AMERICAN DEFENSE SYSTEMS INC - FORM 10-Q

Attached files

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EX-31.2 - EX-31.2 - AMERICAN DEFENSE SYSTEMS INC	v194834_ex31-2.htm
EX-31.1 - EX-31.1 - AMERICAN DEFENSE SYSTEMS INC	v194834_ex31-1.htm
EX-32.1 - EX-32.1 - AMERICAN DEFENSE SYSTEMS INC	v194834_ex32-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended June 30, 2010

Commission File Number 001-33888

American Defense Systems, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		83-0357690
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

230 Duffy Avenue

Hicksville, NY 11801

(516) 390-5300

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

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 definition of “accelerated filer,” “large accelerated filer” and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer ¨		Accelerated Filer ¨

Non-Accelerated Filer ¨		Smaller Reporting Company x

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

As of August 18, 2010, 49,357,454 shares of common stock, par value $0.001 per share, of the registrant were outstanding.

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements	3
	Condensed Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December 31, 2009	3
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2010 and 2009 (Unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and 2009 (Unaudited)	6
	Notes to Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosure About Market Risk	32
Item 4.	Controls and Procedures	32

PART II — OTHER INFORMATION

Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	45
Item 3.	Defaults Upon Senior Securities	45
Item 4.	(Removed and Reserved)	45
Item 5.	Other Information	45
Item 6.	Exhibits	46

SIGNATURES		47

PART I

Item 1. Condensed Consolidated Financial Statements

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

ASSETS	June 30, 2010 (Unaudited)		December 31, 2009 *

CURRENT ASSETS
Cash	$	16,330	$	-
Accounts receivable, net of allowance for doubtful accounts of $312,448 and $222,448 as of June 30, 2010 and December 31, 2009, respectively		5,745,131		2,288,666
Accounts receivable-factoring		237,488		199,876
Tax receivable		108,741		108,741
Costs in excess of billings on uncompleted contracts, net		4,408,818		7,762,836
Prepaid expenses and other current assets		618,195		540,381
Deferred tax assets		-		521

TOTAL CURRENT ASSETS		11,134,703		10,901,021

Property and equipment, net		2,658,252		3,078,724
Deferred financing costs, net		870,498		1,547,551
Notes receivable, net		400,000		400,000
Intangible Assets		634,450		606,000
Goodwill		602,500		450,000
Deposits		471,187		407,137
Other Assets		-		138,001

TOTAL ASSETS	$	16,771,590	$	17,528,434

* Condensed from audited financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

LIABILITIES AND SHAREHOLDERS' DEFICIENCY	June 30, 2010 (Unaudited)			December 31, 2009 *

CURRENT LIABILITIES
Accounts payable	$	6,943,030		$	6,695,712
Cash overdraft		967,457			48,573
Accrued expenses		699,929			498,795
Warrant liability		25,838			35,413


TOTAL CURRENT LIABILITIES		8,636,254			7,278,493

LONG TERM LIABILITIES
Mandatory redeemable Series A Convertible Preferred Stock (cumulative), 15,000 shares authorized issued and outstanding		13,716,542			12,429,832
Deferred rent		176,583			-
Deferred tax liability		-			521

TOTAL LIABILITIES		22,529,379			19,708,846

SHAREHOLDERS' DEFICIENCY

Common stock, $0.001 par value, 100,000,000 shares authorized, 49,357,454 and 46,611,457 shares issued and outstanding as of June 30, 2010 and December 31, 2009, respectively		49,357			46,611
Additional paid-in capital		15,673,573			14,712,414
Accumulated Deficit		(21,480,719	)		(16,939,437	)

TOTAL SHAREHOLDERS' DEFICIENCY		(5,757,789	)		(2,180,412	)

TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIENCY	$	16,771,590		$	17,528,434

* Condensed from audited financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2010			2009			2010			2009

CONTRACT REVENUES EARNED	$	11,438,765		$	14,033,575		$	26,884,309		$	23,523,277

COST OF REVENUES EARNED (exclusive of depreciation shown separately below)		9,610,274			8,659,865			19,596,952			14,112,974

GROSS PROFIT		1,828,491			5,373,710			7,287,357			9,410,303

OPERATING EXPENSES
General and administrative expenses		1,528,758			1,610,723			3,392,047			3,097,252
General and administrative salaries		933,288			1,022,366			1,817,507			2,095,403
Sales and Marketing		571,800			723,779			1,134,609			1,457,573
T2 expenses		204,479			124,070			423,327			237,672
Research and development		151,997			16,841			273,714			203,227
Settlement of litigation		-			63,441			-			63,441
Depreciation		290,423			278,083			579,252			519,412
Professional fees		694,163			612,613			1,267,683			1,200,079
TOTAL OPERATING EXPENSES		4,374,908			4,451,916			8,888,139			8,874,059

OPERATING INCOME (LOSS)		(2,546,417	)		921,794			(1,600,782	)		536,244

OTHER INCOME (EXPENSE)
Unrealized (loss) gain on adjustment of fair value Series A convertible preferred stock classified as a liability		(226,915	)		9,142			(873,015	)		(685,312	)
Unrealized gain (loss) on warrant liability		34,004			(107,022	)		9,575			(26,350	)
Loss on deemed extinguishment of debt		-			(2,613,630	)		-			(2,613,630	)
Other income (expense)		-			(12,730	)		-			(12,730	)
Interest expense		(505,761	)		(438,421	)		(1,150,490	)		(781,151	)
Interest expense - Mandatorily redeemable preferred stock dividends		(375,000	)		(374,380	)		(750,000	)		(749,380	)
Interest income		-			10			-			8,856
Finance charge		(97,082	)		-			(176,863	)		-
TOTAL OTHER INCOME (EXPENSE)		(1,170,754	)		(3,537,031	)		(2,940,793	)		(4,859,697	)

LOSS BEFORE INCOME TAXES		(3,717,171	)		(2,615,237	)		(4,541,575	)		(4,323,453	)

INCOME TAX PROVISION		-			-			-			-

NET LOSS	$	(3,717,171	)	$	(2,615,237	)	$	(4,541,575	)	$	(4,323,453	)

Weighted Average Shares Outstanding (Basic and Diluted)		47,878,737			41,484,307			47,341,485			41,484,307

NET LOSS per Share - Basic and Diluted:	$	(0.08	)	$	(0.06	)	$	(0.10	)	$	(0.10	)

The accompanying notes are an integral part of these condensed consolidated financial statements.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
	2010			2009

CASH FLOWS FROM OPERATING ACTIVITIES:
NET LOSS	$	(4,541,575	)	$	(4,323,453	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Change in costs in excess of billings reserve		60,000			-
Loss on deemed extinguishment of debt		-			2,613,630
Change in fair value associated with preferred stock and warrants liabilities		863,442			711,662
Stock based compensation expense		160,311			221,692
Amortization of deferred financing costs		677,053			297,916
Amortization of Discount on Series A preferred stock		467,582			269,104
Depreciation and amortization		579,252			519,412
Bad debt expense		90,000			-
Deferred rent		176,582			-
Stock issued for payment of dividends on preferred stock		750,000			1,199,380

Changes in operating assets and liabilities:
Accounts receivable		(3,546,465	)		(3,629,428	)
Accounts receivable-Factoring		(37,612	)		-
Deposits and other assets		(64,050	)		127,811
Other assets		138,001			-
Cost in excess of billing on uncompleted contracts		3,294,019			(1,366,455	)
Prepaid expenses and other assets		(106,264	)		(577,039	)
Accounts payable and accrued expenses		295,952			3,603,243
Cash overdraft		918,884			-
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES		175,112			(332,525	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of equipment		(158,782	)		(300,169	)
NET CASH USED IN INVESTING ACTIVITIES		(158,782	)		(300,169	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from line of credit		-			1,429,789
Repayments of short term financing		-			55,490
Deferred financing costs		-			(878,380	)
NET CASH PROVIDED BY FINANCING ACTIVITIES		-			606,899

NET INCREASE (DECREASE) IN CASH		16,330			(25,795	)

CASH AT BEGINNING OF YEAR		-			374,457
CASH AT THE END OF PERIOD	$	16,330		$	348,662

The accompanying notes are an integral part of these condensed consolidated financial statements.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
	2010		2009

Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	-	$	25,157
Cash paid during the period for taxes	$	-	$	-

Supplemental disclosure of non-cash investing and financing activities
Modification of the terms of the Series A preferred stock	$	53,887	$	-
Contingent payment for APSG acquisition	$	152,500	$	-
Stock options issued in lieu of compensation	$	-	$	214,131
Stock issued in lieu of cash compensation	$	-	$	156,847
Stock issued as payment toward accrued and future interest	$	-	$	1,199,380
Stock issued in connection with investor warrants	$	-	$	2,550,000

The accompanying notes are an integral part of these condensed consolidated financial statements.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.	NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

American Defense Systems, Inc. (the “Company” or “ADSI”) was incorporated under the laws of the State of Delaware on December 6, 2002.

On May 1, 2003, the stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”) exchanged all of his issued and outstanding shares for shares of American Defense Systems, Inc. The exchange was accounted for as a recapitalization of the Company, wherein the stockholder retained all the outstanding stock of American Defense Systems, Inc. At the time of the acquisition American Defense Systems, Inc. was substantially inactive.

On November 15, 2007, the Company entered into an Asset Purchase Agreement with Tactical Applications Group (“TAG”), a North Carolina based sole proprietorship, and its owner. TAG has a retail establishment located in Jacksonville, North Carolina that supplies tactical equipment to military and security personnel. As discussed more fully in Note 6, the operations of TAG were discontinued on January 2, 2009.

In January 2008, American Physical Security Group, LLC (“APSG”) was established as a wholly owned subsidiary of the Company for the purposes of acquiring the assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle barricades. This acquisition represents a new product line for the Company. APSG is located in North Carolina.

Interim Review Reporting

The accompanying interim unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. For further information, refer to the financial statements and footnotes thereto included in the Company’s Form 10-K annual report for the year ended December 31, 2009 filed on April 15, 2010.

Nature of Business

The Company designs and supplies transparent and opaque armor solutions for both military and commercial applications. Its primary customers are United States government agencies and general contractors who have contracts with governmental entities. These products, sold under Vista trademarks, are used in transport and fighting vehicles, construction equipment, sea craft and various fixed structures which require ballistic and blast attenuation.

The Company also provides engineering and consulting services, develops and installs detention and security hardware, entry control and monitoring systems, intrusion detection systems, and security glass. The Company also supplies vehicle anti-ram barriers. Its primary customer for these services and products are the detention and security industry.

Principles of Consolidation

The consolidated financial statements include the accounts of American Defense Systems, Inc. and its wholly-owned subsidiaries, A.J. Piscitelli & Associates, Inc. and APSG. All significant intercompany accounts and transactions have been eliminated in consolidation.

Terms and Definitions

ADSI		American Defense Systems, Inc. (or, the “Company”)
AJP		A.J. Piscitelli & Associates, Inc., a subsidiary
APSG		American Physical Security Group, LLC, a subsidiary
ASC		FASB Accounting Standards Codification
FASB		Financial Accounting Standards Board
GAAP		Generally Accepted Accounting Principles
PCAOB		Public Companies Accounting Oversight Board
SEC		Securities Exchange Commission
SFAS or FAS		Statement of Financial Accounting Standards
TAG		Tactical Applications Group, a subsidiary

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Management Liquidity Plans

As of June 30, 2010, the Company had working capital of $2,498,449, an accumulated deficit of $21,480,719, shareholders’ deficiency of $5,757,789 and cash on hand of $16,330. The Company had net losses of $3,717,171 and $4,541,575, respectively, for the three and six months ended June 30, 2010. The Company believes that its current net accounts receivable and cost in excess of billing together with its expected cash flows from operations and its ability to sell accounts receivable under its factoring agreement, will be sufficient to meet its anticipated cash requirements for working capital at least through June 30, 2011. The Series A Convertible Preferred Stock (the “Series A Preferred”) had a mandatory redemption date of December 31, 2010. On April 8, 2010, the Company entered into a waiver agreement with the holders of its Series A Preferred (the “Series A Holders”) which extended the maturity redemption date from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity redemption date from April 1, 2011 to July 1, 2011. The Company is currently seeking to raise capital or obtain access to capital sufficient to permit the Company to effect such redemption. If the Company is unable to timely raise capital or obtain access to a credit facility or other source of funds sufficient to fund such redemption, its cash flow could be adversely affected and its business significantly harmed. In addition, restrictions imposed pursuant to the General Corporation Law of the State of Delaware (the “DGCL”), its state of incorporation, would prohibit the Company from satisfying such redemption if the Company lacks sufficient surplus, as such term is defined under the DGCL.

The carrying amounts of assets and liabilities presented in the financial statements do not necessarily purport to represent realizable or settlement values. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Reclassifications

Certain amounts in the prior year financial statements have been reclassified for comparative purposes to conform to the presentation in the current year financial statements. These reclassifications have no effect on previously reported income.

Use of Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Significant estimates for all periods presented include cost in excess of billings, allowance for doubtful accounts, liabilities associated with the Series A Preferred and warrants and valuation of deferred tax assets.

Subsequent Events

The Company has evaluated events that occurred subsequent to June 30, 2010 through the date these financial statements were issued. Management concluded that no additional subsequent events required disclosure in these financial statements except as discussed below.

On July 31, 2010, the Company issued an option to purchase 175,000 shares of its common stock to a consultant as compensation under the Company’s 2007 Incentive Compensation Plan (the “2007 plan”). The exercise price for the option is $0.26 per share and 20% of the option vests annually with the first 20% vesting upon the first anniversary of the grant date.

On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from April 1, 2011 to July 1, 2011.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Revenue and Cost Recognition

The Company recognizes revenue in accordance with the provisions of Accounting Standards Codification (“ASC”) 605, “Revenue Recognition”, which states that revenue is realized and earned when all of the following criteria are met:

(a) persuasive evidence of the arrangement exists,

(b) delivery has occurred or services have been rendered,

(d) collectibility is reasonably assured.

The Company recognizes revenue and reports profits from purchase orders filled under master contracts when an order is complete. Purchase orders received under master contracts may extend for periods in excess of one year. Purchase order costs are accumulated as deferred assets and billings and/or cash received are charged to a deferred revenue account during the periods of construction. However, no revenues, costs or profits are recognized in operations until the period of completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and, the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of June 30, 2010 and December 31, 2009, there were no such provisions made.

Contract Revenue

Cost in Excess of Billing

All costs associated with uncompleted customer purchase orders under contract are recorded on the balance sheet as a current asset called “Costs in Excess of Billings on Uncompleted Contracts.” Such costs include direct material, direct labor, and project-related overhead. Upon completion of a purchase order, costs are then reclassified from the balance sheet to the statement of operations as costs of revenue. A customer purchase order is considered complete when a satisfactory inspection has occurred, resulting in customer acceptance and delivery.

Concentrations

The Company’s bank accounts are maintained in financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.

The Company received certain of its components from sole suppliers. The Company has two suppliers that each provide greater than 10% of its supply needs. Additionally, the Company relies on a limited number of contract manufacturers and suppliers to provide manufacturing services for its products. The inability of any contract manufacturer or supplier to fulfill supply requirements of the Company could materially impact future operating results.

For the six months ended June 30, 2010, the Company derived 71% and 18% of its revenues from various U.S. government entities and one other customer, respectively.

Allowance for Doubtful Accounts

The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. Management performs on-going credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by the review of their current credit information. Collections and payments from customers are continuously monitored. While such bad debt expenses have historically been within expectations and allowances established, the Company cannot guarantee that it will continue to experience the same credit loss rates that it has in the past. At June 30, 2010 and December 31, 2009, the allowance for doubtful accounts was $312,448 and $222,448, respectively.

Loss per Share

Basic loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive potential common shares would primarily consist of employee stock options, warrants and convertible preferred stock.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Securities that could potentially dilute basic EPS in the future that were not included in the computation of the diluted EPS because to do so would be anti-dilutive consist of the following:

	June 30
In Thousands	2010		2009

Warrants to purchase Common Stock		675,001		1,448,681

Options to Purchase Common Stock		2,330,000		2,195,000

Series A Convertible Preferred Stock		30,000,000		7,500,000

Total Potential Common Stock		33,005,001		11,143,681

Fair Value of Financial Instruments

Fair value of certain of the Company’s financial instruments including cash, accounts receivable, note receivable, accrued compensation, and other accrued liabilities approximate cost because of their short maturities. The Company measures and reports fair value in accordance with ASC 820, “Fair Value Measurements and Disclosure” which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value investments.

Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:

Level 1

Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;

Level 2

Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities; and

Level 3

Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.

Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of operations.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company did not have any assets or liabilities categorized as Level 1 or Level 2 as of June 30, 2010.

The following summarizes the Company’s assets and liabilities measured at fair value as of June 30, 2010:

	Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical		Significant Other Observable		Significant Unobservable
	Balance as of		Assets		Inputs		Inputs
Description	June 30, 2010		(Level 1)		(Level 2)		(Level 3)

Liabilities
Series A Preferred (1)	$	13,716,542	$	—	$	—	$	13,716,542
2005 Warrants (1)		—		—		—		—
2006 Warrants (1)		—		—		—		—
Placement Agent Warrants (1)		25,838		—		—		25,838

Total Liabilities	$	13,742,380	$	—	$	—	$	13,742,380

(1)	Methods and significant inputs and assumptions are discussed in Note 5 below.

The following is a reconciliation of the beginning and ending balances for the Company’s liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2010:

	Series A Preferred			2005 Warrants			2006 Warrants			Placement Agent Warrants			Total
Balance – January 1, 2010	$	12,429,832		$	4,372		$	1,494		$	29,547		$	12,465,245

Amortization of debt discount		467,582			-			-			-			467,582
Change in fair value		873,015			(4,372	)		(1,494	)		(3,709	)		863,440
Modification of terms		(53,887	)		-			-			-			(53,887	)

Balance – June 30, 2010	$	13,716,542		$	-		$	-		$	25,838		$	13,742,380

The change in fair value recorded for Level 3 liabilities for the periods above are reported in other income (expense) on the condensed consolidated statement of operations.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Recent Accounting Pronouncements

In June 2009, the FASB issued new accounting guidance, under ASC Topic 810, which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance clarified that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. An ongoing reassessment is required of whether a company is the primary beneficiary of a variable interest entity. Additional disclosures are also required about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. This guidance was effective as of the beginning of each reporting entity’s first annual reporting period that began after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The adoption of this guidance did not have a material effect on the Company’s consolidated financial position or results of operations.

In October 2009, the FASB issued new accounting guidance, under ASC Topic 605, on revenue recognition which addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Specifically, this guidance amends the criteria for Subtopic 605-25, Revenue Recognition-Multiple Element Arrangements, for separating consideration in multiple-deliverable arrangements. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence, (b) third-party evidence, or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangements to all deliverables using the relative selling price method and also requires expanded disclosures. This guidance is effective for all new or materially modified arrangements entered into on or after January 1, 2011 with earlier application permitted as of the beginning of a fiscal year. Full retrospective application of the new guidance is optional. The adoption of this standard will have an impact on the Company’s consolidated financial position and results of operations for all multiple deliverable arrangements entered into or materially modified in 2011.

In January 2010, the FASB issued new accounting guidance, under ASC Topic 820, on Fair Value Measurements and Disclosures, which requires new disclosures and clarifies some existing disclosure requirements about fair value measurement. Under the new guidance, a reporting entity should (a) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers, and (b) present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs. This guidance was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of the guidance effective for interim and annual reporting periods beginning after December 15, 2009 did not have a material impact upon the Company’s consolidated financial position or results of operations. The adoption of the guidance effective for fiscal years beginning after December 15, 2010 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2.	COSTS IN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTS AND ACCOUNTS RECEIVABLE

Costs in Excess of Billings and Billing in Excess of Costs

The cost in excess of billings on uncompleted purchase orders issued pursuant to contracts reflects the accumulated costs incurred on purchase orders in production but not completed. Upon completion, inspection and acceptance by the customer, the purchase order is invoiced and the accumulated costs are charged to the statement of operations as costs of revenues earned. During the production cycle of the purchase order, should any progress billings occur or any interim cash payments or advances be received, such billings and/or receipts on uncompleted contracts are accumulated as billings in excess of costs. The Company fully expects to collect net costs incurred in excess of billing within twelve months and periodically evaluates each purchase order and contract for potential disputes related to overruns and uncollectable amounts.

Costs in excess of billing on uncompleted contracts were $4,408,818 and $7,762,836 as of June 30, 2010 and December 31, 2009, respectively.

Backlog

The estimated gross revenue on work to be performed on backlog was $38 million as of June 30, 2010.

Accounts Receivable

The Company records accounts receivable related to its long-term contracts, based on billings or on amounts due under the contractual terms. Accounts receivable consist primarily of receivables from completed purchase orders and progress billings on uncompleted contracts. Allowance for doubtful accounts is based upon a review of outstanding receivables, historical collection information, and existing economic conditions. Any amounts considered recoverable under the customer’s surety bonds are treated as contingent gains and recognized only when received.

Accounts receivable throughout the year may decrease based on payments received, credits for change orders, or back charges incurred. At June 30, 2010 and December 31, 2009, the Company had accounts receivable of $5,745,131and $2,288,666, respectively and an allowance for doubtful accounts of $312,448 and $222,448, respectively. The Company recorded bad debt expense of $45,000 and $90,000 for the three and six months ended June 30, 2010, respectively. No bad debt expense was recorded for the three or six months ended June 30, 2009.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

3.	COMMITMENTS AND CONTINGENCIES

Legal Proceedings

The Company is subject to various claims and contingencies in the ordinary course of its business, including those related to litigation, business transactions, employee-related matters, and others. When the Company is aware of a claim or potential claim, it assesses the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, the Company will record a liability for the loss. The liability recorded includes probable and estimable legal costs associated with the claim or potential claim. If the loss is not probable or the amount of the loss cannot be reasonably estimated, the Company discloses the claim if the likelihood of a potential loss is reasonably possible and the amount involved could be material. While there can be no assurances, the Company does not expect that any of its pending legal proceedings will have a material financial impact on the Company’s results.

On February 29, 2008, Roy Elfers, a former employee commenced an action against the Company for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. The Complaint seeks damages of approximately $87,000. The Company filed an answer to the complaint and discovery and depositions have been completed. The Company anticipates submitting a motion for summary judgment to dismiss the complaint shortly. No trial date has been set. The Company believes that meritorious defenses to the claims exist and the Company intends to vigorously defend this action. The Company’s attorneys have advised that it is too early to determine an outcome at this time.

On March 4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000. On April 2, 2008, the Company filed a response to the charges. On March 7, 2008, Mr. Cusack also commenced a second action against the Company for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, the Company served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack’s breach of contract claims and stock conversion claim. On or about October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, the Company filed an answer to the complaint and filed counterclaims against Mr. Cusack for fraud and rescission. The parties have completed discovery and depositions. On June 15, 2010, both parties submitted motions for summary judgment. No trial date has been set yet. The Company believes that meritorious defenses to the claims exist and the Company intends to vigorously defend this action. The Company’s attorneys have advised that it is too early to determine an outcome at this time.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4.	SHAREHOLDERS’ DEFICIENCY

The following table summarizes the changes in shareholders' deficiency for the six months ended June 30, 2010:

Balance - January 1, 2010	$	(2,180,412	)

Stock based compensation		160,311

Shares issued for payment of dividends recorded as interest expense		750,000

Modification of Series A Convertible Preferred Stock		53,887

Net Loss		(4,541,575	)

Balance - June 30, 2010	$	(5,757,789	)

Warrants

The following is a summary of stock warrants outstanding at June 30, 2010:

	Warrants			Weighted Average Exercise Price		Weighted Average Remaining Contractual Lives (in years)
Balance – January 1, 2010		1,448,681		$	1.47		1.75
Granted		-			n/a		-
Exercised		-			n/a		-
Cancelled, Forfeited or expired		(773,680	)		1.00		-
Balance – June 30, 2010		675,001		$	2.00		2.69

Exercisable – June 30, 2010		675,001

Stock Option Plan

The Company accounts for all stock based compensation as an expense in the financial statements and associated costs are measured at the fair value of the award. The Company also recognizes the excess tax benefit related to stock option exercises as financing cash inflows instead of operating inflows. As a result, the Company’s net loss before taxes for the six months ended June 30, 2010 and 2009 included $160,311 and $221,692 of stock based compensation, respectively and $42,304 and $93,685, respectively, for the three months ended June 30, 2010 and 2009. The stock based compensation expense is included in general and administrative expense in the condensed consolidated statements of operations. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following is a summary of stock options outstanding at June 30, 2010:


	Stock Options		Weighted- Average Exercise Price		Aggregate Intrinsic Value		Weighted Average Remaining Contractual Life (In years)
Outstanding, January 1, 2010		2,230,000	$	1.81		-		4.64
Granted		100,000		0.40		-		6.58
Exercised		-		n/a		n/a		n/a
Cancelled/forfeited		-		n/a		n/a		n/a
Outstanding, June 30, 2010		2,330,000	$	1.75		-		4.72

Exercisable, June 30, 2010		867,000	$	1.88				4.50

As of June 30, 2010, there was a total of $333,694 of unrecognized compensation arrangements granted under the 2007 Plan. The cost is expected to be recognized through 2014.

On January 25, 2010, the Company issued an option to purchase 100,000 shares of its common stock to an officer as compensation under the 2007 Plan pursuant to an amendment to the officer’s employment agreement. The exercise price for the option is $0.40 per share and 40% of the option vested on the grant date and 20% of the option vests annually thereafter with the first 20% vesting upon the first anniversary of the grant date.

The Black-Scholes method option pricing model was used to estimate fair value as of the date of grant using the following assumptions:

Risk-Free rate		3.12	%
Expected volatility		98.76	%
Forfeiture rate		0	%
Expected life	7 Years
Expected dividends		0%

Based on the assumptions noted above, the fair market value of the option issued during the six months ended June 30, 2010 was $31,312.

Stock Grants

On January 1, 2010, the Company issued 125,000 shares of its common stock to the Company’s non-employee directors as part of the director compensation under the 2007 Plan. The fair value on the date of grant was $50,000 based on the stock price on the date of issuance.

On January 19, 2010, the Company issued 75,000 shares of its common stock to an employee as compensation under the 2007 Plan. The fair value on the date of the grant was $28,500 based on the stock price on the date of issuance.

On March 2, 2010, the Company issued 12,500 shares of its common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of the grant was $4,500 based on the stock price on the date of issuance.

All of these awards were fully vested on the date of grant. The Company recorded stock based compensation of approximately $0 and $83,000 for the three and six months ended June 30, 2010 related to these awards.

On March 31, 2010, the Company issued 1,035,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended March 31, 2010.

On May 7, 2010, the Company issued 17,361 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $5,729 based on the stock price on the date of issuance.

On May 28, 2010, the Company issued 26,136 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $7,318 based on the stock price on the date of issuance.

On June 30, 2010, the Company issued 1,455,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended June 30, 2010.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

5.	SERIES A CONVERTIBLE PREFERRED STOCK AND WARRANT LIABILITIES

Features of the Series A Preferred and Warrants Liabilities

2005 Warrants

On June 30, 2005, in connection with the closing of its 2005 private placement offering, the Company issued purchase warrants for up to 555,790 shares of common stock at the exercise price of $1.10 per share and with the expiration date of June 30, 2010 (the “2005 Warrants”).

On August 16, 2005, the Company issued 50,000 shares of its common stock at an effective price per share of $1.00 to one of the Company’s employees for accepting a job offer. As a result of this issuance, in accordance with the terms of the 2005 Warrants agreements, the exercise price was adjusted to $1.00 per share and the number of shares of common stock that would be acquired was adjusted to 576,587.

As of June 30, 2010, the 2005 Warrants have expired pursuant to their terms and there are no outstanding 2005 Warrants.

2006 Warrants

On October 24, 2006, in accordance with the terms and conditions of the Company’s closing of its 2005 private placement offering, the Company issued purchase warrants for up to 179,175 shares of common stock at the exercise price of $1.10 per share and with the expiration date of June 30, 2010 (the “2006 Warrants”).

On February 8, 2007, the Company issued an aggregate of 260,000 shares of its common stock at an effective price per share of $1.00 to certain of its employees for services rendered. As a result of this issuance, in accordance with the terms of the 2006 Warrants agreements, the exercise price was adjusted to $1.00 per share and the number of shares of common stock that would be acquired was adjusted to 197,093.

As of June 30, 2010, the 2006 Warrants have expired pursuant to their terms and there are no outstanding 2006 Warrants.

Series A Preferred and Investor Warrants and Placement Agent Warrants

The Company entered into a Securities Purchase Agreement (“Purchase Agreement”) on March 7, 2008 to sell shares of its Series A Preferred and warrants (“Investor Warrants”) to purchase shares of its common stock, and to conditionally sell shares of the Company’s common stock, to the Series A Holders. The Series A Holders purchased an aggregate of 15,000 shares of Series A Preferred and Investor Warrants to purchase up to 3,750,000 shares of common stock, and to conditionally purchase 100,000 shares of common stock. The aggregate purchase price for the Series A Preferred and Investor Warrants was $15,000,000 and the aggregate purchase price for the common stock was $500,000. The Company completed the sale of the Series A Preferred and Investor Warrants in two rounds, on March 7, 2008 and April 4, 2008, and the Company and the Series A Holders determined not to complete the conditional sale of the 100,000 shares of common stock. The Series A Holders are entitled to receive cumulative dividends, due at each subsequent calendar quarter-end until maturity, at a rate of 9% if settled via cash or at a rate of 10% if settled via shares (at the option of the Company) of the Company’s common stock. The dividends rate is subject to increase in the event of a “Triggering Event” under the Certificate of Designations, Preferences and Rights of the Series A Preferred (the “Certificate of Designations”) and in the event of an “Equity Condition Failure” under the Certificate of Designations, settlement via shares would not be allowed for the remaining dividend payments.

The Series A Holders may convert shares of Series A Preferred, plus the amount of accrued but unpaid dividends, into shares of the Company’s common stock at the conversion price of $0.50, as amended on April 8, 2010. The Conversion Price is subject to certain adjustments upon issuance of certain securities, under the Certificate of Designation, with a lower exercise price and/or with negative dilutive effect. The Series A Holders may require the Company to redeem all or any portion of the outstanding shares of Series A Preferred in cash, at the amount of 100% of the “Conversion Amount” or 110% of the “Conversion Amount”, upon a Triggering Event or Equity Condition Failure.

The Company may redeem all or any portion of the outstanding shares of Series A Preferred in cash at the amount of (i) 100% of the “Conversion Amount” at any time after either the two-year anniversary of the “Public Company Date”, if certain other conditions are met, or the six-month anniversary of the “Qualified Public Offering Date”, if certain other conditions are met under the Certificate of Designations (ii) 110% of the Conversion Amount upon an Equity Condition Failure or (iii) 115% of the Conversion Amount prior to any “Fundamental Transaction” under the Certificate of Designations.

Pursuant to the terms of the Series A Preferred, the Company was required to redeem, in cash, any outstanding shares of the Series A Preferred on December 31, 2010. On April 8, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity date for the mandatory redemption of all outstanding Series A Preferred from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity redemption date from April 1, 2011 to July 1, 2011.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Settlement Agreement

In connection with a Notice of Triggering Event Redemption received by the Company on April 14, 2009, the Company entered into a Settlement Agreement, Waiver and Amendment with the Series A Holders on May 22, 2009 (the “ Settlement Agreement ”) pursuant to which, among other things, (i) the Series A Holders waived any breach by the Company of certain financial covenants or its obligation to timely pay dividends on the Series A Preferred for any period through September 30, 2009 and waived any Equity Conditions Failure and any Triggering Event otherwise arising from such breaches (ii) the Investor Warrants were amended to reduce the exercise price thereof from $2.40 per share to $0.01 per share, (iii) the Company issued the Series A Holders an aggregate of 2,000,000 shares of the Company’s common stock (the “ Settlement Shares ”), in full satisfaction of the Company’s obligation to pay dividends under the Certificate of Designations as of March 31, 2009, June 30, 2009 and September 30, 2009, and (iv) the Company agreed to redeem $7,500,000 in stated value of the Series A Preferred by December 31, 2009 (the “December 2009 Redemption”). The Company agreed that, if it fails to so redeem $7,500,000 in stated value of the Series A Preferred by that date (a “ Redemption Failure ”), then, in lieu of any other remedies or damages available to the Series A Holders (absent fraud), (i) the redemption price payable by the Company will increase by an amount equal to 10% of the stated value, (ii) the Company will use its best efforts to obtain stockholder approval to reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 (which would increase the number of shares of common stock into which the Series A Preferred is convertible), and (iii) the Company will expand the size of its board of directors by two, will appoint two persons designated by the Series A Holders to fill the two newly-created vacancies, and will use its best efforts to amend the Company’s certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board.

Pursuant to the terms of the Settlement Agreement, the Company entered into a Registration Rights Agreement with the Series A Holders pursuant to which, among other things, the Company agreed to file with the SEC, by June 1, 2009, a registration statement covering the resale of the Settlement Shares, and to use its best efforts to have such registration statement declared effective as soon as practicable thereafter. The Company further agreed with the Series A Holders to include in such registration statement the shares of common stock issued upon the exercise of the Investor Warrants in May and June 2009. A registration statement was filed, and subsequently declared effective on August 10, 2009.

Pursuant to the terms of the Settlement Agreement, each of the Company’s directors and executive officers has entered into a Lock-Up Agreement, pursuant to which each such person has agreed that, for so long as any shares of Series A Preferred remain outstanding, he will not sell any shares of the Company’s common stock owned by him as of May 22, 2009. Also pursuant to the terms of the Settlement Agreement, the Company’s Chief Executive Officer, President and Chairman, entered into an Irrevocable Proxy and Voting Agreement with the Series A Holders (the “ Voting Agreement ”), pursuant to which the Company’s CEO agreed, among other things, that if a Redemption Failure occurs he will vote all shares of the Company’s voting stock owned by him in favor of (i) reducing the Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) amending the Company’s certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board of directors (collectively, the “ Company Actions ”). The Company’s CEO also appointed WCOF as his proxy to vote his shares of the Company’s voting stock in favor of the Company Actions, and against approval of any opposing or competing proposal, at any stockholder meeting or written consent of the Company’s stockholders at which such matters are considered.

The Company did not meet the December 2009 Redemption and has increased the size of its board of directors by two and held a special meeting of shareholders on April 8, 2010. At this special meeting, the shareholders approved the amendments to the Company’s certificate of incorporation to (i) reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) grant the Series A holders the right, voting as a separate class, to elect two persons to serve on the Company’s board of directors. On April 8, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity date for the mandatory redemption of all outstanding Series A Preferred from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from April 1, 2011 to July 1, 2011.

Investor Warrants

In connection with the sale of the Series A Preferred, Investor Warrants to purchase up to 3,750,000 shares of common stock at $2.40 per share were issued and with an expiration date of April 11, 2011. The holders of the Investor Warrants may require the Company to repurchase their warrants upon the occurrence of certain defined events in the Investor Warrant agreement. As such the Company recorded the Investor Warrants as a derivative at fair value at issuance and subsequent reporting periods in accordance with ASC 815 “Derivatives and Hedging”. Changes in the fair value from period to period are reported in the statement of operations. In accordance with the Settlement Agreement entered into on May 22, 2009, the Investor Warrants were amended to reduce the exercise price from $2.40 to $0.01. The Investor Warrants were fully exercised on May 27, 2009, June 1, 2009, and June 8, 2009.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Placement Agent Warrants

In connection with the sale of the Series A Preferred and Investor Warrants, the placement agent for such sale received warrants (the “Placement Agent Warrants”) to purchase a total of 6% of the number of common stock issued in the Series A Preferred financing or 675,001 shares at the exercise price of $2.00 per share and with the expiration date of March 7, 2013.

Accounting for the Series A Preferred and Warrant Liabilities

2005 Warrants, 2006 Warrants, and Placement Agent Warrants

Upon issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the requirements for equity classification set forth in EITF Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, and SFAS No. 133, as codified in ASC 815. However, effective January 1, 2009 the Company was required to analyze its then outstanding financial instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on the Company’s analysis, its 2005 Warrants, 2006 Warrants, and Placement Agent Warrants, include price protection provisions whereby the exercise price could be adjusted upon certain financing transaction at a lower price per share and could no longer be viewed as indexed to the Company’s common stock. As a result, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants are accounted for as “derivatives” under ASC 815 and recorded as liabilities at fair value as of January 1, 2009 with changes in subsequent period fair value recorded in the statement of operations.

Series A Preferred

The Series A Preferred is redeemable on July 1, 2011 and convertible into shares of common stock at a rate of 2,000 shares of common stock for each share of Series A Preferred. As a result the Company elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the consolidated statement of operations.

The proceeds from the issuance of the Series A Preferred and Investor Warrants, net of direct costs including the fair value of warrants issued to placement agent in connection with the transaction, were allocated to the instruments based upon relative fair value upon issuance as these instruments must be measured initially at fair value.

Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred was adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss.

The Settlement Agreement provides that $7,500,000 in stated value of the Series A Preferred was to be redeemed at December 31, 2009. The Company did not effect such redemption. As a result, in lieu of any other remedies or damages available to Series A Holders, the redemption price payable by the Company increased by an amount equal to 10% of the stated value, and the Company amended its certificate of incorporation to (i) reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 (which increased the number of shares of its common stock into which the Series A Preferred is convertible) and (ii) grant the Series A Holders, voting as a separate class, the right to elect two persons to serve on its board of directors.

Valuation – Methodology and Significant Inputs Assumptions

Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates. Such amounts and the recognition of such amounts are subject to significant estimates which may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the 2005 Warrants, 2006 Warrants, Placement Agent Warrants, and Series A Preferred are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.

2005 and 2006 Warrants

All 2005 and 2006 Warrants expired on June 30, 2010; therefore the fair value of these instruments is $0 as of June 30, 2010.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Placement Agent Warrants

A Black-Scholes-Merton option-pricing model was utilized to estimate the fair value of the Placement Agent Warrants as of June 30, 2010. This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

Input	June 30, 2010
Quoted Stock Price	$	0.23
Exercise Price	$	2.00
Expected Life (in years)		2.69
Stock Volatility		99.13	%
Risk-Free Rate		1.00	%
Dividend Rate		0	%

Series A Preferred

A binomial lattice model was utilized to estimate the fair value of the Series A Preferred as of June 30, 2010. The binomial model considers the key features of the Series A Preferred, as noted above, and is subject to the significant assumptions discussed below. First, a discrete simulation of the Company’s stock price was conducted at each node and throughout the expected life of the instrument. Second, an analysis of the higher position of a conversion position, redemption position, or holding position (i.e. fair value of the respective future nodes value discounted using the applicable discount rate) was conducted relative to each node until a final fair value of the instrument is conducted at the node representing the measurement date. This model requires the following key inputs with respect to the Company and/or instrument:

Input	June 30, 2010
Risk-Free Rate		3.74	%
Expected volatility		72.92	%
Expected remaining term until maturity (in years)	0.75
Expected dividends		0.00	%
Strike price	$	0.50
Quoted Stock price	$	0.23
Effective discount rate		33.2	%

The following are significant assumptions utilized in developing the inputs

Stock volatility was estimated by considering (i) the annualized daily volatility of the Company’s stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instruments and (ii) the annualized daily volatility of comparable companies’ stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instrument. Historic prices of the Company and comparable companies’ common stock were used to estimate volatility as the Company did not have traded options as of the valuation dates;

Based on the Company’s historical operations and management’s expectations for the near future, the Company’s stock was assumed to be a non-dividend-paying stock;

Based on management’s expectations for the near future, the Company is expected to settle the future quarterly dividends due to the Series A Holders via shares;

The quoted market price of the Company’s stock was utilized in the valuations because ASC 820-10 requires the use of quoted market prices, if available, without considerations of blockage discounts (if the input is considered as a Level 1 input). Because the stock is thinly traded, the quoted market price may not reflect the market value of a large block of stock; and

The quoted market price of the Company’s stock as of measurement dates and expected future stock prices were assumed to reflect the effect of dilution upon conversion of the instruments to shares of common stock.

The changes in fair value estimate between reporting periods are related to the changes in the price of the Company’s common stock as of the measurement dates, the expected volatility of the Company’s common stock during the remaining term of the instrument, changes in the conversion price and estimated discount rate.

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

6.	DISPOSAL OF TAG

On January 2, 2009, the Company entered into an agreement with the prior owners of TAG to sell the assets and liabilities back to TAG. TAG was accounted for as a discontinued operation under GAAP, which requires the income statement information be reformatted to separate the divested business from the Company’s continuing operations.

There were no discontinued operations related to TAG for the three or six month period ended June 30, 2010 and 2009.

In accordance with the terms of the agreement, the original owners of TAG agreed to repay $1,000,000 of the original $2,000,000 in consideration as follows:

2009	$	100,000
2010	$	100,000
2011	$	200,000
2012	$	300,000
2013	$	300,000
Total	$	1,000,000

The original owners of TAG have collateralized the note receivable with their personal residence and the 250,000 shares issued to them on the date of acquisition. These shares are being held by the Company in escrow since January 2009 and will be returned upon final payment toward the note receivable.

Due to cash flow constraints, TAG is experiencing difficulty repaying the amounts due to the Company.

The Company and the original owners of TAG are currently in the process of finalizing a re-negotiation of the contract with a new payment schedule starting in 2011. The Company recorded a reserve on the note receivable of $575,000 as of June 30, 2010 and December 31 2009 of which $175,000 was included in current assets and $400,000 is in long term assets. In addition, the Company recorded a $575,000 loss from disposal of discontinued division for the year ended December 31, 2009. The Company has included the entire amount as notes receivable on its balance sheet, of which $400,000 is included within long term assets.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended December 31, 2009.

Except for statements of historical fact, certain information described in this report contains “forward-looking statements” that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “project,” “will,” “would” or similar words. The statements that contain these or similar words should be read carefully because these statements discuss our future expectations, contain projections of our future results of operations or of our financial position, or state other “forward-looking” information. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able accurately to predict or control. Further, we urge you to be cautious of the forward-looking statements which are contained in this report because they involve risks, uncertainties and other factors affecting our operations, market growth, service and products. You should not place undue reliance on any forward-looking statement, which speaks only as of the date made. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Risk Factors” in Item 1A of Part II.

Overview

We are a defense and security products company engaged in three business areas: customized transparent and opaque armor solutions for construction equipment and tactical and non-tactical transport vehicles used by the military; architectural hardening and perimeter defense, such as bullet and blast resistant transparent armor, walls and doors, as well as vehicle anti-ram barriers such as bollards, steel gates and steel wedges that deploy out of the ground; and tactical training products and services consisting of our live-fire interactive T2 Tactical Training System and our American Institute for Defense and Tactical Studies.

We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Our customers include various branches of the U.S. military through the U.S. Department of Defense (or DoD) and to a much lesser extent other U.S. government, law enforcement and correctional agencies as well as private sector customers.

Our recent historical revenues have been generated primarily from a limited number of large contracts and a series of purchase orders from a single customer. To continue expanding our business, we are seeking to broaden our customer base and to diversify our product and service offerings. Our strategy to increase our revenue, grow our company and increase stockholder value involves the following key elements:

·	increase exposure to military platforms in the U.S. and internationally;

·	develop strategic alliances and form strategic partnerships with original equipment manufacturers (OEMs);

·	capitalize on increased homeland security requirements and non-military platforms;

·	focus on an advanced research and development program to capitalize on increased demand for new armor materials; and

·	pursue strategic acquisitions.

We are pursuing each of these growth strategies simultaneously, and expect one or more of them to result in additional revenue opportunities within the next 12 months.

Sources of Revenues

We derive our revenues by fulfilling orders under master contracts awarded by branches of the United States military, law enforcement and corrections agencies and private companies involved in the defense market and other customer purchase orders. Under these contracts and purchase orders, we provide customized transparent and opaque armor products for transport and construction vehicles used by the military, group protection kits and spare parts. We also derive revenues from sales of our architectural hardening and perimeter defense products, which we sometimes refer to as physical security products. To date, we have generated nominal revenues from our T2 and other training solutions and we are evaluating the continued offering of such training products and services and expect to continue that process over the next several months.

Our contract backlog as of June 30, 2010 was $38 million. We estimate that $22 million of contract backlog as of June 30, 2010 will be filled in 2010. Accordingly, in order to maintain our current revenue levels and to generate revenue growth, we will need to win more contracts with the U.S. government and other commercial entities, achieve significant penetration into critical infrastructure and public safety protection markets, and successfully further develop our relationships with OEM’s and strategic partners. Notwithstanding the anticipated significant troop reductions in Afghanistan and Iraq, we expect that demand in those countries for armored military construction vehicles will continue in order to repair significant war damage and for nation-building purposes. In addition, we are exploring interest in armored construction equipment in other countries with mine-infested regions.

We continue to aggressively bid on projects and are in preliminary talks with a number of international firms to pursue long-term government and commercial contracts, including with respect to Homeland Security. While no assurances can be given that we will obtain a sufficient number of contracts or that any contracts we do obtain will be of significant value or duration, we are confident that we will continue to have the opportunity to bid and win contracts as we have in 2009.

Cost of Revenues and Operating Expenses

Cost of Revenues. Cost of revenues consists of parts, direct labor and overhead expense incurred for the fulfillment of orders under contract. These costs are charged to expense upon completion and acceptance of an order. Costs of revenue also includes the costs of prototyping and engineering, which are expensed upon completion of an order as well. These costs are included as costs of revenue because they are incurred to modify products based upon government specifications and are reimbursable costs within the contract. These costs for the production of goods under contract are expensed when they are complete. We allocate overhead expenses such as employee benefits, computer supplies, depreciation for computer equipment and office supplies based on personnel assigned to the job. As a result, indirect overhead expenses are included in cost of revenues and each operating expense category.

Sales and Marketing. Expenses related to sales and marketing consist primarily of compensation for our sales and marketing personnel, sales commissions and incentives, trade shows and related travel. Sales and marketing costs are charged to expense as incurred.

Research and Development. Research and development expenses are incurred as we perform ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. Such expenses typically include compensation and employee benefits of engineering and testing personnel, materials, travel and costs associated with design and required testing procedures associated with our product line. We expect that in 2010, research and development expenses will remain relatively consistent with 2009 in absolute dollars and as a percentage of revenues. Research and development costs are charged to expense as incurred.

General and Administrative. General and administrative expenses consist of compensation and related expenses for executive, finance, accounting, administrative, legal, professional fees, other corporate expenses and allocated overhead. We expect that in 2010, general and administrative expenses will decrease as compared to 2009 in absolute dollars and as a percentage of revenue due to a cost cutting initiative implemented at the end of 2009 and in January 2010.

General and Administrative Salaries. General and administrative salaries expenses consist of compensation for the officers, and IT, design and engineering personnel. We expect that in 2010, general and administrative salaries expenses will decrease as compared to 2009 in absolute dollars and as a percentage of revenues due to a cost cutting measures, which include reduction in labor costs, implemented at the end of 2009 and in January 2010.

Critical Accounting Policies

Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.

We believe that of our significant accounting policies, which are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2009, involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.

Revenue and Cost Recognition. We recognize revenue in accordance with Accounting Standards Codification (ASC) 605, “Revenue Recognition”, which states that revenue is realized and earned when all of the following criteria are met: (a) persuasive evidence of the arrangement exists, (b) delivery has occurred or services have been rendered, (c) the seller’s price to the buyer is fixed and determinable and (d) collectability is reasonably assured. Under this provision, revenue is recognized upon delivery and acceptance of the order.

We recognize revenue and report profits from purchases orders filled under master contracts when an order is complete, as defined below. Purchase orders received under master contracts may extend for periods in excess of one year. Purchase order costs are accumulated as deferred assets and billings and/or cash received are charged to a deferred revenue account during the periods of construction. However, no revenues, costs or profits are recognized in operations until the period of completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and, the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of June 30, 2010 and December 31, 2009, there were no such provisions made.

Stock-Based Compensation. Stock based compensation consists of stock or options issued to employees, directors and contractors for services rendered. We accounted for the stock issued using the estimated current market price per share at the date of issuance. Such cost was recorded as compensation in our statement of operations at the date of issuance.

In December 2007, we adopted our 2007 Incentive Compensation Plan pursuant to which we have issued and intend to issue stock-based compensation from time to time, in the form of stock, stock options and other equity based awards. Our policy for accounting for such compensation in the form of stock options is as follows:

We account for stock based compensation in accordance with Accounting Standards Codification (ASC) 718 “Compensation–Stock Compensation” (ASC 718). In accordance with ASC 718, we use the Black-Scholes option pricing model to measure the fair value of our option awards. The Black-Scholes model requires the input of highly subjective assumptions including volatility, expected term, risk-free interest rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, as codified in ASC 718-10-599, which provides supplemental implementation guidance for ASC 718.

Because we have only recently become a public entity, we have a limited trading history. The expected term of an award is based on the “simplified” method allowed by ASC 718-10-599, whereby the expected term is equal to the period of time between the vesting date and the end of the contractual term of the award. The risk-free interest rate will be based on the rate on U.S. Treasury zero coupon issues with maturities consistent with the estimated expected term of the awards. We have not paid and do not anticipate paying a dividend on our common stock in the foreseeable future and accordingly, use an expected dividend yield of zero. Changes in these assumptions can affect the estimated fair value of options granted and the related compensation expense which may significantly impact our results of operations in future periods.

Stock-based compensation expense recognized will be based on the estimated portion of the awards that are expected to vest. We will apply estimated forfeiture rates based on analyses of historical data, including termination patterns and other factors.

We recognized $160,311 and $221,692 in stock compensation expense for the six months ended June 30, 2010 and 2009, respectively, and $42,304 and $93,685 for the three months ended June 30, 2010 and 2009, respectively.

Fair Value Measurements. We have adopted the provisions of ASC 820, “Fair Value Measurements and Disclosures” (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments. ASC 820 was effective for financial assets and liabilities on January 1, 2008. The statement deferred the implementation of the provisions of ASC 820 relating to certain non-financial assets and liabilities until January 1, 2009.

Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, whether using an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, our credit risk.

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques requires significant judgment and are primarily dependent upon the characteristics of the asset or liability, the principal (or most advantageous) market in which participants would transact for the asset or liability, and the quality and availability of inputs. Inputs to valuation techniques are classified as either observable or unobservable within the following hierarchy:

·	Level 1 Inputs: These inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 Inputs: These inputs are other than quoted prices that are observable, for an asset or liability. This includes: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

·	Level 3 Inputs: These are unobservable inputs for the asset or liability which require our own assumptions.

Series A Convertible Preferred Stock, Investor Warrants and Placement Agent Warrants

Series A Convertible Preferred Stock. The Series A Convertible Preferred Stock (or Series A Preferred) is redeemable on July 1, 2011 (as extended from December 31, 2010 to April 1, 2011 pursuant to a waiver agreement with the Series A Holders dated April 8, 2010 and further extended pursuant to a waiver agreement with the Series A Holders dated August 13, 2010) and convertible into shares of common stock at a rate of 2,000 shares of common stock for each share of Series A Preferred subject to adjustment should we issue future common stock at a lesser price. As a result we elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the statement of operations.

The proceeds from the issuance of the Series A Preferred and accompanying common stock warrants (or Investor Warrants), net of direct costs including the fair value of warrants issued to a placement agent in connection with the transaction, must be allocated to the instruments based upon relative fair value upon issuance as they must be measured initially at fair value. Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred must be adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss. On March 7, 2008, the date of initial issuance, we recorded a derivative liability of $9.8 million. On April 4, 2008, the date of the second issuance, we recorded a derivative liability of $3.6 million. The fair value of the Series A Preferred was adjusted as of June 30, 2010, resulting in a loss of $226,915 and $873,015 for the three and six months then ended, respectively. As of June 30, 2010, the adjusted fair value of the Series A Preferred is $13.7 million.

Derivative Warrants

Investor Warrants. The Investor Warrants met the criteria under ASC 815 “Derivatives and Hedging”. Under ASC 815, the warrants were recorded at fair value upon the date of issuance, with changes in the value fair value recognized as a gain or loss as they occur. On March 7, 2008, the date of initial issuance, we recorded a derivative liability of $1.1 million. On April 4, 2008, the date of the second issuance, we recorded a derivative liability of $0.4 million.

On May 22, 2009 we entered into a Settlement Agreement, Waiver and Amendment (or Settlement Agreement) with the holders of the Series A Preferred (or Series A Holders) pursuant to which, among other things, the Investor Warrants were amended to reduce the exercise price thereof from $2.40 per share to $0.01 per share. The warrants were exercised in full during May and June 2009 and the Investor Warrant liability was accordingly reclassified to Additional Paid-In Capital.

For additional information, see “Liquidity and Capital Resources - Series A Convertible Preferred Stock” below.

Placement Agent Warrants

The warrants issued to the placement agent with respect to the sale of the Series A Preferred and Investor Warrants (or Placement Agent Warrants) were accounted for as a transaction cost associated with the issuance of the Series A Preferred. The Placement Agent Warrants are recorded at fair value at the date of issuance. Under EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, as codified in ASC 815, we satisfy the criteria for classification of the Placement Agent Warrants as equity on the date of issuance. We have recorded the corresponding amount recorded as a deferred financing cost since the Series A Preferred and Investor Warrants are classified as liabilities and are amortized as additional financing costs over the term of the Series A Preferred using the interest method. At the date of each issuance, we recorded $1.0 million and $0.4 million in deferred financing costs. Effective January 1, 2009, we were required to analyze these instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on our analysis, the Placement Agent Warrants include price protection provisions whereby the exercise price could be adjusted upon certain financing transaction at a lower price per share and could no longer be viewed as indexed to our common stock. As a result, we accounted for these warrants as a “derivative” under ASC 815 and recorded as liabilities at fair value on January 1, 2009 of $91,743. The fair value of these warrants is $25,838 as of June 30, 2010. A gain of $33,893 and $3,709 was recorded on the change in fair value in the statement of operations for the three and six months ended June 30, 2010, respectively.

2005 Warrants and 2006 Warrants

Upon issuance, warrants issued in connection with the closing of the Company’s private placement offering in 2005 and 2006 (or the 2005 Warrants and 2006 Warrants) met the requirements for equity classification set forth in EITF Issue 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock”, and SFAS No. 133 as codified in ASC 815. However, effective January 1, 2009, we were required to analyze these instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on our analysis, the 2005 Warrants and 2006 Warrants include price protection provisions whereby the exercise price could be adjusted upon certain financing transaction at a lower price per share and could no longer be viewed as indexed to our common stock. As a result, the 2005 Warrants and 2006 Warrants were accounted for as “derivatives” under ASC and recorded as liabilities at fair value on January 1, 2009 of $74,032. The fair value of these warrants was $0 as of June 30, 2010. A gain of $111 and $5,866 was recorded on the change in fair value in the statement of operations for the three and six months ended June 30, 2010, respectively.

Consolidated Results of Operations

The following discussion should be read in conjunction with the information set forth in the condensed consolidated financial statements and the related notes thereto appearing elsewhere in this report.

Comparison of the Three Months Ended June 30, 2010 and 2009

Revenues. Revenues for the three months ended June 30, 2010 were $11.4 million, a decrease of $2.6 million, or 18.5%, as compared to revenues of $14 million in the comparable period in 2009. This decrease was due primarily to completed but unbilled work of $2.9 million under a contract that was awaiting customer acceptance as of June 30, 2010. For the three months ended June 30, 2010 the revenues for our physical security product business was $3 million, an increase of $1.9 million or 172.7% over revenues of $1.1 million for the three months ended June 30, 2009.

Cost of Revenues. Cost of revenues for the three months ended June 30, 2010 was $9.6 million, an increase of $0.9 million, or 10.3%, over cost of revenues of $8.7 million in the comparable period in 2009. This increase reflects costs associated with the above-mentioned completed but unbilled work of $2.9 million under a contract that was awaiting customer acceptance as of June 30, 2010 as well as increased sales of certain of our crew protection kits (or CPKs), which have lower gross margins than our other CPKs, as compared to the three months ended June 30, 2009. The costs of revenue also increased due to additional costs of sales from our physical security product business during the three months ended June 30, 2010.

Gross Profit. Gross profits for the three months ended June 30, 2010 and 2009 were $1.8 million and $5.4 million, respectively. Gross profit margin was 15.8% and 38.6% for three months ended June 30, 2010 and 2009, respectively. The decrease in gross profit margin resulted primarily from an increase in overall costs incurred during the three months ended June 30, 2010 that were associated with the above completed but unbilled work of $2.9 million as well as a product mix that had a less favorable gross margin as discussed above in “Cost of Revenues”.

Sales and Marketing Expenses. Sales and marketing expenses for the three months ended June 30, 2010 and 2009 were $571,800 and $723,779, respectively, representing a decrease of $151,979, or 21%. The decrease was due primarily to a decrease in trade show expenses and related expenses from selling and marketing and the cost cutting initiative we implemented at the end of 2009 and in January 2010.

T2 Expenses. T2 expenses for the three months ended June 30, 2010 and 2009 were $204,479 and $124,070, respectively, representing an increase of $80,409, or 64.8%. The increase was due primarily to an increase in T2 salary expense resulting from the increase in the number of T2 employees.

Research and Development Expenses. Research and development expenses for the three months ended June 30, 2010 and 2009 were $151,997 and $16,841, respectively. The increase of $135,156 or 802.5% from 2009 to 2010 was primarily the result of additional testing of our CPKs, and to a lesser extent, improvements of existing products and continued work on our products in development during the three months ended June 30, 2010.

General and Administrative Expenses. General and administrative expenses for the three months ended June 30, 2010 and 2009 were $1.5 million and $1.6 million, respectively.

General and Administrative Salaries Expense. General and administrative salaries expenses for the three months ended June 30, 2010 and 2009 were $933,288 and $1,022,366, respectively. The decrease of $89,078 or 8.7% was a result of the cost cutting initiative we implemented at the end of 2009 and in January 2010.

Depreciation Expense. Depreciation expense was $290,423 and $278,083 for the three months ended June 30, 2010 and 2009, respectively. The increase of $12,340, or 4.4%, was the result of our higher property and equipment balance as of June 30, 2010 versus June 30, 2009. This increase was the result of additional property and equipment purchased in 2010 for our Hicksville facility and physical security product business, and T2 equipment. This higher capital balance as of June 30, 2010 resulted in higher depreciation expense for the three months then ended.

Professional Fees. Professional fees for the three months ended June 30, 2010 and 2009 were $694,163 and $612,763, respectively.

Other (Income) and Expense. Our Series A Preferred and certain warrants, are recorded at fair value with changes in fair value recorded in the statement of operations. Changes in the price of our common stock affect these fair values. We experienced a loss on adjustment of fair value with respect to our Series A Preferred and Warrants of $192,911 and $97,880 for the three months ended June 30, 2010 and 2009, respectively. In addition, we incurred interest expense associated with the amortization of the deferred financing costs and discount on the Series A Preferred of $503,325 and $266,700 for the three months ended June 30, 2010 and 2009, respectively. As a result of the modification of the terms of our Series A Preferred pursuant to the May 22, 2009 Settlement Agreement we recorded a loss of $2.6 million on deemed extinguishment of debt for the three months ended June 30, 2009.

Comparison of the Six Months Ended June 30, 2010 and 2009

Revenues. Revenues for the six months ended June 30, 2010 were $26.9 million, an increase of $3.4 million, or 14.5%, over revenues of $23.5 million in the comparable period in 2009. This increase was due primarily to our increased production under DoD contracts and increased sales of our physical security products, partially offset by completed but unbilled work of $2.9 million under a contract where customer acceptance was pending as of June 30, 2010. For the six months ended June 30, 2010 the revenues for our physical security product business was $7.1 million, an increase of $5 million or 238.1% over revenues of $2.1 million for the six months ended June 30, 2009.

Cost of Revenues. Cost of revenues for the six months ended June 30, 2010 was $19.6 million, an increase of $5.5 million, or 39%, over cost of revenues of $14.1 million in the comparable period in 2009. This increase reflects costs associated with completed but unbilled work of $2.9 million under a contract which was awaiting customer acceptance as of June 30, 2010. The costs of revenue also increased due to additional costs of sales from our physical security product business during the six months ended June 30, 2010.

Gross Profit. Gross profits for the six months ended June 30, 2010 and 2009 were approximately $7.3 million and $9.4 million, respectively. Gross profit margin was 27.1% and 40% for the six months ended June 30, 2010 and 2009, respectively. The decrease in gross profit margin percentage from 2009 to 2010 resulted primarily from the above mentioned $2.9 million completed but unbilled work as well as an increase in overall costs incurred during the six months ended June 30, 2010 that were associated with a product mix that had a less favorable gross margin.

Sales and Marketing Expenses. Sales and marketing expenses for the six months ended June 30, 2010 and 2009 were $1.1 million and $1.5 million, respectively, representing a decrease of $0.4 million, or 26.7%. The decrease was due primarily to a decrease in trade show expenses and related expenses from selling and marketing and the cost cutting initiative we implemented at the end of 2009 and in January 2010.

T2 Expenses. T2 expenses for the six months ended June 30, 2010 and 2009 were $423,327 and $237,672, respectively, representing an increase of $185,655, or 78.1%. The increase was due primarily to an increase in T2 salary expense resulting from the increase in the number of T2 employees.

Research and Development Expenses. Research and development expenses for the six months ended June 30, 2010 and 2009 were $273,714 and $203,227, respectively. The increase of $70,487 or 34.7% from 2009 to 2010 was primarily the result of additional testing of our CPKs, and to a lesser extent, improvements of existing products and continued work on our products in development during the six months ended June 30, 2010.

General and Administrative Expenses. General and administrative expenses for the six months ended June 30, 2010 and 2009 were $3.4 million and $3.1 million, respectively. The increase of $0.3 million, or 9.7%, was primarily due to an increase in rent expense and the expensing of deferred offering costs associated with a potential secondary public offering.

General and Administrative Salaries Expense. General and administrative salaries expenses for the six months ended June 30, 2010 and 2009 were $1.8 million and $2.1 million, respectively. The decrease of $0.3 million or 14.3% was a result of the cost cutting initiative we implemented at the end of 2009 and in January 2010.

Depreciation Expense. Depreciation expense was $579,252 and $519,412 for the six months ended June 30, 2010 and 2009, respectively. The increase of $59,840, or 11.5%, was the result of our higher property and equipment balance as of June 30, 2010 versus June 30, 2009. This increase was the result of additional property and equipment purchased in 2010 for our Hicksville facility and physical security product business. This higher capital balance as of June 30, 2010 resulted in higher depreciation expense for the six months then ended.

Professional Fees. Professional fees for the six months ended June 30, 2010 and 2009 were $1.3 million and $1.2 million, respectively.

Other (Income) and Expense. Our Series A Preferred and certain warrants, are recorded at fair value with changes in fair value recorded in the statement of operations. Changes in the price of our common stock affect these fair values. We experienced a loss on adjustment of fair value with respect to our Series A Preferred and Warrants of $863,440 and $711,662 for the six months ended June 30, 2010 and 2009, respectively. In addition, we incurred interest expense associated with the amortization of the deferred financing costs and discount on the Series A Preferred of $1.1 million and $567,020 for the six months ended June 30, 2010 and 2009, respectively. As a result of the modification of the terms of our Series A Preferred pursuant to the May 22, 2009 Settlement Agreement we recorded a loss of $2.6 million on deemed extinguishment of debt for the six months ended June 30, 2009.

Liquidity and Capital Resources

The primary sources of our liquidity during the six months ended June 30, 2010 have come from operations. As of June 30, 2010, our principal sources of liquidity were net accounts receivable of $5.7 million, costs in excess of billings of $4.4 million and the sale of accounts receivable under an accounts receivable purchase agreement with Republic Capital Access (or RCA), of which RCA has not received payment from our customers for $2.1 million.

We believe that our current net accounts receivable and costs in excess of billings together with our expected cash flows from operations and ability to sell accounts receivable to RCA will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least through June 30, 2011. The Series A Preferred is redeemable on July 1, 2011, as extended from December 31, 2010 to April 1, 2011, pursuant to a waiver agreement with the Series A Holders dated April 8, 2010 and further extended pursuant to a waiver agreement with the Series A Holders dated August 13, 2010. We are currently seeking to raise capital or obtain access to capital sufficient to permit us to effect such redemption. If we are unable to timely raise capital or obtain access to a credit facility or other source of funds sufficient to fund such redemption, our cash flow could be adversely affected and our business significantly harmed. In addition, restrictions imposed pursuant to the General Corporation Law of the State of Delaware (the “DGCL”), our state of incorporation, would prohibit us from satisfying such redemption if we lack sufficient surplus, as such term is defined under the DGCL.

Cash Flows from Operating Activities. Net cash provided by operating activities was approximately $175,112 for the six months ended June 30, 2010 compared to net cash used in operating activities of approximately $332,525 for the six months ended June 30, 2009. Net cash provided by operating activities during the six months ended June 30, 2010 consisted primarily of changes in our operating assets and liabilities of $892,465, including changes in accounts receivable, cost in excess of billing, prepaid expense, accounts payable and accrued liabilities. The changes in accounts receivable and costs in excess of billing of an increase of $3.5 million and a decrease of $3.3 million, respectively, reflects the increases in receivables from completed projects and a decrease in costs incurred on projects in process as of June 30, 2010. Our prepaid expenses and other current assets increased $106,264 due to amounts paid in advance in connection with prepayment of legal expense and insurance. Net cash used in operating activities during the six months ended June 30, 2009 consisted primarily of changes in our operating assets and liabilities including accounts receivable, cost in excess of billing, prepaid expense, accounts payable and accrued liabilities. The changes in accounts receivable and costs in excess of billing of $3.6 million and $1.4 million, respectively, reflect the increases in projects in process as of June 30, 2009. Our prepaid expenses and other current assets increased $577,039 due to the payment in advance of legal and marketing expenses.

As of December 31, 2009, we had a net operating loss carryforward of $9.3 million available to reduce future taxable income. The taxable income generated in future periods will be offset by net operating loss carryforward and result in no current tax liability. We have a full valuation allowance against our deferred tax assets as our management concluded that it was more likely than not that we would not realize the benefit of our deferred tax assets by generating sufficient taxable income in future years. We expect to continue to provide a full valuation allowance until, or unless, we can sustain a level of profitability that demonstrates our ability to utilize these assets.

Net Cash Used In Investing Activities. Net cash used in investing activities for the six months ended June 30, 2010 and 2009 was approximately $158,782 and $300,169, respectively. Net cash used in investing activities for the six months ended June 30, 2010 consisted of amounts paid out for the general and computer equipment and miscellaneous leasehold improvements. Net cash used in investing activities for the six months ended June 30, 2009 consisted primarily of cash paid for the acquisition of equipment and leasehold improvements and cash paid out for the acquisition of assets in excess of cash received.

Net Cash Provided by Financing Activities. Net cash provided by financing activities for the six months ended June 30, 2010 and 2009 was $0 and $606,899, respectively. Net cash provided by financing activities during 2009 consisted of proceeds from the line of credit of approximately $1.4 million and proceeds from a short term loan payable of $55,490 offset by $878,380 paid for deferred financing costs.

Accounts Receivable Purchase Agreement

In July 2009, we entered into an accounts receivable purchase agreement with RCA, which was amended in October 2009. Under the purchase agreement, we can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the purchase agreement, generally are our receivables under prime government contracts.

Under the terms of the purchase agreement, we may offer eligible accounts receivable to RCA and if RCA purchases such receivables, we will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from our customer for such receivable, they will pay to us the remaining 10% of the receivable less its fees. In addition to a discount factor fee and an initial enrollment fee, we are required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2.25 million and RCA’s initial expenses in negotiating the purchase agreement and other expenses in certain specified situations. The purchase agreement also provides that in the event, but only to the extent, that the conveyance of receivables by us is characterized by a court or other governmental authority as a loan rather than a sale, we shall be deemed to have granted RCA effective as of the date of the first purchase under the purchase agreement, a security interest in all of our right, title and interest in, to and under all of the receivables sold by us to RCA, whether now or hereafter owned, existing or arising.

The initial term of the purchase agreement was to end on December 31, 2009 and will renew annually after the initial term, unless earlier terminated by either of the parties. Pursuant to the October 2009 amendment, the term during which we may offer and sell eligible accounts receivable to RCA has been extended from December 31, 2009 to October 15, 2010, and the discount factor rate has been reduced from 0.524% to 0.4075%. As of June 30, 2010, RCA holds $2.1 million of accounts receivable for which RCA has not received payment from our customers.

Series A Convertible Preferred Stock

In March and April 2008, we sold shares of our Series A Preferred and Investor Warrants. We received aggregate gross proceeds of $15.0 million, before fees and expenses of the placement agent in the transaction and other expenses.

In connection with our application to list our common stock on the NYSE Amex, we entered into a Consent and Agreement (or Consent Agreement) on May 23, 2008 with the Series A Holders where the Series A Holders agreed to limit the number of shares of common stock issuable upon conversion of, or as dividends on, the Series A Preferred and upon the exercise of the Investor Warrants without approval of our common stockholders (which stockholder approval was received on December 12, 2008). In return, among other things, we agreed for the fiscal year ending December 31, 2008 (A) to achieve (i) revenues equal to or exceeding $50,000,000 and (ii) consolidated EBITDA equal to or exceeding $13,500,000, and (B) to publicly disclose and disseminate, and to certify to the Series A Holders, our operating results for such period, no later than February 15, 2009 (we collectively refer to these as the Financial Covenants). Under the Consent Agreement, the breach of the Financial Covenants were each deemed a ‘‘Triggering Event’’ under the Certificate of Designations, Preferences and Rights of the Series A Convertible Preferred Stock (or Certificate of Designations), which would purportedly give the Series A Holders the right to require us to redeem all or a portion of their Series A Preferred shares at a price per share calculated under the Certificate of Designations.

We did not satisfy the terms of the Financial Covenants and in April 2009 we received a Notice of Triggering Event Redemption from the holder of 94% of our Series A Preferred. The notice demanded the full redemption of such holder’s Series A Preferred as a consequence of the breach of the Financial Covenants, and demanded payment of accrued dividends on the Series A Preferred and legal fees and expenses incurred in connection with negotiations concerning the breach of the Financial Covenants.

On May 22, 2009, we entered into the Settlement Agreement pursuant to which, among other things, (i) the Series A Holders waived any breach by us of the Financial Covenants or our obligation to timely pay dividends on the Series A Preferred for any period through September 30, 2009, and waived any ‘‘Equity Conditions Failure’’ and any ‘‘Triggering Event’’ under the certificate of designations of the Series A Preferred otherwise arising from such breaches, (ii) the Investor Warrants were amended to reduce their exercise price from $2.40 per share to $0.01 per share, (iii) we issued the Series A Holders an aggregate of 2,000,000 shares of our common stock (or Settlement Shares), in full satisfaction of our obligation to pay dividends under the Certificate of Designations as of March 31, 2009, June 30, 2009 and September 30, 2009, and (iv) we agreed to redeem $7.5 million in stated value of the Series A Preferred by December 31, 2009. We agreed that, if we fail to so redeem $7.5 million in stated value of the Series A Preferred by that date (a Redemption Failure), then, in lieu of any other remedies or damages available to the Series A Holders (absent fraud), (i) the redemption price payable by us will increase by an amount equal to 10% of the stated value, (ii) we will use our best efforts to obtain stockholder approval to reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 (which would increase the number of shares of common stock into which the Series A Preferred is convertible), and (iii) we will expand the size of our board of directors by two, will appoint two persons designated by the Series A Holders to fill the two newly-created vacancies, and will use our best efforts to amend our certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board (or Series A Directors).

Pursuant to the terms of the Settlement Agreement, we also entered into a Registration Rights Agreement with the Series A Holders, in which we agreed to file with the SEC, by June 1, 2009, a registration statement covering the resale of the Settlement Shares, and to use our best efforts to have such registration statement declared effective as soon as practicable thereafter. We further agreed with the Series A Holders to include in such registration statement the shares of common stock issued upon the exercise of the Investor Warrants. A registration statement was filed, and subsequently declared effective on August 10, 2009.

Also pursuant to the terms of the Settlement Agreement, each of our directors and executive officers entered into a Lock-Up Agreement, pursuant to which each such person agreed that, for so long as any shares of Series A Preferred remain outstanding, he will not sell any shares of our common stock owned by him as of May 22, 2009.

Also pursuant to the terms of the Settlement Agreement, on May 22, 2009 our Chief Executive Officer, President and Chairman, entered into an Irrevocable Proxy and Voting Agreement with the Series A Holders, pursuant to which he agreed, among other things, that if a Redemption Failure occurs he will vote all shares of voting stock owned by him in favor of (i) reducing the Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) amending our certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board of directors (collectively referred to as the Company Actions). Our CEO also appointed one of the Series A Holders as his proxy to vote his shares of voting stock in favor of the Company Actions, and against approval of any opposing or competing proposal, at any stockholder meeting or written consent of our stockholders at which such matters are considered.

The Settlement Agreement provides that if as of December 1, 2009, we do not reasonably believe that we can fund the required redemption on or before December 31, 2009, we need to take actions required to seek to obtain the stockholder approval for an amendment to our certificate of incorporation necessary for reducing the Conversion Price and granting the Series A Holders the right to elect two directors designated by such preferred stockholder (or Series A Directors), including, without limitation, (i) calling a meeting of our stockholders to consider such amendment; (ii) submitting to the SEC a preliminary proxy statement for such meeting of stockholders; and (iii) upon receipt of the requisite stockholder approval, filing the amendment to our certificate of incorporation.

We were unable to effect the redemption of the $7.5 million in stated value of the Series A Preferred by December 31, 2009 and we have accordingly increased the number of directors constituting our board of directors by two and held a special meeting of our stockholders on April 8, 2010. At this special meeting, the stockholders approved the amendments to our certificate of incorporation to reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 and provide for the ability of the Series A Holders to elect the Series A Directors, and we amended the certificate of incorporation as of April 9, 2010. Based on the reduction of the Conversion Price of the Series A Preferred, the number of our common stock into which the Series A Preferred is convertible into increased from 7.5 million to 30.0 million. Notwithstanding the Settlement Agreement and compliance with the remedies described above for the failure to redeem the $7.5 million in stated value of the Series A Preferred by December 31, 2009, the terms of the Series A Preferred provided that we are to redeem any such preferred stock outstanding on the Maturity Date, December 31, 2010, as such term is further defined in the Certificate of Designations (such redemption provision hereinafter referred to as the Mandatory Redemption Provision).

On April 8, 2010, we entered into a waiver agreement with the Series A Holders, pursuant to which the Series A Holders agreed to extend the Maturity Date from December 31, 2010 to April 1, 2011, and on August 13, 2010, we entered into a waiver agreement with the Series A Holders which further extended the Maturity Date to July 1, 2011 (the period from December 31, 2010 to July 1, 2011 is referred to as the extension period). Pursuant to the waiver agreements, during the extension period, (i) the Series A Holders agreed to waive any right to the redemption of the Series A Preferred under the Mandatory Redemption Provision until the last day of the extension period and (ii) our failure to comply with the Mandatory Redemption Provision prior to the last day of the extension period shall be deemed not to be a breach of such provision or the terms and conditions of, or applicable to, the Series A Preferred. We currently are seeking to raise capital or obtain access to capital sufficient to permit us to effect the mandatory redemption.

The terms of the Series A Convertible Preferred Stock were amended to reduce its Conversion Price from $2.00 to $0.50 and extend the Maturity Date from December 31, 2010 to April 1, 2011. We evaluated these modifications in order to determine if the modifications were cause for the application of extinguishment accounting. Extinguishment accounting is to be applied if there has been a substantial modification of debt instrument terms. The modifications would be considered substantial under the guidance of ASC 470-50-40-10, if:

(1) The change in the present value of future cash flows is at least 10% or if

(2) The change in the fair value of the conversion option is at least 10% of the carrying amount of the preferred stock.

Based on our analysis, neither the extension of the maturity date nor the reduction of the Conversion Price qualifies the modification as substantial. Thus, extinguishment accounting should not be applied to the transaction. Since the fair value of the embedded conversion option increased as a result of the modification, the increase to the fair value of the embedded conversion option reduces the carrying amount of the debt instrument and increases paid-in capital in accordance with ASC 470-50-40-15.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this Item 3.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures, as defined in Rules 13(a)-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (or Exchange Act), are controls and other procedures that are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified by the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As a result of our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2010 because of the material weaknesses set forth below.

The following is a summary of our material weaknesses as of June 30, 2010:

Financial Reporting

Due to a lack of adequate systems, processes, and resources with sufficient GAAP knowledge, experience, and training, we did not maintain effective controls over the period-end financial close and reporting processes as of June 30, 2010. Due to the actual and potential effect on financial statement balances and disclosures, the resulting restatement of our financial statements and the importance of the financial closing and reporting processes, we concluded that, in the aggregate, these deficiencies in internal controls over the period-end financial close and reporting process constituted a material weakness in internal control over financial reporting. The specific deficiencies contributing to this material weakness were as follows:

•

Inadequate policies and procedures. We did not design, establish, and maintain effective documented GAAP-compliant financial accounting policies and procedures, nor a formalized process for determining, documenting, communicating, implementing, monitoring, and updating accounting policies and procedures, including policies and procedures related to significant, complex, and non-routine transactions.

•

Inadequate GAAP expertise. We did not have individuals with adequate GAAP knowledge in specific complex areas and non-routine transactions such as preferred stock, warrants, discontinued operations, costs related to registration, acquisitions, and financing.

•

Equity Compensation. We did not maintain adequate policies and procedures to ensure effective controls over the administration, accounting, and disclosure for stock-based compensation sufficient to prevent a material misstatement of related compensation expense. Specifically, the following deficiencies in our granting, administration, and accounting for awards were identified:

	º	Inaccurate accounting and disclosure. We did not maintain adequate procedures or effective controls over accounting, communication, and disclosure of compensation expense related to awards. Specifically, we lacked a process of financial and administrative oversight over the stock-based compensation process.

	º	Inadequate administration of awards. We did not maintain effective controls as it related to the reconciliation of grants to source data.

Insufficient tracking of employee data. We did not maintain adequate procedures or effective controls over tracking awards that ultimately impacted the timely accounting for compensation expense.

General Computing Controls

We did not maintain adequate general computing control policies and procedures. The following individual material weaknesses were identified:

	•	Inadequate system access controls. System access controls over our accounting information system were not in place to appropriately prohibit or limit user access in areas including journal entries, invoice processing, master-file maintenance.

•

Inadequate general computing controls. Overall general user and system administration were inadequate in the following areas where procedures were in place but not formalized or documented:

Backup and recovery of financial data

Systems development and change management

Incident management

Security monitoring

Our efforts to improve our internal controls are ongoing and focused on expanding our organizational capabilities to improve our control environment and on implementing process changes to strengthen our internal control and monitoring activities.

As part of our ongoing remedial efforts, we are planning, among other things, to:

•

expand our accounting policy and controls organization by creating and filling a new position with permanent and/or temporary resources with GAAP expertise around specific topics;

•

engage external subject matter experts to:

	º	advise on accounting for and disclosure of stock-based compensation related matters, including providing additional ASC 718 training and accounting assistance;

	º	develop and implement formal remediation plans;

develop, implement and/or enhance accounting and finance-related policies and procedures, including end-user computing;

•

initiate a project to review our key financial systems security processes and responsibilities to appropriately design automated controls that adequately segregate job responsibilities; and

•

communicate to all employees the importance of adhering to IT system access segregation and change request protocols, to prevent unauthorized changes and improper accesses from recurring.

We believe that the foregoing actions will improve our internal control over financial reporting, as well as our disclosure controls and procedures. We intend to perform such procedures and commit such resources as necessary to continue to allow us to overcome or mitigate these material weaknesses such that we can make timely and accurate quarterly and annual financial filings until such time as those material weaknesses are fully addressed and remediated.

Changes in Internal Controls

There were no changes in our internal controls over financial reporting during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to affect, our internal control over financial reporting.

Limitations on the Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our Disclosure Controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls.

The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, a control may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

PART II

Item 1. Legal Proceedings

On February 29, 2008, Roy Elfers, a former employee commenced an action against us for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. The Complaint seeks damages of approximately $87,000. We filed an answer to the complaint and discovery and depositions have been completed. We anticipate submitting a motion for summary judgment to dismiss the complaint shortly. No trial date has been set. We believe meritorious defenses to the claims exist and we intend to vigorously defend this action.

On March 4, 2008, Thomas Cusack, our former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000. On April 2, 2008, we filed a response to the charges. We believe the allegations to be without merit and intend to vigorously defend against the action. On March 7, 2008, Mr. Cusack also commenced a second action against us for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, we served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims and stock conversion claim. On or about October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, we filed an answer to the complaint and filed counterclaims against Mr. Cusack for fraud and rescission. The parties have completed discovery and depositions. On June 15, 2010, both parties submitted motions for summary judgment. No trial date has been set yet. We believe meritorious defenses to the claims exist and we intend to vigorously defend this action.

Item 1A. Risk Factors

Our business, industry and common stock are subject to numerous risks and uncertainties. The discussion below sets forth all of such risks and uncertainties that we have identified as material, but are not the only risks and uncertainties facing us. Any of the following risks, if realized, could materially and adversely affect our revenues, operating results, profitability, financial condition, prospects for future growth and overall business, as well as the value of our common stock. Our business is also subject to general risks and uncertainties that affect many other companies, such as overall U.S. and non-U.S. economic and industry conditions, including a global economic slowdown, geopolitical events, changes in laws or accounting rules, fluctuations in interest and exchange rates, terrorism, international conflicts, major health concerns, natural disasters or other disruptions of expected economic and business conditions. Additional risks and uncertainties not currently known to us or that we currently believe are immaterial also may impair our business operations and liquidity.

Risks Relating to Our Company

We depend on the U.S. Government for a substantial amount of our sales and if we do not continue to experience demand for our products within the U.S. Government, our business may fail. Moreover, our growth in the last few years has been attributable in large part to U.S. wartime spending in support of troop deployments in Iraq and Afghanistan. If such troop levels are reduced, our business may be harmed.

We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Customers for our products include the U.S. Department of Defense, including the U.S. Marine Corps and U.S. Army Tank Automotive and Armaments Command (TACOM), and the U.S. Department of Homeland Security. Government tax revenues and budgetary constraints, which fluctuate from time to time, can affect budgetary allocations for these customers. Many government agencies have in the past experienced budget deficits that have led to decreased spending in defense, law enforcement and other military and security areas. Our results of operations may be subject to substantial period-to-period fluctuations because of these and other factors affecting military, law enforcement and other governmental spending.

U.S. defense spending historically has been cyclical. Defense budgets have received their strongest support when perceived threats to national security raise the level of concern over the country’s safety, such as in Iraq and Afghanistan. As these threats subside, spending on the military tends to decrease. Accordingly, while U.S. Department of Defense funding has grown rapidly over the past few years, there is no assurance that this trend will continue. Rising budget deficits, the cost of the war on terror and increasing costs for domestic programs continue to put pressure on all areas of discretionary spending, and the federal government has signaled that this pressure will most likely impact the defense budget. A decrease in U.S. government defense spending, including as a result of planned significant U.S. troop level reductions in Iraq or Afghanistan, or changes in spending allocation could result in our government contracts being reduced, delayed or terminated. Reductions in our government contracts, unless offset by other military and commercial opportunities, could adversely affect our ability to sustain and grow our future sales and earnings.

Our revenues historically have been concentrated in a small number of contracts obtained through the U.S. Department of Defense and the loss of, or reduction in estimated revenue under, any of these contracts, or the inability to contract further with the U.S. Department of Defense could significantly reduce our revenues and harm our business.

Our revenues historically have been generated by a small number of contracts. During the three and six months ended June 30, 2010, four contracts with the U.S. Department of Defense organizations represented approximately 69% and 71%, respectively, of our revenue. While we believe we have satisfied and continue to satisfy the terms of these contracts, there can be no assurance that we will continue to receive orders under such contracts. Our government customers generally have the right to cancel any contract, or ongoing or planned orders under any contract, at any time. If any of our significant contracts were canceled, or our customers reduce their orders under any of these contracts, or we were unable to contract further with the U.S. Department of Defense, our revenues could significantly decrease and our business could be severely harmed.

We are required to redeem any outstanding Series A Preferred, of which $15.0 million in stated value is outstanding, as of July 1, 2011. If we do not generate, raise or obtain access to funds sufficient to redeem our Series A Preferred or if we fail to redeem such Preferred Stock, our cash flow could be adversely affected and our business significantly harmed.

On May 22, 2009, we entered into a Settlement Agreement, Waiver and Amendment with the holders of our Series A Preferred, pursuant to which, among other things, we have agreed to redeem $7,500,000 in stated value of Series A Preferred by December 31, 2009. We did not effect such redemption. As a result, in lieu of any other remedies or damages available to the holders of our Series A Preferred, the redemption price payable by us increased by an amount equal to 10% of the stated value, and we amended our certificate of incorporation to (i) reduce the conversion price of the Series A Preferred from $2.00 to $0.50 (which increased the number of shares of our common stock into which the Series A Preferred is convertible) and (ii) grant the holders of Series A Preferred, voting as a separate class, the right to elect two persons to serve on our board of directors.

We currently have outstanding $15.0 million in stated value of our Series A Preferred. The terms of such stock provide that we are to redeem any such stock outstanding as of July 1, 2011, as such date was extended from December 31, 2010 to April 1, 2011 pursuant to a waiver agreement between us and the Series A Holders dated April 8, 2010 and further extended pursuant to a waiver agreement between us and the Series A Holders dated August 13, 2010. We are seeking to raise capital or obtain access to funds sufficient to timely redeem our Series A Preferred. If we are not successful and we do not timely redeem such preferred stock, our cash flow could be adversely affected and our business significantly harmed. For additional information, please refer to Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Series A Convertible Preferred Stock.

We are required to comply with complex laws and regulations relating to the procurement, administration and performance of U.S. government contracts, and the cost of compliance with these laws and regulations, and penalties and sanctions for any non-compliance could adversely affect our business.

We are required to comply with laws and regulations relating to the administration and performance of U.S. government contracts, which affect how we do business with our customers and impose added costs on our business. Among the more significant laws and regulations affecting our business are the following:

The Federal Acquisition Regulations: Along with agency regulations supplemental to the Federal Acquisition Regulations, comprehensively regulate the formation, administration and performance of federal government contracts;

The Truth in Negotiations Act: Requires certification and disclosure of all cost and pricing data in connection with contract negotiations;

The Cost Accounting Standards and Cost Principles: Imposes accounting requirements that govern our right to reimbursement under certain cost-based federal government contracts; and

Laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the export of certain products and technical data. We engage in international work falling under the jurisdiction of U.S. export control laws. Failure to comply with these control regimes can lead to severe penalties, both civil and criminal, and can include debarment from contracting with the U.S. government.

Our contracting agency customers periodically review our performance under and compliance with the terms of our federal government contracts. We also routinely perform internal reviews. As a result of these reviews, we may learn that we are not in compliance with all of the terms of our contracts. If a government review or investigation uncovers improper or illegal activities, we may be subject to civil or criminal penalties or administrative sanctions, including:

Termination of contracts;

Forfeiture of profits;

Cost associated with triggering of price reduction clauses;

Suspension of payments;

Fines; and

Suspension or debarment from doing business with federal government agencies.

If we fail to comply with these laws and regulations, we may also suffer harm to our reputation, which could impair our ability to win awards of contracts in the future or receive renewals of existing contracts. If we are subject to civil and criminal penalties and administrative sanctions or suffer harm to our reputation, our current business, future prospects, financial condition, and/or operating results could be materially harmed. In addition, we are subject to the industrial security regulations, protocols, and procedures of the U.S. Government as set forth in the National Industrial Security Program Operating Manual (NISPOM), which are designed to protect and safeguard classified information from unauthorized release to individuals and organizations not possessing a security clearance or the requisite level of clearance necessary to access that information. Accordingly, any failure to adhere to the requirements of the NISPOM could expose us to severe legal and administrative consequences, including, but not limited to, our suspension or debarment from government contracts, the revocation of our clearance, and the termination of our government contracts, the occurrence of any of which could substantially harm our existing business and preclude us from competing for or receiving future government contracts.

Government contracts are usually awarded through a competitive bidding process that entails risks not present in the acquisition of commercial contracts.

A significant portion of our contracts and task orders with the U.S. government is awarded through a competitive bidding process. We expect that much of the business we seek in the foreseeable future will continue to be awarded through competitive bidding. Budgetary pressures and changes in the procurement process have caused many government customers to increasingly purchase goods and services through indefinite delivery/indefinite quantity (IDIQ) contracts, General Services Administration (GSA) schedule contracts and other government-wide acquisition contracts (GWACs). These contracts, some of which are awarded to multiple contractors, have increased competition and pricing pressure, requiring us to make sustained post- award efforts to realize revenue under each such contract. Competitive bidding presents a number of risks, including without limitation:

the need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and cost overruns;

the substantial cost and managerial time and effort that we may spend to prepare bids and proposals for contracts that may not be awarded to us;

the need to estimate accurately the resources and cost structure that will be required to service any contract we are awarded; and

the expense and delay that may arise if our or our partners’ competitors protest or challenge contract awards made to us or our partners pursuant to competitive bidding, and the risk that any such protest or challenge could result in the resubmission of bids on modified specifications, or in the termination, reduction or modification of the awarded contract.

If we are unable to consistently win new contract awards over any extended period, our business and prospects will be adversely affected, and that could cause our actual results to be adversely affected. In addition, upon the expiration of a contract, if the customer requires further services of the type provided by the contract, there is frequently a competitive rebidding process. There can be no assurance that we will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract, and the termination or non-renewal of any of our significant contracts would cause our actual results to be adversely affected.

The U.S. government may reform its procurement or other practices in a manner adverse to us.

Because we derive a significant portion of our revenues from contracts with the U.S. government or its agencies, we believe that the success and development of our business will depend on our continued successful participation in federal contracting programs. The current administration has signed a Memorandum for the Heads of Executive Departments and Agencies on Government Contracting, which orders significant changes to government contracting, including the review of existing federal contracts to eliminate waste and the issuance of government-wide guidance to implement reforms aimed at cutting wasteful spending and fraud. The federal procurement reform called for in the Memorandum requires the heads of several federal agencies to develop and issue guidance on review of existing government contracts and authorizes that any contracts identified as wasteful or otherwise inefficient be modified or cancelled. If any of our contracts were to be modified or cancelled, our actual results could be adversely affected and we can give no assurance that we would be able to procure new U.S. Government contracts to offset the revenues lost as a result of any modification or cancellation of our contracts. In addition, there may be substantial costs or management time required to respond to government review of any of our current contracts, which could delay or otherwise adversely affect our ability to compete for or perform contracts. Further, if the ordered reform of the U.S. Government’s procurement practices involves the adoption of new cost-accounting standards or the requirement that competitors submit bids or perform work through teaming arrangements, that could be costly to satisfy or could impair our ability to obtain new contracts. The reform may also involve the adoption of new contracting methods to GSA or other government-wide contracts, or new standards for contract awards intended to achieve certain socio-economic or other policy objectives, such as establishing new set-aside programs for small or minority-owned businesses. In addition, the U.S. government may face restrictions from other new legislation or regulations, as well as pressure from government employees and their unions, on the nature and amount of services the U.S. government may obtain from private contractors. These changes could impair our ability to obtain new contracts. Any new contracting methods could be costly or administratively difficult for us to implement and, as a result, could harm our operating results.

Our contracts with the U.S. government and its agencies are subject to audits and cost adjustments. Unfavorable government audits could force us to adjust previously reported operating results, could affect future operating results and could subject us to a variety of penalties and sanctions.

U.S. government agencies, including the Defense Contract Audit Agency (DCAA), routinely audit and investigate government contracts and government contractors’ incurred costs, administrative processes and systems. Certain of these agencies, including the DCAA, review our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. They also review the adequacy of our internal control systems and policies, including our purchase, property, estimation, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not be reimbursed, and any such costs already reimbursed must be refunded. Moreover, if any of the administrative processes and systems are found not to comply with government requirements, we may be subjected to increased government scrutiny and approval that could delay or otherwise adversely affect our ability to compete for or perform contracts. Therefore, an unfavorable outcome of an audit by the DCAA or another government agency could cause actual results to be adversely affected and differ materially from those anticipated. If a government investigation uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with the U.S. government. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us. Each of these events could cause our actual results to be adversely affected.

A portion of our business depends upon obtaining and maintaining required security clearances, and our failure to do so could result in termination of certain of our contracts or cause us to be unable to bid or re-bid on certain contracts.

Obtaining and maintaining personal security clearances for employees involves a lengthy process, and it can be difficult to identify, recruit and retain employees who already hold security clearances. If our employees are unable to obtain or retain security clearances, or if such employees who hold security clearances terminate their employment with us, the customer whose work requires cleared employees could terminate their contract with us or decide not to exercise available options, or to not renew it. To the extent we are not able to engage employees with the required security clearances for a particular contract, we may not be able to bid on or win new contracts, or effectively re-bid on expiring contracts, which could adversely affect our business.

A facility security clearance (FCL) is an administrative determination by the Defense Security Service (DSS), a U.S. Department of Defense component, that a particular contractor facility has the requisite level of security, procedures, and safeguards to handle classified information requirements for access to classified information. Our ability to obtain and maintain FCLs has a direct impact on our ability to compete for and perform U.S. government contracts, the performance of which requires access to classified information. Our inability to so obtain or maintain any facility security clearance level could result in the termination, non-renewal or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.

We may not realize the full amount of revenues reflected in our backlog, which could harm our operations and significantly reduce our future revenues.

There can be no assurances that our backlog estimates will result in actual revenues in any particular fiscal period because our customers may modify or terminate projects and contracts and may decide not to exercise contract options. We define backlog as the future revenue we expect to receive from our contracts. We include potential orders expected to be awarded under IDIQ contracts. Our revenue estimates for a particular contract are based, to a large extent, on the amount of revenue we have recently recognized on that contract, our experience in utilizing capacity on similar types of contracts, and our professional judgment. Our revenue estimate for a contract included in backlog can be lower than the revenue that would result from our customers utilizing all remaining contract capacity. Our backlog includes estimates of revenues the receipt of which require future government appropriation, option exercise by our clients and/or is subject to contract modification or termination. At June 30, 2010, our backlog was approximately $38 million; $22 million of which we estimate will be realized in 2010. These estimates are based on our experience under such contracts and similar contracts, and we believe such estimates to be reasonable. However, we believe that the receipt of revenues reflected in our backlog estimate for the following twelve months will generally be more certain than our backlog estimate for periods thereafter. If we do not realize a substantial amount of our backlog, our operations could be harmed and our future revenues could be significantly reduced.

U.S. government contracts often contain provisions that are typically not found in commercial contracts and that are unfavorable to us, which could adversely affect our business.

U.S. government contracts contain provisions and are subject to laws and regulations that give the U.S. government rights and remedies not typically found in commercial contracts, including without limitation, allowing the U.S. government to:

terminate existing contracts for convenience, as well as for default;

establish limitations on future services that can be offered to prospective customers based on conflict of interest regulations;

reduce or modify contracts or subcontracts;

decline to make orders under existing contracts;

cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable;

decline to exercise an option to renew a multi-year contract; and

claim intellectual property rights in products provided by us.

The ownership, control or influence of our company by foreigners could result in the termination, non-renewal of or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.

We are subject to industrial security regulations of the U.S. Department of Defense and other federal agencies that are designed to safeguard against unauthorized access by foreigners and others to classified and other sensitive information. If we were to come under foreign ownership, control or influence, our clearances could be revoked and our U.S. government customers could terminate, or decide not to renew, our contracts, and such a situation could also impair our ability to obtain new contracts and subcontracts. Any such actions would reduce our revenues and harm our business.

We depend on our suppliers and two, in particular, each currently provide us with more than 10% of our supply needs. If we cannot obtain certain components for our products or we lose any of our key suppliers, we would have to develop alternative designs that could increase our costs or delay our operations.

We depend upon a number of suppliers for components of our products. Two of these suppliers, Action Group, Inc. and Industrial Door Contractors, Inc., each accounted for more than 10% of our total purchases during the six months ended June 30, 2010. There is an inherent risk that certain components of our products will be unavailable for prompt delivery or, in some cases, discontinued. We have only limited control over any third-party manufacturer as to quality controls, timeliness of production, deliveries and various other factors. Should the availability of certain components be compromised through the loss of, or impairment of the relationship with, any of our three key suppliers or otherwise, it could force us to develop alternative designs using other components, which could add to the cost of goods sold and compromise delivery commitments. If we are unable to obtain components in a timely manner, at an acceptable cost, or at all, we would need to select new suppliers, redesign or reconstruct processes we use to build our transparent and opaque armored products. We may not be able to manufacture one or more of our products for a period of time, which could materially adversely affect our business, results from operations and financial condition.

If we fail to keep pace with the ever-changing market of security-related defense products, our revenues and financial condition will be negatively affected.

The security-related defense product market is rapidly changing, with evolving industry standards. Our future success will depend in part upon our ability to introduce new products, designs, technologies and features to meet changing customer requirements and emerging industry standards; however, there can be no assurance that we will successfully introduce new products or features to our existing products or develop new products that will achieve market acceptance. Any delay or failure of these products to achieve market acceptance would adversely affect our business. In addition, there can be no assurance that products or technologies developed by others will not render our products or technologies non-competitive or obsolete. Should we fail to keep pace with the ever-changing nature of the security-related defense product market, our revenues and financial condition will be negatively affected.

We believe that, in order to remain competitive in the future, we will need to continue to invest financial resources to develop new and adapt or modify our existing offerings and technologies, including through internal research and development, acquisitions and joint ventures or other teaming arrangements. These expenditures could divert our attention and resources from other projects, and we cannot be sure that these expenditures will ultimately lead to the timely development of new offerings and technologies. Due to the design complexity of our products, we may in the future experience delays in completing the development and introduction of new products. Any delays could result in increased costs of development or deflect resources from other projects. In addition, there can be no assurance that the market for our offerings will develop or continue to expand as we currently anticipate. The failure of our technology to gain market acceptance could significantly reduce our revenues and harm our business. Furthermore, we cannot be sure that our competitors will not develop competing technologies which gain market acceptance in advance of our products.

We may be subject to personal liability claims for our products and if our insurance is not sufficient to cover such claims, our expenses may increase substantially.

Our products are used in applications where the failure to use our products properly or their malfunction could result in bodily injury or death, and we may be subject to personal liability claims. Although we currently maintain general liability insurance which includes $1 million of product liability coverage, our insurance may not be adequate to cover such claims. As a result, a significant lawsuit could adversely affect our business. We may be exposed to liability for personal injury or property damage claims relating to the use of our products. Any future claim against us for personal injury or property damage could materially adversely affect our business, financial condition, and results of operations and result in negative publicity. We currently maintain insurance for this type of liability as well as seek Support Antiterrorism by Fostering Effective Technologies Act of 2002 (also known as the SAFETY Act) certification for our products where we deem appropriate. However, although we maintain insurance coverage, we may experience legal claims outside of our insurance coverage, or in excess of our insurance coverage, or that insurance will not cover. Even if we are not found liable, the costs of defending a lawsuit can be high.

We are subject to substantial competition.

We are subject to significant competition that could harm our ability to win business and increase the price pressure on our products. We face strong competition from a wide variety of firms, including large, multinational, defense and aerospace firms. Most of our competitors have considerably greater financial, marketing and technological resources than we do, which may make it difficult to win new contracts and we may not be able to compete successfully. Certain competitors operate larger facilities and have longer operating histories and presence in key markets, greater name recognition and larger customer bases. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their products. Moreover, we may not have sufficient resources to undertake the continuing research and development necessary to remain competitive.

We must comply with environmental regulations or we may have to pay expensive penalties or clean-up costs.

We are subject to federal, state, local and foreign laws, and regulations regarding protection of the environment, including air, water, and soil. Our manufacturing business involves the use, handling, storage, discharge and disposal of, hazardous or toxic substances or wastes to manufacture our products. We must comply with certain requirements for the use, management, handling, and disposal of these materials. If we are found responsible for any hazardous contamination, we may have to pay expensive fines or penalties or perform costly clean-up. Even if we are charged, and later found not responsible, for such contamination or clean-up, the cost of defending the charges could be high. Authorities may also force us to suspend production, alter our manufacturing processes, or stop operations if we do not comply with these laws and regulations.

We may not be able to adequately safeguard our intellectual property rights and trade secrets from unauthorized use, and we may become subject to claims that we infringe on others’ intellectual property rights.

We rely on a combination of trade secrets, trademarks, and other intellectual property laws, nondisclosure agreements and other protective measures to preserve our proprietary rights to our products and production processes.

We currently have five utility and one provisional U.S. pending patent applications. We do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. We have not emphasized, and do not presently intend to emphasize, patents as a source of significant competitive advantage; however, if we are issued patents we intend to seek to enforce them as commercially appropriate.

These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we may face other obstacles to enforcing our intellectual property rights outside the United States including the ability to enforce judgments, the possibility of conflicting judgments among courts and tribunals in different jurisdictions and locating, hiring and supervising local counsel in such other countries.

Although we implement protective measures and intend to defend our proprietary rights, these efforts may not be successful. From time to time, we may litigate within the United States or abroad to enforce our licensed patents, to protect our trade secrets and know-how or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive, require management’s attention and might not bring us timely or effective relief.

Furthermore, third parties may assert that our products or processes infringe their patent or other intellectual property rights. Our patents, if granted, may be challenged, invalidated or circumvented. Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief, which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we may not be able to obtain any such licenses on acceptable terms, if at all.

We depend on management and other key personnel and we may not be able to execute our business plan without their services.

Our success and our business strategy depend in large part on our ability to attract and retain key management and operating personnel. Such individuals are in high demand and are often subject to competing employment offers. We depend to a large extent on the abilities and continued participation of our executive officers and other key employees. We presently maintain “key man” insurance on Anthony Piscitelli, our President and Chief Executive Officer. We believe that, as our activities increase and change in character, additional experienced personnel will be required to implement our business plan. Competition for such personnel is intense and we may not be able to hire them when required, or have the ability to retain them.

We may partner with foreign entities, and domestic entities with foreign contacts, which may affect our business plans by increasing our costs.

We recognize that there may be opportunities for increased product sales in both the domestic and global defense markets. We have recently initiated plans to strategically team with foreign entities as well as domestic entities with foreign business contacts in order to better compete for both domestic and foreign military contracts. In order to implement these plans, we may incur substantial costs which may include additional research and development, prototyping, hiring personnel with specialized skills, implementing and maintaining technology control plans, technical data export licenses, production, product integration, marketing, warehousing, finance charges, licensing, tariffs, transportation and other costs. In the event that working with foreign entities and/or domestic entities with foreign business contacts proves to be unsuccessful, this strategy may ineffectively use our resources which may affect our profitability and the costs associated with such work may preclude us from pursuing alternative opportunities.

We are presently classified as a small business and the loss of our small business status may adversely affect our ability to compete for government contracts.

We are presently classified as a small business as determined by the Small Business Administration based upon the North American Industry Classification Systems (NAICS) industry and product specific codes which are regulated in the United States by the Small Business Administration. While we do not presently derive a substantial portion of our business from contracts which are set-aside for small businesses, we are able to bid on small business set-aside contracts as well as contracts which are open to non-small business entities. It is also possible that we may become more reliant upon small business set-aside contracts. Our continuing growth may cause us to lose our designation as a small business, and additionally, as the NAICS codes are periodically revised, it is possible that we may lose our status as a small business and may sustain an adverse impact on our current competitive advantage. The loss of small business status could adversely impact our ability to compete for government contracts, maintain eligibility for special small business programs and limit our ability to partner with other business entities which are seeking to team with small business entities as may be required under a specific contract.

We intend to pursue international sales opportunities which may require export licenses and controls and result in the commitment of significant resources and capital.

In order to pursue international sales opportunities, we have initiated a program to obtain product classifications, commodity jurisdictions, licenses, and technology control plans, technical data export licenses and export related programs. Due to our diverse products, it is possible that some products may be subject to classification under the United States State Department International Traffic in Arms Regulations (ITAR). In the event that a product is classified as an ITAR-controlled item, we will be required to obtain an ITAR export license. While we believe that we will be able to obtain such licenses, the denial of required licenses and/or the delay in obtaining such licenses may have a significant adverse impact on our ability to sell products internationally. Alternatively, our products may be subject to classification under the United States Commerce Department’s Export Administration Regulations (EAR). We also anticipate that we may be required to comply with international regulations, tariffs and controls and we intend to work closely with experienced freight forwarders and advisors. We anticipate that an internal compliance program for international sales will require the commitment of significant resources and capital.

Increases in our international sales may expose us to unique and potentially greater risks than are presented in our domestic business, which could negatively impact our results of operations and financial condition.

If our international sales grow, we may be exposed to certain unique and potentially greater risks than are presented in our domestic business. International business is sensitive to changes in the budgets and priorities of international customers, which may be driven by potentially volatile worldwide economic conditions, regional and local economic and political factors, as well as U.S. foreign policy. International sales will also expose us to local government laws, regulations and procurement regimes which may differ from U.S. Government regulation, including import-export control, exchange control, investment and repatriation of earnings, as well as to varying currency and other economic risks. International contracts may also require the use of foreign representatives and consultants or may require us to commit to financial support obligations, known as offsets, and provide for penalties if we fail to meet such requirements. As a result of these and other factors, we could experience award and funding delays on international projects or could incur losses on such projects, which could negatively impact our results of operations and financial condition.

We have made, and expect to continue to make, strategic acquisitions and investments, and these activities involve risks and uncertainties.

In pursuing our business strategies, we continually review, evaluate and consider potential investments and acquisitions. In evaluating such transactions, we are required to make difficult judgments regarding the value of business opportunities, technologies and other assets, and the risks and cost of potential liabilities. Furthermore, acquisitions and investments involve certain other risks and uncertainties, including the difficulty in integrating newly-acquired businesses, the challenges in achieving strategic objectives and other benefits expected from acquisitions or investments, the diversion of our attention and resources from our operations and other initiatives, the potential impairment of acquired assets and the potential loss of key employees of the acquired businesses.

The outcome of litigation in which we have been named as a defendant is unpredictable and an adverse decision in any such matter could have a material adverse effect on our financial position or results of operations.

We are defendants in a number of litigation matters. These matters may divert financial and management resources that would otherwise be used to benefit our operations. Although we believe that we have meritorious defenses to the claims made in the litigation matters to which we have been named a party and intend to contest each lawsuit vigorously, no assurances can be given that the results of these matters will be favorable to us. An adverse resolution or outcome of any of these lawsuits, claims, demands or investigations could have a negative impact on our financial condition, results of operations and liquidity. Please see Part II, Item 1, Legal Proceedings.

Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability.

We are subject to income taxes in the United States. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. Furthermore, changes in domestic or foreign income tax laws and regulations, or their interpretation, could result in higher or lower income tax rates assessed or changes in the taxability of certain sales or the deductibility of certain expenses, thereby affecting our income tax expense and profitability. Although we believe our tax estimates are reasonable, the final determination of tax audits could be materially different from our historical income tax provisions and accruals. Additionally, changes in the geographic mix of our sales could also impact our tax liabilities and affect our income tax expense and profitability.

Risks Relating to Our Common Stock

If we fail to maintain an effective system of internal controls over financial reporting, we may not be able to report accurately our financial results. This could have a material adverse effect on our share price.

Effective internal controls are necessary for us to provide accurate financial reports. We completed documenting and testing our internal control procedures to satisfy the requirements of Section 404 of the Sarbanes Oxley Act of 2002 and the related rules of the SEC, which require, among other things, our management to assess annually the effectiveness of our internal control over financial reporting and our independent registered public accounting firm to issue a report on that assessment.

As a result of the material weaknesses identified during the course of our evaluation of our controls and procedures, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. We identified material weaknesses in our period-end financial close processes and general computing controls. To address these material weaknesses, we intend to engage outside experts to provide counsel and guidance in areas where we cannot economically maintain the required expertise internally.

There can be no assurance that we will maintain adequate controls over our financial processes and reporting in the future or that those controls will be adequate in all cases to uncover inaccurate or misleading financial information that could be reported by members of management. If our controls failed to identify any misreporting of financial information or our management or independent registered public accounting firm were to conclude in their reports that our internal control over financial reporting was not effective, investors could lose confidence in our reported financial information and the trading price of our shares could drop significantly. In addition, we could be subject to sanctions or investigations by the stock exchange upon which our common stock may be listed, the SEC or other regulatory authorities, which would require additional financial and management resources.

Volatility of our stock price could adversely affect stockholders.

The market price of our common stock could fluctuate significantly as a result of:

quarterly variations in our operating results;

cyclical nature of defense spending;

interest rate changes;

changes in the market’s expectations about our operating results;

our operating results failing to meet the expectation of securities analysts or investors in a particular period;

changes in financial estimates and recommendations by securities analysts concerning our company or the defense industry in general;

operating and stock price performance of other companies that investors deem comparable to us;

news reports relating to trends in our markets;

changes in laws and regulations affecting our business;

material announcements by us or our competitors;

sales of substantial amounts of common stock by our directors, executive officers or significant stockholders or the perception that such sales could occur;

general economic and political conditions such as recessions and acts of war or terrorism; and

other matters discussed in the Risk Factors.

Fluctuations in the price of our common stock could contribute to the loss of all or part of an investor’s investment in our company.

We currently do not intend to pay dividends on our common stock and consequently your only opportunity to achieve a return on your investment is if the price of common stock appreciates.

We currently do not plan to declare dividends on our common stock in the foreseeable future. Any payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our board of directors. Agreements governing future indebtedness will likely contain similar restrictions on our ability to pay cash dividends. Consequently, your only opportunity to achieve a return on your investment in the common stock of our company will be if the market price of our common stock appreciates and you sell your common stock at a profit.

In addition, under the Certificate of Designations for our Series A Preferred, an affirmative vote at a meeting duly called or the written consent without a meeting of the holders of such preferred stock representing at least a majority of the then outstanding shares of the Series A Preferred is required for us to pay dividends or any other distribution on our common stock.

Provisions in our certificate of incorporation and bylaws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our stock.

Our certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:

establish a classified board of directors so that not all members of our board of directors are elected at one time;

provide that directors may only be removed “for cause” and only with the approval of 66 2⁄3 percent of our stockholders;

provide that only our board of directors can fill vacancies on the board of directors;

require super-majority voting to amend our bylaws or specified provisions in our certificate of incorporation;

authorize the issuance of “blank check” preferred stock that our board of directors could issue to increase the number of outstanding shares and to discourage a takeover attempt;

limit the ability of our stockholders to call special meetings of stockholders;

prohibit common stockholder action by written consent, which requires all common stockholder actions to be taken at a meeting of our stockholders;

provide that the board of directors is expressly authorized to adopt, amend, or repeal our bylaws, subject to the rights of our stockholders to do the same by super-majority vote of stockholders; and

establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

In addition, Section 203 of the DGCL may discourage, delay or prevent a change in control of our company.

These and other provisions contained in our amended and restated certificate of incorporation and bylaws could delay or discourage transactions involving an actual or potential change in control of us or our management, including transactions in which our stockholders might otherwise receive a premium for their shares over then current prices, and may limit the ability of stockholders to remove our current management or approve transactions that our stockholders may deem to be in their best interests and, therefore, could adversely affect the price of our common stock.

Shares of stock issuable pursuant to our stock options, warrant and Series A Preferred may adversely affect the market price of our common stock.

As of August 18, 2010, we had outstanding stock options to purchase an aggregate of 2,505,000 shares of common stock under our 2007 Incentive Compensation Plan of which 969,000 were exercisable and warrants to purchase an aggregate of 675,001 shares of common stock. In addition, we have 1,864,003 shares of common stock reserved for issuance under our 2007 Incentive Compensation Plan and 30,000,000 shares reserved for issuance upon the conversion of our Series A Preferred. Our outstanding warrants and Series A Preferred also contain provisions that increase, subject to limited exceptions, the number of shares of common stock that may be acquired upon the conversion or exercise of such securities in the event we issue (or are deemed to have issued) shares of our common stock at a per share price that is less than their then existing exercise price, in the case of the warrants, and Conversion Price, in the case of the Series A Preferred. The exercise of the stock options and warrants would further reduce a stockholder’s percentage voting and ownership interest. Further, the stock options and warrants are likely to be exercised when our common stock is trading at a price that is higher than the exercise price of these options and warrants, and we would be able to obtain a higher price for our common stock than we will receive under such options and warrants. The exercise, or potential exercise, of these options and warrants or conversion of our Series A Preferred could adversely affect the market price of our common stock and adversely affect the terms on which we could obtain additional financing.

Future sales, or the availability for sale, of our common stock may cause our stock price to decline.

We have registered shares of our common stock that are subject to outstanding stock options, or reserved for issuance under our stock option plan, which shares can generally be freely sold in the public market upon issuance. Pursuant to a settlement with the holders of our Series A Preferred in May 2009, we also have registered the resale of up to 5,695,505 shares of our common stock and expect to register additional shares of our common stock acquired by such preferred stockholders as dividends on the Series A Preferred. Sales, or the availability for sale, of substantial amounts of our common stock in the public market could adversely affect the market price of our common stock and could materially impair our future ability to raise capital through offerings of our common stock.

The continued listing of our common stock on the NYSE Amex is subject to compliance with their continued listing requirements. While we have not received any notice of intent to delist our common stock, if such stock were delisted, the ability of investors in our common stock to make transactions in such stock would be limited.

Our common stock is listed on the NYSE Amex, a national securities exchange. Continued listing of our common stock on the NYSE Amex requires us to meet continued listing requirements set forth in the NYSE Amex’s Company Guide. These requirements include both quantitative and qualitative standards. While we have not received any notice of intent to delist our common stock, investors should be aware that if the NYSE Amex were to delist our common stock from quotation on its exchange, this would limit investors’ ability to make transactions in our common stock.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

As of June 30, 2010, we issued an aggregate of 1,455,000 shares of our common stock to the holders of our Series A Preferred as dividends pursuant to the Certificate of Designations, Preferences and Rights of Series A Preferred. We relied on the exemption provided by Section 4(2) of the Securities Act of 1933 and Regulation D promulgated thereunder.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

(Removed and Reserved)

Item 5.

Other Information

None.

Item 6.

Exhibits

Exhibit Number		Exhibit
3.1 (1)		Third Amended and Restated Certificate of Incorporation.

3.2 (2)		Amended and Restated Bylaws.

3.3 (3)		First Amendment to Third Amended and Restated Certificate of Incorporation.

3.4 (4)		First Amendment to Amended and Restated Bylaws.

31.1*		Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

31.2*		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Act of 1934, as amended.

32.1*		Certification of Chairman and Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Filed herewith.

(1)	Previously filed as an Exhibit to Amendment No. 3 to the Form 10, filed on April 22, 2008.

(2)	Previously filed as an Exhibit to Amendment No. 1 to the Form 10, filed on March 21, 2008.

(3)	Previously filed as an Exhibit to the Current Report on Form 8-K, filed on April 15, 2010.

(4)	Previously filed as an Exhibit to the Current Report on Form 8-K, filed on January 28, 2010.

(5)	Previously filed as an Exhibit to the Annual Report on Form 10-K for the year ended December 31, 2009, filed on April 15, 2010.

SIGNATURES

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

	AMERICAN DEFENSE SYSTEMS, INC.

Date: August 23, 2010	By:	/s/ Gary Sidorsky
		Chief Financial Officer

Index to Exhibits

Exhibit Number		Exhibit

31.1		Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Act of 1934, as amended.

32.1		Certification of Chairman and Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Attached files

AMERICAN DEFENSE SYSTEMS INC Reports

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