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EX-5.1 - STEELCLOUD INCv168970_ex5-1.htm
EX-23.1 - STEELCLOUD INCv168970_ex23-1.htm
EX-4.3.2 - STEELCLOUD INCv168970_ex4-3x2.htm
EX-10.27.1 - STEELCLOUD INCv168970_ex10-271.htm
EX-10.30.2 - STEELCLOUD INCv168970_ex10-30x2.htm
As filed with the Securities and Exchange Commission on December 30, 2009
Registration No.: 333-158703  
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Amendment No. 7
 
to
FORM S-1
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933


STEELCLOUD, INC.
(Exact name of registrant as specified in its charter)
 
Commonwealth of Virginia
 
506
 
54-1890464
(State or other jurisdiction of
 
(Primary SIC Number)
 
(I.R.S. Employer
incorporation or organization)
     
Identification No.)

13962 Park Center Road
Herndon, VA 20171
(703) 674-5500

(Address, including zip code, and telephone number, including area code, of principal executive offices)

 (Name, address, including zip code, and telephone number, including area code, of agent for service)

With a copy to:
 
Gersten Savage LLP
Jay Kaplowitz, Esq.
Arthur Marcus, Esq.
Paula Pescaru, Esq.
600 Lexington Avenue
New York, NY 10022-6018
Tel: (212) 752-9700 Fax: (212) 980-5192

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.     x

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.     ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.     ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.     ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer   ¨
Accelerated filer   ¨
   
Non-accelerated filer     ¨     (Do not check if a smaller reporting company)
Smaller reporting company   x
 

 
CALCULATION OF REGISTRATION FEE
 
Title of Securities to be Registered
 
Amount to be
Registered (1)
   
Proposed
Maximum
Offering Price
per Share (2)
   
Proposed
Maximum
Aggregate
Offering Price
   
Amount of
Registration
Fee
 
Common Stock, par value $0.001 per share underlying placement agent warrants
    800,000     $ 0.38     $ 304,000     $ 16.98  
 

(1)
The total number of shares of common stock (including shares of common stock underlying warrants) registered is 32,800,000. The registration fee for 32,800,000 shares was paid with the initial filing of the registration statement and prior amendments.

(2)
Estimated solely for the purpose of calculating the registration fee under Rule 457(o) of the Securities Act of 1933, as amended.
 
This Registration Statement shall also cover any additional shares of our common stock which may become issuable by reason of any stock dividend, stock split, recapitalization or other similar adjustments.

We hereby amend this registration statement on such date or dates as may be necessary to delay its effective date until we shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until this registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.
 

 
The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.
 
Preliminary Prospectus
Dated December 29, 2009
 

Up to 16,000,000 Shares of Common Stock together with 16,000,000 Common Stock Purchase Warrants

And
 
Up to 800,000 Shares of Common Stock Underlying Placement Agent Warrants

This prospectus relates to the offering of 16,000,000 shares of our common stock, $0.001 par value (the “Shares”) accompanied by 16,000,000 common stock purchase warrants (the “Warrants”) on a best efforts basis at a fixed price between $0.08 and $0.30 cents per Share and an exercise price per Warrant equal to 150% of the final offering Share price, and accordingly, we would receive gross proceeds of up to $1,280,000, assuming sales at $0.08 per Share, or up to $4,800,000, assuming sales at $0.30 per Share, in the event that we sell all of  these Shares.  The shares of common stock underlying the Warrants are being registered pursuant to the registration statement of which this prospectus forms a part. In the event that we are only able to sell (a) 75% or 12,000,000 of the offered Shares, we would receive gross proceeds of $960,000 assuming sales at $0.08 per Share, or $3,600,000 assuming sales at $0.30 per Share; (b) 50% or 8,000,000 of the offered Shares, we would receive gross proceeds of $640,000 assuming sales at $0.08 per Share, or $2,400,000 assuming sales at $0.30 per Share; (c) 25% or 4,000,000 of the offered Shares, we would receive gross proceeds of $320,000 assuming sales at $0.08 per Share, or $1,200,000 assuming sales at $0.30 per Share; or (d) 10% or 1,600,000 of the offered Shares, we would receive gross proceeds of $128,000 assuming sales at $0.08, or $480,000 assuming sales at $0.30. Each Share is accompanied by one Warrant to purchase one additional share of common stock. This prospectus also relates to the registration of up to 800,000 shares of common stock underlying Placement Agent Warrants described below. We will receive additional proceeds from any exercise of the Warrants and the Placement Agent Warrants described below.   

There is no minimum number of Shares and accompanying Warrants that must be sold in this offering and, as a result, we may receive no proceeds or very minimal proceeds from the sale of the Shares and accompanying Warrants.  Proceeds that we receive from the offering of Shares and accompanying Warrants will not be placed into escrow.

Each Warrant will entitle an investor to purchase one share of our common stock for 150% of the final offering Share price, commencing on the sixth month anniversary of such investor's purchase of the Shares and accompanying Warrants (the “Purchase”), and expiring on the three year anniversary of the Purchase.

The offering will commence promptly after the date of this prospectus and close no later than 90 days after the date of this prospectus.  However, we may extend the offering for up to 90 days following the expiration of the first 90-day offering period.  We will pay all expenses incurred in this offering. 
 
This offering is a self-underwritten offering and there will be no underwriter involved in the sale of the Shares and accompanying Warrants.  We intend to offer the Shares and accompanying Warrants through our officers and directors who will not be paid any commission for such sales.   We have also retained Westminster Securities, a Division of Hudson Securities Inc. (OTCBB: HDHL), as our placement agent (the “Placement Agent”) to use their best efforts to solicit offers to purchase our Shares and accompanying Warrants in this offering. The Placement Agent is not purchasing the Shares and accompanying Warrants offered by us, and is not required to sell any specific number or dollar amount of Shares and accompanying Warrants, but will assist us in this offering on a “best efforts” basis.

   
Per Share and
Accompanying
Warrant
   
Total
 
Maximum Offering Price1
 
$
0.30
   
$
4,800,000
 
Placement Agent’s Fees1
 
$
0.024
 
 
$
384,000
 
Maximum Offering Proceeds before expenses1
 
$
0.30
   
$
4,800,000
 
 
1
The Placement Agent will receive a 8% cash fee from the gross proceeds received from the sale of the Shares and accompanying Warrants (subject to certain limitations), warrants to purchase an aggregate of 5% of the total Shares sold in this offering (the “Placement Agent Warrants”) and an expense allowance of 2% of the proceeds of this offering, but in no event more than $35,000. For more information related to our arrangement with the Placement Agent, please see “Plan of Distribution” at page 11.
 
Our common stock is traded on the NASDAQ Capital Market under the symbol “SCLD”.  On December 28, 2009, the closing price of our common stock was $0.29.  There is no public market for our Warrants and we have not applied for listing or quotation on any public market. We have arbitrarily determined the exercise price per Warrant offered hereby. The offering price bears no relationship to our assets, book value, earnings or any other customary investment criteria.
 
Our business is subject to many risks and an investment in our Shares and the accompanying Warrants will also involve a high degree of risk. You should carefully consider the factors described under the heading “risk factors” beginning at page 7 before investing in the Shares and accompanying Warrants.
 
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.
 
The date of this prospectus is ___, 2009

 
 

 
 
TABLE OF CONTENTS

   
PAGE
     
GENERAL
 
3
SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS
 
3
PROSPECTUS SUMMARY
 
3
RISK FACTORS
 
7
USE OF PROCEEDS
 
10
DETERMINATION OF OFFERING PRICE
 
10
DILUTION
 
10
PLAN OF DISTRIBUTION
 
11
DESCRIPTION OF SECURITIES
 
12
INTERESTS OF NAMED EXPERTS AND COUNSEL
 
14
BUSINESS
 
14
DESCRIPTION OF PROPERTY
 
18
LEGAL PROCEEDINGS
 
18
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
 
19
FINANCIAL STATEMENTS
 
21
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
22
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
36
DIRECTORS AND EXECUTIVE OFFICERS
 
36
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
38
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
39
EXECUTIVE COMPENSATION
 
40
DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES ACT LIABILITIES
 
43
PROSPECTUS
 
44
INFORMATION NOT REQUIRED IN PROSPECTUS
 
II-1
SIGNATURES
 
II-8
 
 
2

 
 
GENERAL

As used in this prospectus, references to “the Company”, “SteelCloud”, “we”, “our”, “ours” and “us” refer to SteelCloud, Inc. and its consolidated subsidiaries, unless otherwise indicated.  In addition, references to our “financial statements” are to our consolidated financial statements except as the context otherwise requires.
 
SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

This prospectus contains “forward-looking statements” and information relating to our business that are based on our beliefs as well as assumptions made by us or based upon information currently available to us. When used in this prospectus, the words anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “should” and similar expressions are intended to identify forward-looking statements. These forward-looking statements include, but are not limited to, statements relating to our performance in “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. These statements reflect our current views and assumptions with respect to future events and are subject to risks and uncertainties. Actual and future results and trends could differ materially from those set forth in such statements due to various factors. Such factors include, among others: our ability to obtain financing in the short term, general economic and business conditions; industry capacity; industry trends; competition; changes in business strategy or development plans; project performance; and availability of qualified personnel. These forward-looking statements speak only as of the date of this prospectus. Subject at all times to relevant securities law disclosure requirements, we expressly disclaim any obligation or undertaking to disseminate any update or revisions to any forward-looking statement contained herein to reflect any change in our expectations with regard thereto or any changes in events, conditions or circumstances on which any such statement is based. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
 
PROSPECTUS SUMMARY

WHERE YOU CAN FIND US

Our principal executive offices are located at 13962 Park Center Road Herndon, Virginia 20171.  Our telephone number is (703) 674-5500, our fax number is (703) 450-0407 and our website address is www.steelcloud.com . The information on our website is not incorporated by reference into this prospectus and should not be relied upon with respect to this offering.
 
ABOUT OUR BUSINESS

Founded in 1987, we are a developer of mobility software solutions primarily for the Research In Motion® (“RIM”) Blackberry market. We design and integrate our software into specialized server appliances targeted at the Federal Government and in particular the Department of Defense (“DoD”), public sector, commercial, and remote hosting customers.
 
We were originally incorporated as Dunn Computer Operating Company on July 27, 1987 under the laws of the Commonwealth of Virginia.  On February 26, 1998, Dunn Computer Corporation ("Dunn") was formed and incorporated in the Commonwealth of Virginia to become a holding company for several entities including Dunn Computer Operating Company.  On May 15, 2001, our shareholders approved an amendment to our Articles of Incorporation to change our corporate name from Dunn Computer Corporation to SteelCloud, Inc.  On December 31, 2003, Dunn was merged with and into SteelCloud.

 
3

 
 
THE OFFERING
 
Securities Offered
 
We are offering up to 16,000,000 shares of our common stock, $0.001 par value (the “Shares”) together with 16,000,000 common stock purchase warrants (the “Warrants”) on a best efforts basis at a fixed price between $0.08 and $0.30 cents per Share and an exercise price per Warrant equal to 150% of the final offering Share price, and accordingly, we would receive gross proceeds of up to $1,280,000, assuming sales at $0.08 per Share, or up to $4,800,000, assuming sales at $0.30 per Share, in the event that we sell all of  these Shares.  In the event that we are only able to sell (a) 75% or 12,000,000 of the offered Shares, we would receive gross proceeds of $960,000 assuming sales at $0.08 per Share, or $3,600,000 assuming sales at $0.30 per Share; (b) 50% or 8,000,000 of the offered Shares, we would receive gross proceeds of $640,000 assuming sales at $0.08 per Share, or $2,400,000 assuming sales at $0.30 per Share; (c) 25% or 4,000,000 of the offered Shares, we would receive gross proceeds of $320,000 assuming sales at $0.08 per Share, or $1,200,000 assuming sales at $0.30 per Share; or (d) 10% or 1,600,000 of the offered Shares, we would receive gross proceeds of $128,000 assuming sales at $0.08, or $480,000 assuming sales at $0.30 per share. Each Share is accompanied by one Warrant to purchase one additional share of common stock.  The NASDAQ Marketplace Rules require shareholder approval of the issuance of common stock or securities convertible into common stock equal to 20% or more of the common stock outstanding before the issuance for less than the greater of book or market value of the stock. On October 23, 2009 we received the required approval from our shareholders.
 
There is no minimum number of Shares that must be sold in this offering and, as a result, we may receive no proceeds or very minimal proceeds from the sale of the Shares and accompanying Warrants.  Proceeds that we receive from the offering of Shares and accompanying Warrants will not be placed into escrow.
 
We have retained Westminster Securities, a Division of Hudson Securities Inc. (OTCBB: HDHL), as our placement agent (the “Placement Agent”) to use their best efforts to solicit offers to purchase our Shares and accompanying Warrants in this offering. The Placement Agent will receive a 8% cash fee from the gross proceeds of the sale of the Shares and accompanying Warrants (subject to certain limitations), Placement Agent Warrants to purchase 5% of the total Shares sold in this offering, and an expense allowance of 2% of the proceeds of this offering, but in no event more than $35,000. For more information related to our arrangement with the Placement Agent, please see “Plan of Distribution” at page 11.
   
We intend to use the net proceeds received from the sale of the Shares and accompanying Warrants pursuant to this best efforts offering for general working capital purposes.
 
Shares Underlying Placement Agent Warrants
 
We are also registering up to 800,000 shares of our common stock, $0.001 par value, underlying the Placement Agent Warrants.
     
Shares Outstanding Prior to the Offering
 
15,614,001, as of  December 28, 2009.
     
Share to be Outstanding After the Offering
 
31,614,001 (assuming all Shares are sold but excluding shares of common stock issuable upon exercise of the Warrants and the Placement Agent Warrants).
     
Dividend Policy
 
We have not declared or paid any dividends on our common stock since our inception, and we do not anticipate paying any such dividends for the foreseeable future.
     
Warrants Outstanding Prior to the Offering
 
1,465,000, as of December 28, 2009.
     
Warrants to be Outstanding After the Offering:
 
18,265,000 (assuming all (a) Shares and accompanying Warrants are sold, and (b) 800,000, representing the maximum amount of Placement Agent Warrants issuable to the Placement Agents, are issued).
 
4

 
Use of Proceeds:
 
Proceeds from this offering will be used for general working capital purposes.
     
NASDAQ Capital Market Symbol
 
Our common stock is traded on the Nasdaq Capital Market under the symbol “SCLD”.   Please see “Risk Factors”– “ If our common stock is delisted from the NASDAQ Capital Market, the market price of our common stock could decrease significantly” at page 7,   and “Market for Registrant’s Common Equity, Related Stockholder Matters” at page 21.
     
Risk Factors:
 
See “Risk Factors” beginning at page 7 and the other information in this prospectus for a discussion of the factors you should consider before deciding to invest in shares of our common stock.
 
5

 
SUMMARY FINANCIAL DATA
 
The following summary financial information includes statement of expenses and balance sheet data from our audited financial statements. The information contained in this table should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and the financial statements and accompanying footnotes included in this prospectus.
 
Our financial status creates substantial doubt whether we will continue as a going concern.
 
Statement of Operations

   
Year Ended October
31,
 
   
2007
   
2008
 
   
(in thousands)
 
Consolidated Statement of Operations Data:
           
Net revenues
  $ 23,316     $ 19,019  
Gross profit
    4,945       3,095  
Loss from operations
    (1,964 )     (2,768 )
Net loss attributable to common stockholders
    (1,945 )     (2,760 )
Basic and diluted loss per share
  $ (0.14 )   $ (0.19 )
Weighted average shares outstanding
    14,287       14,493  
 
Balance Sheet Data

   
At October 31,
 
   
2007
   
2008
 
   
(in thousands)
 
Consolidated Balance Sheet Data:
           
Working capital
  $ 3,707     $ 1,681  
Total assets
    7,936       4,052  
Long-term debt
    170       140  
Total liabilities
    3,229       1,436  
Stockholders' equity
    4,707       2,616  
 
 
6

 
 
RISK FACTORS

An investment in our Shares and accompanying Warrants involves a high degree of risk. You should carefully consider the risks described below and the other information before deciding to purchase the securities offered in this best efforts offering. The risks described below are not the only ones facing our company. Additional risks not presently known to us or that we currently consider immaterial may also adversely affect our business. If any of the following risks actually happen, our business, financial condition and operating results could be materially adversely affected. In this case, you could lose all or part of your investment.

Risks Related to our Securities

Our common stock may be subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond our control, that may prevent our stockholders from reselling our common stock at a profit.
 
The securities markets have experienced significant price and volume fluctuations in recent months and the market price of our common stock has been volatile. This market volatility, as well as general economic, market or political conditions, has, and could continue to, reduce the market price of our common stock. In addition, our operating results could be below the expectations of public market analysts and investors, and in response the market price of our common stock could decrease significantly. Investors may be unable to resell their shares of our common stock for a profit. The decline in the market price of our common stock and market conditions generally may adversely affect our ability to raise additional capital.
 
As a “thinly-traded” stock, large sales can place downward pressure on our common stock price.

Our common stock, despite certain increases of trading volume from time to time, is generally considered “thinly traded.” Financing transactions resulting in a large number of newly issued shares that become readily tradable, or other events that cause current stockholders to sell shares, could place downward pressure on the trading price of our common stock. In addition, the lack of a robust resale market may require a stockholder who desires to sell a large number of shares to sell the shares in increments over time to mitigate any adverse impact of the sales on the market price of our common stock.
 
The offering of the Shares and accompanying Warrants is a self-underwritten offering.
 
This offering of Shares and accompanying Warrants is a self-underwritten offering, which means that we will offer the shares through our officers, directors and the Placement Agent. This offering does not involve the participation of an underwriter to market, distribute or sell the shares offered under this prospectus.   Although we have engaged a Placement Agent to use their best efforts to solicit offers to purchase Shares and Warrants in this offering, we can offer no assurance that our officers, directors or the Placement Agent will be successful in selling all or any of the Shares and accompanying Warrants offered hereby.
 
If our common stock is delisted from the NASDAQ Capital Market, the market price of our common stock could decrease significantly.
 
We have received delisting notices from NASDAQ because of our failure to comply with (1) NASDAQ Market Place Rule 5450(a)(1) because the bid price of our common stocks closed below the minimum $1.00 per share requirement for 30 consecutive business days prior to September 15, 2009, and (2) NASDAQ Listing Rule 5550(b) (formerly known as Market Place Rule 4310(c)(3)), which requires that we maintain a minimum of (a) $2,500,000 in stockholder’s equity, (b) $35,000,000 market value of listed Securities, or (c) $500,000 of net income from continuing operations (please see “Market for Registrant’s Common Equity, Related Stockholder Matters” for additional information). If we are unable to satisfy the NASDAQ Capital Market continued listing criteria in the future, our common stock may be delisted from the NASDAQ Capital Market. If this occurs, trading, if any, in our common stock would thereafter be conducted in the over-the-counter market on the “pink sheets” or the Over-the-Counter Bulletin Board. If our common stock is delisted from the NASDAQ Capital Market, a shareholder may find it more difficult to dispose of, or to obtain quotations as to the price of our common stock. Additionally, if our common stock is delisted from the NASDAQ Capital Market, the market price of our common stock could decrease significantly.
 
We may issue more shares in connection with a merger or acquisition; this would result in substantial dilution to you.
 
Any merger or acquisition effected by us may result in the issuance of additional securities without stockholder approval and may result in substantial dilution in the percentage of our common stock held by our then existing stockholders. Moreover, the common stock issued in any such merger or acquisition transaction may be valued on an arbitrary or non-arm’s-length basis by our management, resulting in an additional reduction in the percentage of common stock held by our then existing stockholders. Our Board of Directors has the power to issue any or all of such authorized but unissued shares without stockholder approval. To the extent that additional shares of common stock or preferred stock are issued in connection with a business transaction, combination or otherwise, dilution to the interests of our stockholders will occur and the rights of the holders of common stock may be materially adversely affected.
 
We may seek to undertake a reverse share split which will reduce the amount of shares you own.

We may seek to undertake a reverse share split to increase the trading price of our common stock and increase investor interest in our Company.  In a reverse share split the number of our outstanding common shares that our shareholders own will decline but the share price per common share will generally increase proportionately.  Management cannot offer any assurance that a reverse share split would be successful in increasing the trading price of our common stock proportionately to the decrease in the number of outstanding shares, or if successful, that the trading price of our common stock would not decline shortly after the reverse share split is effectuated.
 
Fluctuations in our quarterly operating results may cause the market price of our common stock to fluctuate.

Our operating results have in the past fluctuated from quarter to quarter and we expect this trend to continue in the future. As a result, the market price of our common stock could be volatile. In the past, following periods of volatility in the market price of stock, many companies have been the object of securities class action litigation. If we were to be sued in a securities class action, it could result in substantial costs and a diversion of management's attention and resources which could adversely affect our results of operations.

Our Board of Directors has the power to designate a series of preferred stock without shareholder approval that could contain conversion or voting rights that adversely affect the voting power of holders of our common stock.

Our Articles of Incorporation authorizes issuance of capital stock including 2,000,000 undesignated preferred shares, and empowers our Board of Directors to prescribe by resolution and without shareholder approval a class or series of undesignated shares, including the number of shares in the class or series and the voting powers, designations, rights, preferences, restrictions and the relative rights in each such class or series.

 
7

 
 
Because we do not intend to pay any dividends on our common stock, holders of our common stock must rely on stock appreciation for any return on their investment.
 
We have not declared or paid any dividends on our common stock since our inception, and we do not anticipate paying any such dividends for the foreseeable future. Accordingly, holders of our common stock will have to rely on capital appreciation, if any, to earn a return on their investment in our common stock.

Risks Related to Our Company

Our auditors have expressed doubt regarding our ability to continue as a going concern.

The report of our independent registered public accounting firm on our consolidated financial statements for the fiscal year ended October 31, 2008 contains an explanatory paragraph regarding our ability to continue as a going concern based upon our history of net losses.  We have had recurring annual operating losses since our fiscal year ended October 31, 2004.  We expect that such losses will continue at least until our fiscal year ending October 31, 2010. 

We cannot offer assurances that any of the strategic options that we are considering to improve our liquidity and provide our Company with working capital will occur or be successful.

We are considering a variety of strategic options to improve our liquidity and provide us with working capital to fund our continuing business operations. These options include equity offerings, asset sales, debt financing and merger and acquisition transactions as alternatives to improve our cash needs.  However, there can be no assurance that we will be successful in negotiating or concluding any of these transactions.  If we are unable to consummate one or more of these transactions, and adequate funds are not available to us or are not available on acceptable terms, we will likely not be able to continue as a going concern.

We may not be able to continue our operations without additional funding.
 
As of July 31, 2009, we had cash and cash equivalents of approximately $366,210 and a working capital deficit. Management believes our current cash and cash equivalents are sufficient to maintain our operations for less than 30 days from December 28, 2009.  We require between $1,500,000 and $2,000,000 in cash to continue our operations for the next 12 months, which we may obtain through issuances of debt and/or equity.  Such financing may not be forthcoming. As widely reported, the domestic financial markets have been extremely volatile in recent months.  If such conditions and constraints continue, we may not be able to acquire additional funds either through credit markets or through equity markets. Even if additional financing is available, it may not be available on terms we find favorable. At this time, there are no anticipated sources of additional financing in place. Failure to secure the needed additional financing will have an adverse effect on our ability to remain in business.
 
We may not be able to compete successfully against current and future competitors.

The market for our products and services is highly competitive. Many of our competitors offer broader product lines and have substantially greater financial, technical, marketing and other resources than we do, which could seriously harm our net sales and results of operation. Additionally, our competitors may receive beneficial prices from purchasing component parts in large quantities and may be parties to product and process technology license arrangements that are more favorable in terms of pricing and availability than our arrangements. As a result, we may have difficulty increasing our market share.

 
8

 
 
Our new business model relies heavily on the success of BlackBerry products and services.

We developed SteelWorks® Mobile and SteelWorks FedMobile in conjunction with Research in Motion (“RIM”) as a solution specifically designed for the BlackBerry Enterprise Server (“BES”).  SteelWorks® Mobile and SteelWorks FedMobile is an integrated server appliance that enables virtually any size organization to implement BES.  Our new business model, and the success of SteelWorks® Mobile and SteelWorks FedMobile, relies heavily on the success of BlackBerry products and services and any changes in the technology or the market demand for those products could negatively impact our business.
 
If we are unable to attract, assimilate and retain highly skilled technical personnel, our business could be seriously harmed.

Our future success is largely dependent upon our ability to identify, attract, hire, train, retain and motivate highly skilled technical personnel.  Competition in this market is intense, and we cannot be certain that we will be able to attract, assimilate or retain sufficiently qualified personnel. Our inability to do so could have a material adverse effect on our business, results of operations and financial condition.

 
9

 
 
USE OF PROCEEDS
 
The net proceeds to us from the sale of up to 16,000,000 Shares and accompanying Warrants to purchase an additional 16,000,000 shares of our common stock, offered at a fixed public offering price between $0.08 and $0.30 per Share, will vary depending upon the total number of Shares actually sold. There is no minimum number of Shares and accompanying Warrants that must be sold in this offering and, as a result, we may receive no proceeds or very minimal proceeds from the sale of the Shares and accompanying Warrants. Proceeds that we receive from the offering of Shares and accompanying Warrants will not be placed into escrow. Regardless of the number of Shares and accompanying Warrants sold, we expect to incur offering expenses estimated at approximately $57,000 for legal, accounting, Securities and Exchange Commission (“SEC”), EDGAR filing fees, printing, and transfer agent fees in connection with this offering. Additionally, we will incur Placement Agent fees of 8% of the gross proceeds of the sale of the Shares and accompanying Warrants.
 
The table below sets forth the net proceeds to us from this offering in the event that we sell 16,000,000, 12,000,000, 8,000,000, 4,000,000 or 1,600,000 Shares at the minimum offering price of $0.08 and the maximum offering price of $0.30.  This table does not set forth (a) the proceeds we will receive from the exercise of Warrants or Placement Agent Warrants or (b) all possibilities. The Placement Agent fees set forth below assume that the Placement Agent has sold the total number of Shares represented in bold. There is no guarantee that we will be successful at selling any of the securities being offered in this prospectus. Accordingly, the actual amount of proceeds we will raise in this offering, if any, may differ.
 
   
$0.08 per
Share
   
$0.30 per
Share
 
             
16,000,000 (100%) Shares Sold
           
             
Gross Proceeds
  $ 1,280,000     $ 4,800,000  
                 
Less Offering Expenses
  $ 57,000     $ 57,000  
                 
Less Placement Agent Fee
  $ 102,400     $ 384,000  
                 
Net Offering Proceeds
  $ 1,120,600     $ 4,359,000  
                 
12,000,000 (75%) Shares Sold
               
                 
Gross Proceeds
  $ 960,000     $ 3,600,000  
                 
Less Offering Expenses
  $ 57,000     $ 57,000  
                 
Less Placement Agent Fee
  $ 76,800     $ 288,000  
                 
Net Offering Proceeds
  $ 826,200     $ 3,255,000  
                 
8,000,000 (50%) Shares Sold
               
                 
Gross Proceeds
  $ 640,000     $ 2,400,000  
                 
Less Offering Expenses
  $ 57,000     $ 57,000  
                 
Less Placement Agent Fee
  $ 51,200     $ 192,000  
                 
Net Offering Proceeds
  $ 531,800     $ 2,151,000  
                 
4,000,000 (25%) Shares Sold
               
                 
Gross Proceeds
  $ 320,000     $ 1,200,000  
                 
Less Offering Expenses
  $ 57,000     $ 57,000  
                 
Less Placement Agent Fee
  $ 25,600     $ 96,000  
                 
Net Offering Proceeds
  $ 237,400     $ 1,047,000  
                 
1,600,000 (10%) Shares Sold
               
                 
Gross Proceeds
  $ 128,000     $ 480,000  
                 
Less Offering Expenses
  $ 57,000     $ 57,000  
                 
Less Placement Agent Fee
  $ 10,240     $ 38,400  
                 
Net Offering Proceeds
  $ 60,760     $ 384,600  

Our officers and directors will not receive any compensation for their efforts in selling our Shares and the accompanying Warrants.
 
The net proceeds from this offering will be used for the general working capital, during the twelve months following the completion of this offering. In all instances, after the effectiveness of the registration statement of which this prospectus forms a part, we will need some amount of working capital to maintain our general existence and comply with our public reporting obligations. In addition to changing allocations because of the amount of proceeds received, we may change the use of proceeds because of changes in our business plan. Investors should understand that we have wide discretion over the use of proceeds.
  
DETERMINATION OF OFFERING PRICE
  
The determination of the offering price for the Shares and the exercise price of the accompanying Warrants (and the Placement Agent Warrants) has been arbitrarily determined and does not necessarily relate to our asset value, net worth, or other established criteria of value, and may not be indicative of prices that will prevail in the trading market.
   
DILUTION
 
Purchasers of our Shares will experience an immediate dilution of net tangible book value per share of our common stock. Our net tangible book value as of December 28, 2009 was approximately $218,578, or $0.01 per share of our common stock (based upon 15,614,001 shares of our common stock outstanding). Net tangible book value per share is equal to our total net tangible book value, which is our total tangible assets less our total liabilities, divided by the number of shares of our outstanding common stock. Dilution per share equals the difference between the amount per share paid by purchasers of Shares and accompanying Warrants in this offering and the net tangible book value per share of our common stock immediately after this offering.
 
The following table illustrates an offering based on $0.19 per Share, which is between the minimum offering price of $0.08 per Share and the maximum of $0.30 per Share, and after deducting approximately $57,000 of offering expenses together with the 8% Placement Agent fee payable by us.
 
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Assuming
 
   
100% or
16,000,000
Shares Sold
   
75% or
12,000,000
Shares Sold
   
50% or
8,000,000
Shares Sold
   
25% or
4,000,000
Shares Sold
   
10% or
1,600,000
Shares Sold
 
                               
Subscription price per Share
 
$
0.19
     
0.19
     
0.19
     
0.19
     
0.19
 
Net tangible book value per Share prior to the offering
   
0.01
     
0.01
     
0.01
     
0.01
     
0.01
 
Increase per Share attributable to the offering
   
0.13
     
0.11
     
0.09
     
0.05
     
0.02
 
Pro forma net tangible book value per Share after the offering
   
0.14
     
0.13
     
0.10
     
0.06
     
0.04
 
Dilution in net tangible book value per Share to purchasers
 
$
0.05
     
0.06
     
0.09
     
0.13
     
0.15
 
    
PLAN OF DISTRIBUTION

We intend to sell our Shares and accompanying Warrants during the 90-day period following the date of this prospectus at a fixed price between $0.08 and $0.30 per Share, and at an exercise price of $0.12 and $0.45 per Warrant share. For each Share purchased the buyer will receive one Warrant.  There is no minimum number of Shares and accompanying Warrants that must be sold in this offering and, as a result, we may receive no proceeds or very minimal proceeds from the sale of the Shares.  Proceeds that we receive from the offering of Shares and accompanying Warrants will not be placed into escrow.  We may extend this offering for up to 90 days following the expiration of the first 90-day offering period.

We have retained Westminster Securities, a Division of Hudson Securities Inc., as our Placement Agent to use their best efforts to solicit offers from selected investors to purchase our Shares and underlying Warrants in this offering. The Placement Agent is not obligated to, and has advised us that they will not, purchase any Shares or Warrants for their own account.

The compensation of the Placement Agent in connection with serving as placement agent for this offering will consist of the placement fee and reimbursement of expenses described below. We will pay the Placement Agent a cash commission fee of 8% from the gross proceeds of this offering (the “Placement Agent Fee”); however, the Placement Agent shall not receive Placement Agent Fee for (i) investments made by Caledonia Capital Corporation (an entity to which we have issued a promissory note) and our executive officers and directors, and (ii) investments made by investors introduced by our executive officers or directors prior to receipt by the Placement Agent of a no-objection letter from FINRA relating to the Placement Agent’s compensation and services described herein. Additionally, we will issue to the Placement Agent Placement Agent Warrants (the Placement Agent Warrants together with the Placement Agent Fee, the “Fee”) to purchase 5% of the total Shares sold in this offering but excluding all common stock issued and issuable (i) to Caledonia Capital Corporation and our executive officers and directors in this offering, and (ii) for investments made by investors introduced to us by our executive officers or directors prior to receipt by the Placement Agent of a no-objection letter from FINRA relating to the Placement Agent’s compensation and services described herein. The Placement Agent Warrants shall be exercisable at 125% of the final offering Share price and shall have a term of exercise expiring no later than five years from the effective date of the registration statement of which this prospectus forms a part.

The Placement Agent Warrants shall not have anti-dilution protections or be transferable for six months from the date of the final closing of this offering except as permitted by Financial Industry Regulatory Authority (“FINRA”) Rule 5110, in that such Placement Agent Warrants may be transferred during the restriction period: (i)  by operation of law or by reason of our reorganization; (ii) to any FINRA member firm participating in the offering and the officers or partners thereof, if all securities so transferred remain subject to the lock-up restriction set forth in Rule 5110 for the remainder of the time period;  (iii) if the aggregate amount of our securities held by the holder of the Placement Agent Warrants or related person do not exceed 1% of the securities being offered; (iv) to the extent of a transfer of a security that is beneficially owned on a pro-rata basis by all equity owners of an investment fund, provided that no participating member manages or otherwise directs investments by the fund, and participating members in the aggregate do not own more than 10% of the equity in the fund;  or (v) in connection with the exercise or conversion of any security, if all securities received remain subject to the six month lock-up restriction for the remainder of the time period.

We have agreed to reimburse the Placement Agent, subject to compliance with FINRA Rule 5110(f)(2)(D), for its accountable fees, disbursements and expenses (with supporting invoices/receipts) up to a maximum of 2% of the aggregate gross proceeds raised in the Financing (excluding (i) investments made by Caledonia Capital and our executive officers and directors, and (ii) investments made by investors introduced by our executive officers or directors prior to receipt by the Placement Agent of a no-objection letter from FINRA relating to the Placement Agent’s compensation and services described herein) but in no event more than $35,000. We have agreed to pay an advance of $20,000 for such expenses, which amount shall be non-refundable to the extent Westminster provides us with supporting invoices/receipts of actual expenses incurred.

Furthermore, we have agreed to indemnify the Placement Agent and its controlling persons from and against, and to make contributions for payments made by such person ’ s with respect to, certain liabilities, including liabilities arising under the Securities Act of 1933, as amended (the “Securities Act”). The Placement Agent may be deemed an “underwriter” within the meaning of the Securities Act.

The Shares and accompanying Warrants will also be sold by our executive officers and directors. We are relying upon Rule 3a4-1 of the General Rules and Regulations promulgated under the Securities Act (“Rule 3a4-1”), to not deem our executive officers and directors as brokers. None of our executive officers or directors are registered broker-dealers or affiliates of broker-dealers, and to the extent that our executive officers and directors sell Shares and accompanying Warrants, no commissions or other remuneration based either directly or indirectly on transaction in securities will be paid to such persons. In addition, our executive officers and directors will conduct their selling activity in accordance with paragraphs (a)(4)(ii) of Rule 3a4-1, in that each person primarily performs substantial duties for us other than in connection with transactions in securities, each person is not a broker or dealer or affiliated with a broker or dealer in the last twelve months and each person does not participate in selling an offering of securities more than once every twelve months other than as permitted under Rule 3a4-1 

 
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DESCRIPTION OF SECURITIES

Common Stock
 
In this offering, we are offering up to 16,000,000 Shares of our common stock at a fixed price between $0.08 and $0.30 per share, accompanied by Warrants to purchase up to an additional 16,000,000 shares of our common stock. Each Warrant has an exercise price of 150% of the price of the final offering price of the Shares, has a term of three years, and is exercisable on or after the six month anniversary from the purchase date until on or before the three year anniversary of the purchase date. Each Share is accompanied by one Warrant to purchase one additional share of our common stock. The shares of common stock underlying the Warrants are being registered pursuant to the registration statement of which this prospectus forms a part.
 
The Shares will be sold during the 90-day period following the date of this prospectus, which period may be extended for an additional 90 days.
 
We are also registering up to 800,000 shares of our common stock underlying the Placement Agent Warrants.
 
On December 28, 2009,  15,614,001 shares of our common stock were outstanding.
 
The NASDAQ Marketplace Rules require shareholder approval for the issuance of common stock or securities convertible into common stock equal to 20% or more of the common stock outstanding before the issuance for less than the greater of book or market value of the stock. On October 23, 2009 we received the required approval from our shareholders.
 
Warrants

Each Share will be accompanied by one Warrant to purchase one additional share of our common stock.  The exercise price per Warrant share will be equal to 150% of the final offering Share price.  The Shares underlying the Warrants will have such rights and preferences which are attributable to all the shares of our common stock, $0.001 par value. The Shares of common stock underlying the Warrants are being registered; however, the Warrants are not being registered and there will be no market for the Warrants.
 
Exercise. Holders of the Warrants may exercise their Warrants to purchase shares of our common stock on or before the expiration date by delivering (i) an exercise notice, appropriately completed and duly signed, and (ii) payment of the exercise price for the number of shares with respect to which the Warrant is being exercised. Warrants may be exercised in whole or in part, but only for full shares of common stock, and any portion of a Warrant not exercised prior to the expiration date shall be and become void and of no value.
 
The shares of common stock issuable on exercise of the Warrants will be, when issued in accordance with the Warrants, duly and validly authorized, issued and fully paid and non-assessable. We will authorize and reserve at least that number of shares of common stock equal to the number of shares of common stock issuable upon exercise of all outstanding Warrants.
 
Delivery of Certificates . Upon the holder’s exercise of a Warrant, we will promptly, but in no event later than five business days after the exercise date, issue and deliver, or cause to be issued and delivered, a certificate for the shares of common stock issuable upon exercise of the Warrant, free of restrictive legends  (provided such shares are covered by an effective registration statement at the time of exercise).
 
Other Adjustments . The exercise price and the number of shares of common stock purchasable upon the exercise of the Warrants are subject to adjustment upon the occurrence of specific events, including stock dividends, stock splits, and combinations of our common stock. If we make or issue a dividend or other distribution payable in securities of the company other than shares of common stock, or in cash or other property, then each holder’s Warrant will become the right to receive, upon exercise of such warrant, in addition to the number of shares of common stock issuable under the Warrant, the same kind and amount of securities, cash or other property as it would have been entitled to receive upon the occurrence of such transaction, if the Warrant had been exercised immediately prior to such transaction.

 
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Additional Provisions . The above summary of certain terms and provisions of the Warrants is qualified in its entirety by reference to the detailed provisions of the Warrants, the form of which has been filed as Exhibit 4.2 to the registration statement of which this prospectus forms a part. We are not required to issue fractional shares upon the exercise of the Warrants. No holders of the Warrants will possess any rights as a shareholder under those Warrants until the holder exercises those Warrants.
 
Placement Agent Warrants
 
The exercise price per Placement Agent Warrant shall be 125% of the final offering Share price. The Placement Agent Warrants shall not have anti-dilution protection or be transferable for six months from the final closing of this offering, except as otherwise permitted by FINRA Rule 5110. The shares of common stock underlying the Placement Agent Warrants are being registered; however, the Placement Agent Warrants are not being registered and there will be no market for the Placement Agent Warrants.
 
Exercise .   The Placement Agent may exercise the Placement Agent Warrants to purchase shares of our common stock for five years from the effective date of the registration statement of which this prospectus forms a part. The Placement Agent Warrants may be exercised in whole or in part, but only for full shares of common stock, and any portion of a Placement Agent Warrant not exercised prior to the expiration date shall be and become void and of no value.
 
The shares of common stock issuable on exercise of the Placement Agent Warrants will be, when issued in accordance with the Placement Agent Warrants, duly and validly authorized, issued and fully paid and non-assessable. We will authorize and reserve at least that number of shares of common stock equal to the number of shares of common stock issuable upon exercise of the outstanding Placement Agent Warrants.

Further, for a period of six months after the issuance date of the Placement Agent Warrants (which shall not be earlier than the closing date of this offering pursuant to which the Placement Agent Warrants are being issued), neither the Placement Agent Warrants nor any shares underlying the Placement Agent Warrants issued upon exercise of the Placement Agent Warrants shall be sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put, or call transaction that would result in the effective economic disposition of the securities by any person for a period of 180 days immediately following the date of effectiveness or commencement of sales of this offering pursuant to which the Placement Agent Warrants are being issued, except the transfer of any security:

(i) by operation of law or by reason of our reorganization;

(ii) to any FINRA member firm participating in the offering and the officers or partners thereof, if all securities so transferred remain subject to the six month lock-up restriction for the remainder of the time period;

(iii) if the aggregate amount of our securities held by the Placement Agent or related person do not exceed 1% of the securities being offered in this offering;

(iv) that is beneficially owned on a pro-rata basis by all equity owners of an investment fund, provided that no participating member manages or otherwise directs investments by the fund, and participating members in the aggregate do not own more than 10% of the equity in the fund;  or

(v) the exercise or conversion of any security, if all securities received remain subject to the six month lock-up restriction for the remainder of the time period.

Delivery of Certificates . Upon the Placement Agent’s exercise of a Placement Agent Warrant, we will promptly, but in no event later than five business days after the exercise date, issue and deliver, or cause to be issued and delivered, a certificate for the shares of common stock issuable upon exercise of the Placement Agent Warrant, free of restrictive legends (provided that such shares are covered by an effective registration statement at the time of exercise).
 
Other Adjustments . Subject to FINRA Rule 5110, the exercise price and the number of shares of common stock purchasable upon the exercise of the Placement Agent Warrants are subject to adjustment upon the occurrence of specific events, including stock dividends, stock splits, and combinations of our common stock. If we make or issue a dividend or other distribution payable in securities other than shares of common stock, or in cash or other property, then each Placement Agent Warrant will become the right to receive, upon exercise of such Placement Agent Warrant, in addition to the number of shares of common stock issuable under the Placement Agent Warrant, the same kind and amount of securities, cash or other property as it would have been entitled to receive upon the occurrence of such transaction, if the Placement Agent Warrant had been exercised immediately prior to such transaction.
 
Additional Provisions . The above summary of certain terms and provisions of the Placement Agent Warrants is qualified in its entirety by reference to the detailed provisions of the Placement Agent Warrants, the form of which has been filed as Exhibit 4.3.2 to the registration statement of which this prospectus forms a part. We are not required to issue fractional shares upon the exercise of the Placement Agent Warrants. The Placement Agent will not possess any rights under the Placement Agent Warrants as a shareholder under those Placement Agent Warrants until the Placement Agent exercises the Placement Agent Warrants.

 
13

 

INTERESTS OF NAMED EXPERTS AND COUNSEL

The financial statements as of October 31, 2008 and 2007 included in this prospectus, and in the registration statement of which this prospectus forms a part, have been audited by Grant Thornton LLP, an independent registered public accounting firm, to the extent and for the period set forth in their report appearing elsewhere herein and in the registration statement, and are included in reliance upon such report given upon the authority of said firm as experts in auditing and accounting.

The validity of the issuance of the common stock offered hereby will be passed upon for us by Gersten Savage LLP, 600 Lexington Avenue, New York, New York 10022, included in the opinion letter filed as an exhibit to the registration statement of which this prospectus forms a part. Jay M. Kaplowitz a partner of Gersten Savage LLP, serves as a director of our Company.
 
No expert or counsel named in this prospectus as having prepared or certified any part of this prospectus or having given an opinion upon the validity of the securities being registered or upon other legal matters in connection with the registration or offering of the common stock was employed on a contingency basis or had, or is to receive, in connection with the offering, a substantial interest, directly or indirectly, in our Company, nor was any such expert connected with us as a promoter, managing or principal underwriter, voting trustee, director, officer or employee.

BUSINESS
 
OVERVIEW

Founded in 1987, we are a developer of mobility appliance software solutions primarily for the Research In Motion® (RIM) BlackBerry market.  We design and integrate our software into specialized server appliances targeted at the Federal Government and in particular, the Department of Defense (“DoD”), public sector, commercial, and remote hosting customers.

Until July 2009, we offered computer integration solutions for the federal marketplace and Independent Software Vendors.  In July 2009, we entered into an Asset Purchase Agreement with NCS Technologies, Inc., a Virginia corporation (“NCS”), pursuant to which we agreed to sell to NCS, and NCS agreed to purchase from us, all of our right, title and interest in and to the assets relating to our computer integration business.   Further, in July 2009 our management and Board of Directors determined to shift the focus of our operations, resources and investments to our BlackBerry-related technologies and products.

RECENT DEVELOPMENTS

November Line of Credit and Note Payable

On November 3, 2009, we entered into a Line of Credit and Security Agreement (the “Credit and Security Agreement”) with Caledonia Capital Corporation, a Delaware corporation (the “Lender”) pursuant to which the Lender agreed to extend to us a revolving line of credit in the amount of $150,000, in the form of a Revolving Line of Credit Promissory Note (the “Credit Note”).  The Credit Note bears interest at a rate of 15% per annum, and is payable in monthly installments commencing 30 days after November 3, 2009, which was the date when we issued the Credit Note.  The principal amount of the Credit Note, together with interest accrued and unpaid thereon and all other sums due, shall be due and payable in full upon the earlier to occur of (a) March 31, 2010, or (b) the date we shall have raised a total of not less than $1,000,000 in capital invested in our equity which is accompanied by our issuing shares of stock which were not trading in the public markets prior to the date of the Credit Note (“New Equity Capital”).   There are no penalties for early prepayment of the Credit Note.

The Credit Note is a revolving line of credit note.  Principal advances may be made, from time to time, by the Lender up to the principal amount of the Credit Note, and principal payments may be made, from time to time by us to reduce the principal balance owing pursuant to the Credit Note.
  
Our obligations under the Credit and Security Agreement and the Credit Note are secured by a lien in and to all of our rights, title and interest in and to its furniture, fixtures, equipment, supplies, receivables, intangibles, and inventory, together with all present and future substitutions, replacements and accessories thereto and all present and future proceeds and products thereof, in any form whatsoever (the “Collateral”).
   

 
14

 

Pursuant to the Credit and Security Agreement, in the event that (a) we fail to pay when due any principal, interest or other sum owing on any of the obligations described in the Agreement when due; (b) we fail to perform any other covenant or agreement in the Agreement, in the Warrant or in any of the other loan documents and such default continues uncorrected for a period of thirty (30) days after written notice of such default from the Lender to us; (c) if any warranty or representation that we made to the Lender shall be untrue or misleading in any material respect; (d) if a trustee or receiver is appointed for us or for all or a substantial part of our assets; or if we make a general assignment for the benefit of creditors; or if we file for bankruptcy; or if an involuntary bankruptcy petition is filed against us and such petition is not dismissed within forty-five (45) days after the filing of the same; (e) if any property that we pledged or hypothecated to Lender, or any deposit account held by Lender, is levied upon or attached or further encumbered, or garnished or the Collateral shall otherwise be impaired and same is not removed within thirty (30) days after written notice thereof from Lender us, as determined by Lender; (f) if there occurs any material adverse change in our financial condition or value of the Collateral, as determined by Lender; (g) if a final judgment is entered against us, and the same is not discharged, appealed (provided such appeal stays such judgment) or satisfied within thirty (30) calendar days; (h) if we are liquidated or dissolved; or (i) a default shall occur under that certain Note in the original principal amount of $250,000 from SteelCloud to Lender dated July 1, 2009, then the Lender may, without any further notice or demand, (1) declare any or all of the obligations not already due to be immediately due and payable; (2) enforce, by any proceedings or otherwise, any of the obligations; (3) take exclusive possession of any or all of the Collateral, (4) enforce any liens or security interests securing the obligations; (5) demand, compromise, collect, sue for and receive any money or property at any time due, (6) endorse SteelCloud name on any promissory notes or other instruments, checks, drafts, money orders or other items of payment constituting Collateral, or collections or other proceeds of Collateral, that may come into Lender's possession or control from time to time; and/or (7) terminate, or cease extending credit under, any or all outstanding commitments or credit accommodations of Lender to SteelCloud.

As an inducement to the Lender to make the loan, we agreed to issue to the Lender a warrant (the “Credit Warrant”) to purchase 2.5 shares of our common stock for every dollar we borrow pursuant to the Credit and Security Agreement.  The Credit Warrant is exercisable for four years at an exercise price of $0.25 per share.  The exercise price may be adjusted in the event of any stock dividend, stock split, stock combination, reclassification or similar transaction. Additionally, our Board of Directors (the “Board”) has the discretion to reduce the then-current exercise price to any amount at any time during the term of the Warrant for any period of time the Board deems appropriate.  We have agreed to prepare and file a registration statement for the purposes of registering the resale of the shares of common stock underlying the Credit Warrant, commencing on or about December 31, 2009.

On November 4, 2009, we borrowed $60,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 150,000 shares of our common stock pursuant to the Credit and Security Agreement.  On November 23, 2009, we borrowed the additional $90,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 225,000 shares of our common stock.

Sale of Integration Business

On July 10, 2009, we entered into an Asset Purchase Agreement (the “Agreement”) with NCS Technologies, Inc., a Virginia corporation (referred to herein as “NCS”), pursuant to which we agreed to sell to NCS, and NCS agreed to purchase from us, all of our right, title and interest in and to the assets relating to our computer integration business.   The purchase price was $475,000 of which $150,000 was paid as a deposit and the remaining $325,000 is an earn-out amount, which is payable from and to the extent of revenue NCS receives during the three-year period after the closing date from certain existing and prospective clients, at a rate equal to 15% of the net sales price received by NCS from such clients.  Any payments by NCS to us are due on or before the 10th business day following the month in which NCS receives the payments from the client(s).

We have classified the integration business as discontinued operations for the three and nine month periods ending July 31, 2009 as well as all comparative periods presented.  Certain amounts have been reclassified in order to conform to current period presentation.

July Loan and Note Payable

On July 1, 2009, we entered into a Business Loan and Security Agreement (the “Agreement”) with Caledonia Capital Corporation, a Delaware Corporation (referred to herein as the “Lender”) pursuant to which the Lender agreed to lend us $250,000 in the form of a Secured Promissory Note (the “Note”) which was issued on July 1, 2009. The Note originally provided for a maturity date of December 29, 2009 (the “Maturity Date”) and an annual interest rate of 15%.  The Note was amended on December 29, 2009 to provide that (a) the annual interest rate of the Note is 20%, (b) accrued interest under the Note shall be payable in monthly installments commencing February 1, 2010, and continuing on the first business day of each successive month, and (c) the Maturity Date is March 31, 2010.  There are no penalties for early prepayment of the Note.

In the event that any installment of principal and/or interest due under the Note is not received by the Lender within ten (10) days after the date when the same is due, then we shall be required to pay a late charge of 5.0% of such installment.

Additionally, in the event that we receive investments from one or more investors in one or more transactions in an aggregate amount in excess of $750,000, whether in the form of cash, negotiable or non-negotiable instruments or any form of payment in exchange for the issuance of any certificated or non-certificated security, whether in the form of debt or equity (an “Equity Raise”), at any time between the Issuance Date and the Maturity Date, shall be required, within five (5) business days after the Equity Raise first exceeds $750,000, to curtail the accrued interest and outstanding principal balance of the Note by an amount equal to the amount by which the Equity Raise then exceeds $750,000 (but in no event by more than the then outstanding principal balance and interest accrued on the Note). Until delivery of such funds to the Lender, all such funds shall be deemed held in trust by us for and on behalf of the Lender.  All funds that we deliver to the Lender from the Equity Raise shall be deemed prepayments of the Note.

Pursuant to the Agreement and the Note, our obligations thereunder are secured by a first priority lien in and to all of our intellectual property rights, title and interest in and to the SteelWorks® Mobile integrated server appliance software.

As an inducement to the Lender to make the loan, we issued to the Lender a warrant to purchase up to 625,000 shares of our common stock, par value $0.001 per share.  The Warrant is exercisable for four years at an exercise price of $0.15 per share.  We determined fair value of these warrants utilizing the Black-Sholes method.  The fair value of these warrants at issuance date was approximately $130,000. As an inducement for the Lender to amend the terms of the Note, we agreed to pay the Lender $25,000.

Board of Directors Investment

On June 15, 2009, we sold an aggregate of 350,000 shares of our common stock, $.001 par value, to our seven directors, for aggregate cash proceeds of $87,500.  The shares of common stock were sold at $0.25 per share, or $.01 higher than the closing price of the common stock on the date of sale.  Each share of common stock is accompanied by one warrant to purchase one additional share of common stock (the “Warrant”).  The Warrants are exercisable for five years from the date of issuance at an exercise price of $0.25 per share.   The seven directors entered into lock-up agreements with us, restricting their ability to exercise the warrants until we receive shareholder approval for the issuance of the Warrants.  We received shareholder approval for the issuance on October 23, 2009.

 
15

 

BLACKBERRY® ENTERPRISE SERVER SOLUTION (STEELWORKS®)

As an extension of our business, we developed SteelWorks® Mobile (“SteelWorks Mobile”), an appliance solution specifically for the BlackBerry Enterprise Server (“BES”).  SteelWorks Mobile was developed in conjunction with Research in Motion (“RIM”).   SteelWorks Mobile is an integrated server appliance that enables virtually any size organization to implement BES at a fraction of the cost, time, and resource commitment.  We have filed for patent protection for the SteelWorks Mobile technology we created for the installation wizard, backup and restore features.  These patents are currently pending approval from the U.S. Patent and Trademark Office.

In addition, we developed SteelWorks FedMobile, our BlackBerry Enterprise Server appliance solution specifically for the Department of Defense (“DoD”) and other related agencies.  The SteelWorks FedMobile appliance builds upon SteelWorks Mobile by automating the application of the Defense Information Systems Agency’s Security Technical Implementation Guides (“STIGs”) to the BES installation process.  STIGs mandate the policies for which the DoD and related agencies must operate their wireless communications.  As a result, our SteelWorks FedMobile appliance allows DoD organizations to implement a STIG compliant BES infrastructure in a fraction of the time, cost, or resources necessary to what is otherwise a time intensive and manual STIG process.

PROFESSIONAL SERVICES

We provide information technology (“IT”) consulting and contract staffing solutions for our commercial and government clients.  Our consultants are subject matter experts in network infrastructure complexities and security technologies including firewalls, content inspection, intrusion detection, spam and vulnerability scanning.  For our contract staffing solutions, our personnel function as “virtual” employees, performing work directly under the auspices of client management and serve as an extension of the client’s in-house staff resources.

RESEARCH AND PRODUCT DEVELOPMENT

By investing in product development, we believe we will have more control over the functionality and marketing of our products.  We also believe that the resulting intellectual property will increase the competitiveness of our offerings and improve product margins.  For the three and nine months ended July 31, 2009, we incurred research and development costs of approximately $54,000 and $152,000, respectively.  We will continue to incur costs for product development in the future.

MARKETING

We market our products and services to government and commercial users through sales channels that include distributors, integrators and value added resellers.  We primarily market to the sales channel organizations instead of the end users.  We use an in-house sales force and program managers to market our products and services.  Our products and services are marketed worldwide.  We maintain an Internet website containing our product offerings located at www.steelcloud.com.

JOINT VENTURE

In October 2008, we created a joint venture in the United Arab Emirates (UAE) region with XSAT SteelCloud MEA, LLC (Middle East, Africa) the newly formed joint venture company, is jointly owned, 20% by XSAT and 80% by SteelCloud.  Under the terms of the joint agreement, XSAT will provide a local presence for our products to its customers within the UAE region.  XSAT will also provide warranty and support for the products sold within that region.

 
16

 

COMPETITION

Our products assist organizations with the installation and maintenance of their BlackBerry network environment.  Our products provide the end user base with an alternative means to perform the installation and maintenance process.  There are currently no other products available in the marketplace that compete with SteelWorks® Mobile or SteelWorks FedMobile.

Our main source of competition is from individuals within organizations who choose to install and maintain their BlackBerry network environment internally and without the aid of our products.

Management believes that it maintains a strong relationship with Research in Motion (“RIM”), the maker of the BlackBerry line of products.  Management further believes that our relationship with RIM may be a barrier to entry for other organizations that may seek to enter into this market.

SUPPLIERS

We devote significant resources to establishing and maintaining relationships with key suppliers.  We have recently executed an Original Equipment Manufacturer partnership agreement with Dell, Inc. (“Dell”) to supply SteelWorks Mobile and SteelWorks FedMobile on their network servers.  SteelWorks Mobile and SteelWorks FedMobile will be manufactured and produced by Dell.   In addition, Dell will supply the logistics and warranty support for the hardware.   Dell will be the primary vendor for SteelWorks Mobile and SteelWorks FedMobile, however, we intend to maintain relationships with multiple vendors to manufacture and produce our products should the need arise.

PATENTS, TRADEMARKS AND LICENSES

We work closely with computer product suppliers and other technology developers to stay abreast of the latest developments in computer technology.  While we do not believe our continued success depends upon the rights to a patent portfolio, there can be no assurance that we will continue to have access to existing or new technology for use in our products.

On March 20, 2008, we were issued patent 3,396,156 titled ”SteelWorks.”

On September 15, 2008, we were issued community trademark Registration 006430359 (European); Japan #948064 (International), Canada Application Approval titled “SteelRestore.”

On October 21, 2008, we were issued patent 3,521,899 titled “Sure Audit.”

We conduct our business under the trademarks and service marks of “SteelCloud,” “SteelCloud Company” and “Dunn Computer Corporation.”  We believe our copyrights, trademarks and service marks have significant value and are an important factor in the marketing of our products.

 
17

 

GOING CONCERN

We have had recurring annual operating losses since our fiscal year ended October 31, 2004.  We expect that such losses will continue at least until our fiscal year ending October 31, 2010.  The report of our independent registered public accounting firm on our consolidated financial statements for the fiscal year ended October 31, 2008 contains an explanatory paragraph regarding our ability to continue as a going concern based upon our history of net losses.   We are dependent upon available cash and operating cash flow to meet our capital needs.  We are considering all strategic options to improve our liquidity and provide us with working capital to fund our continuing business operations which include equity offerings, asset sales or debt financing as alternatives to improve our cash needs; however, there can be no assurance that we will be successful in negotiating financing on terms agreeable to us or at all.  If adequate funds are not available or are not available on acceptable terms, we will likely not be able to take advantage of unanticipated opportunities, develop or enhance services or products, respond to competitive pressures, or continue as a going concern.  There is no assurance we will be successful in raising working capital as needed.  Further, there are no assurances that we will have sufficient funds to execute our business plan, pay our operating expenses and obligations as they become due or generate positive operating results.

We are in the process of executing on several restructuring initiatives which include:
 
 
Obtaining additional capital through debt and/or equity;
 
Further reducing our operating costs; and
 
Reduction of occupancy costs.

While we believe that these initiatives will better align our costs with our anticipated revenues going forward, it will take time for these initiatives to have an impact on our net revenue and operating income.
 
Employees
 
As of October 31, 2008, and December 28, 2009, we had 48 and 15 employees, respectively.  None of our employees are covered by a collective bargaining agreement and we consider our relationships with our employees to be good.
 
We believe our future success depends in large part upon our continued ability to attract and retain highly qualified management, technical, and sales personnel.  We have an in-house training and mentoring program to develop our own supply of highly qualified technical support specialists.  There can be no assurance, however, that we will be able to attract and retain the qualified personnel necessary for our business.

Principal Executive Offices

Our principal executive offices are located at 13962 Park Center Road Herndon, Virginia 20171.  Our telephone number is (703) 674-5500, fax number is (703) 450-0407 and our website address is www.steelcloud.com. The information on our website is not incorporated by reference into this prospectus and should not be relied upon with respect to this offering.
 
DESCRIPTION OF PROPERTY

We lease approximately 24,000 square feet of office space in Herndon, Virginia.  Our monthly rent expense is approximately $21,000.

LEGAL PROCEEDINGS

On May 22, 2009, we entered into a Stipulation/Consent Order with CRP (the “Stipulation”), pursuant to an Affidavit and Statement of Account (the “Affidavit”), stating, as declared by a general manager of Jones Lang LaSalle, a property management company and agent for CRP Holdings A-1, LLC (“CRP”), the landlord of 14040 Park Center Road, Suite 210, Herndon, Virginia 20171 (the “Premises”), that CRP, as landlord, was seeking a judgment against us for: (i) possession of the Premises, and (ii) monetary damages for nonpayment of rent due under a sublease, dated September 28, 2004, by and between us and NEC America, Inc. (“NEC”) (the “Sublease”), and a subsequent assignment of the Sublease to CRP from NEC, dated December 15, 2008.  In the Stipulation we acknowledged that the balance due for rent and additional rent for the Premises was $168,637.96, together with attorney’s fees and court expenses of $7,041.00 through May 22, 2009 (the “Judgment Amount”).  Pursuant to the Stipulation, we paid $30,000 (the “Forbearance Payment”) on May 22, 2009 toward the Judgment Amount.  Further we agreed to, and have, vacated the Premises.  CRP agreed to stay enforcement of the Judgment Amount until the earlier of (a) our receipt of capital in the amount of at least $500,000, or (b) May 31, 2010.  The matter was returned to the court’s files pending our compliance with the terms of the Stipulation.  

 
18

 
 
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS

Market Information
 
Prior to the quotation of our common stock beginning on April 22, 1997, there was no established trading market for our common stock.  Our common stock is listed on The NASDAQ Stock Market, Inc.’s Capital Market.  We changed our symbol from “DNCC” to “SCLD” on October 19, 2000.
 
The following table sets forth the high and low selling prices as reported on the NASDAQ Capital Market for each fiscal quarter during the fiscal years ended October 31, 2008 and 2007, as well as for the first, second, third and fourth quarters of fiscal 2009 through September 8, 2009.  These quotations reflect inter-dealer prices without retail mark-up, markdown, or commission and may not represent actual transactions.

   
Fiscal 2007
 
   
High
   
Low
 
             
First Quarter
 
$
1.34
   
$
0.61
 
Second Quarter
 
$
1.47
   
$
0.94
 
Third Quarter
 
$
1.74
   
$
1.12
 
Fourth Quarter
 
$
1.68
   
$
1.12
 

   
Fiscal 2008
 
   
High
   
Low
 
             
First Quarter
 
$
1.25
   
$
0.87
 
Second Quarter
 
$
1.21
   
$
0.80
 
Third Quarter
 
$
1.58
   
$
1.06
 
Fourth Quarter
 
$
1.26
   
$
0.56
 

   
Fiscal 2009
 
   
High
   
Low
 
             
First Quarter
 
$
0.75
   
$
0.30
 
Second Quarter
 
$
0.38
   
$
0.14
 
Third Quarter
 
$
0.48
   
$
0.15
 
Fourth Quarter
 
$
0.66
   
$
0.20
 
 
     
Fiscal 2010
 
     
High
     
Low
 
First Quarter (through December 28, 2009)
 
$
0.39
   
$
0.20
 
 
On December 28, 2009, the closing price of our common stock as reported on the NASDAQ Capital Market was $0.29 per share.  There were approximately 5,100 shareholders of our common stock as of such date.
 
Dividend Policy
 
We have not paid cash dividends on our common stock and do not intend to do so in the foreseeable future.

 
19

 
Equity Compensation Plan Information
 
The following table sets forth the number of securities to be issued upon the exercise of outstanding options, warrants and rights which were issued pursuant to our equity compensation plans as of October 31, 2008.
 
Plan category
 
Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights
   
Weighted-average
exercise price of
outstanding options,
warrants and rights
   
Number of securities remaining available
for future issuance under equity
compensation plans (excluding securities
reflected in column (a))  2
 
  
 
(a)
   
(b)
   
(c)
 
Equity compensation plans approved by security holders 1
   
2,049,166
   
$
1.20
     
1,859,809
 
Equity compensation plans not approved by security holders
                       
Total
   
2,049,166
   
$
1.20
     
1,859,809
 

 
1
Descriptions of our equity compensation plans can be found in Note 10 “Stock-Based Compensation” of the Footnotes to our Annual Consolidated Financial Statements for the fiscal year ended October 31, 2008.
 
2
In addition to being available for future issuance upon exercise of options that may be granted after October 31, 2008, all of the remaining 1,433,334 shares under our Amended 2007 Stock Option and Restricted Stock Plan, or the 2007 Option and Restricted Stock Plan, may instead be issued in the form of restricted stock.

NASDAQ  
 
On March 23, 2009, we received notice, under NASDAQ Marketplace Rule 4310(c)(3), that our common stock was subject to potential delisting from the NASDAQ Capital Market because we did not meet the criteria of NASDAQ Listing Rule 5550(b) (the “Rule”) and did not have a minimum of $2,500,000 in stockholders’ equity, $35,000,000 market value of listed securities, or $500,000 of net income from continuing operations for the most recently completed fiscal year or two of the three most recently completed fiscal years.  We provided NASDAQ with a specific plan of how we intend to achieve and sustain compliance with all the NASDAQ Capital Market listing requirements, including a time frame for completion of such plan.  Our plan includes the following two strategies: (i) increasing our stockholders equity in excess of the minimum $2,500,000 requirement by raising between $3,000,000 to $4,000,000 through an equity transaction; and (ii) identifying a strategic partner interested in either merging with or acquiring us.  On April 28, 2009 we received notice from NASDAQ indicating that NASDAQ had granted our request for an extension of time to regain compliance with the Rule.  Pursuant to the terms of the extension, we were required to: (a) on or before July 6, 2009, complete an equity transaction or a merger and/or acquisition, and (b) make appropriate disclosures to the SEC and Nasdaq on a Form 8-K.    We were not able to complete an equity transaction or a merger and/or acquisition by July 6, 2009, and on July 8, 2009, we received written notification from NASDAQ stating that we did not meet the terms of the extension, and that, as a result, our common stock would be subject to suspension from trading at the opening of business on July 17, 2009, and delisted from NASDAQ.  The notification stated that a hearing request made to the NASDAQ Hearing Panel (the “Panel”) to appeal the determination would stay the delisting of our common stock pending the Panel’s decision.  On July 15, 2009, we requested a hearing to appeal the determination before the Panel and to present our plan for regaining compliance with the Rule (the “Appeal”).  On August 4, 2009, we received notice that NASDAQ received our Appeal, and that the delisting action has been stayed, pending a final written decision by the Panel after an oral/written hearing (the “Hearing”), where we were required to demonstrate our ability to regain and sustain compliance with the Rule.  The Hearing took place at 11:00 A.M. EST, on September 3, 2009.  On October 5, 2009, we received notice that the Panel has granted our request for continued listing, subject to our evidencing, on or before January 4, 2010 compliance with the Rule.
 
On September 15, 2009 we received notice from NASDAQ, under Marketplace Rule 5450(a)(1), that our common stock is subject to potential delisting from the NASDAQ Capital Market because the bid price of our common stock closed below the minimum $1.00 requirement for 30 consecutive business days prior to September 15, 2009. We have been granted an initial 180 calendar days, or until March 15, 2010 to regain compliance.  

 
20

 

FINANCIAL STATEMENTS

Annual Financial Statements
SteelCloud, Inc. (a Virginia Corporation)
   
Report of Independent Registered Public Accounting Firm
 
F-1
Consolidated Balance Sheets as of October 31, 2007 and 2008
 
F-2
Consolidated Statements of Operations for the two years ended October 31, 2008
 
F-3
Consolidated Statements of Stockholders' Equity for the two years ended October 31, 2008
 
F-4
Consolidated Statements of Cash Flows for the two years ended October 31, 2008
 
F-5
Notes to Consolidated Financial Statements
 
F-6

Interim Financial Statements
Condensed Consolidated Balance Sheet
 
F-22
Unaudited Condensed Consolidated Statements of Operations
 
F-23
Unaudited Condensed Consolidated Statements of Cash Flows
 
F-24
Notes to Unaudited Condensed Consolidated Financial Statements
 
F-25
 
21

 
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders
SteelCloud, Inc.
 
We have audited the accompanying consolidated balance sheets of SteelCloud, Inc. (a Virginia Corporation) and subsidiaries (the Company) as of October 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended October 31, 2008.  Our audits of the basic financial statements included the financial statement schedule listed in the index appearing under Item 15 (a) 2.  These financial statements and financial statement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of October 31, 2008 and 2007, and the results of its operations and its cash flows for each of the two years in the period ended October 31, 2008 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1, the Company incurred a net loss of $2,759,562 during the year ended October 31, 2008, and, as of that date, the Company had an accumulated deficit of $44,868,564 and working capital of $1,680,645.  These factors, among others, as discussed in Note 1 to the consolidated financial statements, raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans in regard to these matters are also described in Note 1.  The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
/s/ Grant Thornton LLP
 
McLean, Virginia
January 29, 2009
 
F-1

 
STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEETS
 
   
OCTOBER 31,
 
   
2007
   
2008
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
 
$
2,622,654
   
$
752,351
 
Accounts receivable, net of allowance for doubtful accounts of $40,000 and $36,000 as of October 31, 2007 and 2008, respectively
   
2,625,372
     
1,571,673
 
Inventory, net
   
1,178,395
     
521,920
 
Prepaid expenses and other current assets
   
255,924
     
130,446
 
Deferred contract costs
   
83,753
     
-
 
Total current assets
   
6,766,098
     
2,976,390
 
Property and equipment, net
   
802,288
     
626,440
 
Equipment on lease, net
   
323,904
     
442,099
 
Other assets
   
44,053
     
7,020
 
Total assets
 
$
7,936,343
   
$
4,051,949
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
1,789,329
   
$
718,316
 
Accrued expenses
   
1,158,641
     
561,009
 
Notes payable, current portion
   
12,842
     
7,538
 
Unearned revenue
   
98,255
     
8,882
 
Total current liabilities
   
3,059,067
     
1,295,745
 
Notes payable, long-term portion
   
15,442
     
7,903
 
Other
   
154,520
     
132,055
 
Total long-term liabilities
   
169,962
     
139,958
 
Stockholders’ equity:
               
Preferred stock, $.001 par value; 2,000,000 shares authorized, 0 and 0 shares issued and outstanding at October 31, 2007 and 2008, respectively
   
-
     
-
 
Common stock, $.001 par value; 50,000,000 shares authorized 14,716,934 and    15,138,376 shares issued at October 31, 2007 and 2008, respectively
   
14,717
     
15,138
 
Additional paid-in capital
   
50,234,099
     
50,902,172
 
Treasury stock, 400,000 shares at October 31, 2007 and 2008, respectively
   
(3,432,500
)
   
(3,432,500
)
Accumulated deficit
   
(42,109,002
)
   
(44,868,564
)
Total stockholders’ equity
   
4,707,314
     
2,616,246
 
Total liabilities and stockholders’ equity
 
$
7,936,343
   
$
4,051,949
 
 
See accompanying notes.
 
F-2

 
 
STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
 
   
YEARS ENDED OCTOBER
31,
 
   
2007
   
2008
 
             
Products
 
$
21,421,129
   
$
16,333,600
 
Services
   
1,894,551
     
2,685,296
 
Net revenues
   
23,315,680
     
19,018,896
 
                 
Products
   
17,064,855
     
13,764,101
 
Services
   
1,305,604
     
2,159,753
 
Costs of revenues
   
18,370,459
     
15,923,854
 
                 
Gross profit
   
4,945,221
     
3,095,042
 
                 
Selling and marketing
   
1,614,817
     
1,259,416
 
General and administrative
   
4,315,254
     
3,901,499
 
Research and product development
   
661,550
     
702,231
 
Severance and restructuring
   
317,548
     
-
 
                 
Loss from operations
   
(1,963,948
)
   
(2,768,104
)
                 
Other income (expense):
               
Interest income
   
46,458
     
26,912
 
Interest expense
   
(27,105
)
   
(18,370
)
                 
Net loss attributable to common stockholders
 
$
(1,944,595
)
 
$
(2,759,562
)
                 
Loss per share, basic and diluted:
               
Net loss per share
 
$
(0.14
)
 
$
(0.19
)
 
See accompanying notes.

 
F-3

 

STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
   
Preferred Stock
   
Common Stock
   
Additional
Paid-In
   
Treasury
   
Accumulated
       
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Stock
   
Deficit
   
Total
 
                                                 
Balance at October 31, 2006
   
     
     
14,662,176
   
$
14,662
   
$
49,834,658
   
$
(3,432,500
)
 
$
(40,164,407
)
 
$
6,252,413
 
                                                                 
Issuance of common stock in connection with employee stock purchase plan exercises
   
     
     
33,254
     
33
     
16,037
     
     
     
16,070
 
Stock compensation expense
   
     
     
     
     
322,136
     
     
     
322,136
 
Issuance of warrants in conjunction with the retainage of a financial services firm
   
     
     
     
     
40,000
     
     
     
40,000
 
Issuance of common stock to the Company’s board of directors
   
     
     
21,504
     
22
     
21,268
     
     
     
21,290
 
Net (loss)
   
     
     
     
     
     
     
(1,944,595
)
   
(1,944,595
)
Balance at October 31, 2007
   
     
     
14,716,934
     
14,717
   
$
50,234,099
   
$
(3,432,500
)
 
$
(42,109,002
)
 
$
4,707,314
 
                                                                 
Issuance of common stock in connection with employee stock purchase plan exercises
   
     
     
5,152
     
5
     
4,408
     
     
     
4,413
 
Issuance of common stock in connection with employee stock option plan exercises
   
     
     
196,290
     
196
     
121,503
     
     
     
121,699
 
Stock compensation expense
   
     
     
     
     
368,032
     
     
     
368,032
 
Issuance of common stock in connection with exercise of warrants
   
     
     
220,000
     
220
     
118,580
     
     
     
118,800
 
Issuance of warrants in conjunction with the retainage of a investor relations firm
   
     
     
     
     
55,550
     
     
     
55,550
 
Net (loss)
   
     
     
     
     
     
     
(2,759,562
)
   
(2,759,562
)
Balance at October 31, 2008
   
     
     
15,138,376
     
15,138
   
$
50,902,172
   
$
(3,432,500
)
 
$
(44,868,564
)
 
$
2,616,246
 
 
See accompanying notes.

 
F-4

 
STEELCLOUD, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
YEARS ENDED OCTOBER
31,
 
   
2007
   
2008
 
Operating activities
           
Net loss
 
$
(1,944,595
)
 
$
(2,759,562
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
               
Stock based compensation
   
343,426
     
368,032
 
Depreciation and amortization of property and equipment
   
578,920
     
482,294
 
Warrant based expense
   
40,000
     
55,550
 
Changes in operating assets and liabilities:
               
Accounts receivable, net
   
1,116,751
     
1,053,699
 
Inventory
   
6,674
     
656,475
 
Prepaid expenses and other assets
   
61,862
     
162,511
 
Deferred contract costs
   
133,741
     
83,753
 
Accounts payable
   
(850,017
)
   
(1,071,013
)
Accrued expenses
   
(224,490
)
   
(613,001
)
Unearned revenue
   
(72,021
)
   
(96,469
)
Net cash used in operating activities
   
(809,749
)
   
(1,677,731
)
Investing activities
               
Purchase of property and equipment
   
(223,494
)
   
(424,641
)
Net cash used in investing activities
   
(223,494
)
   
(424,641
)
Financing activities
               
Proceeds from exercise of common stock options
   
16,070
     
244,912
 
Payments on notes payable
   
(15,336
)
   
(12,843
)
Net cash provided by financing activities
   
734
     
232,069
 
                 
Net decrease in cash and cash equivalents
   
(1,032,509
)
   
(1,870,303
)
Cash and cash equivalents at beginning of year
   
3,655,163
     
2,622,654
 
Cash and cash equivalents at end of year
 
$
2,622,654
   
$
752,351
 
                 
Supplemental cash flow information
               
Interest paid
 
$
27,105
   
$
18,370
 
Income taxes paid
   
-
     
-
 

See accompanying notes
 
F-5

 
 
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 2007 AND 2008
 
1.
Organization
 
Founded in 1987, SteelCloud, Inc. (the “Company” or “SteelCloud”) is a leading manufacturer of embedded integrated computing systems solutions for the federal marketplace and Independent Software Vendors (“ISV(s)”).  The Company designs, manufactures and integrates specialized servers for federal market prime contractors (“federal integrators”) and Independent Software Vendors (ISVs) who use the specialized servers to deliver software application to their clients.
 
SteelCloud was originally incorporated as Dunn Computer Operating Company on July 27, 1987 under the laws of the Commonwealth of Virginia.  On February 26, 1998, Dunn Computer Corporation ("Dunn") was formed and incorporated in the Commonwealth of Virginia to become a holding company for several entities including Dunn Computer Operating Company.  The Company's subsidiary is International Data Products ("IDP"), acquired in May 1998.  On May 15, 2001, the shareholders approved an amendment to the Company’s articles of incorporation to change the corporate name from Dunn Computer Corporation to SteelCloud, Inc.  On December 31, 2003, Dunn was merged with and into SteelCloud.  On February 17, 2004, the Company acquired the assets of Asgard Holding, LLC ("Asgard").  In July of 2006, as part of its restructuring efforts, the Company closed its sales office and ceased all of its operations in Florida.  The Company’s former subsidiaries, Puerto Rico Industrial Manufacturing Operations Acquisition Corporation (“PRIMO”), and STMS Corporation (“STMS”), are inactive.
 
The accompanying financial statements include the accounts of the Company and its subsidiaries, International Data Products Corporation (“IDP”), Puerto Rico Industrial Manufacturing Operations Acquisition Corporation (“PRIMO”), and STMS Corporation (“STMS”).  All intercompany accounts and activity have been eliminated in the consolidation process.

Going Concern
 
The Company’s independent accountants stated in their report on the consolidated financial statements of the Company for the year ended October 31, 2008 that the Company has had recurring operating losses that raise substantial doubt about its ability to continue as a going concern.  For the year ended October 31, 2008, the Company incurred a net loss of $2,759,562 and had an accumulated deficit of $44,868,564 as of that date.  The consolidated financial statements do not include any adjustments related to the recovery and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event the Company cannot continue as a going concern.
 
The Company is dependent upon available cash and operating cash flow to meet its capital needs.  The Company is considering all strategic options to improve its liquidity and provide it with working capital to fund its continuing business operations which include equity offerings, assets sales or debt financing as alternatives to improve its cash needs however, there can be no assurance that it will be successful in negotiating agreeable financing terms or at all.  If adequate funds are not available or are not available on acceptable terms, the Company will likely not be able to take advantage of unanticipated opportunities, develop or enhance services or products, respond to competitive pressures, or continue as a going concern.  There is no assurance the Company will be successful in raising working capital as needed.  There are no assurances that the Company will have sufficient funds to execute its business plan, pay its operating expenses and obligations as they become due or generate positive operating results.
 
The Company is in the process of executing on several restructuring initiatives which have occurred from late 2008 to the present that include:
 
 
A reorganization in  November 2008 that included personnel terminations from all parts of the organization;

 
Sales of certain of the Company’s  leased assets to customers;

 
Elimination of all non-essential costs; and

 
Reduction of occupancy costs.

While the Company believes that these initiatives will better align its costs with its anticipated revenues going forward, it will take time for these initiatives to have an impact on its net revenue and operating income.
 
F-6

 
 
2.
Management Change, Restructuring and Operations
 
In August 2007, the Company’s Board of Directors appointed Robert Frick as the Company's Executive Director.  The appointment was part of the transition plan that the Company initiated in 2006 when Clifton Sink, was charged to lead the Company to a return to profitability and an increased share price.  Also in August 2007, the Company entered into an Employment Resignation Agreement with Cliff Sink pursuant to which Mr. Sink resigned his positions as President and Chief Executive Officer and Board Member of the Company effective November 1, 2007.  On November 1, 2007, Mr. Frick assumed all leadership responsibilities as President and Chief Executive Officer of the Company and was appointed to the Board of Directors to fill the vacancy created by Mr. Sink's resignation.  The financial impact of the Employment Resignation Agreement was recorded as a charge to operations of approximately $318,000 in the Company’s fiscal 2007 fourth quarter.

3.
Significant Accounting Policies
 
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Revenue Recognition
 
The Company recognizes revenue in accordance with Security and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, corrected copy (“SAB 104”).  Generally, SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable: and (4) collectability is reasonably assured.
 
Effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, the Company adopted Emerging Issues Task Force Issue No. 00-21, “ Revenue Arrangements with Multiple Deliverables ” (“EITF 00-21”).  Issued in December 2002 by the Financial Accounting Standards Board (“FASB”), EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities.  This Issue addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting.  This Issue does not change otherwise applicable revenue recognition criteria.  In the event the Company enters into a multiple element arrangement and there are undelivered elements as of the balance sheet date, the Company assesses whether the elements are separable and have determinable fair value in determining the amount of revenue to record.
 
The Company recognizes revenue associated with the resale of maintenance contracts on a net basis in accordance with Emerging Issues Task Force Issue No 99-19, “ Reporting Revenue Gross as a Principal versus Net as an Agent” (“EITF 99-19”),   and interpretations thereof.
 
Beginning in June 2006, the FASB Emerging Issues Task Force reached a consensus on Issue No. 06-03, "How Sales Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement" ("EITF 06-03").  The Company collects and remits sales and property taxes on products and services that it purchases and sells under its contracts with customers, and reports such amounts under the net method in its consolidated statements of operations.  Accordingly, there are no sales and property taxes included in gross revenue.
 
The Company derives its revenue from the following sources: product revenue, information technology support services, software license as a reseller and support revenue and software training and implementation revenue.
 
F-7

 
 
For product sales where title transfers upon shipment and risk of loss transfers to the customer, the Company generally recognizes revenue at the time of shipment.  For product sales where title and risk of loss transfers upon destination, the Company generally recognizes revenue when products reach their destination.  Revenue from hardware leased to customers under operating lease arrangements is recognized over the contract term.  When product and installation services that are not essential to the functionality of the product are sold as part of a bundled agreement, the fair value of the installation services, based on the price charged for the services when sold separately, is deferred and recognized when the services are performed.  The products sold are generally covered by a warranty for periods ranging from one to three years.  The Company accrues an estimated warranty reserve in the period of sale to provide for estimated costs to provide warranty services.
 
In October 2008 the Company began delivering its appliance solution specifically developed for Blackberry Enterprise Servers (“BES”).  This solution is a bundled hardware-software system and subject to American Institute of Certified Public Accountants’ Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” The software does not require significant modification and customization services.   The Company does not have vendor-specific objective evidence (“VSOE”) of fair value for its software.  Accordingly, when the software is sold in conjunction with the Company’s hardware, software revenue is recognized upon delivery of the hardware.

For services revenue under time and material contracts, the Company recognizes revenue as services are provided based on the hours of service at stated contractual rates.
 
The Company is a value-added solution provider for certain software products.  When resold software licenses, and related maintenance, customization and training services are all provided together to an individual customer the Company recognizes revenue for the arrangement after the Company has delivered the software license and the customer has approved all implementation and training services provided.  In instances where the Company only resells the software license and maintenance to the customer, the Company recognizes revenue after the customer has acknowledged and accepted delivery of the software.  The software manufacturer is responsible for providing software maintenance.  Accordingly, revenue from maintenance contracts is recognized upon delivery or acceptance, as the Company has no future obligation to provide the maintenance services and no right of return exists.
 
The Company incurs shipping and handling costs, which are recorded in cost of revenues.
 
Deferred revenue includes amounts received from customers for which revenue has not been recognized.  This generally results from certain customer contracts, ISV releases, warranties, hardware maintenance and support, and consulting services.  The deferred revenue associated with customer contracts and ISV releases represents payments received for milestones achieved prior to recognition of revenue.  This revenue will be recognized as products are shipped.  Revenues from warranties and hardware maintenance and support are recognized ratably over the service term selected by the customer.  Deferred service revenues from consulting are recognized as the services are performed.

Significant Customers
 
During fiscal year 2008, contracts with two customers, a Federal Integrator and a Commercial Customer, represented $9.5 million and $1.9 million respectively of our net revenues or 50% and 10% of total net revenues, respectively, for the fiscal year 2008.  Given the nature of the products manufactured by us as well as the delivery schedules established by our partners, revenue and accounts receivable concentration by any single customer will fluctuate from year to year.  Future revenues and results of operations could be adversely affected should these customers reduce their purchases, eliminate product lines or choose not to continue to buy products and services from us.

Equity-Based Compensation
 
The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “ Share-Based Payment ” (“SFAS 123R”) on November 1, 2005.  Issued in December 2004, SFAS 123R requires that the fair value compensation cost relating to share-based payment transactions be recognized in financial statements.  Under the provisions of SFAS 123R, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized over the employee’s requisite service period.  The fair value of the Company’s stock options and employee stock purchase plan (“ESPP”) awards was estimated using a Black-Scholes option valuation model.  This model requires the input of highly subjective assumptions and elections in adopting and implementing SFAS 123R, including expected stock price volatility and the estimated life of each award.  The fair value of equity-based awards is amortized over the vesting period of the award and the Company has elected to use the straight-line method for amortizing its stock option and ESPP awards.  The Company adopted the modified prospective transition method as provided by SFAS 123R and compensation costs for all awards granted after the date of adoption and the unvested portion of previously granted awards outstanding are measured at their estimated fair value.
 
F-8

 
 
Other Equity-Based Compensation
 
The Company accounts for equity instruments issued in exchange for the receipt of goods or services from other than employees and non-employee directors in accordance with SFAS No. 123R, and the conclusions reached by the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services” (“EITF 96-18”).  Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable.  The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services as defined by EITF 96-18.  Stock-based compensation recognized under SFAS No. 123 and EITF 96-18 for services from non-employees was $40,000 and $55,550 during the fiscal years ended October 31, 2007 and 2008, respectively.

Income Taxes
 
The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of certain assets and liabilities.  A valuation allowance is established, as necessary, to reduce deferred income tax assets to an amount expected to be realized in future periods.  The Company determines its valuation allowance pursuant to the provisions of SFAS No. 109, “Accounting for Income Taxes” , which requires the Company to weigh all positive and negative evidence including past operating results and forecasts of future taxable income.  In assessing the amount of the valuation allowance as of October 31, 2007 and 2008, the Company considered, in particular, its forecasted operations for the upcoming fiscal year, current backlog of orders, including those recently received, and other significant opportunities currently in its sales and marketing pipeline with a high probability of generating revenues.  Based upon this review, the Company will continue to fully reserve for all deferred tax assets as of October 31, 2008.
 
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), on November 1, 2007.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” .  It prescribes that a company should use a more-likely-than-not recognition threshold based on the technical merits of the tax position taken.  Tax positions that meet the more-likely-than-not recognition threshold should be measured as the largest amount of the tax benefits, determined on a cumulative probability basis, which is more likely than not to be realized upon effective settlement in the financial statements.  The Company’s unrecognized tax benefits at October 31, 2008 are approximately $61,000, which includes approximately $49,000 of unrecognized tax benefits for windfall tax benefits from stock options exercised that are not recognized under SFAS No. 123R.  During the year ended October 31, 2008, the Company increased its unrecognized tax benefits by approximately $100,000 due to windfall benefits from stock options exercised and additional exposures identified during the year.  The Company reduced its unrecognized tax benefits by approximately $654,000 by adjusting its NOL carryforwards and making an automatic change in accounting method.  Both of these adjustments were made with the filing of the Company’s income tax return for the tax year ended October 31, 2007.  The Company added $49,000 of unrecognized tax benefit associated with tax deductions for stock option and warrant exercises in excess of corresponding book charges per SFAS 123R.  The Company also added $51,000 of unrecognized tax benefit to account for revisions in supporting documentation.  The Company has a valuation allowance against the full amount of its net deferred tax assets and therefore the adoption of FIN 48 had no impact on its retained earnings.  The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is $0.
 
The Company conducts business in the U.S. and is subject to U.S. taxes.  As a result of our business activities, the Company files tax returns that are subject to examination by the respective federal and state tax authorities.  For income tax returns filed by us, the Company is no longer subject to U.S. federal, or state tax examination by tax authorities for years before the tax year ended October 31, 2005, although significant net operating loss carry forward tax attributes that were generated prior to the tax year ended October 31, 2005 may still be adjusted upon examination by tax authorities if they either have been or will be utilized.  The Company’s accounting policy is to recognize interest and penalties related to income tax matters in general and administrative expense.  The Company has $0 accrued for interest and penalties as of October 31, 2008.
 
Inventory
 
Inventory consists of materials and components used in the assembly of the Company’s products or maintained to support maintenance and warranty obligations and are stated at the lower of cost or market using actual costs on a first-in, first-out basis.  The Company maintains a perpetual inventory system and continuously records the quantity on-hand and actual cost for each product, including purchased components, subassemblies and finished goods.  The Company maintains the integrity of perpetual inventory records through periodic physical counts of quantities on hand.  Finished goods are reported as inventory until the point of title transfer to the customer.  Generally, title transfer is documented in the terms of sale.  When the terms of sale do not specify, the Company assumes title transfers when it completes physical transfer of the products to the freight carrier unless other customer practices prevail.
 
F-9

 
 
The Company periodically evaluates its inventory obsolescence reserve to ensure inventory is recorded at its net realizable value.  The Company’s policy is to assess the valuation of all inventories, including manufacturing raw materials, work-in-process, finished goods and spare parts in each reporting period.  In fiscal 2007, the Company adjusted the cost of excess and obsolete inventory to its net realizable value and released the obsolete or excess inventory reserve that was created in prior fiscal years.   Inherent in managements estimates of excess and obsolete inventory are management’s forecasts related to the Company’s future manufacturing schedules, customer demand, technological and/or market obsolescence and possible alternative uses.  If future customer demand or market conditions are less favorable than the Company’s projections, additional inventory write-downs may be required, and would be reflected in cost of sales in the period the revision is made.  For fiscal year ending 2007 and 2008 the Company incurred charges to expense of $86,000 and $186,000, respectively, associated with excess and obsolete inventory cost adjustments.

Warranty
 
Typically, the sale of the Company’s specialized servers includes providing parts and service warranty to customers as part of the overall price of the system.  The Company offers warranties for its systems that typically cover a period of 1 to 2 years and commence upon shipment of the system to the customer.  When appropriate, the Company records a reserve for estimated warranty expenses to cost of sales for each system upon revenue recognition.  The amount recorded is based on an analysis of historical activity.  All actual parts and labor costs incurred in subsequent periods are charged to the established reserves.
 
Actual warranty expenses are incurred on a system-by-system basis, and may differ from the Company’s original estimates.  While the Company periodically monitors the performance and cost of warranty activities, if actual costs incurred are different than its estimates, the Company may recognize adjustments to the reserve in the period in which those differences arise or are identified.
 
In addition to the provision of standard warranties, the Company offers customer-paid extended warranty services.  Revenues for extended maintenance and warranty services with a fixed payment amount are recognized on a straight-line basis over the term of the contract.

Research and Product Development Expenses
 
The Company expenses research and product development costs as incurred.  These costs consist primarily of labor charges associated with development of the Company’s commercial and federal products.  These research and development expenses amounted to approximately $662,000 and $702,000 during fiscal 2007 and 2008, respectively.
 
The Company invests in intellectual property in the form of proprietary products such as SteelWorks®.  SteelWorks® is an appliance management software that provides self-management and self-maintenance functionality to its appliance server offerings and allows its customers to quickly create a fully integrated turnkey appliance server.  The Company is working to expand SteelWorks® to address the needs of small to midsize businesses that require access to company data and attachments via their Blackberry handheld device.  This product is called SteelWorks® Mobile for the Blackberry Enterprise Server.  This mobile business solution makes a BlackBerry® connection to company data and attachments easy to install and easy to manage.  It is hardware and software in a low cost easy to install solution.

Cash and Cash Equivalents
 
The Company maintains demand deposit accounts with principally one financial institution.  At times, deposits exceed federally insured limits, but management does not consider this a significant concentration of credit risk based on the strength of the financial institution.  The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents.
 
Financial Instruments and Concentration of Credit Risk
 
The carrying value of the Company’s financial instruments including cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, notes payable and its line of credit approximates fair value.  Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and accounts receivable.  The cash is held by high credit quality financial institutions.  For accounts receivable, the Company performs ongoing credit evaluations of its customers’ financial condition and generally does not require collateral.  The Company maintains reserves for possible credit losses.  As of October 31, 2007 and 2008, the Company had allowance for doubtful account balances of approximately $40,000 and $36,000, respectively.  The carrying amount of the receivables approximates their fair value.
 
F-10

 
 
Advertising Expenses
 
The Company expenses advertising costs as incurred.  Advertising costs consisted of expenditures for tradeshows, website maintenance, radio advertisements, and other charges associated with the dissemination of important Company news and product features to the public.  Advertising expense amounted to approximately $125,000 and $298,000 during fiscal 2007 and 2008, respectively.

Earnings Per Share
 
The Company follows the provisions of Statement of Financial Accounting Standards No. 128, “ Earnings Per Share” which requires the Company to present basic and fully diluted earnings per share.  Basic earnings per share is based on the weighted average shares outstanding during the period.  Diluted earnings per share increases the shares used in the basic share calculation by the dilutive effect on net income from continuing operations of stock options and warrants.  The dilutive weighted average number of common shares outstanding excluded potential common shares from stock options of approximately 557,000 and 352,000 for the fiscal years ending October 31, 2007 and 2008 respectively.  These shares were excluded from the earnings per share calculation due to their antidilutive effect resulting from the loss from operations.

Recent Pronouncements
 
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “ Fair Value Measurements” (“SFAS No. 157”).  SFAS No. 157 provides a common definition of fair value and establishes a framework to make the measurement of fair value in U.S. Generally Accepted Accounting Principles more consistent and comparable.  SFAS No. 157 also requires expanded disclosures to provide information about the extent to which fair value is used to measure assets and liabilities, the methods and assumptions used to measure fair value, and the effect of fair value measures on earnings.  SFAS No. 157 is effective for fiscal years beginning after November 15, 2007.  Therefore, the Company is required to adopt SFAS No. 157 in the first quarter of 2009.  The Company does not believe the provisions of SFAS 157 will have a material impact on its financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS No. 159”).  SFAS No. 159 provides a choice to measure many financial instruments and certain other items at fair value and requires disclosures about the election of the fair value option.  Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings.  SFAS No. 159 is effective for fiscal years beginning after November 15, 2007.  Therefore, the Company is required to adopt SFAS No. 159 in the first quarter of 2009.  The Company does not believe the provisions of SFAS 159 will have a material impact on its financial statements.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised 2007) “Business Combinations” (“SFAS No. 141R”).  SFAS No. 141R, which replaces SFAS No. 141, requires that the acquisition method of accounting (which SFAS No. 141 called the “purchase method”) be used for all business combinations and for an acquirer to be identified for each business combination.  SFAS No. 141R also establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS No. 141R also requires that acquisition-related costs be recognized separately from the business combination.  SFAS No. 141R will apply prospectively to business combinations for which the acquisition date is after fiscal years beginning on or after December 15, 2008.  The Company is in the process of evaluating the effect, if any; the adoption of SFAS No. 141(R) will have on its financial statements.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements.  Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests.  This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008.  Earlier adoption is prohibited.  The Company is in the process of evaluating the effect, if any; the adoption of SFAS No. 160 will have on its financial statements.
 
In February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2 deferred the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.  The Company is in the process of evaluating the effect, if any; the adoption of FSP 157-2 will have on its financial statements.
 
F-11

 
 
In October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active” (“FSP 157-3”).  FSP 157-3 provides guidance for determining the fair value of a financial asset in an inactive market.  The Company is in the process of evaluating the effect, if any; the adoption of FSP 157-3 will have on its financial statements.
 
In May 2008, the FASB issued Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion.” (“APB 14-1”). APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate.  The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense.  APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period.  The Company in the process of evaluating the effect, if any; the adoption of APB 14-1 will have on its financial statements.

4.
Inventories
 
Inventories consisted of the following:
 
   
Years ended October 31,
 
   
2007
   
2008
 
Raw materials
 
$
758,154
   
$
344,898
 
Work in process
   
290,603
     
-
 
Finished goods
   
129,638
     
177,022
 
   
$
1,178,395
   
$
521,920
 
 
5.
Property and Equipment and Equipment on Lease
 
Property and equipment, including leasehold improvements, are stated at cost.  Property and equipment are depreciated using the straight-line method over the estimated useful lives ranging from one to five years.  Furniture and fixtures are depreciated over an estimated useful life of five years.  Leasehold improvements are amortized over the related lease term.
 
Any tenant allowances have been recorded as deferred rent and will be recognized as a reduction in rent expense over the applicable lease term.
 
Property and equipment consisted of the following:
 
   
Years ended October 31,
 
   
2007
   
2008
 
Computer and office equipment
 
$
637,063
   
$
296,215
 
Furniture and fixtures
   
38,530
     
38,530
 
Leasehold improvements
   
941,617
     
941,617
 
Other
   
230,279
     
112,668
 
     
1,847,489
     
1,389,030
 
Less accumulated depreciation and amortization
   
(1,045,201
)
   
(762,590
)
   
$
802,288
   
$
626,440
 
 
As discussed in Note 3 “Significant Accounting Policies” to the Notes to Consolidated Financial Statements, the Company owns equipment that is currently at customer sites under multiple operating lease agreements.  The cumulative cost of the equipment was $1,196,195 and $987,741 at October 31, 2007 and 2008 respectively.  The Company depreciates its leased property and equipment assets over the lesser of the related lease term or the useful life of the leased asset.  The related cumulative accumulated depreciation on the equipment was $872,291 and $545,642 at October 31, 2007 and 2008, respectively.
 
F-12

 
 
6.
Bank Lines of Credit and Notes Payable
 
Operating Line of Credit
 
On March 6, 2008, the Company renewed its bank line of credit that allows the Company to borrow an amount to the lesser of its collateralized cash on hand or $3.5 million.  The line of credit bears interest at the LIBOR Market Index rate plus 1.25%.  The line of credit is secured by all assets of the Company   and expires and is subject to renewal on March 31, 2009.  There were no outstanding borrowings on the line of credit at October 31, 2007 and 2008.
 
Notes Payable
 
Notes payable consisted of the following:
 
   
Years ended October 31,
 
   
2007
   
2008
 
Asset loans, bearing interest at annual interest rates from 0.0% to 4.9% due in aggregate monthly payments of $676 to expire in October 2010,  $348 and $359, that expired in July 2008 and July 2008, respectively, secured by certain assets of the Company
 
$
28,284
   
$
15,441
 
Less current portion
   
12,842
     
7,538
 
Notes payable, long-term
 
$
15,442
   
$
7,903
 
 
7.
Commitments
 
Operating Leases
 
The Company has executed non-cancelable leases for its headquarters and operations facilities.  The operating expenses associated with these facilities are included in the monthly rent expense.  The operations facilities lease expires in August 2014 and the headquarters lease expires in August 2009.  The Company recognizes rent holiday periods, scheduled rent increases and tenant improvement allowances on a straight-line basis over the lease term beginning with the commencement date of the lease.  Rent expense for office space under these leases, which is recorded on a straight-line basis over the life of each lease, was approximately $526,000 and $526,000 for the years ended October 31, 2007, and 2008, respectively.
 
 Additionally, the Company leases office equipment under non-cancelable operating leases expiring in September of 2009.  Total rental expense was $21,000 and $19,000 for the years ended October 31, 2007, and 2008, respectively.
 
Future minimum lease expenditures under all non-cancelable operating leases at October 31, 2008 are as follows:
 
2009
   
485,823
 
2010
   
268,991
 
2011
   
268,991
 
2012
   
268,991
 
2013
   
268,991
 
2014
   
224,160
 
Total
 
$
1,785,947
 

8.
Employment Agreements
 
 The Company has employment contracts for two key executives.  The agreements have terms of 3 years, expiring in August 2010 and October 2010, respectively, and automatically renew for additional one-year terms unless terminated by either the Company or the employee.  The aggregate annual minimum commitment under these agreements is approximately $475,000.
 
In August 2007, the Company entered into an employment agreement with Mr. Frick pursuant to which Mr. Frick will serve as the Company's President and Chief Executive Officer.  The term of the Employment Agreement is for three years, subject to certain termination provisions.  Also in August 2007, the Company entered into an employment resignation agreement with Cliff Sink pursuant to which Mr. Sink resigned his positions as President and Chief Executive Officer and Board Member of the Company effective November 1, 2007.
 
F-13

 
 
On October 31, 2007, the Company entered into an amended employment agreement with Kevin Murphy, the Company's current Chief Financial Officer, pursuant to which the terms of Mr. Murphy's employment agreement, dated June 8, 2004, were amended.  Under the terms of the Amended Agreement, Mr. Murphy shall continue to serve as the Chief Financial Officer of the Company for an additional thirty-six (36) months, commencing from the date of the Amended Agreement.  Mr. Murphy shall also serve as the Company's Executive Vice President.

9.
Stockholders’ Equity
 
Issuance of Unregistered Common Stock
 
On March 7, 2007, the Company issued 21,504 shares of our common stock to members of its Board of Directors.  The shares were valued at $0.99 based upon the closing price of the Company’s common stock on that date.  The total expense associated with this stock issuance was approximately $21,000.
 
Warrants
 
On September 14, 2007, the Company issued 100,000 warrants in exchange for investor relations services valued at approximately $56,000.  The warrants were issued at an exercise price of $1.28 and expires on September 14, 2012.  The fair value of the warrants was estimated in four equal tranches over a four-month vesting period using the Black- Scholes Option pricing fair value model.
 
The Company recognized $40,000 and $56,000 of sales and marketing expense associated with the issuance of warrants in exchange for services for the fiscal years ended October 31, 2007 and 2008 respectively.

10.
Stock Based Compensation
 
The Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “ Share-Based Payment ” (“SFAS No. 123R”) on November 1, 2005.  Issued in December 2004, SFAS No. 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements.  Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized over the employee’s requisite service period.  Stock-based compensation expense for the year ended October 31, 2007 and 2008 increased the Company’s basic and diluted loss per share by approximately $0.03 and $0.03, respectfully.  The estimated fair value of the Company’s stock-based awards is amortized on a straight-line basis over the awards’ vesting period.
 
A summary of the total stock-based compensation expense for the fiscal years ended October 31, 2007 and 2008 is as follows:
 
   
Year ended October 31,
 
   
2007
   
2008
 
Stock based expense allocation  
               
Cost of goods sold
 
$
-
   
$
24,000
 
General and administrative
   
286,000
     
294,000
 
Selling and marketing
   
-
     
29,000
 
Research and development
   
-
     
21,000
 
Severance and restructuring
   
57,000
     
-
 
Total stock compensation
 
$
343,000
   
$
368,000
 
 
 
F-14

 
 
Stock Option s
 
In January 1997, the Company adopted the 1997 Stock Option Plan (the “1997 Option Plan”).  Under the 1997 Option Plan, options to purchase a maximum of 2,650,000 shares of the Company’s common stock (subject to adjustments in the event of stock splits, stock dividends, recapitalizations and other capital adjustments) may be granted to employees, officers and directors of the Company and certain other persons who provide services to the Company.  In addition, the Company established the 2002 Stock Option Plan (the “2002 Option Plan”) in May 2002, which permits the Company to grant up to 750,000 options to employees, officers and directors of the Company and certain other persons who provide services to the Company under that Plan.  In May 2004, the Company’s shareholders approved an amendment to the Company’s 2002 Stock Option Plan to increase the number of options available under the plan from 750,000 to 1,500,000.  In May 2007, the Company’s shareholders approved the 2007 Stock Option Plan which permits the Company to grant up to 1,500,000 options to employees, officers and directors of the Company.  In May 2008, the Company’s shareholders approved an amendment to the Company’s 2007 Stock Option Plan creating the Amended 2007 Stock Option and Restricted Stock Plan (the “2007 Option and Restricted Stock Plan”).  The 2007 Stock Option and Restricted Stock Plan permits the Company to issue restricted stock awards to employees, officers and directors of the Company in addition to stock option awards.
 
As of October 31, 2008, there were no options available for future grants under the 1997 Option Plan, 158,710 options available for future grants under the 2002 Option Plan and 1,433,334 options and/or restricted stock awards available for future grants under the 2007 Option and Restricted Stock Plan.
 
Stock options are generally granted at the fair market value of its common stock at the date of grant.  The options vest ratably over a stated period of time not to exceed four years.  The contractual terms of the options are five or ten years.
 
A summary of the Company’s stock option activity as of October 31, 2008 is presented below:
 
   
Shares
   
Weighted-
Average
Exercise
Price
   
Weighted-
Average
Remaining
Contractual
Term (years)
 
Outstanding at October 31, 2007
   
1,786,000
   
$
1.13
     
3.17
 
Exercisable at October 31, 2007
   
686,625
   
$
1.60
     
2.33
 
Options granted
   
1,015,000
   
$
1.26
         
Options exercised
   
196,290
   
$
0.62
         
Options canceled or expired
   
622,210
   
$
1.13
         
Outstanding at October 31, 2008
   
1,982,500
   
$
1.24
     
3.42
 
Exercisable at October 31, 2008
   
879,584
   
$
1.36
     
2.51
 
 
The total options outstanding do not include 600,000 non-qualified options granted to the former IDP stockholders that are not included in the Option Plan.
 
The aggregate intrinsic value of options exercised during the fiscal years ended October 31, 2008 was approximately $93,000.  There were no options exercised during the fiscal year ended October 31, 2007.  The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the option.  There was no intrinsic value for options outstanding or options exercisable for year ended October 31, 2008.
 
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing fair value model.  This model is calculated based on exercise price, an expected annual dividend yield of 0% and several subjective assumptions, including the expected term and expected stock price volatility over the expected term.  The weighted-average grant-date fair value of options granted during the fiscal years ended October 31, 2007 and 2008 was $0.39 and $0.51, respectively.

 
F-15

 
 
The fair value of the Company’s Stock Option awards granted during the fiscal year ended October 31, 2007 were estimated based upon the following assumptions:
 
   
Years ended October 31,
 
   
2007
   
2008
 
Expected term (years) 1
 
0.42 to 3.50
   
3.25 to 3.70
 
Expected stock price volatility 2
 
58.2% to 64.2%
   
57.6% to 60.1%
 
Weighted average volatility 2
 
59.4%
   
58.80%
 
Risk-free interest rate 3
 
3.81% to 5.03%
   
2.03% to 2.92%
 
 
1 - Expected term.   For awards granted   prior to January 1, 2008 , expected term for the stock option awards was calculated based upon the simplified method set out in the SEC Staff Accounting Bulletin No. 107 (“ SAB 107”).  For awards granted after January 1, 2008 the Company continued to use the simplified method set out in SAB 107 for grants with two-year graded vesting for which it lacked sufficient historical share option exercise data in accordance with SEC Staff Accounting Bulletin No. 110.  Expected term for grants of one year cliff vesting stock option awards was calculated based upon historical share option exercises for which the Company did have sufficient historical data.
 
2 - Expected stock price volatility.   Expected stock price volatility for Stock Option awards is calculated using the weighted average of the Company’s historical volatility over the expected term of the award.
 
3 - Risk-free interest rate.   The risk-free interest rate is calculated based on the U.S Treasury yield curve on the grant date and the expected term of the award.
 
The Company modified the stock option agreement of one employee in fiscal year 2007.  As a result of the modification the Company recorded and additional $57,000 of stock-based compensation expense which was recorded as severance and restructuring expense.
 
A summary of the Company’s outstanding stock options at October 31, 2008 is as follows:
 
   
Options Outstanding
   
Options Exercisable
 
Range of Exercise Prices
 
Number
Outstanding
   
Weighted-
Average
Exercise
Price
   
Average
Remaining
Contractual
Life
   
Number
Outstanding
   
Weighted-
Average
Exercise
Price
 
                               
$0.55-$1.75
   
1,687,500
   
$
1.04
     
3.84
     
584,584
   
$
0.85
 
$1.76-$4.50
   
295,000
   
$
2.37
     
1.00
     
295,000
   
$
2.37
 
$0.55-$4.50
   
1,982,500
   
$
1.24
     
3.42
     
879,584
   
$
1.36
 
 
A summary of the status of the Company’s nonvested shares as of October 31, 2008, and changes during the fiscal year ended October 31, 2008, is presented below:
 
   
Shares
   
Weighted-
Average
Grant-Date
 
Nonvested at October 31, 2007
   
1,099,375
   
$
.046
 
Options granted
   
1,015,000
   
$
0.51
 
Options vested
   
(606,459
)
 
$
0.51
 
Options forfeited
   
(405,000
)
 
$
0.36
 
Nonvested at October 31, 2008
   
1,102,916
   
$
0.52
 
 
The Company recognized approximately $306,000 and $364,000 of stock-based compensation expense associated with stock option awards in the fiscal years ended October 31, 2007 and 2008, respectively.  As of October 31, 2008, unrecognized compensation expense related to nonvested stock options was $341,000 which is expected to be recognized through September 2010 over a weighted average period of 0.65 years.  The total fair value of shares vested during the years ended October 31, 2007, and 2008 was approximately $111,000 and $309,000 respectively.

 
F-16

 
 
Employee Stock Purchase Plan
 
In August, 1998, the Board adopted an Employee Stock Purchase Plan (“ESPP”) whereby employees may purchase Company stock through a payroll deduction plan.  The purchase price of the stock is the lower of 85% of the fair market value on the first or last day of the applicable six month offering period.  All employees, including officers but not directors, are eligible to participate in this plan.  Executive officers whose stock ownership of the Company exceeds five percent of the outstanding common stock are not eligible to participate in this plan.  In May 2007, the Company’s shareholders approved an amendment to the ESPP that increased the number of shares available for issuance from 300,000 to 600,000.
 
As of October 31, 2008, there were 267,765 options available for future grants under the Amended Stock Purchase Plan.
 
The fair value of each ESPP award is estimated on the date of the grant using the Black-Scholes option-pricing fair value model.  This model is calculated based on exercise price, an expected annual dividend yield of 0%, the expected term and a subjective assumption, expected stock price volatility over the expected term.  The Company used FASB Technical Bulletin No. 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option,” in determining the fair value of its ESPP awards.  The fair value of the Company’s ESPP awards granted during the fiscal year ended October 31, 2007 and 2008 was estimated based upon the following assumptions:
 
   
Years ended October 31,
 
   
2007
 
2008
 
Expected term (years) 1
 
0.50
   
0.50
 
Expected stock price volatility 2
 
67.9% to 83.6%
   
64.6
%
Risk-free interest rate 3
 
4.15% to 5.09%
   
1.53
%
 
1 - Expected term.   Expected term for ESPP awards is equal to the vesting period of the award.
 
2 - Expected stock price volatility.   Expected stock price volatility for ESPP awards is calculated using the weighted average of the Company’s historical volatility over the expected term of the award.
 
3 - Risk-free interest rate.   The risk-free interest rate is calculated based on the U.S. Treasury yield curve on the grant date and the expected term of the award.
 
The Company recognized approximately $4,000 of stock-based compensation expense associated with ESPP awards in the fiscal year ended October 31, 2008.  As of October 31, 2008, there was not any unrecognized compensation cost related to ESPP awards.
 
Restricted Stock Awards
 
Restricted stock awards are issued pursuant to the Company’s 2007 Stock Option and Restricted Stock Plan.  The Company’s restricted stock grants are accounted for as equity awards.  The expense is based on the price of the Company’s common stock, and is recognized on a straight-line basis over the requisite service period.  The Company’s restricted stock agreements do not contain any post-vesting restrictions.  The restricted stock award grants vest ratably over a two to three year period.
 
In September of 2007, the Company granted 180,000 shares of restricted stock.  The weighted average restricted stock grant fair value for fiscal year ended October 31, 2007 was $1.22.  None of the restricted stock award grants were vested or cancelled in the fiscal year ended October 31, 2007.  No restricted stock awards were granted during the fiscal year ended October 31, 2008.
 
A summary of the Company’s restricted stock award activity as of October 31 , 2008, and changes during the year then ended are as follows:
 
   
Shares
   
Weighted-
Average
Price/Share
   
Intrinsic
Value
Nonvested at October 31, 2007
   
180,000
   
$
1.22
     
Granted
   
-
   
$
-
     
Vested and issued
   
-
   
$
-
     
Cancelled
   
(113,334
)
 
$
1.24
     
Nonvested at October 31, 2008
   
66,666
   
$
1.20
 
39,332
 
The Company recognized $5,000 of stock-based compensation expense associated with restricted stock awards in the fiscal year ended October 31, 2007.  The Company did not recognize any stock-based compensation expense associated with restricted stock awards in the fiscal year ended October 31, 2008.  As of October 31, 2008, unrecognized compensation expense related to nonvested restricted stock awards was $75,000 which is expected to be recognized through September 2010 over a weighted average period of 1.36 years.

 
F-17

 

11.
Income Taxes
 
The provision for income taxes consists of the following:
 
   
Years ended October 31,
 
   
2007
   
2008
 
             
Current:
           
Federal
 
$
-
   
$
-
 
State
   
-
     
-
 
Deferred:
               
Federal
   
-
     
-
 
State
   
-
     
-
 
Total Provision for income taxes
 
$
-
   
$
-
 
 
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
 
Components of the Company’s net deferred tax asset balance are as follows:
 
   
Years ended October 31,
 
   
2007
   
2008
 
Deferred tax assets:
           
Current portion:
           
     Accrued expenses
 
$
114,633
   
$
61,390
 
     Asset reserves
   
14,498
     
72,156
 
     Other
   
3,452
     
31,674
 
Total current portion
   
132,583
     
165,220
 
Long term portion:
               
     Net operating loss carryforwards
   
15,357,452
     
16,318,196
 
     Deferred rent
   
65,603
     
58,768
 
Stock compensation
   
25,418
     
83,890
 
Investment reserve
   
55,009
     
55,252
 
     Depreciation
   
149,823
     
153,128
 
     Intangibles
   
827,821
     
757,560
 
Total long term portion
   
16,481,126
     
17,426,794
 
Deferred tax credit:
               
Valuation allowance
   
(16,613,709
)
   
(17,525,032
)
Total deferred tax asset
 
$
-
   
$
66,982
 
Deferred tax liabilities:
               
Current portion:
               
Change in accounting method
   
-
     
(33,491
)
Long term portion:
               
Change in accounting method
   
-
     
(33,491
)
Total deferred tax liability
 
$
-
   
$
(66,982
)
Net deferred tax asset
 
$
-
   
$
-
 
 
As of October 31, 2008, the Company had approximately $44.4 million in pretax net operating loss carryforwards reported on its tax returns, which expire between 2011 and 2028.  Of this amount, approximately 132,000 is unrecognized in the financial statement under SFAS 123R related to stock-based compensation that has not yet provided a benefit due to the Company’s net operating loss position.  The Company completed an analysis as of October 31, 2008 to determine whether there was any limitation on its net operating loss carryforwards under Section 382 of the Internal Revenue Code.  The Company determined that as of October 31, 2008, there was no limitation on its net operating loss carryforwards.

 
F-18

 
 
As of October 31, 2008, the Company has recorded a valuation allowance of approximately $17.5 million against the total deferred tax asset of $17.6 million.  The portion of the valuation allowance for which subsequently recognized benefits will increase stockholders’ equity was $0.3 million.  In assessing the amount of the valuation allowance as of October 31, 2008, we considered, in particular, our forecasted operations for the next fiscal year, taking into account our year to date results of operations, current backlog of orders, including those recently received, and other significant opportunities currently in our sales and marketing pipeline with a high probability of generating revenues.  Based upon this review, management determined that it is not more likely than not its net deferred tax assets will be realized and has provided a valuation allowance against all deferred tax assets as of October 31, 2008.
 
The reconciliation of income tax from the federal statutory rate of 34% is:
 
   
Years ended October 31,
 
   
2007
   
2008
 
             
Tax at statutory rates:
 
$
(661,162
)
 
$
(938,251
)
Non-deductible (income) expenses, net
   
8,141
     
8,866
 
Stock based compensation
   
92,718
     
73,784
 
Valuation allowance
   
(957,715
)
   
911,323
 
State income tax, net of federal benefit
   
(51,974
)
   
(78,216
)
Change in state tax rates
   
885,957
     
(73,201
)
True-up of net-operating loss
   
687,854
     
87,985
 
Other
   
(3,819
)
   
7,710
 
   
$
-
   
$
-
 
 
The Company conducts business in the U.S. and is subject to U.S. taxes.  As a result of its business activities, the Company files tax returns that are subject to examination by the respective federal and state tax authorities.  For income tax returns filed by the Company, the Company is no longer subject to U.S. federal, or state tax examination by tax authorities for years before the tax year ended October 31, 2005, although significant net operation loss carry forward tax attributes that were generated prior to the tax year ended October 31, 2005 may still be adjusted upon examination by tax authorities if they either have been or will be utilized.
 
As a result of the adoption of FIN 48, the Company identified unrecognized tax benefits of $615,674 related to tax positions taken in prior years that did not meet the more-likely-than-not recognition threshold based on the technical merits of the tax position taken.    We have a valuation allowance against the full amount of our net deferred tax assets and therefore, the adoption of FIN 48 had no impact on our retained earnings.
 
During the year ended October 31, 2008, we increased our unrecognized tax benefits by approximately $100,000 due to windfall benefits from stock options exercised and additional exposures identified during the year.  The Company reduced its unrecognized tax benefits by approximately $654,000 by adjusting its NOL carryforwards and making an automatic change in accounting method.  Both of these adjustments were made with the filing of the Company’s income tax return for the year ended October 31, 2007 in July 2008.
 
The change in the Company’s unrecognized tax benefits   related to FIN 48 and SFAS 123R are shown in the table below:

Balance at November 1, 2007
 
$
615,674
 
Additions related to current year tax positions
   
50,971
 
Additions related to current year windfall tax benefits not recognized under SFAS 123R
   
48,697
 
Reduction for tax positions related to the current year
   
-
 
Additions for tax positions of prior years
   
54
 
Reductions for tax positions of prior years
   
-
 
The amounts of decreases in the unrecognized tax benefits relating to settlements with taxing authorities
   
(654,251
)
Expiration of the statute of limitations for the assessment of taxes
   
-
 
Balance at October 31, 2008
 
$
61,145
 

The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is zero.   The Company does not expect its unrecognized tax benefit liability to change significantly over the next 12 months.   The Company’s accounting policy is to recognize interest and penalties related to income tax matters in general and administrative expense.  The Company has $0 accrued for interest and penalties as of October 31, 2008.

 
F-19

 
 
The exercise of stock options during the year ended October 31, 2008 generated an income tax deduction equal to the excess of the fair market value over the exercise price.  In accordance with SFAS No. 123R, the Company will not recognize a deferred tax asset with respect to the excess stock compensation deductions until those deductions actually reduce the Company’s income tax liability.  As such, the Company has not recorded a deferred tax asset related to the net operating losses of approximately $132,000 resulting from the exercise of these stock options in the accompanying financial statements.  At such time as the Company utilizes these net operating losses to reduce income tax payable, the tax benefit will be recorded as an increase in additional paid in capital.
 
12.
Earnings Per Share
 
Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period.  Diluted net income per share is computed, using the treasury stock method, as though all potential common shares that are dilutive were outstanding during the period.  The following table provides a reconciliation of the numerators and denominators of the basic and diluted computations for net (loss) per share.
 
   
Years ended October 31,
 
   
2007
   
2008
 
Numerator:
           
Net (loss) from operations
 
$
(1,944,595
)
 
$
(2,759,562
)
Denominator:
               
Denominator for basic earnings per share- weighted-average shares
   
14,286,551
     
14,493,215
 
Effect of dilutive securities:
               
Employee stock options
   
     
 
Warrants
   
     
 
Restricted stock
   
     
 
Dilutive potential common shares
   
     
 
Denominator for diluted earnings per share - adjusted weighted-average shares and assumed conversions
   
14,286,551
     
14,493,215
 
(Loss) per share from operations, basic and diluted
 
$
(0.14
)
 
$
(0.19
)

13.
Retirement Plans
 
401(k) Plans
 
The Company maintains a 401(k) (the “Plan”) for all current employees.  Under the Plan, employees are eligible to participate the first calendar day of the month following their first day of service and attaining the age of 18.  Employees could defer up to $15,500 of compensation in calendar year 2008.  Employee contributions are subject to Internal Revenue Service limitations.  All employees who contributed to the Plan are eligible to share in discretionary Company matching contributions.  The Company match is equal to 50% of employee contributions up to 6%.  Company contributions vest over 5 years.  In fiscal 2007 and 2008, the Company contributed approximately $88,000 and $72,000 to the participants of the 401(k), respectively.

14.
Segment Reporting
 
FASB Statement of Financial Accounting Standards No. 131, “ Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”) , establishes standards for reporting information about operating segments.  Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance.  SFAS No. 131 also establishes a quantitative threshold, whereby an enterprise should report separately information about operating segments if its reported revenue is 10% or more of the combined revenue of all reported operating segments.  The Company is organized on the basis of products and services.  The Company’s chief operating decision maker is the Company’s Chief Executive Officer.  While the Chief Executive Officer is apprised of a variety of financial metrics and information, the Chief Executive Officer makes decisions regarding how to allocate resources and assess performance based on a single operating unit.

 
F-20

 

15.
Related Party Transactions
 
An individual who is a director is also founding member of Gersten Savage LLP, who provides legal services to the Company.  During the fiscal years ended October 31, 2007 and 2008, the Company paid Gersten Savage LLP approximately $83,000 and $93,000, respectively, in legal fees.

16.
Commitments and Contingencies
 
The Company has accrued approximately $58,000 pertaining to non-income taxes and related interest and penalties that would have resulted from the failure to file the associated returns.  The Company intends to file the necessary returns to resolve the contingency.

17.
Subsequent Event
 
On January 12, 2009, the Company and Robert E. Frick, the Company’s Chief Executive Officer and President, mutually terminated Mr. Frick’s employment agreement as a result of Mr. Frick’s health.  Mr. Frick also resigned from the Board.
 
On January 14, 2009, the Board appointed Brian Hajost, a former executive officer of the Company, as the Company’s Chief Executive Officer, President and a member of the Board, and Kevin Murphy, the Company’s current Chief Financial Officer and Executive Vice President, as a member of the Board.

 
F-21

 

STEELCLOUD, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
October 31,
   
July 31,
 
   
2008
   
2009
 
  
       
(unaudited)
 
ASSETS
           
Current assets
           
Cash and cash equivalents
 
$
752,351
   
$
366,210
 
Accounts receivable, net
   
1,571,673
     
202,201
 
Inventory, net  of inventory reserve of $0
   
521,920
     
111,457
 
Prepaid expenses and other current assets
   
130,446
     
249,362
 
Deferred contract costs
   
-
     
38,140
 
Total current assets
   
2,976,390
     
967,370
 
                 
Property and equipment, net
   
626,440
     
477,643
 
Equipment on lease, net
   
442,099
     
1,818
 
Other assets
   
7,020
     
11,102
 
                 
Total assets
 
$
4,051,949
   
$
1,457,933
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities
               
Accounts payable
 
$
718,316
   
$
614,365
 
Accrued expenses
   
561,009
     
224,078
 
Notes payable, current
   
7,538
     
176,910
 
Unearned revenue
   
8,882
     
96
 
Total current liabilities
   
1,295,745
     
1,015,449
 
                 
Long-term liabilities
               
Notes payable, long-term
   
7,903
     
-
 
Other long-term
   
132,055
     
223,906
 
Total long-term liabilities
   
139,958
     
223,906
 
                 
Stockholders’ equity
               
Preferred stock, $.001 par value: 2,000,000 shares authorized, no shares issued and outstanding at October 31, 2008 and July 31, 2009
   
     
-
 
Common stock, $.001 par value: 50,000,000 shares authorized, 15,138,376 and 15,733,376 shares issued at October 31, 2008 and July 31, 2009, respectively
   
15,138
     
15,733
 
Additional paid in capital
   
50,902,172
     
51,256,046
 
Treasury stock, 400,000 shares at October 31, 2008 and July 31, 2009
   
(3,432,500
)
   
(3,432,500
)
Accumulated deficit
   
(44,868,564
)
   
(47,620,701
)
Total stockholders’ equity
   
2,616,246
     
218,578
 
                 
Total liabilities and stockholders’ equity
 
$
4,051,949
   
$
1,457,933
 

The Accompanying Notes Are an Integral Part of these Condensed Consolidated Financial Statements

 
F-22

 
 
STEELCLOUD, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 
   
Three Months Ended
July 31,
   
Nine Months Ended
July 31,
 
   
2008
   
2009
   
2008
   
2009
 
Revenues
                       
Products
 
$
57,228
   
$
88,518
   
$
1,863,083
   
$
188,319
 
Services
   
846,215
     
193,187
     
1,954,564
     
971,945
 
Total revenues
   
903,443
     
281,705
     
3,817,647
     
1,160,264
 
                                 
Cost of revenues
                               
Products
   
34,152
     
35,502
     
1,569,694
     
87,226
 
Services
   
675,966
     
126,997
     
1,596,479
     
740,555
 
Total cost of revenues
   
710,118
     
162,499
     
3,166,173
     
827,781
 
                                 
Gross profit
   
193,325
     
119,206
     
651,474
     
332,483
 
                                 
Selling and marketing
   
248,557
     
153,412
     
640,738
     
369,276
 
Research and product development
   
58,066
     
53,637
     
179,523
     
151,869
 
General and administrative
   
899,042
     
591,397
     
2,635,418
     
1,886,485
 
Severance and restructuring
   
-
     
-
     
-
     
73,205
 
                                 
Operating loss from continuing operations
   
(1,012,340
)
   
(679,240
)
   
(2,804,205
)
   
(2,148,352
)
                                 
Interest (expense) income, net
   
(5,825
)
   
(20,761
)
   
5,417
     
(20,351
)
                                 
Loss from continuing operations before income taxes
   
(1,018,165
)
   
(700,001
)
   
(2,798,788
)
   
(2,168,703
)
                                 
(Provision) benefit for income taxes
   
(312,096
)
   
-
     
393,596
     
-
 
                                 
Loss from continuing operations
   
(1,330,261
)
   
(700,001
)
   
(2,405,192
)
   
(2,168,703
)
                                 
Discontinued Operations:
                               
                                 
Loss from disposal of discontinued operations (net of applicable taxes of $0)
   
-
     
(19,565
)
   
-
     
(19,565
)
                                 
Income (loss) from discontinued operations, net of tax
   
388,575
     
(178,868
)
   
797,350
     
(563,869
)
                                 
Income (loss) from discontinued operations
   
388,575
     
(198,433
)
   
797,350
     
(583,434
)
                                 
Net loss
 
$
(941,686
)
 
$
(898,434
)
 
$
(1,607,842
)
 
$
(2,752,137
)
                                 
Basic and diluted (loss) income per share:
                               
Continuing Operations
 
$
(0.09
)
 
$
(0.05
)
 
$
(0.17
)
 
$
(0.14
)
Discontinued Operations
   
0.03
     
(0.01
)
   
0.06
     
(0.04
)
Net loss
 
$
(0.06
)
 
$
(0.06
)
 
$
(0.11
)
 
$
(0.18
)
                                 
Weighted–average shares outstanding:
                               
Basic
   
14,595,649
     
15,140,024
     
14,426,565
     
14,903,494
 
Diluted
   
14,595,649
     
15,140,024
     
14,426,565
     
14,903,494
 

The Accompanying Notes Are an Integral Part of these Condensed Consolidated Financial Statements

 
F-23

 
 
STEELCLOUD, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Nine Months Ended
July 31,
 
   
2008
   
2009
 
Operating activities
           
Net loss
 
$
(1,607,842
)
 
$
(2,752,137
)
                 
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
               
                 
Loss on disposal
   
-
     
19,565
 
Depreciation and amortization
   
370,931
     
228,795
 
Stock-based compensation
   
273,771
     
181,394
 
                 
Changes in operating assets and liabilities:
               
 Accounts receivable
   
1,514,098
     
1,362,354
 
 Inventory
   
1,527
     
174,533
 
 Deferred contract costs
   
52,217
     
(38,140
)
 Prepaid expenses and other assets
   
97,210
     
(122,998
)
 Accounts payable
   
(801,318
)
   
(103,951
)
 Unearned revenue
   
(59,285
)
   
(8,786
)
 Accrued expenses and other liabilities
   
(494,954
)
   
(146,358
)
Net cash  used in operating activities
   
(653,645
)
   
(1,205,729
)
                 
Investing activities
               
Sale of hardware integration business
   
-
     
150,000
 
(Purchase) sale of property and equipment
   
(382,362
)
   
347,544
 
Net cash (used in) provided by investing activities
   
(382,362
)
   
497,544
 
                 
Financing activities
               
Proceeds from exercise of common stock options
   
231,297
     
-
 
Proceeds from the sale of common stock
   
-
     
87,500
 
Proceeds from issuance of notes payable
   
-
     
250,000
 
Payments on notes payable
   
(11,012
)
   
(15,456
)
Net cash provided by (used in) financing activities
   
220,285
     
322,044
 
                 
Net decrease in cash and cash equivalents
   
(815,722
)
   
(386,141
)
                 
Cash and cash equivalents at beginning of period
   
2,622,654
     
752,351
 
Cash and cash equivalents at end of period
 
$
1,806,932
   
$
366,210
 
                 
Supplemental cash flow information
               
Interest paid
 
$
17,514
   
$
22,779
 
Income taxes paid
 
$
-
   
$
-
 
Non-cash investing and financing activities
 
$
-
   
$
85,575
 
 
The Accompanying Notes Are an Integral Part of these Condensed Consolidated Financial Statements

 
F-24

 

1.
Nature of Business and Basis of Presentation
 
Founded in 1987, SteelCloud, Inc. (the “Company” or “SteelCloud”) is a developer of mobility appliance software solutions primarily for the Research In Motion (“RIM”) Blackberry market.  SteelCloud designs and integrates its software into specialized server appliances targeted at Department of Defense (“DoD”), public sector, commercial, and remote hosting customers.
 
SteelCloud has developed SteelWorks® (“SteelWorks”), an appliance solution specifically for the BlackBerry Enterprise Server (“BES”).  SteelWorks was developed in conjunction with RIM.  SteelWorks is an integrated server appliance that enables virtually any size organization to implement the BES at a fraction of the cost, time, and resource commitment.  SteelCloud has filed for patent protection for the SteelWorks technology it created for the installation wizard, backup and restore features.  These patents are currently pending approval from the U.S. Patent and Trademark Office.  Additionally, SteelCloud developed SteelWorks FedMobile, a BlackBerry Enterprise Server appliance solution specifically for the DoD and other related agencies.  The SteelWorks FedMobile appliance builds upon SteelWorks by automating the application of the Defense Information Systems Agency’s and DoD’s Security Technical Implementation Guide (“STIG”) to the BES installation process.  The STIG mandates the policies in accordance with which the DoD and related agencies must operate their wireless communications.  As a result, SteelCloud’s FedMobile appliance allows DoD organizations to implement a STIG compliant BES infrastructure in a fraction of the time, cost, or resources necessary to what is otherwise a time intensive and manual STIG process.
 
In addition, the Company serves information technology end users directly, in both the public and private sectors, with services focused on IT-centric solutions.  SteelCloud’s IT centric solutions consist primarily of consulting and staff augmentation services.
 
As further discussed in Note 2, SteelCloud sold its Federal and ISV integration business on July 10, 2009.
 
The following unaudited condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and note disclosures, normally included in annual financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading.  It is suggested that these condensed financial statements be read in conjunction with the financial statements and the Footnotes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 31, 2008, filed with the SEC on February 12, 2009 and subsequently amended on March 4, 2009.
 
All adjustments that are of a normal recurring nature, in the opinion of management, which are necessary for a fair presentation for the periods presented have been reflected as required by Regulation S-X, Rule 10-01.
 
The Company’s consolidated financial statements for the three and nine months ended July 31, 2009 do not give effect to any adjustments to recorded amounts and their classifications, which would be necessary should the Company be unable to continue as a going concern and therefore, be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the consolidated financial statements.
 
Going Concern
 
SteelCloud has had recurring annual operating losses since its fiscal year ended October 31, 2004.  SteelCloud expects that such losses will continue at least through its fiscal year ending October 31, 2009.  The report of SteelCloud’s independent registered public accounting firm on SteelCloud’s consolidated financial statements for the fiscal year ended October 31, 2008 contains an explanatory paragraph regarding SteelCloud’s ability to continue as a going concern based upon its history of net losses.

 
F-25

 
 
SteelCloud is dependent upon available cash and operating cash flow to meet its capital needs.  SteelCloud is considering all strategic options to improve its liquidity and provide it with working capital to fund its continuing business operations, including equity offerings, asset sales or debt; however, there can be no assurance that SteelCloud will be successful in negotiating financing on terms agreeable to it or at all.  If adequate funds are not available or are not available on acceptable terms, SteelCloud will likely not be able to take advantage of unanticipated opportunities, develop or enhance services or products, respond to competitive pressures, or continue as a going concern.  There is no assurance that SteelCloud will be successful in raising working capital as needed.  Further, there are no assurances that SteelCloud will have sufficient funds to execute its business plan, pay its operating expenses and obligations as they become due or generate positive operating results or continue as a going concern.
 
SteelCloud is in the process of executing on several restructuring initiatives which include the following:
 
 
A reorganization that included personnel terminations from all parts of the organization;
     
 
Elimination of all non-essential costs;
     
 
Reduction of occupancy costs; and
     
 
Obtaining capital or bridge financing.

While SteelCloud believes that these initiatives will better align its costs with its anticipated revenues going forward, it will take time for these initiatives to have an impact on SteelCloud’s net revenue and operating income.  Furthermore, in reviewing its business strategies, SteelCloud’s management has determined that it is in the Company’s best interest to focus its resources and investments on its BlackBerry-related technologies and products.  The Company sold its hardware integration business on July 10, 2009 and is evaluating other strategic alternatives with regards to obtaining capital.
 
2.
Sale of Integration Business
 
On July 10, 2009, SteelCloud entered into an Asset Purchase Agreement (the “Agreement”) with NCS Technologies, Inc., a Virginia corporation (“NCS”), pursuant to which SteelCloud agreed to sell to NCS, and NCS agreed to purchase from SteelCloud, all of SteelCloud’s right, title and interest in and to the assets relating to SteelCloud’s computer integration business.   The purchase price was $475,000 of which $150,000 was paid as a deposit and the remaining $325,000 is an earn-out amount, which is payable from and to the extent of revenue NCS receives during the three-year period after the closing date from certain existing and prospective clients, at a rate equal to 15% of the net sales price received by NCS from such clients.  Any payments by NCS to SteelCloud are due on or before the tenth business day following the month in which NCS receives the payments from the client(s).
 
The Company has classified the hardware integration business as discontinued operations in the statements of operations for the three and nine month periods ending July 31, 2009 as well as all comparative periods presented.  Certain amounts have been reclassified in order to conform with the current period presentation.  Revenues from discontinued operations for the three and nine months ended July 31, 2009 were $374,621 and $1,581,036, respectively. Revenues from discontinued operations for the three and nine months ended July 31, 2008 were $1,661,029 and $12,937,931, respectively.    Current assets and current liabilities of discontinued operations at October, 31, 2008 were approximately $1.7 million and $575,000, respectively.  Total assets and total liabilities of discontinued operations on October 31, 2008 were approximately $2.1 million and $707,000, respectively.  No assets or liabilities remain as of July 31, 2009.

 
F-26

 

3.
Recently Issued Accounting Pronouncements
 
Effective November 1, 2008, the Company adopted the provisions of Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”) and Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”).  SFAS 157, which defines fair value, establishes a framework for measuring fair value in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), and expands disclosures about fair value measurements.  SFAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell asset or paid to transfer a liability in an orderly transaction between market participants.  SFAS 159 permits an entity to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period. For the three and nine month periods ended July 31, 2009, the Company has elected not to use the fair value option permitted under SFAS 159 for any of its financial assets and financial liabilities that are not already recorded at fair value.
 
In February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2 deferred the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.  The Company is in the process of evaluating the effect, if any, the adoption of FSP 157-2 will have on its financial statements.
 
In October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active” (“FSP 157-3”).  FSP 157-3 provides guidance for determining the fair value of a financial asset in an inactive market.  The Company adopted FSP 157-3 for the quarter ended July 31, 2009.  The adoption did not have a material impact on the financial statements.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised 2007) “Business Combinations” (“SFAS No. 141R”).  SFAS No. 141R, which replaces SFAS No. 141, requires that the acquisition method of accounting (which SFAS No. 141 called the “purchase method”) be used for all business combinations and for an acquirer to be identified for each business combination.  SFAS No. 141R also establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS No. 141R also requires that acquisition-related costs be recognized separately from the business combination.  SFAS No. 141R will apply prospectively to business combinations for which the acquisition date is after fiscal years beginning on or after December 15, 2008.  The Company is in the process of evaluating the effect, if any, the adoption of SFAS No. 141(R) will have on its financial statements , if the Company undertakes an acquisition.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements.  Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests.  This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008.  Earlier adoption is prohibited.  The Company is in the process of evaluating the effect, if any, the adoption of SFAS No. 160 will have on its financial statements.
 
In May 2008, The FASB issued Statement of Financial Accounting Standards No.162 “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), which reorganizes the GAAP hierarchy.  SFAS 162 is intended to improve financial reporting by providing a consistent framework for determining what accounting principles should be used in preparing GAAP financial statements.  With the issuance of SFAS 162, the FASB concluded that the GAAP hierarchy should be directed toward the entity and not its auditor, and reside in the accounting literature established by the FASB as opposed to the American Institute of Certified Accountants Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”.  SFAS 162 will become effective 60 days following the SEC approval of the Public Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles” and is not expected to have any impact on the Company’s financial statements.

 
F-27

 
 
In May 2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"). SFAS 165 is intended to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. SFAS 165 is effective for interim or annual financial periods ending after June 15, 2009.  The Company adopted SFAS 165 for the quarter ended July 31, 2009.  Except for the required disclosures, there was no material impact to the financial statements.
 
In April 2009, the FASB issued FSP FAS 107-1 and APB-28-1, “Interim Disclosure about Fair Value of Financial Instruments” (FSP 107-1/APB 28-1). FSP 107-1/APB 28-1 requires interim disclosures regarding the fair values of financial instruments that are within the scope of FAS 107, “Disclosures about the Fair Value of Financial Instruments”. Additionally, FSP107-1/APB28-1 requires disclosure of the methods and significant assumptions used to estimate the fair value of financial instruments on an interim basis as well as changes of the methods and significant assumptions from prior periods. FSP 107-1/APB 28-1 does not change the accounting treatment for these financial instruments and is effective for interim reporting periods ending after June 15, 2009. The Company has adopted FSP 107-1/APB 28-1 during the quarter ended July 31, 2009 and  disclosed the fair value of its financial instruments in the financial statements.

In April 2009, the FASB issued FSP 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairment” (FSP 115-2/124-2). FSP 115-2/124-2 amends the requirements for the recognition and measurement of other-than-temporary impairments for debt securities by modifying the pre-existing “intent and ability” indicator. Under FSP 115-2/124-2, an other-than-temporary impairment is triggered when there is an intent to sell the security, it is more likely than not the security will be required to be sold before recovery, or the security is not expected to recover the entire amortized cost basis of the security.  Additionally, FSP 115-2/124-2 changes the presentation of another-than-temporary impairment in the income statement for those impairments involving credit losses. The credit loss component will be recognized in earnings and the remainder of the impairment will be recorded in other comprehensive income. FSP 115-5 2/124-2 is effective for interim and annual reporting periods ending after June 15, 2009. The Company has adopted FSP 107-1/APB 28-1 during the quarter ended July 31, 2009.  The adoption did not have a material impact on the financial statements.

4.
Loan and Note Payable
 
On July 1, 2009, the Company entered into a Business Loan and Security Agreement with Caledonia Capital Corporation, a Delaware corporation (the “Lender”) pursuant to which the Lender agreed to lend to SteelCloud $250,000 in the form of a Secured Promissory Note (the “Note”) which was issued on July 1, 2009 (the “Issuance Date”).  The Note bears interest at a rate of 15% per annum, and is payable in quarterly installments commencing three months after the Issuance Date, or October 1, 2009.  The principal amount of the Note is due and payable in full on December 29, 2009 (the “Maturity Date”).  There are no penalties for early prepayment of the Note.
 
Additionally, in the event that the Company receives investments from one or more investors in one or more transactions in an aggregate amount in excess of $750,000, whether in the form of cash, negotiable or non-negotiable instruments or any form of payment in exchange for the issuance of any certificated or non-certificated security of the Company, whether in the form of debt or equity (an “Equity Raise”), at any time between the Issuance Date and the Maturity Date, then, the Company shall be required, within five (5) business days after the Equity Raise first exceeds $750,000, to curtail the accrued interest and outstanding principal balance of the Note by an amount equal to the amount by which the Equity Raise then exceeds $750,000 (but in no event by more than the then outstanding principal balance and interest accrued on the Note). Until delivery of such funds to the Lender, all such funds shall be deemed held in trust by the Company for and on behalf of the Lender.  All funds that the Company delivers to the Lender from the Equity Raise shall be deemed prepayments of the Note.

Pursuant to the Agreement and the Note, the Company’s obligations thereunder are secured by a first priority lien in and to all of SteelCloud’s intellectual property rights, title and interest in and to the SteelWorks® Mobile integrated server appliance software.
 
F-28

 
 
As an inducement to the Lender to make the loan to the Company, the Company issued to the Lender a warrant to purchase up to 625,000 shares of SteelCloud’s common stock, par value $0.001 per share.  The Warrant is exercisable for four years at an exercise price of $0.15 per share.  The Company determined the fair value of these warrants utilizing the Black-Sholes method.  The fair value of these warrants at issuance date was approximately $130,000.

The loan amount of $250,000 was allocated between the note payable and warrants based upon their relative fair market values. The difference between the face amount of the note of $250,000 and the note payable amount of $164,425 recorded at date of execution represents the debt discount of $85,575 which will be amortized over the life of the note.  To determine the fair value of the warrants, management used the Black-Scholes Model which includes assumptions on the period end stock price, historical stock volatility, risk free interest rate and term of warrants.
The fair value of the loan at July 31, 2009 was approximately $180,035.

5.
Equity
 
Investment
 
On June 15, 2009, the Company sold an aggregate of 350,000 shares of its common stock, $.001 par value, to its seven directors, for aggregate cash proceeds of $87,500.  The shares of common stock were sold at $0.25 per share, or $.01 higher than the closing price of the common stock on the date of sale.  Each share of common stock was accompanied by one warrant to purchase one additional share of common stock (the “Warrant”).  The Warrants are exercisable for five years from the date of issuance at an exercise price of $0.25 per share.  The seven directors have entered into a lock-up agreement with the Company, restricting their ability to exercise the warrants until the Company receives shareholder approval for the issuance of the Warrants.
 
Stock-based Compensation
 
The Company recognized approximately $53,000 and $110,000 of stock-based compensation expense during the three month periods ended July 31, 2009 and 2008, respectively.  Stock-based compensation expense for the three-month period ended July 31, 2009 and 2008 increased the Company’s basic and diluted loss per share by $0.01.  The Company recognized approximately $181,000 and $274,000 of stock-based compensation expense during the nine month periods ended July 31, 2009 and 2008, respectively.  Stock-based compensation expense for the nine month periods ended July 31, 2009 and 2008 decreased the Company’s basic and diluted loss per share by $0.01.  The estimated fair value of the Company’s stock-based awards is amortized on a straight-line basis over the awards’ original service period.
 
F-29

 
 
On February 28, 2009, the Company entered into an Employment Agreement Amendment with Kevin Murphy, the Company’s current Chief Financial Officer in which Mr. Murphy agreed to forfeit options to purchase an aggregate of 225,000 shares of the Company’s common stock, $0.001 par value per share and instead entered into separate Incentive Stock Option and Restricted Stock agreements with the Company.  Pursuant to the Incentive Stock Option agreement Mr. Murphy was granted an option to purchase 150,000 shares of common stock, which shall vest quarterly in arrears over a one year period.  Pursuant to the Restricted Stock Agreement with the Company, Mr. Murphy shall receive 90,000 shares of restricted stock which shall vest ratably over 12 months, or 7,500 shares per month, so long as Mr. Murphy is employed by the Company on the last day of each month.  The cancellation and reissuance of equity awards to Mr. Murphy was treated as a modification of Mr. Murphy’s forfeited awards in accordance with SFAS No. 123R.
 
Restricted Stock
 
During the nine month period ended July 31, 2009, the Company granted 546,000 shares of restricted common stock pursuant to its Amended 2007 Stock Option and Restricted Stock Plan.  The Company did not grant any restricted stock for the three month periods ended July 31, 2009 and July 31, 2008 or the nine month period ended July 31, 2008.  The fair value of the restricted stock was determined based upon the closing stock price on the date of grant.  The restricted stock grants vest quarterly over a one year period.  As of July 31, 2009, 150,000 of the restricted stock grants vested.  The Company’s restricted stock grants are accounted for as equity awards and are recognized on a straight-line basis over the requisite service period.  The Company’s restricted stock agreements do not contain any post-vesting restrictions.  For the three and nine month periods ended July 31, 2009, the Company recognized $32,000 and $109,000, respectively, of stock-based compensation expense associated with these restricted stock awards.
 
Additional Paid-in Capital
 
Additional paid in capital has increased approximately $354,000 during the nine month period ended July 31, 2009  due to $181,000 of stock based compensation expense, $86,000 due to the issuance of warrants and $87,500 due to sales of common stock.
 
6.
Inventories
 
Inventories consisted of the following:
 
   
October 31,
   
July 31,
 
   
2008
   
2009
 
Raw materials
 
$
344,898
   
$
80,451
 
Work in process
   
-
     
-
 
Finished goods
   
177,022
     
31,006
 
   
$
521,920
   
$
111,457
 
 
F-30

 
 
7.
Earnings per Share
 
Basic earnings per share is based on the weighted average number of common shares outstanding during the period and is calculated by dividing the net earnings (loss) by the weighted average number of common shares outstanding. Diluted earnings per share is based on the weighted average number of common shares outstanding plus common stock equivalents associated with stock options and warrants and is calculated by dividing net earnings by the weighted average number of common shares outstanding used in the basic earnings per share calculation plus the common stock equivalent of stock options and warrants. The dilutive weighted average number of common stock outstanding excluded potential common stock from stock options and warrants of approximately 128,000 and 340,000 for the three month periods ended July 31, 2009 and 2008, respectively, and 128,000 and 404,000 for the nine month periods ended July 31, 2009 and 2008, respectively.  These shares were excluded from the earnings per share calculation due to their antidilutive effect resulting from the loss from operations.
 
8.
Income Tax
 
In the three and nine month periods ended July 31, 2008, the Company recorded an income tax benefit attributable to discontinued operations of $(312,096) and income tax expense from discontinued operations of $393,596.  In accordance with intra-period tax allocation rules the Company recorded a corresponding income tax expense on continuing operations $312,396 and income tax benefit on continuing operations of $(393,596) for the three and nine month periods ended July 31, 2008.  The income tax benefit from discontinued operations in the three month period ended July 31, 2008 was due to a significant decrease in the Company’s estimated taxable income for discontinued operations for the fiscal year ended October 31, 2008.
 
On November 1, 2007, the Company adopted FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues.  The Company has an unrecognized tax benefit of approximately $61,000 and does not expect any of this amount to reverse in the next twelve months.  The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is $0.
 
The Company conducts business in the U.S. and is subject to tax in that jurisdiction. As a result of its business activities, the Company files tax returns that are subject to examination by the respective federal and state tax authorities. For income tax returns filed by the Company, the Company is no longer subject to U.S. federal, or state tax examination by tax authorities for years before October 31, 2006, although carryforward tax attributes that were generated prior to October 31, 2006 may still be adjusted upon examination by tax authorities if they either have been or will be utilized.  The Company’s accounting policy is to recognize interest and penalties related to income tax matters in general and administrative expense. The Company had $0 accrued for   interest and penalties as of July 31, 2009.
 
9.
Commitments and Contingencies
 
The Company has accrued approximately $51,000 pertaining to payroll taxes and related interest resulting from the failure to report certain employee reimbursements as compensation.  The Company has filed the necessary returns.  The Company has retained the contingency to account for additional taxes, interest and penalties that may be assessed.
 
10.
Subsequent Events
 
The Company has evaluated subsequent events through September 14, 2009.

NASDAQ Listing  

On March 23, 2009, the Company received notice, under NASDAQ Marketplace Rule 4310(c)(3), that its common stock was subject to potential delisting from the NASDAQ Capital Market because the Company did not meet the criteria of NASDAQ Listing Rule 5550(b) (the “Rule”) and did not have a minimum of $2,500,000 in stockholders’ equity, $35,000,000 market value of listed securities, or $500,000 of net income from continuing operations for the most recently completed fiscal year or two of the three most recently completed fiscal years.  The Company provided NASDAQ with a specific plan of how it intended to achieve and sustain compliance with all the NASDAQ Capital Market listing requirements, including a time frame for completion of such plan.  The plan included the following two strategies: (i) increasing our stockholders equity in excess of the minimum $2,500,000 requirement by raising between $3,000,000 to $4,000,000 through an equity transaction; and (ii) identifying a strategic partner interested in either merging with or acquiring the Company.  On April 28, 2009 the Company received notice from NASDAQ indicating that NASDAQ had granted the Company’s request for an extension of time to regain compliance with the Rule.  Pursuant to the terms of the extension, the Company was required to: (a) on or before July 6, 2009, complete an equity transaction or a merger and/or acquisition, and (b) make appropriate disclosures to the SEC and NASDAQ on a Form 8-K.  The Company was not able to complete an equity transaction or a merger and/or acquisition by July 6, 2009, and on July 8, 2009, the Company received written notification from NASDAQ stating that it did not meet the terms of the extension, and that, as a result, the Company’s common stock would be subject to suspension from trading at the opening of business on July 17, 2009, and delisted from NASDAQ.  The notification stated that a hearing request made to the NASDAQ Hearing Panel (the “Panel”) to appeal the determination would stay the delisting of the Company’s common stock pending the Panel’s decision.  On July 15, 2009, the Company requested a hearing to appeal the determination before the Panel and to present its plan for regaining compliance with the Rule (the “Appeal”).  On August 4, 2009, the Company received notice that NASDAQ received its Appeal, and that the delisting action has been stayed, pending a final written decision by the Panel after an oral/written hearing (the “Hearing”), where the Company was required to demonstrate its ability to regain and sustain compliance with the Rule.  The Hearing was held at 11:00 A.M. EST, on September 3, 2009. The Company presented its updated plan of compliance to the Panel on that date.  The Company is awaiting response from the Panel regarding the determination of its appeal.  There can be no assurance that the Panel will grant the Company’s request for continued listing.
 
F-31

 
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements contained herein may constitute forward-looking statements within the meaning of  Section 27A of the Securities Act, Section 21E of the Exchange Act and the Private Securities Litigation Reform Act of 1995.  Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements.  Factors that could cause actual results to differ materially include, but are not limited to, our ability to obtain financing in the short term, risks associated with the integration of businesses following an acquisition, concentration of revenue from one source, competitors with broader product lines and greater resources, emergence into new markets, the termination of any of our significant contracts or partnerships, our inability to maintain working capital requirements to fund future operations or our inability to attract and retain highly qualified management, technical and sales personnel.

You should read the following discussion and analysis in conjunction with the audited Financial Statements and Footnotes attached thereto, and the other financial information appearing elsewhere in this prospectus.

OVERVIEW
 
Founded in 1987, we are a developer of mobility appliance software solutions primarily for the Research In Motion® (“RIM”) BlackBerry market. We design and integrate our software into specialized server appliances targeted at the Federal Government and in particular the Department of Defense (“DoD”), public sector, commercial, and remote hosting customers.
 
BlackBerry® Enterprise Server Solution (SteelWorks® Mobile)
 
We developed SteelWorks® Mobile (“SteelWorks Mobile”), an appliance solution specifically for the BlackBerry Enterprise Server (“BES”).  SteelWorks Mobile was developed in conjunction with RIM.   SteelWorks Mobile is an integrated server appliance that enables virtually any size organization to implement the BES at a fraction of the cost, time, and resource commitment.  We have filed for patent protection for the SteelWorks Mobile technology we created for the installation wizard, backup and restore features.  These patents are currently pending approval from the U.S. Patent and Trademark Office.
 
In addition, we developed SteelWorks FedMobile, our BlackBerry Enterprise Server appliance solution specifically for the DoD and other related agencies.  The SteelWorks FedMobile appliance builds upon SteelWorks Mobile by automating the application of the Defense Information Systems Agency’s and DoD’s Security Technical Implementation Guide (“STIG”) to the BES installation process.  The STIG mandates the policies for which the DoD and related agencies must operate their wireless communications.  As a result, our FedMobile appliance allows DoD organizations to implement a STIG compliant BES infrastructure in a fraction of the time, cost, or resources necessary to what is otherwise a time intensive and manual STIG process.
 
Federal Systems Integrator/Independent Software Vendors
 
Until July 10, 2009, federal integrators outsourced their specialized requirements to us and considered us to be an integral part of their product and service delivery capability.  We designed and manufactured specialized embedded and integrated computing systems that were the foundation upon which the integrators developed and delivered their application software.
 
On July 10, 2009, we entered into an Asset Purchase Agreement, referred to as the “Agreement”, with NCS Technologies, Inc., a Virginia corporation, referred to as “NCS”, pursuant to which we agreed to sell to NCS, and NCS agreed to purchase from us, all of our right, title and interest in and to the assets relating to our computer integration business (comprised of our Federal Systems Integrator business and the Independent Software Vendors business).  The purchase price was $475,000, subject to post-closing adjustments as set forth in the Agreement.  Please see “Liquidity and Capital Resources” at page 32 for additional information.
 
Professional Services
 
We provide information technology (“IT”) consulting and contract staffing solutions for our commercial and government clients.  Our consultants are subject matter experts in network infrastructure complexities and security technologies including firewalls, content inspection, intrusion detection, spam and vulnerability scanning.  For our contract staffing solutions, our personnel function as “virtual” employees, performing work directly under the auspices of client management and serve as an extension of the client’s in-house staff resources.
 
22

 
 
RESULTS OF OPERATIONS

Fiscal Year Ended October 31, 2008 Compared To Fiscal Year Ended October 31, 2007 :

Net Revenue Discussion:
 
The following table summarizes our net revenue for the fiscal years ended October 31, 2007 and 2008 in dollars and as a percentage of net revenues.
 
   
Fiscal Year Ended October 31,
 
   
2007
   
2008
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Products
 
$
21,421,129
     
91.87
%
 
$
16,333,600
     
85.88
%
 
$
(5,087,529
)
   
(23.75
)%
Services
   
1,894,551
     
8.13
%
   
2,685,296
     
14.12
%
   
790,745
     
41.74
%
                                                 
Total net revenues
 
$
23,315,680
     
100.00
%
 
$
19,018,896
     
100.00
%
 
$
(4,296,784
)
   
(18.43
)%
 
The decrease in product revenue is primarily attributable to a decrease in our integrator business as a result of certain program delays and a reduction in purchases from our ISV customers.  The current economic downturn has prolonged the award of the integrator programs, as well as affected the amount purchased by our ISV customers.  We plan for revenue to grow as we continue to focus our resources on our chosen markets and our end user solution line of products.
 
The increase in service revenue is the result of to new client acquisitions as a result of the Company expanding its service offerings.  We expect service revenue to continue to grow in the future.

Gross Profit Discussion:

The following table summarizes our gross profit for the fiscal years ended October 31, 2007 and 2008 in dollars, as a percentage of gross profit and as a percentage of net revenues.
 
   
Fiscal Year Ended October 31,
 
   
2007
   
2008
   
Increase (decrease)
 
         
% of
Gross
         
% of
Gross
             
   
Dollars
   
Profit
   
Dollars
   
Profit
   
Dollars
   
Percentage
 
                                     
Products
 
$
4,356,274
     
88.09
%
 
$
2,569,499
     
83.02
%
 
$
(1,786,775
)
   
(41.02
)%
Products – GP%
   
20.34
%
           
15.73
%
                       
                                                 
Services
   
588,947
     
11.91
%
   
525,543
     
16.98
%
   
(63,404
)
   
(10.77
)%
Services – GP%
   
31.09
%
           
19.57
%
                       
                                                 
Total gross profit
 
$
4,945,221
     
100.00
%
 
$
3,095,042
     
100.00
%
 
$
(1,850,179
)
   
(37.41
)%
Total – GP%
   
21.21
%
           
16.27
%
                       
 
The decrease in product gross margin percentage is largely attributable to maintaining our production facility at normal capacity in anticipation of receiving the delayed integrator contracts.  We expect gross profit as a percentage of net revenues to continue to fluctuate from quarter to quarter as product lines expand, new products are brought to market, start up costs are incurred and new discounts, incentives and rebates become available.
 
23

 
 
The decrease in services gross profit percentage is attributable to our incurring costs associated with obtaining new clients.  We have been successful in expanding our customer base during fiscal year 2008 as compared to fiscal year 2007, which contributed to an increase in services revenue.  We will continue to incur lower initial margins as we expand into new markets and increase our service offerings.  We anticipate gross profit for services to fluctuate in future quarters as we continue to realign and grow the services division.

Operating Expense Discussion:
 
The following table summarizes our operating expenses for the fiscal years ended October 31, 2007 and 2008 in dollars and as a percentage of net revenues.
 
   
Fiscal Year Ended October 31,
 
   
2007
   
2008
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Selling and marketing
 
$
1,614,817
     
6.93
%
 
$
1,259,416
     
6.62
%
 
$
(355,401
)
   
(22.01
)%
General and administrative
   
4,315,254
     
18.51
%
   
3,901,499
     
20.51
%
   
(413,755
)
   
(9.59
)%
Research and product development
   
661,550
     
2.84
%
   
702,231
     
3.69
%
   
40,681
     
6.15
%
Severance and restructuring costs
   
317,548
     
1.36
%
   
-
     
-
     
(317,548
)
   
(100.00
)%
Total operating expenses
 
$
6,909,169
     
29.63
%
 
$
5,863,146
     
30.83
%
 
$
(1,046,023
)
   
(15.14
)%
 
The decrease in selling and marketing expenses is the result of aligning expenses to our current and future business models during fiscal year 2008.  During fiscal year 2008, marketing activities, specifically in the area of marketing campaigns and tradeshows, and expense associated with selling and marketing personnel decreased as a result of our cost cutting efforts.  Selling and marketing expenses have been kept in line with projected revenue.  We will continue to evaluate our costs relative to our revenues and gross margins.
 
General and administrative expenses decreased as a result of cost cutting efforts incurred during fiscal year 2008 as compared to fiscal year 2007.  The cost reductions continue to include curtailing expenses related to non-revenue generating activities, terminating non-essential employees, and instituting across the board departmental expense reductions.  Our cost reductions were offset by approximately $202,000 of fees incurred related to us implementing FIN 48 for the fiscal year 2008.  Although we continue to manage our costs relative to our revenues and gross margins, additional resources may be required in order to invest in our federal integrator, ISV, and SteelWorks® Mobile business.
 
Research and development expenses have remained consistent as we continue to make investments in our SteelWorks® mobile products as well as bringing new products to market.  We continue to make investments in research and product development to maintain and enhance current products.  We believe that research and product development expenses will fluctuate from quarter to quarter as new products are being developed and introduced into the marketplace.
 
The decrease in severance and restructuring charges for the twelve months ended October 31, 2008 compared to the twelve months ended October 31, 2007 is the result of incurring approximately $318,000 of non recurring costs associated with the employment resignation agreement entered into with our previous CEO during fiscal year 2007.

 
24

 
Other Income (Expense) Discussion:
 
The following table summarizes our other income (expense) for the fiscal years ended October 31, 2007 and 2008 in dollars and as a percentage of net revenues.
 
   
Fiscal Year Ended October 31,
 
   
2007
   
2008
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Interest income net
 
$
19,353
     
0.08
%
 
$
8,542
     
0.04
%
 
$
(10,811
)
   
(55.86
)%
                                                 
Total interest income, net
 
$
19,353
     
0.08
%
 
$
8,542
     
0.04
%
 
$
(10,811
)
   
(55.86
)%
 
The decrease in net interest expense for fiscal year 2008 is due to lower interest income attributable to lower cash balances and interest rates earned over the twelve months ended October 31, 2008 compared to the same period in fiscal year 2007.
 
Net (Loss) Discussion:
 
The following table summarizes our net (loss) for the fiscal years ended October 31, 2007 and 2008 in dollars and as a percentage of net revenues.
 
   
Fiscal Year Ended October 31,
 
   
2007
   
2008
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Net (loss)
 
$
(1,944,595
)
   
8.34
%
 
$
(2,759,562
)
   
14.51
%
 
$
814,967
     
41.91
%
 
The increase in net loss for the twelve months ended October 31, 2008 as compared to the same period in fiscal 2007 is the result of lower revenues and corresponding gross margin dollars.  We have instituted a conservative revenue and cost of goods sold plan to minimize our net loss in fiscal year 2009.  This plan also includes company-wide personnel terminations and the elimination of all non-essential costs to reduce our operating expenses for the upcoming year.

For the three months ended July 31, 2009 compared to the three months ended July 31, 2008 :
 
Net Revenue Discussion:
 
The following table summarizes our net revenue for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Products
 
$
57,228
     
6.33
%
 
$
88,518
     
31.42
%
 
$
31,290
     
54.68
%
Services
   
846,215
     
93.67
%
   
193,187
     
68.58
%
   
(653,028
)
   
(77.17
)%
Total  net revenues
 
$
903,443
     
100.00
%
 
$
281,705
     
100.00
%
 
$
(621,738
)
   
(68.82
)%

The increase in product revenue is primarily attributable to the introduction of our new SteelWorks Mobile appliances.  Fiscal year 2008 product revenues relate to other technology products that are not related to the SteelWorks Mobile appliances.  Accordingly, we experienced 100% growth in this appliance product in fiscal 2009.  The SteelWorks Mobile appliance was launched in early fiscal 2009 and we anticipate sales will increase in future periods as demand for the product increases.
 
The decrease in service revenue for the three-month period ended July 31, 2009 as compared to the same period in fiscal 2008 is the result of our completing a fiscal 2008 large services contract in December 2008.  We anticipate service revenues will continue to fluctuate in future periods given the current economic environment.
 
Gross Profit Discussion:
 
The following table summarizes our gross profit for the three months ended July 31, 2008 and 2009 in dollars, as a percentage of gross profit and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of
Gross
         
% of
Gross
             
   
Dollars
   
Profit
   
Dollars
   
Profit
   
Dollars
   
Percentage
 
                                     
Products
 
$
23,076
     
11.94
%
 
$
53,016
     
44.47
%
 
$
29,940
     
129.75
%
Products - GM%
   
40.32
%
           
59.89
%
                       
                                                 
Services
   
170,249
     
88.06
%
   
66,190
     
55.53
%
   
(104,059
)
   
(61.12
)%
Services – GM%
   
20.12
%
           
34.26
%
                       
                                                 
Total gross profit
 
$
193,325
     
100.00
%
 
$
119,206
     
100.00
%
 
$
(74,119
)
   
(38.34
)%
Total – GM%
   
21.40
%
           
42.32
%
                       
 
25

 
 
The increase in product gross profit percentage for the three months ended July 31, 2009 as compared to the same period in fiscal 2008 is primarily the result of our new SteelWorks Mobile appliance.  Given the amount of intellectual property and software created and developed for this product, we will achieve significantly higher product gross margins as compared to the hardware integration business.  We anticipate that the gross product margins will fluctuate from quarter to quarter based on new functions and features created for the product.  We believe that our gross margin percentage for our SteelWorks Mobile family of products will be between 40% and 60%.
 
The increase in services gross profit for the three months ended July 31, 2009 as compared to the same period in fiscal 2008 is primarily attributable to the completion of a low margin services contract in December 2008.
 
Operating Expense Discussion:
 
The following table summarizes our operating expenses for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Selling and marketing
 
$
248,557
     
27.51
%
 
$
153,412
     
54.46
%
 
$
(95,145
)
   
(38.28
)%
Research and product development
   
58,066
     
6.43
%
   
53,637
     
19.04
%
   
(4,429
)
   
(7.63
)%
General and administrative
   
899,042
     
99.51
%
   
591,397
     
209.93
%
   
(307,645
)
   
(34.22
)%
Total operating expenses
 
$
1,205,665
     
133.45
%
 
$
798,446
     
283.43
%
 
$
(407,219
)
   
(33.78
)%

The decrease in selling and marketing expense is the result of aligning expenses to our current and future business models to focus on our SteelWorks Mobile products. For the three months ended July 31, 2009 compared to the three months ended July 31, 2008, marketing activities and expenses associated with selling and marketing personnel decreased as a result of cost cutting efforts.  We anticipate our sales and marketing costs will increase in future periods in order to create demand for our new products.
 
The research and product development expense for the three months ended July 31, 2009 slightly decreased compared to the three months ended July 31, 2008.  We continue to make research and development investment into our SteelWorks Mobile family of products.  We anticipate that these research and development costs will continue in future periods.
 
The decrease in general and administrative expenses for the three months ended July 31, 2009 compared to the three months ended July 31, 2008 is primarily attributable to a reduction in operating costs once the sale of our hardware integration business was complete.  Furthermore, we have significantly reduced our operating expenses from the prior year specifically relating to rent, personnel, insurance and other corporate costs. We have  reduced our overhead and personnel costs given the reduction of the business as certain positions and resources are no longer needed to maintain operations.
 
26

 
 
Other Income (Expense) Discussion:
 
The following table summarizes our other income (expense) for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
(Increase) decrease
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Interest expense
 
$
(5,825
)
   
0.65
%
 
$
(20,761
)
   
7.37
%
 
$
(14,936
)
   
(256.4
)%

The increase in net interest expense for the three-month period ended July 31, 2009 is the result of us executing a loan from Caledonia Capital Corporation on July 1, 2009.  The note bears an annual interest rate of 15% payable on October 1, 2009 and December 29, 2009.  In addition, we have accrued interest associated with the settlement with our former landlord on May 22, 2009.   Interest on the settlement accrues at an annual rate of 18%.
 

The following table summarizes our income tax expense for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
   
Dollars
   
% of Net
Revenues
   
Dollars
   
% of Net
Revenues
   
Dollars
   
Percentage
 
                                     
Income Tax Expense
 
$
312,096
     
34.55
%
 
$
-
     
0.00
%
 
$
(312,096
)
   
(100.00
)%

In the three month period ended July 31, 2008 we recorded an income tax benefit attributable to discontinued operations and income tax expense on continuing operations in accordance with intraperiod tax allocation rules. The income tax benefit was due to a significant decrease in our estimated taxable income for discontinued operations for the fiscal year ended October 31, 2008.  As such, we adjusted our income tax expense for the three month period ended July 31, 2008 to reflect our change in estimates.
 
Loss from Continuing Operations Discussion:
 
The following table summarizes our loss from continuing operations for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
(Increase) decrease
 
   
Dollars
   
% of Net
Revenues
   
Dollars
   
% of Net
Revenues
   
Dollars
   
Percentage
 
                                     
Loss from continuing operations
 
$
(1,330,261
)
   
(147.24
)%
 
$
(898,434
)
   
(318.93
)%
 
$
431,827
     
32.46
%

The decrease in our loss from continuing operations for the three months ended July 31, 2009 as compared to the same period in fiscal 2008 is a result of increasing our gross margins and reduction of operating costs.
 
Income (loss) from Discontinued Operations Discussion:
 
The following table summarizes our income (loss) from discontinued operations for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Three Months Ended July 31,
 
   
2008
   
2009
   
(Increase) decrease
 
   
Dollars
   
% of Net
Revenues
   
Dollars
   
% of Net
Revenues
   
Dollars
   
Percentage
 
                                     
Income (loss) from discontinued operations
 
$
388,575
     
23.39
%
 
$
(198,433
)
   
52.97
%
 
$
(587,008
)
   
(48.93
)%

During the 2008 fiscal year, we had several significant hardware integration contracts which produced income.  Given the overall downward economic climate, we experienced contract delays, non-renewals and order constriction in our commercial business.  As a result of the continuing declines in revenues as well as the cumulative losses, we determined to discontinue our hardware integration business in the third quarter of the 2009 fiscal year.
 
For The Nine Months Ended July 31, 2009 Compared To The Nine Months Ended July 31, 2008:
 
The overall economic downturn has impacted virtually every area of our business. As a result, on July 10, 2009, we sold our hardware integration business to NCS. Accordingly, we have reclassified amounts associated with this business as discontinued operations. The discussion below represents our analysis of the continuing operations. Discontinued operations are also discussed below, separately.
 
27

 
 
 
The following table summarizes our net revenue for the nine months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Products                          
 
$
1,863,083
     
48.80
%
 
$
188,319
     
16.23
%
 
$
(1,674,764
)
   
(89.89
)%
Services                          
   
1,954,564
     
51.20
%
   
971,945
     
83.77
%
   
(982,618
     
(50.27
)%
Total  net revenues
 
$
3,817,647
     
100.00
%
 
$
1,160,264
     
100.00
%
 
$
(2,657,383
)
   
(69.61
)%

The decrease in product revenue is primarily attributable to sales of ancillary product revenues in fiscal 2008 to existing customers that were not included in the sale of the hardware integration business.  Given the new focus of our business in fiscal 2009, we do not anticipate a significant portion of our revenues to be generated from ancillary technology products that are not focused around the SteelWorks Mobile product line, however, we will continue to support our existing customers and may sell products outside of our SteelWorks Mobile product line from time to time.   Given the foregoing, SteelWorks Mobile revenue increased 100% in fiscal 2009 compared to fiscal 2008.
 
The decrease in service revenue for the nine month period ended July 31, 2009 as compared to the same period in fiscal 2008 is the result of us completing a large services contract in December 2008.  We anticipate service revenues to fluctuate in future periods as the current economic climate improves.
 
Gross Profit Discussion:
 
The following table summarizes our gross profit for the nine months ended July 31, 2008 and 2009 in dollars, as a percentage of gross profit and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of
Gross
         
% of
Gross
             
   
Dollars
   
Profit
   
Dollars
   
Profit
   
Dollars
   
Percentage
 
                                     
Products
 
$
293,388
     
91.45
%
 
$
101,092
     
30.04
%
 
$
(192,296
)
   
(65.54
)%
Products - GM%
   
15.75
%
           
53.68
%
                       
                                                 
Services
   
358,084
     
8.55
%
   
231,390
     
69.59
%
   
(126,694
)
   
(35.38
)%
Services – GM%
   
18.32
%
           
23.81
%
                       
                                                 
Total gross profit
 
$
651,472
     
100.00
%
 
$
332,482
     
100.00
%
 
$
(318,990
)
   
(48.96
)%
Total – GM%
   
17.06
%
           
28.66
%
                       

The significant increase in gross profit percentage for the nine months ended July 31, 2009 as compared to the same period in fiscal 2008 is the result of our SteelWorks Mobile sales.  The product was launched in early fiscal 2009.  Given the significant intellectual property and software we have created and developed for this product, we anticipate margins will continue to improve in future periods.
 
28

 
The increase in services gross profit for the nine months ended July 31, 2009 as compared to the same period in fiscal 2008 is primarily attributable to the completion of a low margin services contract in December 2008.
 
Operating Expense Discussion:
 
The following table summarizes our operating expenses for the nine months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Selling and marketing
  $ 640,738       16.78 %   $ 369,276       31.83 %   $ (271,462 )     (42.37 )%
Research and product development
    179,523       4.70 %     151,869       13.09 %   $ (27,654 )     (15.40 )%
General and administrative
    2,635,418       69.03 %     1,886,485       162.59 %   $ (748,933 )     (28.42 )%
Severance and restructuring
    -       0.00 %     73,205       6.31 %   $ 73,205       100.00 %
Total operating expenses
  $ 3,455,679       90.52 %   $ 2,480,835       213.82 %   $ (974,844 )     (28.21 )%

The decrease in selling and marketing expense is the result of aligning expenses to our current and future business models to focus on our SteelWorks Mobile products. For the nine months ended July 31, 2009 compared to the nine months ended July 31, 2008, marketing activities and expense associated with selling and marketing personnel decreased as a result of cost cutting efforts.  We anticipate our sales and marketing costs will increase in future periods in order to create demand for our new products.
 
The research and product development expense for the nine months ended July 31, 2009 slightly decreased compared to the nine months ended July 31, 2008.  We continue to make research and development investment into our SteelWorks Mobile family of products.  We anticipate that these research and development costs will continue in future periods.
 
The decrease in general and administrative expenses for the nine months ended July 31, 2009 compared to the nine months ended July 31, 2008 is primarily attributable to a reduction in operating costs once the sale of our hardware integration business was complete.  Furthermore, we have significantly reduced our operating expenses from the prior year specifically relating to rent, personnel, insurance and other corporate costs. We have reduced our overhead and personnel costs given the reduction of the business as certain positions and resources are no longer needed to maintain operations.
 
We did not incur any severance or restructuring costs in fiscal 2008.  As such, these costs increased 100% in fiscal 2009 compared to fiscal 2008.

 
29

 

Other Income (Expense) Discussion:
 
The following table summarizes our other income (expense) for the nine months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
(Increase) decrease
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Interest income (expense)
 
$
5,417
     
0.14
%
 
$
(20,351
)
   
1.75
%
 
$
(25,768
)
   
(475.69
)%

The increase in net interest expense for the nine month period ended July 31, 2009 is the result of the execution of  a loan from Caledonia Capital Corporation on July 1, 2009.  The note bears an annual interest rate of 15% payable on October 1, 2009 and December 29, 2009.  In addition, we have accrued interest associated with our settlement with our former landlord on May 22, 2009.   Interest on the settlement accrues at an annual rate of 18%.
 
Income Tax (Benefit):
 
The following table summarizes our income tax benefit for the nine months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
   
Dollars
   
% of Net
Revenues
   
Dollars
   
% of Net
Revenues
   
Dollars
   
Percentage
 
                                     
Income Tax Benefit
 
$
(393,596
)
   
10.31
%
 
$
-
     
0.00
%
 
$
393,596
     
100.00
%

In the nine month period ended July 31, 2008 we recorded an income tax expense attributable to discontinued operations and income tax benefit on continuing operations in accordance with intraperiod tax allocation rules. We made a significant decrease in our estimated taxable income for discontinued operations for the fiscal year ended October 31, 2008.  As such, we adjusted our income tax benefit for the three month period ended July 31, 2008 to reflect our change in estimates.
 
Loss from Continuing Operations Discussion:
 
The following table summarizes our loss from continuing operations for the nine months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
   
Dollars
   
% of Net
Revenues
   
Dollars
   
% of Net
Revenues
   
Dollars
   
Percentage
 
                                     
Loss from continuing operations
 
$
(2,405,192
)
   
63.00
%
 
$
(2,168,703
)
   
186.91
%
 
$
(236,489
)
   
9.83
%

The increase in loss from continuing operations for the three months ended July 31, 2009 as compared to the same period in fiscal 2008 is a result of overall economic environment, delay in contract awards, reduction in customer orders and overall lower revenues.  As a result, we determined in the third quarter of our 2009 fiscal year to discontinue the hardware integration business and focus solely on our SteelWorks Mobile products based on the Blackberry Enterprise Server.
 
Income (loss) from Discontinued Operations Discussion:
 
The following table summarizes our income (loss) from discontinued operations for the three months ended July 31, 2008 and 2009 in dollars and as a percentage of net revenues.
 
   
Nine Months Ended July 31,
 
   
2008
   
2009
   
Increase (decrease)
 
         
% of Net
         
% of Net
             
   
Dollars
   
Revenues
   
Dollars
   
Revenues
   
Dollars
   
Percentage
 
                                     
Income (loss) from discontinued operations
 
$
797,350
     
8.11
%
 
$
(583,434
)
   
5.94
%
 
$
(1,380,784
)
   
(173.17
)%
 
30

 
In Fiscal 2008, we had several significant hardware integration contracts which produced income.  Given the overall downward economic climate, we experienced contract delays, non-renewals and order constriction in our commercial business.  As a result of the continuing declines in revenues as well as the cumulative losses, we determined to discontinue our hardware integration business in the third quarter of our 2009 fiscal year.  The net loss on disposal was approximately $20,000.

 
31

 
 
LIQUIDITY AND CAPITAL RESOURCES
 
We have experienced recurring losses from operations and negative cash flows.  For the nine months ended July 31, 2009, we incurred a net loss of $2,752,137 and an accumulated deficit of $47,620,701 as of that date.  The report from our independent registered public accounting firm on our audited financial statements at October 31, 2008 contains an explanatory paragraph regarding doubt as to our ability to continue as a going concern as a result of our net loss from operations.  Despite our history of revenues, we can give no assurance that we will be able to maintain or increase our revenues in fiscal 2009 or that we will be successful in reaching profitability or generate positive cash flows from our operations.  We are considering all strategic options to improve our liquidity and provide us with working capital to fund our continuing business operations including equity offerings, asset sales and debt financing as alternatives to improve our cash needs; however; we can offer no assurance that we will be successful in identifying, obtaining or negotiating financing terms.  If adequate funds are not available or are not available on terms acceptable to us, we will likely not be able to take advantage of unanticipated opportunities, develop or enhance services or products, respond to competitive pressures, or continue as a going concern.
 
Our consolidated financial statements for the three and nine months ended July 31, 2009 do not give effect to any adjustments to recorded amounts and their classifications, which would be necessary should we be unable to continue as a going concern and therefore, be required to realize our assets and discharge our liabilities in other than the normal course of business and at amounts different from those reflected in the consolidated financial statements.
 
As of July 31, 2009, we had cash and cash equivalents of approximately $366,210 and a working capital deficit.  Management believes our current cash and cash equivalents are sufficient to maintain our operations for less than 30 days from December 28, 2009.  We do not have any working capital commitments nor do we presently have any external sources of working capital. We have recently reduced our cash use rate within a range of $150,000 to $200,000 per month.  As such, we conservatively estimate that we will need in the range of approximately $1,500,000 to $2,000,000 in cash to continue our operations for the next 12 months.  Should our sales volumes increase any time over the next 12 month period our cash needs could be significantly reduced.  We plan to obtain this capital through various means which may include any or a combination of equity offerings, assets sales or debt financing.
 
On June 15, 2009, we sold an aggregate of 350,000 shares of our common stock, to our seven directors, for aggregate cash proceeds of $87,500.  Each share of common stock was accompanied by one warrant to purchase one additional share of common stock, referred to as the “Director Warrants”.  The Director Warrants are exercisable for five years from the October 23, 2009, at an exercise price of $0.25 per share.  The members of the Board of Directors have indicated that they may choose to provide further bridge financing at a later date, however, there is no assurance that they will provide bridge financing when we require it or on terms agreeable to us.  If we are unable to obtain capital through equity offerings, asset sales, debt financing or additional funding from our Board of Directors, we will be unable to continue as a going concern.
 
On July 1, 2009, we entered into a Business Loan and Security Agreement (referred to herein as the “Agreement”) with Caledonia Capital Corporation, a Delaware corporation, referred to as the “Lender” pursuant to which the Lender agreed to lend to us $250,000 in the form of a Secured Promissory Note, referred to herein as the “Note”, which was issued on July 1, 2009, referred to as the “Issuance Date”.  The Note originally provided for a maturity date of December 29, 2009 (the “Maturity Date”) and an annual interest rate of 15%.  The Note was amended on December 29, 2009 to provide that (a) the annual interest rate of the Note is 20%, (b) accrued interest under the Note shall be payable in monthly installments commencing February 1, 2010, and continuing on the first business day of each successive month, and (c) the Maturity Date is March 31, 2010.  There are no penalties for early prepayment of the Note. In the event that any installment of principal and/or interest due under the Note is not received by the Lender within ten (10) days after the date when the same is due, then we shall be required to pay a late charge of 5.0% of such installment.  Additionally, in the event that we receive investments from one or more investors in one or more transactions in an aggregate amount in excess of $750,000.00, whether in the form of cash, negotiable or non-negotiable instruments or any form of payment in exchange for the issuance of any certificated or non-certificated security, whether in the form of debt or equity, referred to as an “Equity Raise”, at any time between the Issuance Date and the maturity date, then, we shall be required, within five (5) business days after the Equity Raise first exceeds $750,000.00, to curtail the accrued interest and outstanding principal balance of the Note by an amount equal to the amount by which the Equity Raise then exceeds $750,000.00 (but in no event by more than the then outstanding principal balance and interest accrued on the Note). Pursuant to the Agreement and the Note, our obligations thereunder are secured by a first priority lien in and to all of our intellectual property rights, title and interest in and to the SteelWorks® Mobile integrated server appliance software. The Agreement contains standard representations and warranties for a transaction of this type.  As an inducement to the Lender to make the loan to us, we issued to the Lender a warrant, referred to as the “Warrant” to purchase up to 625,000 shares of our common stock, $0.001 par value per share.  As an inducement for the Lender to amend the terms of the Note, we agreed to pay the Lender $25,000. The Warrant is exercisable for four years at an exercise price of $0.15 per share.  The exercise price may be adjusted in the event of any stock dividend, stock split, stock combination, reclassification or similar transaction. Additionally, our Board of Directors has the discretion to reduce the then-current exercise price to any amount at any time during the term of the Warrant for any period of time the Board deems appropriate.  We have agreed to prepare and file a registration statement on or about August 31, 2009 for the purposes of registering the resale of the shares of common stock underlying the Warrant.

On July 10, 2009, we entered into an Asset Purchase Agreement, referred to as the “Agreement”, with NCS Technologies, Inc., a Virginia corporation, referred to as “NCS”, pursuant to which we agreed to sell to NCS, and NCS agreed to purchase from us, all of our right, title and interest in and to the assets relating to our computer integration business (comprised of our Federal Systems Integrator business and the Independent Software Vendors business). The purchase and sale transaction closed on July 10, 2009, referred to as the “Closing Date”.  The purchase price was $475,000, subject to post-closing adjustments as set forth in the Agreement.  Of this amount, $150,000 was paid as a deposit and the remaining $325,000 is an earn-out amount, which is payable from and to the extent of revenue NCS receives during the three-year period after the Closing Date from certain existing and prospective clients, at a rate equal to 15% of the Net Sales Price (as defined in the Agreement) received by NCS from such clients.  Any payments by NCS to us are due on or before the 10 th business day following the month in which NCS receives the payments from the client(s).  Pursuant to the Agreement, NCS also assumed our liabilities relating to the purchased assets, including fulfillment obligations under customer purchase orders existing as of the Closing Date, and responsibilities to clients under the terms of existing warranties and existing contracts.  In addition, we consigned to NCS certain filter inventory set forth in the Agreement, for a period of two years from the Closing Date. However, all ownership in and title to the consigned filter inventory and the intellectual property rights thereto remain vested in us, until any such items are sold.
 
On November 3, 2009, we entered into a Line of Credit and Security Agreement, referred to herein as the “Credit and Security Agreement”, with the Lender pursuant to which the Lender agreed to extend to us a revolving line of credit in the amount of $150,000, in the form of a Revolving Line of Credit Promissory Note, referred to herein as the “Credit Note”.  The Credit Note bears interest at a rate of 15% per annum, and is payable in monthly installments commencing 30 days after November 3, 2009, which was the date when we issued the Credit Note.  The principal amount of the Credit Note, together with interest accrued and unpaid thereon and all other sums due, shall be due and payable in full upon the earlier to occur of (a) March 31, 2010, or (b) the date we shall have raised a total of not less than $1,000,000 in capital invested in our equity which is accompanied by our issuing shares of stock which were not trading in the public markets prior to the date of the Credit Note.   There are no penalties for early prepayment of the Credit Note.  The Credit Note is a revolving line of credit note.  Principal advances may be made, from time to time, by the Lender up to the principal amount of the Credit Note, and principal payments may be made, from time to time by us to reduce the principal balance owing pursuant to the Credit Note.  Our obligations under the Credit and Security Agreement and the Credit Note are secured by a lien in and to all of our rights, title and interest in and to its furniture, fixtures, equipment, supplies, receivables, intangibles, and inventory, together with all present and future substitutions, replacements and accessories thereto and all present and future proceeds and products thereof, in any form whatsoever, referred to herein as the “Collateral”.  As an inducement to the Lender to make the loan, we agreed to issue to the Lender a warrant, referred to herein as the “Credit Warrant”, to purchase 2.5 shares of our common stock for every dollar we borrow pursuant to the Credit and Security Agreement.  The Credit Warrant is exercisable for four years at an exercise price of $0.25 per share.  The exercise price may be adjusted in the event of any stock dividend, stock split, stock combination, reclassification or similar transaction. On November 4, 2009, we borrowed $60,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 150,000 shares of our common stock pursuant to the Credit and Security Agreement.  On November 23, 2009, we borrowed $90,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 225,000 shares of our common stock pursuant to the Credit and Security Agreement.

 
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For the nine months ended July 31, 2009, we used $1.1 million in cash from operating activities. Our primary use of cash was to finance our operating loss.  The use and availability of our cash is affected by the timing, pricing, and magnitude of orders for our products, and the timing of cash outflows relating to these orders.
 
We generated approximately $498,000 from our investing activities and $322,000 in financing activities for the nine months ended July 31, 2009.

OFF-BALANCE SHEET ARRANGEMENTS
 
Contractual Obligations and Commercial Commitments
 
We have significant contractual obligations for fiscal year 2009 and beyond for our operating leases and employment agreements.
 
On February 27, 2009, we entered into a lease amendment with the landlord of one of our operation facilities whereby the current lease, which is presently scheduled to expire on August 31, 2014, has been amended to provide for (i) the extension of the lease term for a period of one (1) year and four (4) months ending on December 31, 2015, and (ii) certain other modifications, including a reduction in our rent cash payments by approximately $60,000 and $34,000 for the fiscal years 2009 and 2010, respectively.  Our monthly straight-line rent expense will be approximately $21,000 a month for the length of the lease.

On May 22, 2009, we entered into a Stipulation, pursuant to an Affidavit, stating, as declared by a general manager of Jones Lang LaSalle, a property management company and agent for CRP, the landlord of the Premises, that CRP, as landlord, was seeking a judgment against us for: (i) possession of the Premises, and (ii) monetary damages for nonpayment of rent due under the Sublease, dated September 28, 2004, by and between us and NEC, and a subsequent assignment of the Sublease to CRP from NEC, dated December 15, 2008.  In the Stipulation we acknowledged Judgment Amount.  Pursuant to the Stipulation, we made the Forbearance Payment on May 22, 2009 toward the Judgment Amount.  Further we agreed to, and have, vacated the Premises.  CRP agreed to stay enforcement of the Judgment Amount until the earlier of (a) our receipt of capital in the amount of at least $500,000, or (b) May 31, 2010.  The matter was returned to the court’s files pending our compliance with the terms of the Stipulation.

On February 5, 2009, we entered into an Executive Retention Agreement (the “2009 Agreement”) with Brian Hajost, our current President and Chief Executive Officer, effective as of January 16, 2009.  Pursuant to the terms of the 2009 Agreement, as compensation for Mr. Hajost serving as our President and Chief Executive Officer, Mr. Hajost receives (a) a semi-monthly salary of $8,333.33 (or $200,000 annually); (b) a stock grant of 156,000 shares of our common stock, which will vest ratably over 12 months; and (c) a stock option grant of 300,000 shares of our common stock, which will vest ratably over a three year term and have a five year exercise period.  The 2009 Agreement further provides that in the event we terminate Mr. Hajost’s employment without cause (other than due to Mr. Hajost’s request), or if Mr. Hajost terminates his employment for good reason, Mr. Hajost will be entitled to (a) if the termination takes place within three months from the date of the 2009 Agreement, two months salary, (b) if the termination takes place between three and six months from the date of the 2009 Agreement, three months salary, (c) if the termination takes place between six months and one year from the date of the 2009 Agreement, six months salary, (d) if the termination takes place after the first year anniversary of the 2009 Agreement, 12 months salary.  In the event that a majority of our stock or a substantial portion of our assets are acquired, the acquisition closes while Mr. Hajost is employed by us, and Mr. Hajost’s employment with us is terminated without cause (other than due to Mr. Hajost’s request) within 30 days of the acquisition, Mr. Hajost will be entitled to severance pay equal to the lesser of (a) 24 months salary based on his annual rate of pay for the calendar year before the calendar year of termination from service, or (b) two times the IRS limit for qualified plans provided for in 26 U.S.C. § 401(a)(17) for the calendar year of termination of service.  
 
As of July 31, 2009 the total obligation of our employment agreements for fiscal year 2009 is approximately $197,000 and does not include applicable employment taxes and potential bonuses.
 
We do not have any purchase obligations, capital lease obligations or any material commitments for capital expenditures.  We have not engaged in off-balance sheet financing, commodity contract trading or significant related party transactions.

 
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From time to time, we may pursue strategic acquisitions or mergers, which may require significant additional capital. In such event, we may seek additional financing of debt and/or equity. We can provide no assurances that any such financings will be consummated.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles requires management to make certain judgments, estimates and assumptions that could affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  We based our estimates and assumptions on historical experience and on various other assumptions believed to be applicable, and evaluated them on an on-going basis to ensure they remained reasonable under current conditions.  Actual results could differ significantly from those estimates.
 
The significant accounting policies used in the preparation of our financial statements are described in Note 3 “Significant Accounting Policies” of the Footnotes to our Annual Consolidated Financial Statements.  Some of these significant accounting policies are considered to be critical accounting policies.  A critical accounting policy is defined as one that has both a material impact on our financial condition and results of operations and requires us to make difficult, complex and/or subjective judgments, often as a result of the need to make estimates about matters that are inherently uncertain.
 
We believe that the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Recently Issued Accounting Pronouncements

Effective November 1, 2008, we adopted the provisions of Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”) and Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”).  SFAS 157, which defines fair value, establishes a framework for measuring fair value in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), and expands disclosures about fair value measurements.  SFAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell asset or paid to transfer a liability in an orderly transaction between market participants.  SFAS 159 permits an entity to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period. For the three and six month periods ended April 30, 2009, we have elected not to use the fair value option permitted under SFAS 159 for any of our financial assets and financial liabilities that are not already recorded at fair value.

In February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2 deferred the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.  We are in the process of evaluating the effect, if any, the adoption of FSP 157-2 will have on our financial statements.

In October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active” (“FSP 157-3”).  FSP 157-3 provides guidance for determining the fair value of a financial asset in an inactive market.  We are in the process of evaluating the effect, if any, the adoption of FSP 157-3 will have on our financial statements.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised 2007) “Business Combinations” (“SFAS No. 141R”).  SFAS No. 141R, which replaces SFAS No. 141, requires that the acquisition method of accounting (which SFAS No. 141 called the “purchase method”) be used for all business combinations and for an acquirer to be identified for each business combination.  SFAS No. 141R also establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS No. 141R also requires that acquisition-related costs be recognized separately from the business combination.  SFAS No. 141R will apply prospectively to business combinations for which the acquisition date is after fiscal years beginning on or after December 15, 2008.  We are in the process of evaluating the effect, if any, the adoption of SFAS No. 141R will have on our financial statements.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements.  Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests.  This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008.  Earlier adoption is prohibited.  We are in the process of evaluating the effect, if any, the adoption of SFAS No. 160 will have on our financial statements.

 
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In May 2008, The FASB issued Statement of Financial Accounting Standards No.162 “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), which reorganizes the GAAP hierarchy.  SFAS 162 is intended to improve financial reporting by providing a consistent framework for determining what accounting principles should be used in preparing GAAP financial statements.  With the issuance of SFAS 162, the FASB concluded that the GAAP hierarchy should be directed toward the entity and not its auditor, and reside in the accounting literature established by the FASB as opposed to the American Institute of Certified Accountants Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”.  SFAS 162 will become effective 60 days following the SEC’s approval of the Public Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles” and is not expected to have any impact on our financial statements.
 
In May 2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"). SFAS 165 is intended to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. SFAS 165 is effective for interim or annual financial periods ending after June 19, 2009.  We are in the process of evaluating the effect, if any, the adoption of SFAS No. 165 will have on our financial statements.
 
In April 2009, the FASB issued FSP FAS 107-1 and APB-28-1, “Interim Disclosure about Fair Value of Financial Instruments” (FSP 107-1/APB 28-1). FSP 107-1/APB 28-1 requires interim disclosures regarding the fair values of financial instruments that are within the scope of FAS 107, “Disclosures about the Fair Value of Financial Instruments”. Additionally, FSP107-1/APB28-1 requires disclosure of the methods and significant assumptions used to estimate the fair value of financial instruments on an interim basis as well as changes of the methods and significant assumptions from prior periods. FSP 107-1/APB 28-1 does not change the accounting treatment for these financial instruments and is effective for interim reporting periods ending after June 15, 2009. We adopted FSP 107-1/APB 28-1 during the quarter ended July 31, 2009 and disclosed the fair value of our financial instruments in the financial statements.
 
In April 2009, the FASB issued FSP 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairment” (FSP 115-2/124-2). FSP 115-2/124-2 amends the requirements for the recognition and measurement of other-than-temporary impairments for debt securities by modifying the pre-existing “intent and ability” indicator. Under FSP 115-2/124-2, an other-than-temporary impairment is triggered when there is an intent to sell the security, it is more likely than not the security will be required to be sold before recovery, or the security is not expected to recover the entire amortized cost basis of the security.  Additionally, FSP 115-2/124-2 changes the presentation of another-than-temporary impairment in the income statement for those impairments involving credit losses. The credit loss component will be recognized in earnings and the remainder of the impairment will be recorded in other comprehensive income. FSP 115-5 2/124-2 is effective for interim and annual reporting periods ending after June 15, 2009. We adopted FSP 115-5 2/124-2 as of the quarter ended July 31, 2009.

 
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CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There were no changes in and disagreements with accountants on accounting and financial issues during our two last fiscal years or any subsequent interim period.
 
DIRECTORS AND EXECUTIVE OFFICERS

The name, age and position of each of our directors and executive officers are as follows:

Name
 
Age
 
Position
Brian H. Hajost
 
52
 
President and Chief Executive Officer and Director
Steven Snyder
 
50
 
Vice President of Finance, Principal Financial Officer and Secretary
James Bruno
 
73
 
Director
VADM E. A. Burkhalter, Jr. USN
 
80
 
Director
Jay Kaplowitz
 
62
 
Director
Ashok Kaveeshwar
 
67
 
Director
Benjamin Krieger
  
72
  
Director

Brian H. Hajost has most recently served as our consultant. From February 2007 until June 2008, Mr. Hajost served as Executive Vice President of Cryptek, Inc. Mr. Hajost served as Chief Operating Officer of the Company from December 2003 until June 2006 and President from June 2005 until June 2006. Prior to December 2003, he served as the Company's Executive Vice President of Sales & Marketing from June 2001 until his promotion to the Chief Operating Officer position in 2003. Mr. Hajost also founded two consulting companies in 2006 and 2008.

Steven Snyder has served as our Vice President of Finance, Principal Financial Officer and Secretary since November 30, 2009.  Since April 2009, Mr. Snyder has served as the owner of Arinth, LLC, a private consultancy and third-party software development company.  From September 2000 to February 2009, Mr. Snyder served as the Chief Financial Officer of The Richards Corporation, a private, family owned supplier of imagery analysis workstations designed to meet a wide range of aerial surveillance applications used in the United States and by various governments.  During his tenure at The Richards Corporation, Mr. Snyder also simultaneously served as the Vice President of Finance and Information Technology, Operations and Materials Management, where he focused on the generation of profits through the implementation of improved processed, higher level financial analysis and customer profitability reporting.  Mr. Snyder was also responsible for a majority of all due diligence work, including financial reporting, budgets and pro-formas.   Mr. Snyder obtained his Bachelor of Science degree in Accounting from the State University of New York in 1981 and is a Certified Public Accountant.

James Bruno has served as our director since September 2000.  Mr. Bruno has served as a member of the Audit Committee of our Board of Directors since January 2004.  Mr. Bruno was formerly President of Syntrex Corporation, prior to which he served as President of the Computer Division of Perkin Elmer Corporation.  He had formerly served in various management positions with Electronic Associates, Inc.  Mr. Bruno has extensive experience in the computer industry, as well as corporate acquisitions.  He served as a consultant to SteelCloud, Inc. in 1997 and 1998.

Vice Admiral E. A. Burkhalter, Jr.,   USN (Ret.)   has served as our director since January 1997.  In July 2006, Mr. Burkhalter was appointed Chairman of our Board of Directors.  Mr. Burkhalter has served as a member of each of the Audit Committee, Executive Committee and the Compensation Committee of our Board of Directors since January 2004.  Mr. Burkhalter is currently the President of Burkhalter Associates, Inc., a consulting firm providing services in the areas of international and domestic strategy, management policy and technology applications, for both government and industry.  Mr. Burkhalter spent 40 years as a member of the United States Navy, during which time he held several positions, including Director of Strategic Operations for the Chairman of the Joint Chiefs of Staff.  He is currently a member of the Defense Intelligence Agency Leadership Council.  He is also a trustee of the US Naval Academy Foundation, and a trustee of the Benedictine Foundation.

Jay M. Kaplowitz has served as our director since September 2000.  Mr. Kaplowitz has served as a member of the Compensation Committee of our Board of Directors since January 2004.  Mr. Kaplowitz is a founding partner of the law firm Gersten Savage LLP, our securities counsel.  Mr. Kaplowitz has more than thirty years experience in corporate, banking and securities law.  He has negotiated and structured numerous financial and business transactions and has extensive expertise in public and private equity and debt offerings.  Mr. Kaplowitz is a managing member of Formula Capital, LLC, a private equity fund, and is on the board of Rusoro Mining Ltd., a company listed on the TSXV (CDNX: RML.V) and of several private companies.  He received a JD from Boston University, and a BA from Brooklyn College, City University of New York.

 
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Benjamin Krieger has served as our director since September 1999. Mr. Krieger has served as a member of the Compensation Committee and the Audit Committee of our Board of Directors since January 2004. Mr. Krieger is currently a partner with WhiteKnight Solutions, LLC, a business consulting firm that specializes in acquisitions, divestitures and strategic alliances. Mr. Krieger was formerly a partner with Corporate Development International, an international company search firm, where he specialized in the pulp and paper, packaging, graphic arts and distribution industries. Prior to Corporate Development International, he was President, CEO and a director of Ris Paper Company. Mr. Krieger began his career with the Mead Corporation where he was promoted through the Company during his 25-year tenure.

Ashok Kaveeshwar, Ph.D. has served as our director since March 2007. Dr. Kaveeshwar has served as a member of the Executive Committee of our Board of Directors since 2007. Dr. Kaveeshwar has 35 years of technical, management and executive experience with high technology firms serving both the public and private sectors. He has also served in the Federal Government as the first administrator of the Research & Innovative Technology Administration (RITA) at the United States Department of Transportation, a Presidential appointment requiring Senate confirmation. Prior to that, he was President of Orange Technologies, Inc, a company providing government and commercial customers with project life cycle management software and solutions. Previously, Dr. Kaveeshwar held various senior executive positions with Raytheon Corporation, Hughes Electronics Corporation, ST Systems Corporation (STX) and Systems & Applied Sciences Corporation. Dr. Kaveeshwar has a Ph.D. in Physics from the University at Buffalo (SUNY), Buffalo, NY.

In fiscal year 2008, the Board of Directors met seven (7) times (including by teleconference). All directors attended at least 75% of the meetings.

Involvement in Certain Legal Proceedings

No director, person nominated to become a director, executive officer, promoter or control person of ours has, during the last five years: (i) been convicted in or is currently subject to a pending a criminal proceeding (excluding traffic violations and other minor offenses); (ii) been a party to a civil proceeding of a judicial or administrative body of competent jurisdiction and as a result of such proceeding was or is subject to a judgment, decree or final order enjoining future violations of, or prohibiting or mandating activities subject to any Federal or state securities or banking or commodities laws including, without limitation, in any way limiting involvement in any business activity, or finding any violation with respect to such law, nor (iii) any bankruptcy petition been filed by or against the business of which such person was an executive officer or a general partner, whether at the time of the bankruptcy or for the two years prior thereto.

Independence of Directors

The Board has determined that Messrs. Bruno, VADM Burkhalter, Kaplowitz, Kaveeshwar and Krieger, are independent directors as defined in NASDAQ Marketplace Rule 4200.

Committees of the Board

During the fiscal year ended October 31, 2008, the Board of Directors held a total of seven meetings (including teleconference). All incumbent directors attended at least 75% of the aggregate of all meetings of the Board of Directors and any committees of the Board on which they served, during the fiscal year ended October 31, 2008.

The Audit Committee appoints and provides for the compensation of our independent auditors; oversees and evaluates the work and performance of the independent auditors; reviews the scope of the audit; considers comments made by the independent auditors with respect to accounting procedures and internal controls and the consideration given thereto by our management; approves all professional services to be provided to us by our independent auditors; reviews internal accounting procedures and controls with our financial and accounting staff; oversees a procedure that provides for the receipt, retention and treatment of complaints received by us and of confidential and anonymous submissions by employees regarding questionable accounting or auditing matters; and performs related duties as set forth in applicable securities laws, NASDAQ corporate governance guidelines, and the Audit Committee charter (the “Audit Committee”).  The Audit Committee functions pursuant to the Audit Committee charter adopted by the Board in fiscal 2001.  A copy of the Audit Committee Charter can be found on our web site at www.steelcloud.com . The Audit Committee met nine (9) times (including by teleconference) during the fiscal year ended October 31, 2008.  The Audit Committee is currently composed of James Bruno, VADM Burkhalter and Benjamin Krieger.  The Board has determined that all current members of the Audit Committee are independent directors under the rules of the  NASDAQ Stock Market and each of them is able to read and understand fundamental financial statements.  The Board has determined that James Bruno is the Company’s Audit Committee “financial expert” as defined in Item 407(d) of Regulation S-K.

 
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The Compensation Committee has such powers as may be assigned to it by the Board of Directors from time to time and is currently charged with, among other things, determining compensation packages for our Chief Executive Officer, President and Chief Financial Officer, establishing salaries, bonuses and other compensation for our executive officers and with administering the Company’s Amended 2007 Stock Option and Restricted Stock Plan, the Company’s 2007, 2002 and 1997 Incentive Stock Option Plans, as amended (the "Stock Option Plans"), the 1998 Employee Stock Purchase Plan, as amended (the "1998 Purchase Plan") and recommending to the Board of Directors changes to such plans (the “Compensation Committee”).  Generally, on its own initiative the Compensation Committee reviews the performance and compensation of our Chief Executive Officer and Chief Financial Officer and, following discussions with those individuals, establishes their compensation levels where it deems appropriate. For the remaining officers, the Chief Executive Officer makes recommendations to the Compensation Committee that generally, with such adjustments and modifications that are deemed necessary or appropriate by the Compensation Committee, are approved. With respect to equity-based compensation awarded to others, the Compensation Committee grants stock-based compensation, generally based upon the recommendation of the Chief Executive Officer.  The Compensation Committee met four (4) times (including by teleconference) during fiscal 2008.  The Compensation Committee is currently composed of VADM Burkhalter, Jay M. Kaplowitz and Benjamin Krieger.  The Board has determined that all current members of the Compensation Committee are independent directors under the rules of the  NASDAQ Stock Market. The Compensation Committee does not have a charter.

The Board of Directors has an Executive Committee (the "Executive Committee"), the members of which are VADM Burkhalter and Ashok Kaveeshwar. The Executive Committee has such powers as may be assigned to it by the Board of Directors from time to time and is currently charged with, among other things, recommending to the Board of Directors the criteria for candidates to the Board of Directors, the size of the Board of Directors, the number of committees of the Board of Directors and their sizes and functions, and the nomination and selection of Board of Directors' candidates and committee members and rotation of committee members.  In addition, the Executive Committee is responsible for establishing and implementing an annual evaluation process for the Chief Executive Officer and the Board of Directors and periodically assessing the overall composition of the Board of Directors to ensure an effective membership mix and, when appropriate, recommending to the Board of Directors a Chief Executive Officer succession plan and succession process.  The Executive Committee met ten (10) times during fiscal 2008.  The Executive Committee does not have a charter.

Code of Ethics

On September 9, 2004, the Board adopted a Code of Ethics that applies to the Chief Executive Officer, Principal Executive Officers, Senior Financial Officers and Board of Directors.  A copy of the Code of Ethics can be found on our web site at www.steelcloud.com .  The Code of Ethics sets forth our policies and expectations on a number of topics, including: Integrity of Records and Financial Reporting; Compliance with Laws, Rules and Regulations; Conflict of Interest; Corporate Opportunities; Fair Dealing; Confidentiality; Reporting any Illegal or Unethical Behavior; and Waivers.

The Audit Committee of the Board of Directors reviews the Code of Ethics annually, and proposes changes or amendments to the Code of Ethics as appropriate.  Changes or amendments proposed by the Audit Committee are submitted to the Board of Directors for review.
 
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
The following table sets forth certain information, as of December 28, 2009, with respect to the beneficial ownership of our common stock of more than 5% of the outstanding shares thereof, by each of our directors and our executives named in the Summary Compensation Table and by all executive officers and directors.  As of December 28, 2009 we had 15,614,001  shares of our common stock outstanding.  Pursuant to the rules and regulations of the Securities and Exchange Commission, shares of common stock that an individual or group has a right to acquire within 60 days pursuant to the exercise of options or warrants are deemed to be outstanding for the purposes of computing the percentage ownership of such individual or group, but are not deemed to be outstanding for the purposes of computing the percentage ownership of any other person shown in the table.

 
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Title of Class 
 
Name and Address of Beneficial
Owner  1
  
Amount and
Nature
of Beneficial 
Ownership
  
  
Percentage 
of Class
 
Common Stock  
Kevin M. Murphy 2
    556,186       3.56 %  
Common Stock
 
Brian H. Hajost 3
   
256,000
     
1.64
%
Common Stock
 
VADM E.A. Burkhalter 4
   
241,376
     
1.55
%
Common Stock
 
Benjamin Krieger   5
   
219,576
     
1.41
%
Common Stock
 
James Bruno 6
   
232,376
     
1.49
%
Common Stock
 
Jay M. Kaplowitz 7
   
220,506
     
1.41
%
Common Stock
 
Ashok Kaveeshwar 8
   
175,000
     
1.12
%
   
All Executive Officers and Directors as a Group (7 persons)(2)-(7)
   
1,901,020
     
12.18
%
 


1
The address of each of such individuals is c/o SteelCloud, Inc., 13962 Park Center Road, Herndon Virginia 20171.

2
Includes 370,000 shares of our common stock underlying stock options granted pursuant to the 1997 and 2002 Stock Option Plans which expire on December 30, 2009. Also includes 67,500 of vested Restricted Stock, issued to Mr. Murphy pursuant to his employment agreement and 50,000 shares of our common stock underlying warrants. The restricted shares of stock were issued pursuant to our Amended 2007 Stock Option and Restricted Stock Plan. Mr. Murphy resigned from his position with our company effective November 30, 2009.

3
Includes 156,000 of Restricted Stock, issued to Mr. Hajost pursuant to his employment agreement and 50,000 shares of our common stock underlying warrants.  The shares of Restricted Stock vest ratably over a period of one year from the anniversary date of the grant, January 14, 2009.  These restricted shares of stock were issued pursuant to our Amended 2007 Stock Option and Restricted Stock Plan.

4
Includes 100,000 shares of our common stock underlying stock options granted pursuant to the 1997 and 2002 Stock Option Plans, of which all are currently exercisable, 50,000 shares of our common stock underlying warrants and 6,000 shares owned by Mr. Burkhalter’s spouse of which he disclaims beneficial ownership.

5
Includes 75,000 shares of our common stock underlying stock options granted pursuant to the 1997 and 2002 Stock Option Plans, of which all are currently exercisable and 50,000 shares of our common stock underlying warrants.

6
Includes 90,000 shares of our common stock underlying stock options granted pursuant to the 1997 and 2002 Stock Option Plans, of which all are currently exercisable and 50,000 shares of our common stock underlying warrants.

7
Includes 85,000 shares of our common stock underlying stock options granted pursuant to the 1997 and 2002 Stock Option Plans, of which all are currently exercisable and 50,000 shares of our common stock underlying warrants.
 
8
Includes 65,000 shares of our common stock underlying stock options granted pursuant to the 2002 Stock Option Plan, of which all are currently exercisable and 50,000 shares of our common stock underlying warrants.

 
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

We have paid approximately $83,000, $93,000 and $81,000 during fiscal year 2007, 2008, and for the nine months ended July 31, 2009, respectively, to Gersten Savage LLP in connection with legal services.  Jay M. Kaplowitz, a member of our Board of Directors, and a member of the Compensation Committee, is a partner at Gersten Savage LLP.

Our executive officers and directors may be considered our promoters due to their participation in and management of the business since our incorporation.

As the Company previously disclosed in a Current Report on Form 8-K filed with the Securities and Exchange Commission on July 8, 2009, on July 1, 2009 the Company entered into a Business Loan and Security Agreement with Caledonia Capital Corporation, a Delaware corporation, (the “Lender”) pursuant to which the Lender agreed to lend to the Company $250,000 in the form of a Secured Promissory Note (the “Loan”).   The Loan bears interest at a rate of 15% per annum, and is payable in quarterly installments commencing three months after July 1, 2009, or October 1, 2009.  Mr. Steven Snyder, the Company’s Principal Financial Officer, was a member of a group of individuals who invested money with the Lender for purposes of making the Loan to the Company.  Mr. Snyder’s investment in the Loan was $25,000.  At the time of Mr. Snyder’s investment, he was an unrelated party to the Company.   The current amount outstanding on the Loan is $250,000.  To date, the Company has made $9,375 interest payments on the Loan and $0 principal payments on the Loan.

 
39

 

Director Independence

This information is provided under the heading “Directors and Executive Officers-Independence of Directors.”
 
EXECUTIVE COMPENSATION

The following table sets forth certain information regarding compensation paid by us during each of the last two fiscal years to our Chief Executive Officer and to each of our executive officers who were paid in excess of $100,000 (the “Named Officers”).
 
Summary Compensation Table
 
                   
Stock
   
Option
             
       
Salary
   
Bonus
   
Awards
   
Awards
   
Other
   
Total
 
Name and Principal Position
 
Year
 
($)
   
($)
   
($) 1
   
($)
   
($) 2
   
($)
 
Robert E. Frick 3
 
2008
   
267,000
     
-0-
     
-0-
     
50,624
     
21,731
     
339,355
 
President and Chief Executive Officer
 
2007
   
48,333
4
   
40,000
     
5,000
     
2,325
     
5,235
     
100,893
 
                                                     
Kevin M. Murphy 5
 
2008
   
220,000
     
-0-
     
-0-
     
76,274
     
25,988
     
322,262
 
Chief Financial Officer and
 
2007
   
185,000
     
50,000
     
-0-
     
29,432
     
43,818
     
308,250
 
Executive Vice President
                                                   
                                                     
Clifton W. Sink 6
 
2007
   
238,000
     
-0-
     
-0-
     
131,694
7
   
274,034
8
   
643,728
 
Former President and Chief
                                                   
Executive Officer
                                                   
                                                     
Robert Richmond
 
2007
   
154,471
9
   
-0-
     
-0-
     
-0-
     
21,096
     
175,567
 
Former Chief Operating Officer
                                                   

1
In fiscal year 2008, none of the named executive officers forfeited options.  In fiscal year 2007 Mr. Sink forfeited 170,000 options and Mr. Richmond forfeited 100,000 options.  For additional information pertaining to assumptions made in determining the value of the stock awards, please see note 10, “Stock Based Compensation” of our financial statements, in our Annual Report on Form 10-K for the fiscal year ended October 31, 2008, filed with the commission on January 29, 2009.
2
Other compensation includes commissions, accumulated leave payouts, fixed expense allowances, 401K match expense and health and dental insurance provided by us.
3
Mr. Frick joined us in August 2007 as Executive Director and was appointed to our Board of Directors.  In October 2007, Mr. Frick was named our President and Chief Executive Officer.  Mr. Frick’s employment with the Company ended on January 9, 2009.
4
This amount represents Mr. Frick’s pro-rated salary based on an annual salary of $260,000 for fiscal year 2007 per his employment agreement, including approximately $27,000 of compensation attributable to his tenure as Executive Director.
Mr. Murphy resigned from his position with our company effective November 30, 2009. 
6
In August 2007, we entered into an employment resignation agreement with Mr. Sink pursuant to which Mr. Sink resigned his positions as our President and Chief Executive Officer and Board Member effective November 1, 2007.
7
We modified the vesting conditions of Mr. Sink’s stock options issued in November 2006.  The vesting date of the first tranche of options was accelerated from November 24, 2007 to October 31, 2007.  Mr. Sink forfeited the 170,000 remaining options pertaining to the November 2006 grant on the modification date.
8
This amount includes a one-time severance payment of $237,000 per M r. Sink’s employment resignation agreement.
9
This amount represents Mr. Richmond’s pro-rated salary based on an annual salary of $175,000 for fiscal years 2007 per his employment agreement. Mr. Richmond’s employment with us ended on September 18, 2007.

 
40

 

Outstanding Equity Awards at October 31, 2008
 
OPTION AWARDS
   
STOCK AWARDS
 
Name
 
Number of
Securities
Underlying
Unexercised
Options (#)
Exercisable
   
Number of
Securities
Underlying
Unexercised
Options (#)
 Unexercisable
   
Option
Exercise
Price ($)
   
Number of
Shares or
Units of
Stock
That Have
Not Vested
(#)
   
Market
Value of
Shares or
Units
of Stock
That
Have Not
Vested
($) 1
 
                               
Robert E. Frick
    33,334       66,666 2       1.20              
                                     
      -       125,000 3       1.35       66,333       39,137  
Kevin M. Murphy
    100,000       -       2.31                  
      75,000       -       2.40                  
                                         
      110,000       60,000 4       0.62                  
                                         
      50,000       50,000 5       1.25                  
                                         
      -       125,000 3       1.35                  
 
 
1
Based on the closing price of our common stock of $0.59 per share on October 31, 2008.
 
2
33,333 options vest on September 11, 2009 and 33,333 options vest on September 11, 2010.
 
3
All unexercisable options pertaining to this grant vested on June 3, 2009.  Mr. Murphy resigned from his position with our company effective November 30,2009.
 
4
All unexercisable options pertaining to this grant vested on November 24, 2008.
 
5
All unexercisable options pertaining to this grant vested on October 25, 2009.

Employment Agreements; Termination of Employment

On January 12, 2009 (the “Agreement Date”), we entered into an Amendment to Employment Agreement (the “Amended Agreement”) with Robert E. Frick, our then Chief Executive Officer and President, pursuant to which the terms of Mr. Frick’s employment agreement, dated August 27, 2007, were amended. Under the terms of the Amended Agreement, the parties agreed that Mr. Frick’s employment with us terminated effective January 9, 2009 as a result of Mr. Frick’s health.   Further, pursuant to the Amended Agreement, Mr. Frick resigned from our Board of Directors.  Mr. Frick will receive paid family health and dental insurance under our standard policies for six months from the Agreement Date and $10,231 as compensation for Mr. Frick’s retained leave balance of 10 days.  Additionally, Mr. Frick served as a consultant for us for six months from the Agreement Date for compensation of $11,250 per month.

On February 5, 2009, we entered into an Executive Retention Agreement (the “2009 Agreement”) with Brian Hajost, our President and Chief Executive Officer, effective as of January 16, 2009.  Pursuant to the terms of the 2009 Agreement, as compensation for Mr. Hajost serving as our President and Chief Executive Officer, Mr. Hajost receives (a) a semi-monthly salary of $8,333.33 (or $200,000 annually); (b) a stock grant of 156,000 shares of our common stock, which will vest ratably over 12 months; and (c) a stock option grant of 300,000 shares of our common stock, which will vest ratably over a three year term and have a five year exercise period.  The 2009 Agreement further provides that in the event that we terminate Mr. Hajost’s employment without cause (other than due to Mr. Hajost’s request), or if Mr. Hajost terminates his employment for good reason, Mr. Hajost will be entitled to (a) if the termination takes place within three months from the date of the 2009 Agreement, two months salary, (b) if the termination takes place between three and six months from the date of the 2009 Agreement, three months salary, (c) if the termination takes place between six months and one year from the date of the 2009 Agreement, six months salary, (d) if the termination takes place after the first year anniversary of the 2009 Agreement, 12 months salary.  In the event that a majority of our common stock or a substantial portion of our assets are acquired, the acquisition closes while Mr. Hajost is employed by us, and Mr. Hajost’s employment with us is terminated without cause (other than due to Mr. Hajost’s request) within 30 days of the acquisition, Mr. Hajost will be entitled to severance pay equal to the lesser of (a) 24 months salary based on Hajost’s annual rate of pay for the calendar year before the calendar year of termination from service, or (b) two times the IRS limit for qualified plans provided for in 26 U.S.C. § 401(a)(17) for the calendar year of termination of service.

 
41

 

Compensation of Directors

We do not compensate directors who also serve as our executive officers for their services on the Board. During fiscal 2008, we compensated all of our non-employed directors for participation at meetings of the Board and Committees of the Board by granting each of our outside directors stock options to purchase 40,000 shares of our common stock at an exercise price of $1.35 per share in June 2008.  All of the options granted to the outside directors were pursuant to our 1997 and 2002 Stock Option Plans, as amended.  The following table reflects all compensation awarded to, earned by or paid to our directors for the fiscal year ended October 31, 2008.
 
Name
 
Fees
earned or
paid in
cash
($)
   
Option
Awards
($)
   
All other
compensation
($) 1
   
Total
($)
 
                         
James Bruno
    6,000       10,386 2       3,118       19,504  
                                 
Al Burkhalter
    6,000       10,386 3       1,879       18,265  
                                 
Jay M. Kaplowitz
    3,000       10,386 4       376       13,372  
                                 
Ashok Kaveeshwar
    3,000       10,386 5       539       13,925  
                                 
Ben Krieger
    6,000       10,386 6       3,502       19,888  
 
 
1
Consists solely of travel expenses paid by us for travel to Board of Director Meetings.
 
2
100,000 option awards outstanding on October 31, 2008.
 
3
110,000 option awards outstanding on October 31, 2008.
 
4
95,000 option awards outstanding on October 31, 2008.
 
5
65,000 option awards outstanding on October 31, 2008.
 
6
85,000 option awards outstanding on October 31, 2008.

Members of our Board of Directors receive $1,000 for each Board of Directors meeting attended.  In addition, each member of the Audit Committee receives $500 for each Audit Committee meeting attended.  Audit Committee members shall be entitled to receive a total of $1,500 in their capacity as both a director and Audit Committee member.

 
42

 

DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES ACT
LIABILITIES

Insofar as indemnification for liabilities arising under the Securities Act of 1933, as amended (the “Act”) may be permitted for our directors, officers and controlling persons we have been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable.

 
43

 

No dealer, salesperson or any other person is authorized to give any information or make any representations in connection with this offering other than those contained in this prospectus and, if given or made, the information or representations must not be relied upon as having been authorized by us. This prospectus does not constitute an offer to sell or a solicitation of an offer to buy any security other than the securities offered by this prospectus, or an offer to sell or a solicitation of an offer to buy any securities by anyone in any jurisdiction in which the offer or solicitation is not authorized or is unlawful.


Up to 16,000,000 Shares of Common Stock together with 16,000,000 Warrants
And
Up to 800,000 Shares of Common Stock Underlying Placement Agent Warrants.
 

 
PROSPECTUS
 

___, 2009

 
44

 

PART II. INFORMATION NOT REQUIRED IN PROSPECTUS
 
Item 13.
Other Expenses of Issuance and Distribution.
 
The following table sets forth the expenses payable by us in connection with this offering (not including the Placement Agent Fee) of securities described in this registration statement. All amounts shown are estimates, except for the SEC registration fee. We will bear all expenses shown below and the Placement Agent Fee.
 
SEC filing fee
 
$
578
 
Accounting fees and expenses
 
$
15,000
 
Legal fees and expenses
 
$
40,000
 
Printing and engraving expenses
 
$
1,422
 
Other
 
$
-
 
Total
 
$
57,000
 
 
Item 14.
Indemnification of Directors and Officers.

Our By-Laws, as amended to date, provide for indemnification of officers and directors to the fullest extent permitted by the Virginia Stock Corporation Act, provided such officer or director acts in good faith and in a manner which such person reasonably believes to be in or not opposed to the best interests of the registrant, and with respect to any criminal matter, had no reasonable cause to believe such person’s conduct was unlawful.

Virginia Stock Corporation Act
 
Section 697 A of the Virginia Stock Corporation Act (“VSCA”) provides that a corporation may indemnify an individual made a party to a proceeding because he is or was a director against liability incurred in the proceeding if (1) he conducted himself in good faith, (2) he believed, in the case of conduct in his official capacity with the corporation, that his conduct was in its best interests, and, in all other cases, that his conduct was at least not opposed to its best interests, and (3) in the case of any criminal proceeding, he had no reasonable cause to believe his conduct was unlawful. Section 697 C of the VSCA provides that the termination of a proceeding by judgment, order, settlement or conviction is not, of itself, determinative that the director did not meet the standard of conduct set forth in Section 697 A.

Section 697 D of the VSCA provides that a corporation may not indemnify a director under Section 697 in connection with a proceeding by or in the right of the corporation in which the director was adjudged liable to the corporation, or in connection with any other proceeding charging improper personal benefit to him, whether or not involving action in his official capacity, in which he was adjudged liable on the basis that personal benefit was improperly received by him. Indemnification permitted under Section 697 of the VSCA in connection with a proceeding by or in the right of the corporation is limited to reasonable expenses incurred in connection with the proceeding.

Section 698 of the VSCA states that, unless limited by its articles of incorporation, a corporation shall indemnify a director who entirely prevails in the defense of any proceeding to which he was a party because he is or was a director of the corporation against reasonable expenses incurred by him in connection with the proceeding.

Section 701 of the VSCA provides that a corporation may not indemnify a director under Section 697 unless authorized in the specific case after a determination has been made that indemnification of the director is permissible in the circumstances because he has met the standard of conduct set forth in Section 697. Such determination is to be made (1) by the board of directors by a majority vote of a quorum consisting of directors not at the time parties to the proceeding, (2) if such a quorum is not obtainable, by majority vote of a committee duly designated by the board of directors (in which designation directors who are parties may participate), consisting solely of two or more directors not at the time parties to the proceeding, (3) by special legal counsel selected as set forth in the statute, or (4) by the shareholders (without the vote of shares owned by or voted under the control of directors who are at the time parties to the proceeding).

Section 699 of the VSCA provides that a corporation may pay for or reimburse the reasonable expenses incurred by a director who is a party to a proceeding in advance of the final disposition of the proceeding if (1) the director furnishes the corporation a written statement of his good faith belief that he has met the standard of conduct described in Section 697, (2) the director furnishes the corporation a written undertaking to repay the advance if it is ultimately determined that he did not meet the standard of conduct, and (3) a determination is made that the facts then known to those making the determination would not preclude indemnification. Determinations and authorizations of payments under Section 699 are to be made in the manner specified in Section 701 of the VSCA.

 
II-1

 

Under Section 700.1 of the VSCA, an individual who is made a party to a proceeding because he is or was a director of a corporation may apply to a court for an order directing the corporation to make advances or reimbursement for expenses or to provide indemnification. The court shall order the corporation to make advances and/or reimbursement for expenses or to provide indemnification if it determines that the director is entitled to such advances, reimbursement or indemnification and shall also order the corporation to pay the director’s reasonable expenses incurred to obtain the order. With respect to a proceeding by or in the right of the corporation, the court may (1) order indemnification of the director to the extent of his reasonable expenses if it determines that, considering all the relevant circumstances, the director is entitled to indemnification even though he was adjudged liable to the corporation and (2) also order the corporation to pay the director’s reasonable expenses incurred to obtain the order of indemnification.

Section 702 of VSCA states that, unless limited by a corporation’s articles of incorporation, (1) an officer of the corporation is entitled to mandatory indemnification under Section 698 of the VSCA, and is entitled to apply for court-ordered indemnification under Section 700 of the VSCA, to the same extent as a director, and (2) the corporation may indemnify and advance expenses to an officer, employee or agent of the corporation to the same extent as to a director.

Section 703 of the VSCA provides that a corporation may purchase and maintain insurance on behalf of an individual who is or was a director, officer, employee or agent of the corporation, or who, while a director, officer, employee, or agent of the corporation, is or was serving at the request of the corporation as a director, officer, partner, trustee, employee or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan or other enterprise, against liability asserted against him or incurred by him in that capacity, or arising from his status as such, whether or not the corporation would have the power to indemnify him against such liability under the provisions of Sections 697 or 698 of the VSCA.

Section 704 of the VSCA states that a corporation shall have power to make any further indemnity, including indemnity with respect to a proceeding by or in the right of the corporation, and to make additional provision for advances and reimbursement of expenses, to any director, officer, employee or agent that may be authorized by its articles of incorporation or any bylaw made by the shareholders or any resolution adopted, before or after the event, by the shareholders, except an indemnity against (1) his willful misconduct, or (2) a knowing violation of the criminal law. Unless the articles of incorporation, or any such bylaw or resolution expressly provide otherwise, any determination as to the right to any further indemnity shall be made in accordance with Section 701 B of the VSCA. Each such indemnity may continue as to a person who has ceased to have the capacity referred to above and may inure to the benefit of the heirs, executors and administrators of such person.
 
Article 11 of our Articles of Incorporation provides that we shall, to the fullest extent permitted by the law of Virginia, indemnify an individual who is or was our director or officer and who was, is, or is threatened to be made, a named defendant or respondent in any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative and whether formal or informal (collectively, a “proceeding”), against any obligation to pay a judgment, settlement, penalty, fine (including any excise tax assessed with respect to any employee benefit plan) or other liability and reasonable expenses (including counsel fees) incurred with respect to such a proceeding, except such liabilities and expenses as are incurred because of such director’s or officer’s willful misconduct or knowing violation of criminal law.
 
Article 11 also provides that unless a determination has been made that indemnification is not permissible, we shall make advances and reimbursements for expenses reasonably incurred by a director or officer in a proceeding as described above upon receipt of an undertaking from such director or officer to repay the same if it is ultimately determined that such director or officer is not entitled to indemnification.
 
Article 11 also provides that the determination that indemnification is permissible, the authorization of such indemnification (if applicable), and the evaluation as to the reasonableness of expenses in a specific case shall be made as provided by law. Special legal counsel selected to make determinations under such Article 11 may be counsel for us. The termination of a proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent shall not of itself create a presumption that a director or officer acted in such a manner as to make him or her ineligible for indemnification. For the purposes of Article 11, every reference to a director or officer includes, without limitation, (1) every individual who is our director or officer, (2) an individual who, while a director or officer, is or was serving at our request as a director, officer, partner, trustee, employee or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan or other enterprise, (3) an individual who formerly was our director or officer or who, while a director or officer, occupied at our request any of the other positions referred to in clause (2) of this sentence, and (4) the estate, personal representative, heirs, executors and administrators of our director or officer or other person referred to herein. Service as a director, officer, partner, trustee, employee or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan or other enterprise controlled by us is deemed service at our request. A director or officer is deemed to be serving an employee benefit plan at our request if such person’s duties to us also impose duties on, or otherwise involve services by, such person to the plan or to participants in or beneficiaries of the plan.

 
II-2

 

Indemnification Agreements

We may enter into indemnification agreements with our directors and officers for the indemnification of and advancing of expenses to such persons to the fullest extent permitted by law.

In addition, we maintain directors’ and officers’ liability insurance which insures against liabilities that our directors and officers may incur in such capacities.

Reference is made to “Undertakings,” below, for the registrant’s undertakings in this registration statement with respect to indemnification of liabilities arising under the Securities Act of 1933, as amended.

Item 15.
Recent Sales of Unregistered Securities.
 
On June 19, 2009, we sold an aggregate of 350,000 shares of our common stock, $.001 par value per share, to our seven directors, for aggregate cash proceeds of $87,500.  The shares of common stock were sold at $0.25 per share.  Each share of common stock was accompanied by one Director Warrant to purchase one additional share of common stock.  The Director Warrants are exercisable for five years from the date that our shareholders approved the issuance of the Director Warrants, at an exercise price of $0.25 per share.
 
On July 1, 2009, we entered into a Business Loan and Security Agreement, referred to as the “Agreement”, with Caledonia Capital Corporation, a Delaware corporation, referred to as the “Lender”, pursuant to which the Lender agreed to lend to us $250,000 in the form of a Secured Promissory Note, referred to as the “Note”, which was issued on July 1, 2009, referred to as the “Issuance Date”.  The Note originally provided for a maturity date of December 29, 2009 (the “Maturity Date”) and an annual interest rate of 15%.  The Note was amended on December 29, 2009 to provide that (a) the annual interest rate of the Note is 20%, (b) accrued interest under the Note shall be payable in monthly installments commencing February 1, 2010, and continuing on the first business day of each successive month, and (c) the Maturity Date is March 31, 2010.  There are no penalties for early prepayment of the Note.  In the event that any installment of principal and/or interest due under the Note is not received by the Lender within ten (10) days after the date when the same is due, then we shall be required to pay a late charge of 5.0% of such installment.  Additionally, in the event that we receive investments from one or more investors in one or more transactions in an aggregate amount in excess of $750,000.00, whether in the form of cash, negotiable or non-negotiable instruments or any form of payment in exchange for the issuance of any certificated or non-certificated security, whether in the form of debt or equity, referred to as an “Equity Raise”, at any time between the Issuance Date and the maturity date, then, we shall be required, within five (5) business days after the Equity Raise first exceeds $750,000.00, to curtail the accrued interest and outstanding principal balance of the Note by an amount equal to the amount by which the Equity Raise then exceeds $750,000.00 (but in no event by more than the then outstanding principal balance and interest accrued on the Note). Pursuant to the Agreement and the Note, our obligations thereunder are secured by a first priority lien in and to all of our intellectual property rights, title and interest in and to the SteelWorks® Mobile integrated server appliance software.  The Agreement contains standard representations and warranties for a transaction of this type.  As an inducement to the Lender to make the loan to us, we issued to the Lender a warrant, referred to as the “Warrant”, to purchase up to 625,000 shares of our common stock, $0.001 par value per share.  As an inducement for the Lender to amend the terms of the Note, we agreed to pay the Lender $25,000. The Warrant is exercisable for four years at an exercise price of $0.15 per share.  The exercise price may be adjusted in the event of any stock dividend, stock split, stock combination, reclassification or similar transaction. Additionally, our Board of Directors has the discretion to reduce the then-current exercise price to any amount at any time during the term of the Warrant for any period of time the Board deems appropriate.  We have agreed to prepare and file a registration statement on or about August 31, 2009 for the purposes of registering the resale of the shares of common stock underlying the Warrant.  The terms of the transaction were the result of arm’s length negotiations between us and the Lender.  Prior to the completion of the transaction, neither we nor any of our affiliates or officers, directors or their associates had any material relationship with the Lender, other than in respect of the applicable material definitive agreements and the transactions contemplated therein and related thereto.
 
On August 24, 2009, we converted $6,000 of outstanding fees owed to our investor relations firm, Rubenstein Investor Relations into warrants to purchase 115,000 of our common stock, at $0.20 per share.  The warrant is exercisable for five years from August 24, 2009.

On October 23, 2009, we converted $35,000 of outstanding legal fees into shares of our common stock, at $0.32 per share, the closing price of our common stock on October 23, 2009.  As a result of the conversion, we issued 109,375 shares of our common stock to Gersten Savage LLP, our legal counsel.

 
II-3

 

On November 3, 2009, we entered into a Line of Credit and Security Agreement, referred to herein as the “Credit and Security Agreement”, with the Lender pursuant to which the Lender agreed to extend to us a revolving line of credit in the amount of $150,000, in the form of a Revolving Line of Credit Promissory Note, referred to herein as the “Credit Note”.  The Credit Note bears interest at a rate of 15% per annum, and is payable in monthly installments commencing 30 days after November 3, 2009, which was the date when we issued the Credit Note.  The principal amount of the Credit Note, together with interest accrued and unpaid thereon and all other sums due, shall be due and payable in full upon the earlier to occur of (a) March 31, 2010, or (b) the date we shall have raised a total of not less than $1,000,000 in capital invested in our equity which is accompanied by our issuing shares of stock which were not trading in the public markets prior to the date of the Credit Note.   There are no penalties for early prepayment of the Credit Note.  The Credit Note is a revolving line of credit note.  Principal advances may be made, from time to time, by the Lender up to the principal amount of the Credit Note, and principal payments may be made, from time to time by us to reduce the principal balance owing pursuant to the Credit Note.  Our obligations under the Credit and Security Agreement and the Credit Note are secured by a lien in and to all of our rights, title and interest in and to its furniture, fixtures, equipment, supplies, receivables, intangibles, and inventory, together with all present and future substitutions, replacements and accessories thereto and all present and future proceeds and products thereof, in any form whatsoever, referred to herein as the “Collateral”.  As an inducement to the Lender to make the loan, we agreed to issue to the Lender a warrant, referred to herein as the “Credit Warrant”, to purchase 2.5 shares of our common stock for every dollar we borrow pursuant to the Credit and Security Agreement.  The Credit Warrant is exercisable for four years at an exercise price of $0.25 per share.  The exercise price may be adjusted in the event of any stock dividend, stock split, stock combination, reclassification or similar transaction. On November 4, 2009, we borrowed $60,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 150,000 shares of our common stock.  On November 23, 2009, we borrowed $90,000 pursuant to the Credit and Security Agreement and the Credit Note, and issued to the Lender a Credit Warrant to purchase up to 225,000 shares of our common stock.  The terms of the transaction were the result of arm’s length negotiations between us and the Lender.  Prior to the completion of the transaction, neither we nor any of our affiliates or officers, directors or their associates had any material relationship with the Lender, other than in respect of the applicable material definitive agreements and the transactions contemplated therein and related thereto.
 
We relied on the exemption from the registration provisions of the Securities Act of 1933, as amended, contained in Section 4(2) thereof for each of the transactions described above.

Item 16.
Exhibits.

The following exhibits are filed herewith or incorporated by reference herein:
 
Exhibit
Number
 
Description
3.1
 
Articles of Incorporation of the Company, dated February 25, 1998, and effective as of February 26, 1998.  (Filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1, Amendment No. 1, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
3.2
 
By-laws of the Company, effective as of March 5, 1998.  (Filed as Exhibit 3.2 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
4.1
 
Specimen common stock certificate for the Company.  (Filed as Exhibit 4.1 to the Company's S-8 dated July 15, 2002 (File No. 333-47631) and hereby incorporated by reference).
4.2
 
Form of Warrant. (Filed as Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement dated June 25, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
4.3
 
Form of Placement Agent Warrant.  (Filed as Exhibit 4.3 to Amendment No. 5 to the Company’s Registration Statement dated October 23, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
4.3.1
 
Amended Form of Placement Agent Warrant.  (Filed as Exhibit 4.3.1 to Amendment No. 6 to the Company’s Registration Statement dated October 29, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
*4.3.2
 
Amendment No. 2 to Form of Placement Agent Warrant.
*5.1
 
Legal Opinion of Gersten Savage LLP.
10.1
 
Employment Agreement by and between Dunn and Thomas P. Dunne (Filed as Exhibit 99.2 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 000-24015) and hereby incorporated by reference).
10.2
 
1997 Amended Stock Option Plan.  (Filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-92406) and hereby incorporated by reference).
10.3
 
Agreement, dated May 5, 1997, by and between International Data Products, Corp. and the U.S. Air Force, the Desktop V Contract.  (Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
10.4
 
Employee Stock Purchase Plan. (Filed as Exhibit 10.22 to the Company’s 10-K, dated February 16, 1999 (File No. 000-24015) and hereby incorporated by reference).
10.5
 
Employment Agreement by and between SteelCloud, Inc. and Kevin Murphy, dated June 8, 2004. (Filed as Exhibit 10.32 to the Company’s 10-K, dated January 26, 2005 (File No. 000-24015) and hereby incorporated by reference).
 10.6
 
Employment Agreement by and between SteelCloud, Inc. and Brian Hajost, dated June 8, 2004. (Filed as Exhibit 10.33 to the Company’s 10-K, dated January 26, 2005 (File No. 000-24015) and hereby incorporated by reference).
  10.7
 
 
Sublease by and between SteelCloud and NEC America Inc., dated September 28, 2004. (Filed as Exhibit 10.35 to the Company’s 10-K, dated January 26, 2005 and hereby incorporated by reference).
  10.8
 
Revised Rent Commencement Date Agreement, dated March 16, 2005 between OTR and the Company (Filed as Exhibit 10.36 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
 10.9
 
 
Standard Industrial Gross Lease, dated November 4, 2004 between OTR and the Company and Lease Amendment #1, dated March 28, 2005 (Filed as Exhibit 10.37 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
 10.10
 
Loan Agreement, dated January 22, 2004, by and between SteelCloud, Inc. and Wachovia Bank, National Association   and   Promissory Note issued by SteelCloud, Inc. on March 21, 2005 to Wachovia Bank, National Association (Filed as Exhibit 10.36 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.11
 
Employment Agreement by and between SteelCloud, Inc. and Clifton W. Sink (Filed as Exhibit 10.1 to the Company’s 8-K, dated June 8, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.12
 
Separation Agreement by and between SteelCloud, Inc. and Thomas P. Dunne (Filed as Exhibit 10.1 to the Company’s 8-K, dated June 19, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.13
 
Employment Agreement by and between SteelCloud, Inc. and Robert Richmond (Filed as Exhibit 10.1 to the Company’s 8-K, dated September 21, 2006 (File No. 000-24015) and hereby incorporated by reference).

 
II-4

 

 
10.14
 
Amendment, dated April 19, 2006, to Employment Agreement by and between SteelCloud, Inc. and Brian Hajost, dated June 8, 2004, originally filed as Exhibit 10.33 to the Company’s 10-K, dated January 26, 2005 (Filed as Exhibit 10.42 to the Company’s 10-K, dated January 23, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.15
 
Employment Agreement as Executive Director by and between SteelCloud, Inc. and Robert E. Frick (Filed as Exhibit 10.1 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.16
 
Employment Agreement as President and Chief Executive Officer by and between SteelCloud, Inc. and Robert E. Frick (Filed as Exhibit 10.2 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.17
 
Employment Resignation Agreement and Release by and between SteelCloud, Inc. and Clifton W. Sink (Filed as Exhibit 10.2 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.18
 
Amendment, dated October 31, 2007, to Employment Agreement by and between SteelCloud, Inc. and Kevin Murphy, dated June 8, 2004, originally filed as Exhibit 10.32 to the Company’s 10-K, dated January 26, 2005. (Filed as Exhibit 10.1 to the Company’s 8-K, dated November 1, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.19
 
Amended 2002 Employee Stock Option Plan  (Filed as Exhibit 4.1 to the Company’s S-8, dated June 25, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.20
 
Amended Employee Stock Purchase Plan  (Filed as Exhibit 4.3 to the Company’s S-8, dated June 25, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.21
 
Form of Restricted Stock Agreement (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference.).
10.22
 
Amended 2007 Stock Option and Restricted Stock Plan (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference).
10.23
 
SteelCloud MEA Joint Venture Agreement dated October 2008 (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference).
10.24
 
Employment Agreement as President and Chief Executive Officer by and between SteelCloud, Inc. and Brian H. Hajost (Filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on February 5, 2009, and hereby incorporated by reference).
10.25
 
Employment Agreement Amendment by and between SteelCloud, Inc. and Kevin Murphy, dated February 28, 2009 (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on March 5, 2009, and hereby incorporated by reference).
10.26
 
Business Loan and Security Agreement dated as of July 1, 2009 by and between SteelCloud, Inc. and Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
10.27
 
Secured Promissory Note issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.2 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
*10.27.1  
Addendum (dated December 29, 2009) to Secured Promissory Note issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation.  
10.28
 
Warrant issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.3 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
10.29
 
Asset Purchase Agreement dated July 16, 2009, by and between SteelCloud, Inc. and NCS Technologies, Inc. (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on July 16, 2009, and hereby incorporated by reference).
10.30
 
Engagement letter dated September 3, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc. (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on September 10, 2009, and hereby incorporated by reference).
10.30.1
 
Amendment to engagement letter dated October 28, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc. (Filed as Exhibit 10.30.1 to Amendment No. 6 to the Company’s Registration Statement dated October 29, 2009 (Registration No. 333-158703) and hereby incorporated by reference)
*10.30.2
 
Amendment to engagement letter dated December 29, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc.
10.31
 
Line of Credit and Security Agreement dated November 3, 2009 by and between SteelCloud, Inc. and Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.32
 
Revolving Line of Credit Promissory Note issued on November 3, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.2 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.33
 
Warrant issued on November 4, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.3 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.34
 
Warrant issued on November 23, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 23, 2009, and hereby incorporated by reference).
*23.1
 
Consent of Grant Thornton LLP, Independent Registered Public Accounting Firm.
*23.2
 
Consent of Gersten Savage LLP (incorporated in Exhibit 5.1). 
99.1 
 
Correspondence from Kevin Murphy dated November 18 , 2009 (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 23, 2009, and hereby incorporated by reference)
 
*Filed herewith

 
II-5

 

Item 17.
 Undertakings.

Insofar as indemnification by the registrant for liabilities arising under the Securities Act, may be permitted to directors, officers and controlling persons of the registrant pursuant to the provisions referenced in Item 14 of this registration statement, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. If a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer, or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by a director, officer or controlling person in connection with the securities being registered hereunder, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act, and will be governed by the final adjudication of such issue.

The undersigned registrant hereby undertakes:

1. To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement:

(i) To include any prospectus required by Section 10(a)(3) of the Securities Act;

(ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the SEC pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than a 20% change in the maximum aggregate offering price set forth in the “Calculation of Registration Fee” table in the effective registration statement; and

(iii) To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement;

2. That, for the purpose of determining any liability under the Securities Act, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and this offering of such securities at that time shall be deemed to be the initial bona fide offering thereof;

3. To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of this offering;
 
4. For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b) (1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective;
 
5.  For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.
 
6. That, for the purpose of determining liability of the registrant under the Securities Act to any purchaser in the initial distribution of the securities, the undersigned registrant undertakes that in a primary offering of securities of the undersigned registrant pursuant to this registration statement, regardless of the underwriting method used to sell the securities to the purchaser, if the securities are offered or sold to such purchaser by means of any of the following communications, the undersigned registrant will be a seller to the purchaser and will be considered to offer or sell such securities to such purchaser:

(i) any preliminary prospectus or prospectus of an undersigned registrant relating to this offering required to be filed pursuant to Rule 424;

(ii) any free writing prospectus relating to this offering prepared by, or on behalf of, the undersigned registrant or used or referred to by the undersigned registrant;

(iii) the portion of any other free writing prospectus relating to this offering containing material information about an undersigned registrant or its securities provided by or on behalf of the undersigned registrant; and

 
II-6

 

(iv) any other communication that is an offer in this offering made by the undersigned registrant to the purchaser.

7. The undersigned registrant hereby undertakes to file, during any period in which offers or sales are being made, a supplement to the prospectus included in this Registration Statement which sets forth, with respect to a particular offering, the specific number of shares of common stock to be sold, the name of the holder, the sales price, the name of any participating broker, dealer, underwriter or agent, any applicable commission or discount and any other material information with respect to the plan of distribution not previously disclosed.
 
           8. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue.

 
II-7

 

SIGNATURES
 
Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this Amendment No. 7 to the Registration Statement on Form S-1 to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Herndon, State of Virginia on December 29, 2009.
 
 STEELCLOUD, INC.
 
/s/ Brian H. Hajost
 
Brian H. Hajost
Chief Executive Officer
 
 
Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 7 to the Registration Statement has been signed by the following persons in the capacities and on the dates stated.

Name
 
Title
 
Date
         
/s/ Brian H. Hajost
       
Brian H. Hajost
 
Chief Executive Officer and President
 
December 29, 2009
         
/s/Steven Snyder
       
Steven Snyder
 
Vice President of Finance and Principal Financial Officer and Secretary
 
December 29, 2009
         
/s/VADM E.A. Burkhalter
       
VADM E. A. Burkhalter USN (Ret.)
 
Director
 
December 29, 2009
         
/s/James Bruno
       
James Bruno
 
Director
 
December 29, 2009
         
/s/Jay Kaplowitz
       
Jay Kaplowitz
 
Director
 
December 29, 2009
         
/s/Benjamin Krieger
       
Benjamin Krieger
 
Director
 
December 29, 2009
         
/s/Ashok Kaveeshwar
       
Ashok Kaveeshwar
 
Director
 
December 29, 2009

 
II-8

 

Exhibit Index
 
Exhibit
Number
 
Description
3.1
 
Articles of Incorporation of the Company, dated February 25, 1998, and effective as of February 26, 1998.  (Filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1, Amendment No. 1, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
3.2
 
By-laws of the Company, effective as of March 5, 1998.  (Filed as Exhibit 3.2 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
4.1
 
Specimen common stock certificate for the Company.  (Filed as Exhibit 4.1 to the Company's S-8 dated July 15, 2002 (File No. 333-47631) and hereby incorporated by reference).
4.2
 
Form of Warrant. (Filed as Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement dated June 25, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
4.3
 
Form of Placement Agent Warrant.  (Filed as Exhibit 4.3 to Amendment No. 5 to the Company’s Registration Statement dated October 23, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
4.3.1
 
Amended Form of Placement Agent Warrant.  (Filed as Exhibit 4.3.1 to Amendment No. 6 to the Company’s Registration Statement dated October 29, 2009 (Registration No. 333-158703) and hereby incorporated by reference).
*4.3.2
 
Amendment No. 2 to Form of Placement Agent Warrant.
*5.1
 
Legal Opinion of Gersten Savage LLP.
10.1
 
Employment Agreement by and between Dunn and Thomas P. Dunne (Filed as Exhibit 99.2 to Dunn's Registration Statement on Form SB-2, Amendment 2, dated April 4, 1997 (File No. 000-24015) and hereby incorporated by reference).
10.2
 
1997 Amended Stock Option Plan.  (Filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-92406) and hereby incorporated by reference).
10.3
 
Agreement, dated May 5, 1997, by and between International Data Products, Corp. and the U.S. Air Force, the Desktop V Contract.  (Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-1, Amendment No. 2, dated April 23, 1998 (File No. 333-47631) and hereby incorporated by reference).
10.4
 
Employee Stock Purchase Plan. (Filed as Exhibit 10.22 to the Company’s 10-K, dated February 16, 1999 (File No. 000-24015) and hereby incorporated by reference).
10.5
 
Employment Agreement by and between SteelCloud, Inc. and Kevin Murphy, dated June 8, 2004. (Filed as Exhibit 10.32 to the Company’s 10-K, dated January 26, 2005 (File No. 000-24015) and hereby incorporated by reference).
 10.6
 
Employment Agreement by and between SteelCloud, Inc. and Brian Hajost, dated June 8, 2004. (Filed as Exhibit 10.33 to the Company’s 10-K, dated January 26, 2005 (File No. 000-24015) and hereby incorporated by reference).
  10.7
 
Sublease by and between SteelCloud and NEC America Inc., dated September 28, 2004. (Filed as Exhibit 10.35 to the Company’s 10-K, dated January 26, 2005 and hereby incorporated by reference).
  10.8
 
Revised Rent Commencement Date Agreement, dated March 16, 2005 between OTR and the Company (Filed as Exhibit 10.36 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
 10.9
 
 
Standard Industrial Gross Lease, dated November 4, 2004 between OTR and the Company and Lease Amendment #1, dated March 28, 2005 (Filed as Exhibit 10.37 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
 10.10
 
Loan Agreement, dated January 22, 2004, by and between SteelCloud, Inc. and Wachovia Bank, National Association   and   Promissory Note issued by SteelCloud, Inc. on March 21, 2005 to Wachovia Bank, National Association (Filed as Exhibit 10.36 to the Company’s 10-K, dated January 30, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.11
 
Employment Agreement by and between SteelCloud, Inc. and Clifton W. Sink (Filed as Exhibit 10.1 to the Company’s 8-K, dated June 8, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.12
 
Separation Agreement by and between SteelCloud, Inc. and Thomas P. Dunne (Filed as Exhibit 10.1 to the Company’s 8-K, dated June 19, 2006 (File No. 000-24015) and hereby incorporated by reference).
10.13
 
Employment Agreement by and between SteelCloud, Inc. and Robert Richmond (Filed as Exhibit 10.1 to the Company’s 8-K, dated September 21, 2006 (File No. 000-24015) and hereby incorporated by reference).

 
II-9

 

 
10.14
 
Amendment, dated April 19, 2006, to Employment Agreement by and between SteelCloud, Inc. and Brian Hajost, dated June 8, 2004, originally filed as Exhibit 10.33 to the Company’s 10-K, dated January 26, 2005 (Filed as Exhibit 10.42 to the Company’s 10-K, dated January 23, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.15
 
Employment Agreement as Executive Director by and between SteelCloud, Inc. and Robert E. Frick (Filed as Exhibit 10.1 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.16
 
Employment Agreement as President and Chief Executive Officer by and between SteelCloud, Inc. and Robert E. Frick (Filed as Exhibit 10.2 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.17
 
Employment Resignation Agreement and Release by and between SteelCloud, Inc. and Clifton W. Sink (Filed as Exhibit 10.2 to the Company’s 8-K, dated August 31, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.18
 
Amendment, dated October 31, 2007, to Employment Agreement by and between SteelCloud, Inc. and Kevin Murphy, dated June 8, 2004, originally filed as Exhibit 10.32 to the Company’s 10-K, dated January 26, 2005. (Filed as Exhibit 10.1 to the Company’s 8-K, dated November 1, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.19
 
Amended 2002 Employee Stock Option Plan  (Filed as Exhibit 4.1 to the Company’s S-8, dated June 25, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.20
 
Amended Employee Stock Purchase Plan  (Filed as Exhibit 4.3 to the Company’s S-8, dated June 25, 2007 (File No. 000-24015) and hereby incorporated by reference).
10.21
 
Form of Restricted Stock Agreement (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference.).
10.22
 
Amended 2007 Stock Option and Restricted Stock Plan (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference).
10.23
 
SteelCloud MEA Joint Venture Agreement dated October 2008 (Filed as Exhibit 10.21 to the Company’s 10-K for the fiscal year ended October 31, 2008, filed with the Commission on January 29, 2009 (File No. 000-24015), and hereby incorporated by reference).
10.24
 
Employment Agreement as President and Chief Executive Officer by and between SteelCloud, Inc. and Brian H. Hajost (Filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on February 5, 2009, and hereby incorporated by reference).
10.25
 
Employment Agreement Amendment by and between SteelCloud, Inc. and Kevin Murphy, dated February 28, 2009 (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on March 5, 2009, and hereby incorporated by reference).
10.26
 
Business Loan and Security Agreement dated as of July 1, 2009 by and between SteelCloud, Inc. and Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
10.27
 
Secured Promissory Note issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.2 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
*10.27.1  
Addendum (dated December 29, 2009) to Secured Promissory Note issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation.   
10.28
 
Warrant issued on July 1, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.3 to the Company’s 8-K, filed with the Commission on July 8, 2009, and hereby incorporated by reference).
10.29
 
Asset Purchase Agreement dated July 16, 2009, by and between SteelCloud, Inc. and NCS Technologies, Inc. (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on July 16, 2009, and hereby incorporated by reference).
10.30
 
Engagement letter dated September 3, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc. (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on September 10, 2009, and hereby incorporated by reference).
10.30.1
 
Amendment to engagement letter dated October 28, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc. (Filed as Exhibit 10.30.1 to Amendment No. 6 to the Company’s Registration Statement dated October 29, 2009 (Registration No. 333-158703) and hereby incorporated by reference)
*10.30.2
 
Amendment to engagement letter dated December 29, 2009, by and between SteelCloud, Inc. and Westminster Securities, a Division of Hudson Securities, Inc.
10.31
 
Line of Credit and Security Agreement dated November 3, 2009 by and between SteelCloud, Inc. and Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.32
 
Revolving Line of Credit Promissory Note issued on November 3, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.2 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.33
 
Warrant issued on November 4, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.3 to the Company’s 8-K, filed with the Commission on November 9, 2009, and hereby incorporated by reference).
10.34
 
Warrant issued on November 23, 2009 by SteelCloud, Inc. to Caledonia Capital Corporation (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 23, 2009, and hereby incorporated by reference).
*23.1
 
Consent of Grant Thornton LLP, Independent Registered Public Accounting Firm.
*23.2
 
Consent of Gersten Savage LLP (incorporated in Exhibit 5.1). 
99.1 
  Correspondence from Kevin Murphy dated November 18, 2009 (filed as Exhibit 10.1 to the Company’s 8-K, filed with the Commission on November 23, 2009, and hereby incorporated by reference)
 
 
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