INTZ · Read the filing

Item 1A. Risk Factors

We had a net loss of $6.5 million for the

year ended December 31, 2020, and we have an accumulated deficit of $61.3 million as of December 31, 2020. To improve our financial

performance, we must increase revenue levels.

For the year ended December

31, 2020, we had a net loss of $6.5 million and had an accumulated deficit of approximately $61.3 million as of December 31, 2020,

compared to a net income of $4.5 million for the year ended December 31, 2019 and an accumulated deficit of approximately $54.8

million at December 31, 2019. We need to increase current revenue levels from the sales of our solutions if we are to regain profitability.

If we are unable to increase revenue levels, losses could continue for the near term and possibly longer, and we may not regain

profitability or generate positive cash flow from operations in the future.

We may be unable to successfully market,

promote, and sell our new commercial solution, INTRUSION Shield, and market it through new sales channels to a new set of

prospective customers.

We anticipate significant

resources will be required in order to succeed in launching our new Shield solution, including the time, attention,

and focus of our senior management and our research and development team, coordination of new marketing strategies highlighting

this new offering and promoting it through new and expanded sales channels to a wider audience of prospective customers than we

have historically marketed and sold our solutions and services. In addition, significant financial resources will be required to

successfully manage the implementation of this new solution. This could result in diversion of those resources from critical areas

of our company operations and a potential strain on our liquidity and ability to meet our current and these anticipated increases

in our cash-flow needs.

We could experience damage to our reputation

in the cybersecurity industry in the event that our Shield solution fails to meet our customers’ needs or to achieve market

acceptance.

Our reputation in the industry

as a provider of entity identification, data mining, and advanced persistent threat detection solutions may be harmed, perhaps

significantly, in the event that Shield fails to perform as we expect it to. If Shield does not perform

as we expect, if we experience delivery delays, or if our customers do not perceive the benefits of purchasing and using Shield

as part of their comprehensive cybersecurity solution, our position as a leader in this technology space may be damaged

and could affect the willingness of our customers, as well as potential customers, to purchase our other solutions that function

separately from Shield. Any reputational damage could result in a decrease in orders for all of our solutions, the

loss of current customers, and a decrease in our overall revenues which could in turn have a material adverse effect on our results

of operation.

The effect of the coronavirus, particularly

in the diversion of time and resources of the federal, state, and local governmental entities which make up a significant concentration

of our customer base, have and may continue to cause material adverse effects on our operations and our financial results.

A significant concentration

of our federal, state, and local governmental customers have been forced to allocate scarce and competing resources and balance

budgetary demands placed upon them as a result of the effects of the coronavirus, mandatory quarantines, decreased travel, interruptions

in workforce populations, scarcity of commodities, and similar economic and operational effects of the virus upon their own constituencies.

Considerable uncertainties continue with respect to the spread and containment of the pandemic, including, without limitation,

the effects of mutations in the virus and the efficacy of vaccination efforts throughout the country and the world. These adverse

effects have resulted in decreased demand by some of our customers for our current product offerings and cybersecurity solutions,

negatively affecting historic revenue levels for the Company. In turn, we are continuing to adapt our operations and the efficiency

of our own staff, employees, and strategic partners, including increased reliance on remote workplace solutions during 2020 and

continuing indefinitely into 2021. A continued decrease in orders for our solutions by our government customers and losses of efficiency

or diversions of resources in our own operations may continue to cause material adverse effect on our operations and financial

results, which may not be offset even with the successful introduction of Shield solution into the marketplace.

We must expend time and resources addressing potential

cybersecurity risk, and any breach of our information security safeguards could have a material adverse effect on the Company.

The threat of cyber-attacks

requires additional time and money to be expended in efforts to prevent any breaches of our information security protocols. However,

we can provide no assurances that we can prevent all such attempts from being successful, which could result in expenses to address

and remediate such breaches as well as potentially losing the confidence of our customers who depend upon our services to prevent

and mitigate such attacks on their respective business. Should a material breach of our information security systems occur, it

would likely have a material adverse impact on our business operations, our customer relations, and our current and future sales

prospects, resulting in a significant loss of revenue.

Fluctuations in our quarterly revenues may cause

the price of our common stock to decline.

Our operating results have

varied significantly from quarter to quarter in the past, and we expect our operating results to vary from quarter to quarter in

the future due to a variety of factors, many of which are outside of our control. Therefore, if revenues are below our expectations,

this shortfall is likely to adversely and disproportionately affect our operating results. Accordingly, we may not attain positive

operating margins in future quarters. Any of these factors could cause our operating results to be below the expectations of securities

analysts and investors, which likely would negatively affect the price of our common stock.

A large percentage of our current revenues

are received from U.S. government entities, and the loss of these customers or our failure to widen the scope of our customer base

to include general commercial enterprises could negatively affect our revenues.

A large percentage of our current

revenues result from sales to U.S. government entities. If we were to lose one or more of these customers, our revenues could decline

and our business and prospects may be materially harmed. Further, sales to the government present risks in addition to those involved

in sales to commercial customers, including potential disruption due to appropriation and spending patterns, delays in approving

a federal budget and the government’s right to cancel contracts and purchase orders for its convenience. While we expect

that developing relationships with non-governmental customers will mitigate or eliminate this dependence on, and risk from, serving

governmental entities, we can offer no assurances that we will be able to sufficiently diversify our customer portfolio in a time

and manner to adequately mitigate this risk.

Almost all of our existing revenues are

currently from one family of solutions with a limited number of customers, and the decrease of revenue from sales of this family

of solutions could materially harm our business and prospects. Timeliness of orders from customers may cause volatility in growth.

Almost all of our existing revenues

result from sales of one cybersecurity solution. TraceCop revenues were $6.2 million for the year ended December

31, 2020, compared to $13.4 million for the year ended December 31, 2019. While we anticipate the introduction of our new Shield

solution will reduce our dependence on this single solution, we can offer no assurances as such, and in the absence of a shift

in solution mix, we may continue to face risks in the event that sales of this key solution to these limited customers were to

decrease.

We are highly dependent on sales of our current

solutions through indirect channels, the loss of which would materially adversely affect our operations.

For the years ended December 31, 2019 and

2020, we derived 70.3% and 49.3% of our revenues from sales through indirect sales channels, such as distributors, value-added

resellers, system integrators, original equipment manufacturers and managed service providers. We must expand sales of our current

solutions as well as any new solutions, such as Shield, through these indirect channels in order to increase our

revenues. We cannot assure you that our current solutions or future solutions will gain market acceptance in these indirect sales

channels or that sales through these indirect sales channels will increase our revenues. Further, many of our competitors are also

trying to sell their products and solutions through these indirect sales channels, which could result in lower prices and reduced

profit margins for sales of our solutions.

You will experience substantial dilution upon

the exercise of certain stock options currently outstanding.

On February 12, 2021, we had

17,538,779 shares of common stock outstanding. Upon the exercising of current options exercisable at or below the exercise price

of $4.75, we would have approximately 18,014,116 shares of common stock outstanding, a 2.71% increase in the number of shares of

our common stock outstanding.

We resemble a developmental stage company and

our business strategy may not be successful.

We depend exclusively on revenues

generated from the sale of our current network security/advanced persistent threat detection solution (Savant), which

has received limited market acceptance, and our entity identification, data mining and analytic solution (TraceCop).

We can provide no assurances that these solutions or our newly developed Shield solution will ever achieve widespread

market acceptance or that an adequate market for these solutions will ever emerge. Consequently, we resemble a developmental stage

company and will face the following inherent risks and uncertainties:

· our ability to manage costs and expenses;

· our dependence on key personnel;

· our ability to obtain financing on acceptable terms; and

· our ability to offer greater value than our competitors.

Our business strategy may not

successfully address these risks. If we fail to recognize significant revenues from the sales of our current and in-development

solutions, our business, financial condition and operating results would be materially adversely affected.

If we fail to respond to rapid technological

changes in the network security industry, we may lose customers or our solutions may become obsolete.

The network security industry

is characterized by frequent product and service introductions, rapidly changing technology and continued evolution of new industry

standards. We have and must continue to introduce upgrades to our current solutions rapidly in response to customer needs such

as new computer viruses or other novel external attacks on computer networks. Further, our new Shield solution represents

our efforts to continue to provide state-of-the art first-in-time innovation for our customer’s cybersecurity solutions.

As a result, our success depends upon our ability to develop and introduce timely upgrades, enhancements, and new solutions to

meet evolving customer requirements and industry standards. The development of technologically advanced network security products

and solutions is a complex and uncertain process requiring high levels of innovation, rapid response, and accurate anticipation

of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support

new or enhanced solutions successfully in a timely manner. Further, we or our competitors may introduce new solutions or enhancements

that shorten the life cycle of our existing solutions or cause our existing solutions to become obsolete.

We face intense competition from both start-up

and established companies that may have significant advantages over us and our solutions.

The market for our solutions

is intensely competitive. There are numerous companies competing with us in various segments of the data security markets, and

their products or solutions may have advantages over our solutions in areas such as conformity to existing and emerging industry

standards, interoperability with networking and other cybersecurity products, management and security capabilities, performance,

price, ease of use, scalability, reliability, flexibility, features, and technical support.

Our principal competitors

in the data mining and advanced persistent threat market include Niksun, NetScout, FireEye, and Darktrace. Our current and potential

competitors may have one or more of the following significant advantages over us:

· greater financial, technical and marketing resources;

· better name recognition;

· more comprehensive security solutions;

· better or more extensive cooperative relationships; and

· larger customer base.

We cannot assure you that we will be able

to compete successfully with our existing or new competitors. Some of our competitors may have, in relation to us, one or more

of the following:

· longer operating histories;

· longer-standing relationships with OEM and end-user customers; and

· greater customer service, public relations and other resources.

As a result, these competitors may be able

to more quickly develop or adapt to new or emerging technologies and changes in customer requirements, or devote greater resources

to the development, promotion and sale of their products or solutions. Additionally, it is likely that new competitors or alliances

among existing competitors could emerge and rapidly acquire significant market share.

Our management and larger stockholders currently

exercise significant control over our Company and such influence may be in conflict to your interests.

As of February 12, 2021, our

executive officers and directors beneficially own approximately 8.7% of our voting power. In addition, other related affiliate

parties control approximately 47.5% of voting power. As a result, these stockholders have been able to exercise significant control

over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions.

Although we follow our policies regarding related party transactions, we cannot entirely eliminate the influence of these stockholders

as long as they hold such a concentration of the voting power of our common stock.

Our solutions are highly technical and if

they contain undetected errors, our business could be adversely affected and we might have to defend lawsuits or pay damages in

connection with any alleged or actual failure of our solutions and services.

Our solutions are highly technical and

complex, are critical to the operation of many networks and, in the case of ours, provide and monitor network security and may

protect valuable information. Our solutions have contained and may contain one or more undetected errors, defects or security vulnerabilities.

Some errors in our solutions may only be discovered after a solution has been installed and used by end customers. Any errors or

security vulnerabilities discovered in our solutions after commercial release could result in loss of revenues or delay in revenue

recognition, loss of customers and increased service and warranty cost, any of which could adversely affect our business and results

of operations. In addition, we could face claims for product liability, tort, or breach of warranty. Defending a lawsuit, regardless

of its merit, is costly and may divert management’s attention. In addition, if our business liability insurance coverage

is inadequate or future coverage is unavailable on acceptable terms or at all, our financial condition could be harmed.

A breach of network security could harm public

perception of our cybersecurity solutions, which could cause us to lose revenues.

If an actual or perceived breach of network

security occurs in the network of a customer of our cybersecurity solutions, regardless of whether the breach is attributable to

our solutions, the market perception of the effectiveness of our solutions could be harmed. This could cause us to lose current

and potential end customers or cause us to lose current and potential value-added resellers and distributors. Because the techniques

used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against

a target, we may be unable to anticipate these techniques.

If our solutions do not interoperate with

our customers’ networks, installations will be delayed or cancelled and could harm our business.

Our solutions are designed to interface

with our customers’ existing networks, each of which have different specifications and utilize multiple protocol standards

and products or solutions from other vendors. Many of our customers’ networks contain multiple generations of products that

have been added over time as these networks have grown and evolved. Our solutions will be required to interoperate with many products

and solutions within these networks as well as future products or solutions in order to meet our customers’ requirements.

If we find errors in the existing software or defects in the hardware used in our customers’ networks, we may have to modify

our software or hardware to fix or overcome these errors so that our solutions will interoperate and scale with the existing software

and hardware, which could be costly and negatively impact our operating results. In addition, if our solutions do not interoperate

with those of our customers’ networks, demand for our solutions could be adversely affected, orders for our solutions could

be cancelled, or our solutions could be returned. This could hurt our operating results, damage our reputation and seriously harm

our business and prospects.

We must adequately protect our intellectual

property in order to prevent loss of valuable proprietary information.

We rely primarily on a combination of patent,

copyright, trademark and trade secret laws, confidentiality procedures, and non-disclosure agreements to protect our proprietary

technology. However, unauthorized parties may attempt to copy or reverse- engineer aspects of our solutions or to obtain and use

information that we regard as proprietary. Policing unauthorized use of our solutions is difficult, and we cannot be certain that

the steps we have taken will prevent misappropriation of our intellectual property. This is particularly true in foreign countries

whose laws may not protect proprietary rights to the same extent as the laws of the United States and may not provide us with an

effective remedy against unauthorized use. If protection of our intellectual property proves to be inadequate or unenforceable,

others may be able to use our proprietary developments without compensation to us, resulting in potential cost advantages to our

competitors.

We may incur substantial expenses defending

ourselves against claims of infringement.

There are numerous patents held by many

companies relating to the design and manufacture of network security systems. Third parties may claim that our solutions infringe

on their intellectual property rights. Any claim, with or without merit, could consume our management’s time, result in costly

litigation, cause delays in sales or implementations of our solutions or require us to enter into royalty or licensing agreements.

Royalty and licensing agreements, if required and available, may be on terms unacceptable to us or detrimental to our business.

Moreover, a successful claim of product infringement against us or our failure or inability to license the infringed or similar

technology on commercially reasonable terms could seriously harm our business.

The price of our common stock has been volatile

in the past and may continue to be volatile in the future due to factors outside of our control.

The market price of our common stock has

been highly volatile in the past and may continue to be volatile in the future. Our common stock was traded on the OTCQB until

October 9, 2020, when it began trading on the Nasdaq Capital Market. For the twelve months ended December 31, 2020, the market

price of our common stock fluctuated between $2.70 and $19.09. The market value of our common stock may fluctuate significantly

in the future in response to a number of factors, some of which are outside our control, including:

· variations in our quarterly operating results;

· changes in estimates of our financial performance by securities analysts;

· changes in market valuations of our competitors;

· thinly traded common stock;

· product or design flaws, product recalls or similar occurrences;

· additions or departures of key personnel;

· sales of common stock in the future; and

Item 2. Properties

Our corporate headquarters are currently

located in 8,331 square feet of space at 101 East Park Blvd, Suite 1300, Plano Texas. This facility houses our corporate administration,

sales and marketing. The lease for this facility extends until September 2023. The Company vacated its previous space in Richardson,

Texas beginning in the fourth quarter of 2020. The lease for this 23,000 square foot facility extends through November 2024 and

is the subject of a lawsuit the Company filed against the landlord on February 16, 2021. We have charged this landlord with breach

of contract, constructive eviction, and we have requested a declaratory judgment relieving us of any further payment obligations

under this lease.

For a variety of reasons, the Company encouraged

its Texas based engineers and analysts to work remotely beginning in fourth quarter 2020. Approximately 13 percent of our security

software research and development and engineering staff are currently working remotely from home offices in California. We have

one small facility in San Marcos, California under a lease and expiring in March 2021. We have one engineer working from home in

New Mexico.

We believe that the existing facilities

will be adequate to meet our operational requirements through 2021, although we periodically review our leased space to in order

to ensure such space is secure and suitable for our current and future needs. We believe that all such facilities are adequately

covered by appropriate property insurance. See Note 4 to our Consolidated Financial Statements for additional information regarding

our obligations under leases.

Item 3. Legal Proceedings.

On February 16, 2021, Intrusion Inc. instituted

legal proceedings in the District Court of Dallas County, Texas, 14th Judicial District against Purple Plaza LLC, the

landlord for the facilities we previously occupied in Richardson, Texas. This lawsuit claims damages for breach of contract for,

among other things, failure to maintain and repair the leased facilities and to provide adequate heating, air conditioning, and

ventilation on the premises, resulting in a constructive eviction. Intrusion is seeking damages in excess of $1,000,000 together

with a declaratory judgment that any of Intrusion’s remaining obligations under the lease have terminated. The landlord filed

a general denial on March 5, 2021.

In addition to this pending litigation,

we are subject to various other legal proceedings and claims that may arise in the ordinary course of business. We do not believe

that any claims exist where the outcome of such matters would have a material adverse effect on our consolidated financial position,

operating results or cash flows. However, there can be no assurance such legal proceedings will not have a material impact on future

results.

PART II

Item 5. Market for Common Equity and Related Stockholder Matters and Business Issuer Purchases of Equity Securities. – Intrusion Equity Accounting

Our common stock trades on the Nasdaq Capital

Market, where it is currently listed under the symbol “INTZ.” As of February 12, 2021, there were approximately 105

registered holders of record of our common stock. Quotations on the OTCQB reflect inter-dealer prices, without retail mark-up,

mark-down or commission and may not represent actual transactions.

All stock option plans under which our common

stock is reserved for issuance have previously been approved by our stockholders. The following table provides summary information

as of December 31, 2020 for all of our equity compensation plans (in thousands, except per share data). See Note 9 to our

consolidated financial statements for additional discussion.

Equity compensation plans approved by security holders 1 1,035 2.87 46

Equity compensation plans not approved by security holders – – –

__________________

Item 7.Management’s

Discussion and Analysis of Financial Condition and Results of Operations.

Our Business

We develop, sell and support products that

protect any-sized company or government organization by fusing advanced threat intelligence with real-time artificial intelligence

to neutralize cyberattacks as they occur – including Zero-Day attacks. We market and distribute our solutions through a direct

sales force and value-added resellers. Our end-user customers include U.S. federal government entities, state and local government

entities, and companies ranging in size from mid-market to large enterprises.

Our Solutions

INTRUSION Shield

INTRUSION Shield, our cornerstone

cybersecurity solution is a comprehensive, real-time AI-based Security-as-a-Service that inspects and kills all dangerous network

connections before they can do damage. What makes our approach unique is that it inspects every packet of inbound and outbound

traffic and analyzes the reputation of the IP addresses (source and destination), the domain and ports it is communicating on,

along with many other fields in the packet to neutralize malicious connections.

Most breaches today are caused by malware

free compromises that trigger no alarms in a firewall or endpoint solution. The common denominator is network communications, which

Shield monitors and analyses, allowing Shield to identify and stop all attacks, even malware-free attacks.

Shield’s capabilities continuously evolve based on constant machine learning and neural networking technology.

Unlike traditional industry approaches that rely heavily on human mitigation and defensive approaches, which malicious actors and

nation states have learned to bypass, Shield’s proprietary architecture isolates and neutralizes malicious

traffic and network flows that existing solutions cannot identify before they harm a corporation or government organization.

Shield is designed as a next

generation Network Detection and Response solution. After 30 years of providing research, analysis, tools and services to the federal

government and enterprise corporations, Intrusion possesses a comprehensive and proprietary data set of petabytes of Internet traffic,

including information about the activities of malicious online actors. Shield integrates this rich TraceCop

data set with artificial intelligence (AI) and Savant real-time process flow technology to provide our customers

with a unique and affordable tool to detect, identify, and neutralize cyberattacks. In particular, the Shield AI

has been specifically trained to identify and stop Zero-Day attacks and ransomware, the most prolific and crippling forms of malware

today.

INTRUSION TraceCop

INTRUSION TraceCop is

our big data tool with extensive IP intelligence canvassing the entire Internet. It contains largest repository of reputation information

on known good and known bad active IP addresses (both IPv4 and IPv6). TraceCop contains an inventory of network selectors

and enrichments useful to support forensic investigations. The data contains a history of IPv4 and IPv6 block

allocations and transfers, historical mappings of IP addresses to Autonomous Systems (ASNs) as observed through BGP, and approximately

one billion historically registered domain names and registration context. TraceCop contains tens of billions

of historic DNS resolutions of Fully Qualified Domain Names (FQDNs or hostnames) on each of these domains. Together, this shows

relationships, hosting, and attribution for Internet resources. TraceCopalso contains web server

content surveys of content, such as natural language and topic of the content on hundreds of millions of websites and servers and

OS fingerprints of services showing applications running on an IP. This context allows Shield to assess the use and

purpose of an Internet resource. TraceCopalso contains a history of threat and reputation for each

hostname and IP address over time. All this makes it a very effective network forensics and cybersecurity analysis tool to inform

Shield.

INTRUSION Savant

INTRUSION Savant is a network

monitoring solution that leverages the rich data available in TraceCop to identify suspicious traffic in real-time.

Savant uses several original patents to uniquely characterize and record all network flows. Savant

is a network reconnaissance and attack analysis tool used by forensic analysts in the DoD, Federal Government and corporations

with in-house threat research teams. For example, Savant users can create various automated rules to inspect packets

matching (or not) certain criteria such as creating a rule to ensure the Source MAC address field in the Ethernet header and Source

IP address from the IP header are always the same, failing which could indicate MAC or IP Spoofing in progress. Similarly, threat

investigators can create rules using regular expressions by combining multiple fields in the packet headers. Ultimately, the rich

capabilities of Savant provides the real-time analysis that Shield uses to make decisions on whether

or not a packet is malicious.

Critical Accounting Policies and

Estimates

Management’s discussion and analysis

of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared

in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements

requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and

related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related

to product returns, bad debts, inventories, income taxes, warranty obligations, maintenance contracts and contingencies. We base

our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances,

the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily

apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting

policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We generally recognize product revenue

upon shipment or after meeting certain performance obligations. These products can include hardware, perpetual software licenses

and data sets. Data set updates are the majority of sales. We do not currently offer software on a subscription basis. Warranty

costs and sales returns for our current products have not been material.

We recognize sales of our data sets in

accordance with FASB ASC Topic 606 whereby revenue from contracts with customers is not recognized until all five of the following

have been met:

· identify the contract with a customer;

· identify the performance obligations in the contract;

· determine the transaction price;

· allocate the transaction price to the separate performance obligations; and

· recognize revenue upon satisfaction of a performance obligation.

Data updates are typically done monthly,

and revenue will be matched accordingly. Product sales may include maintenance and customer support allocated revenue in an arrangement

using estimated selling prices of the delivered goods and services based on a selling price hierarchy using the relative selling

price method. All of our solution offering and service offering market values are readily determined based on current and prior

stand-alone sales. We may defer and recognize maintenance, updates and support revenue over the term of the contract period, which

is generally one year.

Service revenue, primarily including maintenance,

training and installation, are recognized upon delivery of the service and typically are unrelated to product sales. To date, maintenance,

training and installation revenue has not been material. Our normal payment terms offered to customers, distributors and resellers

are net 30 days domestically and net 45 days internationally. We do not offer payment terms that extend beyond one year and rarely

do we extend payment terms beyond our normal terms. If certain customers do not meet our credit standards, we do require payment

in advance to limit our credit exposure.

Shipping and handling costs are billed

to the customer and included in product revenue. Shipping and handling expenses are included in cost of product revenue.

Allowances for Doubtful Accounts

We maintain allowances for doubtful accounts

for estimated losses resulting from the inability of our customers to make required payments. Our receivables are uncollateralized,

and we expect to continue this policy in the future. If the financial condition of our customers were to deteriorate, resulting

in an impairment of their ability to make payments, increased allowances may be required. Historically, our estimates for sales

returns and doubtful accounts have not differed materially from actual results.

Fair Value of Financial Instruments

We calculate the fair value of our assets

and liabilities which qualify as financial instruments and include additional information in the notes to consolidated financial

statements when the fair value is different than the carrying value of these financial instruments. The estimated fair value of

accounts receivable, accounts payable and accrued expenses, and dividends payable approximate their carrying amounts due to the

relatively short maturity of these instruments. Financing leases and PPP loan approximate fair value as they bear market rates

of interest.

Results of Operations

The following tables set forth, for the

periods indicated, certain financial data as a percentage of net revenue.

Year Ended December 31,

Total cost of revenue 40.9 39.2

Operating expenses:

Sales and marketing 57.7 9.5

Research and development 57.4 9.6

General and administrative 42.5 8.7

Operating income (loss) (98.5 ) 33.0

Interest expense (0.1 ) (0.3 )

Interest income 0.1 –

Income (loss) from operations before income taxes (98.5 ) 32.7

Income tax provision – –

Preferred stock dividends accrued (1.2 ) (1.0 )

Net income (loss) attributable to common stockholders (99.7 )% 31.7 %

2020 compared with 2019

Net Revenue

Total revenue decreased 51.5% to $6.6 million

in 2020 from $13.6 million in 2019. We did not meet sales projections for our TraceCop product line. We expect our

product revenues to increase in the future if we can increase sales to existing customers and add new customers.

There were no export sales in 2020 and 2019

primarily due to our focus on domestic revenue sales. Sales of our products internationally may be subject to currency exchange

risk, which may cause our products to effectively increase in price, if the exchange rate moves significantly and the dollar gains

value over the foreign currency.

Historically, due to the timing of our sales

cycle, a significant portion of our monthly sales occurs in the second half of the month. Accordingly, our receivables increase

at the end of each month, which causes a higher accounts receivable balance at month end. This monthly trend also causes an inflated

comparative relationship between revenue and accounts receivable. We believe that this monthly trend will continue because monthly

sales forecast and planning meetings are held in the first week of every month, the middle of the month is focused on sales calls

to customers and the latter half of the month on closing sales.

Gross Profit

Gross profit decreased 52.9% to $3.9 million

in 2020 from $8.3 million in 2019. As a percentage of net revenue, gross profit decreased from 60.8% in 2019 to 59.1% in 2020.

Gross profit as a percentage of revenue, decreased in 2020 compared to 2019 because of higher labor costs related to certain projects.

Gross profit as a percentage of net revenue

is impacted by several factors, including shifts in product mix, changes in channels of distribution, sales volume, fluctuations

in manufacturing costs, labor costs, pricing strategies, and fluctuations in sales of integrated third-party products.

Sales and Marketing

Sales and marketing expenses increased to

$3.8 million or 57.7% of net revenue in 2020, compared to $1.3 million or 9.5% of net revenue in 2019. The increase in sales and

marketing expense was primarily two activities: building, training, and preparing a sales department to sell our new commercial

product in 2021; and applying a dedicated $1.2 million marketing and promotion budget. Sales and marketing expenses may vary in

the future. We expect sales and marketing expenses to increase if net revenue levels increase in 2021.

Research and Development

Research and development expenses increased

to $3.8 million or 57.4% of net revenue in 2020 compared to $1.3 million or 9.6% of net revenue in 2019. The increase in research

and development expense was due to less labor expense shifted to direct labor costs. Our research and development costs are expensed

in the period in which they are incurred. We expect research and development expenses to increase if we are able to increase net

revenue levels in 2021. Research and development expense levels may fluctuate due to labor expense shifting to direct labor.

General and Administrative

General and administrative expenses increased

to $2.8 million, or 42.5% of net revenue in 2020 compared to $1.2 million or 8.7% of net revenue in 2019. This was primarily a

result of a non-cash write off for a $1.1 million abandoned operating lease asset. Other contributing expenses were related to

increases in administrative and Human Resources. Excluding the $1.1 million non-cash write off for the abandonment of prior office

lease, we expect general and administration expenses to remain constant but increase if net revenue levels increase in 2021.

Interest Expense

Interest expense decreased to $6 thousand

in 2020, compared to $46 thousand in 2019. Interest expense decreased due to a combination of a zero balance under an unsecured

revolving promissory note to borrow up to $3,700,000 from G. Ward Paxton, the Company’s former Chief Executive Officer (the

“CEO Note”) and declining balances in financial leases and remained steady for operating leases. Interest expense will

vary in the future based on our cash flow and borrowing needs.

Interest Income

Interest income earned on bank deposits

was $11 thousand in 2020 compared to $4 thousand in 2019.

Income Taxes

Our effective income tax rate was 0% in

2020 and 2019 as valuation allowances have been recorded for the entire amount of the net deferred tax assets due to uncertainty

of realization. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (“the Tax Act”) which significantly

changed U.S. tax law. The Tax Act lowered the Company’s statutory federal income tax rate from a maximum of 39% to a rate

of 21% effective January 1, 2018.

Liquidity and Capital Resources

Our principal source of liquidity at December 31,

2020 was $16.7 million of cash and cash equivalents. As of December 31, 2020, we did not hold investments with a stated maturity

beyond one year. Working capital at December 31, 2020 was $16.2 million, while at December 31, 2019, it was $3.1 million.

Net cash used in operations for the twelve

months ended December 31, 2020, was $5.2 million due primarily to a net loss of $6.5 million and the following uses of cash: a

$339 thousand decrease in deferred revenue, a $258 thousand increase in prepaid expenses and other assets, and a $334 thousand

decrease in accounts payable and accrued expenses. This was partially offset by these sources of cash and non-cash items: a $1.1

million non-cash write-off for an abandoned operating lease asset, a $333 thousand decrease in accounts receivable, $322 thousand

in stock-based compensation, $231 thousand in depreciation expense and amortization expense, and $294 thousand in noncash lease

costs.

Net cash provided by operations for the

twelve months ended December 31, 2019, was $4.3 million due primarily to a net income of $4.5 million and the following sources

of cash and non-cash items: $232 thousand in noncash lease costs, a $401 thousand decrease in accounts receivable, $184 thousand

in depreciation expense and amortization expense, $47 thousand in stock-based compensation, and $6 thousand in waived penalties

on dividends. This was partially offset by a $496 thousand decrease in accounts payable and accrued expenses, a $488 thousand decrease

in deferred revenue, and a $61 thousand increase in prepaid expenses and other assets. Future fluctuations in accounts receivable,

inventory balances and accounts payable will be dependent upon several factors, including quarterly sales, timely collection of

accounts receivable, and the accuracy of our forecasts of product demand and component requirements.

Net cash used in investing activities in

2020 was $320 thousand for purchases of property and equipment. Net cash used in investing activities in 2019 was $260 thousand

for purchases of property and equipment.

Net cash provided by financing activities

in 2020 was $18.9 million with proceeds of $18.2 million from a stock offering, $629 thousand from a PPP loan, and proceeds from

exercise of stock options of $209 thousand. This was directly offset by the following uses of cash: payments for preferred stock

dividends of $99 thousand and payment on principal of finance right-of-use leases of $43 thousand. Net cash used in financing activities

in 2019 was $2.3 million primarily due to payments on the loan by an officer of $1.8 million, $714 thousand payment of dividends

on preferred stock, and $58 thousand payments on principal on financing leases. This was directly offset by a provision of cash

of $239 thousand from the exercise of stock options.

At December 31, 2020, we had a commitment

of $21 thousand for future finance lease liabilities. Operating lease commitments of $2.6 million are detailed in the Contractual

Obligations section below. At December 31, 2019, we had a commitment of $66 thousand for future finance lease liabilities,

while operating lease commitments were $1.8 million. During 2020, we funded our operations through the use of available cash and

cash equivalents.

As of December 31, 2020, we had cash and

cash equivalents of approximately $16.7 million, up from approximately $3.3 million as of December 31, 2019. We generated a net

loss of $6.5 million for the year ended December 31, 2020 compared to a net income of $4.5 million for the year ended December

31, 2019.

We expect to fund our operations through

anticipated Company profits together with the approximately $18 million in net proceeds we received from our Secondary Public Offering,

which we believe will be sufficient to finance our operations, the additional expenses of marketing, promoting, and selling our

new Shield solution and the development of its follow-on solutions, as well as other expected capital expenditures for the next

twelve months.

We may explore the possible acquisitions

of businesses, products and technologies that are complementary to our existing business. We are continuing to identify and prioritize

additional security technologies, which we may wish to develop, either internally or through the licensing, or acquisition of products

from third parties. While we may engage from time to time in discussions with respect to potential acquisitions, there can be no

assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business. In

order to finance such acquisitions and working capital it may be necessary for us to raise additional funds through public or private

financings. Any equity or debt financings, if available at all, may be on terms, which are not favorable to us and, in the case

of equity financings, may result in dilution to our stockholders.

Contractual Obligations

The following table sets forth certain information

concerning the future contractual obligations under our leases at December 31, 2020. We had no other significant contractual

obligations at December 31, 2020.

Future minimum lease obligations consisted of the following

at December 31, 2020 (in thousands):

Operating Finance

Period ending December 31, ROU Leases ROU Leases Total

Less Interest* (230 ) –

*Interest is imputed for operating ROU leases and classified

as lease expense and is included in operating expenses in the accompanying condensed consolidated statement of operations.

Off-Balance Sheet Arrangements

As of December 31, 2020, we did not

have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.

Recent Accounting Pronouncements

See Note 2 Consolidated Financial Statements

Item 8.Financial Statements

The information required by this Item 8 begins on page F-1

of this Annual Report on Form 10-K.

Item 9A.Controls and

Procedures

Evaluation of Effectiveness of Disclosure Controls and Procedures

The Company’s management, under the

supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, conducted an evaluation

of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and

15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation,

the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the

Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be

disclosed by the Company in 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, and is accumulated and

communicated to management, including the Company’s principal executive officer and principal financial officer, as appropriate,

to allow timely decisions regarding required disclosure.

Management Report on Internal Control over Financial Reporting

The Company’s 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) to provide reasonable assurance regarding the reliability of the Company’s financial

reporting and the preparation of consolidated financial statements for external purposes in accordance with U.S. generally accepted

accounting principles.

The Company’s management, under the

supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer , conducted an evaluation

of the effectiveness of the Company’s internal control over financial reporting based on criteria established in 2013

Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Management’s evaluation included an assessment of elements such as the design and operating effectiveness of key financial

reporting controls, process documentation, accounting policies, and the Company’s overall control environment. Based on its

evaluation, management concluded that the Company’s internal control over financial reporting was effective as of the year

ended December 31, 2020 to provide reasonable assurance regarding the reliability of the Company’s financial reporting

and the preparation of consolidated financial statements for external reporting purposes in accordance with U.S. generally accepted

accounting principles. The Company reviewed the results of management’s assessment with the Audit Committee of the Board

of Directors.

This Annual Report does not include an attestation

report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s

report was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the Securities

and Exchange Commission that permit the Company to provide only management’s report in this Annual Report. This report shall

not be deemed to be filed for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section,

and is not incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of

any general incorporation language in such filing.

Inherent Limitations on Effectiveness of Controls

The Company’s management, including

our Chief Executive Officer and our Chief Financial Officer, does not expect that the Company’s disclosure controls or internal

control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed

and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The

design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered

relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide

absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if

any, have been detected. The design of any system of controls is based in part on certain assumptions about the likelihood of future

events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Projections of any evaluation of the effectiveness of controls to future periods are subject to risks. Over time, controls may

become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

Changes in Internal Control over Financial Reporting

During the quarter ended December 31,

2020, there were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under

the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial

reporting.

PART III

Certain information required by Part III

is omitted from this Form 10-K because we will file a definitive Proxy Statement for our 2021 annual meeting of stockholders

pursuant to Regulation 14A (the “Proxy Statement”) no later than 120 days after the end of the fiscal year

covered by this Annual Report on Form 10-K, and certain information to be included therein is incorporated herein by reference.