Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003

COMMISSION FILE NUMBER 0-20270

SAFLINK CORPORATION

(Exact name of registrant as specified in its charter)

777 108th Ave NE, Bellevue, Washington 98004

(Address of principal executive offices and zip code)

(425) 278-1100

(Registrant’s telephone number, including area code)

11911 NE 1st Street, Suite B-304, Bellevue, WA 98005

(Former address 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 is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).  Yes  ¨  No  x

There were 25,908,372 shares of SAFLINK Corporation’s common stock outstanding as of May 7, 2003.

Table of Contents

SAFLINK Corporation

FORM 10-Q

For the Quarter Ended March 31, 2003

INDEX

Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SAFLINK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)

See accompanying notes to condensed consolidated financial statements.

3

Table of Contents

SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share and per share data)

See accompanying notes to condensed consolidated financial statements.

4

Table of Contents

SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See accompanying notes to condensed consolidated financial statements.

5

Table of Contents

SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Basis of Presentation

The accompanying condensed consolidated financial statements present unaudited interim financial information and therefore, in accordance, do not contain certain information included in the annual consolidated financial statements of SAFLINK Corporation and its wholly-owned subsidiary, SAFLINK International, Inc., (the “Company” or “SAFLINK”). The balance sheet at December 31, 2002 has been derived from the Company’s audited financial statements as of that date. In the opinion of management, all adjustments (consisting only of normally recurring items) it considers necessary for a fair presentation have been included in the accompanying condensed consolidated financial statements. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002, as filed with the Securities and Exchange Commission (the “SEC”) on March 28, 2003.

Certain balances have been reclassified to conform to current period presentation. Such reclassifications had no impact on the results of operations or stockholders’ equity for any period presented. All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s condensed consolidated interim financial statements are not necessarily indicative of results to be expected for a full fiscal year.

2. Stock Based Compensation

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to account for its stock options. Under this method, compensation expense is recognized only if the current market price of the underlying stock exceeded the exercise price on the date of grant. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net loss if the fair-value-based method had been applied to all outstanding and unvested awards in each period.

The Company accounts for non-employee stock-based compensation in accordance with SFAS No. 123 and EITF No. 96-18.

6

Table of Contents

SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

3. Stockholders’ Equity

During January 2003, in accordance with anti-dilution provisions contained in certain warrants to purchase shares of the Company’s common stock, the number of shares of common stock issuable upon exercise of Series A warrants increased by approximately 200,000 shares and the exercise price per share decreased from $3.50 to either $2.83 or $3.12, dependent upon the warrant holders’ contractual rights. In addition, the number of shares of the Company’s common stock issuable upon exercise of Series C warrants increased by approximately 247,000 shares and the exercise price per share decreased from $2.25 to $2.14. The number of shares of the Company’s common stock issuable upon exercise of other warrants increased by an aggregate of approximately 42,000 shares with corresponding exercise price reductions.

On February 20, 2003, an aggregate of 1,054,000 shares of common stock were issued to SDS Merchant Fund, LP upon conversion of 7,378 shares of Series E preferred stock. Also, during the three months ended March 31, 2003, 36,429 shares of common stock were issued to other various investors upon conversion of 255 shares of Series E preferred stock.

In January and February 2003, the Company received approximately $9.4 million in net proceeds upon the exercise of warrants to purchase approximately 4.9 million shares of common stock. Approximately 4.1 million shares of common stock were issued upon exercise of Series C warrants, 11,133 shares of common stock were issued upon exercise of Series A warrants, and 355,500 shares of common stock were issued upon exercise of warrants associated with the June 2002 financing. In addition, 300,824 shares of common stock were issued upon exercise, and 185,133 shares of common stock were surrendered in connection with the exercise of warrants issued to placement agents and net exercises related to previous financings. At March 31, 2003, there were approximately 61,000 shares of common stock issuable upon exercise of outstanding warrants to purchase common stock.

During the three months ended March 31, 2003, the Company granted options to purchase an aggregate of 814,320 shares of common stock. Also, during this same period, options to purchase 233,061 shares of common stock were exercised and 170,843 options either expired or were canceled.

4. Guarantees

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. The Company adopted FIN No. 45 during the quarter ended December 31, 2002. In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FIN No. 45 except for standard indemnification and warranty provisions that are contained within many of its customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN No. 45.

Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in its industry. The duration of the Company’s product warranties generally does not exceed 90 days following delivery of its products. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically and does not expect to incur significant obligations in the near future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

7

Table of Contents

SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

5. Concentration of Credit Risk and Significant Customers

Two customers accounted for 25% and 21% of the Company’s revenue for the three months ended March 31, 2003, while three customers accounted for 32%, 12% and 12% of accounts receivable as of March 31, 2003. During the three months ended March 31, 2002, three customers accounted for approximately 31%, 28% and 27% of the Company’s revenue and three customers accounted for 48%, 16% and 15% of the Company’s accounts receivable as of March 31, 2002.

6. Comprehensive Loss

For the three months ended March 31, 2003 and 2002, total comprehensive loss was $2,012,000 and $1,694,000, respectively, which equaled the net loss for both periods.

7. Net Loss Per Share

In accordance with Statement of Financial Accounting Standard No. 128, “Earnings Per Share”, the Company has reported both basic and diluted net loss per common share for each period presented. Basic net loss per common share is computed on the basis of the weighted-average number of common shares outstanding for the period. Diluted net loss per common share is computed on the basis of the weighted-average number of common shares plus dilutive potential common shares outstanding. Dilutive potential common shares are calculated under the treasury stock method. Securities that could potentially dilute basic income per share consist of outstanding stock options and warrants and convertible preferred stock. Net loss attributable to common stockholders includes net loss and preferred stock dividends. As the Company had a net loss attributable to common stockholders in each of the periods presented, basic and diluted net loss per common share are the same. All outstanding warrants and options to purchase shares of common stock were excluded because their effect was anti-dilutive.

Potential common shares consisted of options and warrants to purchase approximately 12.0 million and 10.8 million shares of common stock at March 31, 2003 and 2002, respectively, and approximately 2.2 million and 4.3 million shares of common stock issuable upon conversion of Series E preferred stock at March 31, 2003 and 2002, respectively.

8. Segment Information

Operating segments are revenue-producing components of the enterprise for which separate financial information is produced internally for the Company’s management. Under this definition, the Company operated, for all periods presented, as a single segment.

9. Legal Proceedings

On March 13, 2003, the receiver for Alex Jones, Ltd., an alleged creditor of Jotter Technologies, Inc., filed a civil complaint in United States District Court of Utah against Jotter Technologies and SAFLINK. The complaint alleges breach of contract and judgment on a promissory note against Jotter in connection with a promissory note executed by Jotter and delivered to Alex Jones, Ltd., and unjust enrichment, fraudulent conveyance and declaratory judgment against all parties in connection with our purchase of substantially all of the intellectual property and fixed assets of Jotter in December 2000. The complaint seeks relief from Jotter in the amount of $800,000 in principal and approximately $163,333 in interest on the promissory note, including attorneys’ fees and costs. The complaint also seeks unspecified monetary and equitable relief against SAFLINK and Jotter. We believe that Jotter has the obligation to indemnify us for any claims or losses in connection with the asset purchase pursuant to the terms of the asset purchase agreement between Jotter and SAFLINK, and we have demanded such indemnification from Jotter. We intend to vigorously and actively defend this action.

8

Table of Contents

SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Litigation is subject to significant uncertainty and any final result could be greater or less than current management expectations. However, the Company believes that the outcome of these matters will not have a material adverse effect on our results of operations or financial condition.

10. Recently Issued Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires the Company to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. The Company also records a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. The Company adopted SFAS No. 143 on January 1, 2003. The adoption of SFAS No. 143 did not have a material effect on the Company’s consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provisions of the Statement related to the rescission of Statement No. 4 is applied in fiscal years beginning after May 15, 2002. The provisions of the Statement related to Statement No. 13 were effective for transactions occurring after May 15, 2002, with early application encouraged. The adoption of SFAS No. 145 did not have a material effect on the Company’s consolidated financial statements. In the second quarter of 2003, due to the adoption of SFAS No. 145, the Company will be required to reclassify an extraordinary gain from debt restructuring in 2001.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Company adopted SFAS No. 146 on January 1, 2003. The adoption of SFAS No. 146 did not have a material effect on the Company’s consolidated financial statements.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (“EITF 00-21”), Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15, 2003. The adoption of EITF 00-21 is not expected to have a material impact on the Company’s financial position and results of operations.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities

9

Table of Contents

SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

obtained after January 31, 2003. The application of this Interpretation is not expected to have a material effect on the Company’s financial statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective. The Company has no interest in variable interest entities.

11. Subsequent Events

During the period between April 1 and May 7, 2003, 4,286 shares of common stock were issued upon conversion of Series E preferred stock, 66,852 shares of common stock were issued upon exercise of warrants to purchase common stock, and 142,000 shares of common stock were issued upon exercise of stock options.

10

Table of Contents

This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes included in this document and the 2002 audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 28, 2003.

This quarterly report on Form 10-Q contains statements and information about management’s view of the Company’s future expectations, plans and prospects that constitute forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. These forward-looking statements include without limitation statements regarding our expectations and beliefs about the market and industry, our goals, plans, and expectations regarding our products and services and product development, our intentions and strategies regarding customers and customer relationships, our relationships with the software development community, our intent to continue to invest resources in research and development, our intent to develop relationships and strategic alliances, our beliefs regarding the future success of our products and services, our expectations and beliefs regarding competition, competitors, the basis of competition and our ability to compete, our expectations regarding future growth and financial performance, our expectations regarding licensing arrangements and our revenues, our expectations and beliefs regarding revenue and revenue growth, our expectations regarding our strategies and long-term strategic relationships, and our beliefs and expectations regarding our results of operation and financial position. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those anticipated, including the factors described in the sections of this quarterly report on Form 10-Q, entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors That May Affect Future Results.” We undertake no obligation to publicly release the result of any revisions to these forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, conditions or circumstances.

The following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with management’s discussion and analysis of financial condition and results of operations included in our annual report on Form 10-K for the year ended December 31, 2002.

As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “we,” “us,” “our,” “the Company,” and “SAFLINK” refer to SAFLINK Corporation, a Delaware corporation, and its subsidiaries.

Overview

We provide cost-effective network security software solutions to protect the safety of information assets and track network access by authorized personnel. We develop biometric authentication software and resell hardware from leading manufacturers of biometric hardware devices. Our products can be used to protect business and personal information by replacing passwords and personal identification numbers (PINs) with biometric identifiers in order to safeguard and simplify access to electronic systems. Biometric technologies identify computer users by electronically capturing a specific biological or behavioral characteristic of that individual, such as a fingerprint or voice or facial feature, and creating a unique digital identifier from that characteristic. Because this process relies on largely unalterable human characteristics, it is both highly secure and highly convenient for the individual seeking access.

The process of identity authentication typically requires that a person present for comparison one or more of the following factors:

11

Table of Contents

Comparison of biological and behavioral characteristics has historically been the most reliable and accurate of the three factors, but has also been the most difficult and costly to implement given the complex nature of enterprise computer systems. However, recent advances in the development of integrated biometric software solutions, reduced cost of biometric devices, and the emergence of recognized industry standards to connect biometric components to applications have reduced the cost of implementing biometrics in commercial environments. We believe that government and private sector organizations will increasingly use this method of identity authentication because of the higher level of security and greater user convenience it provides and the reduced cost of password administration associated with such a security system.

Our software products are designed for large-scale and complex computer networks and allow computer users to be identified from various biometric technologies. Our products comply with recognized industry standards, which allows us to integrate a large variety of biometric technologies within a common application environment without costly development related to the integration of each technology. Our products also provide our customers with the flexibility to deploy a mixture of different biometric technologies within their network to meet specific user needs and environmental requirements while providing protection against technology obsolescence since new devices can be added to, or upgraded within, the system without replacing or modifying the underlying biometric network support infrastructure.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of commitments and contingencies. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe our most critical accounting policy is revenue recognition and it affects the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. We derive revenue from license fees for software products, reselling of hardware and fees for services relating to the software products including maintenance services, technology and programming consulting services.

We recognize revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9 and related interpretations, including technical practice aids, which provide specific guidance and stipulate that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post contract customer support, installation or training. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence of fair value exists for these elements. In multiple element arrangements in which fair value exists only for undelivered elements, the fair value of the undelivered elements is deferred and the residual arrangement fee is assigned to the delivered elements. If evidence of fair value for any of the undelivered elements does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered.

Revenue from software license fees is recognized upon delivery, net of an allowance for estimated returns, provided persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If customers receive pilot or test versions of products, revenue from these arrangements is recognized upon

12

Table of Contents

customer acceptance of permanent license rights. If our software is sold through a reseller, revenue is recognized when the reseller delivers its product to the end-user or if there are non-refundable minimum guaranteed fees upon delivery to the reseller. We also act as a reseller of hardware. Such revenue is recognized upon delivery of the hardware, provided that all other conditions of the sale have been met.

Service and other revenue includes payments under support and upgrade contracts and fees from consulting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Consulting revenue is primarily related to installation, integration and training services performed on a time-and-materials basis under separate service arrangements. Fees from consulting are recognized as services are performed.

Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

Results of Operations

We believe that period-to-period comparisons of our operating results may not be a meaningful basis to predict our future performance. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets. We may not be able to successfully address these risks and difficulties.

We incurred net losses attributable to common stockholders of approximately $2.0 million for the three months ended March 31, 2003. This compared to a net loss attributable to common stockholders of $6.4 million for three months ended March 31, 2002. The net loss attributable to common stockholders for the three months ended March 31, 2002 included an in-substance dividend of approximately $4.7 million resulting from the modification of our Series A and B warrants, sale of common stock, and issuance of our Series C warrants during the quarter.

The following discussion presents certain changes in our revenue and operating expenses that have occurred during the three months ended March 31, 2003, as compared to the three months ended March 31, 2002.

Revenue and Cost of Revenue

We recorded revenue primarily from three sources during the three months ended March 31, 2003 and 2002: software, hardware and services. Product revenue consists of revenue from sales of licenses to use software produced by us and from the re-sale of hardware purchased from third parties. Service revenue consists of revenue from post-contract customer support, consulting services and training. During the three months ended March 31, 2003, software license sales were approximately $180,000, while sales of hardware and services were approximately $90,000 and $327,000, respectively. During the same period in 2002, software license sales were approximately $15,000, while sales of hardware and services were approximately $121,000 and $60,000, respectively. Total revenue of approximately $597,000 for the three months ended March 31, 2003 increased approximately $401,000, or 205%, from revenue of approximately $196,000 for the three months ended March 31, 2002. A portion of this increase was attributable to the recognition of approximately $110,000 in service revenue that had been deferred in connection with a 5-year contract with XL Vision, Inc., which expired in March 2003.

Total cost of revenue includes product cost of revenue and service cost of revenue. Product cost of revenue consists of packaging and production costs for software license sales and cost of hardware purchased from third parties for hardware sales. Service cost of revenue consists of labor and expenses for post-contract customer support, consulting services and training. During the three months ended March 31, 2003, cost of revenue from software, hardware and services were approximately $7,000, $48,000, and $84,000, respectively. During the

13

Table of Contents

same period in 2002, cost of revenue from software, hardware and services were approximately $17,000, $94,000 and $27,000, respectively. Despite the 205% increase in total revenue, total cost of revenue increased only slightly to approximately $139,000 for the three months ended March 31, 2003 from approximately $138,000 for the three months ended March 31, 2002, primarily because there was no cost of revenue incurred during the three months ended March 31, 2003 associated with the recognition of the XL Vision, Inc. service revenue.

Our gross margins for the three months ended March 31, 2003 and 2002 were approximately 77% and 30%, respectively. The changes from 2002 to 2003 were primarily due to a higher mix of software sales to hardware sales, and the recognition of approximately $110,000 for the XL Vision, Inc. contract for which there were no direct costs of revenue during the three months ended March 31, 2003.

Operating Expenses

Total operating expenses for the three months ended March 31, 2003 increased approximately $758,000, or 44%, to approximately $2.5 million from approximately $1.7 million for the comparable period in 2002. This increase was primarily due to increased compensation and related benefits ($262,000) resulting from a 21% (9 employees) increase in headcount in the first three months of 2003, higher advertising and promotion expenses ($108,000) associated with increased spending on trade shows and public relations, and an increase in non-cash professional services ($314,000), as a result of the issuance of common stock as well as options and warrants to purchase shares of common stock granted to consultants and providers of financial advisory services.

The following table provides a breakdown of the dollar and percentage changes in operating expenses for the three months ended March 31, 2003, as compared to the same period in 2002:

Product Development – Product development expenses consist primarily of salaries, benefits and equipment for software developers and quality assurance personnel. Product development expenses increased during the three months ended March 31, 2003, compared to the same period in 2002, as a result of increased software and equipment purchases, and legal fees associated with intellectual property matters.

Sales and Marketing – Sales and marketing expenses consist primarily of salaries and commissions earned by sales and marketing personnel, advertising and promotional expenses and travel and entertainment costs. Sales and marketing expenses increased substantially during the three months ended March 31, 2003, compared to the same period in 2002. This increase is a result of increased headcount, which include eight new employees hired in the first three months of 2003, recruiting costs, travel, consulting fees and marketing activities, such as trade shows and public relations.

General and Administrative – General and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, human resource and administrative personnel, professional services fees and allowances for bad debt. General and administrative expenses increased slightly during the three months ended March 31, 2003 primarily due to non-cash amortization associated with the issuance of common stock and grants of options and warrants to purchase shares of common stock to third-party providers of financial advisory services, offset by reduced legal and other professional service fees.

14

Table of Contents

Liquidity and Capital Resources

We expended $2.8 million in operating activities during the first three months of 2003, compared to $2.2 million for the same period in 2002. The operating use of cash was unusually high due to the acceleration of payments on customer accounts in the preceding quarter, as well as the deferral of related payments to equipment vendors until the current quarter.

We used approximately $153,000 in investing activities related to the purchases of equipment in the three months ended March 31, 2003, compared to approximately $1,000 for the same period in 2002. Net cash provided from financing activities was $9.6 million in the first three months of 2003, compared to $4.1 million during the same period in 2002.

Cash and working capital as of March 31, 2003 were approximately $14.1 million and $14.6 million, respectively, compared to approximately $7.4 million and $7.1 million, respectively, as of December 31, 2002. The increase in our cash and working capital as of March 31, 2003, compared to December 31, 2002, was primarily due to the net proceeds of approximately $9.4 million from warrant exercises of our Series C warrants and warrants associated with our June 2002 financing. This increase in cash is being used to expand our existing sales and product development teams, purchase equipment and supplies, market and promote our products, and general corporate purposes.

In March 2003, we signed a 3-year lease for 9,569 square feet in Bellevue, Washington that serves as our principal executive offices. Contractual commitments associated with this lease are $161,000, $217,000, $220,000, and $92,000 for the years 2003, 2004, 2005, and 2006, respectively.

The following table reflects our contractual commitments for operating leases as of March 31, 2003 (in thousands):

Factors That May Affect Future Results

This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our business, operating results, financial performance, and share price may be materially adversely affected by a number of factors, including but not limited to the following risk factors, any one of which could cause actual results to vary materially from anticipated results or from those expressed in any forward-looking statements made by us in this quarterly report on Form 10-Q or in other reports, press releases or other statements issued from time to time. Additional factors that may cause such a difference are set forth elsewhere in this quarterly report on Form 10-Q and in our annual report on Form 10-K.

In addition to other information contained in this quarterly report on Form 10-Q, the following factors, among others, sometimes have affected, and in the future could affect our actual results and could cause future results to differ materially from those in any forward looking statements made by us or on our behalf. Factors that could cause future results to differ from expectations include, but are not limited to the following:

We have accumulated significant losses since we started doing business and may not be able to generate significant revenue or any net income in the future, which would negatively impact our ability to run our business.

We may continue to accumulate losses. We have accumulated net losses of approximately $87.3 million from our inception through March 31, 2003. We have continued to accumulate losses after March 31, 2003 to date and we may be unable to generate significant revenue or any net income in the future. We have funded our operations primarily through the issuance of equity securities to investors and may not be able to generate a positive cash flow in the future.

15

Table of Contents

Our success depends on significant growth in the biometrics market and on broad acceptance of products in this market.

Because almost all of our revenue will come from the sale of products that use biometric technologies, our success will depend largely on the expansion of markets for biometric products domestically and internationally. Even if use of biometric technology gains market acceptance, our products may not achieve sufficient market acceptance to ensure our viability. We cannot accurately predict the future growth rate of this industry or the ultimate size of the biometric technology market.

Because they own approximately 51% of our company, two investors could significantly influence our affairs which may preclude other stockholders from being able to influence stockholder votes.

Given that two investors, combined, own in excess of 50% of our currently outstanding common stock, they would be able to significantly influence the vote on those corporate matters to be decided by our stockholders if they decided to act together. In addition, as of March 20, 2003, these investors beneficially own warrants to purchase an additional 430,442 shares of our common stock. If these investors exercised their warrants in full, they would own approximately 52% of our outstanding common stock.

If we are unable to maintain our Nasdaq SmallCap Market listing, our common stock may be subject to delisting from the SmallCap Market and your ability to trade shares of our common stock could suffer.

In April 2003, the Company was approved for relisting its common stock on the Nasdaq SmallCap Market and began trading on April 25, 2003. To remain listed on the Nasdaq SmallCap Market, we must meet the minimum listing requirements for continued listing, including, among other requirements, minimum bid price and market value of public float requirements. If we fail to continue to meet the minimum listing requirements, we may be delisted from the Nasdaq SmallCap Market. The Nasdaq SmallCap Market is typically less liquid and usually involves larger variations between the bid and ask price than stock trading on the Nasdaq National Market. If our common stock is delisted from the Nasdaq SmallCap Market, sales of our common stock would likely be conducted only in the over-the counter market or potentially in regional exchanges. This may have a negative impact on the liquidity and the price of our common stock, and investors may find it more difficult to purchase or dispose of, or to obtain accurate quotations as to the market value of, our common stock. In addition, if our common stock is not listed on the Nasdaq National Market or the Nasdaq SmallCap Market and the trading price of our common stock fell below $1.00 per share, trading in our common stock would also be subject to the requirements of certain rules which require additional disclosures by broker-dealers in connection with any trades involving a stock defined as a “penny stock.” In such event, the additional burdens imposed upon broker-dealers to effect transactions in our common stock could further limit the market liquidity of our common stock and the ability of investors to trade our common stock.

If the market price of our common stock continues to be volatile, the value of our stock may decline.

Like many other technology companies, the market price of our common stock has been, and may continue to be, volatile, which means the value of your SAFLINK stock may fluctuate. Factors that are difficult to predict such as

contribute to volatility and may have a significant impact on the market price of our common stock. If we are unable to raise additional capital, our common stock may become worthless.

16

Table of Contents

The issuance of common stock reserved for our stock option plans and the exercise of warrants could dilute the value of our stock and may create a negative public perception of the value of our stock.

Our issuance of a large number of additional shares of our common stock upon the exercise of outstanding stock options or warrants could decrease the market price of our common stock. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur. If we issue our common stock to option and warrant holders, it will dilute our investors’ interest. In addition, if a large number of option or warrant holders sell their shares of our common stock, it could create a negative public perception of the value of our stock.

We are partly dependent on third parties for our product distribution and if these parties do not promote our products, it may limit our ability to generate revenue.

We utilize third parties such as resellers, distributors and makers of complementary technology to complement our full-time sales staff in promoting sales of our products. If these third parties do not actively promote our products, our ability to generate revenue may be limited. We cannot control the amount and timing of resources that these third parties devote to marketing activities on our behalf. Some of these business relationships are formalized in agreements which can be terminated with little or no notice and may be subject to amendment. We also may not be able to negotiate acceptable distribution relationships in the future and cannot predict whether current or future distribution relationships will be successful.

Since a large percentage of our historic revenue has been derived from a limited number of customers, our sales have experienced wide fluctuations.

Two customers accounted for 25% (BearingPoint—for the Department of Defense’s CAC program) and 21% (XL Vision, Inc.) of our revenue for the three months ended March 31, 2003. Three customers accounted for approximately 46% (Freddie Mac), 24% (BearingPoint—for the Department of Defense’s CAC program), and 11% (Kaiser Permanente) of our 2002 revenue, respectively. As a result of this concentration of sales to a limited number of customers, our sales have experienced wide fluctuations, and may continue to experience wide fluctuations in the future.

In order to succeed, we will have to keep up with rapid technological change in the software industry and various factors could impact our ability to keep pace with these changes.

Software design and the biometric technology industry are characterized by rapid development and technological improvements. Because of these changes, our success will depend on our ability to keep pace with a changing marketplace and integrate new technology into our software and introduce new products and product enhancements to address the changing needs of the marketplace. Various technical problems and resource constraints may impede the development, production, distribution and marketing of our products and services. In addition, laws, rules, regulations or industry standards may be adopted in response to these technological changes, which in turn, could materially adversely affect how we do business.

Our future success will depend upon our ability to develop and introduce a variety of new products and services and enhancements to these new products and services in order to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometric industry require assessments to be made of the future directions of technology and technology markets generally, which are inherently risky and difficult to predict. Delays in introducing new products, services and enhancements, the failure to choose correctly among technical alternatives or the failure to offer innovative products and services at competitive prices may cause customers to forego purchases of our products and services and purchase those of our competitors.

Continued participation by us in the market for governmental agencies may require the investment of our resources in upgrading our products and technology for us to compete and to meet regulatory and statutory standards. We may not have adequate resources available to us or may not adequately keep pace with appropriate requirements in order to effectively compete in the marketplace.

17

Table of Contents

Provisions in our Certificate of Incorporation and our Certificate of Designation, Preferences and Rights of the Series E preferred stock may prevent or impact the value of a takeover of our company even if a takeover is beneficial to stockholders.

Our Certificate of Incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, which may adversely affect our common stockholders. We may issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as the board of directors determines. Specifically, the issuance of preferred stock may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, voting control of our company even if the acquisition would benefit stockholders. In addition, the issuance of the Series E preferred stock may impact the value of a takeover to common stockholders because the holders of the Series E preferred stock are entitled to demand that we redeem their stock for cash equal to 125% of the price paid for this stock by the holders in connection with certain acquisitions in which more than 40% of our stock is issued.

A significant number of shares of our common stock eligible for future sale could drive down the market price for our common stock and the availability of a large number of our shares on the open market could make it difficult for us to raise capital.

As of May 7, 2003, 25,908,372 shares of our common stock were outstanding. In addition, there are approximately 8.6 million shares of common stock issuable upon exercise or conversion of outstanding warrants and preferred stock. Sales of shares of common stock in the public market or the perception that sales of large numbers of our shares may occur could adversely affect the market price of our common stock. These sales or the perception of possible sales could also impair our ability to raise capital in the future. It is possible that this scenario will have an adverse effect on the market price of the common stock.

Our business will not grow unless the market for biometric solutions expands both domestically and internationally.

Our product revenue and a portion of our service revenue is derived from the sale of biometric products and services. Biometric solutions have not gained widespread commercial acceptance. We cannot accurately predict the future growth rate, if any, or the ultimate size of the biometric technology market. The expansion of the market for our products and services depends on a number of factors including without limitation:

Even if biometric solutions gain wide market acceptance, our products and services may not adequately address the market requirements and may not gain wide market acceptance.

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

Our financial and operating results may fluctuate from quarter to quarter because of the following reasons:

18

Table of Contents

Particularly important is the need to invest in planned technical development programs to maintain and enhance our competitiveness, and to develop and launch new products and services. Improving the manageability and likelihood of success of such programs requires the development of budgets, plans and schedules for the execution of these programs and the adherence to such budgets, plans and schedules. The majority of such program costs are payroll and related staff expenses, and secondarily materials, subcontractors and promotional expenses. These costs are very difficult to adjust in response to short-term fluctuations in our revenue, compounding the difficulty of achieving profitability in the event of a revenue downturn.

Our lengthy and variable sales cycle will make it difficult to predict operating results.

Certain of our products often have a lengthy sales cycle while the customer evaluates and receives approvals for purchase. If, after expending significant funds and effort pursuing a sales opportunity, we fail to receive an order, a negative impact on our financial results and stock price could result.

We derive a substantial portion of our revenue from government contracts, which are often non-standard, involve competitive bidding, may be subject to cancellation without penalty and may produce volatility in earnings and revenue.

Our performance in any one reporting period is not necessarily indicative of sales trends or future operating or earnings performance because of our reliance on a small number of large customers, a substantial portion of which are government agencies. Government contracts frequently include provisions that are not standard in private commercial transactions. For example, government contracts may include bonding requirements and provisions permitting the purchasing agency to cancel the contract without penalty in certain circumstances. As public agencies, our prospective customers are also subject to public agency contract requirements that vary from jurisdiction to jurisdiction. Some of these requirements may be onerous or impossible to satisfy.

Failure by us to maintain the proprietary nature of our technology and intellectual property could have a material adverse effect on our business, operating results, financial condition and stock price and on our ability to compete effectively.

We principally rely upon patent, trademark, copyright, trade secret and contract law to establish and protect our proprietary rights. There is a risk that claims allowed on any patents or trademarks we hold may not be broad enough to protect our technology. In addition, our patents or trademarks may be challenged, invalidated or circumvented and we cannot be certain that the rights granted thereunder will provide competitive advantages to us. Moreover, any current or future issued or licensed patents, or trademarks, or currently existing or future developed trade secrets or know-how may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of our already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others. In addition, there is a risk that others may independently develop proprietary technologies and processes, which are the same as, substantially equivalent or superior to ours, or become available in the market at a lower price.

19

Table of Contents

There is a risk that we have infringed or in the future will infringe patents or trademarks owned by others, that we will need to acquire licenses under patents or trademarks belonging to others for technology potentially useful or necessary to us, and that licenses will not be available to us on acceptable terms, if at all.

We may have to litigate to enforce our patents or trademarks or to determine the scope and validity of other parties’ proprietary rights. Litigation could be very costly and divert management’s attention. An adverse outcome in any litigation may have a severe negative impact on our financial results and stock price. We also rely on trade secrets and proprietary know-how, which we seek to protect by confidentiality agreements with our employees, consultants, service providers and third parties. There is a risk that these agreements may be breached, and that the remedies available to us may not be adequate. In addition, our trade secrets and proprietary know-how may otherwise become known to or be independently discovered by others.

If we fail to adequately manage the size of our business, it could have a severe negative impact on our financial results or stock price.

Our management believes that in order to be successful, we must appropriately manage the size of our business. This may mean reducing costs and overhead in certain economic periods, and selectively growing in periods of economic expansion. In addition, we will be required to implement operational, financial and management information procedures and controls that are efficient and appropriate for the size and scope of our operations. The management skills and systems currently in place may not be adequate and we may not be able to manage any significant reductions or growth effectively.

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

We are dependent on the continued availability of the services of our employees, many of whom are individually key to our future success, and the availability of new employees to implement our business plans. The market for skilled employees is highly competitive, especially for employees in technical fields. Although our compensation programs are intended to attract and retain the employees required for us to be successful, there can be no assurance that we will be able to retain the services of all of the key employees or a sufficient number to execute our plans, nor can there be any assurances that we will be able to continue to attract new employees as required.

Our personnel may voluntarily terminate their relationship with us at any time, and competition for qualified personnel, especially engineers, is intense. The process of locating additional personnel with the combination of skills and attributes required to carry out our strategy could be lengthy, costly and disruptive.

If we lose the services of key personnel, or fail to replace the services of key personnel who depart, we could experience a severe negative impact on our financial results and stock price. In addition, there is intense competition for highly qualified engineering and marketing personnel in the locations where we principally operate. The loss of the services of any key engineering, marketing or other personnel or our failure to attract, integrate, motivate and retain additional key employees could have a material adverse effect on our business, operating and financial results and stock price.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market rate risk for changes in interest rates relates primarily to money market funds included in our cash and cash equivalents portfolio. Investments in fixed rate earning instruments carry a degree of interest rate risk as their fair market value may be adversely impacted due to a rise in interest rates. As a result, our future investment income may fall short of expectations due to changes in interest rates. We do not use any hedging transactions or any financial instruments for trading purposes and we are not a party to any leveraged derivatives.

20

Table of Contents

We have certain foreign operations whose expenses are incurred in its local currency. As exchange rates vary, transaction gains or losses will be incurred and may vary from expectations and adversely impact overall profitability. If, in the remainder of fiscal 2003, the US dollar uniformly changes in strength by 10% relative to the currency of the foreign operations, our operating results would likely not be significantly affected.

ITEM 4. CONTROLS AND PROCEDURES

(a) Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended, within 90 days of the filing date of this report. Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.

(b) There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 13, 2003, the receiver for Alex Jones, Ltd., an alleged creditor of Jotter Technologies, Inc., filed a civil complaint in United States District Court of Utah against Jotter Technologies and SAFLINK. The complaint alleges breach of contract and judgment on a promissory note against Jotter in connection with a promissory note executed by Jotter and delivered to Alex Jones, Ltd., and unjust enrichment, fraudulent conveyance and declaratory judgment against all parties in connection with our purchase of substantially all of the intellectual property and fixed assets of Jotter in December 2000. The complaint seeks relief from Jotter in the amount of $800,000 in principal and approximately $163,333 in interest on the promissory note, including attorneys’ fees and costs. The complaint also seeks unspecified monetary and equitable relief against SAFLINK and Jotter. We believe that Jotter has the obligation to indemnify us for any claims or losses in connection with the asset purchase pursuant to the terms of the asset purchase agreement between Jotter and SAFLINK, and we have demanded such indemnification from Jotter. We intend to vigorously and actively defend this action.

Litigation is subject to significant uncertainty and any final result could be greater or less than current management expectations. However, we believe that the outcome of these matters will not have a material adverse effect on our results of operations or financial condition.

ITEM 2. CHANGES IN SECURITIES

During the three months ended March 31, 2003, we issued an aggregate of 1,090,429 shares of our common stock to certain holders of our Series E Preferred stock upon the conversion of shares of our Series E Preferred stock. No consideration was received in connection with the issuance of such shares. The issuances of the shares of our common stock upon exchange of our Series E Preferred stock were exempt from registration under Section 4(2) of the Securities Act of 1933, were made without general solicitation or advertising, and each holder was a sophisticated investor with access to all relevant information.

During the three months ended March 31, 2003, we issued 4,752,111 shares of common stock upon the exercise of warrants associated with previous financings.

Options to purchase shares of common stock exercised by employees and consultants during the three months ended March 31, 2003 resulted in the issuance of 223,561 shares of common stock.

21

Table of Contents

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.

(b) Reports on Form 8-K.

On March 6, 2003, we filed a current report on Form 8-K regarding the exercise of certain warrants during the first two months of 2003.

On May 6, 2003, we filed a current report on Form 8-K regarding our announcement that our application for relisting our common stock on the Nasdaq SmallCap Market had been approved.

On May 14, 2003, we filed a current report on Form 8-K regarding our press release announcing our financial results for the quarter ended March 31, 2003.

22

Table of Contents

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.

23

Table of Contents

CERTIFICATIONS

I, Glenn L. Argenbright, certify that:

Date: May 15, 2003

24

Table of Contents

I, Jon C. Engman, certify that:

Date: May 15, 2003

25

Table of Contents

Exhibit Index