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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004 or

For the transition period from              to             

Commission file number 0-20270

SAFLINK CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (425) 278-1100

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 par value per share

(Title of Class)

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of June 30, 2004, was approximately $40,288,692.

There were 79,806,989 shares of the registrant’s common stock outstanding as of March 15, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this Report, to the extent not set forth herein, is incorporated herein by reference from the registrant’s definitive proxy statement relating to the registrant’s 2005 annual meeting of stockholders.

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PART I

Certain statements in this Annual Report on Form 10-K constitute forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that are not historical facts but rather reflect our current expectations concerning future results and events. Words such as “believe,” “expect,” “intend,” “plan,” “anticipate,” “likely,” “will,” “may,” “shall” and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of our company (or entities in which we have interests), or industry results, to differ materially from historical results or future results, performance or achievements expressed or implied by such forward-looking statements.

Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s view only as of the date of this Annual Report on Form 10-K. 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 beliefs regarding trademark and copyright protections, our beliefs and expectations regarding infringement claims, our beliefs regarding the development of industry standards, our expectations and beliefs regarding our ability to hire and retain personnel, our beliefs regarding period to period results of operations, our expectations regarding future growth and financial performance, our expectations regarding licensing arrangements and our revenue, our expectations and beliefs regarding revenue and revenue growth, our expectations regarding our strategies and long-term strategic relationships, our expectations regarding defects in products, our expectations regarding fluctuations in revenue and operating results, our beliefs and expectations regarding our existing facilities and the availability of additional space in the future, our intent to use all available funds for the development and the operation of our business and not to declare or pay any common stock cash dividends, our expectations regarding software development costs, our beliefs and expectations regarding our results of operations and financial position, our beliefs regarding estimates in valuing in-process research and development, our intentions and expectations regarding deferred tax assets, our beliefs and expectations regarding liquidity and capital resources and that cash flow from existing operations, existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements for the foreseeable future, and our expectations regarding the impact of recent accounting pronouncements and revenue recognition matters. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those anticipated. These risks and uncertainties include without limitation those identified in the section of this Annual Report on Form 10-K entitled “Risk Factors That May Affect Future Results” below. 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.

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

Overview

SAFLINK Corporation offers software and hardware solutions for protecting critical business assets. SAFLINK’s solutions provide Identity Assurance Management^™, a framework designed to improve trust through secure authentication, verification and management of identities. Our products allow an enterprise, commercial or governmental, to verify the identity of users and control their access to computer networks, physical facilities,

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applications, event tracking systems, and time and attendance systems. For logical and physical access control needs, SAFLINK develops biometric and smart card application software and hardware, and also resells biometric and smart card hardware and device control software from leading manufacturers. Biometric technologies automatically identify computer users by electronically capturing a specific biological or behavioral characteristic of that individual, such as a fingerprint, iris pattern, voiceprint or facial feature, creating a unique digital identifier from that characteristic and then comparing it against a previously created and stored digital identifier. Because this process relies on largely unalterable human characteristics, it is both highly secure and highly convenient for the individual seeking access. Smart card solutions operate similarly for identity verification and authentication and have historically been used in conjunction with a Public Key Infrastructure (PKI) deployment. Smart cards employing PKI technology can be used for logical access decisions as well as securing electronic communications. The combination of biometrics with smart cards or other security tokens is known as “credentialing.” Credentialing is emerging as a significant market in the security industry, especially in government sectors.

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

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 enterprise environments. There have been a number of security, or credentialing, initiatives launched inside the federal government within the past 24 months that employ biometrics and tokens as primary authentication components to enhance security. Some of these programs include the Department of Homeland Security’s (DHS) US-VISIT program and the Transportation Security Administration’s (TSA) Transportation Worker Identification Credential (TWIC) and Registered Traveler programs. In addition, Homeland Security Presidential Directive (HSPD) 12, issued in August of 2004, outlines the need for interoperable credentials for federal and Department of Defense employees. HSPD-12 has led to the creation of new Federal Information Processing Standards (FIPS) for personal identity verification (PIV) that is expected to impact all federal procurements.

As a result, we believe the federal government will lead the way in terms of defining the credentialing market and developing the key standards to be followed in employing credentialing or other security solutions. We also believe that the commercial market is being influenced by recent developments in the governmental sector and that private organizations will begin to employ similar solutions in the near future. With multi-factor authentication for identity management, an organization can improve access control by combining multiple authentication methods. This allows the organization to set the level of security and user convenience and reduce the cost of password administration associated with many existing security systems.

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

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In December 1997, SAFLINK and the National Security Agency (NSA) jointly introduced and demonstrated the Human Authentication Application Programming Interface, or HA-API. HA-API was the first definition of a standard way to allow software developers and biometric technology suppliers to build their products using a uniform method for connecting many different biometric devices to computer systems. HA-API was developed by SAFLINK under a contract from the NSA and was subsequently released into the public domain as a proposed biometric interoperability standard. HA-API subsequently became the basis of the next generation standard called BioAPI. BioAPI was published by the American National Standards Institute (ANSI) in February 2002, and has been designated as ANSI/INCITS 358-2002, The BioAPI Specification. Version 2.0 of this standard is now progressing through the International Organization for Standardization (ISO). It is currently at Final Draft International Standard (FDIS) level and ballot approval is expected to take place in the second half of 2005. One of our employees serves as the elected Chair of the BioAPI Consortium that represents over 120 organizations that collaborated to develop the original BioAPI standard and is the technical editor of the 2.0 version at ISO. This SAFLINK employee also serves as an officer in Technical Committee M1 (Biometrics) within the International Committee for Information Technology Standards (INCITS), which is developing a number of biometric standards in the areas of interfaces, biometric data formats, testing, and conformance, and serves at the U.S. Head of Delegation to ISO/IEC JTC1 SC37, which is the ISO subcommittee responsible for developing biometric standards. We also support other related biometric standards efforts, including the Common Biometric Exchange Formats Framework (CBEFF) specification, also recently adopted by ANSI, and we intend to keep all of our products compliant with these and other standards as they continue to evolve.

We are positioning and promoting our SAFLINK brand in conjunction with selected biometric, smart card and other identification technologies currently available in the marketplace including those from:

Available Information

We are headquartered at 777 108^th Avenue NE, Bellevue, WA 98004. We file reports with the Securities and Exchange Commission (SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q and other reports from time to time. The public may read and copy any materials we file with the SEC at the SEC’s public reference room at 450 Fifth Street NW, Washington, DC 20549. The public may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. We are an electronic filer and the SEC maintains an Internet site at http://www.sec.gov that contains the reports, proxy and information statements, and other information filed electronically.

Our Internet site is http://www.saflink.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the SEC. Information contained on our website is not part of this report.

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Market Overview

As computer use migrates towards a networked environment, and our economy shifts towards information as a primary asset, individuals and organizations are becoming more concerned with protecting individual privacy and ensuring the security of information maintained on personal computers, the Internet, and corporate networks. Physical security for buildings and sensitive areas has also become a focal point in light of terrorism, workplace violence, and theft by employees of retail goods.

A number of technologies and strategies have been developed to address these concerns, including encryption methods, firewalls, intrusion detection tools, access permission systems, passwords, identification cards or tokens, magnetic stripe cards, digital certificates, and single sign-on applications. However, the effectiveness of each of these technologies and strategies is dependent upon the most critical and vulnerable component of the security process—positive personal identification and authentication of the individual seeking access.

With the growth of electronic commerce and the realities of business operations, access points to the Internet and enterprise networks have increased significantly, and now include desktops, home PCs, mobile laptops, and hand-held devices. Using passwords as the primary method of verifying the identity of users (remote and local) is subject to a number of security weaknesses. Passwords are frequently shared. Passwords are often written down and placed where others can see them. Common passwords like a user’s pet’s name or spouse’s name can be guessed. More complex passwords can be broken in minutes through sophisticated “dictionary” attacks based on tools that are easily available from Internet websites. Attempts to increase security by requiring complex passwords comprised of letters, numbers, and symbols are often met with significant resistance by employees. For large organizations, there is also a measurable cost of managing forgotten and expired passwords relating to administration overhead and lost employee productivity. Disgruntled or unethical employees also account for a large percentage of the increasing incidence of significant financial loss from unauthorized access to electronic data or files.

Traditional methods of controlling physical access to buildings and secure areas also have a number of risks. PINs, magnetic stripe cards, and radio frequency badges, by themselves have security vulnerabilities. Risk at the physical access points can be reduced by deploying technology that utilizes multiple authentication methods and device solutions.

Organizations performing computer-based electronic transactions, such as recording actions taken in a manufacturing process, the act of dispensing pharmaceuticals, or the process of approving electronic documents, need to have a simple and secure way of authenticating digital signatures. The use of biometric authentication represents a cost-effective means of providing positive proof of identity when auditing events or approving computer-based transactions. The resultant audit trail of events links certain events to an individual’s unique biometric characteristics.

We believe that a sustainable market is developing for higher assurance authentication technologies used in information security, data privacy, and electronic access control applications. There are several factors that we believe will contribute to the growth of this industry:

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Quantifiable Business Benefits

Our credentialing solutions are designed to ensure protection, security, and safety for an enterprise’s computer network, facilities, and intellectual property, as well as to provide increased convenience in accessing physical and computer network locations. Specifically, these benefits include:

Technical Features and Benefits

Our products also offer a number of technical features and benefits which help administrators, who are responsible for large-scale enterprise networks and facilities, easily deploy our products to their existing user bases and provide effective administration over the long term. Primary features include:

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Industry-Specific Value Proposition

Over the past 24 months, our strategy has been to assemble what we believed would be the necessary technological components to address the major security programs that were developing in the federal sector. Through internal development, acquisitions, and partnerships, we believe we have created a credentialing product suite well-suited to address these and other governmental initiatives. We then set out to establish key advisory or technology vendor positions on these programs, with the expectation that these programs could help define the security industry in both the public and private sectors.

As a result of our strategy and developments in the security industry, we have aligned our sales and marketing efforts across various vertical markets. While our products are not designed to provide functionality or features that are different across industries, we believe it is important that we position them differently when addressing the unique requirements and business drivers of the respective vertical markets. There are a number of internal and external market drivers which are specific to individual industries. We have focused our sales and marketing efforts on the following sectors:

Government

Due in part to the increased recognition of the need for infrastructure security following the events of 9/11, government agencies have been looking for a way to positively verify an individual’s identity. The use of biometric identification, in combination with smart cards or other tokens, is being considered in a number of federal agency credentialing projects as well as by the Department of Defense.

During 2004, government credentialing programs such as US-VISIT, TWIC and Registered Traveler entered new and important phases in their evolution. DHS awarded the multi-billion dollar US-VISIT program to the Smart Border Alliance, which is a consortium of companies that bid on the project, led by Accenture and includes SAFLINK. The US-VISIT program focuses on revamping the nation’s border entry and exit systems through the use of credentialing solutions, including biometrics. The TWIC program, designed to improve security in and around air and sea ports through the use of biometrics credentials for transportation workers, entered a prototype or limited deployment phase at 34 ports, affecting as many as 150,000 to 200,000 individuals. SAFLINK credentialing solutions account for a significant portion of the technology deployment for this phase of the TWIC program, which is being led by prime contractor, BearingPoint. The Registered Traveler program launched various pilot programs across the nation designed to assess the viability of using biometric credentials to increase the speed of security check-in processes at airports while also improving security. SAFLINK is bringing together a group of companies to pursue potential opportunities related to the Registered Traveler program.

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In August 2004, the White House issued Homeland Security Presidential Directive (HSPD) 12. HSPD-12 calls for a “standard” identification verification methodology capable of serving government agencies. In addition to serving the agencies, the identification verification system will also act a reciprocal credential between agencies. The Computer Security Division of the National Institute of Standards and Technology (NIST) initiated a Personal Identity Verification (PIV) project and released new Federal Information Processing Standards (FIPS) known as FIPS 201. FIPS 201 was issued on February 25, 2005, and is the basis for planning and implementation by agencies by October 2005, as called for in HSPD 12. Among other details, HSPD 12 and the FIPS 201 documents call for standards for creating a government credential, with appropriate assurance of the identity of the government employee or contractor from trusted enrollment, as well as an electronic mechanism to rapidly validate the identity of holders of the credential. Government agencies will have four months to outline programs to demonstrate compliance with the directive and the agencies will have until October 2005 to institute programs compliant with the Personal Identity Verification project.

Interoperability is also a strong requirement in the government sector, since government agencies are often large and must accommodate a variety of individual and environmental requirements. We believe our standards-based approach to support credentialing solutions addresses these concerns, as demonstrated by our involvement on some the nation’s most important security initiatives.

Healthcare

One of the strongest market drivers in the healthcare industry is a broad series of government regulations, introduced by the Health Insurance Portability and Accountability Act of 1996 (HIPAA), designed to protect the privacy of patient data. These regulations specify each healthcare organization must provide “irrefutable identification” of individuals accessing electronic patient information. Since biometric authentication is based on unique physical characteristics, it provides an effective solution to this problem—biometrics cannot be lost, borrowed or stolen. Multi-factor authentication is also a HIPAA requirement, which our products support through integration of unique user IDs, smart cards, tokens and RF badges.

Manufacturing

In the pharmaceutical manufacturing business, FDA regulations (21 CFR Part 11) dictate that individuals who are completing electronic forms relating to the various steps in researching, testing, or manufacturing an FDA regulated product must record their identity through a digital signature for any specific action. On the manufacturing floor, employees may have to authenticate as many as 300 times each shift. Not only is this cumbersome, but it takes time and can be subject to error. Our system also helps to prevent loss of intellectual property, which is a severe problem in manufacturing environments. A study by the American Society for Industrial Security (ASIS) estimates that the average manufacturing company loses $50 million in intellectual property per year due to theft. Since the utilization of biometrics can save time and provide audit trails and proof of identity, our value proposition here is very compelling.

Financial Services

Title V of the Financial Services Modernization Act of 1999 highlights the obligation of financial services institutions to protect the security and confidentiality of customer nonpublic personal information. Our products provide a valuable tool to help these institutions fulfill their obligations to protect information in their databases against unauthorized access. The elimination of passwords can provide banks a higher level of access protection while also providing financial savings by eliminating the management of multiple passwords. In the case of one of our Fortune 100 financial services clients, brokers are accessing as many as 30 applications in a given day, each with a unique username and password. By using biometric authentication and a single sign-on (SSO) solution, these brokers can now substitute one fingerprint for multiple passwords and improve their productivity while reducing password management costs.

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Education

In educational environments, IT administrators face several challenges, including students “borrowing” passwords from other students to surf undesirable Internet sites, delays in starting computer training classes due to password-related problems, and a constantly rotating end-user base. Since a biometric identifier is based on a physical characteristic and cannot be shared, lost, or stolen, it provides a reliable solution to these problems for students needing to access their work assignments and grades over the network.

Products

Our products support a wide variety of biometric and smart card technologies designed to improve security of workstations, computer networks, facilities and physical access points. Instead of a user providing a password, users provide either a unique biometric characteristic, using any one of a number of biometric technologies, or a PKI enabled smart card/credential. Our products can be divided into two groups: computer access products and physical access products.

Computer Access Products

Our enterprise products that are designed to operate in the computer network environment of large organizations include:

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Physical Access Products

Marketing and Distribution

We use both direct and indirect sales and marketing to market our products and services. Our sales staff focuses on selling our products to end-user customers primarily within the sectors of government, healthcare, manufacturing, and financial services, primarily in North America. Our channel management staff trains and supports our indirect distribution channel partners, who resell our products primarily in North America.

We market our products to potential customers across a wide range of general business sectors primarily through:

Our relationships with resellers and sales agents are generally formalized in written contracts addressing specific products to be sold, applicable discounts and the geographic territory within which our products can be sold. Our strategic alliances are generally with companies that have formal “partner” programs. These companies generally publicize our status as an alliance partner on their web sites and in other publications and forums. Alliance partnerships can provide us with specific benefits such as:

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Our marketing goals include identifying potential resellers of our products, creating awareness of our product offerings, generating leads for follow-on sales and achieving greater order volume by disseminating our products through multiple direct and indirect distribution channels worldwide.

Some of our reseller partners combine our enterprise software with their own biometric technology and sell the combined product through their own sales channels.

Our software products are typically priced on the basis of the number of users that have enrolled their biometric information into the central server database or directory or based upon the number of “seats” using our smart card middleware. As the number of users increases, the software license price per user generally decreases. Resellers purchase our products at a discount for resale at a price that provides an attractive gross margin for the reseller. We believe that this pricing model is competitive and cost-effective for the end-user customer and is attractive to our resellers.

Computer Access Products

We intend to focus on promoting our enterprise network security products to take advantage of the growing awareness of the importance of protecting enterprise network infrastructures from unauthorized access. We have a team of business development and sales professionals who are located in various regions of the country. They focus their marketing efforts on high profile end-user customers. They also identify, recruit, train and support a network of resellers. Typically, these resellers are already selling enterprise network products that are based on Microsoft, Citrix, Computer Associates, or Novell products, which our products are designed to complement. Our network of resellers often provides a range of additional services to their customers, including network component sales, network consulting, security consulting, systems installation, technical services and network management services.

We also sell our products alongside the sales organizations of our strategic alliance partners. We believe that our products complement theirs and fill a customer need that would not otherwise be met. We strive to leverage the existing sales organizations and reseller networks of these companies to achieve sales of our products at minimum expense. We work closely with each of these strategic alliance partners to support these joint sales efforts.

We intend to offer our SAFsolution Workstation product through biometric technology resellers and PC manufacturers who plan to package this product with biometric technology to create a bundled product for their customers. We intend to market SAFsolution Workstation through the direct and traditional reseller channels .We believe this will provide a set of biometric authentication functions that can be utilized “out of the box” as a first step to deploy biometric authentication within an enterprise setting to create a bundled product for the customer. SAFsolution Workstation provides a straightforward upgrade path to the enterprise versions of our products.

Physical Access Products

We intend to offer our physical access solutions primarily through our team of business development and sales professionals located in various regions of the country as well as a third-party channel organization. We believe many of our current customers or prospects for network security could also be potential users of our physical access products, creating cross-selling opportunities for our sales force and third-party resellers.

Technology Partnerships and Licensed Technology

Selected technology partners supply us with fingerprint-based hardware devices and algorithm software, which are used to capture a fingerprint image. The software we develop allows our customers to use fingerprint hardware and algorithm software to gain secure access to computer networks and workstations. Our technology partners’ products are packaged with ours into a single product for sale to our customers. Most of the business

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relationships with these companies can be characterized as manufacturer-to- reseller agreements. Most of the fingerprint device suppliers that we support have established no-cost software licensing arrangements with us. We are authorized to sell fingerprint readers or software provided by the following companies:

We also resell iris recognition, voice verification and facial feature recognition software from various companies with which we have licensing arrangements. We bundle our technology partners’ recognition software into our own software products for sale to end-users. These license agreements are with the following companies:

We are not dependent on any of these licensing arrangements. Additionally, the bulk of our business relates to fingerprint technology and those relationships are primarily based on no-cost licensing arrangements.

We buy iris recognition camera hardware from Panasonic Security and Digital Imaging Company for use with the Iridian Technologies licensed software.

We are able to provide our customers with a choice of technology by combining the appropriate “snap-in” biometric service provider (BSP) software module with our API standards-based application software product framework. The customer may purchase these standards-compliant BSP modules, and the related biometric device hardware, that will work with software from SAFLINK or third parties. Our strategy is to evaluate, qualify, and integrate select biometric technology available from new and current technology vendors. We are in various stages of qualification of additional potential technology partners.

Competition

The markets for our products and solutions are highly competitive and are characterized by rapid technological change. We expect competition to increase as other companies introduce products that are

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competitively priced, which may have increased performance or functionality or that incorporate technological advances that we have yet developed or implemented. Other companies that have developed software products that utilize biometric identification technology and are active in the United States include BNX, Inc., Digital Persona, Identix, Inc. and smart card related capabilities such as ActivCard and SafeNet. Our strategy is to differentiate our products in the marketplace by offering products that:

We expect to continue to face competition from non-biometric technologies such as traditional passwords, token cards, smart cards, and digital certificates. For example, “digital certificates” provide a secure method of encrypting messages and accessing services. However, only a password or PIN often protects the sender’s certificate key. We currently offer the Secure Authentication Framework^™ (SAF) product line that supports smart cards, radio-frequency proximity badges and digital certificates, and we intend to continue to enhance and expand these offerings.

As a non-exclusive licensee of biometric technologies, we could also experience competition from other products and services incorporating the technology that we license. Some of our present and potential competitors have substantially greater financial, marketing and research resources than we do. In order to effectively compete in this environment, we must continually develop and market new and enhanced products at competitive prices, and have the resources to invest in significant research and development activities. We may not be able to make the technological advances necessary to compete successfully. New or existing competitors may develop new technologies or enhancements to existing products or introduce new products that will offer superior price or performance features, which could render our products obsolete.

We believe that the most important competitive factors for our products are the degree of security provided, ease of use, functionality, price, size and reliability. In addition to competition from companies developing and marketing other biometric security applications, we face competition from technologies relying on PINs, smart cards, tokens or passwords. In competing with these non-biometric products, we believe that the most important competitive issue is our ability to effectively communicate to our customers that we offer a choice of biometric technologies that work in combination with traditional authentication methods to provide our customers with the ability deploy the most appropriate authentication management solution that meets their unique requirements. We believe that the replacement of traditional computer passwords by our products is a very cost effective solution.

Patents and Trademarks

We hold one issued software patent covering biometric software solutions which we believe covers certain components of our enterprise product offering. In addition, we hold five issued patents covering fingerprint imaging technology which we believe can be utilized to enhance and create strategic relationships with fingerprint technology companies, television set-top companies, and hand held computer companies that will promote or use SAF software products. We also hold nine issued patents covering methods for more secure, higher speed smart card, biometric, and reader systems which we believe can be utilized to enhance and create strategic relationships with smart card technology companies, computer manufacturers, and hand held computer companies that will promote or use software products.

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In addition, we have published and unpublished pending applications for our SAF software. There is no assurance that we will be granted any pending patents, that any patent previously granted will prove enforceable, or that any competitive advantage will exist for us because of these patents or patent applications.

We also rely on unpatented know-how, trade secrets and continuing research and development. We may not have any protection from other parties who independently develop the same know-how and trade secrets. Protection of our proprietary products and services may be important to our business, and our failure or inability to maintain this type of protection could have a material adverse affect on our business, financial condition, results of operations and prospects. Moreover, while we do not believe that the production and sale of our proposed products or services infringe on rights of third parties, if we are incorrect in this regard, our failure to obtain needed licenses from these third parties could have a material adverse effect on our ability either to complete the development of certain products or services or to produce and market these products or services. Failure to obtain any of these types of licenses could adversely impact our business, condition (financial or otherwise), results of operations and prospects.

We license certain patents or other intellectual property (including biometric hardware or software products) from other companies. The competitive nature of our industry makes any patents and patent applications of our licensors important to us. There is no assurance that any of the patent applications of these licensors will be granted, that patents previously granted will prove enforceable, or that any of these patents or patent applications will lead to any competitive advantage for us.

We have registered certain service marks and trademarks with the United States Patent and Trademark Office. However, we have not registered certain other trademarks and trade names which we use with the United States Patent and Trademark Office nor in any foreign government trademark offices. With respect to unregistered trademarks, we generally accompany the use of these trademarks with our name to indicate the origin of the products to which they are applied, to distinguish them from the products of competitors and to build goodwill in these trademarks.

Employees

As of March 15, 2005, we had 143 full-time employees. From time to time, we utilize consultants or contractors for specific assignments. None of our employees are represented by a labor union and we have never experienced a work stoppage. We believe that our relationship with our employees is good.

We lease our current principal executive offices, consisting of approximately 15,350 square feet, in Bellevue, Washington, under a lease that expires in June 2006. We also lease approximately 8,100 square feet of office space, under a lease expiring in March 2007, in Edmonton, Alberta, Canada. In Reston, Virginia, we lease 6,083 square feet of office space, under a lease that expires in April 2009. In connection with our asset purchase on December 29, 2003, we assumed a lease from Information Systems Support, Inc., consisting of 4,484 square feet in Charleston, South Carolina, which expired in February 2005. On March 11, 2005, we signed a new one-year lease for the same property in Charleston, South Carolina, that will expire in February 2006. In connection with our acquisition of SSP-Litronic on August 6, 2004, we assumed the leases of two properties in Irvine, California and Reston, Virginia. In Irvine, we lease 20,702 square feet of office space that serves as the principal office for Litronic, Inc. This lease expires in February 2012 and the lessor is KRDS, Inc., an entity that is majority-owned by three employees of Litronic, Inc., one of whom is Kris Shah, the president of Litronic, Inc. and a member of our board of directors. The other lease assumed in the acquisition of SSP-Litronic is for 5,130 square feet in Reston, Virginia, under a lease that expires in February 2009. We believe that our facilities are

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adequate to satisfy our projected requirements for the foreseeable future, and that additional space will be available if needed. The following is a summary of our current property leases:

We completed our merger transaction with SSP Solutions, Inc., dba SSP-Litronic, on August 6, 2004, following which SSP-Litronic became a wholly-owned subsidiary of SAFLINK and was renamed Litronic, Inc. Litronic had been named as a potentially responsible party, or PRP, along with many other PRPs, that contributed to groundwater and soil contamination at the Omega Chemical Superfund Site in Whittier, California. On September 24, 2004, Litronic executed a settlement with the EPA. The cost of the settlement is $108,000, which was reflected in the allocation of the purchase price to the acquired liabilities of Litronic.

We are involved in various claims and legal actions arising in the ordinary course of business. In our opinion, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations or liquidity.

No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2004.

PART II

Prior to August 9, 2001, our common stock was listed on the Nasdaq SmallCap Market under the symbol “ESAF.” On August 9, 2001, our stock was delisted from the Nasdaq SmallCap Market. Our stock began trading on the Pink Sheets on August 10, 2001, and was quoted on the OTC Bulletin Board (OTCBB) through April 24, 2003. On April 25, 2003, our stock resumed trading on the Nasdaq SmallCap Market as we met all requirements for relisting.

On November 19, 2001, we effected a one-for-seven reverse stock split and changed our stock symbol to “SFLK.” As of March 15, 2005, there were 493 record holders of our common stock. This does not include the number of beneficial owners whose stock is in nominee or street name accounts through brokers.

The last sale price of our common stock as reported on the Nasdaq SmallCap Market on March 15, 2005, was $2.01 per share. The following table sets forth the range of high and low close prices for our common stock as reported on the OTCBB (without retail markup or markdown and without commissions) for each full quarterly period from January 1, 2003, through April 24, 2003, and the range of high and low close prices for our common stock as quoted on the Nasdaq SmallCap Market from April 25, 2003, through December 31, 2004. The over-the-

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counter market figures shown below reflect inter-dealer prices, without retail markup, markdown or commission, and may not necessarily represent actual transactions.

We have never paid or declared cash dividends on our common stock, and we do not intend to pay or declare cash dividends on our common stock in the foreseeable future.

The following financial statement data should be read in conjunction with the consolidated financial statements and the notes thereto and the information contained in the section of this annual report entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Historic results are not necessarily indicative of future results.

This Management’s Discussion and Analysis contains forward-looking statements. All statements other than statements of historical fact made in this annual report are forward-looking. Forward-looking statements reflect

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management’s current expectations and are subject to risks and uncertainties discussed below, and identified in the section of this annual report on Form 10-K entitled “Risk Factors That May Affect Future Results” that could cause actual results to differ materially from historical results or those anticipated.

Overview

Our primary source of revenue is the sale of our software and hardware products and consulting services combined with the resale of software applications and hardware products sourced or assembled from third parties. For logical access control needs, we develop biometric and smart card application software, and resell biometric and smart card hardware and device control software from leading manufacturers. Biometric technologies automatically identify individuals by electronically capturing a specific biological or behavioral characteristic of that individual, such as a fingerprint, iris pattern, voiceprint or facial feature, creating a unique digital identifier from that characteristic and then comparing it against a previously created and stored digital identifier. Because this process relies on largely unalterable human characteristics, it is both highly secure and highly convenient for the individual seeking access. Smart card solutions operate similarly for identity verification and authentication but typically are used in conjunction with a Public Key Infrastructure (PKI) deployment. Smart cards employing PKI technology can be used for logical access decisions as well as securing electronic communications.

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

Our financial focus continues to be the growth of our top-line revenue while maintaining acceptable gross margins. We believe that our products and services are best sold through a consultative sales approach that requires experienced enterprise sales personnel to pursue and manage sales opportunities over several months, and possibly beyond a year in length. We believe our current headcount in the area of sales and marketing is sufficient for us to attain meaningful top-line revenue growth in the future.

The primary challenge for management is to convert a significant sales pipeline into revenue. We believe that we have been successful in building and managing a relatively large sales pipeline of opportunities. However, we have not been successful in converting this pipeline into significant revenue. Some of the primary challenges that can impact our success in this area include general market factors influencing purchasing of computer network and security solutions, a relatively long sales cycle associated with our types of solutions and services, and the relative immaturity of the biometrics market.

Our ability to translate the value proposition of our products and services into revenue will be a key factor in our ability to achieve financial and operational success. The biometrics market is relatively immature and new to numerous potential customers in the commercial or governmental sectors. This makes it even more important, compared to a more mature or established market, that we successfully identify the positive attributes of our solutions, and then translate those to the customers, so that they are motivated to purchase our products and services.

Among the key challenges to our business is whether we can establish sales and profitability success prior to the emergence of a dominant competitor in our targeted markets. Our goal has been to grow our market share while the biometric market matures. To be successful in this area, we will need to see our revenues significantly

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increase as the market matures, while we maintain an operating expense structure that grows modestly, if at all. We believe that sales of large enterprise deployments, in the public or private sector, will be the first signs that we are beginning to achieve our goal of growth in market share.

On August 6, 2004, we merged with SSP-Litronic, which was subsequently renamed Litronic, Inc. and is our wholly-owned subsidiary. We acquired all of the outstanding shares of SSP-Litronic common stock in a stock-for-stock transaction where each outstanding share of SSP-Litronic common stock was converted into the right to receive 0.6 shares of our common stock. We issued 40,137,148 shares of our common stock in exchange for the outstanding shares of SSP-Litronic common stock.

Litronic designs and develops innovative data and communication security solutions for both corporate and government institutions. Litronic also provides network security, desktop protection, and high assurance messaging systems for many organizations of the U.S. Government. We believe that our merger with SSP-Litronic, among other benefits, will help broaden our customer base and will enable us to offer an integrated smart card plus biometric solution to the government and commercial sectors.

On December 29, 2003, we acquired certain assets and rights used in connection with the digital identity and biometric-enhanced physical access security business of Information Systems Support, Inc. (ISS) and Biometric Solutions Group, Inc. (BSG). The primary reason we made the purchase was to expand our market by entering the physical access market and to meld the physical access product into our existing logical access product. We paid approximately $3.9 million, which consisted of $500,000 in cash and 1,122,855 shares of our common stock. We acquired certain intellectual property, tangible assets and inventory in the transaction. We did not assume any liabilities on behalf of BSG as part of this acquisition, other than to accept assignment of a facilities lease for the offices of BSG in Charleston, South Carolina.

Critical Accounting Policies and Estimates

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

Revenue Recognition

We derive revenue from license fees for software products, selling our manufactured hardware, reselling third party hardware and software applications, and fees for services related to these software and hardware products, including maintenance services, installation and integration consulting services.

We recognize revenue in accordance with the provisions of 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 provides specific guidance and stipulates that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post-contract customer support, installation, integration and/or training. Under this guidance, the determination of fair value is based on objective evidence that is specific to the vendor. In multiple element arrangements in which fair value exists for undelivered elements, the fair value of the undelivered elements is deferred and the residual arrangement fee is assigned to the delivered elements. If evidence of fair value for any of the undelivered elements does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist, or until all elements of the arrangement are delivered.

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We recognize revenue from biometric software and data security license fees 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, we recognize revenue from these arrangements upon customer acceptance of permanent license rights. If our software is sold through a reseller, we recognize revenue when the reseller delivers its product to the end-user. Certain software delivered under a license requires a separate annual maintenance contract that governs the conditions of post-contract customer support. Post-contract customer support services can be purchased under a separate contract on the same terms and at the same pricing, whether purchased at the time of sale or at a later date. We recognize revenue from these separate maintenance support contracts ratably over the maintenance period. Other software delivered under a license includes a first year of maintenance, in which case we recognize the value of such maintenance ratably over the initial license period. The value of such deferred maintenance revenue is established by the price at which the customer may purchase a renewal maintenance contract.

We recognize revenue from hardware that we manufacture generally upon shipment, unless contract terms call for a later date, net of an allowance for estimated returns, provided persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. Revenue from some data security hardware products contains embedded software. However, the embedded software is considered incidental to the hardware product sale. We also act as a reseller of third-party hardware and software applications. Generally, we recognize such revenue upon shipment of the hardware or software application, unless contract terms call for a later date, provided that all other conditions above have been met.

Service revenue includes payments under support and upgrade contracts and consulting fees. We recognize support and upgrade revenue ratably over the term of the contract, which typically is twelve months. Consulting revenue primarily relates to installation, integration and training services performed on a time-and-materials or fixed-fee basis under separate service arrangements. Fees from consulting are recognized as services are performed. If a transaction includes both license and service elements, license fees are recognized separately upon delivery of the licensed software, provided services do not include significant customization or modification of the software product, the licenses are not subject to acceptance criteria, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If the services do include significant customization or modification of the software product or if the services are under a fixed-fee contract, we recognize the revenue in accordance with the relevant guidance from the American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1).

We recognize revenue for these types of arrangements as services are rendered using the percentage-of-completion method with progress-to-complete measured using labor hour or labor cost inputs. Cost estimates on percentage-of-completion contracts are reviewed periodically with adjustments recorded in the period in which the revisions are made. Any anticipated losses on contracts are charged to operations as soon as they are determinable. The complexity of the estimation process and factors relating to the assumptions, risks and uncertainties inherent with the application of the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, availability of qualified personnel and project requirement and/or scope changes. Billings on uncompleted contracts may be less than or greater than the revenues recognized and are recorded as either unbilled receivable (an asset) or deferred revenue (a liability) in the consolidated financial statements.

Our 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.

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Goodwill and Other Intangible Assets with Indefinite Useful Lives

Goodwill represents the excess of costs over fair value of assets of businesses acquired. We have applied the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142), since adoption on January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized.

We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference.

We also assess the impairment of intangible assets with indefinite useful lives on at least an annual basis, or more frequently if any of the above factors exist that might cause impairment to the carrying value. We compare the fair value of the intangible asset, which is determined based on a discounted cash flow valuation method, with the carrying value of the intangible asset. If we were to determine that the fair value of an intangible asset was less than its carrying value, based upon the discounted cash flow valuation, we would recognize impairment loss in the amount of the difference between fair value and the carrying value of the asset.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Asset” (SFAS No. 144), we review long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We measure recoverability of assets to be held and used by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, we would recognize an impairment charge in the amount by which the carrying amount of the asset exceeds the fair value of the asset.

Stock-Based Compensation

We applied 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 our employee 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. SFAS No. 123, “Accounting for

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Stock-Based Compensation,” and FASB Statement No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” an amendment to FASB Statement No. 123, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, we elected to continue to apply the intrinsic-value-based method of accounting described above, and have adopted only the disclosure requirements of SFAS No. 123, as amended.

We accounted for non-employee stock-based compensation in accordance with SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, “Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

Valuation of Outstanding Warrants

In accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS No. 150), we classified certain warrants to purchase shares of our common stock as a liability because they contain characteristics of debt. We value the outstanding warrants using a Black-Scholes model and use estimates for an expected dividend yield, a risk-free interest rate, and price volatility of our common stock. Each interim period and year end, as long as the warrants are outstanding and contain characteristics of debt, the warrants will be revalued and any difference from the previous valuation date will be recognized as a change in fair value of outstanding warrants in our statement of operations.

Results of Operating Activities

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 review financial information on a consolidated basis and, therefore, have operated as single segment for all periods discussed.

We incurred a net loss attributable to common stockholders of $18.1 million for the year ended December 31, 2004, as compared to a net loss attributable to common stockholders of $10.7 million for the year ended December 31, 2003. Excluding a warrant modification charge of $2.2 million related to our July 2004 special warrant offering in which we lowered the exercise price of certain warrants to $2.50, the net loss for the year ended December 31, 2004, was $15.9 million. Besides the warrant modification charge, the increased 2004 net loss was primarily caused by the acquisition of SSP-Litronic, which nearly doubled our headcount and added two additional facilities. In addition, the intangible asset amortization related to this acquisition was $1.1 million for the twelve months ended December 31, 2004.

The following discussion presents certain changes in our revenue and operating expenses which have occurred between fiscal years 2004 and 2003, and between fiscal years 2003 and 2002, and should be read in conjunction with our consolidated financial statements, including the notes thereto, included elsewhere in this Form 10-K.

Year Ended December 31, 2004, Compared to Year Ended December 31, 2003

Revenue and Cost of Revenue

Revenue of $6.4 million for the year ended December 31, 2004, increased compared to revenue of $2.0 million for the year ended December 31, 2003. Revenue of $4.6 million came from product sales and $1.8 million from services during 2004. Product revenue increased by $3.8 million in 2004, while service revenue increased by $590,000. Product revenue consists of license fees for software products, sales of our manufactured hardware and the reselling of third party hardware and software applications. The increase in product revenue was primarily due to the additional hardware and software revenue contributed by Litronic, after the acquisition

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of SSP-Litronic on August 6, 2004. During 2004, software license revenue increased by $201,000, while the sales of our own hardware and third party hardware increased by $3.1 million, the majority of which can be attributed to Litronic. Also, included in product revenue is the sale of third party software applications, which was $451,000 in 2004, compared to no sales in 2003. The service revenue increase of $590,000 in 2004 over 2003 was primarily related to work performed on several government projects, either directly through the government or as a subcontractor to a systems integrator, as well as the completion of our development project in the manufacturing automation vertical market. During 2004, one customer – BearingPoint, Inc. – accounted for 15% of our revenue, which was earned as a subcontractor to them on two government projects. Sales to the government accounted for 72% of revenue in 2004.

Cost of revenue consisted of software packaging and materials, the cost our manufactured hardware, the cost of third party hardware and software applications, the cost of labor and services related to projects and software maintenance, as well as the amortization of intangible assets. Our cost of revenue increased from $778,000 in 2003 to $4.6 million in 2004. This increase was directly related to the 218% increase in revenue in 2004 over 2003, and can also be attributed to the addition of $1.2 million in amortization of intangible assets in connection with our asset purchase from BSG and ISS on December 29, 2003, and our merger with SSP-Litronic on August 6, 2004. Gross margin percentage, excluding the effect of the amortization of intangible assets, was also down in 2004 (48%), when compared to 2003 (61%), due to the higher mix of hardware revenue to software revenue during 2004. This change in product mix can also be attributed to the SSP-Litronic merger, since 81% of that subsidiary’s revenue was hardware, which garners a lower gross margin percentage than software.

The cost of revenue, as a percentage of sales, may increase as a result of amortization of intangible assets acquired in the SSP-Litronic merger. This amortization, classified as cost of revenue, will be approximately $624,000 per quarter in 2005, assuming no impairment of any of these intangible values. The cost of revenue could also be impacted by a shift in the software and hardware revenue mix. With the addition of Litronic, our hardware sales as percentage of total products sales are likely to increase in the coming year, thus increasing our cost of sales related to product revenue.

Operating Expenses

Operating expenses increased from $12.0 million in 2003 to $19.7 million in 2004. The increase was primarily due to the two business combinations consummated during December 2003 and August 2004, which added approximately 80 new employees and three new facility locations.

The following table provides a breakdown of the dollar and percentage changes in operating expenses from 2003 to 2004:

Product Development

Product development expenses consist primarily of salaries, benefits, allocated rent expense, supplies and equipment for software developers and architects, hardware engineers, program managers and quality assurance personnel, as well as legal fees associated with our intellectual property. Product development expenses increased

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from $2.5 million in 2003 to $5.6 million in 2004. The increase in product development costs was primarily due to increased compensation and related benefits of $2.3 million, increased general and other expenses of $383,000, increased occupancy expense of $218,000, increased travel of $179,000 and a net increase of $103,000 for all other categories. Product development headcount increased by a net 47 employees, or 115%, in 2004, which was the main cause of the 128% increase in 2004 product development expense when compared to 2003.

In January 2005, we reduced product development headcount by 7 employees. As of March 15, 2005, we had 77 employees in product development departments and we expect that number to remain fairly constant throughout 2005.

Sales and Marketing

Sales and marketing expenses consist primarily of salaries and commissions earned by sales and marketing personnel, trade show and promotional expenses, allocated rent and supplies, and travel and entertainment costs. Sales and marketing expenses increased from $5.3 million in 2003 to $7.2 million in 2004. The increase in sales and marketing costs was primarily due to increases in compensation and related benefit costs of $1.6 million, occupancy expenses of $206,000, and a net increase in all other categories of $106,000. This increase can primarily be attributed to the additional headcount and Reston, Virginia sales office that were added as a result of the SSP-Litronic merger. Sales and marketing headcount increased by 29 employees, or 107%, in 2004.

In January 2005, we reduced our sales and marketing headcount by 8 employees. As of March 15, 2005, we had 46 employees in sales and marketing departments and we expect that number to remain fairly constant throughout 2005.

General and Administrative

General and administrative expenses consist primarily of salaries, benefits, allocated rent and supplies, and related costs for our executive, finance, legal, human resource, information technology and administrative personnel, and professional services fees, including legal counsel and audit fees. General and administrative expenses increased from $3.6 million in 2003 to $5.9 million in 2004. The increase in general and administrative costs was primarily due to increases in personnel costs of $1.1 million, legal and professional services of $372,000, occupancy costs of $149,000, travel and entertainment costs of $74,000, and general supplies, equipment and insurance expense increases of $579,000. These increases were also directly related to the SSP-Litronic merger in August 2004, which added 12 employees, approximately doubling the size of the department in terms of headcount.

In January 2005, we reduced our general and administrative headcount by 2 employees. As of March 15, 2005, we had 20 employees in general and administrative departments and we expect that number to remain fairly constant throughout 2005.

Amortization of intangible assets

Amortization of intangible assets is related to non-competition agreements we have with certain executives related to the asset purchase from BSG and ISS in December 2003 and various intangible assets related to the merger with SSP-Litronic in August 2004. These assets were valued as of the date acquired and are being amortized over their estimated useful lives. Amortization of intangible assets, excluding amounts included in cost of revenue, was $97,000 and $0, for the twelve months ended December 31, 2004 and 2003, respectively. We expect amortization of intangible assets to increase in 2005, assuming no impairment of the underlying assets, as we incur a full year of expense related to the SSP-Litronic merger.

In 2005, we decided to discontinue use of two tradenames that were acquired in connection with the SSP-Litronic merger and will incur a $900,000 impairment loss on intangible assets during the first quarter of 2005.

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This will not affect the anticipated amounts for amortization of intangible assets in 2005 because, as of the acquisition date, the tradenames were deemed to have indefinite lives and were not being amortized during 2004.

Stock-based compensation

Deferred stock-based compensation is amortized over the vesting periods of the equity instrument. Stock based compensation for 2004 is primarily related to the issuance of restricted common stock grants to certain executives in June and August 2004, the issuance of options to purchase shares of common stock to employees at an exercise price less than fair market value, and the assumption of options to purchase common stock in connection with the merger with SSP-Litronic in August 2004. Stock based compensation expense was $859,000 and $680,000, for the twelve months ended December 31, 2004, and 2003, respectively. For 2004, $794,000 in stock-based compensation was related to employees and classified as compensation and related benefits, while $65,000 was related to the amendment of stock options held by third party consultants and has been classified in legal and professional services. During 2003, all stock-based compensation expense related to the issuance of options and warrants to third party consultants and was amortized over the consultant’s period of performance. In 2003, the $680,000 in stock-based compensation expense was classified as legal and professional service. We expect stock-based compensation to increase in 2005, as we incur a full year of amortization expense related to the June and August 2004 issuances of restricted common stock and the assumption of stock options related to the SSP-Litronic merger.

Interest Expense

Interest expense for the twelve months ended December 31, 2004, and 2003, was $59,000 and $14,000, respectively. Interest expense during 2004 and 2003 consisted of interest accrued from the financing of certain insurance policies over a nine month period and, as of the SSP-Litronic merger in August 2004, included interest expense related to the convertible notes assumed in that acquisition. We expect interest expense to increase in 2005, as we will incur a full year of interest expense related to the outstanding convertible note, assuming it is held to its maturity date of December 31, 2005.

Other Income, Net

Other income, net for the twelve months ended December 31, 2004, and 2003, was $204,000 and $65,000, respectively. Other income primarily consisted of interest earned on cash, money market balances and short-term certificates of deposit. The increase was due to increased cash balances during 2004 when compared to 2003.

Income tax provision

We recorded a non-cash income tax provision of $52,000 for the twelve months ended December 31, 2004. This charge is required because we have a deferred tax liability related to goodwill associated with our BSG asset purchase, which is being amortized for tax purposes, but not for book purposes. As the goodwill has an indeterminable life, we cannot reasonably estimate the amount, if any, of deferred tax liabilities related to BSG goodwill which will reverse during the net operating loss carry forward period, and thus offset deferred tax assets. Accordingly, we increase the valuation allowance with a corresponding deferred tax provision as the deferred tax liability related to BSG goodwill increases due to continued amortization of goodwill for tax purposes.

Change in fair value of outstanding warrant

Change in fair value of outstanding warrants for the twelve months ended December 31, 2004, resulted in a net gain of $1.8 million, while there was no change in fair value of outstanding warrants during 2003. The change in fair value of outstanding warrants was related to two separate warrant issuances that had potential cash obligations and thus giving these equity instruments debt characteristics.

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The majority of the non-cash gain is related to warrants issued in connection with the February 2004 financing. Per the original registration rights agreement, if we did not meet certain criteria, we may have been required to pay liquidated damages to each stockholder until the applicable event was cured. On September 28, 2004, we amended the registration rights agreement to substitute our cash obligation to remedy any conditions that were not met, with shares of common stock instead. The gain of $1.8 million represents the change in fair value between the initial grant date, February 26, 2004, and the day the registration rights agreement was amended, September 28, 2004. The fair value of the outstanding warrants as of September 28, 2004, was reclassified to equity as the registration rights amendment eliminated the debt characteristics of these warrants.

In addition, our Litronic merger triggered certain redemption provisions in connection with our Series A warrants. The cash redemption value was estimated to be $765,000 as of August 2, 2004, the date we notified the warrant holders of the merger, and is fixed as long as the warrants are outstanding or until expiration in June 2006.

On August 6, 2004, the closing date of the merger, these warrants were reclassified as a liability because the warrants then contained characteristics of a debt instrument. Each interim period and year end until the warrants expire in June 2006, the remaining outstanding warrants will be revalued and any difference from the previous valuation date will be recognized as a change in fair value of outstanding warrants and charged or credited to change in fair value of outstanding warrants.

Operating Expenses Analysis by Functional Activity

The following table provides an analysis of the 2004 over 2003 change in total operating expenses by functional category:

Year Ended December 31, 2003, Compared to Year Ended December 31, 2002

Revenue and Cost of Revenue

Revenue of $2.0 million for the year ended December 31, 2003, did not increase compared to revenue of $2.0 million for the year ended December 31, 2002. $787,000 in revenue came from product sales and $1.2 million from services. One customer—Eli Lilly & Company—accounted for 39% of our 2003 revenue. Product revenue declined by $388,000 in 2003, while service revenue increased by $397,000. The decrease in product revenue was primarily due to a $591,000 decrease in hardware revenue. Software revenue, however, increased by $203,000 during 2003, and partially offset the hardware revenue decline in the combined product revenue total. The service revenue increase in 2003 was mainly attributable to work performed on a development project in the manufacturing automation vertical market. This project, for a large pharmaceutical company, accounted for $783,000 in service revenue during 2003.

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Cost of revenue consisted of software materials, third-party hardware, and services costs in 2003 and 2002. Our cost of revenue decreased from $1.1 million in 2002 to $778,000 in 2003. This decrease was primarily driven by a $113,000 reduction in software cost of revenue due to the termination of royalty expense associated with a licensing agreement. Hardware and service cost of revenue, as a percentage of hardware and service revenue in 2003 were consistent with prior year results. A more favorable mix of higher margin software compared to lower margin hardware in 2003 also contributed to the reduction of cost of revenue.

Operating Expenses

Operating expenses increased from $7.4 million in 2002 to $12.0 million in 2003. The increase was primarily due to a 90% increase in headcount from January 1, 2003, to December 31, 2003, which resulted in a $2.6 million increase in compensation and related benefits and a $347,000 increase in travel and entertainment costs. Advertising and promotion expense increased $505,000 due to increased trade show appearances and public relations efforts. Legal and professional service costs increased $540,000 primarily caused by increased recruitment expense related to the significant number of new hires and an increase in consulting fees during 2003.

The following table provides a breakdown of the dollar and percentage changes in operating expenses from the 2002 to 2003:

Product Development

Product development expenses consisted primarily of salaries, benefits, supplies and equipment for software developers, product management and quality assurance personnel, as well as legal fees associated with our intellectual property. Product development expenses increased from $1.8 million in 2002 to $2.5 million in 2003. The increase in product development costs was primarily due to increased compensation and related benefits of $438,000, increased general and other expenses of $170,000, and increased professional service expense of $105,000, which related to intellectual property legal fees and recruitment expense. Product development headcount increased by 17 employees, or 71%, in 2003, which was the main cause of the 40% increase in 2003 product development expense when compared to 2002. The increase in compensation and related benefits for this period was reduced significantly, $303,000, by the allocation of those expenses to cost of services because of labor incurred by product development personnel on revenue-producing projects.

Sales and Marketing

Sales and marketing expenses consisted primarily of salaries and commissions earned by sales and marketing personnel, trade show and promotional expenses, and travel and entertainment costs. Sales and marketing expenses increased from $1.9 million in 2002 to $5.3 million in 2003. The increase in sales and marketing costs was primarily due to increases in compensation and related benefit costs of $1.8 million, travel and entertainment expenses of $343,000, advertising and promotion expenses of $604,000, professional services and recruiting fees of $669,000, and other occupancy and general expense increases of $124,000. This substantial increase in expense during 2003 was caused by the build-out of a direct regional sales team that included

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salespeople and sales engineers. Sales and marketing headcount increased by 16 employees, or 146%, in 2003. In an effort to generate leads for the newly formed sales team, trade show and marketing expenses increased. Travel and entertainment expenses increased, as well, due to the increased number of sales personnel.

General and Administrative

General and administrative expenses consisted primarily of salaries, benefits and related costs for our executive, finance, human resource, information technology and administrative personnel, professional services fees and allowances for bad debt. General and administrative expenses increased from $3.1 million in 2002 to $3.6 million in 2003. The increase in general and administrative costs was primarily due to increases in personnel costs of $379,000, occupancy costs of $82,000, and general supplies, equipment and insurance expense increases of $231,000. These increases were partially offset by decreases in legal and professional services costs of $330,000. Headcount increased in general and administrative from 7 to 12 during 2003, a 71% increase, primarily to support the 90% overall headcount growth company-wide.

Interest Expense

Interest expense primarily consisted of interest expense associated with debt obligations and credit facilities. Interest expense decreased from $44,000 in 2002 to $14,000 in 2003. We had no debt obligations in 2003, other than the financing of certain insurance policies for a nine-month term.

Other Income, Net

Other income, net consisted of earnings on our cash, cash equivalent and short-term investment balances, augmented by gains and offset by any miscellaneous charges. Other income, net decreased from $310,000 in 2002 to $65,000 in 2003. The decrease was primarily due to a non-recurring gain in 2002 of $292,000 resulting from a favorable settlement on an accounts payable obligation which was expensed in prior years over several operating and non-operating expense categories. Excluding that gain in 2002, other income rose in 2003 due to increased interest income on larger cash reserves when compared to 2002.

Operating Expenses Analysis by Functional Activity

The following table provides an analysis of the 2003 over 2002 change in total operating expenses by functional category:

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Liquidity and Capital Resources

Our operations have never generated any net income. We have accumulated net losses of approximately $114.1 million from our inception through December 31, 2004, and we have continued to accumulate net losses since December 31, 2004. Historically, we have funded our operations primarily through the issuance of equity securities to investors. We financed our operations during fiscal 2004 primarily from existing working capital at December 31, 2003, $8.5 million in net proceeds from our private placement in February 2004, net proceeds of $10.8 million from warrant exercises in July 2004, and $13.5 million in cash that was acquired through the SSP-Litronic merger. As of December 31, 2004, our principal source of liquidity consisted of $22.2 million in cash and cash equivalents and $19.3 million of working capital, compared to cash and cash equivalents of $7.1 million and $6.7 million in working capital as of December 31, 2003. We invest our cash in excess of current operating requirements in a money market fund with a commercial bank.

We used cash of $17.7 million for operating activities in 2004, which was $7.1 million more than the amount used in operations during 2003. The increase in the use of cash was primarily due to increased headcount and occupancy expense related to the two business acquisitions completed in December 2003 and August 2004. Cash provided by investing activities was $12.5 million in 2004, which consisted of $13.5 million, net of transaction costs, acquired through the SSP-Litronic merger, $252,000 in transaction costs paid related to the asset purchase from BSG, and $730,000 used for purchases of equipment, furniture and leasehold improvements. This compares to $1.1 million used in investing activities in 2003, which included payments of $510,000 related to the asset purchase from BSG, and $633,000 for furniture, equipment and leasehold improvements. Net cash provided by financing activities increased to $20.3 million in 2004, compared to $11.4 million in 2003. In February 2004, we raised $8.5 million in net proceeds through a private financing. In July 2004, through a warrant modification and subsequent exercises, we raised $10.8 million in net proceeds, and throughout the year we received $929,000 in proceeds from the exercise of stock options. During 2003, there were no private financings; however, we received net proceeds of $9.9 million from warrant exercises and $1.5 million from stock option exercises.

As a result of the capital raised and acquired through the merger with SSP-Litronic during 2004, we believe we have sufficient funds to continue our operations beyond the first quarter of 2006, assuming no significant and unexpected uses of cash. However, we currently do not have a credit line or other borrowing facility to fund our operations. In addition, we may not be able to secure additional financing on favorable terms, or at all. If we need additional cash to fund our operations, we may need to raise capital through the issuance of additional equity securities to investors. The issuance of a large number of additional equity securities could cause substantial dilution to existing stockholders and could cause a decrease in the market price for shares of our common stock, which could impair our ability to raise capital in the future through the issuance of equity securities. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of or to cease our operations.

We currently occupy our headquarters in Bellevue, Washington under a lease that expires in June 2006, and are required to pay taxes, insurance, and maintenance as well as monthly rental payments. In addition, we lease office space in Edmonton, Alberta, Canada for our product development team that expires in March 2007. Further, we lease office space for our government sales team and Enterprise Solutions Group in Reston, Virginia, which expires in April 2009. In connection with our asset purchase from BSG in December 2003, we assumed a lease for our development group in Charleston, South Carolina, that expires in February 2006. And lastly, in connection with our SSP-Litronic merger on August 6, 2004, we assumed the leases of two properties in Irvine, California and Reston, Virginia, which expire in February 2012 and February 2009, respectively. The lessor for the Irvine, California property is KRDS, Inc., an entity that is majority-owned by three employees of our subsidiary Litronic, Inc., one of whom is Kris Shah, the president of Litronic, Inc. and a member of our board of directors.

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The following table reflects our contractual commitments for operating leases and our convertible promissory note principal and interest as of December 31, 2004 (in thousands):

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), which requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in an entity’s statement of income. The accounting provisions of SFAS 123R are effective for reporting periods beginning after June 15, 2005. We are required to adopt SFAS 123R in the quarter ending September 30, 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. See “Stock-Based Compensation” (Note 2) for the pro forma net loss and net loss per share amounts for 2004, 2003 and 2002, as if we had applied the fair value recognition provisions of SFAS 123 to measure compensation expense for employee stock incentive awards. Although we have not yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS 123, we expect the adoption to have a material impact on the consolidated statements of operations for the six months ended December 31, 2005. This estimate is based on preliminary information and could materially change based on actual facts and circumstances arising during the six months ending December 31, 2005.

Factors That May Affect Future Results

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

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

We have accumulated net losses of approximately $114.1 million from our inception through December 31, 2004. We have continued to accumulate losses after December 31, 2004 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. If we are unable to generate sufficient cash flow from operations, we will need to seek additional funds through the issuance of additional equity or debt securities or other sources of financing. We may not be able to secure such additional financing on favorable terms, or at all. Any additional financings will likely cause substantial dilution to existing stockholders. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of, or cease, our operations.

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We have not generated any significant sales of our products within the competitive commercial market, nor have we demonstrated sales techniques or promotional activities that have proven to be successful on a consistent basis, which makes it difficult to evaluate our business performance or our future prospects.

We are in an emerging, complex and competitive commercial market for digital commerce and communications security solutions. Potential customers in our target markets are becoming increasingly aware of the need for security products and services in the digital economy to conduct their business. Historically, only enterprises that had substantial resources developed or purchased security solutions for delivery of digital content over the Internet or through other means. Also, there is a perception that security in delivering digital content is costly and difficult to implement. Therefore, we will not succeed unless we can educate our target markets about the need for security in delivering digital content and convince potential customers of our ability to provide this security in a cost-effective and easy-to-use manner. Even if we convince our target markets about the importance of and need for such security, there can be no assurance that it will result in the sale of our products. We may be unable to establish sales and marketing operations at levels necessary for us to grow this portion of our business, especially if we are unsuccessful at selling our products into vertical markets. We may not be able to support the promotional programs required by selling simultaneously into several markets. If we are unable to develop an efficient sales system, or if our products or components do not achieve wide market acceptance, then our operating results will suffer and our earnings per share will be adversely affected.

A significant number of shares of our common stock are or will be eligible for sale in the open market, which could reduce the market price for our common stock and make it difficult for us to raise capital.

In our merger transaction with SSP-Litronic we assumed options, warrants and convertible promissory notes of SSP-Litronic that, as of March 15, 2005, represented the right to acquire 3,527,837 shares of our common stock, 1,936,500 of which have exercise or conversion prices below the fair market value of our common stock of $2.01 as of March 15, 2005.

As of March 15, 2005, 79,806,989 shares of our common stock were outstanding. In addition, including the securities assumed in the SSP-Litronic merger, there were a total of 13,503,111 million shares of our common stock issuable upon exercise or conversion of outstanding options, warrants, and convertible promissory notes. We have issued options and warrants to acquire shares of common stock to our employees and certain other persons at various prices, some of which have exercise prices below the current market price for our common stock. As of March 15, 2005, options to acquire 8,739,405 shares of our common stock were outstanding and our existing stock incentive plan had 3,005,796 shares available for future issuance.

The issuance of a large number of additional shares of our common stock upon the exercise or conversion of outstanding options, warrants or convertible promissory notes would cause substantial dilution to existing stockholders and could decrease the market price of our common stock due to the sale of a large number of shares of common stock in the market, or the perception that these sales could occur. These sales, or the perception of possible sales, could also impair our ability to raise capital in the future.

Because they own approximately 51% of our common stock, seven stockholders could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes or corporate actions.

Seven of our stockholders (together with their affiliates) beneficially own approximately 51.5% of our outstanding common stock as of March 15, 2005. Given this substantial ownership, if they decided to act together, they would be able to significantly influence the vote on those corporate matters to be decided by our stockholders. In addition, these stockholders hold options, warrants and convertible promissory notes representing the right to acquire an additional 1,402,404 shares of our common stock. If these stockholders exercised their options and warrants and converted their promissory notes in full, they would own approximately 52.4% of our outstanding common stock. Such concentrated ownership may decrease the value of our common

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stock and could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes.

If we do not generate significant revenue from our participation in large government security initiatives or increase the level of our participation in these initiatives, our business performance and future prospects may suffer.

We play various roles in certain large government security initiatives, which includes being a part of the consortium of companies, led by Accenture, that was awarded the Department of Homeland Security’s US-VISIT contract, and our involvement in the Transportation Security Administration’s TWIC program where our credentialing solutions account for a significant portion of the technology deployment for the prototype or limited deployment phase. We have invested a substantial amount of time and resources in our efforts to participate in these and other government security initiatives, but we have not generated significant revenue from our participation in these security initiatives to date. If we are not able to generate significant revenue from our participation in these or other government programs, or if we incur substantial additional expenses related to government programs before we earn associated revenue, we may not have adequate resources to continue to operate or to compete effectively in the government or the commercial marketplace.

If the market for our products and services does not experience significant growth or if our biometric and smart card products do not achieve broad acceptance in this market, our ability to generate significant revenue in the future would be limited and our business would suffer.

A substantial portion of our product revenue and a portion of our service revenue are derived from the sale of biometric and smart card products and services. Biometric and smart card solutions have not gained widespread acceptance. We cannot accurately predict the future growth rate of this market, if any, or the ultimate size of the biometric and smart card technology market. The expansion of the market for our products and services depends on a number of factors such as:

Even if biometric and smart card solutions gain wide market acceptance, our products and services may not adequately address market requirements and may not gain wide market acceptance. If biometric or smart card solutions or our products and services do not gain wide market acceptance, our business and our financial results will suffer.

Our reported financial results will suffer as a result of purchase accounting treatment, the impact of amortization of certain intangibles relating to the merger with SSP-Litronic and the direct transaction costs of the merger, and may suffer further if goodwill is deemed in the future to have been impaired.

We have accounted for the merger as a purchase of SSP-Litronic by us under the purchase method of accounting. Under purchase accounting, we recorded the fair value of the consideration given for the SSP-Litronic common stock and for options and warrants to purchase SSP-Litronic common stock assumed by us, plus the amount of direct transaction costs, as the cost of acquiring SSP-Litronic. We allocated these costs to the individual assets acquired and liabilities assumed, including various identifiable intangible assets such as

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developed technology, acquired trade names, acquired patents, customer relationships, and non-competition agreements based on their respective fair values. Goodwill will be tested at least annually, and may be deemed in the future to have been impaired. As a result, the purchase accounting treatment for the merger will result in a reduction of earnings and earning per share for the foreseeable future. This change could cause the market price of our stock to decline.

Any acquisition we make in the future could disrupt our business and harm our financial condition.

To date, most of our revenue growth has been created by acquisition. In any future acquisitions or business combinations, we are subject to numerous risks and uncertainties, including:

We may not be able to successfully complete the integration of the businesses, products or technologies or personnel in the businesses or assets that we might acquire in the future, and any failure to do so could disrupt our business and seriously harm our financial condition.

We have depended on a limited number of customers for a substantial percentage of our revenue, and due to the non-recurring nature of these sales, our revenue in any quarter may not be indicative of future revenue.

One customer accounted for 15% of our revenue for the twelve months ended December 31, 2004, while one customer accounted for 39% of our revenue for the twelve months ended December 31, 2003. A substantial reduction in revenue from any of our significant customers would adversely affect our business unless we were able to replace the revenue received from those customers. As a result of this concentration of revenue from a limited number of customers, our revenue has experienced wide fluctuations, and we may continue to experience wide fluctuations in the future. Many of our sales are not recurring sales, and quarterly and annual sales levels could fluctuate and sales in any period may not be indicative of sales in future periods.

Doing business with the United States government entails many risks that could adversely affect us by decreasing the profitability of government contracts we are able to obtain and interfering with our ability to obtain future government contracts.

Government sales accounted for 72% of our revenue for the twelve months ended December 31, 2004. Our sales to the U.S. government are subject to risks that include:

In addition, the government may be in a position to obtain greater rights with respect to our intellectual property than we would grant to other entities. Government agencies also have the power, based on financial difficulties or investigations of their contractors, to deem contractors unsuitable for new contract awards. Because we will engage in the government contracting business, we will be subject to audits and may be subject to investigation by governmental entities. Failure to comply with the terms of any government contracts could result in substantial civil and criminal fines and penalties, as well as suspension from future government

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contracts for a significant period of time, any of which could adversely affect our business by requiring us to spend money to pay the fines and penalties and prohibiting us from earning revenues from government contracts during the suspension period.

Furthermore, government programs can experience delays or cancellation of funding, which can be unpredictable. For example, the U.S. military’s involvement in Iraq has caused the diversion of some Department of Defense funding away from certain projects in which we participate, thereby delaying orders under certain of our government contracts. This makes it difficult to forecast our revenues on a quarter-by-quarter basis.

Our efforts to expand our international operations are subject to a number of risks, including our potential inability to obtain government authorization regarding exports of our products, any of which could adversely affect our future international sales.

We must comply with U.S. laws regulating the export of our products in order to ship internationally. In some cases, authorization from the U.S. government may be needed in order to export our products. The export regimes applicable to our business are subject to frequent changes, as are the governing policies. Although we have obtained approvals to export certain of our products, we cannot assure you that such authorizations to export will be available to us or for our products in the future. If we cannot obtain the required government approvals under these regulations, we may not be able to sell products abroad or make products available for sale internationally.

Additionally, our international operations could be subject to a number of risks, any of which could adversely affect our future international sales, including:

If third parties, on whom we partly depend for our product distribution, do not promote our products, our ability to generate revenue may be limited and our business and financial condition could suffer.

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

The lengthy and variable sales cycle of some of our products makes it difficult to predict operating results.

Certain of our products have lengthy sales cycles while customers complete in-depth evaluations of the products and receive approvals for purchase. In addition, new product introduction often centers on key trade shows and failure to deliver a product prior to such an event can seriously delay introduction of a product. As a result of the lengthy sales cycles, we may incur substantial expenses before we earn associated revenues because a significant portion of our operating expenses is relatively fixed and based on expected revenues. The lengthy sales cycles make forecasting the volume and timing of orders difficult. In addition, the delays inherent in lengthy sales cycles raise additional risks that customers may cancel or change their minds. If customer cancellations or product delays occur, we could lose anticipated sales.

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Our failure to maintain the proprietary nature of our technology and intellectual property could adversely affect our business, operating results, financial condition and stock price and our ability to compete effectively.

We principally rely upon patent, trademark, copyright, trade secret and contract law to establish and protect our proprietary rights. There is a risk that claims allowed on any patents or trademarks we hold may not be broad enough to protect our technology. In addition, our patents or trademarks may be challenged, invalidated or circumvented, and we cannot be certain that the rights granted thereunder will provide competitive advantages to us. Further, because we do business with the government, we may already have granted, or we may in the future have to grant, greater rights with respect to our intellectual property than we would grant to other entities. Moreover, any current or future issued or licensed patents, or trademarks, or existing or future trade secrets or know-how, may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of our already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others. In addition, there is a risk that others may independently develop proprietary technologies and processes that are the same as, or substantially equivalent or superior to ours, or become available in the market at a lower price. There is a risk that we have infringed or in the future will infringe patents or trademarks owned by others, that we will need to acquire licenses under patents or trademarks belonging to others for technology potentially useful or necessary to us, and that licenses will not be available to us on acceptable terms, if at all.

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

We may be unable to keep pace with rapid technological change in the information security industry, which could lead to an increase in our costs, a loss of customers or a delay in market acceptance of our products.

Software design and the biometric and smart card technology industry are characterized by rapid development and technological improvements. Because of these changes, our success will depend in part on our ability to keep pace with a changing marketplace, integrate new technology into our software and hardware 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 and adversely affect how we will do business.

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

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

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Our reliance on third party technologies for some specific technology elements of our products and our reliance on third parties for manufacturing may delay product launch, impair our ability to develop and deliver products or hurt our ability to compete in the market.

Our ability to license new technologies from third parties will be critical to our ability to offer a complete suite of products that meets customer needs and technological requirements. Some of our licenses do not run for the full duration of the third party’s patent for the licensed technology. We may not be able to renew our existing licenses on favorable terms, or at all. If we lose the rights to a patented technology, we may need to stop selling or may need to redesign our products that incorporate that technology, and we may lose a competitive advantage. In addition, competitors could obtain licenses for technologies for which we are unable to obtain licenses, and third parties may develop or enable others to develop a similar solution to digital communication security issues, either of which events could erode our market share. Also, dependence on the patent protection of third parties may not afford us any control over the protection of the technologies upon which we rely. If the patent protection of any of these third parties were compromised, our ability to compete in the market also would be impaired.

We face intense competition and pricing pressures from a number of sources, which may reduce our average selling prices and gross margins.

The markets for our products and services are intensely competitive. As a result, we face significant competition from a number of sources. We may be unable to compete successfully because many of our competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than we have. In addition, there are several smaller and start-up companies with which we compete from time to time. We expect competition to increase as a result of consolidation in the information security technology industry.

The average selling prices for our products may decline as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. The pricing of products depends on the specific features and functions of the products, purchase volumes and the level of sales and service support required. As we experience pricing pressure, the average selling prices and gross margins for our products may decrease over product lifecycles. These same competitive pressures may require us to write down the carrying value of any inventory on hand, which would adversely affect our operating results and adversely affect our earnings per share.

Any compromise of public key infrastructure, or PKI, technology would adversely affect our business by reducing or eliminating demand for many of our information security products.

As a result of our merger with SSP-Litronic, many of our products are now based on PKI technology, which is the standard technology for securing Internet-based commerce and communications. The security afforded by this technology depends on the integrity of a user’s private key, which depends in part on the application of algorithms, or advanced mathematical factoring equations. The occurrence of any of the following could result in a decline in demand for our information security products:

A security breach of our internal systems or those of our customers due to computer hackers or cyber terrorists could harm our business by adversely affecting the market’s perception of our products and services.

Since we provide security for Internet and other digital communication networks, we may become a target for attacks by computer hackers. The ripple effects throughout the economy of terrorist threats and attacks and military activities may have a prolonged effect on our potential commercial customers, or on their ability to

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purchase our products and services. Additionally, because we provide security products to the United States government, we may be targeted by cyber terrorist groups for activities threatened against United States-based targets.

We will not succeed unless the marketplace is confident that we provide effective security protection for Internet and other digital communication networks. Networks protected by our products may be vulnerable to electronic break-ins. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. Although we have never experienced any act of sabotage or unauthorized access by a third party of our internal network to date, if an actual or perceived breach of security for Internet and other digital communication networks occurs in our internal systems or those of our end-user customers, it could adversely affect the market’s perception of our products and services. This could cause us to lose customers, resellers, alliance partners or other business partners.

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

Our financial and operating results have fluctuated in the past and our financial and operating results could fluctuate in the future from quarter to quarter for the following reasons:

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

We may be exposed to significant liability for actual or perceived failure to provide required products or services.

Products as complex as those we offer may contain undetected errors or may fail when first introduced or when new versions are released. Despite our product testing efforts and testing by current and potential customers, it is possible that errors will be found in new products or enhancements after commencement of

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commercial shipments. The occurrence of product defects or errors could result in adverse publicity, delay in product introduction, diversion of resources to remedy defects, loss of or a delay in market acceptance, or claims by customers against us, or could cause us to incur additional costs, any of which could adversely affect our business. Because our customers rely on our products for critical security applications, we may be exposed to claims for damages allegedly caused to an enterprise as a result of an actual or perceived failure of our products. An actual or perceived breach of enterprise network or information security systems of one of our customers, regardless of whether the breach is attributable to our products or solutions, could adversely affect our business reputation. Furthermore, our failure or inability to meet a customer’s expectations in the performance of our services, or to do so in the time frame required by the customer, regardless of our responsibility for the failure, could result in a claim for substantial damages against us by the customer, discourage customers from engaging us for these services, and damage our business reputation.

Delays in deliveries from suppliers or defects in goods or components supplied by vendors could cause our revenues and gross margins to decline.

Our Litronic business relies on a limited number of vendors for certain components for the products it is developing. Any undetected flaws in components supplied by its vendors could lead to unanticipated costs to repair or replace these parts. Litronic currently purchases some of its components from a single supplier, which presents a risk that the components may not be available in the future on commercially reasonable terms, or at all. For example, Atmel Corporation has completed the masks for production of specially designed Forté and jForté microprocessors for which Litronic developed the Forté and jForté operating systems. Commercial acceptance of the Forté and jForté microprocessors will depend on continued development of applications to service customer requirements. Any inability to receive or any delay in receiving adequate supplies of the Forté and jForté microprocessors, whether as a result of delays in development of applications or otherwise, would adversely affect our ability to sell the Forté and jForté PKI cards.

We do not anticipate maintaining a supply agreement with Atmel Corporation for the Forté and jForté microprocessors. If Atmel Corporation were unable to deliver the Forté and jForté microprocessors for a lengthy period of time or were to terminate its relationship with us, we would be unable to produce the Forté and jForté PKI cards until we could design a replacement computer chip for the Forté and jForté microprocessors. This could take substantial time and resources to complete, resulting in delays or reductions in product shipments that could adversely affect our business by requiring us to expend resources while preventing us from selling the Forté and jForté PKI cards.

Government regulations affecting security of Internet and other digital communication networks could limit the market for our products and services.

The United States government and foreign governments have imposed controls, export license requirements and restrictions on the import or export of some technologies, including encryption technology. Any additional governmental regulation of imports or exports or failure to obtain required export approval of encryption technologies could delay or prevent the acceptance and use of encryption products and public networks for secure communications and could limit the market for our products and services. In addition, some foreign competitors are subject to less rigorous controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than us in the United States and in international security markets for Internet and other digital communication networks. In addition, governmental agencies such as the Federal Communications Commission periodically issue regulations governing the conduct of business in telecommunications markets that may adversely affect the telecommunications industry and us.

Litronic has outsourced a portion of our commercial software development to India, which could prove to be unprofitable due to risks inherent in international business activities.

Litronic has outsourced portions of its commercial software development activities to India in an effort to reduce operating expenses. We are subject to a number of risks associated with international business activities

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that could adversely affect any operations we may develop in India and could slow our growth. These risks generally include, among others:

Any of these risks could adversely affect our business and results of operations.

Conflicts involving India could adversely affect any operations we may establish in India, which could interfere with our ability to conduct any or all of our other operations.

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

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

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

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

Provisions in our certificate of incorporation may prevent or adversely affect the value of a takeover of our company even if a takeover would be beneficial to stockholders.

Our certificate of incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, the issuance of which could adversely affect our common stockholders. We can issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as our board of directors determines. Specifically, the potential issuance of preferred stock may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, voting control of our company even if the acquisition would benefit stockholders.

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

We have Canadian operations whose expenses are incurred in its local currency, the Canadian dollar. As exchange rates vary, transaction gains or losses will be incurred and may vary from expectations and adversely impact overall profitability. If in 2004 and 2003, the US dollar uniformly changed in strength by 10% relative to the currency of the foreign operations, our operating results would likely not be significantly affected.

We have a current liability related to warrants and the value is dependent upon the market price of our common stock. The value of these warrants is estimated using the Black-Scholes model, which incorporates the market price of our common stock as a significant variable. The value of these warrants was $937,000 at December 31, 2004. As long as the warrants are outstanding, this value will fluctuate each reporting period to reflect the change in fair value of these warrants from period to period. The value will increase if the stock price and volatility increase, and will decrease through the passage of time as the term of the warrants gets shorter, or if the stock price and volatility decrease. However, the value cannot fall below $765,000, the cash redemption value of the warrants. The fluctuation in value will be in the form of a gain or a loss, depending upon the estimated valuation, and will be reflected in the condensed consolidated statement of operations. If, as of December 31, 2004, the closing price of our common stock would have ended 10% higher or lower than the actual close price, our net loss would have been either increased or decreased by approximately $50,000, respectively. We did not have these warrants classified as liabilities in 2003.

See Index to Financial Statements.

None.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.

There have been no changes in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

On March 11, 2005, we signed a new one-year lease for the 4,484 square feet of office space that we occupy in Charleston, South Carolina, with South Carolina Research Authority. The lease term is one year and is set to expire on February 25, 2006. Total rent for this initial lease term is $92,678.

On March 29, 2005, our board of directors, upon recommendation of the compensation committee, modified the terms of the repurchase right with respect to 301,928 shares of our common stock held by Glenn L.

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Argenbright. As modified, in the event that Mr. Argenbright’s service is terminated for cause before June 23, 2007, any unvested shares are subject to a repurchase right and may be reacquired by us.

On March 29, 2005, our board of directors, upon recommendation of the compensation committee, revised the compensation structure to be paid to members of our board of directors and committees of the board of directors who are not employees, effective as of March 29, 2005, as follows:

PART III

Information concerning our directors and officers is included in the definitive proxy statement for our 2005 annual meeting of stockholders, which is incorporated herein by reference.

Information concerning our executives’ compensation is included in the definitive proxy statement for our 2005 annual meeting of stockholders, which is incorporated herein by reference.

Information required to be disclosed hereunder is included in the definitive proxy statement for our 2005 annual meeting of stockholders, which is incorporated herein by reference.

Information required to be disclosed hereunder is included in the definitive proxy statement for our 2005 annual meeting of stockholders, which is incorporated herein by reference.

Information required to be disclosed hereunder is included in the definitive proxy statement for our 2005 annual meeting of stockholders, which is incorporated herein by reference.

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PART IV

The financial statements filed as a part of this report are listed in the “Index to Financial Statements.”

All schedules have been omitted because they are either not applicable, not material or the required information has been given in the financial statements or related notes.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: March 30, 2005

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Glenn L. Argenbright his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of registrant and in the capacities and on the dates indicated.