SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
ANNUAL REPORT
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
Commission file No. 0-11447
DATAKEY, INC.
(Name of small business issuer in its charter)
MINNESOTA 41-1291472
(State of incorporation or organization) (I.R.S. Employer Identification No.)
407 West Travelers Trail, Burnsville, Minnesota 55337
(Address of principal executive offices)
Issuer's telephone number, including area code: (612) 890-6850
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.05 per share (Title of Class)
Check whether the Issuer (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 Issuer was required to file such
reports) and (2) has been subject to such filing requirements for the last 90
days. YES X NO ____
Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B contained herein and no disclosure will be contained, to the best
of Issuer's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ X ]
Issuer's revenues for its most recent fiscal year: $6,558,025.
The aggregate market value of the voting stock (Common Stock) held by
non-affiliates was approximately $5,278,000 based upon the closing sale price of
the Issuer's Common Stock on March 20, 1997.
As of March 20, 1997, there were 2,887,235 shares of the Issuer's Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Part II of this Annual Report on Form 10-KSB incorporates by reference
information (to the extent specific sections are referred to herein) from the
Issuer's Annual Report to Shareholders for the year ended December 31, 1996 (the
"1996 Annual Report"). Portions of the Company's definitive Proxy Statement for
its Annual Meeting of Shareholders to be held on June 4, 1997 are incorporated
by reference pursuant to Rule 12b-23 into Items 9, 10 and 11 of Part III.
Transitional Small Business Disclosure Format (check one) YES ___ NO X
<PAGE>
PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
Datakey, Inc. (the "Company") was incorporated under the laws of the
State of Minnesota in 1976 under the name "The Systems Group, Inc." In 1980, the
Company changed its name to Datakey, Inc. The Company provides product,
subsystem and system solutions to record, store and transmit electronic
information. Datakey is also developing products and systems directed to the
information security market which will enable user identification and
authentication, secure data exchange and information validation. It also
provides OEM products, consisting of proprietary memory keys, cards and other
custom-shaped tokens that serve as a convenient way to carry electronic
information and are packaged to survive in portable environments.
The Company's first portable information system, consisting of an
electronic key and support electronics, was introduced in 1981 for applications
requiring convenient storage, transportation and management of information. The
Company's current system utilizes semiconductor technology to provide a storage
device more versatile than conventional portable information products such as
keys, badges and magnetic stripe cards. The Company's current product line of
portable data carriers and associated interface products provide up to 2,048,000
bits of data storage which are used in a wide range of applications including
communications security, computer security, facility security, vending and
process control.
Each of the Company's personal portable information systems consists of
one or more portable data carriers, access devices and, for certain models,
interface modules containing microprocessors. These components, together with
the user's processor-based equipment, function as an integrated system allowing
instantaneous processing of personalized data carried within a portable data
carrier. Through the incorporation of advanced semiconductor memory technology,
the Company's portable data carrier is able to store and carry substantial
amounts of information. When the portable data carrier is used in conjunction
with the other components of the Company's system, information can be
selectively altered, added to or erased, as required, to effectively and
reliably manage or control a particular activity or transaction.
The Company has introduced an end-user system level product which is
designed to provide electronic signatures on computer aided drafting (CAD)
drawings, and is developing additional end-user systems that are designed to
provide advanced information security utilizing digital signatures and
encryption. These systems will incorporate hardware and software to provide a
higher level of security than is obtainable with current software only
solutions.
Current Products and Products Under Development
OEM Products
Portable Data Carrier Devices. Portable data carriers are electronic
memory devices which store information. They have a plastic exterior, are in the
forms of keys, cards, or custom shaped tokens and encapsulate semiconductor
memory. Certain devices have been designed to store information which may be
retrieved, altered, erased or updated; while other devices have been designed to
store one-time programmable information which may be retrieved but not altered
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or updated. The storage capacities of the Company's portable memory devices
range from 1,000 bits (150 alphanumeric characters) to 2,048,000 bits. The
portable data carriers are priced generally between $2 and $100 per unit,
depending on capacities and quantities purchased.
Access Device. The access device is the element into which a portable
data carrier is inserted to provide the interconnection between the portable
data carrier and the electronic interface circuitry or the host processor-based
equipment. It is through this physical interconnection that the data contained
in the portable data carrier's memory is transmitted to the electronic interface
or to the host interface. Several models of the access device have been
developed to handle the Company's different portable data carriers. The access
devices are priced generally between $15 and $120 per unit, depending on models
and quantities purchased.
Interface. The interface is the electronics control module between the
access device and a customer's processor-based equipment. This module is used
with the Company's serial communication key and contains all the necessary
electronics to control information within the key and to coordinate the
information requests of the host equipment. This communication process is
managed by the system's firmware, which is a software program existing within
the interface. For some applications, this firmware structures, secures and
verifies the information within the portable device, and may allow separate
groups or files of data to reside in a single portable device and be secure from
access except by equipment authorized to manage a particular group or file of
data. The interface is priced between $70 and $120 per unit, depending on models
and quantities purchased.
End-User Systems (Advanced Information Security Products)
For the past year, Datakey has been developing new products that
provide advanced security solutions to the problems of organizations, worldwide.
All of Datakey's new products, some of which Datakey expects to begin to
introduce by mid-1997, incorporate hardware tokens such as the key-shaped tokens
that the Company has been known for in the past. The launch and success of such
products is dependent on further successful development efforts and market
acceptance, along with other risks. See "Outlook and Risks."
SignaSURE CIP and SignaSURE CSP. Password-based software programs that
implement public-key cryptography technology for information security offer
easier operation and improved data integrity over older symmetric cryptography
software. Password-based security, however, is insufficient for private networks
with connections outside of the corporation. The Company's SignaSURE CIP
(Cryptoki Interface Provider) and SignaSURE CSP (Cryptographic Service Provider)
are designed to solve this problem, allowing the Internet to be used safely for
electronic commerce.
Both SignaSURE CIP and SignaSURE CSP will allow users and value-added
resellers to upgrade their software-only systems to token-based information
security and gain the benefit of secure Internet operation. Token-based
information security implements a two-level security scheme--something that is
owned (a hardware token) and something that is known (a password to activate the
token) for a much stronger level of security than password-based software
solutions. SignaSURE CIP provides token upgrades for Cryptoki or PKCS-11
standard information security interface applications. SignaSURE CSP provides the
same capability for applications that incorporate Microsoft's CryptoAPI. Both
products offer "load, plug and play" convenience for strong information
security.
SignaSURE CIP and SignaSURE CSP products include a user-unique smart
card or smart key that holds the critical information to perform the
cryptographic functions necessary for information privacy and data integrity, a
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companion reader/writer that plugs into a computer's serial port, and software
which is loaded into the workstation and interfaces to the application program.
The Company expects to begin to sell the SignaSURE CIP and SignaSURE CSP in
mid-1997.
SignaSURE DTK. As public-key information security grows due to the
technology's adoption by well-known software companies such as Microsoft and
Netscape, smaller software developers are also implementing public-key
information security into their specialized applications. Because no easy method
was available for smaller application developers to implement a token-based
public key infrastructure, the Company developed its SignaSURE DTK (Developers
Tool Kit) so that developers could easily and cost-effectively launch their
applications with the much stronger, token-based information security.
SignaSURE DTK is a turnkey package that the Company is designing to
allow software developers to integrate Datakey hardware tokens and a public-key
infrastructure into their applications. DTK includes up to three main
components: hardware cryptographic tokens, interface and integration software
and security infrastructure products. DTK is available in four configurations
ranging from just a token with a reader/writer and integration software, to the
full public-key infrastructure configuration that issues and manages hardware
tokens and digital certificates. This product flexibility allows userdevelopers
who utilize SignaSURE DTK to integrate just what is needed for their
application. The Company expects to begin to sell the SignaSURE DTK in mid-1997.
SignaSURE EDM. Design and drafting was revolutionized several decades
ago with the introduction of computer aided-design (CAD) software. However,
engineers still must print their CADcreated designs, approve the documents with
hand-written signatures, and archive these hand-signed originals to maintain
change control and ensure design traceability. The Company's SignaSURE EDM
(Electronic Document Manager), which Datakey began to sell in late 1996,
provides a way to sign an electronic document to ensure its authenticity, thus
eliminating the need for hand-signed originals and all of the storage and
archiving requirements for paper-based engineering drawings and documents.
SignaSURE EDM adds digital signatures to CAD and other documents to
ensure document authenticity, configuration control and conformance to ISO 9000
document management requirements. SignaSURE EDM provides for copying,
distributing and archiving of electronically generated documents with a level of
authenticity formerly obtainable only with hand-signed paper documents. It
answers questions of document authorship, integrity and culpability quickly,
easily and unambiguously. With SignaSURE EDM, documents in electronic form can
be transmitted over local area networks, intranets and the Internet with their
authenticity assured.
SignaSURE EDM includes a smart card or smart key that generates the
user's digital signature, a companion reader/writer that plugs into a computer's
serial port, and a software program which is loaded into the workstation.
SignaSURE EDM operates on all Windows(TM) operating systems, is compatible with
all CAD programs and file formats, and moves design and drafting to a paperless
environment.
SignaSURE ESS. Many of today's organizations have made the transition
from large mainframe systems to more flexible, but much less secure,
client-server networks and intranets. Client-server networks and intranets allow
digital information to reside on networks, rather than at the desktop so
authorized users can access the same information. Authorized users can include
company employees, suppliers and customers who can be connected to the network,
or located remotely from the enterprise. With the advent of the Internet,
information transmission over any distance can be accomplished quickly and cost
effectively, but not securely. Datakey believes its SignaSURE ESS (Enterprise
Security Suite) offers a solution to manage a network, intranet and Internet
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computing structure to allow authorized users ready access to information, but
deny it to the unauthorized. Information can then be transmitted securely and
stored safely on both private and public networks without privacy and data
integrity concerns.
SignaSURE ESS is an integrated end-to-end data security system that the
Company believes will assure secure network access, confidential information
exchange, integrity of data and transaction nonrepudiation. Secure, personalized
smart tokens are employed within a public key infrastructure to provide a higher
level of information security than is provided by software-only solutions.
Security functions are integrated into applications like Microsoft Office(TM),
thereby providing seamless security operation to the user. SignaSURE ESS will
operate over the Internet, and wide and local area networks enabling secure
information exchange for all users, whether local or remote to the enterprise.
SignaSURE ESS includes a user-personalized smart card or smart key
hardware token and companion reader/writer for workstation or laptop that
perform the functions necessary for information privacy and data integrity. It
also incorporates client software that manages secure information and interfaces
to applications, and server-based, enterprise infrastructure hardware and
software that initialize SignaSURE ESS and continually ensures all users are
authorized. The Company expects to begin selling SignaSURE ESS in the second
half of 1997.
The following chart shows the Company's SignaSURE products:
<TABLE>
<CAPTION>
===================================================================================================================================
SignaSURE Product
- -----------------------------------------------------------------------------------------------------------------------------------
Attribute CIP CSP DTK EDM ESS
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Customer Organizational End-User x x x
Engineer/Architect End-User x
Software Developer x
- -----------------------------------------------------------------------------------------------------------------------------------
System Type Integrated Solution x x
Add-on Subsystem x x
Component x
- -----------------------------------------------------------------------------------------------------------------------------------
Application Information Security x x x
Paperless Automation x
Token Integration x x x
- -----------------------------------------------------------------------------------------------------------------------------------
Hardware Datakey Smart Token x x x x x
Datakey Reader/Writer x x x x x
- -----------------------------------------------------------------------------------------------------------------------------------
Software Security Solution x x
Token Interface x x x
===================================================================================================================================
</TABLE>
Research and Development
During 1996, the Company continued the development of portable data
carriers to expand its line of standard products as well as newly designed
custom products. The Company also substantially increased its development of
token-based information security products.
As the need for computer security products continues to grow, the
Company has been expending significant effort into development of token-based
computer information security systems. The Company's SignaSURE line of
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information security products, which are expected to be released for sale during
1997, are designed to provide encryption and digital signatures required for
electronically generated documents on computer networks.
The technology involved in information systems in undergoing rapid
expansion and advancement which could result in the development of new products
and systems which may make the Company's present information security products
obsolete. As a result, the Company must continue to improve its present
information security products in order to remain competitive.
In 1996, 1995 and 1994, research and development expenses were
$2,263,000, $704,000 and $771,000, respectively. The Company expects that
research and development expenses in 1997 will be significantly higher than in
1996.
Manufacturing
The Company's in-house manufacturing capabilities include
microelectronic assembly, plastic injection molding, automated surface mount
assembly, and general electronic assembly. The Company also utilizes independent
subcontractors from time to time to perform certain manufacturing functions. The
Company provides a 90-day warranty on domestic sales, a 180-day warranty on
sales to its international distributors to cover the longer shelf life of the
Company's products, and a 180-day warranty on sales to the government.
In an effort to more efficiently produce products, to reduce product
costs, and to increase its manufacturing flexibility, the Company intends to
continue to improve certain manufacturing processes and add capital equipment to
its manufacturing operations. While the Company believes that these steps will
provide a greater level of control over, and flexibility in, its manufacturing
processes, there are no assurances that the Company's ability to produce
products and to meet required delivery schedules will be sufficiently improved
to meet the demands created by increased sales and more complex manufacturing
processes.
Sources of Supply
The Company purchases microprocessors for its advanced information
security products (the SignaSURE line of products) from a single supplier. This
supplier also provides a proprietary card and key (token) operating system which
will be discontinued after the current supply of microprocessors is depleted.
The Company believes the current supply is sufficient to meet the expected need
in 1997. Upon depletion of this supply, however, the Company will be required to
purchase new microprocessors from this sole source or an alternative source and
provide its own smart token operating system. The Company has a significant
development effort underway to produce its own proprietary smart token operating
system and expects it to be available by the time the current microprocessor
supply is exhausted. Negotiations and evaluations are also underway to qualify
and procure new microprocessors from the same source or an alternative source.
Although the Company has a schedule and plan in place to avoid any gap in supply
of the microprocessors and operating system, there are no assurances that the
current supply will not be exhausted earlier than expected, that the new
operating system will be available on time and operate as intended or that new
microprocessors will be available when needed and operate satisfactorily.
The Company has several qualified sources from which to purchase
printed circuit boards and electronic components for most of its standard
portable data carriers. The components for the Company's products are, in
general, available from multiple suppliers. Some of the plastic components are
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molded on the Company's in-house molding equipment or suppliers' molding
equipment using Company-owned tooling.
The Company purchases integrated circuits primarily through nationwide
multivendor distributors. If, for any reason, the Company would have to cancel
or reduce a particular integrated circuit order, it might thereafter have to pay
a higher price for the integrated circuits. Since general economic conditions
have an effect on the supply and cost of integrated circuits, there is no
guarantee that the Company will be able to obtain adequate quantities of
integrated circuits to meet all of its production needs during periods of short
supply.
Significant Customer
The Company sells its OEM products to a number of commercial original
equipment manufacturers (OEMs) and other customers, including governmental
entities. At this time, the Company is not dependent on any one customer or few
customers, the loss of which would have a material adverse effect on its
business.
Marketing
General. While there appears to be a broad range of applications and
potential customers for portable data carriers, no single application group has
evidenced strong, long-term growth potential. The diversity of potential
applications has made it difficult for the Company to focus its limited
marketing resources. In 1995, commercial sales to OEM customers increased 33% to
$6,205,000 and in 1996 they decreased 9% to $5,669,000. The Company believes
that commercial OEM sales may decrease again in 1997.
New end-user products being developed for the information security
marketplace are planned for sales introduction by mid-1997 and, based upon
current expectations, are expected to result in material revenue during the
second half of 1997. As with any new product line, revenue will depend on
customer acceptance, the extent of which is difficult to assess at this time.
Commercial Market of OEM Products. To date, most applications in the
commercial market have used the Data Key for electronic security and equipment
control applications. The Company is seeking to develop other long-term business
in this market. The Company markets its products to both domestic and
international customers using the following channels.
Domestic. The Company markets its portable information
products domestically through a combination of direct and indirect sales
personnel. In addition, it utilizes advertising, trade shows and direct mail to
reach its buying audience. In 1996, 1995 and 1994, sales to domestic customers,
and the corresponding percentage of total revenue, were approximately $3,763,000
(57%), $4,319,000 (60%) and $2,953,000 (50%), respectively.
International. The Company presently markets its portable
information products internationally through an independent sales agent in the
United Kingdom and agents and/or distributors in Columbia, Australia, Belgium,
the Netherlands and Germany. The Company has customers in other countries who
are handled on a direct basis from the Company's headquarters in the United
States. The Company intends to expand into other international market areas in
the future. In 1996, 1995 and 1994, sales to international customers, and the
corresponding percentage of total revenue, were approximately $1,906,000 (29%),
$1,907,000 (26%) and $1,716,000 (29%), respectively.
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Government Market. The Company markets its products to government
agencies through its direct sales and marketing personnel. The Company's primary
activity in this segment has been in the marketing of its portable data and
access devices to government agencies for use in various secure information
systems and in the development of custom designed portable data devices for
other government programs. In 1996, 1995 and 1994, sales to government agencies
and government subcontractors, and the corresponding percentage of total
revenue, were approximately $889,000 (14%), $993,000 (14%) and $1,146,000 (20%),
respectively.
End-User Products
Datakey plans to market and sell its advanced information security
products (the initial offerings in its end-user systems line) through a
combination of direct sales and marketing personnel, dealers, distributors,
value added resellers and system integrators/developers.
The direct sales and marketing personnel will concentrate primarily on
relationships with large security-conscious organizations either through direct
or indirect contact, establishing alliances with system integrators/developers
and setting up dealer/distributor relationships for its products. The future
revenue of Datakey end-user systems is dependent on the success of a new and
untested marketing and direct sales organization. Also, see "Issues and
Uncertainties" in the Management's Discussion and Analysis contained in the
Company's 1996 Annual Report, portions of which are included in Exhibit 13.1 of
this Report.
Backlog
As of March 7, 1997, the Company had an order backlog, totaling
approximately $4,127,000, including approximately $1,187,000 with scheduled
shipment dates in 1998, compared to $2,813,000 a year ago, all of which were
scheduled for shipment in 1996. Although the orders contain scheduled shipment
dates, they may be accelerated, delayed or canceled at the customer's request.
The Company does not believe that the current backlog is necessarily indicative
of future backlog levels.
Competition
OEM Products. The Company's primary competition for its OEM products is
presently, and is expected to remain, conventional portable information systems,
such as keys and cards, and more advanced portable information systems including
those in the familiar credit card format, such as "smart cards," Personal
Computer Memory Card Industry Association (PCMCIA) cards, magnetic stripe cards,
bar-code cards and laser technology cards. The Company's products, when used as
a portable data base, may also compete with centralized data base systems. Many
of the manufacturers of these portable information devices and systems are
large, well-established companies.
A number of European and Japanese firms continue to develop and refine
the smart card technologies. Some of these companies have established branch
offices in the United States to explore the United States market. To date, the
smart card has been used primarily in Europe, where it has been implemented in
prepaid telephone systems. In the United States, smart cards are currently being
used mainly in field trial environments. Although the Company does not have
complete information about the status of these trials, the Company believes
that, in time, the smart card will be successfully developed and could become a
competitor, especially in those markets which have a history of using a card or
a preference for card-type devices.
Memory cards, such as PCMCIA standard cards, are functionally
equivalent to the Company's portable data carriers in that they utilize
semiconductor memory in card-shaped devices made of plastic.
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Memory cards generally have larger memory capacities than the devices currently
offered by the Company and historically incorporated volatile, battery-backed
memory elements. More recently, nonvolatile (principally "Flash Memory") memory
elements which do not require battery backup have become more prominent. They
are used in such applications as laser printer fonts, instrumentation,
electronic lettering machines and fax/modems, and are also used as replacements
or "add ons" to diskettes and hard drives for data storage in certain desktop,
notebook and smaller portable computers.
Magnetic stripe cards are relatively inexpensive and are used
extensively in the access control industry and in the banking and credit card
industries. These markets are not priority markets for the Company's portable
information devices. Magnetic stripe cards are not conveniently updatable, have
limited storage capacity and generally have a useful life of one or two years.
As a result, the Company believes its products are technologically superior and
may be more cost-effective for applications requiring more complex technologies.
Another technology utilizes a strip of reflective material which is
laminated into a card. Information is inscribed on this material through use of
a laser beam. Since these cards can contain several million bits of information,
the Company believes that this technology will be a competitor in portable
information markets where very large information storage capacities are required
and instantaneous management of information is not essential.
The Company's ability to compete in the portable information market
will depend primarily on its ability to demonstrate superior product performance
at cost-effective prices and on the enhanced features of its system which make
it more effective than competing systems.
End-User Systems. Datakey currently offers token-based (smart card,
smart key) information security products which are primarily utilized in
encryption for electronic mail and other electronic document privacy and digital
signatures for electronic document authentication. The Company also sells a
digital signature based product, known as SignaSURE EDM, which enables users to
electronically sign computer-aided drafting (CAD) documents. The Company is
presently undertaking a significant product development effort to expand the
applications and ease-of-use of its products and systems. See
"Products--End-User Systems."
Competition in the information security business is varied with
companies offering hardware solutions, software solutions and combinations of
hardware and software solutions. As awareness for security on the Internet and
company intranets and other local area networks has increased over the past few
years, many companies have introduced software and/or hardware based products to
provide security. These products range from software-based password only systems
to firewalls, which may be very sophisticated. Other applications are using hand
held hardware devices, commonly referred to as tokens, to provide access to
networks and, in some cases, use encryption and digital signatures to further
secure networks.
The Company's advanced information security products currently in
development are based upon a smart card or smart key and utilize encryption and
digital signatures. They also include extensive software to make the system
user-friendly and seamless with common desktop software packages. The Company
feels this will provide a unique combination of advanced security features at a
reasonable selling price. There are several companies operating in this highly
competitive and rapidly changing marketplace, however, and many of such
companies have strong name recognition and vast financial resources. The Company
believes it can compete on the basis of its unique design and ease of use. There
are no assurances, however, that the products will be readily accepted in the
marketplace when they become available.
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Patents and Trademarks
The Company has been granted several patents by the United States
Patent and Trademark Office relative to the Data Key, its key interface and its
overall portable information device technology. The Company has sought and will,
when appropriate, continue to seek patent protection in several foreign
countries. The federal registration of the Datakey trademark was approved in
1985. The Company also has patents in application or in the filing process. In
an industry characterized by rapid technological change, the Company believes
that the knowledge, experience and creativity of its employees will prove to be
more important than patent protection.
Employees
The Company presently employs 50 full-time employees, 18 of whom are
involved in manufacturing, 4 in materials handling, 2 in quality assurance, 11
in engineering, 8 in marketing/sales and 7 in general and administrative areas.
In addition, the Company uses contract labor during peak production times and
for major projects. The Company's employees are not subject to a collective
bargaining agreement, and the Company believes that its employee relations are
good.
Outlook and Risks
As provided for under the Private Securities Litigation Reform Act of
1995, the Company wishes to caution investors that the following important
factors, among others, in some cases have affected and in the future could
affect the Company's actual results of operations and cause such results to
differ materially from those anticipated in forward-looking statements made in
this document and in the Company's 1996 Annual Report by or on behalf of the
Company:
Uncertainty of Market Acceptance of New Products. The Company is
currently developing new data security products, some of which it expects to
introduce by mid-1997. While Datakey performs market research and beta testing
to determine the viability of its new products, actual user acceptance will
ultimately dictate the success of the marketing and sales efforts of new
products such as SignaSURE EDM and ESS. Although the Company believes that the
decision to fund these new products is correct, there are no assurances that the
investments already made and additional investments planned for 1997 will result
in a financial return.
New Product Development and Product Delivery. Substantial additional
development work is required for the introduction of the Company's planned new
information security products. The Company expects extensive software
development and staffing expenses to contribute to an overall research and
development expense figure for 1997 in excess of that for 1996 and substantially
in excess of previous years. No assurance can be given that the Company's
timetable for these development plans will be achieved or that development
efforts will be successful. Delays in the release of new products will cause
operational inefficiencies, increased development costs and reduced revenues.
Dependence on Key Personnel. The Company is highly dependent on a
limited number of key management and technical personnel, including Carl P.
Boecher who has been President and Chief Executive Officer since December 1996
and was Vice President of Marketing and Sales from January 1995 to December
1996, Alan G. Shuler who has been the Vice President and Chief Financial Officer
since June 1992 and Jim Foley, who joined the Company in January 1997 as Vice
President of Engineering. The loss of key personnel, especially while working to
add a new product line, could have an adverse effect on the Company's business,
financial condition and results of operations.
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Fluctuations in Operating Results. Due to the Company's historical
dependence on sales to OEM customers who, themselves, must successfully sell
products containing components produced by Datakey, the Company has experienced
year to year fluctuations in its revenue. During the past three years, Datakey
has marketed secure microprocessor-based tokens in the smart card format and its
patented key shaped format, along with a file based software package for
encrypting and digitally signing electronic documents in the emerging
information data security market. The information data security market is a
rapidly developing and changing market, but to date the Company has not achieved
a high sales level on its current product offerings. In addition, the Company
plans to spend substantially more for research and development of such new
products. Therefore, the Company believes that its results of operations may
fluctuate as a result of the new product mix and the timing of releases of new
products and product upgrades. As a result of its product development
expenditures, the Company expects to have significant losses in 1997.
Competition - General. Both the Company's OEM Products business,
consisting of portable memory-based systems, subsystems and custom-designed
components for security-driven markets, and the information data security
(end-user) market are highly competitive. The information data security market
is rapidly developing. There can be no assurance that the Company will be able
to effectively compete within such markets, and that others will not enter these
markets. Competition in the sale of information data security products occurs
principally on the basis of price and functionality. Many of the manufacturers
of portable information devices and systems are large, well-established
companies. Datakey's information security end-user products such as SignaSURE
EDM(TM) and SignaSURE ESS(TM) will integrate hardware tokens with software that
provide a much higher level of security than software implementations alone.
There is a possibility that software-only solutions may overcome this deficiency
in the future.
Price Competition. While Datakey believes that its strategy of
providing token-based product solutions at a price that is competitive with
software-only products is attainable, there are no assurances that competitive
pressures will not force the Company to accept reduced margins to compete in the
future. Large companies have recognized the need for information security and
could enter this market as competitors with much greater financial resources. A
portion of its new end-user products' cost is royalties and license fees which
would need to be re-negotiated to maintain acceptable margins.
Integrated information security products. Although the Company's new
products will operate seamlessly with popular application programs, new
application programs that integrate information security into their product
could erode the future market for these Datakey products.
Marketing and sales. The future revenue of Datakey products is
dependent on the success of a new and untested marketing and direct sales
organization.
Need for information security. Although corporate utilization of the
Internet and internal intranets dictate a need for information security, there
are no assurances that other, more secure information transmission media may not
become available in the future that would preclude the need for the type of
information security provided by the Company's products.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's corporate offices and manufacturing facility, located at
407 West Travelers Trail, Burnsville, Minnesota, consists of 18,488 square feet.
Approximately one-half of the space is used for manufacturing and warehousing,
11
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and the balance for present and future office space. All of this space is rented
under a lease which extends through June 1999. The annual rent expense for the
space currently occupied is $97,000, plus a portion of the operating expenses
and real estate taxes. The Company believes its space is sufficient for its
needs in the foreseeable future, and it believes its property is adequately
insured.
ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings pending to which the Company is
a party or of which any of its property is the subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of fiscal year 1996.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the NASDAQ National Market
System under the symbol DKEY. The high and low sale prices for the common stock
by quarter as reported by NASDAQ are set forth in the following table for 1996
and 1995.
On March 17, 1997, the Company had approximately 1,350 shareholders,
including approximately 1,000 beneficial owners. The Company has never paid
dividends and does not plan to in the foreseeable future.
Sale Prices
High Low
1996
1st Quarter.................................... $5 7/8 $3 3/4
2nd Quarter.................................... $8 3/4 $3 7/8
3rd Quarter.................................... $7 3/4 $4 1/4
4th Quarter.................................... $5 3/8 $3
1995
1st Quarter.................................... $4 $2 7/8
2nd Quarter.................................... $4 1/8 $3 1/2
3rd Quarter.................................... $4 1/4 $2 1/2
4th Quarter.................................... $8 3/4 $3 3/8
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
The information required by Item 6 is incorporated by reference from
the Company's 1996 Annual Report, portions of which are included herewith in
Exhibit 13.1 to this Report.
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ITEM 7. FINANCIAL STATEMENTS
The information required by Item 7 is incorporated by reference from
the Company's 1996 Annual Report, portions of which are included herewith in
Exhibit 13.1 to this Report.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
None.
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PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
PERSONS, COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The information required by Item 9 regarding the Company's directors
and executive officers is incorporated by reference to the Company's proxy
statement for its 1997 Annual Meeting of Shareholders under the captions
"Determination of Number and Election of Directors" and "Executive Officers of
the Company." The Company's proxy statement will be filed pursuant to Rule 14a-3
within 120 days after the close of the fiscal year for which this report is
filed.
The information relating to compliance with Section 16(a) of the
Exchange Act is incorporated by reference to the Company's proxy statement for
its 1997 Annual Meeting of Shareholders under the caption "Compliance With
Section 16(a) of the Exchange Act."
ITEM 10. EXECUTIVE COMPENSATION
The information required by Item 10 is incorporated by reference to the
Company's proxy statement for its 1997 Annual Meeting of Shareholders under the
caption "Executive Compensation."
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
The information required by Item 11 is incorporated by reference to the
Company's proxy statement for its 1997 Annual Meeting of Shareholders under the
caption "Security Ownership of Management and Certain Beneficial Owners."
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following exhibits are included in this report: See
"Exhibit Index" immediately following the signature page of this Form 10-KSB.
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the
quarter ended December 31, 1996.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Issuer has caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Dated: March 28, 1997 DATAKEY, INC.
BY: /s/ Carl P. Boecher
Carl P. Boecher
Chief Executive Officer and Director
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the Company,
in the capacities, and on the dates, indicated:
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints Carl
P. Boecher and Alan G. Shuler as his true and lawful attorneys-in-fact and
agents, each acting alone, with full power of substitution and resubstitution,
for him and in his name, place and stead, in any and all capacities, to sign any
or all amendments to this Annual Report on Form 10-KSB and to file the same,
with all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, acting alone, full power and authority to do and perform each and every
act and thing requisite and necessary to be done in and about the premises, as
fully to all intents and purposes as he might or could do in person, hereby
ratifying and confirming said attorneys-in-fact and agents, acting alone, or his
substitute or substitutes, may lawfully do or cause to be done by virtue
thereof.
SIGNATURES TITLES DATE
/s/ Carl P. Boecher Chief Executive Officer and March 28, 1997
Carl P. Boecher Director (Principal Executive
Officer)
/s/ Alan G. Shuler Vice President and Chief March 28, 1997
Alan G. Shuler Financial Officer (Principal
Financial and Accounting Officer)
/s/ Thomas R. King Director and Secretary March 28, 1997
Thomas R. King
/s/ Terrence W. Glarner Director March 28, 1997
Terrence W. Glarner
/s/ Gary R. Holland Chairman of the Board of March 28, 1997
Gary R. Holland Directors
/s/ Eugene W. Courtney Director March 28, 1997
Eugene W. Courtney
/s/ John H. Underwood Director March 28, 1997
John H. Underwood
15
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DATAKEY, INC.
EXHIBIT INDEX TO ANNUAL REPORT
ON FORM 10-KSB
For the Fiscal Year Ended December 31, 1996
Exhibit No. Description
3.1 Restated Articles of Incorporation, as amended (Incorporated by
reference to Exhibit 3.1 to Form 10-K for fiscal year ended December
31, 1987)
3.2 Bylaws, as Amended (Incorporated by reference to Exhibit 3.2 to Form
10-K for fiscal year ended December 31, 1988)
10.1 Agreement between National Security Agency and the Company dated
September 30, 1986, as amended on October 16, 1986 (Incorporated by
reference to Exhibit 10.5 to Form 10-K for fiscal year ended December
31, 1986)
10.2 Amendments dated May 8, 1987, May 29, 1987, June 30, 1987 and February
17, 1988 to Agreement between National Security Agency and the Company
dated September 30, 1986 (Incorporated by reference to Exhibit 10.6 to
Form 10-K for fiscal year ended December 31, 1987)
10.3 1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to
Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)**
10.4 Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock Option Plan
(Incorporated by reference to Exhibit 10.5 to Form 10-K for fiscal year
ended December 31, 1991)**
10.5 Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey, Inc.
Stock Option Plan**
10.6 License Agreement between CTS Corporation and the Company dated March
9, 1988 (Incorporated by reference to Exhibit 10.8 to Form 10-K for
fiscal year ended December 31, 1987)
10.7 Agreement between Maryland Procurement Office and the Company dated
September 24, 1988 as amended on September 26, 1988, November 7, 1988,
November 9, 1988 and December 19, 1988 (Incorporated by reference to
Exhibit 10.9 to Form 10- K for fiscal year ended December 31, 1988)
10.8 Agreement between Maryland Procurement Office and the Company dated
October 2, 1989 as amended on November 8, 1989 (Incorporated by
reference to Exhibit 10.10 to Form 10-K for fiscal year ended December
31, 1989)
10.9 Agreement between Maryland Procurement Office and the Company dated
September 28, 1990 as amended on October 29, 1990, February 22, 1991
and May 15, 1991 (Incorporated by reference to Exhibit 10.10 to Form
10-K for fiscal year ended December 31, 1991)
10.10 Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987,
as amended on February 10, 1988, December 23, 1988, February 13, 1992
and April 1, 1992 (Incorporated by reference to Exhibit 10.12 to Form
10-K for fiscal year ended December 31, 1991)
16
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10.11 Agreement between National Institute of Standards & Technology
Acquisition of Assistance Division and the Company dated June 2, 1992,
as amended on June 3, 1992 (Incorporated by reference to Exhibit 10.12
to Form 10-KSB for fiscal year ended December 31, 1992)*
10.12 Agreement between Maryland Procurement Office and the Company dated
July 29, 1992,* as amended on October 13, 1992 (Incorporated by
reference to Exhibit 10.13 to Form 10-KSB for fiscal year ended
December 31, 1992)
10.13 Agreement between Maryland Procurement Office and the Company dated
November 16, 1993 (Incorporated by reference to Exhibit 10.15 to Form
10-KSB for fiscal year ended December 31, 1993)*
10.14 Manufacturing Agreement between Duncan Industries and the Company dated
August 27, 1993 (Incorporated by reference to Exhibit 10.16 to Form
10-KSB for fiscal year ended December 31, 1993)
10.15 Employment Agreement between Alan G. Shuler and the Company dated
January 1, 1995 (Incorporated by reference to Exhibit 10 to Form 10-QSB
for fiscal year ended July 1, 1995)
10.16 Employment Agreement between James P. Foley and the Company dated
January 1, 1996 (Incorporated by reference to Exhibit 10.18 to Form
10-KSB for fiscal year ended December 31, 1995)**
10.17 Consulting Agreement between Gary R. Holland and the Company dated
November 1, 1995 (Incorporated by reference to Exhibit 10.19 to Form
10-KSB for fiscal year ended December 31, 1995)**
10.18 Amendment dated February 11, 1997 to Consulting Agreement between Gary
R. Holland and the Company dated November 1, 1995**
10.19 Employment Agreement between Carl P. Boecher and the Company dated
January 1, 1997**
10.20 Separation Agreement and Release between John H. Underwood and the
Company dated January 1, 1997**
10.21 Management Incentive Plan dated February 27, 1997**
10.22 Lease Amendment No. 5 dated December 17, 1996 to Lease between the
Company and Kraus-Anderson, Inc. dated June 3, 1987
13.1 Portions of 1996 Annual Report
21.1 Subsidiaries of the Company (Incorporated by reference to Exhibit 21.1
to Form 10-KSB for fiscal year ended December 31, 1994)
23.1 Independent Auditor's Consent
24.1 Power of attorney for Carl P. Boecher, Alan G. Shuler, Thomas R. King,
Terrence W. Glarner, Gary R. Holland, Eugene W. Courtney and John H.
Underwood (included on the signature page of this Form 10-KSB)
27 Financial Data Schedule (filed with electronic version only)
* Confidential treatment has been granted for certain portion of this exhibit.
** Designates a management contract or compensatory plan or arrangement.
17
AMENDMENTS TO THE
DATAKEY, INC. 1987 STOCK OPTION PLAN
ADOPTED BY BOARD OF DIRECTORS ON JULY 1, 1995:
1. A new sentence shall be added at the end of subsection (e) of Section 1
Definitions to read as follows:
"For purposes of Section 19, the "Optionee" is a Non-Employee
Director to whom a nonqualified option has been granted."
2. A new subsection (h) shall be added to Section 1 Definitions to read as
follows:
"(h) 'Non-Employee Directors' shall mean members of the Board
who are not employees of the Company or any Subsidiary."
3. Section 17 Amendment of the Plan shall be amended to add a new sentence
at the end of such Section 17 as follows:
"In addition to and notwithstanding the foregoing, the
provisions of Section 19 shall not be amended more than once
every six months, other than to comport with changes in the
Internal Revenue Code, the Employee Retirement Income Security
Act, or the rules thereunder."
4. A new Section 19 Granting of Options to Non-Employee Directors shall be
added to read as follows:
"SECTION 19.
GRANTING OF OPTIONS TO NON-EMPLOYEE DIRECTORS
(a) Upon Joining Board. Each Non-Employee Director of the Company who,
on or after July 1, 1995, the date of approval of this Section 19 by
the Board, is initially elected as a director, shall, as of the date of
such election, automatically be granted an option to purchase 15,000
shares of the Common Stock at an option price per share equal to 100%
of the fair market value of the Common Stock on such date. Options
granted pursuant to this subsection (a) shall be immediately
exercisable to the extent of 3,000 shares subject to such option and to
the extent of an additional 3,000 shares on each of the first, second,
third and fourth anniversaries of the date of grant; provided, however,
that options granted before approval by the Company's shareholders of
an amendment to the Company's 1987 Stock Option Plan adding this
Section 19 to the Plan shall not be exercisable before such approval.
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(b) Upon Re-election to Board. Each Non-Employee Director who, on and
after July 1, 1995, the date of approval of this Section 19 by the
Board, is re-elected as a director of the Company or whose term of
office continues after a meeting of shareholders at which directors are
elected shall, as of the date of such re-election or shareholder
meeting, automatically be granted an option to purchase 2,500 shares of
the Common Stock at an option price per share equal to 100% of the fair
market value of the Common Stock on the date of such re-election or
shareholder meeting. Options granted pursuant to this subsection (b)
shall be immediately exercisable in full.
(c) General. No director shall receive more than one option pursuant to
subsection (b) of this Section 19 in any one fiscal year. All options
granted pursuant to this Section 19 shall be designated as nonqualified
options and shall be subject to the same terms and provisions as are
then in effect with respect to granting of nonqualified options to
officers and employees of the Company except that the option shall
expire on the earlier of (i) three months after the Optionee ceases to
be a director (except by death) and (ii) ten (10) years after the date
of grant. Notwithstanding the foregoing, in the event of the death of a
Non-Employee Director, any option granted to such Non-Employee Director
pursuant to this Section 19 may be exercised at any time within six
months of the death of such Non-Employee Director or on the date on
which the option, by its terms expires, whichever is earlier."
ADOPTED BY BOARD OF DIRECTORS ON MARCH 19, 1996:
Increase of Shares Reserved Under 1987 Stock Option Plan
RESOLVED, that, subject to shareholder approval which shall be
requested at the Annual Meeting, the number of shares reserved for
issuance pursuant to the Company's 1987 Stock Option Plan be and hereby
is increased from 550,000 to 800,000 shares.
AMENDMENTS APPROVED BY SHAREHOLDERS ON JUNE 5, 1996
2
AMENDMENT TO AGREEMENT
WHEREAS, Datakey, Inc. (the "Company") and Gary R. Holland ("Holland")
entered into an Agreement dated November 1, 1995 (the "Agreement"), pursuant to
which Holland was to provide consulting services to the Company until October
31, 1996;
WHEREAS, Holland has provided such services to Datakey in an exemplary
manner; and
WHEREAS, the Company and Holland wish to extend the term of the
Agreement until December 31, 1997.
IT IS THEREFORE AGREED THAT the term of the Agreement shall be extended
until December 31, 1997. Except to the extent affected by this extension, all
other terms of the Agreement remain in full force and effect.
Dated: February 11, 1997
DATAKEY, INC.
By /s/ Carl P. Boecher
Carl P. Boecher, President and
Chief Executive Officer
/s/ Gary R. Holland
Gary R. Holland
EMPLOYMENT AGREEMENT
This Employment Agreement (the "Agreement") made and entered into
effective as of the 1st day of January 1997, by and between Datakey, Inc., a
Minnesota corporation (the "Company" or "Datakey") and Carl P. Boecher
("Executive").
RECITALS
Carl P. Boecher joined the Company in January 1995 as Vice President of
Sales and Marketing. He was appointed President and Chief Executive Officer on
December 1, 1996. The parties desire to memorialize their relationship in the
following Agreement.
AGREEMENT
1. Employment
a. Datakey agrees to continue to employ Executive on a full-time basis
as the President and Chief Executive Officer ("CEO") of Datakey pursuant to the
terms and conditions hereof.
b. Executive agrees that he will, at all times, faithfully,
industriously, and, to the best of his abilities, experience and talents,
continue to perform all the duties and responsibilities that may be required of
him as President and CEO of Datakey.
2. Term of Employment
a. Subject to the terms and conditions hereof, Executive shall be
employed for a term ("Employment Term") commencing on January 1, 1997, and
terminating on January 1, 1998, unless extended as set forth in Subsection 2b
below.
b. This Agreement will be renewed automatically after January 1, 1998,
for additional one-year periods unless either party gives the other party
written notice 30 days before January 1, 1998 or 30 days before the end of any
one-year period thereafter of his or its intention to terminate the Agreement.
3. Base Compensation
As compensation for his services to Datakey, Executive shall be paid an
initial monthly salary of $10,000, payable in accordance with Datakey's payment
periods. Executive's base compensation will be reviewed on an annual basis
throughout the term of this Agreement.
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4. Incentive Compensation
Executive will be paid a target bonus of 30% of his base salary which
will be dependent on attainment of performance targets set by the Company's
Compensation Committee by February 15, 1997. In addition, Executive will be
eligible to participate in any long-term incentive plan approved by Datakey's
Board of Directors.
5. Other Benefits
a. Vacation. Executive will receive four weeks of vacation for every
twelve months of employment. Unused vacation may not be carried over from one
year to the next. Datakey will pay Executive for any earned and unused vacation
upon termination.
b. Automobile Allowance. During the term of this Agreement, Datakey
will pay Executive $500 per month to be applied toward his automobile expenses.
c. Stock Options. Executive has been granted the following incentive
stock options: (i) 50,000 shares at an exercise price of $3.50 per share and
(ii) 25,000 shares at an exercise price of $3.00 per share. Both options have
been or will be memorialized in Stock Option Agreements and will contain
standard terms and conditions, including vesting.
d. Miscellaneous. During the term of this Agreement, Executive will
receive such other benefits which are provided by Datakey to other officers as a
group.
6. Termination
Notwithstanding Section 2 above, the Employment Term or any extension
thereof shall terminate upon the happening of any of the following events:
a. Mutual written agreement between the Board of Directors of
Datakey and Executive to terminate his employment.
b. Executive's death.
c. Executive's disability defined as physically or mentally
unable to perform as CEO with or without reasonable
accommodation for a period of six consecutive months, or
d. For cause (as defined below) upon written notice from the
Board of Directors specifying the nature of the cause. For
purposes of this Agreement, "cause" shall include commission
of any felony, gross misdemeanor, or any act of fraud or
dishonesty in connection with the affairs of Datakey.
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<PAGE>
e. By either party with or without cause upon thirty days written
notice to the other.
7. Payment Upon Termination of Employment For Cause
If Executive is terminated for cause as defined in Section 6 above,
Executive shall not be eligible to receive any severance benefits. The date of
termination under this Section 7 shall be on the day the notice of termination
for cause is given and Executive shall be entitled to no additional compensation
past the date of such notice.
8. Payment Upon Termination of Employment Without Cause or Termination
Upon Failure to Renew Agreement
a. If Executive is terminated without cause or terminated for failure
of Datakey to renew Agreement, Executive shall receive a severance payment equal
to his base compensation payable for twelve months in accordance with Datakey's
payment periods beginning on the 10th day of the first month following the last
month of employment.
b. The payments provided for under this Section 8 shall, in the event
of Executive's death, continue and shall be payable to his wife if she survives
or, if not, to his estate.
c. The Company will also expend up to $6,000 to be applied only to
outplacement counseling of Executive's choice. Payments will be made directly to
the outplacement counselor.
d. The Company will continue to provide to Executive and his covered
dependents access to medical and health coverage under its plans as they
currently exist or may hereafter be amended at company subsidized rates during
the twelve-month severance pay period. Thereafter, Executive and his covered
dependents will be entitled to elect to continue coverage under COBRA to the
extent it is available. Coverage by the Company or under COBRA will end on the
earlier of Executive's obtaining new employment which gives him the ability to
provide medical and health insurance coverage for himself and his family through
his new employer, or the failure to pay any premium when due.
9. Nondisclosure
Except by written permission from Datakey, Executive shall never
disclose or use any trade secrets, sales projections, formulations, customer
lists or information, product specifications or information, credit information,
production know-how, research and development plans or other information not
generally known to the public ("Confidential Information") acquired or learned
by Executive during the course, and on account, of his employment, whether or
not developed by Executive, except as such disclosure or use may be required by
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<PAGE>
his duties to Datakey, and then only in strict accordance with his obligations
of service and loyalty thereto. Upon termination of employment, Executive agrees
to deliver to Datakey all Confidential Information.
10. Noncompetition
a. For a period of one (1) year after the end of the Employment Term or
any extension thereof or after termination of employment for any reason,
Executive will not, directly or indirectly, alone or in any capacity with
another legal entity: (i) engage in any activity that competes in any respect
with Datakey, (ii) contact or in any way interfere or attempt to interfere with
the relationship of Datakey with any current or potential customers of Datakey,
or (iii) employ or attempt to employ any employee of Datakey (other than a
former employee thereof after such employee has terminated employment with the
Datakey);
b. Executive acknowledges that Datakey markets products throughout the
United States and that Datakey would be harmed if Executive conducted any of the
activities described in this Section 10 anywhere in the United States.
Therefore, Executive agrees that the covenants contained in this Section 10
shall apply to all portions of, and throughout, the United States; and
c. To the extent any provision of this Section 10 shall be invalid or
unenforceable, it shall be considered deleted herefrom and the remainder of such
provision and this Section 10 shall be unaffected and shall continue in full
force and effect. In furtherance to and not in limitation of the foregoing,
should the duration or geographical extent of, or business activities covered
by, any provision of this Section 10 be in excess of that which is valid and
enforceable under applicable law, then such provision shall be construed to
cover only that duration, extent or activities which are validly and enforceably
covered. Executive acknowledges the uncertainty of the law in this respect and
expressly stipulates that this Section 10 be given the construction which
renders its provisions valid and enforceable to the maximum extent (not
exceeding its expressed terms) possible under applicable laws.
d. Executive and Datakey acknowledge that the noncompetition provision
of this Section 10 is enforceable against Executive under Minnesota law only if
it is supported by independent consideration because Executive is entering into
this noncompetition agreement after having already accepted employment with
Datakey. Executive specifically acknowledges and agrees that Datakey is
providing him adequate independent consideration for this noncompetition
provision by way of this Agreement, including but not limited to the term of
employment (Section 2), increased base compensation (Section 3), increased
incentive compensation (Section 4), and one-year severance upon termination
(Section 8).
11. Specific Performance
Executive acknowledges that a breach of this Employment Agreement would
cause Datakey irreparable injury and damage which could not be remedied or
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<PAGE>
adequately compensated by damages at law; therefore, Executive expressly agrees
that Datakey shall be entitled, in addition to any other remedies legally
available, to injunctive and/or other equitable relief to prevent a breach of
this Employment Agreement.
12. Miscellaneous
a. Waiver by Datakey of a breach of any provision of this Agreement by
Executive shall not operate or be construed as a waiver of any subsequent breach
by Executive.
b. This Agreement shall be binding upon and inure to the benefit of
Datakey, its successors and assigns, and as to Executive, his heirs, personal
representatives, estate, legatees and assigns.
c. This Agreement constitutes the entire agreement between the parties
hereto with respect to the subject matter hereof and supersedes all prior
agreements whether written or oral relating hereto.
d. This Agreement shall be governed by and construed under the laws of
the State of Minnesota.
IN WITNESS WHEREOF, the parties have hereto executed this Employment
Agreement effective as of the day and year first above written.
DATAKEY, INC.
/s/ Gary R. Holland
By: Gary Holland, Chairman of the Board
/s/ Carl P. Boecher
Carl P. Boecher, Executive
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SEPARATION AGREEMENT AND RELEASE
This Separation Agreement and Release (the "Agreement") is entered into
by and between Datakey, Inc. (the "Company") and John H. Underwood ("Employee")
effective as of January 1, 1997.
RECITALS
John H. Underwood has been an officer, director and employee of the
Company since 1983. In December 1996, Employee resigned as the Chief Executive
Officer of the Company and continued as an employee of the Company through
December 31, 1996. In consideration of his covenants hereunder and his release
of claims set forth hereunder, the Company has made provisions for certain
payments and other benefits to be paid to Employee.
AGREEMENT
NOW THEREFORE, the parties agree as follows:
1. Company. Company, as used herein, means Datakey, Inc., its
successors and assigns, its subsidiaries, and its present and former directors,
officers, shareholders, employees, and agents, whether in their individual or
official capacities.
2. Employee. Employee, as used herein, means John H. Underwood and
anyone who has or obtains legal rights or claims through him.
3. Resignation. On or about December 1, 1996, Employee resigned as the
Chief Executive Officer of the Company. He continued as a non-officer employee
of the Company until December 31, 1996, at which time he resigned as an
employee. Employee will continue as a director of the Company at his discretion
until the next annual meeting of the Company's shareholders or until his
successor has been elected.
4. Agreement Not to Compete.
(a) Restrictive Covenant. Employee agrees that until December
31, 1998, he shall not, directly or indirectly, engage in competition
with the Company in any manner or capacity (e.g., as an advisor,
principal, agent, partner, officer, directors, stockholder, employee,
member of any association, or otherwise) in any phase of the business
which the Company is currently conducting or as part of its business
plan intends to conduct.
(b) Equitable Remedies. The monthly severance payments to be
made to Employee through December of 1998 as set forth in Section 5(a)
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<PAGE>
below are in part in consideration for Employee's agreement not to
compete. If Employee violates his agreement not to compete, the Company
shall have the right to terminate his monthly payment and seek
injunctive relief prohibiting Employee from competing against the
Company.
(c) Geographic Extent of Covenant. The obligations of Employee
not to compete shall apply to the entire United States.
(d) Indirect Competition. Employee further agrees that through
December, 1998, he will not, directly or indirectly, assist or
encourage any other person in carrying out, directly or indirectly, any
activity that would be prohibited by the above provisions of Section
4(a) if such activity were carried out by Employee, either directly or
indirectly; and in particular Employee agrees that he will not,
directly or indirectly, induce any employee of the Company to carry
out, directly or indirectly, any such activity.
(e) Non-Solicitation. Employee further agrees that through
December 31, 1998, he will not solicit or encourage employees of the
Company to terminate their employment with the Company or contact or in
any way interfere or attempt to interfere with the Company's
relationship with any current or potential customers of Datakey.
(f) Construction of Agreement Not to Compete. To the extent
any provision of this Section 4 shall be invalid or unenforceable, it
shall be considered deleted herefrom and the remainder of such
provision and this Section 4 shall be unaffected and shall continue in
full force and effect. In furtherance to and not in limitation of the
foregoing, should the duration or geographical extent of, or business
activities covered by, any provision of this Section 4 be in excess of
that which is valid and enforceable under applicable law, then such
provision shall be construed to cover only that duration, extent or
activities which are validly and enforceably covered. Employee
acknowledges the uncertainty of the law in this respect and expressly
stipulates that this Section 4 be given the construction which renders
its provisions valid and enforceable to the maximum extent (not
exceeding its expressed terms) possible under applicable laws.
5. Benefits.
(a) Through December 31, 1998, Employee shall continue to
receive on a monthly basis, in accordance with Datakey's current
payroll practices, an amount of severance equal to his monthly base
salary in effect on December 31, 1996.
(b) The Company will continue to provide to Employee access to
medical and health coverage, under its plans as they currently exist or
may hereafter be amended, at Company subsidized rates during the
twenty-four month severance pay period. Thereafter, Employee and his
covered dependents will be entitled to elect to continue coverage under
- 2 -
<PAGE>
COBRA to the extent it is available. Coverage by the Company or under
COBRA will end on the earlier of Employee's obtaining new employment
which gives him the ability to provide medical and health insurance
coverage for himself and his family through his new employer, or the
failure to pay any premium when due.
(c) The Company will expend up to $6,000 to be applied only to
actual outplacement counseling of Employee's choice.
(d) Unpaid vacation benefits, if any, will be paid to Employee
on or about January 15, 1997.
(b) Effective as of January 1, 1997 Employee's vested account
balance under the Company's 401(k) Plan and Trust shall be distributed
to Employee or at his direction, pursuant to the terms of the 401(k)
Plan and Employee's election thereunder.
6. Stock Options. Employee has been granted the following stock
options: (i) 25,000 shares at an exercise price of $3.625 per share which
expires on April 30, 2005 and which is vested at 16,600 shares; and (ii) 75,000
shares at an exercise price of $5.75 per share which expires on January 12, 2002
and which is fully vested. After the termination of Employee's employment on
December 31, 1996, Employee will have until February 28, 1999, to exercise his
two stock options.
7. Release of Employment Claims. Employee hereby releases and forever
discharges the Company of and from any and all actions or causes of action,
suits, debts, claims, complaints, contracts (expressed or implied),
controversies, agreements, promises, damages, claims for attorneys' fees,
judgments, costs, disbursements, severance, compensation, vacation pay and other
benefits (except as specifically provided for in this Agreement), known or
unknown, in law or equity, Employee ever had, now has, or shall have as of the
date of this Agreement relating in any manner to Employee's employment with
and/or resignation as an officer, director or employee of the Company,
including, but not limited to, any alleged violation of any federal, state, or
local law, regulation or ordinance prohibiting discrimination or other unlawful
activity on the basis of race, color, creed, marital status, sex, age, religion,
national origin, sexual orientation, sexual harassment, disability, or any other
basis (whether arising under Title VII of the Civil Rights Act, 42 U.S.C. ss.
2000e et seq., the Age Discrimination in Employment Act, 29 U.S.C. ss. 621 et
seq., the Americans With Disabilities Act, 42 U.S.C. ss. 12101 et seq., the
Minnesota Human Rights act, Minn. Stat. ss. 363.01 et seq., or elsewhere), or
any alleged obligation created by statute or by common law contract or tort
theory. Employee releases and discharges Company not only from any and all
claims that he could make on his own behalf, but also those that may or could be
brought by any other person or organization on his behalf. Employee affirms that
as a current or former employee he has not caused or permitted to be filed any
charge, complaint, or action against Company and agrees that he will not cause
or permit to be filed any charge, complaint, or action and that he will not
participate with any other party in the filing of any charge, complaint or
action on the basis of his employee status.
- 3 -
<PAGE>
8. Notification of Rights Pursuant to the Federal Age Discrimination in
Employment Act (29 U.S.C. ss.ss. 621-634) and Minnesota Human Rights Act (Minn.
Stat. Ch. 363). Employee agrees that he is hereby notified that the federal Age
Discrimination in Employment Act provides that he is entitled to wait 21 days to
sign this Agreement. The 21-day period shall begin the day following the day on
which Employee receives the Agreement. Employee acknowledges that the purpose of
the 21-day period is to provide Employee adequate time to consider whether the
terms of this Agreement are acceptable to him. Employee is also hereby notified
of his right to rescind his release of claims arising under the Federal Age
Discrimination in Employment Act within 7 calendar days of his signing of this
Agreement. Employee is further notified of his right to rescind his release of
claims arising under the Minnesota Human Rights Act within 15 calendar days of
his signing of this Agreement. In order to be effective, Employee's rescission
must be in writing and delivered by hand or mail to Gary Holland, Datakey, Inc.,
407 West Travelers Trail, Burnsville, MN 55337-2554. If delivered by mail, the
rescission must be postmarked within the required period, properly addressed to
Gary Holland as set forth above, and sent by certified mail, return receipt
requested. Employee understands that if he rescinds his release of claims as
provided for in this paragraph, Employee will not receive, and will have to
return to Company, all benefits and payments provided for in this Agreement.
9. Confidentiality. The parties agree specifically that the contents
and terms of this Agreement shall remain confidential except as required by
applicable law or regulation (including of the Securities and Exchange
Commission or of the Nasdaq National Market). However, Employee shall be
entitled to discuss the matters contained herein with his legal and financial
advisors and his immediate family, provided they also agree to keep this
Agreement confidential. Provided further that Company shall be entitled to
discuss the matters contained herein with its legal and financial advisers and
its management employees on a need to know basis.
10. Non-Disparagement. Each party agrees not to disparage in any manner
the other party. Any such disparagement will be grounds for rescission of this
Agreement.
11. Corporate Information. Employee agrees that he will not remove any
proprietary corporate information from the Company's offices, including the
office he occupied. The determination of what information is proprietary will be
in the discretion of the Company. Subject to the foregoing, corporate
information shall include, but not be limited to, sales plans, customer
information, employee information, business correspondence and any other
information which is related to Datakey, Inc. or its subsidiaries or their
businesses. All personal property of the Employee, property which is not owned
by or is not proprietary or confidential to the Company, will be returned to
Employee.
12. Assignment. The obligations of Employee under this Agreement may
not be assigned by Employee. However, in the event of Employee's mental or
physical disability, incapacitation or death, all remaining payments shall
continue to be made to Employee's spouse, or in the event of the death of the
- 4 -
<PAGE>
Employee's spouse, the payments will be made to Employee's estate. The Company's
rights and obligations under this Agreement will inure to the benefit and be
binding upon the Company's successors and assignees.
13. Severability. If a court rules that any part of this Agreement is
not enforceable, that part may be modified by the court to make it enforceable.
The parties expressly agree that the restrictions contained in Section 4 are
reasonable and should be enforced to the maximum extent and scope possible.
14. Governing Law. Any disputes arising under this Agreement shall be
governed by the laws of the State of Minnesota.
15. Acknowledgment of Reading and Understanding; Consultation with
Counsel; Period to Consider Agreement. Employee, by signing this Agreement,
acknowledges and agrees that he has carefully read and understood all provisions
of this Agreement and that he has entered into this Agreement knowingly and
voluntarily. Employee further acknowledges that he has consulted with counsel
before signing this Agreement. Employee also acknowledges that Company informed
him that he has 21 days from the receipt of this Agreement to consider whether
its terms are acceptable to him and that he has had the benefit of the 21-day
period. Employee acknowledges and agrees that he has not relied on any
representations or statements by Company, whether oral or written, other than
the express statements of this Agreement, in executing this Agreement.
16. Full Agreement. This Agreement contains the full agreement of the
parties and may not be modified, altered, or changed in any way except by
written agreement signed by both parties. Except as expressly stated in this
Agreement, the parties agree that this Agreement supersedes and terminates any
and all oral and written prior agreements and understandings between the
parties.
DATAKEY, INC.
Dated: January 27, 1997 By /s/ Gary R. Holland
Gary Holland
Chairman of the Board of Directors
Dated: February 27, 1997 /s/ John H. Underwood
John H. Underwood
- 5 -
LTIP NOTES AND ASSUMPTIONS
February 27, 1997
Amended March 10, 1997
The RONAEBIT calculation during the two year period is determined using
operating income after deducting the short-term bonus accrual expense. Since the
stock options will be granted at the fair market value on the date of grant with
a fixed number of options and fixed term, there is no compensation expense to be
recorded during the operating periods. The only accounting transactions that
will take place during the two year period are the footnote disclosure for
FAS123 and the common stock equivalent calculation that is taken into account in
determining primary and fully diluted shares for EPS calculations.
Each manager will be granted three sets of options equal to the one times LTIP
financial performance. If the performance qualifies for a 1 times payout the
first set of options will vest, if the performance qualifies for 2 times payout
the second set will vest, and if it qualifies for 3 times payout the third set
of options will vest. In the event none of the performance criteria are met all
the options will vest at the end of 5 years.
Since the number of shares and the price must be determined at the time the
option is granted in order for compensation expense to be avoided there is no
provision for interpolation of the shares. In other words, if the base number of
shares is 5,000 then the individual gets early vesting of 5,000, 10,000 or
15,000 shares and no intervals in between. If the minimum level is not reached,
all 15,000 shares will vest at the end of five years. To accommodate the same
result as interpolation of shares the vesting schedule will reflect the
financial performance level. For example, at a performance level of .25 in the
enclosed LTIP table (50% revenue growth and 15% RONAEBIT or 25% revenue growth
and 25% RONAEBIT) the number of shares in this example will be as follows: (At
.50 the first set is vested in 3.50 years and at .75 level the first set is
vested at 2.75 years).
5,000 shares vested in 4.25 years first set
5,000 shares vested in 5.00 years second set
5,000 shares vested in 5.00 years third set
------
15,000 Total
At performance level of 1 the number of shares is as follows:
5,000 shares vested in 2.00 years first set
5,000 shares vested in 5.00 years second set
5,000 shares vested in 5.00 years third set
------
15,000 Total
At performance level of 2 the number of shares is as follows:
5,000 shares vested in 2.00 years first set
5,000 shares vested in 2.00 years second set
5,000 shares vested in 5.00 years third set
------
15,000 Total
At performance level of 3 the number of shares is as follows:
5,000 shares vested in 2.00 years first set
5,000 shares vested in 2.00 years second set
5,000 shares vested in 2.00 years third set
------
15,000 Total
To determine the vesting if performance falls in between 1, 2 and 3 the number
of years vesting is determined by using the following vesting schedule for the
fractional performance and adding that to the shares with full performance:
.25 4.25 years
.50 3.50 years
.75 2.75 years
<PAGE>
At a performance level of 2.25, for example, the vesting is as follows:
5,000 shares vested in 2.00 years first set
5,000 shares vested in 2.00 years second set
5,000 shares vested in 4.25 years third set
------
15,000 Total
Part 1: Annual Incentive Plan (AIP)
1. The AIP is applicable to the Management Team and other key contributors
except sales (who have a separate plan).
2. The AIP rewards corporate revenue growth and reduced operating losses
before tax. (See table below)
3. Participation level (target bonus percentage) is based on the
individual's planned contribution to these metrics.
4. The Individual Performance Coefficient is a numerical rating of 0.5 -
1.0 recommended by the President and approved by the Compensation
Committee on the individual's actual contribution to the measurement
metrics.
5. Plan formula is: Base compensation x financial performance coefficient
x target bonus percentage x individual performance coefficient.
6. Pre-tax operating loss for calculation purposes is defined as the loss
before incentive payout.
<TABLE>
<CAPTION>
Financial Performance Coefficient Table
PRETAX OPERATING LOSS
REVENUE greater than 110% plan plan to 75% plan to less than
110% plan to plan 75% plan 50%plan 50% plan
<S> <C> <C> <C> <C> <C>
less than
90% plan 0 0 0 0 0
90% plan to 0 .25 .5 .75 1
100% plan
100% plan to 0 .5 1 1.2 1.4
120% plan
120 % plan to 0 .75 1.2 1.5 1.8
140% plan
greater than 0 1 1.4 1.8 2.2
140% plan
</TABLE>
This table may not be interpolated for incentive payout calculation.
<PAGE>
Part 2: Long Term Incentive Plan (LTIP)
1. The LTIP is applicable to Management team and other recommended key
contributors including sales, and is reissued on an annual basis.
2. The LTIP is based on corporate revenue growth and RONAEBIT. RONAEBIT is
defined as: Earnings before interest and taxes/average net assets
employed and is calculated for the second year of the period.
3. The individual's target participation units are based on his/her
contribution to these metrics.
4. Metrics are defined for a two (2) year period.
5. LTIP payout, made after completion of the two year plan period, will be
in the form of Datakey non-qualified stock options. Option quantity for
each participant will be defined at the beginning of the two year plan
period. Option price will be determined by the average price of Datakey
stock for the 15 day period immediately prior to the January 1
beginning of each two year plan period.
6. LTI Plan awards will be made based on the following formula: Individual
target participation units x LTI performance factor (from table below)
7. RONAEBIT is calculated after all incentives are paid.
LTI Performance Factor Table
Revenue Growth for 2 Year Period
less than 125% or
RONAEBIT 25% 25% 50% 75% 100% greater
less than 15% 0 0 0 0 0 0
15% 0 0 0.25 0.5 .75 1
25% 0 0.25 0.5 1 1.5 2
35% or greater 0 .5 0.75 1.5 2.25 3
This table may be interpolated for incentive payout calculation.
LEASE AMENDMENT
NO. 5
THIS LEASE AMENDMENT No. 5, made and entered into this 17th day of
December, 1996, by and between Kraus-Anderson(R) Incorporated, a Minnesota
Corporation, (hereinafter referred to as "Landlord") and Datakey, Inc., a
Minnesota Corporation (hereinafter referred to as "Tenant");
WITNESSETH THAT:
WHEREAS, Landlord is leasing to Tenant and Tenant is leasing from
Landlord certain premises commonly known as 401-409 West Travelers Trail,
Burnsville, Minnesota and located in the, Gateway Business Park, (the "Leased
Premises") pursuant to written Lease Agreement dated June 3, 1987, as amended
February 10, 1988, December 23, 1988, February 13, 1992 and April 1, 1992 and
(collectively referred to as the "Lease");
WHEREAS, the parties hereto now desire to amend certain provisions of
the Lease;
NOW THEREFORE, in consideration of mutual agreements contained herein,
it is hereby agreed to amend the Lease as follows:
1. ARTICLE 1. PREMISES AND TERM:
The term of this lease is hereby extended for an additional two years
commencing July 1, 1997 through June 30, 1999, (the "Extension Term").
2. ARTICLE 3. BASE RENT AND SECURITY DEPOSIT:
The annual base rent, Article 3, Section 1 during the Extension Term
shall be as follows:
Annual Base Rent for July 1, 1997 through June 30, 1998 shall be One
Hundred Twenty Eight Thousand Four Hundred Ninety One Dollars and
60/100 ($128,491.56) payable in monthly installments of Ten Thousand
Seven Hundred Seven and 63/100 ($10,707.63).
Annual Base Rent for July 1, 1998 through June 30, 1999 shall be One
Hundred Thirty Four Thousand Thirty Eight and 96/100 Dollars
($134,038.96) payable in monthly installments of Eleven Thousand One
Hundred Sixty Nine and 83/100 ($11,169.83).
3. Except as herein specifically modified and amended, the Lease shall
remain in full force and effect and unaltered hereby.
IN WITNESS WHEREOF the parties hereto have caused this Lease Amendment to be
executed the day and year first above written.
KRAUS-ANDERSON, INCORPORATED DATAKEY, INC.
By: /s/ Burton F. Dahlberg By: /s/ Alan Shuler
Its: President Its: Vice President
Landlord Tenant
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Results of Operations
The table below summarizes changes in selected operating indicators, showing
certain income, cost and expense items as a percentage of total revenue for each
of the past three years. Inflation has not been a significant factor in
Datakey's operations to date.
Percentage of Total Revenue
Year Ended December 31, 1996 1995 1994
--------- ------- ---------
Revenue........................ 100% 100% 100%
Cost and Expenses
Cost of goods sold............. 65% 67% 70%
Research and development....... 35 10 13
Marketing and sales............ 20 15 17
General and administrative..... 18 9 10
--------- -------- --------
Total cost and expenses..... 138 101 110
Interest income................ 6 5 5
--------- -------- --------
Income (loss) before income
taxes.......................... (32) 4 (5)
Income taxes (benefit)......... (6) 2 (2)
--------- -------- --------
Net income (loss).............. (26) 2 (3)
========= ======== ========
Comparison of 1996 with 1995
Total Revenue: Total revenue was $6,558,000 in 1996, a decrease of 9 percent
from $7,219,000 in 1995. Commercial sales were $5,669,000 or 86 percent of
revenue with government sales representing $889,000 or 14 percent of revenue.
The revenue decrease is primarily due to customer requested delays in commercial
OEM product shipments during the second half of 1996 resulting from delays in
shipments to their customers.
Gross margins: The gross profit margin increased to 35 percent in 1996 from 33
percent in 1995 in spite of a reduction in revenue which normally reduces the
margin percentage. The improved margin percentage is primarily due to increases
in product selling prices in excess of the increases in material and
manufacturing costs.
Research and development: Research and development expenses increased 221
percent to $2,263,000 in 1996 from $704,000 in 1995 due to the Company's
significant increase in product development activities for new end-user
products.
Marketing and sales, General and administrative: Marketing and sales expense in
1996 increased 17 percent to $1,312,000 from $1,124,000 in 1995 due to an
increase in product promotion expense for newly developed and in-development
end-user products. General and administrative expenses increased 73 percent to
$1,156,000 in 1996 from $670,000 in 1995 primarily due to an accrual for
severance pay and benefits due the Company's former chief executive officer.
Interest income: Interest income decreased 6 percent to $361,000 in 1996 from
$381,000 in 1995 due to a decline in the Company's investment in interest
bearing investments.
Income tax expense (benefit): Income tax benefit for 1996 is $388,000 as
compared to an income tax expense of $106,000 in 1995. The benefit is related to
the 1996 loss before taxes of $2,094,000 for which the Company recorded a
deferred tax asset of $325,000, and 1995 expense is related to the $282,000
income before taxes.
<PAGE>
Comparison of 1995 with 1994
Total Revenue: Total revenue was $7,219,000 in 1995, an increase of 23 percent
from $5,874,000 in 1994. The increase was principally due to a substantial
increase in commercial revenue offset, in part, by a decline in government
revenue. Commercial sales increased 33 percent to $6,205,000 in 1995 from
$4,669,000 in 1994. Commercial sales as a percentage of total revenue was 86
percent in 1995 versus 79 percent in 1994. The increase in commercial sales was
attributed to increased business with existing customers as well as sales,
generally small initially, to several new customers. The decline in government
revenue resulted from a discontinuation of US Government purchases of keys for
the secure telephone program.
Gross margins: The gross profit margin on net sales increased to 33 percent in
1995 from 29 percent in 1994. This increase in gross profit percentage was
achieved primarily by improvements in manufacturing productivity and the
increase in revenue over which the fixed factory overhead is absorbed.
Research and development: Research and development expenses decreased 9 percent
to $704,000 from $771,000 in 1994 and also decreased as a percentage of revenue
to 10 percent in 1995 from 13 percent in 1994. The decrease in 1995 was
primarily related to a reduction in travel and project supplies expense.
Marketing and sales, General and administrative: Marketing and sales expense
increased 16 percent to $1,124,000 in 1995 from $971,000 in 1994. The 1995
increase was principally due to commissions payable on the higher level of
revenue and an increase in travel and promotional expenses. Marketing and sales
expense declined as a percentage of revenue to 15 percent in 1995 from 17
percent in 1994. General and administrative expenses increased 14 percent to
$670,000 in 1995 from $590,000 in 1994. This increase was related to increased
data processing support costs for a more complex computer system as well as
general increases in a variety of administrative costs necessary to support the
growth in the Company. General and administrative expenses as a percentage of
revenue declined to 9 percent in 1995 from 10 percent in 1994.
Interest income: Interest income increased 34 percent to $381,000 in 1995 from
$285,000 in 1994. The increase was due to an increased market interest rate for
the Company's interest bearing investments as well as an increase in the average
balance of these investments.
Liquidity and Capital Resources
The Company's operating activities used $489,000 of cash in 1996 and provided
$938,000 of cash in 1995. The Company had a reduction of $834,000 in cash and
held-to-maturity marketable debt securities in 1996 compared to an increase of
$601,000 in 1995. The 1996 reduction in cash and marketable debt securities was
primarily the result of a significant increase, totaling $1,747,000, in research
and development and marketing expenses which was principally related to the
Company's new product development activities. Trade receivables as of December
31, 1996, were $635,000 compared to $1,055,000 as of December 31, 1995. The
reduction in trade receivables is due to a lower level of shipments in the
fourth quarter of 1996 as compared to the fourth quarter of 1995. Inventory
decreased $94,000 to $1,129,000 as of December 31, 1996, compared to $1,223,000
as of December 31, 1995. The lower 1996 inventory level reflects a reduction in
the expected level of revenue during the fourth quarter of 1996 as well as
improvements in inventory management. Accrued compensation expense increased by
$349,000 primarily due to the accrual of severance pay and benefits due the
Company's former chief executive officer. The Company invested $515,000 in the
purchase of equipment and maintenance of licenses and patents in 1996 compared
to $318,000 in 1995. The 1996 increase is primarily attributable to prepaid
license fees related to licensed client and server software that will be bundled
with the Company's information security systems. Cash, cash equivalents, and
investment in held-to-maturity marketable debt securities as of December 31,
1996, were $6,133,000 as compared to $6,967,000 as of December 31, 1995.
Datakey's balance continues to reflect a strong financial position with
$6,737,000 in working capital and a current assets to current liabilities ratio
of 6.6 to 1 as of December 31, 1996.
<PAGE>
Outlook
The statements in this outlook section are based upon current expectations.
These statements are forward looking and actual results may differ materially
due to the risks, issues and uncertainties set forth below.
Revenue: Customer requested shipment delays experienced in the fourth quarter of
1996 are, based upon customer communications to us, expected to continue through
the first one or two quarters of 1997 and will result in a reduction in OEM
products revenue for the year as compared to 1996. New end-user products being
developed for the information security marketplace are planned for sales
introduction by mid-1997 and, based upon current expectations, are expected to
result in material revenue during the second half of 1997. As with any new
product line, revenue will depend on customer acceptance, the extent of which is
difficult to assess at this time. If this revenue meets the Company's present
expectations the total revenue in 1997 will exceed the 1996 level.
Gross margins: A gradual improvement in gross profit margins during 1997 is
expected through selective price increases, effective material purchasing and
improvements in manufacturing efficiency.
Research and development: The Company will continue to fund new product
development activities at a higher level in 1997 than in 1996, and may also
exceed the 1996 percentage of revenue unless revenue from these new products in
the second half of 1997 is substantial.
Marketing and sales, General and administrative: Marketing and sales expenses
are expected to increase by 30 to 40 percent in 1997 to support new product
introductions and the expected increase in revenue, but will be about the same
percent of revenue as in 1996 provided the revenue from new product sales
materializes as expected. General and administrative expenses in 1997 are
expected to increase only slightly from the 1996 level, exclusive of the
1996 severance pay accrual.
Interest income: Interest income is expected to decline in 1997 as the pany
intends to use the proceeds from maturing investments to fund continuing product
development and marketing activities to support the Company's planned
introduction of advanced information security products.
Income tax benefit: The Company has recorded an income tax benefit and a
corresponding deferred tax asset of $325,000 as of December 31, 1996 related to
the estimated future tax benefit of the Company's net operating loss
carryforward. Management believes it is more likely than not that the Company
will realize income in the future from its existing OEM products business, as
well as income from its new advanced information security products business that
will allow the Company to utilize a portion of the net operating loss
carryforward to reduce future taxable income. However, the net deferred tax
asset could be increased or reduced in the future if management's estimates of
taxable income during the carryforward period change.
Expected loss: For the reasons explained above the Company expects to report a
loss in 1997. Although the Company expects to have new end-user products
available for sale in the second half of 1997, the marketability of these
products will not be known until at least late 1997. The extent of the Company's
loss will depend directly on product availability and market acceptance.
Liquidity and capital resources: The Company plans to continue new product
development and marketing activities during 1997 and expects to spend $4.5 to $5
million on these activities. Inventory levels are expected to increase in 1997
to support advanced information security products that are planned to be
available for sale in the second half of the year. 1997 investments in equipment
and maintenance of licenses and patents in 1997 are expected to be about 2 to 3
times the 1996 level of $515,000 primarily related to prepaid license fees for
client and server software to be bundled with the Company's information security
products. This spending will be funded by a reduction in the Company's
marketable debt securities. The Company's working capital and investments are
sufficient to fund its planned operations and continued development and
promotional activities in 1997.
<PAGE>
Issues and Uncertainties:
While management is optimistic about the companies long-term prospects, the
following issues and uncertainties, as well as those discussed in the outlook
section, should be considered in evaluating its growth outlook.
Rapid technological change. Datakey's information security end-user products
such as SignaSURE EDMTM and SignaSURE ESSTM will integrate hardware tokens with
software that provide a much higher level of security than software
implementations alone. There is a possibility that software-only solutions may
overcome this deficiency in the future.
Customer Acceptance. While Datakey performs market research and beta testing
to determine the viability of its new products, actual user acceptance will
ultimately dictate the success of the marketing and sales efforts of new
products such as SignaSURE EDM and ESS. Although the company believes that the
decision to fund these new products is correct, there are no assurances that the
investments already made and additional investments planned for 1997 will result
in a financial return.
Product delivery schedules. Delays in the release of new products will cause
operational inefficiencies, increased development costs and reduced revenues.
Price competition. While Datakey believes that its strategy of providing
token-based product solutions at a price that is competitive with software-only
products is attainable, there are no assurances that competitive pressures will
not force the company to accept reduced margins to compete in the future. Large
companies have recognized the need for information security and could enter this
market as competitors with much greater financial resources. A portion of the
new end-user products' cost is royalties and license fees which would need to be
re-negotiated in order to maintain acceptable profit margins.
Integrated information security products. Although the Company's new
products will operate seamlessly with popular application programs, new
application programs that integrate information security into their product
could erode the future market for these Datakey products.
Marketing and sales. The future revenue of Datakey end-user systems is
dependent on the success of a new and untested marketing and direct sales
organization.
Need for information security. Although corporate utilization of the
Internet and internal intranets dictate a need for information security, there
are no assurances that other, more secure information transmission media may not
become available in the future that would preclude the need for the type of
information security provided by the Company's products.
<PAGE>
INDEPENDENT AUDITOR'S REPORT
To the Stockholders
Datakey, Inc.
We have audited the accompanying consolidated balance sheets of Datakey, Inc.
and Subsidiary as of December 31, 1996 and 1995, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 1996. These consolidated 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 generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Datakey, Inc. and
Subsidiary as of December 31, 1996 and 1995, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1996, in conformity with generally accepted accounting principles.
McGLADREY & PULLEN, LLP
/s/ McGladrey & Pullen, LLP
Minneapolis, Minnesota
February 5, 1997
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 1996 and 1995
<TABLE>
<S> <C> <C>
ASSETS 1996 1995
- --------------------------------------------------------------------------------------------------------------------
Current Assets
Cash and cash equivalents $ 140,030 $ 713,230
Investment in held-to-maturity securities (Note 2) 5,993,228 6,253,984
Trade receivables, less allowance for doubtful accounts of
$45,000 in 1996 and $34,300 in 1995 (Note 7) 634,538 1,055,075
Inventories (Note 3) 1,128,907 1,222,938
Deferred taxes (Note 4) - 109,000
Prepaid expenses and other 46,962 52,177
Refundable income taxes - 46,642
-------------------------------------
Total current assets 7,943,665 9,453,046
-------------------------------------
Other Assets
Deferred taxes (Note 4) 325,000 -
Licenses and patents, less amortization--1996 $105,531;
1995 $118,702 (Note 8) 228,986 158,264
Noncompete agreement, less amortization--1995 $123,750 - 41,250
-------------------------------------
553,986 199,514
-------------------------------------
Equipment and Leasehold Improvements, at cost
Production tooling 1,179,021 1,109,524
Equipment 2,561,659 2,358,938
Furniture and fixtures 267,482 211,822
Leasehold improvements 234,452 211,761
-------------------------------------
4,242,614 3,892,045
Less accumulated depreciation 2,840,909 2,366,660
-------------------------------------
1,401,705 1,525,385
-------------------------------------
$ 9,899,356 $ 11,177,945
=====================================
</TABLE>
See Notes to Consolidated Financial Statements.
<PAGE>
<TABLE>
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY 1996 1995
- --------------------------------------------------------------------------------------------------------------------
Current Liabilities
Accounts payable $ 559,280 $ 509,683
Accrued expenses:
Compensation (Note 9) 538,664 189,980
Other 108,885 108,692
-------------------------------------
Total current liabilities 1,206,829 808,355
-------------------------------------
Deferred Taxes (Note 4) - 158,000
-------------------------------------
Commitments (Notes 5 and 8)
Stockholders' Equity (Notes 5 and 6)
Convertible preferred stock, voting, stated value $2.50 per
share; authorized 400,000 shares; issued and outstanding
150,000 shares 375,000 375,000
Common stock, par value $0.05 per share; authorized
10,000,000 shares; issued and outstanding 2,882,069 shares
in 1996 and 2,835,236 shares in 1995 144,103 141,762
Additional paid-in capital 4,070,815 3,885,887
Retained earnings 4,102,609 5,808,941
-------------------------------------
8,692,527 10,211,590
-------------------------------------
$ 9,899,356 $ 11,177,945
=====================================
</TABLE>
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<S> <C> <C> <C>
1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------
Net sales (Note 7) $ 6,558,025 $ 7,219,308 $ 5,873,508
---------------------------------------------------------
Costs and expenses:
Cost of goods sold 4,282,062 4,821,516 4,111,131
Research and development 2,262,920 703,816 771,230
Marketing and sales 1,311,663 1,123,781 970,782
General and administrative 1,156,270 669,954 590,078
---------------------------------------------------------
Total costs and expenses 9,012,915 7,319,067 6,443,221
---------------------------------------------------------
Operating loss (2,454,890) (99,759) (569,713)
Interest income 360,558 381,385 284,693
---------------------------------------------------------
Income (loss) before income taxes (2,094,332) 281,626 (285,020)
Income tax expense (benefit) (Note 4) (388,000) 106,000 (112,000)
---------------------------------------------------------
Net income (loss) $ (1,706,332) $ 175,626 $ (173,020)
=========================================================
Net income (loss) per common share $ (.60) $ .06 $ (.06)
Weighted average number of common shares and
common equivalent shares outstanding 2,861,498 3,006,352 2,829,236
</TABLE>
See Notes to Consolidated Financial Statements.
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<CAPTION>
Convertible Preferred Stock Common Stock
------------------------------------------------------
Shares Amount Shares Amount
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balance, December 31, 1993 150,500 $ 376,250 2,829,070 $ 141,454
Conversion of preferred stock (500) (1,250) 500 25
Net loss - - - -
---------------------------- ---------------------------
Balance, December 31, 1994 150,000 375,000 2,829,570 141,479
Issuance of common stock under
stock options (Note 6) - - 5,666 283
Net income - - - -
---------------------------- ---------------------------
Balance, December 31, 1995 150,000 375,000 2,835,236 141,762
Issuance of common stock under
stock options (Note 6) - - 46,833 2,341
Net loss - - - -
---------------------------- ---------------------------
Balance, December 31, 1996 150,000 $ 375,000 2,882,069 $ 144,103
============================ ===========================
</TABLE>
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (continued)
<TABLE>
<CAPTION>
Additional
Paid-In Retained
Capital Earnings Total
- ------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Balance, December 31, 1993 $3,864,406 $ 5,806,335 $ 10,188,445
Conversion of preferred stock 1,225 - -
Net loss - (173,020) (173,020)
--------------------------------------------------
Balance, December 31, 1994 3,865,631 5,633,315 10,015,425
Issuance of common stock under
stock options (Note 6) 20,256 - 20,539
Net income - 175,626 175,626
--------------------------------------------------
Balance, December 31, 1995 3,885,887 5,808,941 10,211,590
Issuance of common stock under
stock options (Note 6) 184,928 - 187,269
Net loss - (1,706,332) (1,706,332)
--------------------------------------------------
Balance, December 31, 1996 $4,070,815 $ 4,102,609 $ 8,692,527
==================================================
</TABLE>
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<S> <C> <C> <C>
1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------
Cash Flows From Operating Activities
Net income (loss) $ (1,706,332) $ 175,626 $ (173,020)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation 475,475 461,378 402,394
Amortization 134,041 133,253 82,549
Change in accrued interest on investment
securities 16,962 (44,399) (96,689)
Deferred taxes (374,000) 114,000 18,500
Changes in assets and liabilities:
Trade receivables 420,537 135,818 133,964
Inventories 94,031 126,047 (639,068)
Accounts payable 49,597 (249,193) 63,488
Other 400,734 85,049 (107,972)
---------------------------------------------------------
Net cash provided by (used in)
operating activities (488,955) 937,579 (315,854)
---------------------------------------------------------
Cash Flows From Investing Activities
Purchase of equipment (351,795) (262,892) (574,752)
Purchase of held-to-maturity securities (5,829,941) (6,073,735) (8,313,568)
Proceeds from maturity of held-to-maturity
securities 6,073,735 5,974,726 6,806,795
License and patent costs (163,513) (55,526) (92,882)
---------------------------------------------------------
Net cash provided by (used in)
investing activities (271,514) (417,427) (2,174,407)
---------------------------------------------------------
(Continued)
</TABLE>
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<S> <C> <C> <C>
1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------
Cash Flows From Financing Activities
Net proceeds from issuance of common stock 187,269 20,539 -
Payments on non-compete obligation - (82,500) (82,500)
---------------------------------------------------------
Net cash provided by (used in)
financing activities 187,269 (61,961) (82,500)
---------------------------------------------------------
Increase (decrease) in cash and
cash equivalents (573,200) 458,191 (2,572,761)
Cash and Cash Equivalents
Beginning 713,230 255,039 2,827,800
---------------------------------------------------------
Ending $ 140,030 $ 713,230 $ 255,039
=========================================================
Supplemental Disclosures of Cash Flow Information
Net cash refunds of income taxes $ 75,112 $ 63,038 $ 136,603
=========================================================
Supplementary Schedule of Noncash Investing and
Financing Activities
Obligation recorded under non-compete
agreement $ - $ - $ 165,000
=========================================================
</TABLE>
See Notes to Consolidated Financial Statements.
<PAGE>
DATAKEY, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Business and Significant Accounting Policies
Nature of business: Datakey, Inc. is an international supplier of electronic
products and services. The Company designs, manufactures, and markets products,
subsystems, and systems solutions to record, store, and transmit electronic
information. The Company is developing products and systems directed to the
information security market which will enable user identification and
authentication, secure data exchange, and information validation. The Company
also provides OEM products, consisting of proprietary memory keys, cards, and
other custom-shaped tokens, that serve as a convenient way to carry electronic
information and are packaged to survive in portable environments. The Company's
practice is to grant credit on an unsecured basis to customers who meet certain
financial criteria.
A summary of significant accounting policies follows:
Principles of consolidation: The consolidated financial statements include the
accounts of Datakey, Inc. and its wholly-owned subsidiary. All significant
intercompany accounts and transactions have been eliminated in consolidation.
Use of estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and cash equivalents: For purposes of reporting the statements of cash
flows, the Company includes all cash accounts and all highly liquid debt
instruments purchased with an original maturity of three months or less as cash
and cash equivalents on the accompanying consolidated balance sheets.
The Company maintains its cash in bank deposit accounts which, at times, may
exceed federally insured limits. The Company has not experienced any losses in
such accounts.
Investment in debt securities: The Company has investments in debt securities
consisting of obligations of the U. S. government with maturities of 12 months
or less. Since the Company intends to hold the debt securities to their
maturities, the investment in debt securities has been classified as
held-to-maturity and is recorded at amortized cost.
Fair value of financial instruments: The Company's financial instruments consist
of cash and cash equivalents, marketable securities, and short-term trade
receivables and payables for which current carrying amounts approximate fair
market value.
Inventories: Inventories are stated at the lower of cost (first-in, first-out
method) or market.
<PAGE>
Note 1. Nature of Business and Significant Accounting Policies (Continued)
Depreciation: Depreciation of equipment and leasehold improvements is computed
on the straight-line and accelerated methods over the following estimated useful
lives:
Years
- -------------------------------------------------------------------------------
Production tooling 2-5
Equipment 5-7
Furniture and fixtures 7
Leasehold improvements Life of lease
Warranty costs: The Company provides for estimated normal warranty costs at the
time of product sales to the customers and for other costs associated with
specific items at the time their existence and amounts are determinable.
Income taxes: Deferred taxes are provided on a liability method whereby deferred
tax assets are recognized for deductible temporary differences and operating
loss or tax credit carryforwards, and deferred tax liabilities are recognized
for taxable temporary differences. Temporary differences are the differences
between the amounts of assets and liabilities recorded for income tax and
financial reporting purposes. Deferred tax assets are reduced by a valuation
allowance when management determines that it is more likely than not that some
portion or all of the deferred tax assets will not be realized. Deferred tax
assets and liabilities are adjusted for the effects of changes in tax laws and
rates on the date of enactment.
Licenses and patents: Licenses and patents are stated at cost and are being
amortized using the straight-line method over their economic useful lives which
has been estimated to be five years. The cost of the license agreement discussed
in Note 8 will be amortized to cost of goods sold as the products incorporating
the licensed units are sold.
Noncompete agreement: During 1994, the Company's former president entered into a
noncompete agreement with the Company payable over a one-year period. The
agreement not to compete was for a period of two years and was amortized over
that term using the straight-line method.
Revenue recognition: The Company records sales revenue upon shipment to the
customer.
Research and development: Research and development costs are charged to expense
as incurred.
Net income (loss) per common share: In 1995, net income per common share and
common equivalent share was based on the weighted-average number of common
shares outstanding during the year, adjusted for the conversion of the preferred
shares into common shares, and the use of the treasury stock method to include
the effect of the exercise of all stock options having exercise prices less than
the average market price of common stock. In 1996 and 1994, the net loss per
common share was based on the weighted-average number of common shares
outstanding.
There was no material difference between primary and fully diluted net income
per share in 1995.
<PAGE>
Note 2. Investment in Held-to-Maturity Securities
The following is a summary of the Company's investment in held-to-maturity
securities as of December 31, 1996 and 1995:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
- ------------------------------------------ --------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
U. S. government securities:
1996 $5,993,228 $ 465 $ 6,445 $5,987,248
1995 6,253,984 8,713 743 6,261,954
</TABLE>
All securities are due within one year and all investment earnings represent
interest income on the above securities and previously held debt securities.
Note 3. Inventories
Inventories consist of the following components as of December 31, 1996 and
1995:
1996 1995
- --------------------------------- -------------- ------------------
Raw materials $ 754,629 $ 822,035
Work in process 87,453 127,567
Finished goods 286,825 273,336
------------ ------------
$ 1,128,907 $ 1,222,938
============ ============
Note 4. Income Taxes
The income tax expense (benefit), consists of the following:
1996 1995 1994
- ------------------------------------- ------------- ----------- -----------
Currently payable (refundable):
Federal $ (15,000) $ (9,000) $(131,500)
State 1,000 1,000 1,000
Deferred (374,000) 114,000 18,500
------------- ----------- -----------
$ (388,000) $ 106,000 $(112,000)
============= =========== ===========
<PAGE>
Note 4. Income Taxes (Continued)
The income tax expense (benefit) is different from that which would be computed
by applying the U. S. federal income tax rate (35 percent) to pretax income
(loss) as follows:
<TABLE>
<CAPTION>
1996 1995 1994
- ------------------------------------------------- ---------- ---------- -----------
<S> <C> <C> <C>
Computed "expected" federal tax expense
(benefit) at statutory rates $ (733,000) $ 99,000 $ (100,000)
Effect of graduated tax rates 21,000 (3,000) 3,000
Effect of net operating loss carryforward, with
no current benefit 338,000 - -
State income taxes, net of federal benefit 1,000 1,000 1,000
Nontaxable municipal bond interest income - - (11,000)
Other (15,000) 9,000 (5,000)
----------- ---------- -----------
Actual tax expense (benefit) $ (388,000) $ 106,000 $ (112,000)
----------- ---------- -----------
</TABLE>
Net deferred tax assets (liabilities) consist of the following components as of
December 31, 1996 and 1995:
1996 1995
-------- --------
Deferred tax assets:
Allowance for doubtful accounts $ 16,000 $ 12,000
Inventory 86,000 59,000
Warranty reserve 18,000 13,000
Compensation and benefits 134,000 13,000
Net operating loss carryforward 698,000 -
Other - 12,000
-------- --------
Total gross deferred tax assets 952,000 109,000
Valuation allowance (455,000) -
-------- --------
Net deferred tax assets 497,000 109,000
Deferred tax liability:
Depreciation (172,000) (158,000)
-------- --------
Net deferred tax asset (liability) $ 325,000 $ (49,000)
======== ========
Realization of deferred tax assets associated with the net operating loss
carryforward is dependent upon the generation of sufficient future taxable
income prior to the expiration of the loss carryforwards. Management has
established a valuation allowance against a portion of the deferred tax asset in
recognition of the risk that part of the loss carryforward may not be realized.
Although realization is not assured for the remaining deferred tax assets,
management believes it is more likely than not that they will be realized
through future taxable income. However, the net deferred tax asset could be
increased or reduced in the future if management's estimates of taxable income
during the carryforward period change.
<PAGE>
Note 4. Income Taxes (Continued)
At December 31, 1996, the Company's net operating loss is approximately
$1,850,000 and expires in the year 2011.
Note 5. Preferred Stock
The preferred shares are convertible at the rate of one share of common stock
for each share of preferred stock, subject to certain antidilution adjustments.
Conversion is mandatory in the event of certain future public offerings of
corporate stock. The holders of the preferred stock have certain piggyback and
demand registration rights, have a liquidation preference of $2.50 per share,
and share in dividends paid on common stock.
Note 6. Stock Options
The Company has reserved 800,000 common shares for issuance under qualified and
nonqualified stock options for its key employees and directors. The Company has
also reserved 50,000 common shares for issuance under nonqualified options to
various distributors, dealers, and consultants. Option prices are the fair
market value of the stock at the time the option was granted. Options become
exercisable as determined at the date of grant by a committee of the Board of
Directors. Options expire ten years after the date of grant unless an earlier
expiration date is set at the time of grant.
The Company has adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation.
Accordingly, no compensation cost has been recognized for the stock option
plans. Had compensation cost for the Company's stock option plans been
determined based on the fair value at the grant date for awards in 1996 and 1995
consistent with the provisions of SFAS No. 123, the Company's net income (loss)
and net income (loss) per share would have changed to the pro forma amounts
indicated below:
1996 1995
- ----------------------------------------------- ------------- ---------------
Net income (loss), as reported $ (1,706,332) $ 175,626
Net income (loss), pro forma (1,844,604) 112,348
Net income (loss), per share, as reported (0.60) .06
Net income (loss), per share, pro forma (0.64) .04
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1996 and 1995:
1996 1995
- ----------------------------------------------- -------------- --------------
Expected dividend yield - -
Expected stock price volatility 48.39% 32.76%
Risk-free interest rate 5.87% 6.71%
Expected life of options 3 years 3 years
<PAGE>
Note 6. Stock Options (Continued)
The pro forma effect on net loss or net income in 1996 and 1995 is not
representative of the pro forma effect in future years because it does not take
into consideration pro forma compensation expense related to grants made prior
to 1995.
Additional information relating to all outstanding options as of December 31,
1996, 1995, and 1994 is as follows:
<TABLE>
<CAPTION>
1996 1995 1994
------------------------ ----------------------- -----------
Weighted- Weighted-
Average Average
Exercise Exercise
Shares Price Shares Price Shares
- ---------------------------- ----------- ---------- ------------- ---------- -----------
<S> <C> <C> <C> <C> <C>
Options outstanding at
beginning of year 452,334 $ 4.16 179,000 $ 5.17 304,000
Options exercised (46,833) 4.00 (5,666) 3.63 -
Options expired (27,334) 3.73 (33,000) 4.66 (145,000)
Options granted 139,000 4.80 312,000 3.62 20,000
-------- --------- --------- --------- -----------
Options outstanding at end
of year 517,167 $ 4.37 452,334 $ 4.16 179,000
======== ========= ========= ========= ===========
Weighted-average fair value
of options, granted during
the year $ 1.29 $ 1.15
</TABLE>
The following table summarizes information about stock options outstanding at
December 31, 1996:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
---------------------------- ---------------------------
Weighted-
Average
Number Remaining Weighted- Number Weighted-
Range of Outstanding Contractual Average Exercisable Average
Exercise at Life Exercise at Exercise
Prices December 31, (Years) Price December 31, Price
1996 1996
- -------------- ------------- -------------- -------------- ------------- ------------- -------------
<C> <C> <C> <C> <C> <C>
$3.00 - $4.44 322,167 8.8 $ 3.62 156,337 $ 3.58
$5.00 - $5.75 180,000 6.8 5.45 90,000 5.63
$7.25 - $8.00 15,000 10.0 7.50 12,500 7.40
- -------------- ---------- ------------- ------------ -------- ---------
$3.00 - $8.00 517,167 8.2 $ 4.37 258,837 $ 4.48
- -------------- ========== ============= ============ ======== =========
</TABLE>
<PAGE>
Note 7. Major Customers and International Sales
Major customers: Net sales for 1996, 1995, and 1994 include sales to the
following major customers.
<TABLE>
<CAPTION>
Amount of Net Sales Trade Receivables Balance
------------------------------------- ------------------------
1996 1995 1994 1996 1995
- ------------------------------ ---------- ----------- ----------- ---------- ----------
<S> <C> <C> <C> <C> <C>
U.S. government agencies $ 889,000 $ 993,000 $ 1,146,000 $ 103,000 $ 192,000
Customer A 1,161,000 2,158,000 781,000 104,000 94,000
Customer B 376,000 563,000 627,000 - -
Customer C 471,000 530,000 603,000 14,000 98,000
---------- ----------- ----------- ---------- ----------
$ 2,897,000 $ 4,244,000 $ 3,157,000 $ 221,000 $ 384,000
========== =========== =========== ========== ==========
</TABLE>
International sales: Export sales to international customers for 1996, 1995, and
1994 were $1,906,000, $1,907,000, and $1,716,000, respectively.
Note 8. Commitments
Lease: The Company leases its office and warehouse facilities under a
noncancelable operating lease which expires June 1999. Total rent expense for
1996, 1995, and 1994 was $97,000. Minimum annual cash commitments under this
lease are approximately $124,000, $131,000, and $67,000 for 1997, 1998, and
1999, respectively.
License agreement: As of December 31, 1996, the Company had paid $110,000 as the
first payment for a license agreement for the use of certain products. Upon the
successful delivery of a beta version of the product by April 1997, the Company
will be required to make additional nonrefundable quarterly payments totaling
$768,000 through October 1998.
Note 9. Fourth Quarter 1996 Operating Results
The Company recorded a pretax loss of $1,356,000 in the 1996 fourth quarter
compared to pretax losses totaling $738,000 in the first three quarters of 1996.
The fourth quarter 1996 loss is due in part to lower than expected revenues
which were primarily due to reduced sales to the Company's OEM customers. The
Company also continued to increase its level of spending on research and
development and marketing for its new information security products and systems.
Fourth quarter expenditures for research and development and marketing totaled
$1,213,000 compared to $2,361,000 for the first three quarters of 1996. In
addition, the Company accrued a $332,000 charge in the fourth quarter of 1996
relating to severance costs to be paid to the Company's former president and
chief executive officer who resigned in December 1996.
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement on
Forms S-8 No.33-14144, No. 33-47068, No. 33-67280, No. 333-11405, and No.
33-80894 of our report dated February 5, 1997, with respect to the financial
statements of Datakey, Inc., which appear in Item 7 of the annual report on Form
10-KSB for the year ended December 31, 1996.
/s/ McGladrey & Pullen, LLP
McGLADREY & PULLEN, LLP
Minneapolis, Minnesota
March 28, 1997
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1
<CURRENCY> U. S. Dollars
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<EXCHANGE-RATE> 1
<CASH> 140,030
<SECURITIES> 5,993,228
<RECEIVABLES> 679,538
<ALLOWANCES> 45,000
<INVENTORY> 1,128,907
<CURRENT-ASSETS> 7,943,665
<PP&E> 4,242,614
<DEPRECIATION> 2,840,909
<TOTAL-ASSETS> 9,899,356
<CURRENT-LIABILITIES> 1,206,829
<BONDS> 0
0
375,000
<COMMON> 144,103
<OTHER-SE> 8,173,424
<TOTAL-LIABILITY-AND-EQUITY> 9,899,356
<SALES> 6,558,025
<TOTAL-REVENUES> 6,558,025
<CGS> 4,282,062
<TOTAL-COSTS> 4,282,062
<OTHER-EXPENSES> 4,730,853
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (2,094,332)
<INCOME-TAX> (388,000)
<INCOME-CONTINUING> (1,706,332)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,706,332)
<EPS-PRIMARY> (.60)
<EPS-DILUTED> (.60)
</TABLE>
