,” as well as in this Report generally. Actual events or results may differ materially from those discussed in forward-looking statements as a result of various factors, including, without limitation, the risks outlined under “Risk Factors” and matters described in this Report generally. In light of these risks and uncertainties, there can be no assurance that the forward-looking statements contained in this report will in fact occur as projected.

 

ITEM 1. DESCRIPTION OF BUSINESS

 

Formation

 

On March 31, 2003, Knowledge Foundations, Inc. (“ KFI ”), now known as BSI2000, Inc., closed its reverse triangular merger with BSI2000, Inc., a privately held Colorado corporation. Immediately prior to the closing, KFI spun-off all of its assets and liabilities (except for a $50,000 note payable and related accrued interest of $6,825) to Dr. Richard Ballard, Jan Pettitt, Michael Dochterman, Robert A. Dietrich, Joel Vest, all of whom are directors, officers, and/or principal shareholders of KFI, and certain other KFI shareholders. In connection with this spin-off, 34,105,900 shares of the common stock of KFI surrendered by the foregoing parties were cancelled. After this spin-off, 5,027,818 shares of KFI remained outstanding.

 

In closing the reverse merger transaction, KFI issued 45,122,570 shares of its common stock for all of the outstanding shares of common stock of BSI2000. Immediately following the closing, KFI changed its name to BSI2000, Inc. and BSI2000., a wholly-owned subsidiary of KFI as a result of the merger, changed its name to BSI Operating, Inc.

 

As a result of the foregoing transactions, KFI divested itself of its business and acquired the business of BSI2000 For financial reporting purposes, the foregoing transactions have been accounted for as a recapitalization of BSI2000. Accordingly the net increase in the BSI2000 outstanding shares of 41,363,488 shares (from 8,786,900 to 50,150,388 shares of common stock) has been reflected in the financial statements as shares issued in the recapitalization of BSI2000, Inc.

 

As a result of the accounting method adopted to record the merger, the historical financial statements of BSI2000, Inc. have become the historical financial statements of the continuing entity for financial reporting purposes. The historical financial statements of KFI are not presented herein.

 

Business

 

BSI2000, Inc. was incorporated under the name “Unified Data Link, Incorporated” in July 1993, and changed its name to “Bank Systems 2000, Inc.” in April 1995. The Company changed its name to “BSI2000, Inc.” on May 19, 1995.

 

BSI2000, Inc. (“ BSI ” or the “ Company ”) designs, builds, and sells high-end security related products for the homeland defense, entry/exit access control, and identification markets. The Company has developed and is beginning to sell patented and patent-pending systems for identifying, authenticating, and tracking people and their activities by combining biometrics, electronic identification (“ ID ”) cards of various types, sensors, extensive embedded software, and advanced cryptography.

 

The Company believes that since the terror attacks on the United States in September 2001, that a global push toward secure identification and tracking with new advanced technologies is underway and accelerating. BSI has developed over the past several years a spectrum of security related products that integrate special hardware and proprietary software to provide turnkey systems to try to meet this new need.

 

The Company identified three specific target submarkets within the overall security market and then built proprietary products that it believes are specific to those vertical markets. The first market is advanced entry/exit access control to protect valuable physical infrastructure such as corporate headquarters buildings, financial and information technology (“ IT ”) facilities, government sites such as nuclear and hydroelectric plants, water treatment works, petrochemical and chemical plants, national laboratories, and the like. The second target market is highly secure identification cards for national IDs and other purposes and the third target market is advanced but inexpensive portable fingerprint scanning systems and devices for use by police, sheriffs, first responders, and coroners.

 

The products that the Company has developed all depend on a central technology core of electronic identification cards, biometrics, and advanced cryptography and, thus, are all related. For example, the fingerprint scanning systems developed by BSI are direct results of the research and development completed by the Company over a period of several years to integrate biometrics into its other products.

 

In 2003, the U.S. Immigration and Naturalization Service (“ INS ”), now part of the United States Department of Homeland Security (“ DHS ”), awarded a small development contract to BSI to build a pilot test Green Card authentication and verification system. Six of the resulting BSI SIGABA2000™ units were delivered to INS for approximately $25,000. As part of that contract, the Company and its senior management and technical staff were granted certain security clearances that enabled BSI to complete classified work for the U.S. Federal Government. In addition, as part of that project, the Company designed and built the Crypto2000™™ encryption, key management, and hardware random number generator hardware/software module which enables cryptographically secure transactions with optical cards that BSI believes is a capability unique to the Company. Key components of the Crypto2000™ unit have been certified under certain conditions by the National Institute of Standards and Technology (“ NIST ”) to the FIPS 140-1 (1, 2, 3) level which is a recognized advanced standard of encryption and, especially, hacker resistance. The Company has a project underway to gain the even stronger FIPS 140-2 (1, 2, 3, (physical) 4) certification from NIST for the entire Crypto2000™ system. The independent laboratory work for that effort is being completed by IBM/Canada (Domus) for submission to NIST. In addition, BSI is in the process of enhancing the Crypto2000™ module to provide similar protection for magnetic stripe, radio frequency identification (“ RFID ”), and contact/contactless smart cards based systems. The Company believes that Crypto2000™ with its associated patent applications provide a competitive advantage for BSI over other companies in the target markets.

 

Current Products. BSI has developed a number of closely related products that are designed specifically for the above described target markets:

 

MAXXNET2000™ Entry/Exit Access Control System. This product is designed to provide site protection for high-value buildings, installations, and facilities. MAXXNET2000™ combines electronic identification cards with biometrics, sensors, database systems, extensive embedded software, and integrated devices to protect commercial, government, and military installations. It is an access control suite of products that incorporate all of the security command and control functions that the Company believes are necessary in today's high-risk environment. With a 50,000 card reader capacity and a guaranteed transaction time of under one second, it is, BSI believes, one of the most powerful access control systems employed anywhere. MAXXNET2000™ features include video badging, graphic alarm monitoring and control through an extensive graphical user interface (“ GUI ”) command and control interface, panel-based biometric template storage, closed circuit television (“ CCTV ”) and digital video recording (“ DVR ”) and audio integration. It also hosts other advanced and unique functions needed, the Company believes, to meet the security requirements of today's increasingly hostile threat environment. Up to 96 workstations can simultaneously monitor alarms and manage reactions within a complete worksite, which, if needed, can be distributed geographically across the globe. The functions of each workstation can be easily tailored to the specific needs of each facility. SECURUS2000™ is scalable from a single personal computer (“ PC ”) to interconnected networks that span the world. Further security is provided by the option of biometric workstation logon. By using its PLC RLLP programming, SECURUS2000™ provides, BSI believes, the operational flexibility to handle the most complex security command and control tasks. A core component of the system is the MAXX-NET™ base entry/exit access control system recently purchased, in its entirety, by the Company from New Sytron, Inc. and CyberCountry Systems, LLC which was then enhanced by BSI to include biometrics, advanced cryptography, and other items. MAXX-NET™ has been sold by New Sytron/CyberCountry and their predecessors to a number of airports, prisons and detention centers, corporate facilities and others. For example, MAXX-NET™ has provided entry/exit access control protection, and continues today, at the Denver International Airport (“ DIA ”), which has the most secure “Category X” rating by the Federal Aviation Administration (“ FAA ”), where it provides distributed and centrally controlled and monitored security for more than 50 individual buildings over 53 square miles with approximately 2,000 controlled and monitored doors and access points. Some 45,000 ID/access electronic cards have been issued to flight crews, airline ground personnel, maintenance workers, vendors, and security personnel. Denver International Airport is the fifth busiest airport in the United States and the 10th busiest in the world. Other installations include Anchorage International Airport, the U.S. Air force Academy, Sterling Correctional Facility in Colorado, San Francisco Water Management, Riverside Justice Center, Rocky Mountain National Park, Missoula Detention Center in Montana, and others. BSI believes that the current installed base of MAXX-NET™ combined with the security enhancements made and underway by BSI including biometrics and advanced cryptography provides a competitive advantage for the Company for its “MAXXNET2000™ product. A patent has been awarded to BSI that the Company believes will help protect certain aspects of MAXXNET2000™ in the marketplace.

 

AQUA2000™ Water Treatment Facility Monitoring, Intrusion Detection, and Access Control System. Since the terror attacks of September 2001, DHS and other national agencies have issued guidance and directives that advise water treatment delivery systems to increase their vigilance to protect their infrastructure from physical attack or sabotage and, especially, to protect against possible chemical, biological, and radiological contamination. BSI developed the AQUA2000™ integrated system to enable treatment and delivery plants to counter such threats. The system combines the MAXXNET2000™ entry/exit access control system with additional capabilities and technologies that are specific to water treatment and was designed and developed in conjunction with leading water treatment engineers and specialists to provide a turnkey package able to monitor, identify, and assess potential and actual threats to the nation's water supply and delivery infrastructure. In April 2005, the Company sold its first AQUA2000™ system to the J. G. Beacham Water Treatment Plant in Athens, Georgia for approximately $250,000. In August 2005, BSI received a follow on order from the J. G. Beacham Plant for certain advanced real-time video monitoring capabilities. The Company has applied for several patents that, if awarded, BSI believes will help protect the product in the marketplace.

 

CLEARID2000™™ Electronic Fingerprint Scanning System. The Company built the CLEARID2000™ specifically as a relatively inexpensive and portable, though advanced, electronic fingerprint scanning machine. It eliminates the manual inking procedures now commonly used and, BSI believes, dramatically increases the accuracy and reliability of print collection by providing immediate scan quality feedback to the operator. The system automatically electronically prints the standard Federal Bureau of Investigations (“ FBI ”) fingerprint FD258 “Blue” and FD249 “Red” hardcopy cards that are used across the country for background checks and scans by law enforcement agencies, school districts, numerous government agencies, contractors, and many others. The product was a direct fallout of the extensive research and development conducted in biometrics and other areas for advanced card entry/exit access control systems. In July 2005, BSI was notified that the FBI had tested the CLEARID2000™-T configuration of the product and had certified it to be in compliance with the FBI's Integrated Automated Fingerprint Identification System (“ IAFIS ”) Image Quality Specifications (“ IQS ”). The Company began to ship CLEARID2000™ units in late June 2005 and current customers include several police and sheriff's departments as well as a coroner's office.

 

VERUS2000™ Green Card Authentication Device. BSI developed the VERUS2000™ system as a result of work performed for the INS, now DHS, under contract, in 2003. The system is designed, the Company believes, to inexpensively and reliably solve the problem of fake and counterfeit Green Cards carried by resident aliens that are used as primary identification by employees. BSI believes that such fraudulent Green Cards are in use across the country in high volume and represent a significant security hole for the defense of this country. VERUS2000™ has been tested by a major airport in the United States; by a state driver's license issuance bureau; and by a major European airline in a large European airport. BSI believes that passage of the REALID Act of 2005 by Congress that was signed by President Bush may open a market for the product as states begin to comply with the Act's requirements to authenticate Green Cards before issuing state driver's licenses where a Green Card is presented as primary photo ID by license applicants. The Company has applied for a patent that, if awarded, BSI believes will help protect the product in the marketplace. However, there can be no assurance that such a market will exist.

 

CIVILITAS2000™ Government Identification System. The Civilitas (the Latin word for “citizen”) optical card is for government issue to record identification data and allows up to 16 separate government programs to be tracked and monitored on a single card, including border crossings, medical records, social pension eligibility and cash transfers, medical records, police records, etc. Each partition can have its own encryption key. Border crossings also may be monitored and flagged, as an option, by advanced heuristic software techniques to automatically notice suspicious events for closer inspection by security personnel. The system was designed and built by BSI to meet the expected requirements of the Italian National ID card project. In addition, the Company has proposed, and plans to continue to propose, the system to other countries. However, there can be no assurance that a market will exist for the product.

 

MICROBANKER2000™ Optical Bank Card. The Company has developed the MICROBANKER2000™ system to enable modern banking services to be easily implemented and deployed anywhere in the world. The system has no requirements for online telecommunications and is designed to operate in those parts of the world where it is difficult or impossible to authenticate and verify standard VISA™-style bankcards because telephone systems are expensive or nonexistent. Information that is written (and read) to (and from) the optical bank cards by the MICROBANKER2000™ terminals include a digital cardholder photograph, scanned fingerprints for biometric identification, name and address information, etc., current bank account balance, and a log/audit trail of all transactions generated and recorded on the card. In short, the MICROBANKER2000™ system provides, BSI believes, everything needed to conduct secure day-by-day financial transactions in those parts of the world where such capabilities do not exist but are needed. The first target market for MICROBANKER2000™ is in South Africa. The Company completed a technology demonstration for a very large social organization with several million members in the remote far north of the country. The original intent of BSI was to create an entity under the so-called “village bank” concept to enable the entity to issue and operate bankcards. However, the South African laws changed which requires the Company to form a partnership with an established bank in South Africa which is the approach that BSI is currently and actively taking. The Company filed a patent in South Africa to, it believes, help protect the MICROBANKER2000™ system and the related concepts in that country. There can be no assurance that a market exists for the product.

 

Technical Information . Most of the systems and products built and marketed by BSI include electronic identification cards. The Company supports all of the major card families such as magnetic stripe, RFID, contact/contactless smart cards, and the very secure optical cards in an effort to provide a spectrum of security levels - from the very low (e.g., magnetic stripe) to the midrange (e.g., smart cards) to the very high (e.g., optical cards).

 

BSI believes that optical cards are the most secure cards in the world because they have on the order of 100x - 1000x the amount of memory of other cards which enables digital cardholder photographs, multiple random biometrics, extensive access rights, and audit trails to be recorded on the card; because the written memory is permanent without the data fallout caused by static electricity and cosmic and natural radiation that is encountered with smart cards; and because optical cards meet certain international travel document and other standards.

 

BSI continues to develop (and apply for patent protection covering) software in the area of strong encryption techniques and high-performance data management methods for card systems. BSI has 19 patent applications pending and has been awarded one patent. These methods are required for secure and efficient card systems to be safely used in the field. Other patent applications cover the use of the technology.

 

The hardware for most applications is fairly straightforward and consists of a metal or plastic shell, internal bracketry, power supply and switching, control button and status light emitting diodes ( LEDs ”), color liquid crystal display (“ LCD ) screen, single board process control computer, integrated optical card device, sound transducer, thermal printer, and others. However, hardware for the MAXXNET2000 entry exit access control system includes a number of custom hardware PC boards.

 

Devices integrated into BSI systems include fingerprint scanners, signature verification pads, and external door lock controls.

 

Patents . BSI has applied to the United States Patent & Trademark Office (the “ USPTO ”) for the following patents among others: (1) medical record maintenance and analysis system, (2) optical card security system, (3) optical prescription card, (4) cryptographic key management device, (5) cryptographically secure transactions with optical cards, (6) hardware random number generator, (7) optical card fitness system, (8) optical banking card, (8) traveler screening system, (9) authenticating optical card reader, (10) cryptographically secure transactions with optical cards - international application, (11) optical motor vehicle card, (12) optical military card, (13) optical card for updating software, (14) systems and methods for reading optical card data, (15) optical immunization card, (16) embedded holograms on optical cards, (17) facility security with optical cards, (18) optical drive, and (19) authentication of optical cards, and others. To date, BSI has filed 19 patent applications in the U.S. and one in South Africa (Optical banking card). One patent has been awarded to the Company - “Optical Card Based System for Individualized Tracking and Record Keeping” (USPTO #6,775,774) which was issued in August 2004.

 

Sales and Marketing, and Sources of Revenue . BSI’s sales and marketing strategy and our plan to create sources of revenue has three primary components:

 

1.   Identify target markets that have, the Company believes, a real need. Design and build products that meet that need. File patents to cover as much of the newly developed technology or new uses for existing technology as practical and as affordable by BSI.

 

2.   Setup sales channels on an individual basis for each product. For example, with AQUA2000™ , build relationships with the consulting engineering companies that work with water treatment plants to design their security upgrades. For CIVILITAS2000™, create teaming agreements with larger companies that have, or are expected to have, contracts in place for national ID card systems for national governments. For CLEARID2000™, put into place agreements with regional and national distributors of security equipment and strive to have the equipment listed in the standard Department of Homeland Security (“ DHS ”) approved equipment lists. For SECURUS2000™, create relationships with regional and national security systems distributors but also work with qualified engineering consulting firms that have contracts or are expected to have contracts to design security systems and upgrades for airports. For VERUS2000™, approach the DHS directly.

 

3.   Market the products of the Company as aggressively as practical and affordable by the methods above and by targeted direct mailings of short marketing video digital video disk (“ DVDs ”) and other material. In addition, work with media outlets to bring BSI and its products to the attention of the customer and potential customer base.

 

Current Contracts .   It is important to note that BSI has not yet delivered product in any significant quantity; however, BSI has put into place various strategic teaming and alliance agreements with substantial external partner companies as follows:

 

L.C. Sistemia . On May 7, 2001, BSI signed a strategic alliance agreement with L.C. Sistemia, an Italian systems engineering and project management company with offices in Rome (“ LCS ”). Pursuant to legislation enacted in 2000 to implement a secure national identification card system, the Italian government awarded two contracts. One contract is held by Siemens A.G. to install and operate card initialization systems (i.e., issuance of secure optical cards) for ultimately up to 58,000,000 people. The second contract is held by LCS to supply the optical cards and card transaction units for use in passport offices, medical clinics, police stations, post offices, and other government offices.

 

Until May 7, 2011, BSI has the exclusive right to develop and market the transaction units into Italy through LCS, as required to satisfy LCS’ contract with the Italian government. LCS has agreed not to design, market or sell any other company’s optical card transaction units to the Italian government. The price for the units will be BSI’s actual direct cost plus 25%. Development costs and changes in products will be borne by BSI. BSI will be paid an additional amount equal to a 1% royalty on all amounts paid for optical cards sold into Italy by LaserCard Systems Corporation, and this royalty will be paid to BSI by LaserCard Systems Corporation. As of the date hereof, BSI has not received an initial order for transaction processing units or an estimate of the amount of the initial order or the timing thereof.

 

BSI has the right to terminate the agreement with LCS if sales into Italy are less than target levels. BSI has developed the Civilitas 2000 national identification card system, which is expected to be used in the LCS portion of the encryption and data programming of cards for the Italian government system. BSI retains all rights to this technology, and intends to market similar systems to other governments.

 

LaserCard Systems . On April 28, 2000, BSI signed a one year agreement with LaserCard Systems, which was renewed on June 3, 2004 for a one-year term. Pursuant to the agreement, LaserCard Systems Corporation had the right to sell its products to other resellers and end-users. During the term of the contract, BSI bought a limited amount of products from LaserCard Systems Corporation. The agreement has been renewed and remains valid until September 5, 2006.

 

Other Agreements. BSI also has in place a number of teaming, distribution, and other agreements, most of which have been recently formed.

 

MAXX-NET™ . On August 25, 2005, BSI2000, Inc. entered into an Assignment of Intellectual Property Rights and related Security Agreement with The New Sytron, Inc., a Colorado corporation (“ NSI ”), pursuant to which BSI purchased all right, title and interest in and to the access control system commonly known as “MAXX-NET™ ” (the “ MAXX-NET™ System ”). As consideration for the purchase, BSI (a) paid $150,000 to NSI, (b) issued NSI a 6%, 48-month secured promissory note in the principal amount of $500,000, and (c) issued NSI a warrant to purchase 1,000,000 shares of the Company’s common stock, par value $0.001 per share, at an exercise price of $0.05 per share. BSI markets, sells and supports the MAXXNET system under the name MAXXNET2000.

 

Competition . The Company believes that its primary competition comes from vendors with similar products but that have significantly less security. For example, there are numerous entry/exit access control systems on the market, but BSI knows of no other system similar to MAXXNET2000™ available that incorporates highly secure cards, effective and certified encryption, and with the large installed base, and credibility, of MAXXNET2000™ . For the fingerprinting market, while there are numerous competitors to the products available from the Company, BSI is not aware of any competing system with the portability and relative low cost of the CLEARID2000™ machine. In addition, the Company believes that the CRYPTO2000™ encryption module is unique and that no competing system exists anywhere for optical cards. However, it should be noted that many of the competitors of BSI are significantly larger with far more resources than the Company. There can be no assurance that BSI will be able to compete in the marketplace.

 

BSI is aware of only one other competitor, Zerco Systems, Inc., a small company, that markets embedded optical card systems of any form. BSI believes it can compete effectively against Zerco as Zerco appears to have only one embedded product and has, the Company believes, very limited sales to date.

 

Manufacturing, Support and Facilities . BSI out sources hardware manufacturing to one or more contract assembly houses on a turnkey basis. The manufacturer will manage all parts purchasing, inventory control, quality control, fabrication and assembly, testing, as well as burn-in operations as volumes of shipped equipment and systems increase.

 

Fully tested and finished hardware products will be shipped to the Company's office in Lakewood, Colorado where the proprietary control and security software will be loaded and encryption keys installed. After complete checkout, the finished software and hardware units will be packaged, inventoried, and shipped to the end-user.

 

The Company believes that the primary advantages to this approach include the ability to control inventory on an agile 30-day (or less) schedule, the ability to benefit from the parts purchasing power of a large assembler, and the elimination of direct purchasing and components overhead.

 

Except for the optical card reader drives and heads that BSI buys from LSI, all purchased electronic components for the products are standard and commercially available from multiple sources. A typical BSI machine has several hundred inventoried components and subassemblies including a number of custom machined pieces.

 

With the present lower volumes, all systems, other than MAXXNET electronic PC boards are assembled and tested in-house and then shipped to the customer.

 

Employees . As of December 31, 2005, BSI had 10 full-time   and no part-time employees, of which three are involved in software programming and support, five are involved in the marketing and deployment of product, and two are involved in BSI’s administrative and financial operations. None of BSI’s employees are represented by a labor union, and BSI has never experienced a work stoppage. BSI believes that its relationship with its employees are good. BSI’s ability to achieve its financial and operational objectives depends in large part upon BSI’s continuing ability to attract, integrate, retain and motivate highly qualified sales, technical and managerial personnel, and upon the continued service of BSI’s senior management and key sales and technical personnel. See the section of this Report entitled “Executive Compensation.” Competition for such qualified personnel in BSI’s industry and the geographical locations of BSI’s offices is intense, particularly in software development and technical personnel.

 

Research & Development . BSI expended $462,304 in 2005 for research and development (“ R&D ”) purposes as compared to $542,635 in 2004. This decrease is attributable to consulting fees of $50,145 and salaries of $23,018. These costs were expensed as incurred and decreased as a result of the needs identified relating to potential markets for BSI’s products in various parts of the world.

 

I