Attached files

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EX-3.1 - 090630_IMX_FORM 10K_EX 3.1 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex3-1.htm
EX-23.1 - 090630_IMX_FORM 10K_EX 23.1 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex23-1.htm
EX-31.2 - 090630_IMX_FORM 10K_EX 31.2 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex31-2.htm
EX-31.1 - 090630_IMX_FORM 10K_EX 31.1 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex31-1.htm
EX-32.1 - 090630_IMX_FORM 10K_EX 32.1 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex32-1.htm
EX-32.2 - 090630_IMX_FORM 10K_EX 32.2 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex32-2.htm
EX-21 - 090630_IMX_FORM 10K_EX 21 - SECURE POINT TECHNOLOGIES INCimxform10k090630_ex21.htm


U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
(Mark One)
   
x
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
   
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 2009
o
 
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
   
SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to

 
Commission File No. 001-14949
 
Implant Sciences Corporation
(Name of small business issuer in its charter)
 
Massachusetts
(State or other jurisdiction of
incorporation or organization)
04-2837126
(I.R.S. Employer Identification No.)
600 Research Drive, Wilmington, MA
 (Address of principal executive offices)
01887
(Zip Code)

 
Issuer’s telephone number (978) 752-1700
 
Securities registered under Section 12(b) of the Exchange Act: None
 
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.10 par value per share
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes q  No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.Yes q  No x
 
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 q
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes x  No q
 
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.q
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company in Rule 12b-2 of the Act (Check one):
 
q  Large Accelerated Filer                                                                                                           q  Accelerated Filer
 
q  Non-accelerated Filer (do not check if a smaller reporting company)                                                                                                                                x  Smaller reporting company
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes q  No x
 
As of October 6, 2009, 15,424,195 shares of the registrant’s Common Stock were outstanding.  As of December 31, 2008, the last business day of the registrant’s most recent completed second quarter, the aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant (without admitting that any person whose shares are not included in such calculation is an affiliate) was $2,680,000 based on the last sale price as reported by the American Stock Exchange on such date.
 

 
 

 
 
 
The Proxy Statement of the registrant to be filed on or before October 28, 2009 is incorporated by reference to Part III herein.

 
 

 

FORM 10-K
FOR THE YEAR ENDED JUNE 30, 2009
INDEX

       
Item 1.
 
Description of Business
 
3
Item 1A.
 
Risk Factors
 
11
Item 1B.
 
Unresolved Staff Comments
 
20
Item 2.
 
Description of Properties
 
20
Item 3.
 
Legal Proceedings
 
20
Item 4.
 
Submission of Matters to a Vote of Security Holders
 
20
PART II
       
Item 5.
 
Market for Registrant’s Common Equity, Related Stockholder Matters
   and Issuer Purchases of Equity Securities
 
21
Item 6.
 
Selected Consolidated Financial Data
 
22
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
23
Item 8.
 
Financial Statements and Supplementary Data
 
34
Item 9.
 
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
 
34
Item 9A(T).
 
Controls and Procedures
 
34
Item 9B.
 
Other Information
 
35
PART III
       
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
36
Item 11.
 
Executive Compensation
 
36
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management
   and Related Stockholder Matters
 
36
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
 
36
Item 14.
 
Principal Accounting Fees and Services
 
36
PART IV
       
         
Item 15.
 
Exhibits, Financial Statement Schedules
 
37
   
Index to Financial Statements
 
F-1
 

 

 
2

 

 
Business
 
 
Cautionary Note Regarding Forward Looking Statements
 
This Annual Report on Form 10-K contains certain statements that are “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Litigation Reform Act”).  These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.
 
The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.
 
In accordance with the provisions of the Litigation Reform Act, we are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Annual Report on Form 10-K.  Important factors that could cause actual results to differ from our predictions include those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business.”  Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.  We urge readers to review carefully the risk factors described in this Annual Report and in the other documents that we file with the Securities and Exchange Commission.  You can read these documents at www.sec.gov.
 
Where we say “we,” “us,” “our,” “Company” or “Implant Sciences” we mean Implant Sciences Corporation and its subsidiaries.
 
 
General
 
Overview
 
We develop, manufacture and sell sophisticated sensors and systems for the Security, Safety and Defense (“SS&D”) industries.  A variety of technologies are currently used worldwide in security and inspection applications.  In broad terms, the technologies focus on detection in two major categories: (i) the detection of “bulk” contraband, which includes materials that would be visible to the eye, such as weapons, explosives, narcotics and chemical agents; and (ii) the detection of “trace” amounts of contraband, which includes trace particles or vapors of explosives, narcotics and chemical agents.  Technologies used in the detection of “bulk” materials include computed tomography, transmission and backscatter x-ray, metal detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and neutron analysis.  Trace detection techniques used include mass spectrometry, gas chromatography, chemical luminescence, or ion mobility spectrometry.
 
We have developed proprietary technologies used in explosives trace detection (“ETD”) applications and market and sell handheld and bench-top ETD systems that use our proprietary ETD technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, vehicles, other objects and people for the detection of trace amounts of explosives.
 

 
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History
 
Since our incorporation in August 1984, we have operated as a multi-faceted company engaging in the development of ion-based technologies and providing commercial services and products to the semiconductor, medical device and security industries.  As further discussed in the Business Strategy section below, however, we have recently divested our semiconductor and medical business activities in order to focus on our security business.
 
Semiconductor Business Unit
 
Our business began as a result of the development of our proprietary ion-beam technology and application of this technology in services to the semiconductor industry.  At the outset, our initial business was to provide ion implantation services to the semiconductor industry for surface modification of silicon wafers.  Our services were provided to semiconductor companies, universities and research facilities as an outsource provider of these ion implantation services.  These services were performed at our Massachusetts facility, where we maintained and operated several ion implanters.
 
In October 2004, we acquired Core Systems Inc., a privately-held semiconductor wafer processing company located in Sunnyvale, California for $7,486,000 in cash and common stock of the Company.  In February 2008, our Board approved a formal plan to sell Core as part of our strategic initiative to focus on our security business.  As of June 30, 2009, the assets and liabilities of Core have been recorded on our balance sheet as held-for-sale.  For the years ended June 30, 2009 and 2008, the operations of Core have been recorded in our statements of operations as discontinued operations.
 
In March 2005, we acquired Accurel Systems International Corporation, a privately-held semiconductor wafer analytical services company located in Sunnyvale, California for $12,176,000 in cash and common stock of the Company.  In March 2007, our Board approved a formal plan to sell Accurel as part of our strategic initiative to focus on our security business.  In May 2007, we completed the sale of Accurel to Evans Analytical Group LLC in exchange for cash of $12,705,000, of which $1,000,000 was placed in escrow.
 
In February 2008, Evans filed suit requesting rescission of the acquisition agreement, plus damages, based on claims of misrepresentation and fraud.  In March 2008, Evans filed a claims notice with the escrow agent prohibiting release of any portion of the escrowed funds pending resolution of the lawsuit.  On March 27, 2009, we announced the settlement of this litigation and the mutual release by the Company and Evans of all claims related to the sale of Accurel.  In settling this litigation, we agreed to pay Evans damages in the amount of approximately $5,700,000 by (i) agreeing to release to Evans approximately $700,000 that had been held in escrow since the time of the closing and (ii) issuing to Evans 1,000,000 shares of Series E Convertible Preferred Stock having an aggregate liquidation preference of $5,000,000.  Please see more detailed discussions of the Evans matter in Note 24 to our consolidated financial statements.
 
Medical Business Unit
 
We also used our ion beam technology to develop ion implantation and thin film coatings applications for medical devices.  As a result of these technologic advancements, which were in part funded by government research grants and awards, we were able expand our business and provide services and products to the medical industry.  The primary medical related businesses in which we engaged were (i) providing services to medical device companies for surface modification of implantable devices, (ii) the development of brachytherapy products, and (iii) the manufacture and sales of our proprietary radioactive seeds for the treatment of prostate cancer.
 
We provided ion implantation services to modify orthopedic joint implant surfaces, resulting in reduced polyethylene wear and increased implant life, through the second quarter of fiscal 2007.  In the second quarter of fiscal 2007, the customer discontinued its product line using our ion implantation services.  Using similar technology, we developed applications for coatings of cardiovascular devices, such as coronary stents.  In May 1999, we received Food and Drug Administration 510(k) clearance to market our radioactive seed for the treatment of prostate cancer.  We began commercial sales of our radioactive seed in fiscal 2001.
 
 
 
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In further support of our strategic initiative to focus on our security business, in June 2007, we sold certain of the assets related to our brachytherapy products and divested our prostate seed and medical software businesses.  In March 2008, we informed our medical coatings customers of our intention to discontinue coating operations by the end of the 2008 calendar year. During the year ended June 30, 2009 we sold certain assets associated with our medical coatings and ion implantation businesses.  As of June 30, 2009and 2008, the assets and liabilities of the Medical Business Unit have been recorded on our balance sheet as held-for-sale.  For the years ended June 30, 2009 and 2008, the operations of the Medical Business Unit have been recorded in our statements of operations as discontinued operations.
 
Security Business Unit
 
Since May 1999, we have been performing research to improve ETD technology, and development of ETD products that can be used for detection of trace amounts of explosives.  At present, we have developed both portable and benchtop systems, which have been marketed and sold both domestically and internationally.  In order to reduce manufacturing costs and be responsive to large quantity orders, we use a contract manufacturer.  As we continue to sell and deliver our security products, we work both independently and in conjunction with various government agencies to develop the next generation of trace explosives detectors and to identify new applications for our proprietary technology.
 
In April 2008, we acquired all of the capital stock of Ion Metrics, Inc., located in San Diego, California.  Ion Metrics develops mass sensor systems to detect and analyze chemical compounds such as explosives, chemical warfare agents, narcotics, and toxic industrial chemicals for the homeland defense, forensic, environmental, and safety/security markets.  Ion Metrics miniaturized devices and system designs provide high performance and reliability in combination with low manufacturing costs. Ion Metrics operating results have been included in our  statement of operations commencing on April 10, 2008.  Please refer to Note 19 to our consolidated financial statements for further information relating to the acquisition of Ion Metrics.
 
Industry Overview
 
We believe that the market for security and inspection products will continue to be affected by the threat of terrorist incidents and by new government mandates and appropriations for security and inspection products in the United States and internationally.
 
The September 11, 2001 terrorist attacks on the World Trade Center and the Pentagon using hijacked airliners led to nationwide shifts in transportation and facilities security policies.  Shortly following these attacks, Congress passed the Aviation and Transportation Security Act and integrated many U.S. security-related agencies, including the Federal Aviation Administration, into the U.S. Department of Homeland Security (“DHS”).  Under its directive from Congress, the DHS has undertaken numerous initiatives to prevent terrorists from entering the country, hijacking airliners, and obtaining and trafficking in weapons of mass destruction and their components, to secure sensitive U.S. technologies and to identify and screen high-risk cargo containers before they are loaded onto vessels destined for the U.S., among others.  These initiatives, more fully described in the Strategic Border Initiative, the Customs-Trade Partnership Against Terrorism and the U.S. Customs and Border Protection Container Security Initiative, have resulted in an increased demand for security and inspection products both in the United States and other nations.
 
These government-sponsored initiatives have also stimulated security programs in other areas of the world as the U.S initiatives call on other nations to bolster their port security strategies, including acquiring or improving their security and inspection equipment.  As a result, the international market for non-intrusive inspection equipment continues to expand as countries that ship goods directly to the United States are required to improve their security infrastructure.
 
The U.S. Congress recently passed legislation that mandated the inspection of international maritime cargo destined for the United States, domestic civil aviation cargo, and for radiological and nuclear threats in cargo entering the United States.  In addition, following recommendations outlined in the “9/11 Commission Report,” issued by the National Commission on Terrorist Attacks Upon the United States, DHS will require the screening of all cargo carried on passenger airlines by 2010.
 
 
 
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Furthermore, DHS’s Science and Technology Directorate has supported the development of new security inspection technologies and products.  We participate in a number of such research and development efforts, including projects to develop new technologies for improving the accuracy of detection of trace amounts of explosives, narcotics and chemical agents; and improved sampling techniques for the application of trace detection to aviation and cargo screening.  The Science and Technology Directorate has also initiated programs for the development of technologies capable of protecting highways, railways and waterways from terrorist attack.
 
In addition, the U.S. Department of Defense has also begun to invest more heavily in technologies and services that screen would-be attackers before they are able to harm U.S. and allied forces.
 
Similar initiatives by international organizations such as the European Union have also resulted in a growing worldwide demand for airline, cargo, port and border inspection technologies.  For example, the European Union is expected to issue uniform performance standards for people, cargo, mail and parcel and hold baggage screening systems as well as new directives related specifically to maritime security.  We anticipate that the promulgation of these new standards will establish performance baselines against which we will be able to direct certain of our research and development spending and market our products to customers located in the European Union.
 
As a result of these and other changes, sales of our security products have improved.  Major projects recently installed or currently underway include system installations at airports, ports and border crossings, government and military facilities and other locations, primarily in the international marketplace.  We anticipate that there may be growing demand from governments and commercial enterprises for increasingly sophisticated screening solutions in the future.
 
 
Technology
 
Since May 1999, we have performed research and development in the area of explosives trace detection (“ETD”).  We have developed several proprietary technologies in key areas of ETD which we believe improve the harvesting, collection and detection of trace particles and vapors of explosives substances.  In addition, we are continuing our development efforts to adapt this technology for the detection of narcotics and other chemical agents.  Our intellectual property portfolio contains 17 security-related patents and patents pending:  eight issued United States patents, eight United States patents pending, and one licensed patent.  We believe that our portfolio of patents and patents pending provides extensive protection in sample harvesting, sample detection and collection.  A key to our past and future success is our ability to innovate and offer differentiation in these areas.
 
We compartmentalize ETD into four major areas: i) harvest, ii) transport, iii) analysis, and iv) reporting.  These technologies are discussed in detail in the following sections.
 
Harvest - Aerosol Particle Release
 
Tiny particles of explosives and narcotics are “sticky” and may adhere to surfaces.  Particles could be transferred if an object, such as fingers or clothing, comes in contact with a particle.  We have demonstrated that a person touching an explosives material can transfer explosives particles to numerous other objects leaving a trail of particles behind.
 
Our competitors commonly swipe a surface to be interrogated for explosives particles with cloth or paper.  We believe that this “contact” methodology provides an effective but inconsistent method of harvesting sample as compared to an automated, non-contact collection of the trace sample.  We have developed a method, which we believe to be more efficient, using an aerosol of fine dry ice particles.  This technique, which is surprisingly inexpensive to use, could increase collection sensitivity substantially and eliminate direct contact with a surface.  Our aerosol technology functions as a very gentle version of “sandblasting” and is safe for almost all surfaces.  Since dry ice sublimes into gas, no residue is left behind, and the aerosol may be used indoors.  We have two patents pending on this methodology.
 
Transport
 
Vortex Sampling
 
Once the trace particle has been released from a surface, it has to be transported to a collection point.  Vortex sampling was the first of our sampling innovations.  We have three patents issued and two patents pending in the area of vortex sampling methodology.
 
Our vortex is similar to a miniature tornado.  A hollow spinning cylinder of air flowing outward surrounds and protects an inner vacuum flowing inward.  It is this vortex sampling technology that enables particles released within the vortex, or blown into it, to be transported with high efficiency to a collection filter.
 
 
 
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Long-Life Sample Trap
 
Once particles have been liberated from the surface being interrogated for the presence of trace amounts of explosives, the particles are transported to our innovative trapping filter, which is an ultra-fine stainless steel woven mesh.  The trapping filter has a long usable life, which could span several years, requiring inexpensive, routine maintenance.  We believe the trapping filter provides an innovative solution to the more costly consumables used by several of our competitors engaged in ETD using contact methodology for sampling and detection.
 
Analysis
 
Flash Desorption
 
Flash desorption is an optical method for converting the chemistry of a particle, such as the chemicals composing explosives or narcotics, into a vapor that can be subjected to analyses for the discrimination of chemical properties.  In conventional trace chemical detectors, a sample is slowly warmed in an oven producing diluted vapor with low chemical concentrations.  Optical flash vaporization heats a sample within microseconds, producing a high sample concentration for detection.
 
This method is not appropriate with conventional sample collection methods, such as paper wipes, because the paper is white, and the light from the bright flash reflects off, producing little heating.  However, by using our trapping filter, a very fast detection response can be achieved without loss in sensitivity.  We have two patents issued and one patent pending in the area of flash desorption methodology.  The first product under development to take advantage of our flash desorption technology is our air cargo screening system described under “Products” below.
 
Photonic Ionization
 
The conventional method of ionizing vapors for analysis is to use a radioactive beta source.  While ETD equipment using radioactive sources are simple, effective, and need no electricity in the ionization process, there are important issues involving safety, licensing, regular verification of source integrity, and disposal.  Some markets, such as Japan and Australia, are known to reject instruments with radioactive sources.  We believe that most markets would prefer not to have to address the issues surrounding ETD equipment with radioactive sources.
 
We have developed two types of photonic, non-radioactive ion sources for our instruments for applications requiring either the ionization of positive ions or negative ions.  These ion sources may be found individually or in combination within our products, depending on the application for which the ETD equipment is to be used.  We have two patents pending in the area of photonic ionization.
 
Reporting
 
Reporting is that portion of the cycle that displays and stores information generated during the analysis phase.  It is this information a system operator sees and indicates if an alarm condition exists or if the test is negative.  Information can be displayed in both graphical and tabular formats.  The reporting also indicates when the instrument is ready for the next sample as well as displaying built-in system diagnostics.
 
 
Intellectual Property
 
It is our policy to protect our proprietary position by, among other methods, filing United States patent applications.  Our intellectual portfolio contains seventeen security-related patents and patents pending:  eight patents have been issued and are active, eight patents are pending and we license one patent.  The eight issued patents expire in the years 2022 through 2027.  We believe our patent portfolio provides extensive protection.  We also rely on unpatented proprietary technology, trade secrets and know how.
 
 
Manufacturing
 
We manufacture our security products primarily through a sole source contract manufacturer located locally in Worcester, Massachusetts.  We believe our strategy to outsource manufacturing reduces manufacturing costs, improve scheduling flexibility, and allows us to focus our internal resources and management on product development, marketing, sales and distribution.  We also maintain an internal production group at our corporate headquarters in Wilmington, Massachusetts responsible for pre-production logistics, oversight of contract manufacturing, quality control and inventory management.
 
 
 
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Products
 
We have developed several explosives detection systems designed for use in aviation and transportation security, high threat facilities and infrastructure, military installations, customs and border protection, and mail and cargo screening.  The systems use our proprietary Quantum SnifferTM technologies, including photon-based, non-radioactive ion source in combination with ion mobility spectrometry, a classic detection tool sensitive to the unique speeds with which ions of various substances move through the air (“IMS”) to electronically detect minute quantities of explosives vapor and particles.
 
Current Products
 
Quantum SnifferTM QS-H150 Portable Explosives Detector
 
The Quantum Sniffer QS-H150 Portable Explosives Detector employs a patented vortex collector for the simultaneous detection of explosives particulates and vapors with or without physical contact and in real-time.  We believe that our advanced QS-H150 is more sensitive than other detection devices.  The QS-HS150 can detect vapors and nanogram quantities of explosives particulates for most explosives substances considered to be threats.  Such substances include, but are not limited to, military and commercial explosives, improvised and homemade explosives, and propellants and taggants.
 
The QS-H150 has automatic and continuous self-calibration.  It monitors its environment, senses changes that would affect its accuracy, and re-calibrates accordingly.  The system requires no user intervention and no calibration consumables.  The detection process begins with the collection of a sample with our patented vortex collector.  After collection, the sample is ionized photonically and analyzed using IMS technology.  The presence of a threat substance is indicated by a visible and audible alarm.  The threat substance is then identified and displayed on the integrated LCD screen.  Optionally, and at any time, a monitor and keyboard may be connected for convenient access to spectrogram display and analysis tools, administrative tools, and diagnostics.
 
When detecting a threat substance, the QS-H150 rapidly alarms.  This real-time detection limits equipment contamination and allows for fast clear-down.  Operation and maintenance are cost-effective.  Since there is no requirement for dopants, calibration consumables or verification consumables, the overall cost of consumables are minimized.  Routine maintenance consists only of care and cleaning using common supplies, and desiccant replacement as required.  There is no radioactive material used in the QS-H150, so there are no associated certifications, licenses, inspections, or end-of-life disposal issues.
 
Quantum SnifferTM QS-B200 Benchtop Explosives Detector
 
The QS-B200 Benchtop Explosives Detector uses dual IMS with non radioactive ionization for the detection and identification of a wide range of military, commercial, and improvised explosives.  The QS-B200 has automatic and continuous self-calibration.  It monitors its environment, senses changes that would affect its accuracy, and re-calibrates accordingly.  For detection, the sample is collected with a standard trap, ionized, and analyzed via IMS.  The presence of a threat is indicated by a visible and audible alarm, and the substance is identified and displayed on the integrated touch screen display.  Users may save data locally, print via a built-in thermal printer, or send data through standard interfaces such as USB, LAN, etc.  Multi-level password-protected data security is standard.  We believe that the operation and maintenance of the QS-B200 are extremely cost-effective. Routine maintenance consists only of care and cleaning using common supplies, and desiccant replacement as required.  No radioactive material is used in the QS-B200, so there are no associated certifications, licenses, inspections, or end-of-life disposal issues.
 
Products Under Development
 
Quantum SnifferTM QS-H300 Air Cargo Screening System
 
With the assistance of funding from DHS, we have developed a hand sampler detector that utilizes our proprietary jetted vortex collector for non-contact collection of trace particulate materials.  We believe the hand sampler, which will be a compact, lightweight device, could significantly improve explosives detection capabilities while also being very user friendly.  Our non-contact method could prove to be more effective than traditional contact sample collection methods, and at a much lower cost to users.  This improved sampling process has applicability for use in detecting trace amounts of explosives found on a wide range of objects such as carry-on luggage, parcels, packages and cargo.  In addition, multiple handheld sampling units could be systematically deployed in concert with a centralized trace explosives detection system to improve efficiency and increase the number of articles screened.  We believe this product could usher in a new way of thinking about how cargo and
 
 
 
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other items can be properly examined in a cost-effective and user friendly manner.  We introduced the QS-HS 300 at the AVSEC 2008 exhibition in Seoul, South Korea in November 2008.
 
Miniature Mass Spectrometer
 
We initially developed our own proprietary ion mobility spectrometer (“IMS”).   We believe that as market demand grows for greater precision of substance identification and the list of substances to be detected increases, more advanced detectors will be required.
 
Our acquisition of Ion Metrics enabled us to obtain miniaturized quadrupole mass spectrometry (“QMS”) detector technology.  The QMS detector is roughly the size of an AA battery and has low manufacturing costs.  When used in conjunction with an IMS, the QMS detector senses the molecular weight of the chemical species resulting in an “orthogonal” detection method in which a more fundamental characteristic of a substance is measured.  We believe that, because it is unlikely that two substances would share the same mass and the same ion mobility in air, QMS detector technology improves the accuracy of detection and minimizes false alarms.  We are currently developing interfaces for integrating the QMS detector into our future products.

Hyphenated Detectors
 

Depending on the application and the number of “interfering” background chemicals, it may be necessary to incorporate additional “orthogonal” detection methods.  The combination of multiple sensors is commonly known as hyphenated systems.  By measuring different properties of the same species, interferents are separated from target species for a deterministic detection and identification and have minimum rates of false alarms. The combination of these sensors in series is commonly known as employing “hyphenated” detection methods.  A hyphenated system is one in which a sequence of different types of detectors all must agree that an alarm has occurred before a valid alarm is declared.

We are currently developing hyphenated systems employing conventional ion mobility, differential mobility and mass spectrometry for the DHS.
 
We believe detection systems incorporating hyphenated detection methods could accelerate the expansion of our product line to more effectively address the needs of the security, safety and defense sector, as well as accelerate our entry into the narcotics, chemical warfare, biological warfare and toxic industrial chemical detection marketplaces.  Combining new technologies with our other innovative products could enhance our competitive position while improving sales volumes and product margins in the future. We expect hyphenated systems to appear in our future product offerings.
 
 
Marketing and Sales
 
We market and sell our products through direct sales and marketing staff located in the United States, in addition to an expansive global network of independent and specialized sales representatives and distributors.  This sales staff is supported by a sales organization located primarily in the United States, as well as a global network of independent distributors.
 
We have not experienced, and do not expect to experience, in any material respect, seasonality in sales of our products.
 
 
Contracts and Material Relationships
 
Government Contracts
 
Research and development contracts from the U.S. government must be won through a competitive proposal process which undergoes peer review.  We are in contact with the Department of Defense, DHS and other agencies at technical conferences to stay informed of the government's needs.  We believe our management and senior scientific staff have earned a strong reputation with these and other agencies. To date we have been awarded research and development contracts by the Department of Defense, the National Science Foundation, the National Aeronautics and Space Administration, the Environmental Protection Agency and the DHS.
 
 
Competition
 
In the trace explosives detection industry, General Electric (GE Security) and Smiths Detection are our two primary competitors.  These two companies also use ion mobility spectrometry; however, they use a radioactive 63Ni source to ionize the explosive molecules.  We believe our technology differs from the competition in that we do not have a radioactive ion source, we have lower operating costs, and can do “real time” detection.  We believe our patented technology provides our device with greater operating advantages and fewer regulatory restrictions.
 
 
 
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Research and Development
 
Our technical staff consists of 11 scientists and engineers, one of whom holds a Ph.D., and five of whom hold Masters degrees.  All of our existing and planned products rely on proprietary technologies developed in our research and development laboratories.  Our research and development efforts may be self-funded, funded by corporate partners or by awards under the Small Business Innovative Research and other programs of the U.S. government.  Under the Small Business Innovative Research program, we retain the right to patent any technology developed pursuant to the program, subject to the retention by the U.S. government of a royalty-free license to use the technology.  We have obtained over $20 million in U.S. government grants and contracts over the past 20 years.
 
We spent approximately $3,306,000 and $3,097,000 on internally funded research and development in the fiscal years ended June 30, 2009 and 2008, respectively.
 
 
Government Regulation and Environmental Compliance
 
From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the approval, manufacturing and marketing of security products.
 
Furthermore, our use, management, transportation, and disposal of certain chemicals and wastes are subject to regulation by several federal and state agencies depending on the nature of the chemical or waste material.  Certain toxic chemicals and products containing toxic chemicals require special reporting to the U.S. Environmental Protection Agency and/or its state counterparts. We are not aware of any specific environmental liabilities to which we are likely to be subject.  Our future operations may require additional approvals from federal and/or state environmental agencies, the cost and effects of which cannot be determined at this time.
 
 
Employees
 
As of June 30, 2009, we had 30 full-time employees at our Massachusetts facility and seven full-time employees in California.
 
None of these employees are covered by a collective bargaining agreement, and management considers its relations with its employees to be good.
 
Geographic Areas
 
Our revenues are derived from both domestic and international sales.  During the fiscal year ended June 30, 2009, foreign sales represented 82% of total revenue with one customer from China representing 48% of our revenue.  For the fiscal year ended June 30, 2008, foreign sales represented 78% of total revenue with one customer from China representing 55% of our revenue.
 

 
10

 

Risk Factors
 
An investment in our common stock involves a high degree of risk. Investors should carefully consider the following risk factors in evaluating our Company and our business.  If any of these risks, or other risks not presently known to us or that we currently believe are not significant, develops into an actual event, then our business, financial condition and results of operations could be adversely affected.  If that happens, the market price of our common stock could decline.
 
Risks Related to our Liquidity
 
We will require additional capital to fund operations and continue the development, commercialization and marketing of our product.  Our failure to raise capital could have a material adverse effect on our business.
 
Management continually evaluates plans to reduce its operating expenses, increase sales and increase its cash flow from operations.  Despite our current sales, expense and cash flow projections and the cash available from our line of credit with DMRJ Group LLC, we will require additional capital in the first quarter of fiscal 2010 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.
 
We will be required to repay our borrowings from DMRJ Group LLC  on December 10, 2009.
 
We will be required to repay all of our borrowings from DMRJ Group LLC on December 10, 2009.  Our obligations to DMRJ are secured by a security interest in substantially all of our assets.  As of June 30, 2009, the outstanding balance due to DMRJ under a senior secured promissory note was $4,600,000.  As of September 30, 2009, the outstanding balances due to DMRJ under that promissory note, a second secured promissory note and a revolving credit facility were $4,600,000, $1,000,000 and $1,833,000, respectively.  If we are unable to repay these amounts as required, refinance our obligations to DMRJ, or negotiate extensions of these obligations, DMRJ may seize our assets and we may be forced to curtail or discontinue operations entirely.
 
We are in default of certain financial covenants related to the senior secured promissory note issued to DMRJ Group LLC.  If we are unable to obtain a waiver from DMRJ, then DMRJ may declare the entire unpaid principal balances of all of our obligations to DMRJ, together with all interest accrued thereon, plus fees and expenses, due and payable.
 
As of March 31, 2009 and June 30, 2009, we were not in compliance with certain financial covenants in our senior secured convertible promissory note payable to DMRJ.  On July 16, 2009, DMRJ waived the March 31, 2009 event of noncompliance and waived any non-compliance with the relevant financial covenants from the date of that waiver until but not including September 4, 2009.  If we are unable to comply with the financial covenants to DMRJ in the future and if we are unable to obtain a waiver of any such noncompliance, DMRJ may declare the entire unpaid principal balance of our obligations to it, together with all interest accrued thereon, plus fees and expenses, due and payable.  Any such action on the part of DMRJ would have a material adverse effect on our liquidity and financial condition and could force us to curtail or discontinue all of our operations.  Our ability to comply with these covenants in the future depends on our ability to generate sufficient sales and to control our expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely.  Further, upon the occurrence of certain events of default under the instruments governing our borrowings from DMRJ,  we could be required to pay interest at a default rate equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance of our obligations.
 

 
11

 

 We have received a qualified audit opinion on our ability to continue as a going concern.
 
The audit report issued by our independent registered public accounting firm issued on our audited financial statements for the fiscal year ended June 30, 2009 contains a qualification regarding our ability to continue as a going concern.  This qualification indicates there is substantial doubt on the part of our independent registered public accounting firm as to our ability to continue as a going concern due to the risk that we may not have sufficient cash and liquid assets at June 30, 2009, to cover our operating capital requirements for the next twelve-month period and if sufficient cash cannot be obtained we would have to substantially alter our operations, or we may be forced to discontinue operations.  Such an opinion from our independent registered public accounting firm may limit our ability to access certain types of financing, or may prevent us from obtaining financing on acceptable terms.  There can be no assurance that our accounting firm will not qualify its opinion in the future.
 
Risks Related to Our Business
 
We have incurred substantial operating losses and we may never be profitable.  There can be no assurance that our revenue will be maintained at the current level or increase in the future.
 
During the fiscal years ended June 30, 2009 and 2008, we had revenues of approximately $8,737,000 and $5,152,000, respectively.  During the fiscal years ended June 30, 2009 and 2008, we had losses from continuing operations of approximately $13,559,000 and $7,714,000, respectively.  During the fiscal years ended June 30, 2009 and 2008, we had net losses of approximately $12,751,000 and $10,735,000, respectively.  There is a risk that we will never be profitable.  We plan to further increase our expenditures to complete the development and commercialization of our new products, and to broaden our sales and marketing capabilities.  As a result, we believe we will likely incur losses over the next several quarters.  Our accumulated deficit as of June 30, 2009 and 2008 was approximately $72,678,000 and $59,720,000, respectively.  Our ability to generate sufficient revenues to achieve profits will depend on a variety of factors, many of which are outside our control, including:
 
·  
the size of the markets we address;
 
·  
the existence of competition and other solutions to the problems we address;
 
·  
the extent of patent and intellectual property protection afforded to our products;
 
·  
the cost and availability of raw material and intermediate component supplies;
 
·  
changes in governmental (including foreign governmental) initiatives and requirements;
 
·  
changes in domestic and foreign regulatory requirements; and
 
·  
the costs associated with equipment development, repair and maintenance; and our ability to manufacture and deliver products at prices that exceed our costs.
 
Our operating results have fluctuated in the past from quarter to quarter and are likely to fluctuate significantly in the future due to a variety of factors, many of which are beyond our control, including:
 
·  
changing demand for our products and services;
 
·  
the timing of actual customer orders and requests for product shipment and the accuracy of our forecasts of future production requirements;
 
·  
the reduction, rescheduling or cancellation of product orders by customers;
 
·  
difficulties in forecasting demand for our products and the planning and managing of inventory levels;
 
·  
the introduction and market acceptance of our new products and changes in demand for our existing products;
 
·  
changes in the relative portion of our revenue represented by our various products, services and customers, including the relative mix of our business across our target markets;
 
·  
changes in competitive or economic conditions generally or in our markets;
 
·  
competitive pressures on selling prices;
 
·  
the amount and timing of costs associated with product warranties and returns;
 
·  
changes in availability or costs of materials, components or supplies;
 
·  
changes in our product distribution channels and the timeliness of receipt of distributor resale information;
 
·  
the amount and timing of investments in research and development;
 
 
 
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·  
difficulties in integrating acquired assets and businesses into our operations; and
 
·  
charges to earnings resulting from the application of the purchase method of accounting following acquisitions.
 
A substantial portion of our revenue in any quarter historically has been derived from orders booked and shipped in the same quarter, and historically, backlog has not been a meaningful indicator of revenues for a particular period.  Accordingly, our sales expectations currently are based almost entirely on our internal estimates of future demand and not from firm customer orders.
 
 
As a result of these factors, many of which are difficult to control or predict, as well as the other risk factors discussed in this Annual Report, we may experience material adverse fluctuations in our future operating results on a quarterly or annual basis.
 
Our markets are subject to technological change and our success depends on our ability to develop and introduce new products.
 
The market for our security products is characterized by:
 
·  
changing technologies;
 
·  
changing customer needs;
 
·  
frequent new product introductions and enhancements;
 
·  
increased integration with other functions; and
 
·  
product obsolescence.
 
Our success will be dependent in part on the design and development of new products.  To develop new products and designs for our security market, we must develop, gain access to and use leading technologies in a cost-effective and timely manner and continue to expand our technical and design expertise.  The product development process is time-consuming and costly, and there can be no assurance that product development will be successfully completed, that necessary regulatory clearances or approvals will be granted on a timely basis, or at all, or that the potential products will achieve market acceptance.  Our failure to develop, obtain necessary regulatory clearances or approvals for, or successfully market potential new products could have a material adverse effect on our business, financial condition and results of operations.
 
Economic, political and other risks associated with international sales and operations could adversely affect our sales.
 
Our business is subject to risks associated with doing business internationally. During the fiscal year ended June 30, 2009, foreign sales represented 82% of total revenue with one customer from China representing 48% of our revenue.  For the fiscal year ended June 30, 2008, foreign sales represented 78% of total revenue with one customer from China representing 55% of our revenue.  We anticipate that revenues from international operations will continue to represent a substantial portion of our total revenue. Accordingly, our future results could be harmed by a variety of factors, including:
 
·  
changes in foreign currency exchange rates;
 
·  
changes in a country's or region's political or economic conditions, particularly in developing or emerging markets;
 
·  
potentially longer payment cycles of foreign customers and difficulty of collecting receivables in foreign jurisdictions;
 
·  
trade protection measures and import or export licensing requirements;
 
·  
differing legal and court systems;
 
·  
differing tax laws and changes in those laws;
 
·  
differing protection of intellectual property and changes in that protection; and
 
·  
different regulatory requirements and changes in those requirements.
 
 
 
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Our explosives detection products and technologies may not be accepted by government agencies or commercial consumers of security products which could harm our future financial performance.
 
There can be no assurance that our explosives detection systems will achieve wide acceptance by government agencies, commercial consumers of security products, and market acceptance generally.  The degree of market acceptance for our explosives detection products and services will also depend upon a number of factors, including the receipt and timing of regulatory approvals and the establishment and demonstration of the ability of our proposed device to detect trace explosives residues on personnel, baggage and other cargo.  Our failure to develop a commercial product to compete successfully with respect to throughput, the ability to scan personnel, baggage and other cargo, and portability could delay, limit or prevent market acceptance.  Moreover, the market for explosives detection systems, especially trace detection, is largely undeveloped, and we believe that the overall demand for explosives detection systems technology will depend significantly upon public perception of the risk of terrorist attacks.  There can be no assurance that the public will perceive the threat of terrorist attacks to be substantial or that governmental agencies and private-industry will actively pursue explosives detection systems technology.  Long-term market acceptance of our products and services will depend, in part, on the capabilities, operating features and price of our products and technologies as compared to those of other available products and services.  As a result, there can be no assurance that currently available products, or products under development for commercialization, will be able to achieve market penetration, revenue growth or profitability.
 
If we cannot obtain the additional capital required to fund our operations on favorable terms, or at all, we may have to delay or reconsider our growth strategy.
 
Our growth strategy may require additional capital for, among other purposes, completing acquisitions of companies and customers’ product lines and manufacturing assets, integrating acquired companies and assets, acquiring new equipment and maintaining the condition of existing equipment.  If cash generated internally is insufficient to fund capital requirements, or if we desire to make additional acquisitions, we will require additional debt or equity financing.  Adequate financing may not be available or, if available, may not be available on terms satisfactory to us.  If we raise additional capital by issuing equity or convertible debt securities, the additional securities will dilute the share ownership of our existing investors.  In addition, we may grant future investors rights that are superior to those of our existing investors.  If we fail to obtain sufficient additional capital in the future, we could be forced to curtail our growth strategy by reducing or delaying capital expenditures and acquisitions, selling assets or restructuring or refinancing our indebtedness.
 
We depend on outside suppliers and subcontractors, and our production and reputation could be harmed if they are unable to meet our volume and quality requirements and alternative sources are not available.
 
We have various “sole source” suppliers who supply key components for our products.  Our outside suppliers may fail to develop and supply us with products and components on a timely basis, or may supply us with products and components that do not meet our quality, quantity or cost requirements.  If any of these problems occur, we may be unable to obtain substitute sources of these products and components on a timely basis or on terms acceptable to us, which could harm our ability to manufacture our own products and components profitably or on time, and to ship products to customers on time and generate revenues.  In addition, if the processes that our suppliers use to manufacture products and components are proprietary, we may be unable to obtain comparable components from alternative suppliers.
 
We depend on a contract manufacturer, and our production and products could be harmed if it is unable to meet our volume and quality requirements and alternative sources are not available.
 
We rely on a single contract manufacturer to provide manufacturing services for our explosives detection products.  If these services become unavailable, we would be required to identify and enter into an agreement with a new contract manufacturer or take the manufacturing in house.  The loss of our contract manufacturer could significantly disrupt production as well as increase the cost of production, thereby increasing the prices of our products.  These changes could have a material adverse effect on our business and results of operations.
 
We may not be able to protect our intellectual property rights adequately.
 
Our ability to compete is affected by our ability to protect our intellectual property rights.  We rely on a combination of patents, trademarks, copyrights, trade secrets, confidentiality procedures and non-disclosure and licensing arrangements to protect our intellectual property rights.  Despite these efforts, we cannot be certain that the steps we take to protect our proprietary information will be adequate to prevent misappropriation of our technology, or that our competitors will not independently develop technology that is substantially similar or superior to our technology.  More specifically, we cannot assure you that any future applications will be approved, or that any
 
 
 
14

 
 
issued patents will provide us with competitive advantages or will not be challenged by third parties.  Nor can we assure you that, if challenged, our patents will be found to be valid or enforceable, or that the patents of others will not have an adverse effect on our ability to do business.  Furthermore, others may independently develop similar products or processes, duplicate our products or processes or design their products around any patents that may be issued to us.
 
Our success depends on our ability to obtain new patents and operate without infringing on the proprietary rights of others.
 
Although we have eight United States patents issued and eight United States patent applications pending for our explosives detection technology and processes, our success will depend, in part, on our ability to obtain the patents applied for and maintain trade secret protection for our technology and operate without infringing on the proprietary rights of third parties.  The validity and breadth of claims in technology patents involve complex legal and factual questions and, therefore, may be highly uncertain.  No assurance can be given that any pending patent applications or any future patent application will issue as patents, that the scope of any patent protection obtained will be sufficient to exclude competitors or provide competitive advantages to us, that any of our patents will be held valid if subsequently challenged or that others will not claim rights in or ownership of the patents and other proprietary rights held by us.
 
Furthermore, there can be no assurance that others have not or will not develop similar products, duplicate any of our products or design around any patents issued or that may be issued in the future to us. In addition, whether or not patents are issued to us, others may hold or receive patents which contain claims having a scope that covers products or processes developed by us.
 
Moreover, there can be no assurances that patents issued to us will not be challenged, invalidated or circumvented or that the rights thereunder will provide any competitive advantage.  We could incur substantial costs in defending any patent infringement suits or in asserting any patent rights, including those granted to third parties.  Patents and patent applications in the United States may be subject to interference proceedings brought by the United States Patent & Trademark Office, or to opposition proceedings initiated in a foreign patent office by third parties.  We may incur significant costs defending such proceedings.  Any litigation or proceedings relating to the intellectual property rights of any parties, whether or not determined in our favor or settled by us, is costly and may divert the efforts and attention of our management and technical personnel.  In addition, we may be required to obtain licenses to patents or proprietary rights from third parties.  There can be no assurance that such licenses will be available on acceptable terms if at all.  If we do not obtain required licenses, we could encounter delays in product development or find that the development, manufacture or sale of products requiring such licenses could be foreclosed.  Accordingly, challenges to our intellectual property, whether or not ultimately successful, could have a material adverse effect on our business and results of operations.
 
We also rely on unpatented proprietary technology, trade secrets and know-how and no assurance can be given that others will not independently develop substantially equivalent proprietary information, techniques or processes, that such technology or know-how will not be disclosed or that we can meaningfully protect our rights to such unpatented proprietary technology, trade secrets, or know-how.  Although we have entered into non-disclosure agreements with our employees and consultants, there can be no assurance that such non-disclosure agreements will provide adequate protection for our trade secrets or other proprietary know-how.
 
Our future success depends on the continued service of management, engineering and sales personnel and our ability to identify, hire and retain additional personnel.
 
Our success depends, to a significant extent, upon the efforts and abilities of members of senior management.  The loss of the services of one or more of our senior management or other key employees could adversely affect our business.  We do not maintain key person life insurance on any of our officers, employees or consultants.
 
There is intense competition for qualified employees in the security industry, particularly for highly skilled design, applications, engineering and sales people.  We may not be able to continue to attract and retain technologists, managers, or other qualified personnel necessary for the development of our business or to replace qualified individuals who could leave us at any time in the future.  Our anticipated growth is expected to place increased demands on our resources, and will likely require the addition of new management and engineering staff as well as the development of additional expertise by existing management employees.  If we lose the services of or fail to recruit engineers or other technical and management personnel, our business could be harmed.
 
 
 
15

 
 
Periods of rapid growth and expansion could place a significant strain on our resources, including our employee base.
 
To manage our possible future growth effectively, we will be required to continue to improve our operational, financial and management systems.  In doing so, we will periodically implement new software and other systems that will affect our internal operations regionally or globally.
 
Future growth would also require us to successfully hire, train, motivate and manage our employees.  In addition, our continued growth and the evolution of our business plan will require significant additional management, technical and administrative resources.  We may not be able to effectively manage the growth and evolution of our current business.
 
We are exposed to product liability claims that could place a substantial financial burden on us if we are sued.
 
The development and sale of explosives detection products entails an inherent risk of product liability.  For example, if our products fail to adequately detect explosives, if we are unable to successfully train technicians to properly use our products, or if the market determines or concludes that any of our products are not safe or effective for any reason, we may be exposed to product liability claims.  We currently do not carry product liability insurance.  A product liability claim, whether meritorious or not, could be time-consuming, distracting and expensive to defend, could be harmful to our reputation, could result in a diversion of management and financial resources away from our primary business and could result in product recalls. In any such case, there could be a material adverse effect on our business and results of operations and our business could fail.
 
We use hazardous materials in our research and manufacturing activities.  Any liability resulting from the misuse of such hazardous materials could adversely affect our business.
 
Our research and manufacturing activities sometimes involve the use of various hazardous materials.  Although we believe that our safety procedures for handling, manufacturing, distributing, transporting and disposing of such materials comply with the standards for protection of human health, safety, and the environment, prescribed by local, state, federal and international regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated.  Nor can we eliminate the risk that one or more of our hazardous material or hazardous waste handlers may cause contamination for which, under laws imposing strict liability, we could be held liable.  While we currently maintain insurance in amounts which we believe are appropriate in light of the risk of accident, we could be held liable for any damages that might result from any such event.  Any such liability could exceed our insurance and available resources and could have a material adverse effect on our business and results of operations.
 
If we are unable to complete our assessments with respect to the adequacy of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.
 
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report by management on the company’s internal controls over financial reporting in their annual reports on Form 10-K.  This report is required to contain an assessment by management of the effectiveness of the company’s internal controls over financial reporting.  If we fail to implement the required new or improved controls, we may be unable to comply with the requirements of Section 404 in a timely manner.  This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations.
 
Under current rules, we are required to report on the effectiveness of our internal controls for the year ended June 30, 2009.  The public accounting firm auditing a public company’s financial statements must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. For the fiscal year ending June 30, 2010, our independent registered public accounting firm will be required to report on the effectiveness of our internal controls.
 
 
 
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Risks Related to Competition
 
We may not be able to compete effectively against existing or new competitors.
 
We believe that our ability to compete in the explosive detection systems market is based upon such factors as: product performance, functionality, quality and features; quality of customer support services, documentation and training; and the capability of the technology to appeal to broader applications beyond the inspection of passengers, baggage, and cargo carried on airlines.  Although we believe that our current product has all of the capabilities to meet the United States government’s decree that all passengers, baggage, and cargo carried on airlines must be screened thoroughly, certain of our competitors may have advantages over our existing technology with respect to these factors.  There can be no assurance that we will be successful in convincing potential customers that our products will be superior to other systems given all of the necessary performance criteria, that new systems with comparable or greater performance, lower price and faster or equivalent throughput will not be introduced, or that, if such products are introduced, customers will not delay or cancel potential orders.  Further, there can be no assurance that we will be able to bring to commercialization and further enhance our product to better compete on the basis of cost, throughput, accommodation of detection of passengers, baggage or other cargo carried onto airlines, or that we will otherwise be able to compete successfully with existing or new competitors.
 
Moreover, there can be no assurance that we will be able to price our products and services at or below the prices of competing products and technologies in order to facilitate market acceptance.  Accordingly, our success will depend, in part, on our ability to respond quickly to technological changes through the development and introduction of new products and enhancements.  Product development involves a high degree of risk, and there can be no assurance that our new product development efforts will result in any commercially successful products.  Our failure to compete or respond to technological change in an effective manner would have a material adverse effect on our business and results of operations.
 
We may face pricing pressures that could prevent us from maintaining the prices of our products.
 
The sales process for our security products is typically a result of a request for quotations or tenders which are subjected to significant and time-consuming scrutiny prior to the determination of an award.  In addition, we face aggressive cost-containment pressures from governmental agencies and the bidding process commonly involves several competitors, many of whom have greater financial and other resources that may enable them to submit bids at prices which might be significantly lower than the prices we may be able to offer.  There can be no assurances that we will be able to maintain current prices in the face of continuing pricing pressures.  Over time, the average price for our products may decline as the markets for these products become more competitive.  Any material reduction in product prices could negatively affect our gross margin, necessitating a corresponding increase in unit sales to maintain any given level of sales.
 
Risks Related to Our Securities
 
The delisting of our common stock by the NYSE Amex has limited our stock’s liquidity and could substantially impair our ability to raise capital.
 
Our common stock was delisted by the NYSE Amex LLC effective in June 2009 as result of our failure to comply with certain continued listing requirements.  Our common stock began trading on the Over-The-Counter-Bulletin-Board under the symbol “IMSC” in May 2009.  We believe the delisting has limited our stock’s liquidity and could substantially impair our ability to raise capital.
 
 
 
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Our stock price is volatile.
 
The market price of our common stock has fluctuated significantly to date.  In the past fiscal year, our stock price ranged from $0.02 to $1.15.  The market price of our common stock may also fluctuate significantly in the future due to:
 
·  
variations in our actual or expected quarterly operating results;
 
·  
announcements or introductions of new products;
 
·  
technological innovations by our competitors or development setbacks by us;
 
·  
the commencement or adverse outcome of litigation;
 
·  
changes in analysts’ estimates of our performance or changes in analysts’ forecasts regarding our industry, competitors or customers;
 
·  
announcements of acquisitions or acquisition transactions; or
 
·  
general economic and market conditions.
 
In addition, the stock market in recent years has experienced extreme price and volume fluctuations that have affected the market prices of many security product companies.  These fluctuations have often been unrelated or disproportionate to the operating performance of companies in our industry, and could harm the market price of our common stock.
 
Additional authorized shares of our common stock and preferred stock available for issuance may adversely affect the market.
 
We are authorized to issue 50,000,000 shares of our common stock.  As of June 30, 2009, there were 15,424,195 shares of common stock issued and outstanding.  However, the total number of shares of our common stock issued and outstanding does not include shares reserved in anticipation of the exercise of options and warrants.  As of June 30, 2009, we had outstanding stock options and warrants to purchase approximately 6,797,000 shares of our common stock, the exercise price of which range between $0.08 per share to $12.45 per share, and we have reserved shares of our common stock for issuance in connection with the potential exercise of these instruments.  To the extent such options, warrants or additional investment rights are exercised the holders of our common stock will experience further dilution.  Stockholders will also experience dilution upon the exercise of options granted under our stock option plans.  In addition, in the event that any future financing or consideration for a future acquisition should be in the form of, be convertible into or exchangeable for, equity securities investors will experience additional dilution.
 
The exercise of the outstanding options and warrants will reduce the percentage of common stock held by our current stockholders.  Further, the terms on which we could obtain additional capital during the life of the derivative securities may be adversely affected, and it should be expected that the holders of the derivative securities would exercise them at a time when we would be able to obtain equity capital on terms more favorable than those provided for by such derivative securities.  As a result, any issuance of additional shares of common stock may cause our current stockholders to suffer significant dilution which may adversely affect the market.
 
In addition, we have 5,000,000 shares of authorized preferred stock, the terms of which may be fixed by our Board, of which 1,000,000 shares of Series E Convertible Preferred Stock were issued and outstanding as of June 30, 2009.  On July 1, 2009, we issued DMRJ 871,763 shares of our Series F Convertible Preferred Stock, which are convertible at DMRJ’s option into 15% of our common stock, calculated on a fully diluted basis. If we do not obtain net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities by August 31, 2009, we will be required to issue DMRJ 774,900 additional shares of Series F Preferred Stock, such that all of the Series F Preferred Stock then held by DMRJ will be convertible into 25% of our common stock, calculated on a fully diluted basis.  DMRJ has extended the August 31, 2009 due date to obtain net proceeds of at least $3,000,000 to October 1, 2009.
 
While we have no present plans to issue any additional shares of preferred stock, our Board of Directors has the authority, without stockholder approval, to create and issue one or more series of such preferred stock and to determine the voting, dividend and other rights of holders of such preferred stock.  The issuance of any of such series of preferred stock may have an adverse effect on the holders of common stock and could make a takeover of our company more difficult.
 
 
 
18

 
 
Shares eligible for future sale may adversely affect the market.
 
From time to time, certain of our stockholders who acquired their shares directly from our company in privately negotiated transactions may be eligible to sell all or some of their shares of common stock by means of ordinary brokerage transactions in the open market pursuant to effective registration statements under the Securities Act of 1933 and under Rule 144, promulgated under the Securities Act.  In general, pursuant to Rule 144, a stockholder (or stockholders whose shares are aggregated) who has satisfied a six-month holding period may, under certain circumstances, sell within any three-month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading volume of the class during the four calendar weeks prior to such sale.  Rule 144 also permits, under certain circumstances, the sale of securities, without any limitation, by our stockholders that are non-affiliates that have satisfied a one-year holding period.  Any substantial sale of our common stock pursuant to Rule 144 or pursuant to any resale registration statement may have material adverse effect on the market price of our securities.
 
There are limitations on director and officer liability which may limit our stockholders’ rights to recover for breaches of fiduciary duty.
 
As permitted by Massachusetts law, our Restated Articles of Organization, as amended, limit the liability of our directors for monetary damages for breach of a director's fiduciary duties except in certain instances.  As a result of these limitations and Massachusetts law, stockholders may have limited rights to recover against directors for breaches of their fiduciary duties.  In addition, our bylaws provide that we will indemnify our directors, officers, employees and agents if such persons acted in good faith and reasoned that their conduct was in our best interest.
 
The anti-takeover provisions of our Restated Articles of Organization and Massachusetts law may delay, defer or prevent a change of control.
 
Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders.  The rights of the holders of common stock will be subject to, and may be harmed by, the rights of the holders of any shares of preferred stock that we have issued to date and which may be issued in the future.  The issuance of preferred stock may delay, defer or prevent a change in control because the terms of any issued preferred stock could potentially prohibit our consummation of any acquisition, reorganization, sale of substantially all of our assets, liquidation or other extraordinary corporate transaction, without the approval of the holders of the outstanding shares of preferred stock.  In addition, the issuance of preferred stock could have a dilutive effect on our stockholders.
 
Our stockholders must give substantial advance notice prior to the relevant meeting to nominate a candidate for director or present a proposal to our stockholders at a meeting.  These notice requirements could inhibit a takeover by delaying stockholder action.  Massachusetts law may also discourage, delay or prevent someone from acquiring or merging with us.
 
We have never paid dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future.
 
We have paid no cash dividends on our common stock to date and we currently intend to retain our future earnings, if any, to fund the development and growth of our business.  In addition, our agreements with lenders prohibit the payment of cash dividends.  As a result, capital appreciation, if any, of our common stock will be shareholders’ sole source of gain for the foreseeable future.
 
 
 
19

 
 
 
Item 1B.
Unresolved Staff Comments
 
None.
 
Item 2.
Description of Properties
 
We operate out of two separate locations.  Our corporate offices are located in an approximately 23,000 square foot leased facility in Wilmington, Massachusetts.  In addition to our corporate offices, this facility houses research and development, sales and marketing, and production.  Our current lease expires in December 2009.  We lease approximately 6,200 square feet of research and office space in San Diego, California, under a lease expiring in January 2012.
 
Legal Proceedings
 
In conjunction with the May 2007 sale of our Accurel business to Evans Analytical, Accurel entered into a sublease of its facility to Evans.  In April 2009, Silicon Valley CA-I, LLC, the lessor of such property to Accurel, filed suit against Accurel and Evans in the Superior Court of the State of California, County of Santa Clara, alleging nonpayment of rent. On June 24, 2009, Accurel and Evans entered into a release and settlement agreement with the lessor, under the terms of which Accurel was required to pay $224,840, representing the amounts that are past due under the lease, plus monthly rents owing under the lease, less the payment that Evans is required to make under the terms of the settlement agreement.  Accurel is required to pay such amount on or before August 31, 2009.  On August 31, 2009, the lessor extended the payment due date to September 4, 2009.   On September 4, 2009, Accurel remitted the settlement payment.  In accordance with the release and settlement agreement, provided that Accurel and Evans have complied with the terms of the lease and payment in accordance with the agreement, the lessor has agreed to dismiss the suit on or before September 14, 2009, and Accurel will have no further obligations or liabilities to the lessor.
 
On April 2, 2009, John Traub, a former officer of the company and Accurel, filed a complaint in the California Superior Court, Santa Clara County, for breach of contract and indemnification against us and our insurer.  The complaint seeks defense costs and indemnification with respect to (i) several lawsuits filed against Traub by Evans Analytical Group, such lawsuits alleging theft of trade secrets, and (ii) one lawsuit filed us and our subsidiary Accurel against Traub alleging various breaches of fiduciary duties.  In May 2009, we filed our response to the complaint denying all material allegations.
 
We are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material affect on our business, assets or results of operations.
 
Submission of Matters to a Vote of Security Holders
 
None.
 

 
20

 

 
Market Information for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Our common stock traded on the NYSE Amex LLC (formerly, the American Stock Exchange) under the symbol “IMX” until June 22, 2009 and was delisted by the NYSE Amex on September 22, 2009. Since May 4, 2009, our common has traded on the Over-the-Counter Bulletin Board under the symbol “IMSC.OB.”  The following table sets forth the high and low bid quotations for our common stock for each of the last two fiscal years, as reported on the American Stock Exchange and the Over-the-Counter Bulletin Board. Quotations from the Over-the-Counter Bulletin Board reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.


   
Fiscal Year 2009
 
   
High
   
Low
 
4th Quarter
  $ 0.65     $ 0.06  
3rd Quarter
  $ 0.25     $ 0.02  
2nd Quarter
  $ 0.72     $ 0.07  
1st Quarter
  $ 1.15     $ 0.51  
                 
                 
   
Fiscal Year 2008
 
   
High
   
Low
 
4th Quarter
  $ 1.65     $ 0.81  
3rd Quarter
  $ 1.97     $ 0.70  
2nd Quarter
  $ 2.45     $ 0.65  
1st Quarter
  $ 2.40     $ 1.50  

As of October 6, 2009, there were approximately 128 stockholders of record.  The last sale price as reported on the Over-the-Counter Bulletin Board on October 6, 2009, was $0.09.  We have never paid a cash dividend on our common stock and do not anticipate the payment of cash dividends in the foreseeable future.  In addition, our agreements with lenders prohibit the payment of cash dividends.
 
 
The table below sets forth certain information as of June 30, 2009 with respect to equity compensation plans under which our common stock is authorized for issuance:


Plan Category
 
Number of securities to be issued upon exercise of outstanding options, warrants and rights
         
Weighted average exercise price of outstanding options, warrants and rights
   
Number of securities remaining available for future issuance
 
Equity compensation plans approved by stockholders
    3,532,788       (1 )   $ 0.32       44,997  
Equity compensation plans not approved by stockholders
    -                       -  
      3,532,788                       44,997  

 
_______________
 
(1)
This total includes shares to be issued upon exercise of outstanding options under the equity compensation plans that have been approved by our stockholders (i.e., our 2000 Incentive and Non-Qualified Stock Option Plan and our 2004 Stock Option Plan).
 

 
21

 

 
 
Recent Sales of Unregistered Securities
 
In May 2009 we issued 300,000 shares of common stock, having a value of $70,000, to JFS Investments, Inc., in consideration of services rendered in connection with the financing provided by DMRJ Group LLC.
 
The issuance of these shares was exempt from registration under the Securities Act of 1933, as amended, pursuant to an exemption provided by Section 4(2) of the Securities Act.
 
Selected Consolidated Financial Data
 
Not Applicable.
 

 
22

 

Item 7.
Management’s Discussion and Analysis or Plan of Operation
 
Forward-Looking Statements
 
This Annual Report on Form 10-K contains certain statements that are “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Litigation Reform Act”).  These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.
 
The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events, are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.
 
In accordance with the provisions of the Litigation Reform Act, we are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Annual Report on Form 10-K.  Important factors that could cause actual results to differ from our predictions include those discussed under “Risk Factors,” this “Management’s Discussion and Analysis” and “Business.”  Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.
 
Overview
 
Since our incorporation in August 1984, we have operated as a multi-faceted company engaging in the development of ion-based technologies and providing commercial services and products to the semiconductor, medical device and security industries.  Beginning in March 2007, we undertook steps to divest our semiconductor and medical business activities in order to focus on our security business.
 
Since May 1999, we have been performing research to improve explosives trace detection (“ETD”) technology, and development of ETD products which can be used for detection of trace amounts of explosives.  We now develop, manufacture and sell sophisticated sensors and systems for the Security, Safety and Defense (“SS&D”) industries.  We have developed handheld and benchtop ETD systems, which have been marketed and sold both domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, vehicles, other objects and people, for the detection of trace amounts of explosives.
 
 
Critical Accounting Policies
 
Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our Annual Report on Form 10-K for the fiscal year ended June 30, 2009.  Our discussion and analysis of our financial condition and results of operations are based upon these 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, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including those related to bad debts, product returns, inventories, investments, intangible assets and warranty obligations.  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.  In the past, actual results have not been materially different from our estimates.  However, results may differ from these estimates under different assumptions or conditions.
 
 
 
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We have identified the following as critical accounting policies, based on the significant judgments and estimates used in determining the amounts reported in our financial statements:
 
 
            ·
Revenue Recognition.  We recognize revenue when there is persuasive evidence of an arrangement with the customer that states a fixed or determinable price and terms, delivery of the product has occurred or the service performed in accordance with the terms of the arrangement, and collectibility of the sale is reasonably assured.
 
Government contract revenue under cost-sharing research and development agreements is recognized as eligible research and development expenses are incurred.  Our obligation with respect to these agreements is to perform the research on a best-efforts basis. For government contracts with a deliverable, revenue is recognized based upon the proportional performance method.
 
Revenues for which we have received payment, but have not yet recognized the revenues, pending fulfilling our obligations under the sales agreement, are reflected on our balance sheet as deferred revenues.
 
·  
Accounts Receivable and Allowance for Doubtful Accounts.  We maintain allowances for estimated losses resulting from the inability of our customers to make required payments.  Judgments are used in determining the allowance for doubtful accounts and are based on a combination of factors.  Such factors include historical collection experience, credit policy and specific customer collection issues.  In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us (e.g., due to a bankruptcy filing), we record a specific reserve for bad debts against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected.  We perform ongoing credit evaluations of our customers and continuously monitor collections and payments from our customers.  While actual bad debts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same bad debt rates that we have in the past.  A significant change in the liquidity or financial position of any of our customers could result in the uncollectibility of the related accounts receivable and could adversely impact our operating cash flows in that period.
 
·  
Sales Returns and Allowances.  We record reductions to revenue for estimated customer returns and allowances.  We record estimated allowances against revenues in the same period the revenue is recorded.  These estimates are based upon historical analysis of our credit memo data and other known factors for pricing and disputes that arise in the normal course of business.  To date, allowances have not been material.  Actual returns may differ significantly from our estimates if factors such as economic conditions or competitive conditions differ from our expectations.
 
            ·
Inventories.  We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead.  In assessing the ultimate realization of inventories, management judgment is required to determine the reserve for obsolete or excess inventory.  Inventory on hand may exceed future demand either because the product is obsolete, or because the amount on hand is more than can be used to meet future need.  We provide for the total value of inventories that we determine to be obsolete or excess based on criteria such as customer demand and changing technologies.
 
            ·
Warranties.  We provide for the estimated cost of product warranties at the time revenue is recognized.  We record an estimate for warranty related costs at the time of sale based on our actual historical return rates and repair costs.  While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same warranty return rates or repair costs that we have in the past.  A significant increase in warranty return rates or costs to repair our products could have a material adverse impact on our operating results for the period or periods in which such returns or additional costs materialize.
 
·  
Valuation of Certain Marketable Equity Securities.  We currently classify our investment securities as available-for-sale securities.  Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” such securities are measured at fair market value in the financial statements with unrealized gains or losses recorded in accumulated other comprehensive income until the securities are sold or otherwise disposed of.  However, in accordance with SFAS No. 115, a decline in fair market value below cost that is other than temporary is accounted for as a realized loss.  During fiscal 2008, we realized losses of approximately $51,000 from the sale of equity securities.
 
 
 
24

 
 
·  
Income Taxes.  Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets.  We have recorded a full valuation allowance against our net deferred tax assets of $16,951,000 as of June 30, 2009, due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods we may need to adjust our valuation allowance which could materially impact our financial position and results of operations.
 
·  
Goodwill and Intangible Assets. SFAS No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill and intangible assets with indefinite lives no longer be amortized but instead be measured for impairment at least annually or whenever events indicate that there may be an impairment.  In order to determine if an impairment exists, management compares the reporting unit's carrying value to the reporting unit’s fair value.  Determining the reporting unit’s fair value requires management to make estimates based on market conditions and operational performance.  Absent an event that indicates a specific impairment may exist, management has selected June 30 as the date for performing our annual goodwill impairment test.  Future events could cause management to conclude that impairment indicators exist and that goodwill associated with our acquired businesses is impaired.  Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.
 
Intangible assets with finite lives consist of acquired customer base, technology and trademarks and are valued according to the future cash flows they are estimated to produce.  These assigned values are amortized on a basis that matches the periods in which those cash flows are estimated to be produced or straight-line over the estimated useful lives, if no other method provides a better result.  We continually evaluate whether events or circumstances have occurred that indicate that the estimated remaining useful life of our intangible assets may warrant revision or that the carrying value of these assets may be impaired.  To compute whether intangible assets with finite lives been impaired, the estimated undiscounted future cash flows for the estimated remaining useful life of the assets are compared to the carrying value.  To the extent that the future cash flows are less than the carrying value, the assets are written down to the estimated fair value of the asset.
 
·  
Equity Transactions.  We evaluate the proper classification of our equity transactions under SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristic of Both Liabilities and Equity.”  SFAS No. 150 requires that for instruments that embody an unconditional obligation requiring the issuer to redeem it by transferring assets at a determinable date or that contain certain conditional obligations, typically classified as equity, be classified as a liability.
 
In many of our financing transactions, we have issued warrants.  We apply the principles of SFAS No. 123(R), “Share-Based Payment,” to value these warrants, which inherently include a number of estimates and assumptions including stock price volatility factors.  We record financing and certain offering costs associated with our capital raising efforts in our statements of operations.  These include amortization of debt issue costs such as cash, warrants and other securities issued to finders and placement agents, and amortization of preferred stock discount created by in-the-money conversion features on convertible debt accounted for in accordance with Emerging Issues Task Force Issue 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and Issue 00-27, “Application of Issue 98-5 to Certain Convertible Instruments,” by other securities issued in connection with preferred stock as a result of allocating the proceeds amongst the securities in accordance with Accounting Principles Board (“APB”) Opinion No. 14, “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants,” based on their relative fair values.  We based our estimates and assumptions on the best information available at the time of valuation, however, changes in these estimates and assumptions could have a material effect on the valuation of the underlying instruments.
 
We determined that our Series D Cumulative Convertible Preferred Stock contained certain derivative instruments and we account for such instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  Under SFAS No. 133, we bifurcated these derivative instruments from the Series D Cumulative Convertible Preferred Stock, recorded them as a liability, and included the changes in the fair value of the instruments within other income (expense) in the accompanying consolidated statement of operations.
 
 
 
25

 
 
·  
Stock-Based Compensation. Effective July 1, 2006, we adopted SFAS 123(R), “Share-Based Payment, which requires the expense recognition of the estimated fair value of all stock-based payments issued to employees.
 
The valuation of employee stock options is an inherently subjective process, since market values are generally not available for long-term, non-transferable employee stock options.  Accordingly, an option pricing model is utilized to derive an estimated fair value.  In calculating the estimated fair value of our stock options we use the Black-Scholes pricing model, which requires the consideration of the following six variables for purposes of estimating fair value:
 
·  
the stock option exercise price;
 
·  
the expected term of the option;
 
·  
the grant price of our common stock, which is issuable upon exercise of the option;
 
·  
the expected volatility of our common stock;
 
·  
the expected dividends on our common stock; and
 
·  
the risk-free interest rate for the expected option term.
 
Stock Option Exercise Price and Grant Date Price of our Common Stock.  Stock option exercise price is typically the closing market price of our common stock on the date of grant.
 
Expected Term.  The expected term of options granted is calculated using our historical option exercise transactions as outlined SFAS 123(R) and reflects the period of time that options granted are expected to be outstanding.
 
Expected Volatility.  The expected volatility is a measure of the amount by which our stock price is expected to fluctuate during the expected term of options granted.  We determine the expected volatility solely based upon the historical volatility of our common stock over a period commensurate with the option’s expected term.  We do not believe that the future volatility of our common stock over an option’s expected term is likely to differ significantly from the past.
 
Expected Dividends.  We have never declared or paid any cash dividends on any of our capital stock and do not expect to do so in the foreseeable future.  Accordingly, we use an expected dividend yield of zero to calculate the grant-date fair value of a stock option.
 
Risk-Free Interest Rate.  The risk-free interest rate is the implied yield available on U.S. Treasury zero-coupon issues with a remaining term equal to the option’s expected term on the grant date.
 
Of the variables above, the selection of an expected term and expected stock price volatility are the most subjective.
 
Upon adoption of SFAS No. 123(R), we were also required to estimate the level of award forfeitures expected to occur and record compensation expense only for those awards that are ultimately expected to vest.  This requirement applies to all awards that are not yet vested, including awards granted prior to July 1, 2006.  We have estimated a forfeiture rate of 10%, which estimate we will review periodically and as changes in the composition of our option pool dictate.
 
Changes in the inputs and assumptions, as described above, can materially affect the measure of estimated fair value of our share-based compensation.  We anticipate the amount of stock-based compensation to increase in the future as additional options are granted.  As of June 30, 2009, there was approximately $314,000 of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense over a weighted average period of 1.81 years.
 
 
 
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Results of Operations
 
Fiscal Year Ended June 30, 2009 vs. June 30, 2008
 
Revenues
 
Security revenues for the year ended June 30, 2009 were $8,737,000 as compared with $5,152,000 for the comparable prior fiscal year, an increase of $3,585,000 or 69.6%.  Revenue from security products for the year ended June 30, 2009 was $7,186,000 as compared with $4,554,000 for the comparable prior year period, an increase of $2,632,000 or 57.8%.  Revenue from government funded contracts and services for the year ended June 30, 2009 was $1,551,000 as compared with $598,000 for the comparable prior year period, an increase of $953,000 or 159.4%.  The increase in security revenue is primarily a result of an increase in the number of units of our explosives detection products sold in fiscal 2009 as compared to fiscal 2008, due primarily to significant shipments of our handheld explosives detection equipment to a customer in China aggregating approximately $4,169,000 in sales in the first quarter of fiscal 2009, which shipments coincided with security preparations for the Beijing Olympics. Approximately $372,000 of security products revenues were recognized in the fourth quarter of fiscal 2008, as compared to $2,431,000 in the comparable prior year period, as a result of a significant shipment of our handheld explosives detection equipment to a customer in China.  The increase in government contract and service revenue during fiscal 2009 as compared to the comparable prior year period was due to increased resources focused on internally funded research projects during fiscal 2009 as compared with fiscal 2008.  Several of the government contacts from which we derived revenues in fiscal 2009 will expire in the first or second quarter of fiscal 2010, which could result in reduced government contract revenues in fiscal 2010, unless we are successful in securing additional government contracts.
 
Cost of Revenues
 
Cost of revenues for the year ended June 30, 2009 was $4,656,000 as compared with $3,577,000 for the comparable prior year, an increase of $1,079,000 or 30.2%.   The increase in cost of revenues is primarily a result of the increase in unit sales of our security products and an increase in government contract revenue and the associated direct expenses.
 
Gross Margin
 
Gross margin for the year ended June 30, 2009 was $4,081,000 or 46.7% of security revenues as compared with $1,575,000 or 30.6% of security revenues for the comparable prior year.  The increase in gross margin is the result of increased sales volume of our handheld explosives detection equipment; improved design changes to our handheld explosives detectors which improved their manufacturability; and overall cost efficiencies realized in the production process, including efficiencies realized by our outsourced contract manufacturer.
 
Research and Development Expense
 
Research and development expense for the fiscal year ended June 30, 2009 was $3,306,000 as compared with $3,097,000 for the comparable prior year, an increase of $209,000 or 6.7%.  We continue to expend funds to expand our staff to further the development of new products in the areas of explosives detection, as well as to prepare for certain government laboratory acceptance testing.  In addition, the increase in research and development expenses relates to the volume and timing of customer funded programs, primarily through government grants and contracts.  We focused additional resources on our internally funded research and development programs during fiscal 2009 as compared with fiscal 2008.  We charge our research and development personnel to cost of revenues for work performed on these contracts and grants.  Research and development expenses incurred prior to starting government contracts are charged to operating expenses.
 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses for the year ended June 30, 2009 were $7,554,000 as compared with $6,414,000 for the comparable prior fiscal year, an increase of $1,140,000, or 17.8%.  The increase is primarily a result of increased legal expenses in connection with our litigation and settlement with Evans Analytical Group, LLC and, to a lesser extent, increased expenditures in our sales and marketing efforts, including increased selling expenses related to our first quarter 2009 China shipments and increased loan financing fees.  Partially offsetting these increases were decreases in the year ended June 30, 2009, as compared to the comparable prior fiscal year, in audit fees, stock-based compensation expense and rent and related facility expenses.
 
 
 
27

 
 
Litigation Settlement
 
For year ended June 30, 2009, we recorded a $5,700,000 charge resulting from the settlement of the litigation with Evans Analytical Group.  In settling this litigation we agreed to release approximately $700,000 that had been held in escrow since the time of the closing of the Accurel sale and agreed to issue 1,000,000 shares of Series E Convertible Preferred Stock having an aggregate liquidation preference of $5,000,000.
 
Other Income and Expense, Net
 
For the year ended June 30, 2009, we recorded other expense, net of $1,080,000 as compared with income, net of $198,000, for the comparable prior year, a, increase in other expense, net of $1,278,000 or 645.5%. The increase in other expense, net, is primarily a result of (i) the realization of the $98,000 unrealized loss of our share of CardioTech International, Inc. stock owned by CorNova, Inc., a privately-held, development stage medical device company; (ii) an increase in interest expense of $1,417,000 resulting, in part, from a penalty of $568,000 assessed on the Series D Preferred Stock due to our failure to meet the amended redemption date, $90,000 of forbearance fees due to cure events of default under our former credit facility and interest expense on our senior secured convertible promissory note due to increased borrowings and a higher effective interest rate; (iii) a decrease in interest income of $149,000 as a result of lower available cash balances for investment; and (iv) a decrease of $133,000 in income related to the embedded derivative associated with the Series D Cumulative Convertible Preferred Stock, which was extinguished on December 10, 2008.
 
Loss from Continuing Operations
 
Loss from continuing operations for the year ended June 30, 2009 was $13,559,000 as compared with $7,738,000 for the comparable prior year, an increase of $5,821,000, or 75.2%.  The increase in loss from continuing operations is primarily the result of the $5,700,000 non-cash charge recorded for the Evans Analytical litigation and settlement, increased interest expense and the realization unrealized loss of our share of CardioTech’s stock owned by CorNova, offset partially by increased sales of our handheld explosives detection product and improved gross margins resulting from these sales and the gain realized on the transfer of our CorNova common stock.
 
Preferred Distribution, Dividends and Accretion
 
Preferred distribution, dividends and accretion on the Series D Cumulative Convertible Preferred Stock for the year ended June 30, 2009 was $207,000 as compared with $1,058,000 for the comparable prior year, a decrease of $851,000 or 80.4%.  The Series D Preferred Stock was extinguished on December 10, 2008.
 
Net Loss from Discontinued Operations
 
Net income from discontinued operations for the year ended June 30, 2009 was $808,000 as compared with a net loss of $3,021,000 for the comparable prior year, an increase of $3,829,000 or 126.7%.  Net income from discontinued operations for fiscal 2009 is composed of (i) operating income of $21,000 from our Core Systems subsidiary, which was sold during the second quarter of fiscal 2009, (ii) operating loss of $264,000 from our medical reporting unit, which includes an impairment charge of $143,000 recorded on long-lived assets (iii) gain on sale of Core Systems of $22,000 and (iv) gain on sale of assets of our medical reporting unit of approximately $1,026,000. Net loss from discontinued operations for fiscal 2008 is composed of operating losses of $840,000 from our  medical reporting and operating losses of $2,181,000 from our semiconductor unit, which includes an impairment charge of $1,487,000, as carrying value of the long-lived assets of the reporting unit exceeded their estimated fair value, which are being reported as held for sale.  The semiconductor reporting unit reflects only our Core Systems subsidiary.
 
Income Taxes
 
As of June 30, 2009, we had federal and state net operating loss carry forwards available to offset future taxable income of approximately $36,360,000 expiring between 2022 and 2030, and $41,533,000, expiring between 2010 and 2025, respectively.  As of June 30, 2009, we had federal and state investment, alternative minimum tax and research credit carry forwards available to offset future taxable income of approximately $666,000, expiring between 2022 and 2030, and $502,000, expiring between 2010 and 2025, respectively.
 
 
 
28

 
 
Liquidity and Capital Resources
 
As of June 30, 2009, we had a cash overdraft of approximately $6,000, a decrease of $418,000 when compared with our cash and cash equivalents balance of $412,000 as of June 30, 2008.  We must repay in full the balance on the senior secured promissory note issued to DMRJ Group LLC on December 10, 2008, by December 10, 2009.  The balance due on that Note as of June 30, 2009 was $4,049,000 and the liquidation value was $4,600,000. In addition, as described below, we must repay by December 10, 2009 the outstanding balances due to DMRJ under a second secured promissory note and a revolving credit facility established after June 30, 2009. As of September 28, 2009, the outstanding balances under that note and under the revolving credit facility were $1,000,000 and $1,833,000, respectively.
 
On December 10, 2008, we used approximately $477,000 of the proceeds from the issuance of senior secured promissory note to DMRJ to repay all of the indebtedness outstanding to Bridge Bank, N.A., and the credit facility with the bank terminated. On December 10, 2008, we also used approximately $1,161,000 of the proceeds from the issuance of the note to redeem all of the Series D Preferred Stock held by Laurus, excluding a portion of such stock which was redeemed effective on that date by the subsequent issuance of 929,535 shares of our common stock. As of June 30, 2009 and 2008, the outstanding balance on the Series D Preferred Stock was $0 and $2,424,000, respectively.
 
During the year ended June 30, 2009 we had net cash outflows of $3,985,000 from operating activities of continuing operations as compared to net cash outflows of continuing operations of $5,007,000 for the comparable prior year period.  The approximately $1,022,000 decrease in net cash outflows used in operating activities of continuing operations during the year ended June 30, 2009, as compared to the comparable prior year period, was due to (i) a decrease in accounts receivable, due to decreased sales of security products in the fourth quarter of fiscal 2009, (ii) decreased inventories, due primarily our decision to reduce raw material inventory, and (iii) an increase in accounts payable due to increased aging of our accounts payable.  For the year ended June 30, 2009, we had net cash outflows of $33,000 from operating activities of discontinued operations, compared with net cash outflows of $587,000 from operating activities of discontinued operations for the comparable prior year period, due primarily to a decrease in the loss from discontinued operations of our semiconductor and medical business units.
 
During the year ended June 30, 2009 we had net cash inflows of $3,637,000 from investing activities of continuing operations as compared to net cash outflows of $1,155,000 from investing activities of continuing operations for the comparable prior year period.  The approximately $4,792,000 increase in net cash outflows used in investing activities of continuing operations during the year ended June 30, 2009, as compared to the comparable prior year period, was primarily a result cash provided from the sale of property and equipment, sale of Core Systems, payments received on a note receivable and the release of funds held in escrow from the Accurel sale.  For the year ended June 30, 2009, we had net cash outflows of $28,000 from investing activities of discontinued operations, compared to net cash outflows of $202,000 from investing activities of discontinued operations for the comparable prior year period, due primarily to a decrease in cash used to purchase property and equipment.
 
During the year ended June 30, 2009 we had net cash outflows of $2,000 from financing activities of continuing operations as compared to net cash outflows of $2,255,000 from financing activities of continuing operations for the comparable prior year period.  The approximately $2,253,000 increase in net cash outflows used in financing activities of continuing operations during the year ended June 30, 2009, as compared to the comparable prior year period, was primarily a result of cash provided by the issuance of the senior secured convertible promissory note, net of principal repayments and proceeds from a note payable with a Company director; offset by the repayments of the Series D Cumulative Convertible Preferred Stock, long-term debt, credit facility, and capital lease obligations.  For the year ended June 30, 2009, we had net cash outflows of $1,000 from financing activities of discontinued operations compared with net cash outflows of $3,000 from financing activities of discontinued operations for the comparable prior year period, due to decreased principal payments of capital lease obligations.  We expect that the absence of negative cash flows from our discontinued operations will have a favorable impact on our future liquidity and capital resources.
 
 
 
29

 
 
On December 10, 2008, we entered into a note and warrant purchase agreement with DMRJ Group LLC, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  The note bears interest at 11.0% per annum and is collateralized by all of our assets.  The effective interest rate on the note is approximately 23.4%.  We prepaid interest in the amount of $616,000 upon the issuance of the note.  In lieu of paying any commitment fees, closing fees or other fees in connection with the purchase agreement, we transferred our entire interest in 1,500,000 share of the common stock of CorNova to DMRJ.  The note, which has been amended and restated,  is convertible in whole or in part at the option of DMRJ into shares of our common stock at a conversion price of $0.26 per share.
 
We valued the note upon issuance at its residual value of $4,356,000 based on the fair values of the financial instruments issued in connection with this convertible debt financing, including the warrants, the original issue discount and the fair value of the CorNova common stock transferred to DMRJ Group LLC.  The amounts recorded in the financial statements represent the amounts attributed to the senior secured convertible debt of $5,600,000, net of $160,000 allocated to the warrants, $616,000 of original issue discount and $468,000 representing the estimated fair value of the CorNova common stock.  The warrant was valued using the Black-Scholes model with the following assumptions:  volatility 98.4%, risk-free interest rate of 2.29%, expected life of five years and expected dividend yield of 0.00%.  As required under the terms of the note, we made a principal payment of $1,000,000 on December 24, 2008.  The note requires us to make a principal payment in an amount equal to any funds released from the escrow created in connection with the May 2007 sales of the assets of Accurel Systems International, upon the release of such funds.  DMRJ waived the requirement that we make a principal repayment in an amount equal to the amount of the escrow funds released in connection with the Evans litigation settlement.
 
On March 12, 2009, we entered into a letter agreement with DMRJ pursuant to which we were granted access to $250,000 of previously restricted cash out of funds held in a blocked account.  The effect of the letter agreement made $250,000 available to us until the close of business on April 14, 2009.  In consideration of the letter agreement, on March 12, 2009, we issued to DMRJ an amended and restated senior secured convertible promissory note and amended and restated warrant to purchase shares of common stock, which replaced the note and warrant issued on December 10, 2008.  The terms of the amended and restated senior secured convertible promissory note and the amended and restated warrant are identical to the terms of the original note and warrant, except that the amended instruments reduced the initial conversion price of the original note from $0.26 to $0.18 and reduced the initial exercise price of the original warrant from $0.26 to $0.18.
 
The remaining principal balance of the amended and restated note, together with outstanding interest, is due and payable on December 10, 2009.  As June 30, 2009, the outstanding balance on the note was $4,049,000, liquidation balance was $4,600,000.
 
The note contains restrictions and financial covenants including:  (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the survivor of such consolidation or merger; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of share of our common stock to provide for the issuance of the warrant shares; maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets minus current liabilities, of no less than 0.60 to 1.00.  As of June 30, 2009, our current ratio was 0.21 to 1.00, our aggregate dollar amount of all accounts payable exceeded 100 days past due and the minimum cash balance required to be maintained in the blocked account was less than the required minimum of at least $500,000.  As such we are not in compliance with the required current ratio and accounts payable financial covenants have requested a waiver for these events of noncompliance.  On July 16, 2009, DMRJ waived the March 31, 2009 events of noncompliance and waived any non-compliance with the relevant financial covenants until but not including September 4, 2009.  If we are unable to comply with the financial covenants to DMRJ in the future and if we are unable to obtain a waiver of any such noncompliance, DMRJ may declare the entire unpaid principal balance of our obligations to it, together with all interest accrued thereon, plus fees and expenses, due and payable.  Any such action on the part of DMRJ would have a material adverse effect on our liquidity and financial condition and could force us to curtail or discontinue all of our operations.
 
 
 
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On July 1, 2009, we entered into an amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued DMRJ a senior secured promissory note in the principal amount of $1,000,000 and 871,763 shares of our  Series F Convertible Preferred Stock.
 
The note bears interest at the rate of 2.5% per month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, will be due and payable on the earlier of (i) December 10, 2009 and (ii) the receipt by us of net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities in one or more transactions. In addition, at its option, DMRJ may require us to prepay such amounts upon (i) certain consolidations, mergers and business combinations involving us; (ii) the sale or transfer of more than 50% of our assets, other than inventory sold in the ordinary course of business, in one or more related or unrelated transactions; or (iii) the issuance by us, in one or more related or unrelated transactions, of any equity securities or securities convertible into equity securities (other than options granted to employees and consultants pursuant to employee benefit plans approved by our Board of Directors), which results in net cash proceeds to us of more than $500,000; provided, however, that DMRJ may not require us to prepay more than the net cash proceeds of any transaction described in the preceding clause (iii) of this sentence. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ.
 
The amendment to the loan agreement provides that, in the event we have not obtained net proceeds from the issuance of debt or equity securities upon terms and conditions acceptable to DMRJ in its sole discretion of (i) $1,000,000 by July 24, 2009 and (ii) to the extent that we have satisfied such requirements, an additional $2,000,000 by August 21, 2009, we will immediately engage in a sale process satisfactory to DMRJ in its sole discretion by implementing a contingency plan which may be established by DMRJ, including, without limitation, the engagement at our expense of a third party investment banker acceptable to DMRJ in its sole discretion.
 
The 871,763 shares of Series F Preferred Stock issued to DMRJ are convertible at the option of DMRJ into 15% of our common stock, calculated on a fully diluted basis. If we do not obtain net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities by August 31, 2009, then we will be required to issue to DMRJ 774,900 additional shares of Series F Preferred Stock, such that all of the Series F Preferred Stock then held by DMRJ will be convertible into 25% of our common stock, calculated on a fully diluted basis.  DMRJ has extended the August 31, 2009 due date for us to obtain net proceeds of at least $3,000,000 to October 1, 2009.  In addition, for so long as the note or the amended and restated senior secured convertible promissory note issued to DMRJ as of December 10, 2008 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless the we simultaneously issue to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which the Series F Preferred Stock held by DMRJ may be converted representing the same percentage ownership of us on a fully diluted basis after such issuance as immediately prior thereto.
 
After the repayment in full of the promissory notes, described above, the number of shares of common stock into which the Series F Preferred Stock is convertible will remain subject to “full ratchet” antidilution protection in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below $.08 per share. Full ratchet” antidilution protection completely protects an investors investment from any subsequent price erosion until the occurrence of a liquidity event. The anti-dilution protection will not apply, however, to issuances of stock and options to our employees, directors, consultants and advisors pursuant to any equity compensation plan approved by our stockholders.
 
The Series F Preferred Stock is entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock. In the event of any liquidation, dissolution or winding up of the company, the holders of the Series F Preferred Stock will be entitled to be paid an amount equal to $.08 per share of Series F Preferred Stock, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our Series E Convertible Preferred Stock or common stock by reason of their ownership of such stock.
 
 
 
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The holders of the Series F Preferred Stock have no voting rights except as required by applicable law.  However, without the consent of the holders of a majority of the Series F Preferred Stock, we may not (i) amend, alter or repeal any provision of its Restated Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series F Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series F Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of our equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series F Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.
 
On August 5, 2009, we entered into a second amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued DMRJ a senior secured promissory note in the principal amount of $700,000.  The note bears interest at the rate of 25% per annum.  The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was due and payable on August 17, 2009.  The outstanding principal balance and interest due under this bridge note was paid on September 4, 2009.
 
On September 4, 2009, we entered into an additional credit agreement with DMRJ, pursuant to which DMRJ provided us with a revolving line of credit in the maximum principal amount of $3,000,000. In connection with the credit agreement, we issued to DMRJ a promissory note evidencing our obligations under the credit facility. Each of our subsidiaries guaranteed our obligations under the credit facility and the obligations of our company and our subsidiaries are secured by grants of first priority security interests in all of our respective assets. In addition, we have agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account will be applied towards the repayment of our obligations to DMRJ under the note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.
 
The note bears interest at the rate of 25% per annum. Interest under the note will be due on the first day of each calendar month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, will be due and payable on December 10, 2009. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ. Subject to applicable cure periods, amounts due under the note are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the note; (ii) any failure to observe or perform any other condition, covenant or agreement contained in the note or certain conditions, covenants or agreements contained in the credit agreement; (iii) certain suspensions of the listing or trading of our common stock; (iv) a determination that any misrepresentation made by us to DMRJ in the credit agreement or in any of the agreements delivered to DMRJ in connection with the credit agreement were false or incorrect in any material respect when made; (v) certain defaults under agreements related to any of our other indebtedness; (vi) the institution of certain bankruptcy and insolvency proceedings by or against us; (vii) the entry of certain monetary judgments against us that are not dismissed or discharged within a period of 20 days; (viii) certain cessations of our business in the ordinary course; (ix) the seizure of any material portion of our assets by any governmental authority; and (x) our indictment for any criminal activity.
 
In lieu of paying DMRJ any commitment fees, closing fees or other fees in connection with the credit agreement, we agreed to pay DMRJ an additional amount equal to 50% of our aggregate net profits generated between the closing date through the termination of the credit facility. Such payments will be due and payable as earned upon (i) each request for an advance under the note, and (ii) the termination of the credit facility.
 
Upon the closing of the credit facility, we requested and were granted an initial advance of approximately $1,633,000, of which we used approximately $715,000 to repay all of our outstanding indebtedness to DMRJ pursuant to a bridge note issued to DMRJ on August 5, 2009, and approximately $548,000 to retire certain obligations owed to other parties. We intend to use the balance of the initial advance, and to use the remainder of the facility, for working capital and ordinary course general corporate purposes.
 
 
 
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Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control our expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.
 
We are currently expending significant resources to develop the next generation of our current products and to develop new products.  Although we continue to fund as much research and development as possible through government grants and contracts in accordance with the provisions of the respective grant awards, we will require additional funding in order to continue the advancement of the commercial development and manufacturing of the explosives detection system.  We will attempt to obtain such financing by: (i) government grants, (ii) private financing, or (iii) strategic partnerships.  However, there can be no assurance that we will be successful in our attempts to raise such additional financing.
 
We will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment.
 
As of September 28, 2009 our obligation to DMRJ under the senior secured promissory note, as amended, the second senior secured promissory note and under the credit facility approximated $4,600,000, $1,000,000 and $1,833,000, respectively.
 
There can be no assurance that we will be successful in refinancing or extending our obligations to DMRJ.  If we are successful, however, then, based on the current sales, expense and cash flow projections, and the proceeds from certain expected sales of assets, management believes it has plans in place to fund operations for the next 12 months.  Because there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in executing these plans, management will continue to closely monitor and attempt to control our costs and will continue to actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through its lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted as can certain selling, general and administrative expenses, based on the availability of cash.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.
 
Off-Balance Sheet Arrangements
 
As of June 30, 2009 we had an irrevocable standby letter of credit outstanding in the approximate amount of $418,000.  The letter of credit provides performance security equal to 10% of the contract amount for product which  shipped in the first quarter of fiscal 2009.  The letter of credit expires on July 31, 2010.
 
As of June 30, 2009, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.
 
 
 
33

 
 
 
Item 8.
Financial Statements and Supplementary Data
 
The following documents are filed as part of this report on Form 10-K
 
   
Page
 
Report of UHY LLP, Independent Registered Public Accounting Firm
 
F-1
 
Consolidated Balance Sheets at June 30, 2009 and 2008
 
F-2
 
Consolidated Statements of Operations for the years ended June 30, 2009 and 2008
 
F-3
 
Consolidated Statements of Stockholders’ Equity for the years ended June 30, 2009 and 2008
 
F-4
 
Consolidated Statements of Cash Flows for the years ended June 30, 2009 and 2008
 
F-5
 
Notes to Consolidated Financial Statements
 
F-7
 
 
 
 
Item 9.
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
 
None.
 
Controls and Procedures
 
The certifications of our Chief Executive Officer and Chief Financial Officer attached as Exhibits 31.1 and 31.2 to this Annual Report on Form 10-K include, in paragraph 4 of such certifications, information concerning our disclosure controls and procedures, and internal control over financial reporting.  Such certifications should be read in conjunction with the information contained in this Item 9A for a more complete understanding of the matters covered by such certifications.
 
 
Disclosure Controls and Procedures.
 
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2009.  The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure.  It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosure controls and procedures as of June 30, 2009, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
 
Management’s Annual Report on Internal Control Over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act).  A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.  Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the interim or annual consolidated financial statements.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
 
 
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Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our internal control over financial reporting as of June 30, 2009 based on the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, our management concluded that, as of June 30, 2009, our internal control over financial reporting was effective based on those criteria.
 
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting.  Management's report was not subject to attestation by our  registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management's report in this annual report.
 
Changes in Internal Control Over Financial Reporting
 
There were no changes to our internal control over financial reporting during the fourth quarter ended June 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Other Information
 
None.
 

 
35

 


Directors, Executive Officers and Corporate Governance
 
The information required by this Item 10 is incorporated by reference to our definitive proxy statement to be filed with the Commission on or before October 28, 2009.
 
Executive Compensation
 
The information required by this Item 11 is incorporated by reference to our definitive proxy statement to be filed with the Commission on or before October 28, 2009.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
The information required by this Item 12 is incorporated by reference to our definitive proxy statement to be filed with the Commission on or before October 28, 2009.
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence
 
The information required by this Item 13 will be incorporated by reference from our definitive proxy statement to be filed with the Commission on or before October 28, 2009.
 
Item 14.
Principal Accounting Fees and Services
 
 

 

 
36

 

PART IV
 
Exhibits, Financial Statement Schedules
 
 
The following are filed as part of this Form 10-K:
 
 
(1)
Financial Statements: For a list of financial statements which are filed as part of this Annual Report on Form 10-K, See Page 31.
 
 
(2)
Exhibits
 
Exhibit No.
Ref. No.
Description
     
2.1
1
Agreement and Plan of Merger and Reorganization, dated April 10, 2008, by and among Implant Sciences Corporation, IMX Acquisition Corp., Ion Metrics, Inc., all shareholders of Ion Metrics, Inc. and David J. Ferran, as Shareholder Representative.
2.2
2
Asset Purchase Agreement, dated June 27, 2008, between Implant Sciences Corporation and International Brachytherapy, s.a.
2.3
2
Xenation License Agreement and related Security Agreement, each dated June 30, 2008, between Implant Sciences Corporation and International Brachytherapy, s.a.
2.4
2
Ytterbium License Agreement and related Security Agreement, each dated June 30, 2008, between Implant Sciences Corporation and International Brachytherapy, s.a.
2.5
3
Asset Purchase Agreement, dated July 18, 2008, between Implant Sciences Corporation and Best Medical International, Inc.
2.6
4
Asset Purchase Agreement, dated November 14, 2008, by and among Core Systems Incorporated, C Acquisition Corp. and Implant Sciences Corporation.
2.7
5
Amendment dated November 24, 2008, to Asset Purchase Agreement dated November 14, 2008, by and among Implant Sciences Corporation, C Acquisition Corp. and Core Systems Incorporated.
2.8
5
Promissory Note, dated November 24, 2008, in the principal amount of $1,625,000, executed by Core Systems Incorporated and delivered to C Acquisition Corp.
2.9
5
 Security Agreement, dated November 24, 2008, between Core Systems Incorporated and C Acquisition Corp.
3.1
 
Restated Articles of Organization, as amended, of Implant Sciences Corporation.
3.2
6
Amended and Restated By-Law, as amended, of Implant Sciences Corporation.
4.1
7
Specimen certificate for the Common Stock of Implant Sciences Corporation.
10.1
8
1992 Stock Option Plan.
10.2
8
Form of Stock Option Agreement under the 1992 Stock Option Plan.
10.3
8
1998 Incentive and Nonqualified Stock Option Plan.
10.4
7
Form of Incentive Stock Option under the 1998 Incentive and Nonqualified Stock Option Plan.
10.5
7
Form of Nonqualified Stock Option under the 1998 Incentive and Nonqualified Stock Option Plan.
10.6
7
Form of Nonqualified Stock Option for Non-Employee Directors under the 1998 Incentive and Nonqualified Stock Option Plan.
10.7
9
2000 Incentive and Non-Qualified Stock Option Plan of Implant Sciences Corporation.
10.8
10
2004 Stock Option Plan of Implant Sciences Corporation.
10.9
11
2006 Employee Stock Purchase Plan of Implant Sciences Corporation.
10.10
12
Employment Agreement, dated June 30, 2004, between Implant Sciences Corporation and Anthony J. Armini.
10.11
13
Transition Agreement, dated as of September 27, 2007, between Implant Sciences Corporation and Dr. Anthony J. Armini.
10.12
14
Amendment, dated November 4, 2008, to the Transition Agreement dated as of September 27, 2007, between Implant Sciences Corporation and Dr. Anthony J. Armini.
 
 
 
37

 
 
10.13
15
Employment Agreement, dated as of September 27, 2007, by and between Implant Sciences Corporation and Phillip C. Thomas.
10.14
16
Employment Agreement, dated as of February 29, 2008, by and between Implant Sciences Corporation and Diane J. Ryan.
10.15
17
Employment Agreement, dated as of July 31, 2008, by and between Implant Sciences Corporation and Glenn D. Bolduc.
10.16
18
Employment Agreement, dated as of February 6, 2009, between Implant Sciences Corporation and Glenn D. Bolduc.
10.17
19
Lease, dated December 11, 2008, between Implant Sciences Corporation and Wakefield Investments, Inc.
10.18
20*
Development, Distribution and Manufacturing Agreement, dated March 23, 2005 by and between Implant Sciences Corporation and Rapiscan Systems, Inc.
10.19
21
Agreement, dated January 4, 2008, between the Implant Sciences Corporation, OSI Systems, Inc. and Rapiscan Systems, Inc.
10.20
22
Form of Securities Purchase Agreement, dated as of June 17, 2004, among Implant Sciences and certain investors.
10.21
22
Form of Common Stock Purchase Warrant, dated June 17, 2004, issued by Implant Sciences Corporation to certain investors.
10.22
22
Form of Additional Investment Right, dated June 17, 2004 among Implant Sciences Corporation and certain investors.
10.23
22
Form of Registration Rights Agreement, dated June 17, 2004 among Implant Sciences Corporation and certain investors.
10.24
23
Form of Securities Purchase Agreement, dated March 3, 2005, by and between Implant Sciences Corporation and certain investors.
10.25
24
Form of Common Stock Purchase Warrant, issued by Implant Sciences Corporation to certain investors.
10.26
24
Form of Common Stock Purchase Warrant, dated March 4, 2005, issued by Implant Sciences Corporation to PacificWave Partners Limited.
10.27
24
Form of Additional Investment Right, dated March 4, 2005, among Implant Sciences Corporation and certain investors.
10.28
24
Form of Registration Rights Agreement, dated March 4, 2005, among Implant Sciences Corporation and certain investors.
10.29
25
Amended and Restated Loan and Security Agreement, dated January 3, 2007, among Implant Sciences Corporation, Accurel Systems International Corporation, C Acquisition Corp. and Bridge Bank, N.A.
10.30
25
Intellectual Property Security Agreement, dated January 3, 2007, between Implant Sciences Corporation and Bridge Bank, N.A.
10.31
25
Intellectual Property Security Agreement dated January 3, 2007, between C Acquisition Corp. and Bridge Bank, N.A.
10.32
25
Intellectual Property Security Agreement dated January 3, 2007, between Accurel Systems International Corporation and Bridge Bank, N.A.
10.33
25
Common Stock Purchase Warrant, dated January 3, 2007, issued by Implant Sciences Corporation to Bridge Bank, N.A.
10.34
26
Form of Securities Purchase Agreement, dated as of July 6, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd.
10.35
26
Form of Secured Term Note, dated as of July 6, 2005, in the principal amount of $3,000,000, executed by Implant Sciences Corporation and delivered to Laurus Master Fund, Ltd.
10.36
26
Form of Subsidiary Guaranty, dated as of July 6, 2005, among C Acquisition Corp., Accurel Systems International Corporation and Laurus Master Fund, Ltd.
10.37
26
Form of Common Stock Purchase Warrant, dated July 6, 2005, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
 
 
 
38

 
 
10.38
26
Form of Funds Escrow Agreement, dated July 6, 2005, by and among Implant Sciences Corporation, Laurus Master Fund, Ltd. and Loeb & Loeb LLP, as escrow agent.
10.39
26
Form of Master Security Agreement, dated July 6, 2005, by and among, Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and Laurus Master Fund, Ltd.
10.40
27
Securities Purchase Agreement, dated as of September 30, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd.
10.41
27
Registration Rights Agreement, dated as of September 30, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd.
10.42
27
Subsidiary Guaranty, dated as of September 30, 2005, by C Acquisition Corp. and Accurel Systems International Corporation, in favor of Laurus Master Fund, Ltd.
10.43
27
Common Stock Purchase Warrant, dated September 30, 2005, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
10.44
27
Funds Escrow Agreement, dated as of September 30, 2005, by and among Implant Sciences Corporation, Laurus Master Fund, Ltd. and Loeb & Loeb LLP, as escrow agent.
10.45
27
Master Security Agreement, dated as of September 30, 2005, by and among, Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and Laurus Master Fund, Ltd.
10.46
27
Stock Pledge Agreement, dated as of September 30, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd.
10.47
28
Form of Amendment, dated May 31, 2006, to Securities Purchase Agreement dated September 30, 2005, by and between Implant Sciences Corporation and Laurus Master Fund.
10.48
28
Form of Common Stock Purchase Warrant, dated May 31, 2006, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
10.49
25
Securities Purchase Agreement, dated December 29, 2006, between Implant Sciences Corporation and Laurus Master Fund, Ltd.
10.50
25
Secured Term Note, dated as of December 29, 2006, in the principal amount of $1,500,000, executed by Implant Sciences Corporation and delivered to Laurus Master Fund, Ltd.
10.51
25
Subsidiary Guaranty, dated as of December 29, 2006, by C Acquisition Corp. and Accurel Systems International Corporation, in favor of Laurus Master Fund, Ltd.
10.52
25
Common Stock Purchase Warrant, dated December 29, 2006, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
10.53
25
Master Security Agreement, dated as of December 29, 2006, by and among, Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and Laurus Master Fund, Ltd.
10.54
29
Omnibus Amendment, dated as of September 30, 2008, among Implant Sciences Corporation and LV Administrative Services, Inc. as administrative and collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore SPV I, Ltd., to (i) the Securities Purchase Agreement, dated as of September 29, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd. and (ii) certain the other related agreements referred to in such securities purchase agreement.
10.55
14
Omnibus Amendment, dated as of October 31, 2008, among Implant Sciences Corporation and LV Administrative Services, Inc., as administrative and collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore SPV I, Ltd., to (i) that certain Securities Purchase Agreement, dated as of September 29, 2005, by and between Implant Sciences Corporation and Laurus Master Fund, Ltd. and (ii) certain the other related agreements referred to in such securities purchase agreement.
10.56
30
Common Stock Purchase Warrant, dated October 7, 2002, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
10.57
31
Common Stock Purchase Warrant, dated August 28, 2003, issued by Implant Sciences Corporation to Laurus Master Fund, Ltd.
10.58
32
Common Stock Purchase Warrant, dated November 25, 2003, issued by Implant Sciences
Corporation to Laurus Master Fund, Ltd.
 
 
 
39

 
 
10.59
33
Note and Warrant Purchase Agreement, dated as of December 10, 2008, between Implant Sciences Corporation and DMRJ Group LLC.
10.60
33
Senior Secured Convertible Promissory Note, dated December 10, 2008, in the principal amount of $5,600,000, issued by Implant Sciences Corporation to DMRJ Group LLC
10.61
33
Warrant to Purchase Shares of Common Stock, dated December 10, 2008, issued by Implant Sciences Corporation to DMRJ Group LLC.
10.62
33
Security Agreement, dated as of December 10, 2008, among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as secured party.
10.63
33
Patent Security Agreement, dated as of December 10, 2008, among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as secured party.
10.64
33
Guaranty, dated as of December 10, 2008, of the obligations of Implant Sciences Corporation by C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp. in favor of DMRJ Group LLC.
10.65
34
Letter Agreement, dated as of March 12, 2009, between Implant Sciences Corporation and DMRJ Group LLC.
10.66
34
Amended and Restated Senior Secured Convertible Promissory Note, dated December 10, 2008, in the principal amount of $5,600,000, issued by Implant Sciences Corporation to DMRJ Group LLC.
10.67
34
Amended and Restated Warrant to Purchase Shares of Common Stock, dated March 12, 2009, issued by Implant Sciences Corporation to DMRJ Group LLC.
10.68
35
First Amendment, dated July 1, 2009, to Note and Warrant Purchase Agreement, dated as of December 10, 2008, between Implant Sciences Corporation and DMRJ Group LLC.
10.69
35
Senior Secured Promissory Note, dated July 1, 2009, in the principal amount of $1,000,000, issued by Implant Sciences Corporation to DMRJ Group LLC.
10.70
36
Credit Amendment, dated September 4, 2009, among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and DMRJ Group LLC.
10.71
36
Promissory Note, dated September 4, 2009, in the maximum principal amount of $3,000,000, issued by Implant Sciences Corporation to DMRJ Group LLC.
10.72
36
 Security Agreement, dated as of September 4, 2009, among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as secured part
10.73
36
 Patent Security Agreement, dated as of September 4, 2009, among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as secured party.
10.74
36
Guaranty, dated as of September 4, 2009, of the obligations of Implant Sciences Corporation by C Acquisition Corp., Accurel Systems International Corporation and IMX Acquisition Corp. in favor of DMRJ Group LLC.
21.1
 
Subsidiaries of Implant Sciences Corporation.
23.1
 
Consent of UHY LLP.
31.1
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
 
Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
 
Certification of the Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
 
Certification of the Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
40

 

 
1
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated April 10, 2008 and filed on April 16, 2008, and incorporated herein by reference.
 
2
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated June 27, 2008 and filed on July 9, 2008 and incorporated herein by reference.
 
3
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated July 18, 2008 and filed July 24, 2008, and incorporated herein by reference.
 
4
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November 14, 2008 and filed November 19, 2008, and incorporated herein by reference.
 
5
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November 24, 2008 and filed December 1, 2008, and incorporated herein by reference.
 
6
Filed as an  Exhibit to Implant Sciences Corporation’s Form 8-K dated December 12, 2007 and filed December 18, 2007, and incorporated herein by reference.
 
7
Filed as an Exhibit to Amendment No. 1 to Implant Sciences Corporation’s Registration Statement on Form SB-2 (Registration No. 333-64499), filed on December 21, 1998, and incorporated herein by reference.
 
8
Filed as an Exhibit to Implant Sciences Corporation’s Registration Statement on Form SB-2 (Registration No. 333-64499), filed on September 29, 1998, and incorporated herein by reference.
 
9
Filed as an Exhibit to Implant Sciences Corporation’s Registration Statement on Form S-8, filed on December 12, 2003, and incorporated herein by reference.
 
10
Filed as an Exhibit to Implant Sciences Corporation’s Registration Statement on Form S-8, filed on October 30, 2006, and incorporated herein by reference.
 
11
Filed as an Exhibit to Implant Sciences Corporation’s Registration Statement on Form S-8, filed on July 26, 2007, and incorporated herein by reference.
 
12
Filed as an Exhibit to Implant Sciences Corporation’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2004, and incorporated herein by reference.
 
13
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September 27, 2007 and filed on October 3, 2007, and incorporated herein by reference.
 
14
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November 4, 2008 and filed on November 6, 2008, and incorporated herein by reference.
 
15
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December 12, 2007 and filed on December 14, 2007, and incorporated herein by reference.
 
16
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated March 18, 2008 and filed on March 24, 2008, and incorporated herein by reference.
 
17
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated July 31, 2008 and filed on August 4, 2008, and incorporated herein by reference.
 
18
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated February 6, 2009 and filed on February 11, 2009, and incorporated herein by reference.
 
19
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December 11, 2008 and filed on December 17, 2008, and incorporated herein by reference.
 
20
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K/A dated March 23, 2005 and filed on April 7, 2005, and incorporated herein by reference.
 
21
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated January 4, 2008 and file on January 10, 2008, and incorporated herein by reference.
 
22
Filed as an Exhibit to Implant Sciences Corporation’s Registration Statement on Form S-3, filed on July 14, 2004, and incorporated herein by reference.
 
23
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K/A dated March 4, 2005 and filed on March 9, 2005, and incorporated herein by reference.
 
24
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated March 4, 2005 and filed on March 9, 2005, and incorporated herein by reference.
 
 
 
41

 
 
 
25
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December 29, 2006 and filed on January 8, 2007, and incorporated herein by reference.
 
26
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated July 8, 2005 and filed on July 14, 2005, and incorporated herein by reference.
 
27
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September 30, 2005 and filed on October 5, 2005, and incorporated herein by reference.
 
28
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated May 31, 2006 and filed on June 6, 2006, and incorporated herein by reference.
 
29
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated October 3, 2008 and filed on October 6, 2008, and incorporated herein by reference.
 
30
Filed as an Exhibit to Implant Sciences Corporation’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2002, and incorporated herein by reference.
 
31
Filed as an Exhibit to Implant Sciences Corporation’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2003, and incorporated herein by reference.
 
32
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December 10, 2003 and filed on December 12, 2003, and incorporated herein by reference.
 
33
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December 10, 2008 and filed December 16, 2008, and incorporated herein by reference.
 
34
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated March 12, 2009 and filed March 18, 2009, and incorporated herein by reference.
 
35
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated July 1, 2009 and filed July 8, 2009, and incorporated herein by reference.
 
36
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September 4, 2009 and filed September 11, 2009, and incorporated herein by reference.
     
 
*
Filed pursuant to a request for confidential treatment.

 

 
42

 

Report of Independent Registered Public Accounting Firm
 

 
The Board of Directors and Stockholders of Implant Sciences Corporation:
 
We have audited the accompanying consolidated balance sheets of Implant Sciences Corporation as of June 30, 2009 and 2008, and the related consolidated statements of operations, stockholders’ deficit, and cash flows for each of the two years then ended.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  We were not engaged to perform an audit of the Company’s internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over  financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Implant Sciences Corporation at June 30, 2009 and 2008 and the related consolidated statements of operations, stockholders' deficit, and cash flows for each of the two years then ended in conformity with U.S. generally accepted accounting principles.
 
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1 to the financial statements, the Company has had recurring net losses and continues to experience negative cash flows from operations.  These conditions raise substantial doubt about its ability to continue as a going concern.  Management’s plan regarding these matters are also described in Note 1.  The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 
 
/s/ UHY LLP
Boston, Massachusetts
October 9, 2009




 
 
 
F-1

 



Implant Sciences Corporation
 
Consolidated Balance Sheets
 
             
   
June 30,
 
   
2009
   
2008
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ -     $ 412,000  
Restricted cash
    664,000       514,000  
Accounts receivable-trade, net of allowance of $65,000 and $9,000,  respectively
    201,000       667,000  
Accounts receivable, unbilled
    138,000       152,000  
Note receivable
    167,000       -  
Inventories
    561,000       725,000  
Prepaid expenses and other current assets
    518,000       369,000  
Current assets held for sale
    169,000       1,883,000  
Total current assets
    2,418,000       4,722,000  
Property and equipment, net
    276,000       443,000  
Amortizable intangible assets, net
    -       54,000  
Note receivable
    766,000       -  
Other non-current assets
    68,000       1,096,000  
Goodwill
    3,136,000       3,136,000  
Non-current assets held for sale
    -       2,645,000  
Total assets
  $ 6,664,000     $ 12,096,000  
                 
LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY
               
Current liabilities:
               
Cash overdraft
  $ 6,000     $ -  
Senior secured convertible note  (liquidation value $4,600,000)
    4,049,000       -  
Current maturities of long-term debt and obligations under capital lease
    27,000       417,000  
Line of credit
    -       477,000  
Notes payable
    100,000       181,000  
Payable to Med-Tec
    56,000       80,000  
Payable to Ion Metrics shareholders
    -       2,514,000  
Accrued expenses
    1,968,000       2,062,000  
Accounts payable
    4,337,000       2,439,000  
Current portion of long-term lease liability
    334,000       317,000  
Deferred revenue
    428,000       66,000  
Current liabilities held for sale
    107,000       1,079,000  
Total current liabilities
    11,412,000       9,632,000  
Long-term liabilities:
               
Long-term debt and obligations under capital lease, net of current maturities
    86,000       113,000  
Long-term lease liability
    84,000       446,000  
Long-term liabilities held for sale
    -       1,000  
Total long-term liabilities
    170,000       560,000  
Total liabilities
    11,582,000       10,192,000  
                 
Commitments and contingencies (Note 9)
               
                 
Series D Cumulative Convertible Preferred Stock, $10 stated value; 500,000 shares
               
authorized, 0 and 242,424 shares outstanding, respectively (liquidation value $2,424,000)
    -       2,269,000  
Series E Convertible Preferred Stock, $5 stated value; 1,000,000 shares
               
authorized, 1,000,000 shares outstanding (liquidation value $5,000,000)
    5,000,000       -  
                 
Stockholders' (deficit) equity:
               
Common stock; $0.10 par value; 50,000,000 shares authorized; 15,434,740 and
15,424,195 at June 30, 2009 and 12,114,553 and 12,104,008 at June 30, 2008
shares issued and outstanding, respectively
    1,543,000       1,211,000  
Additional paid-in capital
    61,290,000       58,317,000  
Accumulated deficit
    (72,678,000 )     (59,720,000 )
Deferred compensation
    -       (2,000 )
Accumulated other comprehensive loss
    -       (98,000 )
Treasury stock, 10,545 common shares, respectively, at cost
    (73,000 )     (73,000 )
Total stockholders' (deficit) equity
    (9,918,000 )     (365,000 )
Total liabilities and stockholders' (deficit) equity
  $ 6,664,000     $ 12,096,000  
                 
                 
                 
The accompanying notes are an integral part of these financial statements.
 



 
 
F-2

 



Implant Sciences Corporation
 
Consolidated Statements of Operations
 
             
             
   
For The Years Ended June 30,
 
   
2009
   
2008
 
Revenues:
           
Security products
  $ 7,186,000     $ 4,554,000  
Government contracts and services
    1,551,000       598,000  
      8,737,000       5,152,000  
Cost of revenues
    4,656,000       3,577,000  
                 
Gross margin
    4,081,000       1,575,000  
                 
Operating expenses:
               
Research and development
    3,306,000       3,097,000  
Selling, general and administrative
    7,554,000       6,414,000  
Litigation settlement
    5,700,000       -  
      16,560,000       9,511,000  
Loss from operations
    (12,479,000 )     (7,936,000 )
Other income (expense), net:
               
Interest income
    55,000       204,000  
Interest expense
    (1,505,000 )     (88,000 )
Change in fair value of embedded derivatives related to
preferred stock features
    -       133,000  
Loss on sale of investments
    -       (51,000 )
Gain on transfer of investment
    468,000       -  
Realized losses in unconsolidated subsidiary
    (98,000 )     -  
Total other income (expense), net
    (1,080,000 )     198,000  
Loss from continuing operations before income tax benefit
    (13,559,000 )     (7,738,000 )
Income tax benefit
    -       24,000  
Loss from continuing operations
    (13,559,000 )     (7,714,000 )
Preferred distribution, dividends and accretion
    (207,000 )     (1,058,000 )
Loss from continuing operations applicable to common shareholders
    (13,766,000 )     (8,772,000 )
Income (loss) from discontinued operations before sale of discontinued operations      786,000        (3,021,000 )
Gain on sale of Core Systems
    22,000       -  
Net income (loss) from discontinued operations
    808,000       (3,021,000 )
Net loss applicable to common shareholders
  $ (12,958,000 )   $ (11,793,000 )
Net loss
  $ (12,751,000 )   $ (10,735,000 )
                 
Loss per share from continuing operations, basic and diluted
  $ (0.96 )   $ (0.65 )
Loss per share from continuing operations applicable to common
shareholders, basic and diluted
  $ (0.97 )   $ (0.73 )
Loss per share from discontinued operations, basic and diluted
  $ 0.06     $ (0.25 )
Net loss per share applicable to common shareholders, basic and diluted
  $ (0.91 )   $ (0.99 )
Net loss per share
  $ (0.90 )   $ (0.90 )
Weighted average shares used in computing net loss per common
share, basic and diluted
    14,193,246       11,935,515  
                 
                 
                 
                 
 The accompanying notes are an integral part of these financial statements.  



 
 
 
 
F-3

 

 
 
Implant Sciences Corporation
 
Consolidated Statements of Stockholders' Equity (Deficit)
 
For the Years Ended June 30, 2008 and 2009
 
                                                             
        Common Stock                
 
              Treasury Stock              
       
Number of Shares
 
 
Amount
     
Additional
Paid-in
Capital
     
Accumulated
Deficit
     
Deferred
Compensation
   
  Accumulated
Other
Comprehensive
Income (Loss)
     
Number
of
Shares
   
Amount
     
Total
Stockholders'
Equity (Deficit)
     
Comprehensive
(Loss)
 
Balance at June 30, 2007
    11,835,661     $ 1,183,000     $ 57,358,000     $ (47,927,000 )   $ (30,000 )   $ (65,000 )     10,545     $ (73,000 )   $ 10,446,000     $ -  
Issuance of common stock in connection with employee stock purchase plan
    57,163       6,000       47,000                                               53,000          
Issuance of common stock in connection with settlement of Rapiscan litigation
    221,729       22,000       178,000                                               200,000          
Fair value of warrants issued to consultants
   
 
              15,000                                               15,000          
Fair value of warrants issued in connection
with Bridge Bank loans
             
 
    29,000                                               29,000          
Amortization of deferred compensation
   
 
              (7,000 )             28,000                               21,000          
Share-based compensation
                    697,000                                               697,000          
Series D accretion and dividends
                            (1,058,000 )                                     (1,058,000 )        
Unrealized loss on available for sale securities
     
 
                                    (33,000 )                     (33,000 )     (33,000 )
Net loss
                            (10,735,000 )                                     (10,735,000 )     (10,735,000 )
Balance at June 30, 2008
    12,114,553     $ 1,211,000     $ 58,317,000     $ (59,720,000 )   $ (2,000 )   $ (98,000 )     10,545     $ (73,000 )   $ (365,000 )   $ (10,768,000 )
                                                                                 
Issuance of common stock in connection with employee stock purchase plan
    31,147       3,000       20,000                                               23,000          
Issuance of common stock in connection with exercise of stock options
    59,505       6,000       6,000                                               12,000          
Issuance of common stock in connection with Ion Metrics, Inc. acquisition
    2,000,000       200,000       2,264,000                                               2,464,000          
Issuance of common stock to consultants
    300,000       30,000       40,000                                               70,000          
Issuance of common stock in payment of Preferred Stock
    929,535       93,000       175,000                                               268,000          
Fair value of warrants issued to consultants
   
 
              9,000                                               9,000          
Fair value of warrants issued in connection with Senior Secured Convertible Promissory Note
             
 
    160,000                                               160,000          
Amortization of deferred compensation
   
 
              (24,000 )             2,000                               (22,000 )        
Share-based compensation
                    323,000                                               323,000          
Series D accretion and dividends
                            (207,000 )                                     (207,000 )        
Realized loss on available for sale securities
   
 
                                      98,000                       98,000       98,000  
Net loss
                            (12,751,000 )                                     (12,751,000 )     (12,751,000 )
Balance at June 30, 2009
    15,434,740     $ 1,543,000     $ 61,290,000     $ (72,678,000 )   $ -     $ -       10,545     $ (73,000 )   $ (9,918,000 )   $ (12,653,000 )
                                                                                 
                                                                                 
                                                                                 
                                                                                 
                                                                                 
The accompanying notes are an integral part of these financial statements.
 


 

 
 
F-4

 
 


Implant Sciences Corporation
 
Consolidated Statements of Cash Flows
 
             
   
For The Years Ended June 30,
 
   
2009
   
2008
 
Cash flows from operating activities:
           
Net loss
  $ (12,751,000 )   $ (10,735,000 )
Less:  Net income (loss) from discontinued operations
    808,000       (3,021,000 )
Loss from continuing operations
    (13,559,000 )     (7,714,000 )
Adjustments to reconcile net loss from continuing operations to net cash flows:
               
Depreciation and amortization
    263,000       284,000  
Bad debt expense (recoveries)
    56,000       (11,000 )
Share-based compensation expense
    315,000       582,000  
Change in fair value of embedded derivatives
    -       (133,000 )
Loss on disposal of fixed assets
    61,000          
Non-cash interest expense
    1,172,000       29,000  
Realized losses in unconsolidated subsidiaries
    98,000       -  
Fair value of warrants issued to non-employees
    (13,000 )     36,000  
Warrant accretion on debt
    96,000       15,000  
Loss on sale of investments
    -       51,000  
Gain on transfer of investment
    (468,000 )     -  
Evans litigation settlement
    5,700,000       -  
Interest on note receivable
    (6,000 )     -  
Changes in assets and liabilities, net of effect of acquisition:
               
Accounts receivable
    424,000       (290,000 )
Inventories
    164,000       (42,000 )
Prepaid expenses and other current assets
    (79,000 )     354,000  
Cash overdraft
    6,000       -  
Accounts payable
    1,860,000       1,628,000  
Accrued expenses
    (92,000 )     482,000  
Deferred revenue
    362,000       (5,000 )
Lease liability
    (345,000 )     (273,000 )
Net cash used in operating activities of continuing operations
    (3,985,000 )     (5,007,000 )
Net cash  used in operating activities of discontinued operations
    (33,000 )     (587,000 )
Net cash used in operating activities
    (4,018,000 )     (5,594,000 )
Cash flows from investing activities:
               
Purchases of property and equipment
    (103,000 )     (99,000 )
Proceeds from release of escrow funds
    300,000       -  
Investments in certificates of deposit
    75,000       (489,000 )
Payments received on note receivable
    699,000       -  
Proceeds from the sale of Core Systems
    1,080,000       -  
Proceeds from the sale of assets of discontinued operations
    1,559,000       -  
Proceeds from the sale of investments
    -       49,000  
Acquisition of Ion Metrics, net of cash received
    -       (231,000 )
Increase in other non-current assets
    27,000       (385,000 )
Net cash provided by (used in) investing activities of continuing operations
    3,637,000       (1,155,000 )
Net cash used in investing activities of discontinued operations
    (28,000 )     (202,000 )
Net cash provided by (used in) investing activities
    3,609,000       (1,357,000 )




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


 
 

 
F-5

 



Implant Sciences Corporation
 
Consolidated Statements of Cash Flows
 
             
   
For The Years Ended June 30,
 
   
2009
   
2008
 
Cash flows from financing activities:
           
Proceeds from common stock issued in connection with exercise
           
of stock options and employee stock purchase plan
    23,000       53,000  
Dividends on Series D Cumulative Convertible Preferred Stock
    (52,000 )     (263,000 )
Payments on Series D Cumulative Convertible Preferred Stock
    (2,724,000 )     (1,515,000 )
Proceeds from the issuance of senior secured convertible debt, net
    4,759,000       -  
Principal payments on senior secured convertible debt
    (1,000,000 )     -  
Proceeds from note payable with Company director
    100,000       -  
Principal repayments of long-term debt and capital lease obligations
    (344,000 )     (1,007,000 )
Net borrowings (repayments) on line of credit
    (764,000 )     477,000  
Net cash used in financing activ