenue from period to period depending
upon both the level and complexity of professional service resources utilized in
the completion of the service element.



Maintenance Gross Profit



                                              Twelve Months Ended
Maintenance gross profit                          December 31,
(dollars in thousands)                        2021            2020         $ Change        % Change
Total maintenance gross profit             $    2,272       $   2,106     $      166                8 %
Percentage of total maintenance revenue            87 %            82 %




Gross profit related to maintenance revenue increased 8% or approximately
$166,000 for the year ended December 31, 2021 as compared to the corresponding
period in 2020. This increase reflects higher maintenance revenue of
approximately $64,000 combined with lower cost of maintenance revenue of
approximately $102,000. The increase in maintenance revenue results from the
provision of certain additional maintenance services to a certain customer
during the year ended December 31, 2021. The decrease cost of maintenance
revenues for the year ended December 31, 2021 as compared to the corresponding
period in 2020 is due primarily to reductions in headcount in our customer
support department and reductions in certain fixed maintenance costs.
Maintenance gross profit can change from period to period depending upon both
the level and complexity of labor resources utilized in the provision of the
maintenance services.



Operating Expense



                                    Twelve Months Ended
                                        December 31,
Operating expense                    2021           2020       $ Change      % Change
(dollars in thousands)
General and administrative        $    6,151       $ 4,102     $   2,049   

50% Percentage of total net income 177% 86% Sales and marketing

               $    2,892       $ 2,936     $     (44 )          (1 )%
Percentage of total net revenue           83 %          61 %

Research and development $4,461 $5,706 ($1,245)

(22)% Percentage of total net income 128% 119% Amortization and depreciation $56 $72 $ (16 )

         (22 )%
Percentage of total net revenue            2 %           2 %




General and administrative costs

General and administrative expenses primarily include salaries and other employee-related costs for management personnel, finance and other infrastructure. General expenses for legal services, accounting and consulting, insurance, occupancy and communication are also included in general and administrative expenses.



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The dollar increase of approximately $2,049,000 in general and administrative
expense for the year ended December 31, 2021 as compared to the corresponding
period in 2020 is comprised of the following major components:



? Overall decrease in personnel costs of approximately $417,000 is of

reductions in the workforce of various changes in senior management positions;

? Increase in professional services of approximately $679,000 which includes

higher legal fees of approximately $93,000upper board of directors costs

approximately $70,000higher audit fees of approximately $25,000upper

contractor and contract service expenses of approximately $635,000 offset by

reductions in patent-related legal and other costs of approximately $115,000,

reductions in corporate overhead costs $11,000 and lower investor and

    public relations fees of approximately $18,000;



? Increase in insurance-related expenses of approximately $191,000 Guided by

increase in insurance premiums for directors and officers, increase in licenses, dues and

subscription fee of approx. $213,000increase in travel

approximately $17,000 and increases of about $10,000 in other

miscellaneous expenses offset by reductions in office costs of

approximately $99,000 carried by the subletting of our former San Diego Office

    facility;



? Recognition of an impairment loss on an operating lease right-of-use asset of

$333,000; From December 31, 2021and up to the date of this report,

management’s review indicated that there had been an impairment of one

right-of-use lease and the Company recorded an impairment loss based on

the excess of book value over fair value, based on market value

when available, or the expected future economic benefits to the business

    operating lease right-of-use asset.




  ? Increase in financing expense of approximately $829,000; and



? Increase in stock-based compensation expense related to options and

    stock units ("RSU's") of approximately $293,000.




We continue to focus our efforts on achieving additional future operating
efficiencies by reviewing and improving upon existing business processes and
evaluating our cost structure. We believe these efforts will allow us to
continue to gradually decrease our level of general and administrative expense
expressed as a percentage of total revenue.



Sales and Marketing Expense



Sales and marketing expense consists primarily of the salaries, commissions,
other incentive compensation, employee benefits and travel expense of our sales,
marketing, and business development personnel.



The dollar decrease of approximately $44,000 during the year ended December 31,
2021 as compared to the corresponding period in 2020 is primarily comprised of
the following major components:



  ? Decrease in personnel related expense of approximately $269,000 driven
    primarily by headcount reductions;




  ? Increase in contractor and contract services of approximately $148,000
    resulting from reduced utilization of certain sales consultants of
    approximately $150,000 offset by higher contract service expense of
    approximately $298,000;




  ? Increase in travel, trade show expense and office related expense of
    approximately $121,000;



? Increase in stock-based compensation expense of approximately $234,000; and

? decrease in our Mexico sales office costs of approx. $278,000 due to

    the shutdown of this sales office.



Research and development costs

Research and development expenses primarily include salaries, benefits and external contractors for new product development, product enhancements, custom integration work and related installation costs.



Research and development expense decreased approximately $1,245,000 for the year
ended December 31, 2021, as compared to the corresponding period in 2020, due
primarily to the following major components:



? Reduction in personnel costs of approximately $1,498,000 due to

    headcount reductions;



? Increase in fees for contractors and contractual services of approximately $109,000;

? Reduced rent, office expenses, and engineering tools and supplies by

    approximately $61,000; and




  ? Increase in stock based-compensation expense of approximately $205,000.




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Depreciation and amortization



During the year ended December 31, 2021, depreciation and amortization expense
decreased approximately $16,000 as compared to the corresponding period in
2020. The relatively small amount of depreciation and amortization reflects the
relatively small property and equipment carrying value.



Interest (Revenue) Expenses, Net



For the year ended December 31, 2021, we recognized interest income of $0 and
interest expense of $2,000. Interest expense for the year ended December 31,
2021 was comprised of approximately $1,000 on our related party notes payable
and approximately $1,000 in deferred financing fee amortization on our related
party notes payable classified as interest expense. For the year ended December
31, 2020, we recognized interest income of $2,000 and interest expense of
$104,000.



Other (Income) Expense, Net



For the year ended December 31, 2021, we recognized other income of
approximately $156,000 and other expense of approximately $82,000. The primary
components of other income were approximately $131,000 from the write-off of
liabilities at amounts less than their carrying value and $25,000 from sublease
income. Other expense for the year ended December 31, 2021 is comprised of
approximately $82,000 from the write-off of abandoned furniture. For the year
ended December 31, 2020, we recognized approximately $2,000 in other expense
related to late payment penalty fees.



(Gain) on change in fair value of derivative liabilities



For the year ended December 31, 2021, we recognized approximately $18,809,000
from the change in fair value of derivative liabilities arising from the Series
D Financing. Such decrease was determined by management using fair value
methodologies and is included as non-cash income under the caption "(Gain on
change in fair value of derivative liabilities" in our consolidated statement of
operations for the year ended December 31, 2021.



For the year ended December 31, 2020, we recognized approximately $369,000 from
the decrease of derivative liabilities arising from the consummation of the
Series C Financing in September 2019. Such decrease was determined by management
using fair value methodologies and is included as non-cash income under the
caption "Change in fair value of derivative liabilities" in our consolidated
statement of operations for twelve months ended December 31, 2020. Also for the
year ended December 31, 2020, we recognized approximately $1,883,000 from the
decrease in fair value of derivative liabilities arising from the Series D
Financing. Such decrease was determined by management using fair value
methodologies and is included as non-cash income under the caption "Change in
fair value of derivative liabilities" in our consolidated statement of
operations for the year ended December 31, 2020.



(Gain) on extinguishment of debt



For the year ended December 31, 2021, we recognized a gain on debt
extinguishment from the forgiveness of our PPP Loan. In September 2021, we
received notification from the Small Business Administration ("SBA") that our
Paycheck Protection Program ("PPP") Loan of $1,571,000 was forgiven in its
entirety along with accrued unpaid interest of approximately $10,000. Such gain
is included in the caption "(Gain) on extinguishment of debt" in our
consolidated statement of operations for the year ended December 31, 2021.



Loss on extinguishment of derivative liabilities



For the year ended December 31, 2021, we recognized a net loss on the
extinguishment of derivative liabilities of approximately $311,000 pursuant to
the conversion of 646 shares of Series D Preferred into Common Stock. Such loss
is included in the caption "Loss on extinguishment of derivative liabilities" in
our consolidated statement of operations for the year ended December 31, 2021.



Income Tax Expense



During the years ended December 31, 2021 and 2020, we recorded an expense for
income taxes of $10,000 and $7,000, respectively. These tax expenses relate to
taxes on income generated in certain foreign jurisdictions offset by research
and development tax credits generated in certain foreign jurisdictions.



We have incurred consolidated pre-tax losses during the years ended December 31,
2021, and 2020, and have incurred operating losses in all prior periods.
Management has determined that it is more likely than not that a tax benefit
from such losses will not be realized and has established a full valuation
allowance for any tax benefits. Accordingly, we did not record a benefit for
income taxes for these periods.



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Liquidity, capital resources and going concern



Historically, our principal sources of cash have included proceeds from the
issuance of common and preferred stock and proceeds from the issuance of debt,
and, to a lesser extent, customer payments from the sale of our products. Our
principal uses of cash have included cash used in operations, product
development, and payments relating to purchases of property and equipment. We
expect that our principal uses of cash in the future will be for product
development, including customization of identity management products for
enterprise and consumer applications, further development of intellectual
property, development of Software-as-a-Service ("SaaS") capabilities for
existing products as well as general working capital requirements. Management
expects that, as our revenue grows, our sales and marketing and research and
development expense will continue to grow, albeit at a slower rate and, as a
result, we will need to generate significant net revenue to achieve and sustain
positive cash flows from operations. Historically the Company has not been able
to generate sufficient net revenue to achieve and sustain positive cash flows
from operations, and this condition is currently expected to continue for the
foreseeable future. As a result, the Company has been dependent on equity and
debt financings to satisfy its working capital requirements and continue as a
going concern. Due to the Company's deteriorating liquidity, management has
determined that there is substantial doubt about the Company's ability to
continue as a going concern.



At December 31, 2021 and 2020, we had negative working capital of $8,046,000 and
$19,349,000, respectively. Included in our negative working capital as of
December 31, 2021 and 2020 are $5,292,000 and $24,128,000, respectively, of
derivative liabilities which are not required to be settled in cash except in
the event of the consummation of a change of control or at any time after the
fourth anniversary of the Series D Preferred issuance, at which time the holders
of the Series D Preferred may require the Company to redeem in cash any or all
of the holder's outstanding Series D Preferred at an amount equal to the Series
D Liquidation Preference Amount. At December 31, 2021 the Liquidation Preference
Amount totaled $23,216,000. Considering the financings consummated in 2020 and
2021, as well as our projected cash requirements, and assuming we are unable to
generate incremental revenue, our available cash will be insufficient to satisfy
our cash requirements in the near term, and for the next twelve months from the
date of this filing. At April 12, 2022, cash on hand approximated $588,000.
Based on the Company's rate of cash consumption during the year ended December
31, 2021 and the first quarter ended March 31, 2022, the Company estimates it
will need additional capital in the second quarter of 2022 and its prospects for
obtaining that capital are uncertain. As a result of the Company's historical
losses, financial condition, and challenges raising additional capital given the
volatile capital markets, there is substantial doubt about the Company's ability
to continue as a going concern.



To address our working capital requirements, management has instituted several
cost cutting measures and has utilized cash proceeds available under the Credit
Facility with Nantahala and other lenders, as described below, and under the
purchase agreement with Lincoln Park Capital Fund, LLC ("Lincoln Park"), as
described below, to satisfy its working capital requirements ("LPC Purchase
Agreement"). In addition, as reported in the Company's Quarterly Report on Form
10-Q filed with the SEC on August 23, 2021, on August 12, 2021, the Company
retained an investment bank to initiate a review of available alternatives to
maximize shareholder value, which may include, among other alternatives, (i) a
merger, consolidation, or other business combination or a purchase involving all
or a substantial amount of the business, securities or assets of the Company,
and/or  (ii) the private placement of securities to meet its working capital
requirements or otherwise as necessary in connection with the consummation of
any of the above transactions.  Other than the LPC Purchase Agreement with
Lincoln Park and our Credit Facility with Nantahala, which are currently
restricted in our ability to access additional capital, there are currently no
financing arrangements to support our projected cash shortfall. We currently
have no other commitments to purchase additional debt and/or equity securities,
or other agreements, and no assurances can be given that we will be successful
in raising additional debt and/or equity securities, or entering into any other
transaction that addresses our ability to continue as a going concern. The
consummation of a transaction will involve substantial dilution to the Company's
stockholders.



In view of the matters described in the preceding paragraphs, recoverability of
a major portion of the recorded asset amounts shown in the accompanying
consolidated balance sheet is dependent upon continued operations of the
Company, which, in turn, is dependent upon the Company's ability to continue to
raise capital, generate positive cash flows from operations, or otherwise
consummate a transaction that addresses the Company's working capital
requirements. There is no assurance that the Company will be able to obtain
additional capital, consummate a transaction that addresses its liquidity
concerns, or operate at a profit or generate positive cash flows in the future.
Therefore, management's plans do not alleviate the substantial doubt of the
Company's ability to continue as a going concern.



The consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts and
classifications of liabilities that might be necessary should the Company be
unable to continue as a going concern.



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December 2021 Credit Facility



On December 29, 2021 (the "Closing Date"), the Company entered into a Term Loan
and Security Agreement (the "Agreement") with certain funds and separate
accounts managed by Nantahala Capital Management, LLC (collectively,
"Nantahala"), as lenders, and the other lenders set forth on the signature pages
thereto (together with Nantahala, the "Lenders"), pursuant to which the Lenders
will provide to the Company a secured term loan credit facility in an aggregate
amount of up to $2,500,000 (the "Credit Facility").  All loans (each a "Loan",
and collectively, the "Loans") under the Credit Facility will bear interest at a
rate of 12% for the initial six months after the Closing Date, and at 17%
thereafter until the maturity date of 12 months from the Closing Date (the
"Maturity Date").  All amounts borrowed by the Company under the Credit Facility
are secured by a first-priority lien on all the assets of the Company.  On the
Closing Date, the Company received in initial draw-downs on the Credit Facility
of $600,000. As of April 12, 2022, the Company received two subsequent draw-down
aggregating $1,050,000. The Company expects to use the proceeds from the Credit
Facility for working capital requirements and corporate purposes.



The Company may prepay amounts borrowed under the Credit Facility in whole or in
part, at a price equal to 105% of the principal amount borrowed under the Credit
Facility (including any interest capitalized thereon).  Upon the occurrence of:
(I) any Debt Issuances, Dispositions, or Equity Interests (each as defined in
the Agreement), the Company must prepay the Loans in an aggregate amount equal
to the lesser of (a) the outstanding principal balance outstanding under the
Credit Facility (including any interest capitalized thereon), and (b) 100% of
the Net Cash Proceeds (as defined in the Agreement) received thereunder; and
(II) a Change of Control (as defined in the Agreement), the Company must prepay
the Loans in an aggregate amount equal to the lesser of (y) the outstanding
principal balance outstanding under the Credit Facility (including any interest
capitalized thereon), and (z) 105% of the Net Cash Proceeds received in
connection therewith.



Pursuant to the Agreement, at any time after the Closing Date, each Lender shall
have the right, but not the obligation, on mutually agreed upon terms, to
exchange each such Lender's pro rata portion of shares of the Company's Series D
Convertible Preferred Stock, par value $0.01 ("Series D Preferred") held by such
Lender for a mutually agreed upon portion of any subsequent Delayed Draw Loan
(as defined in the Agreement) (an "Exchange"). Upon the Company's receipt by a
Lender of a notice stating a Lender's intent to participate in an Exchange, the
Company is required to offer to all holders of Series D Preferred the
opportunity, but not the obligation, to exchange each such holder's pro rata
portion of shares of the Company's Series D Preferred held by such holder for
participation in any subsequent Delayed Draw Loan, upon substantially similar
terms as those provided in the applicable notice of Exchange by a Lender.



The Agreement contains customary events of default (each an "Event of Default").
If an Event of Default occurs, all amounts due and payable under the Credit
Facility shall incur interest at the current rate of interest plus 4%. The
Agreement further contains: (i) customary representations, warranties and
covenants of the Company, including among others, covenants by the Company
regarding title to the Company's Assets, the Company's rights to its
intellectual property, the Company's use of the proceeds received thereunder,
tax liabilities, and status of the Company's material contracts; and (ii)
customary indemnification provisions whereby the Company will indemnify the
Lenders for certain losses arising out of inaccuracies in, or breaches of, the
representations, warranties and covenants of the Company, and certain other
matters.



2021 Lincoln Park Financing



On May 17, 2021 (the "Execution Date"), the Company entered into a purchase
agreement, dated as of the Execution Date (the "2021 LPC Purchase Agreement"),
and a registration rights agreement, dated as of the Execution Date (the
"Registration Rights Agreement"), with Lincoln Park Capital Fund, LLC ("Lincoln
Park"), pursuant to which Lincoln Park has committed to purchase up to
$15,100,000 of the Company's Common Stock.



Under the terms and subject to the conditions of the 2021 LPC Purchase
Agreement, the Company has the right, but not the obligation, to sell to Lincoln
Park, and Lincoln Park is obligated to purchase up to $15,100,000 worth of
shares of Common Stock. Such sales of Common Stock by the Company, if any, will
be subject to certain limitations, and may occur from time to time, at the
Company's sole discretion, over the 24-month period commencing on July 23, 2021,
the date that the registration statement covering the resale of shares of Common
Stock that have been and may be issued under the 2021 LPC Purchase Agreement,
which was filed with the SEC pursuant to the Registration Rights Agreement, and
was declared effective by the SEC and a final prospectus in connection therewith
is filed and the other conditions set forth in the 2021 LPC Purchase Agreement
are satisfied, all of which are outside the control of Lincoln Park (such date
on which all of such conditions are satisfied, the "Commencement Date").



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Under the 2021 LPC Purchase Agreement, on any business day over the term of the
2021 LPC Purchase Agreement, the Company has the right, in its sole discretion,
to present Lincoln Park with a purchase notice (each, a "Purchase Notice")
directing Lincoln Park to purchase up to 250,000 shares of Common Stock per
business day ("Regular Purchase"), which (i) increases to up to 300,000 shares
in the event the price of the Company's Common Stock is not below $0.10 per
share, (ii) increases to 350,000 shares of Common Stock per Business Day in the
event the price of the Company's Common Stock is not below $0.25 per share, and
(iii) increases to 500,000 shares in the event the price of the Company's Common
Stock is not below $0.50 per share (in each case, subject to adjustment for any
reorganization, recapitalization, non-cash dividend, stock split, reverse stock
split or other similar transaction as provided in the 2021 LPC Purchase
Agreement). In each case, Lincoln Park's maximum commitment in any single
Regular Purchase may not exceed $500,000. The parties may mutually agree to
increase the number of shares to be purchased by Lincoln Park pursuant to any
Regular Purchase up to 2,000,000 shares. The 2021 LPC Purchase Agreement
provides for a purchase price per Purchase Share (the "Purchase Price") equal to
the lesser of:


? The lowest selling price of the common shares of the Company on the date of purchase; and

? The average of the three lowest closing prices for the common shares of the Company

Stock for fifteen consecutive working days ending on the working day

    immediately preceding the purchase date of such shares.




In addition, on any date on which the Company submits a Purchase Notice to
Lincoln Park, the Company also has the right, in its sole discretion, to present
Lincoln Park with an accelerated purchase notice (each, an "Accelerated Purchase
Notice") directing Lincoln Park to purchase an amount of stock (the "Accelerated
Purchase") equal to up to the lesser of (i) three times the number of shares of
Common Stock purchased pursuant to such Regular Purchase; and (ii) 30% of the
aggregate shares of the Company's Common Stock traded during all or, if certain
trading volume or market price thresholds specified in the 2021 LPC Purchase
Agreement are crossed on the applicable Accelerated Purchase Date, the portion
of the normal trading hours on the applicable Accelerated Purchase Date prior to
such time that any one of such thresholds is crossed (such period of time on the
applicable Accelerated Purchase Date, the "Accelerated Purchase Measurement
Period"), provided that Lincoln Park will not be required to buy shares of
Common Stock pursuant to an Accelerated Purchase Notice that was received by
Lincoln Park on any business day on which the last closing trade price of the
Company's Common Stock on the OTC Markets (or alternative national exchange in
accordance with the 2021 LPC Purchase Agreement) is below $0.25 per share. The
parties may mutually agree to increase the number of shares to be purchased by
Lincoln Park pursuant to any Accelerated Purchase. The purchase price per share
of Common Stock for each such Accelerated Purchase will be equal to 95% of the
lesser of:


? The volume-weighted average trading price of the common shares of the Company during

       applicable Accelerated Purchase Measurement Period on the applicable
       Accelerated Purchase Date; and



  ? The closing sale price of the Company's Common Stock on the applicable
    Accelerated Purchase Date.




The Company may also direct Lincoln Park on any business day on which an
Accelerated Purchase has been completed and all of the shares to be purchased
thereunder have been properly delivered to Lincoln Park in accordance with the
2021 LPC Purchase Agreement, to purchase an amount of stock (the "Additional
Accelerated Purchase") equal to up to the lesser of (i) three times the number
of shares purchased pursuant to such Regular Purchase; and (ii) 30% of the
aggregate number of shares of the Company's Common Stock traded during a certain
portion of the normal trading hours on the applicable Additional Accelerated
Purchase date as determined in accordance with the 2021 LPC Purchase Agreement
(such period of time on the applicable Additional Accelerated Purchase date, the
"Additional Accelerated Purchase Measurement Period"). The parties may mutually
agree to increase the number of shares to be purchased by Lincoln Park pursuant
to any Additional Accelerated Purchase. Additional Accelerated Purchases will be
equal to 95% of the lower of:



? The volume-weighted average trading price of the common shares of the Company during

    applicable Additional Accelerated Purchase Measurement Period on the
    applicable Additional Accelerated Purchase date; and




  ? The closing sale price of the Company's Common Stock on the applicable
    Additional Accelerated Purchase date.




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The aggregate number of shares that the Company can sell to Lincoln Park under
the 2021 LPC Purchase Agreement may in no case exceed that number which,
together with Lincoln Park's then current holdings of Common Stock, exceed 4.99%
of the Common Stock outstanding immediately prior to the delivery of the
Purchase Notice.



Lincoln Park has no right to require the Company to sell any shares of Common
Stock to Lincoln Park, but Lincoln Park is obligated to make purchases as the
Company directs, subject to certain conditions. There are no upper limits on the
price per share that Lincoln Park must pay for shares of Common Stock.



The Company has agreed with Lincoln Park that it will not enter into any “floating rate” transactions with a third party for a period defined in the LPC 2021 purchase agreement.

The Company issued Lincoln Park 1,000,000 shares of common stock as undertaking shares in consideration for entering into the 2021 LPC Purchase Agreement on the Settlement Date.



The 2021 LPC Purchase Agreement and the Registration Rights Agreement contain
customary representations, warranties, agreements and conditions to completing
future sale transactions, indemnification rights and obligations of the parties.
The Company has the right to terminate the 2021 LPC Purchase Agreement at any
time, at no cost or penalty, subject to the survival of certain provisions set
forth in the 2021 LPC Purchase Agreement. During any "event of default" under
the 2021 LPC Purchase Agreement, all of which are outside of Lincoln Park's
control, Lincoln Park does not have the right to terminate the 2021 LPC Purchase
Agreement; however, the Company may not initiate any regular or other purchase
of shares by Lincoln Park, until such event of default is cured. In addition, in
the event of bankruptcy proceedings by or against the Company, the 2021 LPC
Purchase Agreement will automatically terminate.



Actual sales of shares of Common Stock to Lincoln Park under the 2021 LPC
Purchase Agreement will depend on a variety of factors to be determined by the
Company from time to time, including, among others, market conditions, the
trading price of the Common Stock and determinations by the Company as to the
appropriate sources of funding for the Company and its operations. Lincoln Park
has no right to require any sales by the Company but is obligated to make
purchases from the Company as it directs in accordance with the 2021 LPC
Purchase Agreement. Lincoln Park has covenanted not to cause or engage in any
manner whatsoever, any direct or indirect short selling or hedging of the
Company's shares.



In connection with the execution of the 2021 LPC Purchase Agreement, the Company
has agreed to sell, and Lincoln Park has agreed to purchase, 1,000,000 shares of
Common Stock for a purchase price of $100,000 ("Original Purchase").



Due to the terms of the LPC 2021 purchase agreement described above, management does not currently expect that the proceeds of this agreement will be sufficient to maintain operations for an extended period.

Prior to entering into the 2021 LPC Purchase Agreement, the Company and Lincoln Park have terminated the previous agreement between the Company and Lincoln Park entered into on June 11, 2020 (the “2020 LPC Purchase Agreement”).

Series D Preferred Share Financing



On November 12, 2020 and December 23, 2020, the Company consummated private
placements of 12,060 shares of its Series D Convertible Preferred Stock, par
value $0.01 per share resulting in gross proceeds to the Company of $12.06
million, less fees and expenses. The gross proceeds include approximately $2.2
million in principal amount due and payable under the terms of certain term
loans issued by the Company on September 29, 2020 ("Bridge Notes"), which Bridge
Notes were converted into Series D Preferred at Closing (the "Conversion"). The
issuance of the Series D Preferred was made pursuant to securities purchase
agreements, dated September 28, 2020 (the "Purchase Agreement"), by and between
the Company and certain accredited investors (the "Purchasers"), for the sale of
the Series D Preferred at a purchase price of $1,000 per share of Series D
Preferred. The holders of Series D Preferred may voluntarily convert their
shares of Series D Preferred into shares of the Company's Common Stock at any
time that is at least ninety days following the issuance date, at the conversion
price calculated by dividing the Stated Value by the conversion price of $0.0583
per share of Common Stock, subject to adjustments as set forth in Section 5(e)
of the Certificate of Designations, Preferences, and Rights of Series D
Convertible Preferred Stock (the "Series D Certificate"). Dividends on shares of
Series D Preferred will be paid prior to any junior securities and are to be
paid at the rate of 4% of the Stated Value (as defined in the Series D
Certificate) per share per annum in the form of shares of Series D Preferred.



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On the fourth anniversary of the Issuance Date (as defined in the Series D
Certificate), or in the event of the consummation of a Change of Control (as
defined in the Series D Certificate), if any shares of Series D Preferred are
outstanding, then each holder of Series D Preferred shall have the right (the
"Holder Redemption Right"), at such holder's option, to require the Company to
redeem all or any portion of such holder's shares of Series D Preferred at the
Liquidation Preference Amount per share of Series D Preferred plus an amount
equal to all accrued but unpaid dividends, if any, (such price, the "Holder
Redemption Price"), which Holder Redemption Price shall be paid in cash.



In connection with the sale of the Series D Preferred, we granted certain
registration rights to the Investors with respect to the Conversion Shares and
Dividend Shares, pursuant to a Registration Rights Agreement by and among us and
the Investors. The registration statement registering the Conversion Shares and
Dividend Shares was declared effective by the SEC on February 12, 2021.



Operating Activities



Net cash used in operating activities was approximately $7,737,000 during the
year ended December 31, 2021 as compared to $8,009,000 during the year ended
December 31, 2020. During the year ended December 31, 2021, net cash used in
operating activities consisted of net income of $9,282,000 and an increase in
working capital and other assets and liabilities of $589,000. Those amounts in
addition to approximately $17,608,000 of non-cash income, including $18,809,000
in income from the change in fair value of derivative liabilities and $1,581,000
in income from the extinguishment of debt offset by $1,528,000 in stock-based
compensation, $56,000 in depreciation and amortization, $82,000 in non-cash
expense from the disposal of fixed assets, $364,000 in non-cash expense from the
write-off of deferred stock issuance costs, $311,000 in non-cash expense from
the extinguishment of derivative liabilities, $333,000 from the recognition of
an impairment loss of an operating lease right-of -use asset, $50,000 from the
write-off of an abandoned patent and $58,000 from the issuance of common stock
as compensation in lieu of cash. During the year ended December 31, 2021, we
generated cash of $139,000 from decreases in current assets offset by $44,000
from increases in our operating leases right-of-use assets and generated cash of
$531,000 through increases in current liabilities and deferred revenue offset by
increases of $37,000 in pension liability.



Net cash used in operating activities was $8,009,000 during the year ended
December 31, 2020 as compared to $11,267,000 during the year ended December 31,
2019. During the year ended December 31, 2020, net cash used in operating
activities consisted of net loss of $7,253,000 and an increase in working
capital and other assets and liabilities of $438,000. Those amounts in addition
to approximately $1,194,000 of non-cash income, including $2,252,000 in income
from the change in fair value of derivative liabilities offset by $862,000 in
stock-based compensation, $72,000 in depreciation and amortization and $124,000
from the application of rent deposits.



Investing Activities



Net cash used in investing activities during the year ended December 31, 2021
was $53,000 as compared to $0 for the corresponding period in 2020. For the year
ended December 31, 2021, we used cash of $53,000 to fund capital expenditures of
computer hardware.



Financing Activities



Cash generated from financing activities for the year ended December 31, 2021
was approximately $572,000, which consisted of approximately $600,000 received
by the Company in the form of a draw-down from its Credit Facility, net of
direct financing costs of $77,000 and $100,000 from the sale of 1,000,000 shares
of Common Stock for $0.10 per share and used cash of approximately $51,000 for
the payment of dividends on our Series B Preferred Stock.



Cash generated from financing activities for the year ended December 31, 2020
was approximately $15,475,000, which consisted of approximately $12,060,000
generated from the sale of 12,060 shares of Series D Preferred. Such amount
includes $2,187,000 received by the Company in the form of a Bridge Loan which
was converted into shares of Series D Preferred before recognition of
approximately $726,000 in cash direct stock issuance costs. We also generated
cash of approximately $900,000 from the issuance of related party notes payable
and generated cash of $1,571,000 from the issuance of the PPP Loan under the
CARES Act. Also in the year ended December 31, 2020, we generated cash of
approximately $2,360,000 from the sales of 15,700,000 shares of Common Stock
before recognition of approximately $64,000 in direct stock issuance costs. We
used cash of approximately $575,000 to repay certain related party notes payable
and used cash of approximately $51,000 for the payment of dividends on our
Series B Preferred.



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Real Property Leases



Our corporate headquarters is located in San Diego, California, where we now
occupy approximately 500 square feet of office space at a cost of approximately
$2,000 per month. We entered into this facility's lease in February 2021, with
the new lease commencing on March 1, 2021 on a month-to-month basis.



Prior to entering into our current lease agreement in January 2021, and moving
our corporate headquarters to a new location, we occupied 8,511 square feet of
office space in San Diego, at a cost of approximately $28,000 per month. In
January 2021, we entered in a subleasing agreement for our previously occupied
corporate headquarters located in San Diego, California. The term of the
sublease commenced on April 1, 2021 and expires on April 30, 2025, coterminous
with the expiration of the Company's master lease. Sublease payments due the
Company approximate $26,000 per month over the term of the sublease.



Stock-Based Compensation



Stock-based compensation related to equity options and restricted stock has been
classified as follows in the accompanying consolidated statements of operations
(in thousands):



                                Year Ended December 31,
                                 2021              2020
Cost of revenue              $          29       $      15
General and administrative             842             550
Sales and marketing                    336             163
Research and development               321             134

Total                        $       1,528       $     862



Off-balance sheet arrangements



At December 31, 2021, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, special purpose or variable interest entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. In addition, we
did not engage in trading activities involving non-exchange traded contracts. As
a result, we are not exposed to any financing, liquidity, market or credit risk
that could arise if we had engaged in such relationships. We do not have
relationships and transactions with persons or entities that derive benefits
from their non-independent relationship with us or our related parties except as
disclosed elsewhere in this Annual Report.



Recently issued accounting pronouncements



From time to time, new accounting pronouncements are issued by the Financial
Accounting Standards Board (the "FASB"), or other standard setting bodies, which
are adopted by us as of the specified effective date. Unless otherwise
discussed, the Company's management believes the impact of recently issued
standards not yet effective will not have a material impact on the Company's
consolidated financial statements upon adoption. See Note 2 to these
consolidated financial statements for a detailed discussion of recently issued
accounting pronouncements.



Impact of Inflation



The primary inflationary factor affecting our operations is labor costs, and we
do not believe that inflation has materially affected earnings during the past
four years. Substantial increases in costs and expense, particularly labor and
operating expense, could have a significant impact on our operating results to
the extent that such increases cannot be passed along to customers and end
users.



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