Digital Ally Inc. Annual Report 2012

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FY2012 Annual Report · Digital Ally Inc.

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

 TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from

to _______.

Commission file number: 001-33899

Digital Ally, Inc.

(Exact name of registrant as specified in its charter)

Nevada
(State or other jurisdiction of
incorporation or organization)

20-0064269
(I.R.S. Employer
Identification No.)

9705 Loiret Blvd., Lenexa, KS
(Address of principal executive offices)

66219

(Zip Code)

Registrant’s telephone, including area code: (913) 814-7774

Securities registered under Section 12(b) of the Exchange Act: None.

Securities registered under Section 12(g) of the Exchange Act:

Common Stock, $0.001 par value

NASDAQ

(Title of class)

(Name of each exchange on which registered)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  No 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the

Act. Yes  No 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the

Securities Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  No 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any,

every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such
files). Yes  No 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this
chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or

a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting
company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer 
Non-accelerated filer  (Do not check if a smaller reporting company)

Accelerated filer 
Smaller reporting company 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  No 

As of June 30, 2012, the aggregate market value of the Company’s common equity held by non-affiliates computed by

reference to the closing price ($3.52) of the registrant’s most recently completed second fiscal quarter was: $5,609,758.

The number of shares of our common stock outstanding as of March 15, 2013 was: 2,075,564.

Documents Incorporated by Reference: None.

FORM 10-K
DIGITAL ALLY, INC.
DECEMBER 31, 2012

TABLE OF CONTENTS

PART I

Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.

PART II

Business
Risk Factors
Unresolved Staff Comments
Properties
Legal Proceedings
Mine Safety Disclosures

Page

3
9
18
18
18
19

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer

Item 6.
Item 7.

Item 7a.
Item 8.
Item 9.

Purchases of Equity Securities

Selected Financial Data
Management’s Discussion and Analysis of Financial Condition and Results of

Operations

Quantitative and Qualitative Disclosures About Market Risk
Financial Statements and Supplementary Data
Changes In and Disagreements With Accountants on Accounting and Financial

Disclosure

Item 9A
Item 9B.

Controls and Procedures
Other Information

PART III

Item 10.
Item 11.
Item 12.

Item 13.
Item 14.

PART IV

Directors, Executive Officers and Corporate Governance
Executive Compensation
Security Ownership of Certain Beneficial Owners and Management and Related

Stockholder Matters

Certain Relationships and Related Transactions, and Director Independence
Principal Accounting Fees and Services

Item 15.

Exhibits, Financial Statement Schedules

SIGNATURES

Signatures

21
21

39
39
40

40
41

41
41
41

41
41

NOTE REGARDING FORWARD LOOKING STATEMENTS

This annual report on Form 10-K contains forward-looking statements as that term is defined in
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. In some cases, you can identify forward-looking statements by terminology such as "may," "should,"
"expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue," "intends," and other
variations of these words or comparable words. In addition, any statements that refer to expectations, projections or
other characterizations of events, circumstances or trends and that do not relate to historical matters are forward-
looking statements. These forward-looking statements are based largely on our expectations or forecasts of future
events, can be affected by inaccurate assumptions, and are subject to various business risks and known and unknown
uncertainties, a number of which are beyond our control. Therefore, actual results could differ materially from the
forward-looking statements contained in this document, and readers are cautioned not to place undue reliance on
such forward-looking statements. These statements are only predictions and involve known and unknown risks,
uncertainties and other factors, including the risks in the section entitled “Risk Factors” that may cause our or our
industry’s actual results, levels of activity, performance or achievements to be materially different from any future
results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we

cannot guarantee future results, levels of activity, performance or achievements. You should not place undue
reliance on these forward-looking statements, which speak only as of the date of this report. Except as required by
law, we do not undertake to update or revise any of the forward-looking statements to conform these statements to
actual results, whether as a result of new information, future events or otherwise.

As used in this annual report, “Digital Ally,” the “Company,” “we,” “us,” or “our” refer to

Digital Ally, Inc., unless otherwise indicated.

PART I

Item 1. Business.

Overview

Digital Ally produces digital video imaging and storage products for use in law enforcement, security and
commercial applications. Our current products are a low cost, easy-to-install, in-car digital video rear view mirror
designed for law enforcement vehicles and commercial fleets, such as ambulances and taxis; weather-resistant and
rugged mobile digital video recording systems designed for use in motorcycles, ATV’s and boats; a miniature digital
video system designed to be worn on an individual’s body (clipped to a pocket, belt etc.); a hand-held speed
detection device; and a digital video flashlight. These products make self-contained video and audio recordings onto
flash memory cards that are incorporated in the body of the digital video rear view mirror, officer-worn video and
audio system and flashlight. We sell our products to law enforcement agencies and other security organizations,
consumer and commercial fleet operators through direct sales domestically and third-party distributors
internationally. We have several new and derivative products in research and development that we anticipate will
begin commercial production during 2013.

Corporate History

We were incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. From that date until
November 30, 2004, when we entered into a Plan of Merger with Digital Ally, Inc., a Nevada corporation which was
formerly known as Trophy Tech Corporation (the “Acquired Company”), we had not conducted any operations and
were a closely-held company. In conjunction with the merger, we were renamed Digital Ally, Inc.

The Acquired Company, which was incorporated on May 16, 2003, engaged in the design, development,
marketing and sale of bow hunting-related products. Its principal product was a digital video recording system for
use in the bow hunting industry. It changed its business plan in 2004 to adapt its digital video recording system for
use in the law enforcement and security markets. We began shipments of our in-car digital video rear view mirror
in March 2006.

On January 2, 2008, we commenced trading on the NASDAQ Capital Market under the symbol “DGLY.”
We conduct our business from 9705 Loiret Boulevard, Lenexa, Kansas 66219. Our telephone number is (913) 814-
7774.

Products

We produce and sell digital audio/video recording, storage and other products, including the following

product series:

•

in-car, digital audio/video system that is integrated into a rear view mirror which is designed for
law enforcement purposes. Products using this system are marketed under the DVM-100, DVM-
400, DVM-500Plus and DVM-750 series;

in-car, digital audio/video system that is integrated into a rear view mirror that serves as an “event
recorder” for commercial fleet and mass transit applications, such as ambulances, taxis and buses.
Products using this system are marketed under the DVM-250 and DVM-250Plus series;

all-weather, mobile digital audio/video system that is designed for motorcycle, ATV and boat uses
and marketed as the DV-500Ultra;

• miniature, body-worn digital audio/video camera marketed as the FirstVU system;

•

hand-held, speed detection system known based on LIDAR (Light Detection and Ranging) and
marketed as our Laser Ally system; and

digital audio/video system that is integrated into a large law-enforcement style flashlight and
marketed as our DVF-500 system.

Historically, these product series were used primarily in law enforcement applications, all of which use the
core competency of our technology in digital video compression, recording and storage. During 2011, we completed
the launch of several derivative products as “event recorders” that can be used in taxi cab, limousine, ambulance and
other commercial fleet vehicle applications. We plan to launch additional derivative products in 2013 primarily in
the in-car video and body worn systems. We also intend to produce and sell other digital video devices in the future.
These products incorporate our standards-based digital compression capability that allows the recording of
significant time periods on a chip and circuit board which can be designed into small forms and stored. In addition
to selling our products directly to our customers, we may in the future sell assemblies or complete units containing
our technology incorporating digital video and sound recording for use in non-competing products to OEM (original
equipment manufacturer) customers.

In-Car Digital Video System – DVM-100, DVM-400, DVM-500Plus and DVM-750

In-car video systems for patrol cars are now a necessity and have generally become standard. Current

systems are digital and VHS-based with cameras mounted on the windshield and the recording device generally in
the trunk, headliner, dashboard, console or under the seat of the vehicle. Most manufacturers have already
developed or at least have begun transitioning to digital video, but some have had problems obtaining the
appropriate technology.

Our digital video rear view mirror unit is a self-contained video recorder, microphone and digital storage

system that is integrated into a rear-view mirror, with a monitor, GPS and 900 MHz audio transceiver. Our system is
more compact and unobtrusive than certain of our competitors because it requires no recording equipment to be
located in other parts of the vehicle.

Our in-car digital video rear view mirror has the following features:

• wide angle zoom color camera;

•

standards-based video and audio compression and recording;

system is concealed in the rear view mirror, replacing factory rear view mirror;

• monitor in rear-view mirror is invisible when not activated;

•

eliminates need for analog tapes to store and catalogue;

easily installs in any vehicle;

archives to computers (wirelessly) and to DVDs, CD-ROMs, or file servers;

900 MHz audio transceiver with automatic activation;

• marks exact location of incident with integrated GPS;

•

playback using Windows Media Player;

optional wireless download of stored video evidence;

proprietary software protects the chain of custody; and

records to rugged and durable solid state memory.

In-Car Digital Video”Event Recorder” System – DVM-250 and DVM-250Plus

We believe there are several other markets and industries which may find our in-car digital video rear view

mirror unit useful, such as the ambulance, school bus, mass transit and delivery service industries. We market a
product that we believe addresses these commercial fleet markets with the DVM-250 and DVM-250Plus Event
Recorders. The DVM-250 is a rear-view mirror based digital audio and video recording system with many, but not
all of, the features of our DVM-500Plus and DVM-750 mirror systems at a lower price point. The DVM-250 is
designed to capture “events” such as wrecks and erratic driving or other abnormal occurrences, for evidentiary or
training purposes. These potential markets may find our units attractive from both a feature and cost perspective,
compared to other providers. Our preliminary marketing efforts indicate that these commercial fleets are adopting
this technology, in particular the ambulance and taxi-cab markets.

All-Weather Mobile Digital Video System – DV-500Ultra

This system is a derivative of our in-car video systems, but is more rugged and water-proofed to handle a
more hostile outdoor environment. These systems can be used in many applications and are designed specifically
for use on motorcycles, ATVs and boats. Current systems are digital and VHS-based with cameras mounted in the
frame of the motorcycle, ATV or boat and the recording device generally in the saddle-bag or other compartment.
Most manufacturers have already developed or at least have begun transitioning to digital video, but many have had
problems obtaining the appropriate technology. We are developing a new product for this market, which we believe
is more compact and rugged than our current system and those of our competitors.

Miniature Body-Worn Digital Video System - FirstVU

This system is also a derivative of our in-car video systems, but is much smaller and lighter, more rugged
and water-proofed to handle a more hostile outdoor environment. These systems can be used in many applications
and are designed specifically to be clipped to an individual’s pocket or other outer clothing. The unit is self-
contained and requires no external battery or storage devices. Current systems are digital based but generally
require a battery pack and/or storage device to be connected to the camera by wire or other means. We believe that
our FirstVU product is more desirable for potential users than our competitors’ offerings because of its small size,
shape and lightweight characteristics. We plan to launch our next generation FirstVU HD product that will improve
the video quality, battery life, and the weight of our body-worn camera later in 2013.

Hand-Held Speed Detection System – Laser Ally

This system is a lightweight, hand-held speed detection device that uses LIDAR (Light Detection and

Ranging) technology rather than the traditional radar systems, which use sound waves. LIDAR systems are used in
high congestion traffic areas that require extreme accuracy and identification of the subject vehicles. This system
uses new technology that prevents the Laser Ally from being detected by current detectors or jammed by current
jamming devices. This system was developed and is being manufactured by a third party vendor for us.

Digital Video Flashlight – DVF-500

The digital video flashlight is a high-quality police-type flashlight with a built-in digital video and audio

recording system. All recorded data is stored in an on-board flash memory for later download to a computer. From
the computer, the images and sound can be stored, reviewed or burned to a DVD or CD. Storage can take place at
the police station or transmitted through the internet to a service provider or central storage and recording facility.
Each frame of the video can be date and time stamped to provide evidence that protects the officer and the
individual involved. Thus, there is a proprietary chain of custody software to protect delivery of data back to the
police station.

The unit is a high-quality, water-resistant, machined aluminum body, law enforcement-style flashlight that

integrates a complete digital video and audio recording system. The system is so compact that the size, shape and
weight of the digital video flashlight are virtually the same as a traditional flashlight. This allows the continued use
5

of the flashlight as a standard tactical flashlight or as a defensive baton if necessary. As a self-contained unit, the
digital video flashlight does not rely on transmitters, cables, external batteries or a separate recorder. The digital
video flashlight provides room for the digital video system by replacing regular flashlight bulbs with new ultra-
bright light-emitting diode (“LED”) technology, as opposed to fragile conventional lamps. The small physical size
and mechanical ruggedness of the LED makes it ideal for use in professional flashlights.

We believe that the brightness and light quality of the LED is superior to incandescent bulbs. Our digital

video recording system is easy to use and requires only one button to start and stop recording. It has one button
operation and thus there are no complicated controls or distracting displays to interfere with a police officer’s
normal activities or compromise his or her safety. All internal settings are controlled through an on-board USB
interface or by plugging into an external video monitor. The digital video flashlight includes proprietary software
for downloading and managing video and each frame of video can be date and time stamped.

In addition to law enforcement, the digital video flashlight has potential applications in lighter-duty

activities that require a less rugged flashlight as compared to law enforcement applications. Such lighter-duty
applications include private security, the insurance industry, homeland security, home inspections and underground
inspections of telephone, cable, water and sewer lines. Other potential users are the military, fire departments, Coast
Guard, border patrol and customs inspectors.

Other Products

During the last year, we have focused our research and development efforts to meet the varying needs of

our customers, enhance our existing products and commence development of new products and product categories.
Our research and development efforts are intended to maintain and enhance our competitiveness in the market niche
we have carved out, as well as positioning us to compete in diverse markets outside of law enforcement.

Market and Industry Overview

Historically, our primary market has been domestic and international law enforcement agencies. In 2012,

we expanded our scope by pursuing the commercial fleet vehicle and mass transit markets. In the future, given
sufficient capital and market opportunity, we may address markets for private security, homeland security, general
consumer and commercial and the original equipment manufacturers. We have made inroads into the ambulance
service provider market which has confirmed that our DVM-250 product series can become a significant revenue
producer for us.

Law Enforcement

We believe that a valuable use of our various digital audio/video products may be the recording of roadside

sobriety tests. Without some form of video or audio recording, court proceedings usually consist of the police
officer’s word against that of the suspect. Records show that conviction rates increase substantially where there is
video evidence to back up officer testimony. Video evidence also helps to protect police departments against
frivolous lawsuits.

The largest source of police video evidence today is in-car video. Unfortunately, some police cars still do

not have in-car video, and in those that do, the camera usually points forward rather than to the side of the road
where the sobriety test takes place. The in-car video is typically of little use for domestic violence investigations,
burglary or theft investigations, disorderly conduct calls or physical assaults. In all of these cases, the digital video
flashlight and the FirstVU may provide recorded evidence of the suspect’s actions and reactions to police
intervention.

Additionally, motorcycle patrolmen rarely have video systems. We believe that the digital video flashlight

can become an essential tool for the motorcycle policeman to provide evidence not previously available. We also
have developed the DV-500Ultra as a mobile application of our digital video recording system that can be used by
motorcycle police and water patrol.

Crime scene investigations, including detailed photography, are typically a large part of the budgets of
metropolitan police forces. The digital video flashlight and the FirstVU may record a significant portion of such
evidence at a much lower cost for gathering, analyzing and storing data and evidence.

Commercial and Other Markets

There are numerous potential applications for our digital audio/video camera products. We believe that
other markets for our digital video systems, including the derivatives currently being developed, include private
investigators, SWAT team members, over-the-road trucking fleets, airport security, municipal fire departments, and
the U.S. military. Other commercial markets for our digital video systems include real estate appraisers, plumbers
and electricians.

Private Security Companies

There are thousands of private security agencies in the United States employing a large number of guards.

Police forces use video systems for proof of correct conduct by officers, but private security services usually have no
such tool. We believe that the digital video flashlight and the FirstVU are excellent management tools for these
companies to monitor conduct and timing of security rounds. In addition to the digital video flashlight and FirstVU,
the digital video security camera can provide fill-in security when guards have large areas to cover or in areas that
do not have to be monitored around the clock.

Homeland Security Market

In addition to the government, U.S. corporations are spending heavily for protection against the potential of
terrorist attacks. Private-sector outlays for antiterrorism measures and for protection against other forms of violence
have increased significantly since September 11, 2001. Further, federal, state and local government expenditures for
security have increased substantially since such date. These are all potential markets for our products.

Manufacturing

We have entered into contracts with manufacturers for the assembly of the printed circuit boards used in

our products. Dedicated circuit board manufacturers are well-suited to the assembly of circuit boards with the
complexity found in our products. Dedicated board manufacturers can spread the extensive capital equipment costs
of circuit board assembly among multiple projects and customers. Such manufacturers also have the volume to
enable the frequent upgrade to state-of-the-art equipment. We have identified multiple suppliers who meet our
quality, cost, and performance criteria. We intend to use more than one source for circuit board assembly to ensure
a reliable supply over time. We use contract manufacturers to manufacture our component subassemblies and may
eventually use them to perform final assembly and testing. Due to the complexity of our products, we believe that it
is important to maintain a core of knowledgeable production personnel for consistent quality and to limit the
dissemination of sensitive intellectual property and will continue this practice. In addition, such technicians are
valuable in our service and repair business to support our growing installed customer base. We have a non-
exclusive supply and distribution agreement with DragonEye Technology, LLC regarding the sale and distribution
of our Laser Ally product. This vendor developed and is the only manufacturer of this product. The agreement has
specified terms and requires us to purchase minimum quantities over a 42-month period ending February 2014. We
have purchased approximately $2,470,000 of product under this agreement as of December 31, 2012 and we have
remaining obligations to purchase approximately $987,000 from January 1, 2013 through its expiration in February
2014. The agreement is renewable thereafter on an annual basis unless either of the parties determines not to renew
it and provided the parties are in compliance with the agreement. We also contract with a manufacturer in Asia for
the production of our DVM-100, DVM-400, DVM-250, DVM-250Plus and FirstVU products. The contract
provides for no minimum purchase requirements and has an initial term through July 2016 with Digital Ally having
the right to exercise three additional options to extend the contract for three additional years each.

License Arrangements

We have entered into several software license agreements with Sasken-Ingenient Technologies, Inc.
(“Ingenient”), and Nuvation Research Corporation (“Nuvation”) regarding the license of certain software products
to be used in our video products. The licensors have written certain software for specific Texas Instrument chips
which are included in our products. The licenses generally require upfront payments and contain automatic renewal
provisions unless either party notifies the other of its intent to not renew prior to expiration or unless the agreement
is terminated due to a material breach by the other party.

The following is a summary of our license agreements as of December 31, 2012:

License Type

Production software license
agreement

Effective
Date

Expiration
Date

April 2005

April 2013

Software sublicense agreement October 2007

October 2013

Technology license agreement

July 2007

July 2013

Development, license and
manufacturing agreement

July 2011

July 2016

Terms

Automatically renews for one year
periods unless terminated by either party.

We have three successive options to
renew for three years periods each,
unless terminated by either party.

Limited license agreement

August 2008

Perpetual

May be terminated by either party.

Sales and Marketing

We reorganized our domestic sales force and organization for our law enforcement channel. Traditionally, we
used third party sales agents to market our law enforcement products domestically. We have principally changed to
an employee-based, direct sales force that provides us with more control and monitoring of our sales force and its
daily activities. Additionally, we reduced the size of certain territories and consequently increased the overall
number of domestic sales territories and sales personnel from 15 at the beginning of the 2012 to 22 currently in
order to better penetrate the market. During 2012, we converted one third party sales agent to be an employee-based
direct sales person and replaced the remaining third party sales agents with new employee sales personnel. Our
objective with this new employee-based model, including the replacement of the sales agents, was to encourage our
sales personnel in lower performing territories to improve their efforts and, consequently, their sales results. We
believe a portion of the revenue decrease in 2011 and 2012 was due to third party sales agents reducing their sales
efforts because they did not have the financial resources to travel, meet and market directly to their customers as a
result of the difficult economic conditions. We believe that our reorganization has addressed these concerns. Our
executive team also supports sales agents with significant customer opportunities by providing pricing strategies and
customer presentation support. Our technical support personnel may also provide sales agents with customer
presentations and product specifications in order to facilitate sales activities.

We use our direct sales force and our international distributors to market our products. Our key

promotional activities include:

•
•

•

attendance at industry trade shows and conventions;

use of a cut-away police car model to demonstrate the digital video rear view mirror product at
trade shows, conventions and other marketing venues;

direct sales, with a force of industry-specific sales individuals who identify, call upon and build
on-going relationships with key purchasers and targeted industries;

print advertising in journals with specialized industry focus;

support of our direct sales with passive sales systems, including inside sales and e-commerce;

•
•
•
• web advertising, including supportive search engines and website and registration with appropriate

direct mail campaigns targeted to potential customers;

sourcing entities;

•

public relations, industry-specific venues, as well as general media, to create awareness of our
brand and our products, including membership in appropriate trade organizations; and

brand identification through trade names associated with us and our products.

Competition

The law enforcement and security surveillance markets are extremely competitive. Competitive factors in

these industries include ease of use, quality, portability, versatility, reliability, accuracy and cost. Our primary

competitors include companies with substantially greater financial, technological, marketing, personnel and research
and development resources than we currently have. There are direct competitors with competitive technology and
products in the law enforcement and surveillance markets for all of our products and those we have in development.
We will also compete with any company making surveillance devices for residential and commercial use. There can
be no assurance that we will be able to compete successfully in these markets. Further, there can be no assurance
that new and existing companies will not enter the law enforcement and security surveillance markets in the future.
See “Risk Factors - Competition.”

Intellectual Property

We have entered into supply and distribution agreements with several companies that produce certain of

our products, including our Laser Ally, FirstVU, DVM-100, DVM-250 and DVM-400 products. These supply and
distribution agreements contain certain confidentiality provisions that protect our as well as the third party
manufacturers’ proprietary technology.

These patent applications are under review by the U.S. Patent Office and therefore we have not been issued
any patents in the United States. No assurance can be given that any patents relating to our existing technology will
be issued from the United States or any foreign patent offices, that we will receive any patents in the future based on
our continued development of our technology, or that our patent protection within and/or outside of the United
States will be sufficient to deter others, legally or otherwise, from developing or marketing competitive products
utilizing our technologies.

In addition to seeking patent protection, we rely on trade secrets, know-how and continuing technological
advancement to seek to achieve and thereafter maintain a competitive advantage. Although we have entered into or
intend to enter into confidentiality and invention agreements with our employees, consultants and advisors, no
assurance can be given that such agreements will be honored or that we will be able to effectively protect our rights
to our unpatented trade secrets and know-how. Moreover, no assurance can be given that others will not
independently develop substantially equivalent proprietary information and techniques or otherwise gain access to
our trade secrets and know-how.

Employees

We had 91 full-time employees as of December 31, 2012. Our employees are not covered by any
collective bargaining agreement and we have never experienced a work stoppage. We believe that our relations with
our employees are good.

Item 1A.

Risk Factors.

You should carefully consider the following risk factors in evaluating our business and us. The factors
listed below represent certain important factors that we believe could cause our business results to differ. These
factors are not intended to represent a complete list of the general or specific risks that may affect us. It should be
recognized that other risks may be significant, presently or in the future, and the risks set forth below may affect us
to a greater extent than indicated. If any of the following risks occur, our business, financial condition or results of
operations could be materially and adversely affected. You should also consider the other information included in
this annual report and subsequent quarterly reports filed with the SEC.

Risk Factors

We incurred a loss in 2012.

We had an accumulated deficit of $13,247,561 at December 31, 2012, which reflects our net losses of

$1,970,989 and $3,962,246 for 2012 and 2011, respectively, as noted in our audited consolidated financial
statements. At December 31, 2012, we had working capital of approximately $8.9 million. We have implemented
several initiatives intended to improve our revenues and reduce our operating costs with a goal of restoring
profitability. If we are unsuccessful in this regard, it will have a material adverse impact on our business, prospects,
operating results and financial condition.

Our credit facility

We borrowed $2.5 million under two subordinated promissory notes during 2011, which provided the
funds necessary to pay off our maturing bank line of credit and to fund our operating needs. The subordinated
promissory notes require monthly interest-only payments until their maturity date in May 2014. We have no
revolving credit facility to fund our operating needs should it become necessary. It will be difficult to obtain an
institutional line of credit facility given our recent operating losses and the current banking environment, which may
adversely affect our ability to finance our business, grow or be profitable. Further, any new credit facility may not
be on terms favorable to us.

If we are unable to manage our current business activities, our prospects may be limited and our future
profitability may be adversely affected.

We experienced rapid expansion in business through 2008 followed by a decline in our operating results
from 2009 to 2012. Our revenue level has proven to be unpredictable, which poses significant burdens on us to be
proactive in managing production, personnel levels and related costs. We expanded our production capabilities and
capacity significantly to handle anticipated new products in 2009 and 2010, which strained our managerial, financial
and other resources when revenues unexpectedly declined during this period and later. We will need to improve our
revenues, operations, financial and other internal systems to manage our business effectively, and any failure to do
so may lead to inefficiencies and redundancies which reduce our prospects to return to profitability.

There are risks related to dealing with domestic governmental entities as customers.

One of the principal target markets for our products is the law enforcement community. In this market, the

sale of products will be subject to budget constraints of governmental agencies purchasing these products, which
could result in a significant reduction in our anticipated revenues. Such governmental agencies are currently
experiencing budgetary pressures as a result of the recession and its impact on local sales, property and income taxes
that provide funding for purchasing our products. These agencies also may experience political pressure that dictates
the manner in which they spend money. As a result, even if an agency wants to acquire our products, it may be
unable to purchase them due to budgetary or political constraints. We cannot assure investors that such
governmental agencies will have the necessary funds to purchase our products even though they may want to do so.
Further, even if such agencies have the necessary funds, we may experience delays and relatively long sales cycles
due to their internal decision making policies and procedures.

There are risks related to dealing with foreign governmental entities as customers.

We target the law enforcement community in foreign countries for the sale of many of our products. While

foreign countries vary, generally the sale of our products will be subject to political and budgetary constraints of
foreign governments and agencies purchasing these products, which could result in a significant reduction in our
anticipated revenues. Many foreign governments are experiencing budgetary pressures as a result of the global
recession and its impact on taxes and tariffs that in many cases provide funding for purchasing our products. Law
enforcement agencies within these countries also may experience political pressure that dictates the manner in which
they spend money. As a result, even if a foreign country or its’ law enforcement agencies want to acquire our
products, it may be unable to purchase them due to budgetary or political constraints. We cannot assure investors
that such governmental agencies will have the necessary funds to purchase our products even though they may want
to do so. Further, even if such agencies have the necessary funds, we may experience delays and relatively long
sales cycles due to their internal decision making policies and procedures.

International law enforcement and other agencies that may consider using our products must analyze a wide

range of issues before committing to purchase products like ours, including training costs, product reliability and
budgetary constraints. The length of our sales cycle may range from a few months to a year or more. We may incur
substantial selling costs and expend significant effort in connection with the evaluation of our products by potential
customers before they place an order. Initial orders by foreign governments and agencies typically are for a small
number of units that are used to evaluate the products. If these potential customers do not purchase our products, we
will have expended significant resources and receive no revenue in return. In addition, we may be selected as the
vendor of choice by these foreign customers but never receive the funding necessary to purchase our product due to
political or economic reasons.

We are marketing our DVM-250 and DVM-250Plus event recorder products to commercial fleet customers,
which is a relatively new sales channel for us and we may experience problems in gaining acceptance.

The principal target market for our event recorder products is commercial fleet operators, such as taxi cabs,
limousine services, transit buses, ambulance services and a variety of delivery services. This is a relatively new sales
channel for us and we may experience difficulty gaining acceptance of our other products by the targeted customers.
Our sales of such products will be subject to budget constraints of both the large and small prospective customers,
which could result in a significant reduction in our anticipated revenues. Certain of such companies are
experiencing budgetary and financial pressures as a result of the recession and slow recovery and their impact on
their revenues, all of which may negatively impact their ability to purchase our products. As a result, even if
prospective customers want to acquire our products, they may be unable to do so because of such factors. Further,
even if such companies have the necessary funds, we may experience delays and relatively long sales cycles due to
their internal decision making policies and procedures.

The recent economic downturn has depressed state and local tax revenues from sales, use, income and property
tax sources. The reduction in such revenues has reduced funding to law enforcement agencies that represent our
primary customers.

The national economy has been in a deep recession and slow recovery, resulting in lower tax collections by

state and local taxing authorities. Law enforcement agencies rely on funding from state and local tax sources to
purchase our products. These factors have decreased our primary customers’ ability to purchase our systems unless
they can find other sources of funding to cover the shortfall. While we hoped that the Economic Stimulus Act of
2009 would provide a source of alternative funding, the amount, timing and use of such alternative funding by our
prospective customers have been less than expected. We cannot assure investors that such law enforcement
agencies will have the necessary funds to purchase our products even though they may want to do so.

We are operating in a developing market and there is uncertainty as to market acceptance of our technology and
products.

The markets for our new and enhanced products and technology are developing and rapidly evolving. They

are characterized by an increasing number of market entrants who have developed or are developing a wide variety
of products and technologies, a number of which offer certain of the features that our products offer. Because of
these factors, demand and market acceptance for new products are subject to a high level of uncertainty. There can
be no assurance that our technology and products will become widely accepted. It is also difficult to predict with
any assurance the future growth rate, if any, and size of the market. If a substantial market fails to develop, develops
more slowly than expected or becomes saturated with competitors or if our products do not achieve or continue to
achieve market acceptance, our business, operating results and financial condition will be materially and adversely
affected.

Our technology may also be marketed and licensed to device manufacturers for inclusion in the products

and equipment they market and sell as an embedded solution. As with other new products and technologies
designed to enhance or replace existing products or technologies or change product designs, these potential partners
may be reluctant to integrate our digital video recording technology into their systems unless the technology and
products are proven to be both reliable and available at a competitive price. Even assuming product acceptance, our
potential partners may be required to redesign their systems to effectively use our digital video recording
technology. The time and costs necessary for such redesign could delay or prevent market acceptance of our
technology and products. A lack of, or delay in, market acceptance of our digital video recording technology and
products would adversely affect our operations. There can be no assurance that we will be able to market our
technology and products successfully or that any of our technology or products will be accepted in the marketplace.

We expend significant resources in anticipation of a sale due to our lengthy sales cycle and may receive no
revenue in return.

Generally, law enforcement and other agencies and commercial fleet and mass transit operators that may
consider using our products must analyze a wide range of issues before committing to purchase products like ours,
including training costs, product reliability and budgetary constraints. The length of our sales cycle may range from
sixty days to a year or more. We may incur substantial selling costs and expend significant effort in connection with
the evaluation of our products by potential customers before they place an order. Initial orders by agencies typically
are for a small number of units that are used to evaluate the products. If these potential customers do not purchase
our products, we will have expended significant resources and have received no revenue in return.

Our market is characterized by new products and rapid technological change.

The market for our products is characterized by rapidly changing technology and frequent new product

introductions. Our future success will depend in part on our ability to enhance our existing technologies and
products and to introduce new products and technologies to meet changing customer requirements. We are currently
devoting, and intend to continue to devote, significant resources toward the development of new digital video
recording technology and products both as stand-alone products and embedded solutions in third party products and
systems. There can be no assurance that we will successfully complete the development of these technologies and
related products in a timely fashion or that our current or future products will satisfy the needs of the digital video
recording market. There can also be no assurance that digital video recording products and technologies developed
by others will not adversely affect our competitive position or render our products or technologies non-competitive
or obsolete.

We substantially depend on sales from our in-car video products and if these products become obsolete or not
widely accepted, our growth prospects will be diminished.

We have historically derived our revenues predominantly from sales of our in-car video systems, including

the DVM-500 series and DVM-750 digital video rear view mirrors and accessories, and we expect to continue to
depend on sales of these products during 2013. However, we introduced several new products in 2011 and 2012 and
intend to introduce new products during 2013 with a view to diversifying our revenue sources in the future. A
decrease in the prices of, or the demand for our in-car video products, or the failure to achieve broad market
acceptance of our new product offerings, would significantly harm our growth prospects, operating results and
financial condition.

We substantially depend on our research and development activities to design new products and upgrades to
existing products and if these products are not widely accepted, or we encounter difficulties and delays in
launching these new products, our growth prospects will be diminished.

We have a number of active research and development projects underway at the current time that are

intended to launch new products or upgrades to existing products. We may incur substantial costs and/or delays in
completion of these activities that may not result in viable products or may not be received well by our potential
customers. We incurred $2,528,790 and $2,773,962 in research and development expenses during the years ended
December 31, 2012 and 2011, respectively, which represent a substantial expense in relation to our total revenues
and net loss. If we are unsuccessful in bringing these products from the engineering prototype phase to commercial
production, we could incur additional expenses (in addition to those already spent) without receiving revenues from
the new products. Also, these new products may fail to achieve broad market acceptance and may not generate
revenue to cover expenses incurred to design, develop, produce and market the new product offerings. Substantial
delays in the launch of one or more products could negatively impacted our revenues and increase our costs, which
could significantly harm our growth prospects, operating results and financial condition.

If we are unable to compete in our market, you may lose all or part of your investment.

Our market is highly competitive and highly fragmented. The law enforcement and security surveillance
markets are extremely competitive. Competitive factors in these industries include ease of use, quality, portability,
versatility, reliability, accuracy, cost and other factors. Our primary competitors include: L-3 Mobile-Vision, Inc.,
Watchguard, Kustom Signals, International Police Technologies, Inc. and a number of other competitors who sell or
may in the future sell in-car video systems to law enforcement agencies. There are direct competitors who have
competitive technology and products for all of our products. Many of these competitors have significant advantages
over us, including greater financial, technical, marketing and manufacturing resources, more extensive distribution
channels, larger customer bases and faster response times to adapt new or emerging technologies and changes in
customer requirements. As a result, our competitors may develop superior products or beat us to market with
products similar to ours. Further, there can be no assurance that new companies will not enter our markets in the
future and we expect to encounter new competitors as we develop and market new products. Although we believe
that our products will be distinguishable from those of our competitors on the basis of their technological features
and functionality at an attractive value proposition, there can be no assurance that we will be able to penetrate any of
our anticipated competitors’ portions of the market. Many of our anticipated competitors may have existing
relationships with equipment or device manufacturers that may impede our ability to market our technology to those
potential customers and build market share. There can be no assurance that we will be able to compete successfully
against current or future competitors or that competitive pressures will not have a material adverse effect on our
business, operating results and financial condition. If we are not successful in competing against our current and
future competitors, you could lose your entire investment. See “Description of Business - Competition.”

Defects in our products could impair our ability to sell our products or could result in litigation and other
significant costs.

Any significant defects in our products may result in, among other things, delay in time-to-market, loss of

market acceptance and sales of our products, diversion of development resources, and injury to our reputation, or
increased warranty costs. Because our products are technologically complex, they may contain defects that cannot
be detected prior to shipment. These defects could harm our reputation and impair our ability to sell our products.
The costs we may incur in correcting any product defects may be substantial and could decrease our profit margins.
Additionally, errors, defects or other performance problems could result in financial or other damages to our
customers, which could result in litigation. Product liability litigation, even if we prevail, would be time consuming
and costly to defend. Our product liability insurance may not be adequate to cover claims. Our product liability
insurance coverage per occurrence is $1,000,000, with a $2,000,000 aggregate for our general business liability
coverage and an additional $1,000,000 per occurrence. Our excess or umbrella liability coverage per occurrence and
in aggregate is $5,000,000.

Product defects can be caused by design errors, programming bugs, or defects in component parts or raw

materials. This is common to every product manufactured which is based on modern electronic and computer
technology. Because of the extreme complexity of digital in-car video systems, one of the key concerns is operating
software robustness. Some of the software modules are provided to us by outside vendors under license agreements,
while other portions are developed by our own software engineers. As with any software-dependant product, “bugs”
can occur, even with rigorous testing before release of the product. The software included in our digital video rear
view mirror and digital video flashlight products is designed to be “field upgradeable” so that changes or fixes can
be made by the end user by downloading new software through the internet. We intend to incorporate this
technology into any future products as well, providing a quick resolution to potential software issues that may arise
over time.

As with all electronic devices, hardware issues can arise from many sources. The component electronic

parts we utilize come from many sources around the world. We attempt to mitigate the possibility of shipping
defective products by fully testing sub-assemblies and thoroughly testing assembled units before they are shipped
out to our customers. Because of the nature and complexity of some of the electronic components used, such as
microprocessor chips, memory systems, and zoom video camera modules, it is not technically or financially realistic
to attempt to test every single aspect of every single component and their potential interactions. By using
components from reputable and reliable sources, and by using professional engineering, assembly, and testing
methods, we seek to limit the possibility of defects slipping through. In addition to internal testing, we now have
thousands of units in the hands of police departments and in use every day. Over the past years of field use we have
addressed a number of subtle issues and made refinements requested by the end-user.

We are dependent on key personnel.

Our success will be largely dependent upon the efforts of our executive officers, Stanton E. Ross and

Thomas J. Heckman. We do not have employment agreements with Messrs. Ross or Heckman. The loss of the
services of these individuals could have a material adverse effect on our business and prospects. There can be no
assurance that we will be able to retain the services of such individuals in the future. We have not obtained key-man
life insurance policies on these individuals. We are also dependent to a substantial degree on our technical, research
and development staff. Our success will be dependent upon our ability to hire and retain additional qualified
technical, research, management, marketing and financial personnel. We will compete with other companies with
greater financial and other resources for such personnel. Although we have not experienced difficulty in attracting
qualified personnel to date, there can be no assurance that we will be able to retain our present personnel or acquire
additional qualified personnel as and when needed.

We rely on third party distributors and representatives for our international marketing capability.

Our distribution strategy is to pursue international sales through multiple channels with an emphasis on

independent distributors and representatives. Our inability to recruit and retain distributors and representatives who
can successfully sell our products would adversely affect our international sales. In addition, our arrangements with
our distributors and representatives are generally short-term. If we do not competitively price our products, meet the
requirements of our distributors and representatives or end-users, provide adequate marketing and technical support,
or comply with the terms of our distribution arrangements, our distributors and representatives may fail to
aggressively market our products or may terminate their relationships with us. These developments would likely
have a material adverse effect on our international sales. Our reliance on the sales of products by others also makes
it more difficult to predict our revenues, cash flow and operating results.

We are dependent on manufacturers and suppliers.

We purchase, and intend to continue to purchase, substantially all of the components for our products and
some entire products, from a limited number of manufacturers and suppliers, most of whom are located outside the
United States. Our internal process is principally to assemble the various components and subassemblies
manufactured by our suppliers and test the assembled product prior to shipping to our customers. We do not intend
to directly manufacture any of the equipment or parts to be used in our products. Our reliance upon outside
manufacturers and suppliers, including foreign suppliers, is expected to continue, increase in scope and involves
several risks, including limited control over the availability of components, and products themselves and related
delivery schedules, pricing and product quality. We may experience delays, additional expenses and lost sales if we
are required to locate and qualify alternative manufacturers and suppliers.

A few of the semiconductor chip components for our products are produced by a very small number of

specialized manufacturers. Currently, we purchase one essential semiconductor chip from a single manufacturer.
While we believe that there are alternative sources of supply, if, for any reason, we are precluded from obtaining
such a semiconductor chip from this manufacturer, we may experience long delays in product delivery due to the
difficulty and complexity involved in producing the required component and we may also be required to pay higher
costs for our components.

While we do the final assembly, testing, packaging, and shipment of certain of our products in-house, a

number of our component parts are manufactured by subcontractors. These subcontractors include: raw circuit
board manufacturers, circuit board assembly houses, injection plastic molders, metal parts fabricators, and other
custom component providers. While we are dependent upon these subcontractors to the extent that they are
producing custom subassemblies and components necessary for manufacturing our products, we still own the
designs and intellectual property involved. This means that the failure of any one contractor to perform may cause
delays in production. However, we can mitigate potential interruptions by maintaining “buffer stocks” of critical
parts and subassemblies and by using multiple sources for critical components. We also have the ability to move
our subcontracting to alternate providers. Being forced to use a different subcontractor could cause production
interruptions ranging from negligible, such as a few weeks, to very costly, such as four to six months. Further, the
failure of a foreign manufacturer to deliver products to us timely, in sufficient quantities and with the requisite
quality would have a material adverse impact on our business, operations and financial condition.

The only component group that would require a complete redesign of our digital video electronics package
is the Texas Instruments chips. While there are competitive products available, each chip has unique characteristics
that would require extensive tailoring of product designs to use it. The Texas Instrument chips are the heart of our
video processing system. If Texas Instruments became unwilling or unable to provide us with these chips, we would
be forced to redesign our digital video encoder and decoder systems. Such a complete redesign could take
substantial time (i.e. over six months) to complete. We attempt to mitigate the potential for interruption by
maintaining continuous stocks of these chips to support several months’ worth of production. In addition, we
regularly check on the end-of-life status of these parts to make sure that we will know well in advance of any
decisions by Texas Instruments to discontinue these parts. There are other semiconductors that are integral to our
product design and which could cause delays if discontinued, but not to the same scale as the Texas Instrument
chips.

We are uncertain of our ability to protect technology through patents.

Our ability to compete effectively will depend on our success in protecting our proprietary technology, both
in the United States and abroad. We have filed for patent protection in the United States and certain other countries
to cover certain design aspects of our products. We license the critical technology on which our products are based
from Sasken-Ingenient, Inc., and Nuvation pursuant to license agreements. However, the technology licensed from
these parties is critical because it is the basis of our current product design. We may choose to use other video
encoding and decoding technology in future products, thus lessening our dependence on our licenses with these
companies.

Our patent applications are under review by the U.S. Patent Office and therefore we have not been issued

any patents in the United States. No assurance can be given that any patents relating to our existing technology will
be issued from the United States or any foreign patent offices, that we will receive any patents in the future based on
our continued development of our technology, or that our patent protection within and/or outside of the United
States will be sufficient to deter others, legally or otherwise, from developing or marketing competitive products
utilizing our technologies.

If our patents were to be denied as filed, we would seek to obtain different patents for other parts of our
technology. If our main patent, which relates to the placement of the in-car video system in a rear view mirror, is
denied, it could potentially allow our competitors to build very similar devices. However, we believe that very few
of our competitors would be capable of this because of the level of technical sophistication and level of
miniaturization required. Even if we obtain patents, there can be no assurance that they will be enforceable to
prevent others from developing and marketing competitive products or methods. If we bring an infringement action
relating to any future patents, it may require the diversion of substantial funds from our operations and may require
management to expend efforts that might otherwise be devoted to our operations. Furthermore, there can be no
assurance that we will be successful in enforcing our patent rights.

Further, if any patents are issued there can be no assurance that patent infringement claims in the United
States or in other countries will not be asserted against us by a competitor or others, or if asserted, that we will be
successful in defending against such claims. If one of our products is adjudged to infringe patents of others with the
likely consequence of a damage award, we may be enjoined from using and selling such product or be required to
obtain a royalty-bearing license, if available on acceptable terms. Alternatively, if a license is not offered, we might
be required, if possible, to redesign those aspects of the product held to infringe so as to avoid infringement liability.
Any redesign efforts we undertake might be expensive, could delay the introduction or the re-introduction of our
products into certain markets, or may be so significant as to be impractical.

We are uncertain of our ability to protect our proprietary technology and information.

In addition to seeking patent protection, we rely on trade secrets, know-how and continuing technological

advancement to seek to achieve and thereafter maintain a competitive advantage. Although we have entered into or
intend to enter into confidentiality and invention agreements with our employees, consultants and advisors, no
assurance can be given that such agreements will be honored or that we will be able to effectively protect our rights
to our unpatented trade secrets and know-how. Moreover, no assurance can be given that others will not
independently develop substantially equivalent proprietary information and techniques or otherwise gain access to
our trade secrets and know-how.

Foreign currency fluctuations may affect our competitiveness and sales in foreign markets.

The relative change in currency values creates fluctuations in our product pricing for potential international
customers. These changes in foreign end-user costs may result in lost orders and reduce the competitiveness of our
products in certain foreign markets. These changes may also negatively affect the financial condition of some
existing or potential foreign customers and reduce or eliminate their future orders of our products. We also import
selected components which are used in the manufacturing of some of our products. Although our purchase orders
are in the United States dollar, weakness in the United States dollar could lead to price increases for the components.

Risks related to our license arrangements.

We have licensing agreements with Sasken-Ingenient and Nuvation regarding certain software used as the
platform for the proprietary software we have developed for use in our products. These licensing agreements have
specified terms and are renewable on an annual basis unless both parties determine not to renew them and provided
the parties are in compliance with the agreements. If we fail to make the payments under these licenses or if these
licenses are not renewed for any reason, it would cause us significant time and expense to redevelop our software on
a different software platform, which would have a material adverse effect on our business, operating results and
financial condition.

Risks related to our supply and distribution arrangement.

We have a supply and distribution agreement with DragonEye Technology, LLC regarding the sale and
distribution of our Laser Ally product. This vendor developed and is the only manufacturer of this product. The
agreement has specified terms and requires us to purchase minimum quantities over a 42-month period ending
February 2014. We have purchased approximately $2,470,000 of product under this agreement as of December 31,
2012 and we have remaining obligations to purchase approximately $987,000 through its expiration in February
2014. The agreement is renewable thereafter on an annual basis unless either of the parties determines not to renew
it and provided the parties are in compliance with the agreements. The agreement is non-exclusive, which means
that DragonEye could enter into supply and distribution or similar agreements with other parties for the product,
which could not bear our “Laser Ally” name. We are relying on our sales distribution channel to market and sell a
sufficient quantity of the product to existing and new customers in order to meet our purchase obligation under the
15

agreement. It is likely that we will not be able to make the payments under the agreement, if we fail to do so. In
addition, if this agreement is not renewed for any reason, it would cause us significant time and expense to
redevelop or source a replacement for our Laser Ally product on a different software and hardware platform, which
could have a material adverse effect on our business, operating results and financial condition.

Our revenues and operating results may fluctuate unexpectedly from quarter to quarter, which may cause our
stock price to decline.

Our revenues and operating results have varied significantly in the past and may continue to fluctuate

significantly in the future due to various factors that are both in and outside our control. As a result, we believe that
period-to-period comparisons of our operating results may not be meaningful in the short-term, and our performance
in a particular period may not be indicative of our performance in any future period.

Coalitions of a few of our larger stockholders have sufficient voting power to make corporate governance
decisions that could have significant effect on us and the other stockholders.

Our officers, directors and principal stockholders (greater than five percent stockholders) together control

approximately 34.5%, including options vested or to vest within sixty days, of our outstanding common stock. As a
result, these stockholders, if they act together, will be able to exert a significant degree of influence over our
management and affairs and over matters requiring stockholder approval, including the election of directors and
approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a
change in our control and might affect the market price of our common stock, even when a change in control may be
in the best interest of all stockholders. Furthermore, the interests of this concentration of ownership may not always
coincide with our interests or the interests of other stockholders. Accordingly, these stockholders could cause us to
enter into transactions or agreements that we would not otherwise consider.

We are a party to several lawsuits both as a plaintiff and as a defendant in which we may ultimately not prevail
resulting in losses and may cause our stock price to decline.

We are involved as a plaintiff and defendant in routine litigation and administrative proceedings incidental to

our business from time to time, including customer collections, vendor and employment-related matters. See
“Litigation.” We believe that the likely outcome of any other pending cases and proceedings will not be material to
our business or financial condition. However, there can be no assurance that we will prevail in the litigation or
proceedings or that we may not have to pay damages or other awards to the other party.

Risks Relating to our Common Stock

The possible issuance of common stock subject to options may dilute the interest of stockholders.

We have granted options to purchase a total of 552,650 shares of our common stock under our stock option

and restricted stock plans which were outstanding and unexercised as of December 31, 2012. To the extent that
outstanding stock options are exercised, dilution to the interests of our stockholders may occur. Moreover, the terms
upon which we will be able to obtain additional equity capital may be adversely affected since the holders of the
outstanding options can be expected to exercise them at a time when we would, in all likelihood, be able to obtain
any needed capital on terms more favorable to us than those provided in such outstanding options.

We have never paid dividends and have no plans to in the future.

Holders of shares of our common stock are entitled to receive such dividends as may be declared by our

board of directors. To date, we have paid no cash dividends on our shares of common stock and we do not expect to
pay cash dividends on our common stock in the foreseeable future. We intend to retain future earnings, if any, to
provide funds for operation of our business. Therefore, any return investors in our common stock will have to be in
the form of appreciation, if any, in the market value of their shares of common stock.

We have additional securities available for issuance, which, if issued, could adversely affect the rights of the
holders of our common stock.

Our articles of incorporation authorize the issuance of 9,375,000 shares of our common stock. The

common stock can be issued by our board of directors without stockholder approval. In addition, we are
anticipating seeking approval from our shareholders at our next annual meeting for an amendment to our Articles of
Incorporation in order to increase the number of shares of common stock available for issuance and to approve the

authorization of blank check preferred stock. Any future issuances of equity would further dilute the percentage
ownership of us held by our public shareholders.

Our stock price is likely to be highly volatile because of several factors, including a limited public float.

The market price of our common stock is likely to be highly volatile because there has been a relatively
thin trading market for our stock, which causes trades of small blocks of stock to have a significant impact on our
stock price. You may not be able to resell shares of our common stock following periods of volatility because of the
market’s adverse reaction to volatility.

Other factors that could cause such volatility may include, among other things:

•

•
•

digital video in-car recording products not being accepted by the law enforcement industry or
digital video recording not being accepted as evidence in criminal proceedings;
acceptance of our new products in the marketplace and, in particular, the commercial fleet and
mass transit market;
actual or anticipated fluctuations in our operating results;
the potential absence of securities analysts covering us and distributing research and
recommendations about us;

• we expect our actual operating results to fluctuate widely as we increase our sales and production

capabilities and other operations;

• we may have a low trading volume for a number of reasons, including that a large amount of our

stock is closely held;
overall stock market fluctuations;
•
economic conditions generally and in the law enforcement and security industries in particular;
•
announcements concerning our business or those of our competitors or customers;
•
our ability to raise capital when we require it, and to raise such capital on favorable terms;
•
• we have $2.5 million of borrowings outstanding as of December 31, 2012 under two unsecured

notes payable to a private, third party lender that mature in May 2014;

• we have no institutional line-of-credit available to fund our operations and we may be unable to

obtain a line of credit under terms that are mutually agreeable;
changes in financial estimates by securities analysts or our failure to perform as anticipated by the
analysts;
announcements of technological innovations;
conditions or trends in the industry;
litigation;
changes in market valuations of other similar companies;
announcements by us or our competitors of new products or of significant technical innovations,
contracts, acquisitions, strategic partnerships or joint ventures;
future sales of common stock;

actions initiated by the SEC or other regulatory bodies;
existence or lack of patents or proprietary rights;
departure of key personnel or failure to hire key personnel; and
general market conditions.

•

•
•
•
•
•

Any of these factors could have a significant and adverse impact on the market price of our common stock.

In addition, the stock market in general has at times experienced extreme volatility and rapid decline that has often
been unrelated or disproportionate to the operating performance of particular companies. These broad market
fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating
performance.

Indemnification of officers and directors.

Our articles of incorporation and the bylaws contain broad indemnification and liability limiting provisions
regarding our officers, directors and employees, including the limitation of liability for certain violations of fiduciary
duties. Our stockholders therefore will have only limited recourse against such individuals.

Item 1B.

Unresolved Staff Comments.

None.

Item 2.

Properties.

The Company entered into a non-cancellable, long-term facility lease in September 2012 to combine all of

its operations into one location, commencing in November 2012. The new facility contains approximately 33,776
square feet and is located at 9705 Loiret Boulevard, Lenexa, Kansas 66219. The lease will terminate on April 1,
2020 and provides a rent holiday/abatement period for the first twelve months. Thereafter, the monthly rent will
range from $35,634 to $38,533 over the term.

The leases for the previous Company facilities each expired between October 2012 and December 2012

and were not extended.

Item 3.

Legal Proceedings.

On June 8, 2009, we filed suit against Z3 Technologies, LLC ("Z3") in the U.S. District Court for the District

of Kansas claiming breach of a production software license agreement entered into during October 2008 and the
rescission of a second limited license agreement entered into during January 2009. Among other claims, we asserted
that Z3 failed to deliver the material required under the contracts; that the product that was delivered by Z3 was
defective and/or unusable; and that the January 2009 contract should be rescinded and declared void, unenforceable
and of no force or effect. We paid license fees and made other payments to Z3 totaling $265,000 to-date under these
contracts. Z3 denied our claims and filed counterclaims that allege we did not have the right to terminate the
contracts and therefore that it was damaged for loss of profits and related damages. In those counterclaims, Z3
sought to recover approximately $4.5 million from us exclusive of “prejudgment interest.” Our insurance carrier
settled a portion of the counterclaims under our director and officer liability insurance policy. The counterclaims that
were not resolved by that settlement remained in controversy.

The trial of those claims began on June 25, 2012 and concluded with a jury verdict on July 3, 2012. The

principal parts of the verdict were (i) an award of $30,000 to us on grounds that Z3 had breached its 2008 contract
with us; (ii) an award of $15,000 in favor of Z3 by finding that we had breached the 2008 contract by failing to pay
the balance of certain engineering fees; and (iii) an award of $100,000 in favor of Z3 based on the Court’s finding
that we breached the 2009 contract by failing to place an initial order for so-called “DM-365 modules” from Z3. As
a result, the net judgment against us was $85,000. Further, despite our arguments at trial, the court also refused to
reconsider the interlocutory summary judgment rulings rendered against us prior to trial in the amount of $445,000,
which became final upon conclusion of the trial. Accordingly, the total judgment entered against us was $530,000
and no prejudgment interest on that sum was awarded.

We believe there are a number of errors in the court’s rulings and the judgment entered on July 3, 2012 and

are appealing them. We accrued the $530,000 judgment entered against us as a long-term liability as of
December 31, 2012 due to the expected time required to conclude the appeal process. We have charged $780,350 to
operations during the twelve months ended December 31, 2012 as litigation charge and related expenses. Such
charges include the $530,000 judgment and all related legal fees and expenses incurred and accrued during the
twelve months ended December 31, 2012. We have also accrued the legal fees expected to be incurred during the
appeal process. In order to stay the execution of judgment during the appeal process, we were required to post a
bond in the amount of $662,500 in July 2012 and the respective funds will be reflected as restricted cash in future
balance sheets until such time as the bond is no longer required.

On October 23, 2009, the Circuit Court of Jackson County, Missouri awarded the Company an interlocutory
judgment against a former contract manufacturer. The Company had filed for and received a temporary restraining
order in June 2009 that forbids the supplier from engaging in certain actions involving the Company. The
interlocutory judgment was entered in favor of the Company against the supplier that in effect cancelled all purchase
orders and confirmed that the Company has no further obligations, whether monetary or otherwise, to the supplier.
The Company received a notice of the filing of bankruptcy under Chapter 7 effective October 26, 2009 by this
supplier. In the bankruptcy court, the Company sought and received relief from the automatic stay in order to

liquidate and obtain a final judgment against the supplier. On May 28, 2010, the court granted a default judgment
awarding the Company damages and legal fees totaling $11,166,686.

The Company filed a garnishment claim against all insurance proceeds from policies issued and in force
covering the supplier when these actions occurred. The trial relating to this claim commenced on September 24,
2012. The parties agreed to settle the lawsuit on September 25, 2012. The insurance company involved agreed to
pay $610,000 to settle the litigation relating to the garnishment claim and the Company received the payment on
October 16, 2012. The Company recorded the $610,000 settlement in litigation charge (credit) and related expenses
and all legal fees incurred for the lawsuit were offset against the settlement as of December 31, 2012. The net
amount included in litigation charge (credit) and related expenses at December 31, 2012 for this lawsuit were
$(466,400).

We are also involved as a plaintiff and defendant in ordinary, routine litigation and administrative
proceedings incidental to its business from time to time, including customer collections, vendor and employment-
related matters. Management believes the likely outcome of any other pending cases and proceedings will not be
material to its business or its financial condition.

Item 4.

Mine Safety Disclosures.

Not applicable.

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and

Issuer Purchases of Equity Securities.

PART II

Market Prices

Our common stock commenced trading on the NASDAQ Capital Market on January 2, 2008 under the

symbol “DGLY,” and continues to do so. From July 2007 until we became listed on the NASDAQ Capital Market,
our common stock was traded on the OTC Bulletin Board and prior to that it was quoted in the “Pink Sheets.”

The high/low closing prices of our common stock were as follows for the periods below. The following

quotations have been retroactively restated for the effects of a one-for-eight reverse stock split which was effective
on August 24, 2012. In addition, the quotations below reflect inter-dealer bid prices without retail markup,
markdown, or commission and may not represent actual transactions:

Year Ended December 31, 2012

High Close

Low Close

1st Quarter
2nd Quarter
3rd Quarter
4th Quarter

Year Ended December 31, 2011

1st Quarter
2nd Quarter
3rd Quarter
4th Quarter

$6.16
$6.24
$7.00
$5.90

$15.12
$11.28
$9.60
$7.52

$3.36
$2.50
$2.48
$2.91

$10.40
$7.52
$5.28
$4.80

Holders of Common Stock

As of December 31, 2012, we had approximately 82 shareholders of record for our common stock.

Dividend Policy

To date, we have not declared or paid cash dividends on our shares of common stock. The holders of our

common stock will be entitled to non-cumulative dividends on the shares of common stock, when and as declared by
our board of directors, in its discretion. We intend to retain all future earnings, if any, for our business and do not
anticipate paying cash dividends in the foreseeable future.

Any future determination to pay cash dividends will be at the discretion of our board of directors and will
be dependent upon our financial condition, results of operations, capital requirements, general business conditions
and such other factors as our board of directors may deem relevant.

Stock Repurchase Plan

During June 2008, our Board of Directors approved a program that authorized the repurchase of up to

$10 million of our common stock in the open market, or in privately negotiated transactions, through July 1, 2010.
Our Board of Directors approved an extension of this program to July 1, 2012, at which point it terminated. We
made no purchases under this program during the years ended December 31, 2012 and 2011. The Company has
repurchased 63,518 shares at a total cost of $2,157,226 (average cost of $33.96 per share) under this program from
inception to December 31, 2012.

Securities Authorized for Issuance under Equity Compensation Plans

Our board of directors adopted the 2005 Stock Option and Restricted Stock Plan (the “2005 Plan”) on

September 1, 2005. The 2005 Plan authorizes us to reserve 312,500 shares of our common stock for issuance upon
exercise of options and grant of restricted stock awards. At December 31, 2012, there were 691 shares available for
issuance under the 2005 Plan.

On January 17, 2006, our board of directors adopted the 2006 Stock Option and Restricted Stock Plan (the
“2006 Plan”). The 2006 Plan authorizes us to reserve 187,500 shares for future grants under it. At December 31,
2012, there were 36,387 shares available for issuance under the 2006 Plan.

On January 24, 2007, our board of directors adopted the 2007 Stock Option and Restricted Stock Plan (the

“2007 Plan”). The 2007 Plan authorizes us to reserve 187,500 shares for future grants under it. At December 31,
2012, there were 7,529 shares available for issuance under the 2007 Plan.

On January 2, 2008, our board of directors adopted the 2008 Stock Option and Restricted Stock Plan (the
“2008 Plan”). The 2008 Plan authorizes us to reserve 125,000 shares for future grants under it. At December 31,
2012, there were 2,875 shares available for issuance under the 2008 Plan.

On March 18, 2011, our board of directors adopted the 2011 Stock Option and Restricted Stock Plan (the

“2011 Plan”). The 2011 Plan authorizes us to reserve 62,500 shares for future grants under it. At December 31,
2012, there were 41,875 shares available for issuance under the 2011 Plan.

The 2005 Plan, 2006 Plan, 2007 Plan, 2008 Plan and 2011 Plan are referred to as the “Plans.”

The Plans authorize us to grant (i) to the key employees incentive stock options (except for the 2007 Plan)

to purchase shares of common stock and non-qualified stock options to purchase shares of common stock and
restricted stock awards, and (ii) to non-employee directors and consultants’ non-qualified stock options and
restricted stock. The Compensation Committee of our board of directors administers the Plans by making
recommendations to the board or determinations regarding the persons to whom options or restricted stock should be
granted and the amount, terms, conditions and restrictions of the awards.

The Plans allow for the grant of incentive stock options (except for the 2007 Plan), non-qualified stock

options and restricted stock awards. Incentive stock options granted under the Plans must have an exercise price at
least equal to 100% of the fair market value of the common stock as of the date of grant. Incentive stock options
granted to any person who owns, immediately after the grant, stock possessing more than 10% of the combined
voting power of all classes of our stock, or of any parent or subsidiary corporation, must have an exercise price at
least equal to 110% of the fair market value of the common stock on the date of grant. Non-statutory stock options
may have exercise prices as determined by our Compensation Committee.

The Compensation Committee is also authorized to grant restricted stock awards under the Plans. A

restricted stock award is a grant of shares of the common stock that is subject to restrictions on transferability, risk
of forfeiture and other restrictions and that may be forfeited in the event of certain terminations of employment or
service prior to the end of a restricted period specified by the Compensation Committee.

On July 31, 2008, we filed registration statements on Form S-8 and an amendment to a previously filed

Form S-8 with the SEC which registered 812,500 shares to be issued upon exercise of the stock options underlying
the 2005 Plan, 2006 Plan, 2007 Plan and 2008 Plan. On March 28, 2012, we filed a registration statement on Form
S-8, which registered 62,500 shares to be issued upon exercise of stock options underlying the 2011 Stock Plan.

The following table sets forth certain information regarding the stock option plans adopted by the Company

as of December 31, 2012:

Plan category

Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
(a)

Weighted-average
exercise price of
outstanding options,
warrants and rights
(b)

Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in column (a))

(c)

Equity compensation plans approved by stockholders …………..

435,208

Equity compensation plans not approved by stockholders ……….

117,442

Total all plans ……………………………………………………..

552,650

$17.87

81,828

7,529

89,357

Recent Sales of Unregistered Securities

There have been no sales of unregistered securities during the fiscal years ended December 31, 2012 and

2011.

Item 6.

Selected Financial Data.

Not applicable.

Item 7.
Operation.

Management’s Discussion and Analysis of Financial Condition and Results of

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act

of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “believe,” “expect,” “anticipate,”
“intend,” “estimate,” “may,” “should,” “could,” “will,” “plan,” “future,” “continue,” and other expressions that are
predictions of or indicate future events and trends and that do not relate to historical matters identify forward-
looking statements. These forward-looking statements are based largely on our expectations or forecasts of future
events, can be affected by inaccurate assumptions, and are subject to various business risks and known and unknown
uncertainties, a number of which are beyond our control. Therefore, actual results could differ materially from the
forward-looking statements contained in this document, and readers are cautioned not to place undue reliance on
such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise. A wide variety of factors could cause
or contribute to such differences and could adversely impact revenues, profitability, cash flows and capital needs.
There can be no assurance that the forward-looking statements contained in this document will, in fact, transpire or
prove to be accurate.

Factors that could cause or contribute to our actual results differing materially from those discussed herein or

for our stock price to be adversely affected include, but are not limited to: (1) our losses in fiscal 2009 through
2012; (2) macro-economic risks from the economic downturn and decrease in budgets for the law-enforcement
community; (3) our ability to increase revenues and return to profitability in the current economic environment; (4)
our operation in a developing market and uncertainty as to market acceptance of our technology and new products;
(5) the impact of the federal government’s stimulus program on the budgets of law enforcement agencies, including
the timing, amount and restrictions on funding; (6) our ability to deliver our new product offerings as scheduled,
including the DVM-250 and DVM-100, and have such new products perform as planned or advertised; (7) whether
there will be commercial markets, domestically and internationally, for one or more of our new products, including
our DVM-250 for the commercial fleet and mass transit markets, and the degree to which the interest shown in our
new products will translate into sales during 2013; (8) our ability to maintain or expand our share of the market for
our products in the domestic and international markets in which we compete, including increasing our international
revenues to their historical levels; (9) our ability to produce our products in a cost-effective manner; (10)
competition from larger, more established companies with far greater economic and human resources; (11) our
ability to attract and retain quality employees; (12) risks related to dealing with governmental entities as customers;
(13) our expenditure of significant resources in anticipation of a sale due to our lengthy sales cycle and the potential

to receive no revenue in return; (14) characterization of our market by new products and rapid technological change;
(15) our dependence on sales of our DVM-750 and DVM-500Plus products; (16) potential that stockholders may
lose all or part of their investment if we are unable to compete in our markets and return to profitability; (17) defects
in our products that could impair our ability to sell our products or could result in litigation and other significant
costs; (18) our dependence on key personnel; (19) our reliance on third party distributors and representatives for our
marketing capability; (20) our dependence on a few manufacturers and suppliers for components of our products and
our dependence on domestic and foreign manufacturers for certain of our products; (21) our ability to protect
technology through patents; (22) our ability to protect our proprietary technology and information as trade secrets
and through other similar means; (23) risks related to our license arrangements; (24) our revenues and operating
results may fluctuate unexpectantly from quarter to quarter; (25) sufficient voting power by coalitions of a few of
our larger stockholders, including directors and officers, to make corporate governance decisions that could have
significant effect on us and the other stockholders; (26) sale of substantial amounts of our common stock that may
have a depressive effect on the market price of the outstanding shares of our common stock; (27) possible issuance
of common stock subject to options and warrants that may dilute the interest of stockholders; (28) our ability to
comply with Sarbanes-Oxley Act of 2002 Section 404 as it may be required; (29) our nonpayment of dividends and
lack of plans to pay dividends in the future; (30) future sale of a substantial number of shares of our common stock
that could depress the trading price of our common stock, lower our value and make it more difficult for us to raise
capital; (31) our additional securities available for issuance, which, if issued, could adversely affect the rights of the
holders of our common stock; (32) our stock price is likely to be highly volatile due to a number of factors,
including a relatively limited public float; and (33) indemnification of our officers and directors.

Current Trends and Recent Developments for the Company

Overview

We supply technology-based products utilizing our portable digital video and audio recording capabilities, for

the law enforcement and security industries and for the commercial fleet and mass transit markets. We have the
ability to integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions
to our customers’ requests. We began shipping our flagship digital video mirror in March 2006. We have
developed additional products to complement our DVM-500 and DVM-750 in-car video products including lower
priced in-car video mirrors (the DVM-100 and DVM-400) speed detection (Laser Ally) and body worn camera
(FirstVU) products designed for law enforcement usage. Furthermore, we have recently launched a new line of
digital video mirrors (the DVM-250 and DVM-250Plus) that serve as “event recorders” for the commercial fleet and
mass transit markets that expands our customer base beyond the traditional law enforcement agencies. We have
additional research and development projects that we anticipate will result in several new product launches during
2013. We believe that the launch of these new products will help to diversify and increase our product offerings and
result in increased revenues in the future.

We experienced a negative trend in our operating results in 2012 and 2011 and have reported operating losses

during all but one of the previous eight fiscal quarters. The following is a summary of our recent operating results
on a quarterly basis:

For the Three Months Ended:

December 31,
2012

September
30,
2012

June 30,
2012

March 31,
2012

December 31,
2011

September
30,
2011

June 30,
2011

March 31,
2011

Total revenue

$ 4,638,087

$4,596,768

$4,600,797

$3,782,456

$ 4,286,314

$ 5,817,893

$ 4,743,253

$ 4,729,693

Gross profit

Gross profit
margin
percentage

Total selling,
general and
administrative
expenses

Operating

2,392,397

2,617,310

2,475,663

1,996,617

1,841,104

2,989,496

1,964,557

1,976,773

51.6%

56.9%

53.8%

52.8%

43.0%

51.4%

41.4%

41.8%

2,807,221

2,281,294

3,351,193

2,728,797

3,143,348

3,081,936

3,064,005

3,107,442

(414,824)

336,016

(875,530)

(732,180)

(1,302,244)

(92,440)

(1,099,448)

(1,130,669)

income (loss)

Operating
margin
percentage

Net income
(loss)

(8.9%)

7.3%

(19.0)%

(19.4)%

(30.4%)

(1.6%)

(23.2%)

(23.9%)

$ (487,099)

$270,040

$(949,201)

$(804,729)

$ (1,517,136)

$ (162,918)

$ (1,134,903)

$ (1,147,289)

Our business is subject to substantial fluctuations on a quarterly basis as reflected in the significant

variations in revenues and operating results in the above table. These variations result in part from the timing of
large individual orders from international, as well as domestic, customers and our new products, such as the DVM-
100, DVM-400 and DVM-250. We incurred an operating loss during fourth quarter 2012 of $414,824 on revenues
of $4,638,087 compared to operating income of $336,016 on total revenues of $4,596,768 in the third quarter 2012.
The operating income reported in third quarter 2012 reflected the positive effect of a litigation settlement recorded in
September 2012 (See Note 10 to the Condensed Consolidated Financial Statements) and was the first profitable
quarter since fourth quarter 2009 when we reported operating income of $341,167. We believe that regardless of the
operating loss in the fourth quarter of 2012, the operating results for such quarter demonstrates continued
improvement from late 2011 and early 2012. Our gross margin percentage decreased to 51.6% compared to 56.9%
in third quarter 2012, 53.8% in second quarter 2012 and 52.8% in first quarter 2012 due to an improvement in
international sales, increased costs to improve the wireless transfer modules (“WTM”) and discounting some larger
international sales transactions in the fourth quarter 2012. Our selling, general and administrative (“SG&A”)
expenses increased in fourth quarter 2012 compared to third quarter 2012 due to the litigation settlement reported in
third quarter 2012 that did not recur in the fourth quarter 2012, and the costs incurred to consolidate our operations
into one facility during the fourth quarter 2012 which was approximately $120,000. Our international revenues
during 2012 decreased over 2011 levels as we shipped international orders totaling $1,031,066 in 2012, compared to
$2,028,591 during 2011.

We expect to continue to experience significant fluctuations in revenues in 2013 and beyond due to the

timing of larger orders from international, as well as domestic, customers. For 2013, we are focusing on increasing
revenues and improving gross margins on sales in addition to continuing our general and administrative cost
reduction and containment measures. We plan, however, to continue to invest in research, development, sales and
marketing resources on a prudent basis. Our inventory levels increased slightly during 2012 compared to 2011 and
the primary cause was increases in the Laser Ally products which are subject to minimum purchase requirements.
Management has implemented a program to reduce overall inventory levels in 2013 as we attempt to improve sales,
decrease production rates and reduce procurement costs throughout our supply chain.

There have been a number of factors/trends affecting our recent performance, which include:

• Revenues increased in the fourth quarter 2012 to $4,638,087 from $4,596,768 in the third quarter 2012
and were the highest achieved since third quarter 2011, when revenues aggregated $5,817,893. We
attribute the revenue increases in the second, third and fourth quarters of 2012 to the reorganization of
our law enforcement sales force, which was begun in late 2011 and continued through the first and
second quarters of 2012. We have moved to an employee-based sales force, as opposed to our
historical usage of independent sales agents for domestic markets. We believe the sales force
reorganization will continue to have a positive impact in the future, but recognizes that the economic
climate will continue to depress certain state and local tax bases and may contribute to a challenging
business environment in 2013.

• We have recently launched additional products to complement our DVM-500 and DVM-750 in-car

video products in an effort to diversify our sources of revenue. In that respect, we launched the Laser
Ally speed detection system in third quarter 2010, the DVM-250 event recorder during first quarter
2011, the DVM-100 in-car video system in third quarter 2011 and the DVM-400 in-car video system
in fourth quarter 2011, and plan to launch the new FirstVU HD and UltraVU during 2013. We are
hopeful that our expanded product line will help generate incremental revenues to supplement our
traditional DVM-500Plus and DVM-750 revenues. In addition, the DVM-250 and DVM-250Plus
event recorders are designed for commercial fleet operators, which will allow us to seek new
customers outside of law enforcement. Our recently released products, including the DVM-100, the

DVM-400, the DVM-250, the DVM-250Plus, and the Laser Ally, contributed 13% of the total sales
for 2012 compared to 8% for 2011.

• Our gross profit on sales declined to 51.6% during fourth quarter 2012 reversing the gross profit of

56.9% we achieved in third quarter 2012. Our gross profit was 53.8% in second quarter 2012 and
52.8% in first quarter 2012. The decrease in fourth quarter 2012 was due to an increase in international
revenues, increased costs to improve our WTM’s and discounting of a few larger sales transactions in
the fourth quarter 2012. Gross profit as a percentage of sales increased to 54% for fiscal 2012
compared to 45% for fiscal 2011. We attribute the improvement in 2012 to our supply chain
improvement plan as we continued producing and shipping both DVM-500Plus and DVM-750 units
containing the lower cost components, and our ability to transition sales volume to our recently added
products, which have higher margins than our DVM-500 and DVM-750 in car video products. During
2011, we implemented our supply chain plan to improve gross margin through better outsourcing of
our component parts in the future, including from foreign sources, which allowed us to reduce our
production overhead costs through headcount and other cost reductions. Our goal is to continue to
improve margins during 2013 through our supply chain initiative, reduce manufacturing overhead,
increase sales volume and improve product mix. We continue to focus on reducing the costs of our
products through changes to our supply chain, where we are emphasizing outsourcing of component
part production and changing our supply chain vendors to lower cost alternative suppliers throughout
the world. However, we are experiencing increased price competition and pressure from certain of our
competitors that has led to pricing discounts on larger contract opportunities. We believe this pricing
pressure will continue as our competitors attempt to regain market share and revive sales and expect it
to have a negative impact on our gross margins to some degree during 2013.

• We believe that current and potential customers may be delaying or reducing the size of orders due to
a number of factors, including budget reductions, in order to preserve their currently available funding
and budgets. Many of the existing Federal funding programs require matching funds from the local
agencies that continues to be difficult given the budget restrictions. We cannot predict whether such
funding on a matching basis will have a positive impact on our revenues in the future.

• Our international revenues decreased in fiscal 2012 to $1,031,066 (6% of total revenues), compared to

$2,028,591 (10% of total revenues) for 2011. During second quarter 2012, we reorganized our
international sales structure and believe this will lead to more positive results in the future.
International revenues in the fourth quarter 2012 were higher than the previous three quarters of 2012
combined. International revenues for the fourth quarter 2012 were $634,361 compared to $176,590,
$60,680 and $159,435 for third quarter, second quarter and first quarter 2012, respectively. We have
made a number of bids for international customers; however, international sale cycles generally take
longer than domestic business. We also believe that our new products may appeal to international
customers, in particular the DVM-100, DVM-250 and DVM-250Plus, although we can make no
assurances in this regard. We have built in the capability to install a variety of language packs into our
DVM-750 system, which currently includes English, Spanish, Turkish and Arabic, with additional
languages to become available during 2013. This language flexibility may be a positive factor in our
efforts to improve future international sales.

• We have reorganized our production and manufacturing operations by placing a greater emphasis on

contract manufacturers. Uncertainties regarding the size and timing of large international orders make
it difficult for us to maintain efficient production and staffing levels if all orders are processed through
our manufacturing facility. By outsourcing more of our production requirements to contract
manufacturers, we believe that we can benefit from greater volume purchasing and production
efficiencies, while at the same time reducing our fixed and semi-fixed overhead costs. It is, of course,
important that selected contract manufacturers be able to ramp up production quickly in order to meet
the varying demands of our international customers.

• Our recent operating losses caused deterioration in our cash and liquidity in 2012 and 2011. We

borrowed $2,500,000 under two unsecured subordinated notes (the "Notes") payable to a private, third
party lender. The Notes are due and payable in full on May 30, 2014 and may be prepaid without
penalty at any time. We utilized the proceeds to retire our bank line of credit and provide cash for
operations. We had no institutional credit lines available to provide additional working capital as of
December 31, 2012. At December 31, 2012, we had available cash balances of $703,172 and

approximately $8.9 million of working capital, primarily in the form of inventory and accounts
receivable.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet debt nor did we have any transactions, arrangements, obligations

(including contingent obligations) or other relationships with any unconsolidated entities or other persons that may
have a material current or future effect on financial conditions, changes in the financial conditions, results of
operations, liquidity, capital expenditures, capital resources, or significant components of revenue or expenses.

We are a party to operating leases and license agreements that represent commitments for future payments
(described in Note 10 to our consolidated financial statements) and we have issued purchase orders in the ordinary
course of business that represent commitments to future payments for goods and services.

We entered into a supply and distribution agreement on May 1, 2010 under which we were granted the
exclusive worldwide right to sell and distribute a proprietary law enforcement speed measurement device and
derivatives to its customers. The term of the agreement was 42 months after the date the supplier began full scale
production of the product which commenced in August 2010 and final certification of the product was obtained.
The agreement had minimum purchase requirements of 1,000 units per period over three commitment periods. On
January 31, 2012, the supply and distribution agreement was amended to reduce the minimum purchase commitment
over the second and third years by 52% compared to the original commitment. We agreed to release our world-wide
right to exclusively market the product to the law enforcement community in exchange for the reduction in the
purchase commitment. After the initial term has expired, the parties may continue on a month-to-month basis and is
terminable by either party upon 30 days advance notice. The contract may be terminated earlier in case of material
breach by either party that is not cured within thirty days of notice of the breach.

The agreement contains required minimum order quantities and fixed prices per unit according to the

following schedule:

Minimum order commitment amount ($)

Commitment time period

March 2012 through February 2013 .............................
March 2012 through February 2014 .............................

Commitment
$ 846,240
846,240

Purchases
$ 705,200
—

Remaining
Commitment

$ 141,040
846,240

$ 1,692,480

$ 705,200

$ 987,280

The above table reflects the modified terms of the amended supply and distribution agreement. The

supplier is responsible for all warranty, damage or other claims, losses or liabilities related to the product and is
obligated to defend and indemnify us against such risks. We held approximately $1,535,000 of such products in
finished goods inventory as of December 31, 2012 and have sold approximately 500 units since the beginning of the
agreement through December 31, 2012.

For the Years Ended December 31, 2012 and 2011

Results of Operations

Summarized immediately below and discussed in more detail in the subsequent sub-sections is an analysis

of our operating results for the years ended December 31, 2012 and 2011, represented as a percentage of total
revenues for each respective year:

Revenue
......................................................................................................
Cost of revenue .................................................................................................

100%
46%

100%
55%

Years Ended
December 31,

2012

2011

Gross profit ...........................................................................................

Selling, general and administrative expenses:
Research and development expense .......................................................
Selling, advertising and promotional expense ........................................
Stock-based compensation expense .......................................................
Litigation charge and related expenses ...................................................
General and administrative expense .......................................................

Total selling, general and administrative expenses ...........................................

Operating loss ......................................................................................
Interest income (expense) .................................................................................

Loss before income tax benefit .........................................................................
Income tax (provision) ......................................................................................

Net loss………………………………………………………………...

Net loss per share information:

Years Ended
December 31,

2012

2011

54%

14%
15%
3%
2%
30%

64%

(10%)
(1%)

(11%)
—%

(11%)

45%

14%
11%
4%
0%
34%

63%

(18%)
(2%)

(20%)
—%

(20%)

Basic …………………………………………………………………..

$ (0.97)

$ (1.96)

Diluted ...................................................................................................

$ (0.97)

$ (1.96)

Revenues

Our current product offerings include the following:

Product

Description

DVM-500Plus

An in-car digital audio/video system that is integrated into a rear view mirror
primarily designed for law enforcement customers.

DV-500Ultra

An all-weather mobile digital audio/video system that is designed for
motorcycle, ATV and boat users mirror primarily for law enforcement
customers.

DVM-750

DVF-500

DVM-100

DVM-400

DVM-250

Laser Ally

FirstVU

An in-car digital audio/video system that is integrated into a rear view mirror
primarily designed for law enforcement customers.

A digital audio/video system that is integrated into a law-enforcement style
flashlight primarily designed for law enforcement customers.

An in-car digital audio/video system that is integrated into a rear view mirror
primarily designed for law enforcement customers. This system uses an
integrated fixed focus camera.

An in-car digital audio/video system that is integrated into a rear view mirror
primarily designed for law enforcement customers. This system uses an
external zoom camera.

An in-car digital audio/video system that is integrated into a rear view mirror
primarily designed for commercial fleet customers. We also offer the DVM-
250Plus which has additional features and retails for $1,295.

A hand-held mobile speed detection and measurement device that uses light
beams rather than sound waves to measure the speed of vehicles.

A body-worn digital audio/video camera system primarily designed for law
enforcement customers.

Retail
price

$4,295

$4,595

$4,995

$795

$1,895

$2,795

$995

$2,495

$795

We sell our products and services to law enforcement and commercial customers in the following manner:

•

Sales to domestic and international customers are made direct to the end customer (typically a law
enforcement agency or a commercial customer) through commissioned third-party sales agents or
our direct sales force, who are our employees. Revenue is recorded when the product is shipped to
the end customer.

Sales to international customers are made through independent distributors who purchase products
from the Company at a wholesale price and sell to the end user (typically law enforcement agencies
or a commercial customer) at a retail price. The distributor retains the margin as its compensation
for their role in the transaction. The distributor generally maintains product inventory, customer
receivables and all related risks and rewards of ownership. Revenue is recorded when the product is
shipped to the distributor consistent with the terms of the distribution agreement. For a portion of
2012 we had a number of independent distributors selling under this arrangement.

•

Repair parts and services for domestic and international customers are generally handled by our
inside customer service employees. Revenue is recognized upon shipment of the repair parts and
acceptance of the service or materials by the end customer.

We may discount our prices on specific orders when considering the size of the order, the specific customer

and the competitive landscape. We believe that our systems are cost competitive compared to our primary
competition and generally are lower priced when considering comparable features and capabilities.

Revenues for the years ended December 31, 2012 and 2011 were derived from the following sources:

DVM-500Plus

DVM-750

DVM-100 & DVM-400

Laser Ally

DVM-250 & DVM- 250 Plus

Repair and service

FirstVu

Accessories and other revenues

Years ended
December 31,

2012

47%

20%

17%

2011

58%

23%

100%

We experienced a change in the sales mix of our products for the year ended December 31, 2012 compared
to the year ended December 31, 2011. Our newer products, including the DVM-100, the DVM-400, the DVM-250,
the DVM-250Plus, and the Laser Ally, contributed 13% of our total sales for the twelve months ended December 31,
2012, compared to 8% for the comparable period ending December 31, 2011. We expect that the sales mix will
continue to transition from the DVM-550 Plus and DVM-750 to our newer products during 2013.

Revenues for the years ended December 31, 2012 and 2011 were $17,618,108 and $19,577,153,

respectively, a decrease of $1,959,045 (10%), due to the following factors:

•

Our revenues decreased due to the challenging economy that continued to negatively impact state,
county and municipal budgets which fund our law enforcement customers. We believe that current
and potential customers may have delayed or reduced the size of their orders due to a number of
factors, including their local budget reductions and anticipation of receiving the federal
government’s stimulus funds in order to preserve their currently available funding and budgets. Our
average order size decreased from approximately $3,400 in the year ended December 31, 2011 to
$2,600 during the year ended December 31, 2012. We shipped fifteen individual orders in excess of
$100,000, for a total of approximately $3.2 million in revenue, in the year ended December 31, 2012

compared to thirteen orders individually in excess of $100,000, for total revenue of approximately
$3.6 million in the year ended December 31, 2011. We believe this reflects reduced law
enforcement budgets where the customers are covering only the minimum required needs rather than
full fleet deployments. In addition, the new products we introduced in 2010 and 2011 (FirstVU,
Laser Ally, DVM-250, DVM-250Plus, DVM-100 and DVM-400) all have lower average selling
prices than our legacy digital video mirror lines. Repair orders at lower average invoice amounts
have also increased significantly as our installed base continues to come off of warranty. These
repair orders are at lower average price levels and are impacting our overall average invoice size.
We maintained consistent retail pricing on our law enforcement mirror models during 2012 and do
not plan any material changes in pricing during 2013, including the new products recently
introduced. Our newer mirror-based products include the DVM-100, DVM-250, DVM-250Plus and
the DVM-400, which will be sold at lower retail pricing levels compared to our legacy products
during the 2013 due to fewer features relative to our legacy DVM-500Plus and DVM-750 models.
We are experiencing some price competition and discounting from our competitors as they attempt
to regain market share. For certain opportunities that involve multiple units and/or multi-year
contracts we have occasionally discounted our products to gain or retain market share and revenues.

• We reorganized our domestic sales force and organization for our law enforcement channel during
2012. Traditionally, we have used third party sales agents to market our law enforcement products
domestically. We have changed principally to an employee-based direct sales force that provides us
with more control and monitoring of our sales force and their daily activities. In addition, we have
reduced the size of certain sales territories and consequently increased the overall number of
domestic sales territories and sales personnel, from 15 at the beginning of 2012 to 22 currently, in
order to better penetrate the market. During 2012, we converted one third party sales agent to be an
employee-based direct sales person and replaced the remaining third party sales agents with new
employee-based sales personnel. Our objective with this new employee-based model, including the
replacement of many sales agents, is to encourage our sales personnel in lower performing territories
to improve their efforts and consequently their sales results. We believe that a portion of the revenue
decrease experienced in 2011 and early 2012 revenues resulted from third party sales agents
reducing their sales efforts because they did not have the financial resources to travel, meet and
market directly to their customers as a result of the difficult economic conditions. We reorganized to
address these concerns. We believe that the transition to the employee-based direct sales force
model resulting in a number of new territories and sales personnel during 2012 and the training of
new sales personnel that replaced underperforming salesmen in certain existing territories have
caused temporary disruptions and contributed to the lower revenues in 2012 compared to 2011. In
conjunction with the sales force reorganization, we have identified, hired and trained 14 new sales
personnel in 2012 that principally replaced underperforming sales agents. We hope that this
transition will result in improved revenues from these historically underperforming territories in the
future.

•

Our international revenues decreased to $1,031,066, representing 6% of total revenues, during the
year ended December 31, 2012 compared to $2,028,591, representing 10% of total revenues, during
the year ended December 31, 2011. During second quarter 2012, we reorganized our international
sales structure and believe this will lead to more positive results in the future. International revenues
in the fourth quarter 2012 were better than the previous three quarters of 2012 combined.
International revenues for the fourth quarter 2012 were $634,361 compared to $176,590, $60,680
and $159,435 for third quarter, second quarter and first quarter 2012, respectively. The
reorganization of our international sales personnel and efforts began showing positive results in the
second half of 2012 and we are hopeful this positive trend continues in 2013. We have presented a
number of bids for international customers; however, International sale cycles generally take longer
than domestic business. We also believe that our new products may appeal to international
customers, in particular the DVM-100, DVM-400, DVM-250 and DVM-250Plus. We have built in
the capability to install a variety of language packs into our DVM-750 system, which currently
includes English, Spanish, Turkish and Arabic, with additional languages to become available
during the balance of 2012. This language flexibility may be a positive factor in our efforts to
improve future international sales.

Cost of Revenue

Cost of revenue on units sold for the year ended December 31, 2012 and 2011 was $8,136,121 and
$10,805,223, respectively, a decrease of $2,669,102 (25%). The decrease in costs of goods sold is partially due to
the 10% decrease in revenues during the year ended December 31, 2012 compared to 2011, and improvement in cost
of goods sold as a percent of revenues during the twelve months ended December 31, 2012 compared to 2011. Cost
of sales as a percentage of revenues decreased to 46% during the year ended December 31, 2012 compared to 55%
for the year ended December 31, 2011. Our goal is to reduce cost of sales as a percentage of revenues during 2013
and beyond. Improving gross margins through reductions in conversion costs (engineering changes and rework) and
manufacturing inefficiencies related to our base products, such as the DVM-750 and DVM-500Plus, are main
focuses of management and engineering. In addition, we are continuing to reorganize our production and
manufacturing operations by placing a greater emphasis upon contract manufacturers, including those located
offshore. Uncertainties regarding the size and timing of large international orders make it difficult for us to maintain
efficient production and staffing levels if all orders are processed through our manufacturing facility. By
outsourcing more of our production requirements to contract manufacturers, we believe that we can benefit from
greater volume purchasing and production efficiencies, while at the same time reducing our fixed and semi-fixed
overhead costs. We believe that the selected contract manufacturers will be able to ramp up production quickly in
order to meet the varying demands of our international customers. We expect that our newer product offerings, in
particular the DVM-100, DVM-400, DVM-250, and DVM-250Plus, should improve our cost of goods sold as a
percentage of sales. We do not expect to incur significant capital expenditures to ramp up production of the new
products because our internal process is largely assembling subcomponents, testing and shipping of completed
products or we use contract manufacturers. We rely on our subcontractors to produce finished circuit boards that
represent the primary components of our products, thereby reducing our need to purchase capital equipment.

We had $377,330 and $547,182 in reserves for obsolete and excess inventories at December 31, 2012 and

December 31, 2011, respectively. We are maintaining component parts specific to the legacy DVM-500 in
inventory at levels reasonably expected to be consumed for service and repair demands. Total raw materials and
component parts were $2,475,827 and $2,168,761 at December 31, 2012 and December 31, 2011, respectively, an
increase of $307,096 (14%). The increase in raw materials and component parts is attributable to a buildup in
anticipation of moving our assembly and warehousing operations to a new facility in late November 2012 and the
associated delays in ramping up our assembly operations before December 31, 2012. We believe the introduction of
new parties to our supply chain will continue to help reduce cost of sales as a percent of revenues during 2013.
Finished goods balances were $5,050,572 and $4,844,446 at December 31, 2012 and December 31, 2011,
respectively, an increase of $206,126 (4%). The increase in finished goods was primarily in the Laser Ally products,
which are subject to minimum purchase requirements. Finished goods at December 31, 2012 are primarily the Laser
Ally products and the DVM-500Plus products which will be used to fulfill international and domestic orders during
2013. Finished goods also included increased supplies of our other newer products, including the FirstVU, DVM-
250, DVM-400 and DVM-100 at December 31, 2012. The reserve for excess and obsolete inventory as a percent of
total inventory balances decreased to 4.9% as of December 31, 2012 compared to 7.6% at December 31, 2011. We
believe that our obsolescence risk was less at December 31, 2012 compared to December 31, 2011 because our
management team made a concerted effort in 2012 to dispose of unusable parts from older versions of our products.
Therefore, previously reserved obsolete parts were disposed of during 2012 and have been applied to our reserve
balance. We believe these reserves are appropriate given our inventory levels at December 31, 2012.

Gross Profit

Gross profit for the years ended December 31, 2012 and 2011 was $9,481,987 and $8,771,930,

respectively, an increase of $710,057 (8%). The increase is commensurate with the significant improvement in cost
of sales as a percent of revenue during the twelve months ended December 31, 2012 compared to the same period
2011 offset by the 10% decline in revenues. Cost of sales as a percentage of revenues decreased to 46% for the year
ended December 31, 2012 from 55% for the year ended December 31, 2011. Our goal is to continue to improve our
margins based upon the expected margins of our newer products, in particular the DVM-100, DVM-400, DVM-250
and DVM-250Plus, if they gain traction in the marketplace and increase commercial production in 2013. In
addition, as revenues increase from these products, we will seek to further improve our margins from these new
products through economies of scale and more efficiently utilizing fixed manufacturing overhead components. We
plan to continue our initiative on more efficient management of our supply chain through outsourcing production,
quantity purchases and more effective purchasing practices.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $11,168,505 and $12,396,731 for the years ended

December 31, 2012 and 2011, respectively, a decrease of $1,228,226 (10%). Overall selling, general and
administrative expenses as a percentage of sales increased to 64% from 63% in 2012 and 2011.

The significant components of selling, general and administrative expenses are as follows:

Research and development expense ....................................................
Selling, advertising and promotional expense .....................................
Stock-based compensation expense ....................................................
Professional fees and expense .............................................................
Executive, sales, and administrative staff payroll ...............................
Litigation charge and related expenses ................................................
Other ..........................................................................................

Total……………………………………………………………...

2012

Year ended December 31,
2011
$ 2,773,962
2,232,831
839,232
740,894
2,990,808
—
2,819,004
$ 12,396,731

$ 2,528,790
2,587,427
521,427
657,818
2,119,921
313,950
2,439,172

$ 11,168,505

Research and development expense. We continue to focus on bringing new products to market, including

updates and improvements to current products. Our research and development expenses totaled $2,528,790 and
$2,773,962 for the years ended December 31, 2012 and 2011, respectively, a decrease of $245,172 (9%) because of
our continued cost containment efforts and increased scrutiny of engineering resources. We employed a total of 20
engineers at December 31, 2012, most of whom are dedicated to research and development activities for new
products. Research and development expenses as a percentage of total revenues were 14% in 2012 and 14% in
2011, illustrating our continuing commitment to bring new products to market and expanding our current product
line. We have active research and development projects on several new products, as well as upgrades to our existing
product lines. We anticipate launching at least two new products during 2013, including the FirstVU HD and
UltraVU products, which are the results of our research and development efforts. We consider our research and
development capabilities and new product focus to be a competitive advantage and will continue to invest in this
area on a prudent basis.

Selling, advertising and promotional expenses. Selling, advertising and promotional expense totaled

$2,587,427 and $2,232,831 for the years ended December 31, 2012 and 2011, respectively, an increase of $354,596
(16%). A large component of selling, promotional and advertising expense was commissions paid to our
independent agents who represent our sales force in the domestic market. These agents generally received a
commission on sales ranging from 5.0% to 12% of the gross sales price to the end customer. Sales commissions
totaled $573,863 and $1,930,779 for the years ended December 31, 2012 and 2011, respectively, a decrease of
$1,356,916 (70%), Sales commissions as a percentage of overall sales decreased to 3.3% during the year ended
December 31, 2012 compared to 9.9% for the year ended December 31, 2011. The decrease in our overall sales
commissions as a percentage of sales reflects the results of our sales force reorganization initiative that is intended to
improve our revenues.

As part of such reorganization, we are now principally an employee-based direct sales force model where

such sales personnel receive a base salary plus travel expenses and have the opportunity to earn commissions if their
respective sales exceed their assigned quotas. During the twelve months ended December 31, 2012, we did not
renew contracts with 11 sales agents, converted one sales agent from a third party representative to an employee-
based sales person and increased the number of domestic territories from 15 to 22 territories to improve the coverage
of our potential customer base. Additionally, we are now reimbursing expenses relative to our employee-based
direct sales force to travel, meet with, and market to directly to our customers. The salary component for our law
enforcement and commercial sales channel sales force and managers are included in selling, advertising and
promotional expenses. Such salary expenses are becoming a larger component of our overall selling expenses due to
the sales force reorganization. Sales commissions, salaries and reimbursed travel expenses paid to our employee-
based direct sales force are all components of our selling, advertising and promotional expenses.

Promotional and advertising expenses totaled $518,340 during the years ended December 31, 2012

compared to $302,052 during the year ended December 31, 2011, an increase of $216,288 (72%). The increase is
primarily attributable to media advertising in trade publications and participation in more trade shows. We have
decided to invest in significantly more written media for all of our products, as well as attending more trade shows
focused on both our commercial and law enforcement sales channels. Furthermore, we expect increases in expenses

for brochures and other marketing initiatives designed to help penetrate new commercial markets for our DVM-250
and DVM-250Plus event recorders and to introduce our new FirstVU HD, UltraVU, DVM-400 and the DVM-100
products to the law enforcement channel in 2013.

Stock-based compensation expense. Stock based compensation expense totaled $521,427 and $839,232
for the years ended December 31, 2012 and 2011, respectively, a decrease of $317,805 (38%). The decrease was
primarily attributable to stock options issued in January 2008 to officers and directors becoming fully vested in
January 2012 and the associated stock based compensation expense ceasing in December 2011.

Professional fees and expense. Professional fees and expenses totaled $657,818 and $740,894 for the
years ended December 31, 2012 and 2011, respectively, a decrease of $83,076 (11%). Professional fees during
2012 were related primarily to normal public company matters (including the reverse stock split), intellectual
property matters and litigation matters. The decrease is primarily attributable to the Company’s cost containment
measures coupled with the settlement of certain litigation. In addition, professional fees associated with the
litigation against a former contract manufacturer and Z3 have been classified separately as “Litigation charge and
related expenses” in the Statement of Operations for year ended December 31, 2012. We expect increased legal fees
regarding several patents and trademarks that have been or may be filed on our new products and litigation expense
in 2013.

Executive, sales and administrative staff payroll. Executive, sales and administrative staff payroll
expenses totaled $2,119,921 and $2,990,808 for the years ended December 31, 2012 and 2011, respectively, a
decrease of $870,887 (29%). This decrease is attributable to approximately $100,000 of severance costs we incurred
in first quarter 2011 as part of the cost containment initiative that did not recur in the twelve months ended
December 31, 2012. In January 2012, the Vice President of Marketing retired and the Vice President of Corporate
Development resigned and their responsibilities were assumed by the executive officers for a savings of
approximately $350,000 for the twelve months ended December 31, 2012. In June 2012, the Vice President of
Engineering resigned and his responsibilities were assumed by other engineering management for a savings of
approximately $90,000 for the twelve months ended December 31, 2012. In addition, we reduced the number of our
sales support staff during 2012 in connection with the restructuring of our sales and marketing organization.
Management anticipates the reduction in executive, sales and administrative payroll will continue during 2013 as the
full benefit of the headcount reductions is realized. However, such reductions may be offset partially because we
may find it necessary to hire additional technical support staff in 2013 to handle field inquiries as our installed
customer base continues to increase and additional technical support is required for our new products such as the
FirstVU HD, UltraVU, DVM-250, DVM-400, and DVM-100.

Litigation charge (credit) and related expenses. Litigation charges and expenses totaled $313,950 and

$-0- for the years ended December 31, 2012 and 2011, respectively, an increase of $313,950 (100%). The trial
against a former contract manufacturer began on September 24, 2012 and the parties agreed to a settle the lawsuit on
September 25, 2012. The insurance company involved agreed to pay $610,000 to settle the litigation. Legal fees
incurred for defense of the lawsuit were offset against the proceeds and the net settlement for this lawsuit was
$(466,400) at December 31, 2012. The Z3 trial began on June 25, 2012 and concluded with a jury verdict on July 3,
2012 that resulted in a net judgment against us in the amount of $85,000. Further, despite our arguments at trial, the
court also refused to reconsider the interlocutory summary judgment rulings rendered against us prior to trial in the
amount of $445,000 which became final upon conclusion of the trial. Accordingly, the total judgment entered
against us was $530,000. We believe there were a number of errors in the court's rulings and the judgment entered
on July 3, 2012 and are appealing them. We incurred $250,350 of additional legal fees during the year ended
December 31, 2012 to defend the Z3 lawsuit, which included the accrual of legal fees expected during the appeal
process.

Other. Other selling, general and administrative expenses totaled $2,439,172 and $2,819,004 for the years

ended December 31, 2012 and 2011, respectively, a decrease of $379,832 (14%). The decrease in 2012 was
attributable to our cost containment measures that generally reduced the cost of information technology, telephone
and internet services as we negotiated better contracts rates or moved to new service providers. We plan to continue
our cost containment initiatives in 2013 and expect that other selling, general and administrative costs will continue
to decline in 2013.

Operating Loss

For the reasons previously stated, our operating loss was $1,686,518 and $3,624,801 for the years ended

December 31, 2012 and 2011, respectively, an improvement of $1,938,283 (54%). Operating loss as a percentage of
revenues decreased to 10% in 2012 compared to 18% in 2011.

Interest Income

Interest income decreased to $10,088 in the year ended December 31, 2012 from $16,108 in 2011. The
decrease in interest income was a result of our decreased average cash balances and lower average interest rates
earned on such balances during the year ended December 31, 2012 compared to 2011.

Interest Expense

We incurred interest expense of $294,559 and $222,460 during the years ended December 31, 2012 and

2011, respectively. We issued a Note in the principal amount of $1.5 million during second quarter 2011, the
proceeds of which were used to repay the outstanding line of credit. We issued another Note in the principal amount
of $1.0 million in fourth quarter 2011 and extended the maturity date of the first Note such that both Notes are due
and payable in full on May 30, 2013. In July 2012 we extended the maturity dates of the Notes from May 2013 to
May 30, 2014. The outstanding principal balance on our Notes was $2.5 million as of December 30, 2012, less the
unamortized discount of $96,378.

Loss on Debt Extinguishment

During November 2011, we extended the maturity date of the $1.5 million Note issued in May 2011 and
issued a second Note for $1.0 million under the same terms. The modification of the original Note payable was
treated as an early extinguishment of the debt. Accordingly, the remaining unamortized discount as of the date of
modification ($131,093), was charged off and reflected as a loss on extinguishment of debt in the Statement of
Operations. The Note was restructured again in July 2012 and it was determined this modification was not an early
extinguishment of debt and the remaining unamortized discount of the note payable will be amortized to interest
expense ratably over the modified terms of the Notes.

Loss before Income Tax Benefit

As a result of the above, we reported a loss before income tax benefit of $1,970,989 and $3,962,246 for the

years ended December 31, 2012 and 2011, respectively, an improvement of $1,991,257 (50%).

Income Tax Benefit

We recorded no income tax benefit related to our losses for the years ended December 31, 2012 and 2011,

respectively, due to our decision to continue providing a full valuation reserve on our net deferred tax assets as of
December 31, 2012 and 2011, respectively. During 2012, we increased our valuation reserve on deferred tax assets
by $565,000 whereby our deferred tax assets continue to be fully reserved due to our recent operating losses. We
had approximately $7,800,000 of net operating loss carryforwards and $1,083,000 of research and development tax
credit carryforwards as of December 31, 2012 available to offset future net taxable income.

Net Loss

As a result of the above, for the years ended December 31, 2012 and 2011, we reported net losses of

$1,970,989 and $3,962,246, respectively, an improvement of $1,991,257 (50%).

Basic and Diluted Loss per Share

The basic and diluted loss per share was $0.97 and $1.96 for the years ended December 31, 2012 and 2011,

respectively, for the reasons previously noted. All outstanding stock options were considered antidilutive and
therefore excluded from the calculation of diluted loss per share for the years ended December 31, 2012 and 2011
because of the net loss reported for each period.

Liquidity and Capital Resources

Overall: On May 31, 2011, we borrowed $1.5 million under an unsecured credit facility with a private,

third-party lender. On November 7, 2011, we borrowed an additional $1.0 million under an unsecured credit facility
with the same private, third party lender. The loans are represented by two promissory notes (the "Notes") that bear
interest at the rate of 8% per annum and are payable interest only on a monthly basis. The Notes are subordinated to
all existing and future senior indebtedness; as such term is defined in the Notes. On July 24, 2012, we entered into
an agreement with the lender that extended the maturity dates of both of the Notes from May 30, 2013 to May 30,
2014.

The existing Notes are unsecured and do not prevent us from obtaining new senior secured financings. We

may seek additional credit facilities to complement the Notes and provide us with funding should the need arise to
finance growth or other expenditures.

We had over $700,000 of available cash and equivalents and net working capital of approximately $8.9

million as of December 31, 2012. Net working capital as of December 31, 2012 includes approximately $3.0 million
of accounts receivable and $7.3 million of inventory. Management believes that it can achieve reduced inventory
levels into 2013 to provide funding for operations; however no assurances can be given in that regard.

We do not consider raising capital through an equity offering to be a viable alternative to supplement
working capital needs, given our current public equity valuation. However, we may find it necessary to raise
additional capital if we do not regain profitability during 2013, are unable to improve liquidity through a reduction
in our inventory and accounts receivable levels in the near term, add to our existing credit facilities, and do not have
other means to support our planned operating activities. Our ability to obtain such capital, if required, could have a
material adverse impact on our business, operations and financial condition, including our ability to continue
operating as a going concern. Further such capital, if available, most likely would not be on terms favorable to us
and our shareholders.

Cash and cash equivalents balances: As of December 31, 2012, we had cash and cash equivalents with

an aggregate balance of $703,172, a decrease from a balance of $2,270,393 at December 31, 2011. Summarized
immediately below and discussed in more detail in the subsequent subsections are the main elements of the
$1,567,221 net decrease in cash during the year ended December 31, 2012:

• Operating activities: $440,972 of net cash used in operating activities. Net cash used in operating

activities was $440,972 for the year ended December 31, 2012 compared to net
cash provided by operating activities of $945,519 for the year ended December
31, 2011, a deterioration of $1,386,491. The deterioration in cash flow from
operations for 2012 was primarily the result of our net losses and increases in
inventory and accounts receivable.

•

Investing activities: $1,078,093 of net cash used in investing activities. Cash used in investing

activities was $1,078,093 and $151,101 for the years ended December 31, 2012
and 2011, respectively. During 2012, we consolidated our operations into one
new location which resulted in capital expenditures for new furniture, fixtures,
and equipment. During 2012 and 2011, we also incurred costs for patent
applications on our proprietary technology utilized in our new products and
included in intangible assets. In July, 2012, we were required to post a
supersedeas bond in the amount of $662,500 to stay the execution of a judgment
entered against the Company and appeal the decision.

• Financing activities: $48,156 of net cash used in financing activities. Cash used in financing

activities was $48,156 for the year ended December 31, 2012 compared to net
cash provided by financing activities of $852,500 for the year ended December
31, 2011, a deterioration of $900,656. During the year ended December 31,
2012, we acquired capital equipment financed through capital lease obligations
and payments on such obligations represented the cash used in financing
activities. During the year ended December 31, 2011, we issued subordinated
Notes in the aggregate principal amount of $2.5 million, the proceeds of which
were used to repay the $1,500,000 outstanding balance on our bank line of credit
and to provide working capital. We paid $147,500 of debt issuance costs related
to the Notes issued during 2011

The net result of these activities was a decrease in cash of $1,567,221 to $703,172 for the year ended

December 31, 2012.

Commitments:

We had $703,172 of cash and cash equivalent balances and net positive working capital approximating $8.9

million as of December 31, 2012. Accounts receivable balances represented $2,956,654 of our net working capital
at December 31, 2012. We intend to collect our outstanding receivables on a timely basis and reduce the overall
level during 2013, which would help to provide positive cash flow to support our operations during 2013. Inventory
represented $7,294,721 of our net working capital at December 31, 2012 and finished goods represented $5,050,572
of total inventory. We expect that finished goods will be converted to cash when customer orders are received and
shipments occur during 2013. We are actively managing the overall level of inventory and believe that such levels
will be reduced during 2013 by our sales activities, which should provide additional cash flow to help support our
operations during 2013.

Capital Expenditures. We had commitments for capital expenditures to various contractors who provided

leasehold improvements, furniture and equipment for our new facility that we moved to in late 2012. Such
commitments for capital expenditures totaled $306,975 at December 31, 2012.

Lease commitments-Operating Leases. We have several non-cancelable operating lease agreements for

office space and warehouse space that expire at various dates through April 2020. In September 2012, the Company
entered into a non-cancelable long-term facility lease to combine all of their operations into one location effective
November 2012. We have also entered into month-to-month leases for equipment and facilities. Rent expense for
the years ended December 31, 2012 and 2011 was $405,234 and $383,530, respectively, related to these leases. We
paid a security deposit in conjunction with the new facility lease in September 2012 in the amount of $116,888. As
reflected in the table below, we have a rent holiday and discounted rent for the first 12 months of the new facility
lease, which was effective November 1, 2012.

Year ending December 31:

$ 172,595
428,505
433,965
439,707
1,508,155
$ 2,982,927

License agreements. We have several license agreements whereby we have been assigned the rights to

certain licensed materials used in its products. Certain of these agreements require us to pay ongoing royalties based
on the number of products shipped containing the licensed material on a quarterly basis. Royalty expense related to
these agreements aggregated $35,785 and $19,909 for the years ended December 31, 2012 and 2011, respectively.

Following is a summary of our licenses as of December 31, 2012:

License Type

Production software license
agreement

Effective
Date

Expiration
Date

April 2005

April 2013

Terms

Automatically renews for one year periods unless
terminated by either party.

Software sublicense agreement

October 2007

October 2013 Automatically renews for one year periods unless

Technology license agreement

July 2007

July 2013

Development, license and
manufacturing agreement

July 2011

July 2016

terminated by either party.

Automatically renews for one year periods unless
terminated by either party.

Company has option to renew for three successive
options to renew for three years periods unless
terminated by either party.

Limited license agreement

August 2008

Perpetual

May be terminated by either party.

Supply and distribution agreement. We entered into a supply and distribution agreement on May 1, 2010

under which we were granted the exclusive worldwide right to sell and distribute a proprietary law enforcement
speed measurement device and derivatives to its customers. The term of the agreement was 42 months after the
date the supplier began full scale production of the product which commenced in August 2010 and final certification
of the product was obtained. The agreement had minimum purchase requirements of 1,000 units per period over
three commitment periods. On January 31, 2012, the parties amended the supply and distribution agreement to
reduce the minimum purchase commitments over the second and third years by 52% from the original commitment.
We also agreed to terminate our world wide right to exclusively market the products to the law enforcement
community in exchange for the reduction in the purchase commitment.

After the initial term has expired, the parties may continue on a month-to-month basis and is terminable by

either party upon thirty days advance notice. The contract may be terminated earlier in case of material breach by
either party that is not cured within thirty days of notice of the breach.

The agreement contains required minimum order quantities and fixed prices per unit according to the

following schedule:

Minimum order commitment amount ($)

Commitment time period

March 2012 through February 2013 .............................
March 2012 through February 2014 .............................

Commitment
$ 846,240
846,240

Purchases
$ 705,200
—

Remaining
Commitment
$ 141,040

846,240

$ 1,692,480

$ 705,200

$ 987,280

The above table reflects the modified terms of the amended supply and distribution agreement. The

supplier is responsible for all warranty, damage or other claims, losses or liabilities related to the product and is
obligated to defend and indemnify us against such risks. The Company held approximately $1,535,000 of such
products in finished goods inventory as of December 31, 2012 and have sold approximately 500 units since the
beginning of the agreement through December 31, 2012.

Litigation.

On June 8, 2009, we filed suit against Z3 in the U.S. District Court for the District of Kansas claiming breach

of a production software license agreement entered into during October 2008 and the rescission of a second limited
license agreement entered into during January 2009. Among other claims, we asserted that Z3 failed to deliver the
material required under the contracts; that the product that was delivered by Z3 was defective and/or unusable; and
that the January 2009 contract should be rescinded and declared void, unenforceable and of no force or effect. We
paid license fees and made other payments to Z3 totaling $265,000 to-date under these contracts. Z3 denied our
claims and filed counterclaims that allege we did not have the right to terminate the contracts and therefore that it
was damaged for loss of profits and related damages. In those counterclaims, Z3 sought to recover approximately
$4.5 million from us exclusive of “prejudgment interest”. Our insurance carrier settled a portion of the
counterclaims under our director and officer liability insurance policy. The counterclaims that were not resolved by
that settlement remained in controversy.

The trial of those claims began on June 25, 2012 and concluded with a jury verdict on July 3, 2012. The

We believe there are a number of errors in the court’s rulings and the judgment entered on July 3, 2012 and
are appealing them. We accrued the $530,000 judgment entered against us as a long term liability as of December
31, 2012 due to the expected time required to conclude the appeal process. We have charged $780,350 to operations
during the twelve months ended December 31, 2012 as litigation charge and related expenses. Such charges include
the $530,000 judgment and all related legal fees and expenses incurred and accrued during the twelve months ended
December 31, 2012. We have also accrued the legal fees expected to be incurred during the appeal process. In order
to stay the execution of judgment during the appeal process, we were required to post a bond in the amount of
$662,500 in July 2012 and the respective funds will be reflected as restricted cash in future balance sheets until such
time as the bond is no longer required.

401 (k) Plan. We sponsor a 401(k) retirement savings plan for the benefit of our employees. The plan, as

amended, requires us to provide 100% matching contributions for employees who elect to contribute up to 3% of
their compensation to the plan and 50% matching contributions for employee’s elective deferrals on the next 2% of
their contributions. We made matching contributions totaling $108,312 and $121,745 for the years ended December
31, 2011 and 2010, respectively. Each participant is 100% vested at all times in employee and employer matching
contributions.

Stock Repurchase Program. During June 2008, our Board of Directors approved a program that
authorized the repurchase of up to $10 million of our common stock in the open market, or in privately negotiated
transactions, through July 1, 2010. Our Board of Directors approved an extension of this program to July 1, 2012,
which terminated at such point. We made no purchases under this program during the years ended December 31,
2012 and 2011. The Company has repurchased 63,518 shares at a total cost of $2,157,226 (average cost of $33.96
per share) under this program from inception to December 31, 2012.

Critical Accounting Policies

Our significant accounting policies are summarized in note 1 to our consolidated financial statements

included in Item 1, “Financial Statements”, of this report. While the selection and application of any accounting
policy may involve some level of subjective judgments and estimates, we believe the following accounting policies
are the most critical to our financial statements, potentially involve the most subjective judgments in their selection
and application, and are the most susceptible to uncertainties and changing conditions:

•

Revenue Recognition/ Allowance for Doubtful Accounts;

Allowance for Excess and Obsolete Inventory;

Warranty Reserves;

•

Stock-based Compensation Expense; and

Accounting for Income Taxes.

Revenue Recognition / Allowances for Doubtful Accounts. Revenue is recognized for the shipment of

products or delivery of service when all four of the following conditions are met:

(i)

Persuasive evidence of an arrangement exists;

(ii) Delivery has occurred;

(iii) The price is fixed or determinable; and

(iv) Collectability is reasonably assured.

We review all significant, unusual or nonstandard shipments of product or delivery of services as a routine

part of our accounting and financial reporting process to determine compliance with these requirements.

Our principal customers are state, local and federal law enforcement agencies, which historically have been
low risks for uncollectible accounts. However, we do have commercial customers and international distributors that
present a greater risk for uncollectible accounts than such law enforcement customers and we consider a specific
reserve for bad debts based on their individual circumstances. Our historical bad debts have been negligible with
less than $130,000 charged off as uncollectible on cumulative revenues of $144.9 million since we commenced
deliveries during 2006. As of December 31, 2012 and December 31, 2011, we recorded a reserve for doubtful
accounts of $70,193 and $110,000, respectively.

We periodically perform a specific review of significant individual receivables outstanding for risk of loss
due to uncollectibility. Based on our specific review, we consider our reserve for doubtful accounts to be adequate
as of December 31, 2012. However, should the balance due from any significant customer ultimately become
uncollectible then our allowance for bad debts will not be sufficient to cover the charge-off and we will be required
to record additional bad debt expense in our statement of operations.

Allowance for Excess and Obsolete Inventory. We record valuation reserves on our inventory for
estimated excess or obsolete inventory items. The amount of the reserve is equal to the difference between the cost
of the inventory and the estimated market value based upon assumptions about future demand and market
conditions. On a quarterly basis, management performs an analysis of the underlying inventory to identify reserves
needed for excess and obsolescence. Management uses its best judgment to estimate appropriate reserves based on
this analysis. In addition, we adjust the carrying value of inventory if the current market value of that inventory is
below its cost.

Inventories consisted of the following at December 31, 2012 and December 31, 2011:

Raw material and component parts .........................
Work-in-process ......................................................
Finished goods ........................................................

Subtotal ...........................................................
Reserve for excess and obsolete inventory .............

Total ................................................................

December 31,
2012
$ 2,475,857

145,622

5,050,572

December 31,
2011
$ 2,168,761
217,264
4,844,446

7,672,051
(377,330)
$ 7,294,721

7,230,471
(547,182)

$ 6,683,289

We balance the need to maintain strategic inventory levels to ensure competitive delivery performance to
our customers against the risk of inventory obsolescence due to changing technology and customer requirements.
As reflected above, our inventory reserves represented 4.9% of the gross inventory balance at December 31, 2012,
compared to 7.6% of the gross inventory balance at December 31, 2011. Finished goods at December 31, 2012 are
composed primarily of the Laser Ally and the DVM-500Plus products, which will be used to fulfill international and
domestic orders during 2013. Finished goods also included supplies of our newer products, including the FirstVU,
DVM-250, DVM-400 and DVM-100 at December 31, 2012. Raw material and component part inventory balances
were increased at December 31, 2012 compared to December 31, 2011, as we moved our assembly operations and

warehousing to a new location in late November 2012. We experienced some expected delays in ramping up our
assembly operations as a result of the move which lead to the increased levels in raw materials at December 31,
2012. We believe that our obsolescence risk was less at December 31, 2012 compared to December 31, 2011
because our management team made a concerted effort in 2012 to scrap unusable parts from the older versions of
our products. Therefore, previously reserved obsolete parts were disposed of during 2012 and were applied to our
reserve balance. We believe the reserves are appropriate given our inventory levels at December 31, 2012.

If actual future demand or market conditions are less favorable than those projected by management or

significant engineering changes to our products that are not anticipated and appropriately managed, additional
inventory write-downs may be required in excess of the inventory reserves already established.

Warranty Reserves. We generally provide up to a two-year parts and labor warranty on our products to our

customers. Provisions for estimated expenses related to product warranties are made at the time products are sold.
These estimates are established using historical information on the nature, frequency, and average cost of claims.
We actively study trends of claims and take action to improve product quality and minimize claims. Our warranty
reserves were decreased to $173,385 as of December 31, 2012 compared to $211,421 as of December 31, 2011,
which reflects the decreased number of units under warranty and the resolution of the wireless transfer module
failures experienced in 2012. Our new DVM-750 product failure rate has improved significantly during 2011 and
2012, which has contributed to the relatively stable level of warranty reserves. We have introduced several new
products, including the FirstVU, Laser Ally, DVM-100, DVM-400, DVM-250 and Thermal Ally, for which we have
limited exposure since the third party manufacturers of these products are responsible for all warranty claims. There
is a risk that we will have higher warranty claim frequency rates and average cost of claims than our history has
indicated on our legacy mirror products. Actual experience could differ from the amounts estimated requiring
adjustments to these liabilities in future periods.

Stock-based Compensation Expense. We grant stock options to our employees and directors and such

benefits provided are share-based payment awards which require us to make significant estimates related to
determining the value of our share-based compensation. Our expected stock-price volatility assumption is based on
historical volatilities of the underlying stock which are obtained from public data sources. We granted 141,375
options during the year ended December 31, 2012. The assumptions used for determining the grant-date fair value
of options granted during the year ended December 31, 2012 are reflected in the following table:

Expected term of the options in years ............

Expected volatility of Company stock ...........

Expected dividends ........................................

Risk-free interest rate ....................................

Expected forfeiture rate .................................

Year ended
December 31, 2012

2-5 years

66% - 73%

None

0.24% - .64%

5% - 75%

If factors change and we develop different assumptions in future periods, the compensation expense that we

record in the future may differ significantly from what we have recorded in the current period. There is a high
degree of subjectivity involved when using option pricing models to estimate share-based compensation. Changes
in the subjective input assumptions can materially affect our estimates of fair values of our share-based
compensation. Certain share-based payment awards, such as employee stock options, may expire worthless or
otherwise result in zero intrinsic value compared to the fair values originally estimated on the grant date and
reported in our financial statements. Alternatively, values may be realized from these instruments that are
significantly in excess of the fair values originally estimated on the grant date and reported in our financial
statements. Although the fair value of employee share-based awards is determined using an established option
pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market
transaction.

In addition, we are required to net estimated forfeitures against compensation expense. This requires us to

estimate the number of awards that will be forfeited prior to vesting. If actual forfeitures in future periods are
different than our initial estimate, the compensation expense that we ultimately record may differ significantly from
38

what was originally estimated. The estimated forfeiture rate for unvested options outstanding as of December 31,
2012 range from 5% to 75%.

Accounting for Income Taxes. Accounting for income taxes requires significant estimates and judgments

on the part of management. Such estimates and judgments include, but are not limited to, the effective tax rate
anticipated to apply to tax differences that are expected to reverse in the future, the sufficiency of taxable income in
future periods to realize the benefits of net deferred tax assets and net operating losses currently recorded and the
likelihood that tax positions taken in tax returns will be sustained on audit.

As required by authoritative guidance, we record deferred tax assets or liabilities based on differences

between financial reporting and tax bases of assets and liabilities using currently enacted rates that will be in effect
when the differences are expected to reverse. Authoritative guidance also requires that deferred tax assets be
reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will
not be realized. As of December 31, 2011, cumulative valuation allowances in the amount of $5,830,000 were
recorded in connection with the net deferred income tax assets. Based on a review of our deferred tax assets and
recent operating performance, we determined that our valuation allowance should be increased to $6,395,000 to
fully reserve our deferred tax assets at December 31, 2012. We determined that it was appropriate to continue to
provide a full valuation reserve on our net deferred tax assets as of December 31, 2012 because of the losses we
incurred during the year ended December 31, 2012. We expect to continue to maintain a full valuation allowance
until we determine that we can sustain a level of profitability that demonstrates our ability to realize these assets. To
the extent we determine that the realization of some or all of these benefits is more likely than not based upon
expected future taxable income, a portion or all of the valuation allowance will be reversed. Such a reversal would
be recorded as an income tax benefit and, for some portion related to deductions for stock option exercises, an
increase in shareholders' equity.

As required by authoritative guidance, we have performed a comprehensive review of our portfolio of

uncertain tax positions in accordance with recognition standards established by the FASB, an uncertain tax position
represents our expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax
return, that has not been reflected in measuring income tax expense for financial reporting purposes. We have no
recorded liability as of December 31, 2012 representing uncertain tax positions.

We have generated substantial deferred income tax assets related to our operations primarily from the
charge to compensation expense taken for stock options, certain tax credit carryforwards and net operating loss
carryforwards. For us to realize the income tax benefit of these assets, we must generate sufficient taxable income
in future periods when such deductions are allowed for income tax purposes. In some cases where deferred taxes
were the result of compensation expense recognized on stock options, our ability to realize the income tax benefit of
these assets is also dependent on our share price increasing to a point where these options have intrinsic value at
least equal to the grant date fair value and are exercised. In assessing whether a valuation allowance is needed in
connection with our deferred income tax assets, we have evaluated our ability to generate sufficient taxable income
in future periods to utilize the benefit of the deferred income tax assets. We continue to evaluate our ability to use
recorded deferred income tax asset balances. If we fail to generate taxable income for financial reporting in future
years, no additional tax benefit would be recognized for those losses, since we will not have accumulated enough
positive evidence to support our ability to utilize net operating loss carryforwards in the future. Therefore we may
be required to increase our valuation allowance in future periods should our assumptions regarding the generation of
future taxable income not be realized.

Inflation and Seasonality

Inflation has not materially affected us during the past fiscal year. We do not believe that our business is

seasonal in nature however; generally we generate higher revenues during the second half of the calendar year
compared to the first half.

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 8.

Financial Statements and Supplementary Data.

The financial statements of the Company are included as an exhibit to this annual report on Form 10-K

commencing on page F-1.

Item 9.

Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure.

None.

Item 9A.

Controls and Procedures.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive

officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of
our disclosure controls and procedures to provide reasonable assurance of achieving the control objectives, as
defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. Based on their evaluation as of
December 31, 2012, the end of the period covered by this Annual Report on Form 10-K, our principal executive
officer and principal financial officer concluded that our disclosure controls and procedures were effective at a
reasonable assurance level to ensure that the information required to be disclosed in reports filed or submitted under
the Securities Exchange Act of 1934, including this Annual Report, were recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms, and was accumulated and communicated to
management, including our principal executive officer and principal financial officer, as appropriate to allow timely
decisions regarding required disclosure.

Management's Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial
reporting. Our internal control over financial reporting is designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those policies and procedures that:

• Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the

transactions and dispositions of our assets;

• Provide reasonable assurance that the transactions are recorded as necessary to permit preparation of

financial statements in accordance with generally accepted accounting principles, and that our receipts
and expenditures are being made only in accordance with authorizations of our management and
directors; and

• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use

or disposition of our assets that could have a material effect on the financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those

systems determined to be effective can provide only reasonable assurance with respect to financial statement
preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the
risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the
policies or procedures may deteriorate.

In connection with the filing of this annual report on Form 10-K, our management assessed the
effectiveness of our internal control over financial reporting as of December 31, 2012. In making this assessment,
our management used the criteria set forth by Committee of Sponsoring Organizations of the Treadway Commission
in Internal Control—Integrated Framework. Based on our assessment using those criteria, management believes
that, as of December 31, 2012, our internal control over financial reporting is effective.

This annual report does not include an attestation report of our registered public accounting firm regarding

internal control over financial reporting. Management’s report was not subject to attestation by the Company’s
registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that
permit us to provide only management’s report in this annual report.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal controls over financial reporting during the year ended
December 31, 2012, that have materially affected, or are reasonably likely to materially affect, our internal controls
over financial reporting.

Item 9B.

Other Information.

None.

Item 10.

Directors, Executive Officers and Corporate Governance.

PART III

Information with respect to our directors and executive officers, is incorporated herein by reference to our
definitive proxy statement, to be filed no later than 120 days after December 31, 2012 (our 2013 Proxy Statement).

Information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934, as

amended, is incorporated herein by reference to our 2013 Proxy Statement.

Information with respect to our code of business conduct and ethics is incorporated herein by reference to

our 2013 Proxy Statement.

Information with respect to our corporate governance disclosures is incorporated herein by reference to our

2013 Proxy Statement.

Item 11.

Executive Compensation.

Information with respect to the compensation of our executive officers and our directors is incorporated

herein by reference to our 2013 Proxy Statement.

Item 12.

Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters.

Information with respect to security ownership of certain beneficial owners and management and related

stockholder matters, is incorporated herein by reference to our 2013 Proxy Statement.

Item 13. Certain Relationships and Related Transactions, and Director Independence.

Information with respect to certain relationships and related transactions, and director independence is

incorporated herein by reference to our 2013 Proxy Statement.

Item 14.

Principal Accounting Fees and Services.

Information with respect to the fees paid to and services provided by our principal accountants is

incorporated herein by reference to our 2013 Proxy Statement.

Item 15. Exhibits, Financial Statement Schedules.

PART IV

(a)

The following documents are filed as part of this annual report on Form 10-K:

Consolidated Financial Statements:

The consolidated financial statements required to be included in Part II, Item 8, Financial
Statements and Supplementary Data, begin on Page F-1 and are submitted as a separate section of
this annual report.

Financial Statement Schedules:

All schedules are omitted because they are not applicable or are not required, or because the
required information is included in the consolidated financial statements or notes in this annual
report.

Filed
Herewith

Exhibits:

Exhibit
Number
2.1

3.1

3.2
3.3
3.4

3.5

3.6

3.7

3.8

3.9

4.1
4.2
5.1

10.1

10.2

10.3

10.4

10.5

10.6

10.7

10.8

10.9

10.10

10.11

10.12

10.13

Description
Plan of Merger among Vegas Petra, Inc., a Nevada corporation, and
Digital Ally, Inc., a Nevada corporation, and its stockholders, dated
November 30, 2004.
Amended and Restated Articles of Incorporation of Registrant, dated
December 13, 2004.
Amended and Restated By-laws of Registrant.
Audit Committee Charter, dated September 22, 2005.
Compensation Committee Charter, dated September 22, 2005

Nominating Committee Charter dated December 27, 2007.

Corporate Governance Guidelines

Nominating and Governance Charter, Amended and Restated as of
February 25, 2010.

Strategic Planning Committee Charter, dated June 28, 2009.

Certificate of Change Pursuant to NRS 78.209 of Digital Ally, Inc.

Form of Common Stock Certificate.
Form of Common Stock Purchase Warrant.
Opinion of Quarles & Brady LLP as to the legality of securities being
registered (includes consent).
2005 Stock Option and Restricted Stock Plan.

2006 Stock Option and Restricted Stock Plan.

Form of Stock Option Agreement (ISO and Non-Qualified) 2005
Stock Option Plan.
Form of Stock Option Agreement (ISO and Non-Qualified) 2006
Stock Option Plan.
Promissory Note Extension between Registrant and Acme Resources,
LLC, dated May 4, 2006, in the principal amount of $500,000.
Promissory Note between Registrant and Acme Resources, LLC,
dated September 1, 2004, in the principal amount of $500,000.

Promissory Note Extension between Registrant and Acme Resources,
LLC, dated October 31, 2006.
Software License Agreement with Ingenient Technologies, Inc.,
dated March 15, 2004.*
Software License Agreement with Ingenient Technologies, Inc.,
dated April 5, 2005.*
Stock Option Agreement with Daniels & Kaplan, P.C., dated
September 25, 2006.
Memorandum of Understanding with Tri Square Communications
(Hong Kong) Co., Ltd. dated November 29, 2005.
2007 Stock Option and Restricted Stock Plan.

Form of Stock Option Agreement (ISO and Non-Qualified) 2007
Stock Option Plan.

10.14

Amendment to 2007 Stock Option and Restricted Stock Plan.

10.15

2008 Stock Option and Restricted Stock Plan.

10.16

Form of Stock Option Agreement (ISO and Non-Qualified) 2008
Stock Option Plan.

Incorporated by Reference to:
Exhibit 2.1 of the Company’s Form SB-2,
filed October 16, 2006, No. 333-138025
(the “October 2006 Form SB-2).
Exhibit 3.1 of the October 2006 Form SB-2.

Exhibit 3.2 of the October 2006 Form SB-2.
Exhibit 3.3 of the October 2006 Form SB-2.
Exhibit 3.4 of the October 2006 Form SB-2.

Exhibit 3.5 of the Annual Report on Form
10KSB for the Year ending December 31,
2007.
Exhibit 99.1 of the Current Report on Form
8-K dated November 20, 2009.
Exhibit 3.7 of the Annual Report on Form
10K for the Year ending December 31,
2009.
Exhibit 3.8 of the Annual Report on Form
10K for the Year ending December 31,
2009.
Exhibit 3.1 to Form 8-K filed August 30,
2012.
Exhibit 4.1 of the October 2006 Form SB-2.
Exhibit 4.2 of the October 2006 Form SB-2.
Exhibit 5.1 of the October 2006 Form SB-2.

Exhibit 10.1 of the October 2006 Form SB-
2.
Exhibit 10.2 of the October 2006 Form SB-
2.
Exhibit 10.3 of the October 2006 Form SB-
2.
Exhibit 10.4 of the October 2006 Form SB-
2.
Exhibit 10.5 of the October 2006 Form SB-
2.
Exhibit 10.6 of the Company’s Amendment
No. 1 to Form SB-2, filed January 31, 2007,
No. 333-138025 (“Amendment No. 1 to
Form SB-2”)
Exhibit 10.7 of Amendment No. 1 to Form
SB-2.
Exhibit 10.8 of Amendment No. 1 to Form
SB-2.
Exhibit 10.9 of Amendment No. 1 to Form
SB-2.
Exhibit 10.10 of Amendment No. 1 to Form
SB-2.
Exhibit 10.11 of Amendment No. 1 to Form
SB-2.
Exhibit 10.3 of the Company’s Form S-8,
filed October 23, 2007, No. 333-146874.
Exhibit 10.13 of the Annual Report on
Form 10KSB for the Year ending December
31, 2007.
Exhibit 10.14 of the Annual Report on
Form 10KSB for the Year ending December
31, 2007.
Exhibit 10.15 of the Annual Report on
Form 10KSB for the Year ending December
31, 2007.
Exhibit 10.16 of the Annual Report on
Form 10KSB for the Year ending December

10.18

10.19

10.20

10.21

10.22

10.23

10.24

10.25

10.26

10.27

10.28

10.29

10.30

10.31

10.32

10.33

10.34

14.1

23.1
23.2
24.1
31.1

31.2

32.1

32.2

99.1

10.17

Promissory Note with Enterprise Bank dated February 13, 2009.

First Amendment to Promissory Note with Enterprise Bank dated
February 13, 2009.

First Amendment to Promissory Note with Enterprise Bank dated
June 30, 2009.

Modification and Renewal of Promissory Note with Enterprise Bank
dated February 1, 2010.

Forms of Restricted Stock Agreement for 2005, 2006, 2007 and 2008
Stock Option and Restricted Stock Plans.

Loan Modification or Renewal Agreement of Promissory Note with
Enterprise Bank dated March 2, 2011.

2011 Stock Option and Restricted Stock Plan

31, 2007.
Exhibit 10.17 of the Annual Report on
Form 10KSB for the Year ending December
31, 2007.
Exhibit 10.18 of the Annual Report on
Form 10K for the Year ending December
31, 2008.
Exhibit 10.19 of the Quarterly Report on
Form 10Q for the Quarter ending June 30,
2008.
Exhibit 10.20 of the Annual Report on
Form 10K for the Year ending December
31, 2009.
Exhibit 10.21 of the Annual Report on
Form 10K for the Year ending December
31, 2009.
Exhibit 10.22 of the Annual Report on
Form 10K for the Year ending December
31, 2010.
Exhibit 10.23 to Form 8-K filed June 1,
2011
Exhibit 10.24 to Form 8-K filed June 1,
2011

Form of Stock Option Agreement for 2011 Stock Option and
Restricted Stock Plan
8% Subordinated Promissory Note in principal amount of $1,500,000 Exhibit 10.25 to Form 8-K filed June 3,

Common Stock Purchase Warrant

2011
Exhibit 10.26 to Form 8-K filed June 3,
2011

8% Subordinated Promissory Note in principal amount of $1,000,000 Exhibit 10.27 to Form 8-K filed November

Common Stock Purchase Warrant

Allonge to 8% Subordinated Promissory Note in principal amount of
$1,000,000
Amendment to Common Stock Purchase Warrant

Second Allonge to 8% Subordinated Note, dated July 24, 2012.

Allonge to 8% Subordinated Note ($1.0 million) dated July 24, 2012.

Second Amendment to Common Stock Purchase Warrants (300,000
shares) dated July 24, 2012.
Amendment to Common Stock Purchase Warrants (150,000 shares)
dated July 24, 2012.
Code of Ethics and Code of Conduct.

21.1

Subsidiaries of Registrant

Consent of Grant Thornton LLP
Consent of Quarles & Brady LLP (Included in 5.1 above)
Power of Attorney.
Certificate of Stanton E. Ross, Chief Executive Officer, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Certificate of Thomas J. Heckman, Chief Financial Officer, pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
Certificate of Stanton E. Ross, Chief Executive Officer, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
Certificate of Thomas J. Heckman, Chief Financial Officer, pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
Audited Financial Statements of Digital Ally, Inc. as of and for the
years ended December 31, 2012 and 2011.
XBRL Instance Document.

101.INS**
101.SCH** XBRL Taxonomy Extension Schema Document
101.CAL** XBRL Taxonomy Calculation Linkbase Document.
101.LAB** XBRL Taxonomy Labels Linkbase Document.

10, 2011
Exhibit 10.28 to Form 8-K filed November
10, 2011
Exhibit 10.29 to Form 8-K filed November
10, 2011
Exhibit 10.30 to Form 8-K filed November
10, 2011
Exhibit 10.31 to Form 8-K filed July 30,
2012
Exhibit 10.31 to Form 8-K filed July 30,
2012
Exhibit 10.31 to Form 8-K filed July 30,
2012
Exhibit 10.31 to Form 8-K filed July 30,
2012
Exhibit 3.5 of the Annual Report on Form
10KSB for the Year ending December 31,
2007.
Exhibit 21.1 of the Annual Report on Form
10K for the Year ending December 31,
2009.

Exhibit 5.1 of the October 2006 Form SB-2.

X
X

101.PRE** XBRL Taxonomy Presentation Linkbase Document.

* Information marked [*] has been omitted pursuant to a Confidential Treatment Request filed with the Securities and Exchange Commission.
Omitted material for which confidential treatment has been granted has been filed separately with the Securities and Exchange Commission.

** The XBRL related information in Exhibit 101 to this annual report on Form 10-K shall not be deemed "filed" for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended, or otherwise subject to liability of that Section and shall not be incorporated by reference into any
filing or other document pursuant to the Securities Act of 1933, as amended, except as shall be expressly set forth by specific reference in such
filing or document.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant

has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DIGITAL ALLY, INC.,
a Nevada corporation

By:

/s/ STANTON E. ROSS
Stanton E. Ross
President and Chief Executive Officer

Each person whose signature appears below authorizes Stanton E. Ross to execute in the name of each such

person who is then an officer or director of the registrant, and to file, any amendments to this Annual Report on
Form 10-K necessary or advisable to enable the registrant to comply with the Securities Exchange Act of 1934 and
any rules, regulations and requirements of the Securities and Exchange Commission in respect thereof, which
amendments may make such changes in such Report as such attorney-in-fact may deem appropriate.

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

Signature and Title

/s/ STANTON E. ROSS
Stanton E. Ross, Director and Chief Executive Officer

/s/ LEROY C. RICHIE
Leroy C. Richie, Director

/s/ ELLIOT M. KAPLAN
Elliot M. Kaplan, Director

/s/ DANIEL F. HUTCHINS
Daniel F. Hutchins, Director

/s/ BERNARD A. BIANCHINO
Bernard A. Bianchino, Director

/s/ STEPHEN GANS
Stephen Gans, Director

/s/ STEVEN PHILLIPS
Steven Phillips, Director

/s/ THOMAS J. HECKMAN
Thomas J. Heckman, Chief Financial Officer, Secretary, Treasurer and
Principal Accounting Officer

Date

March 27, 2013

DIGITAL ALLY, INC. AND SUBSIDIARY

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Page(s)

Report of Independent Registered Public Accounting Firm ........................................

F-2

Consolidated Financial Statements:

Consolidated Balance Sheets – December 31, 2012 and 2011 ..................................

F-3

Consolidated Statements of Operations for the Years Ended

December 31, 2012 and 2011 ................................................................................

Consolidated Statements of Stockholders’ Equity for the Years Ended

December 31, 2012 and 2011 ................................................................................

Consolidated Statements of Cash Flows for the Years Ended

December 31, 2012 and 2011 ...............................................................................

F-4

F-5

F-6

Notes to the Consolidated Financial Statements ..........................................................

F-7 - F-24

Report of Independent Registered Public Accounting Firm

To the Board of Directors
Digital Ally, Inc.

We have audited the accompanying consolidated balance sheets of Digital Ally, Inc. (a Nevada
corporation) and subsidiary (the “Company”) as of December 31, 2012 and 2011, and the related
consolidated statements of operations, stockholders’ equity, and cash flows for the years then
ended. These financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. The Company is not required to have, nor were we engaged to perform, an audit of
its internal control over financial reporting. Our audit included consideration of internal control
over financial reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
Company’s internal control over financial reporting. Accordingly, we express no such opinion.
An audit also includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles used and significant
estimates made by management, 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 Digital Ally, Inc. and subsidiary as of December 31,
2012 and 2011, and the results of their operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States of America.

Kansas City, Missouri
March 27, 2013

F-2

DIGITAL ALLY, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2012 AND DECEMBER 31, 2011

December 31,
2012

December 31,
2011

Current assets:

Assets

Cash and cash equivalents ......................................................................................
Accounts receivable-trade, less allowance for doubtful accounts

of $70,193 – 2012 and $125,000 – 2011 .............................................................
Accounts receivable-other ......................................................................................
Inventories ..............................................................................................................
Prepaid expenses .....................................................................................................

$ 703,172

$ 2,270,393

2,956,654
71,148
7,294,721
258,642

2,853,049
104,318
6,683,289
302,318

Total current assets ............................................................................

11,284,337

12,213,367

Furniture, fixtures and equipment .................................................................................
Less accumulated depreciation and amortization ..........................................................

4,392,880
3,454,087

4,073,713
3,212,827

Restricted cash ..............................................................................................................
Intangible assets, net .....................................................................................................
Other assets ....................................................................................................................

938,793

860,886

662,500
217,660
241,446

—
226,802
97,854

Total assets .............................................................................................................

$ 13,344,736

$ 13,398,909

Current liabilities:

Liabilities and Stockholders’ Equity

Accounts payable ....................................................................................................
Accrued expenses ...................................................................................................
Capital lease obligation-current ..............................................................................
Income taxes payable ..............................................................................................
Customer deposits ...................................................................................................

$ 1,520,207
793,524
66,087

$ 847,036
833,260
—
6,717 21,046
31,899

1,878

Total current liabilities ......................................................................

2,388,413

1,733,241

Long-term liabilities:

Subordinated note payable-long-term, net of discount of $96,378 and $142,711 ..
Litigation accrual-long term ...................................................................................
Capital lease obligation-long term ..........................................................................

2,403,622
530,000
120,988

2,357,289
—
—

Total long term liabilities ...............................................................................................

3,054,610

2,357,289

Commitments and contingencies ...................................................................................

Common stock, $0.001 par value; 9,375,000 shares authorized; shares

issued: 2,099,082 – 2012 and 2,082,832 – 2011 .................................................
Additional paid in capital ........................................................................................
Treasury stock, at cost (shares: 63,518 – 2012 and 63,518 - 2011) ........................
Accumulated deficit ................................................................................................

2,099
23,304,401

2,083
22,740,094

(2,157,226)

(13,247,561)

(11,276,572)

Total stockholders’ equity .................................................................

7,901,713

9,308,379

Total liabilities and stockholders’ equity ....................................................

$13,344,736

$13,398,909

See Notes to Consolidated Financial Statements.

F-3

DIGITAL ALLY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED
DECEMBER 31, 2012 AND 2011

Product revenue ......................................................................................
Other revenue ............................................................................................

Total revenue .............................................................................................
Cost of revenue ..........................................................................................

Gross profit ......................................................................................

Selling, general and administrative expenses:

Research and development expense .................................................
Selling, advertising and promotional expense ..................................
Stock-based compensation expense .................................................
Litigation charge and related expenses ............................................
General and administrative expense .................................................

Total selling, general and administrative expenses ....................................

Operating loss ..................................................................................

Interest income ..........................................................................................
Interest expense .........................................................................................
Loss on extinguishment of debt .................................................................
Loss before income tax expense
Income tax expense....................................................................................

Net loss

..................................................................................................

Net loss per share information:

Year ended
December 31,

2012
$16,691,136
926,972
17,618,108
8,136,121
9,481,987

2,528,790
2,587,427
521,427
313,950
5,216,911
11,168,505
(1,686,518)

10,088
(294,559)
—
(1,970,989)
—
$(1,970,989)

2011
$16,691,136
718,497
19,577,153
10,805,223
8,771,930

2,773,962
2,232,831
839,232
—
6,550,706
12,396,731
(3,624,801)

16,108
(222,460)
(131,093)
(3,962,246)
—
$(3,962,246)

Basic .................................................................................................
Diluted .............................................................................................

$ (0.97)
$ (0.97)

$ (1.96)
$ (1.96)

Weighted average shares outstanding:

2,029,109
2,029,109

2,018,979
2,018,979

See Notes to Consolidated Financial Statements.

F-4

DIGITAL ALLY, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
YEARS ENDED DECEMBER 31, 2012 AND 2011

Balance, January 1, 2011 .........................................................

Common Stock

Shares
2,081,582

Amount
$2,082

Additional
Paid In
Capital
$21,664,137

Treasury
stock
$(2,157,226)

Accumulated
deficit
$ (7,314,326)

Total
$12,194,667

Stock-based compensation ......................................................

—

839,232

Restricted common stock grant ...............................................

1,250

(1)

Issuance of common stock purchase warrants related to

issuance of subordinated note payable ...............................

—

Net loss ....................................................................................

—

236,726

—

839,232

—

236,726

—

(3,962,246)

Balance, January 1, 2012 .........................................................

2,082,832

2,083

22,740,094

(2,157,226)

(11,276,572)

9,308,379

Stock-based compensation ......................................................

—

Restricted common stock grant ...............................................

16,250

—

521,427

(16)

Issuance of common stock purchase warrants related to

issuance of subordinated note payable ...............................

—

38,052

Issuance of common stock purchase warrants related to

consulting agreement .........................................................

Net loss ....................................................................................

—
—

4,844

—

—
—

—

(1,970,989)

521,427

—

38,052

4,844
(1,970,989)

Balance, December 31, 2012 ...................................................

2,099,082

$2,099

$23,304,401

$(2,157,226)

$(13,247,561)

$ 7,901,713

See Notes to Consolidated Financial Statements.

F-5

672,090
521,427
(169,852)
(54,807)
—

(48,798)
33,170
(441,580)
42,874
(143,592)

673,171
(39,736)
530,000
(14,329)
(30,021)

(440,972)

(389,037)
(26,556)
(662,500)

1,062,103
839,232
(186,396)
15,000
131,093

1,911,504
241,393
3,041,829
39,266
(6,721)

(2,309,997)
104,781
—
(4,579)
29,257

945,519

(120,978)
(30,123)
—

(151,101)

2,309,774

190,226
(1,500,000)
(147,500)
—

852,500

1,646,918

DIGITAL ALLY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2012 AND 2011

2012

2011

$(1,970,989)

$(3,962,246)

Cash Flows From Operating Activities:

Net loss .................................................................................................
Adjustments to reconcile net loss to net cash flows

used in operating activities:

Depreciation and amortization ......................................................
Stock based compensation ............................................................
Provision for inventory obsolescence ...........................................
Provision for doubtful accounts receivable ...................................
Loss on extinguishment of debt ....................................................

Change in assets and liabilities:
(Increase) decrease in:

Accounts receivable - trade...........................................................
Accounts receivable - other ..........................................................
Inventories ....................................................................................
Prepaid expenses...........................................................................
Other assets ...................................................................................

Increase (decrease) in:

Accounts payable ..........................................................................
Accrued expenses .........................................................................
Litigation accrual ..........................................................................
Income taxes payable ....................................................................
Customer deposits .........................................................................

Net cash provided by (used in) operating activities ..............................

Cash Flows from Investing Activities:

Purchases of furniture, fixtures and equipment ....................................
Additions to intangible assets ...............................................................
Restricted cash for appealed litigation ..................................................

Net cash used in investing activities .....................................................

(1,078,093)

Cash Flows from Financing Activities:

Proceeds from issuance of subordinated note payable ..........................
Proceeds from issuance of common stock purchase warrants ..............
Change in line of credit ........................................................................
Deferred issuance costs for subordinated note payable ........................
Payments on capital lease obligation ....................................................

—
—
—
—
(48,156)

Net cash provided by (used in) financing activities ..............................

(48,156)

Net increase (decrease) in cash and cash equivalents ...................................

(1,567,221)

Cash and cash equivalents, beginning of period ...........................................

2,270,393

623,475

Cash and cash equivalents, end of period .....................................................

$ 703,172

$ 2,270,393

Supplemental disclosures of cash flow information:

Cash payments for interest....................................................................

$ 209,877

$ 112,036

Cash payments for income taxes ..........................................................

$ 9,150

$ 4,416

Supplemental disclosures of non-cash investing and financing activities:
Issuance of common stock purchase warrants for issuance costs of
subordinated notes payable .................................................................

$ 38,052

$ 46,500

Issuance of common stock purchase warrants related to consulting

agreement ............................................................................................

$ 4,844

$ —

Restricted common stock grant .............................................................

$ 16

$ 1

Capital expenditures financed by capital lease obligations ...................

$ 234,933

$ —

See Notes to Consolidated Financial Statements.

F-6

DIGITAL ALLY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business:

Digital Ally, Inc. (the “Digital Ally”) and subsidiary (collectively, the “Company”) produces digital video
imaging, audio recording and related storage products for use in law enforcement and security applications. Its
current products are an in-car digital video/audio recorder contained in a rear-view mirror for use in law
enforcement and commercial fleets, a weather-resistant mobile digital video recording system for use on
motorcycles, ATV’s and boats, a miniature digital video system designed to be worn on an individual’s body; a
digital video/audio recorder contained in a flashlight sold to law enforcement agencies and other security
organizations; and a hand-held laser speed detection device that it is offering primarily to law enforcement agencies.
The Company has active research and development programs to adapt its technologies to other applications. The
Company has the ability to integrate electronic, radio, computer, mechanical, and multi-media technologies to create
unique solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxi
cab and the military.

The Company was originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no

operations until 2004. On November 30, 2004, Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally,
Inc., at which time the merged entity was renamed Digital Ally, Inc.

The following is a summary of the Company’s Significant Accounting Policies:

Basis of Consolidation:

The accompanying financial statements include the consolidated accounts of Digital Ally and its wholly-
owned subsidiary, Digital Ally International, Inc. All intercompany balances and transactions have been eliminated
during consolidation.

Digital Ally formed Digital Ally International, Inc. during August 2009 to facilitate the export sales of its

products.

Fair Value of Financial Instruments:

The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable,

accounts payable and subordinated note payable, approximate fair value because of the short-term nature of these
items.

Revenue Recognition:

Revenues from the sale of products are recorded when the product is shipped, title and risk of loss have

transferred to the purchaser, payment terms are fixed or determinable and payment is reasonably assured.

The Company sells its products and services to law enforcement and commercial customers in the following

manner:

•

Sales to domestic and international customers are made direct to the end customer (typically a law
enforcement agency or a commercial customer) through commissioned third-party sales agents or
our direct sales force (Digital Ally employees). Revenue is recorded when the product is shipped to
the end customer.

Sales to domestic and international customers are made through independent distributors who
purchase products from the Company at a wholesale price and sell to the end user (typically law
enforcement agencies or a commercial customer) at a retail price. The distributor retains the margin
as its compensation for their role in the transaction. The distributor generally maintains product
inventory, customer receivables and all related risks and rewards of ownership. Revenue is
recorded when the product is shipped to the distributor consistent with the terms of the distribution
agreement.

F-7

•

Sales taxes collected on products sold are excluded from revenues and are reported as an accrued expense in

the accompanying balance sheets until payments are remitted.

Other revenue is comprised of revenues from repair services and the sale of scrap and excess raw material and
component parts. Revenue is recognized upon shipment of the product and acceptance of the service or materials by
the end customer.

Sales returns and allowances aggregated $463,717 and $752,452 for the years ended December 31, 2012 and

2011, respectively.

Use of Estimates:

The preparation of the consolidated financial statements in conformity with accounting principles generally
accepted in the United States of America 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 amount of revenues and expenses during the reporting period. Actual results could
differ from those estimates.

Cash and cash equivalents:

Cash and cash equivalents include funds on hand, in bank and short-term investments with original maturities

of ninety (90) days or less.

Accounts Receivable:

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables

based on a review of all outstanding amounts on a weekly basis. The Company determines the allowance for
doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial
condition, credit history, and current economic conditions. Trade receivables are written off when deemed
uncollectible. Recoveries of trade receivables previously written off are recorded when received.

A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more

than thirty (30) days beyond terms. No interest is charged on overdue trade receivables.

Inventories:

Inventories consist of electronic parts, circuitry boards, camera parts and ancillary parts (collectively,
“components”), work-in-process and finished goods, and are carried at the lower of cost (First-in, First-out Method)
or market value. The Company determines the estimate for the reserve for slow moving or obsolete inventories by
regularly evaluating individual inventory levels, projected sales and current economic conditions.

Furniture, fixtures and equipment:

Furniture, fixtures and equipment is stated at cost net of accumulated depreciation. Additions and
improvements are capitalized while ordinary maintenance and repair expenditures are charged to expense as
incurred. Depreciation is recorded by the straight-line method over the estimated useful life of the asset, which
ranges from 3 to 10 years.

Intangible assets:

Intangible assets include deferred patent costs and license agreements. Legal expenses incurred in preparation
of patent application have been deferred and will be amortized over the useful life of granted patents. Costs incurred
in preparation of applications that are not granted will be charged to expense at that time. The Company has entered
into several sublicense agreements whereby it has been assigned the exclusive rights to certain licensed materials
used in its products. These sublicense agreements generally require upfront payments to obtain the exclusive rights
to such material. The Company capitalizes the upfront payments as intangible assets and amortizes such costs over
their estimated useful life.

F-8

Long-Lived Assets:

Long-lived assets such as property, plant and equipment and purchased intangible assets subject to

amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for
possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or
asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an
undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair
value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted
market values and third-party appraisals, as considered necessary. As of December 31, 2012 and December 31,
2011, there were no impairment indicators that required the Company to test for impairment in the carrying value of
long-lived assets.

Warranties:

The Company’s products carry explicit product warranties that extends up to two years from the date of
shipment. The Company records a provision for estimated warranty costs based upon historical warranty loss
experience and periodically adjusts these provisions to reflect actual experience. Accrued warranty costs are
included in accrued expenses.

Customer Deposits:

The Company requires deposits in advance of shipment for certain customer sales orders, in particular when

accepting orders from foreign customers for which the Company does not have a payment history. Customer
deposits are reflected as a current liability in the accompanying consolidated balance sheets.

Shipping and Handling Costs:

Shipping and handling costs for outbound sales orders totaled $74,273 and $105,655 for the years ended
December 31, 2012 and 2011, respectively. Such costs are included in selling, general and administrative expenses
in the statements of operations.

Advertising Costs:

Advertising expense includes costs related to trade shows and conventions, promotional material and supplies,

and media costs. Advertising costs are expensed in the period in which they are incurred. The Company incurred
total advertising expense of approximately $518,340 and $302,052 for the years ended December 31, 2012 and
2011, respectively. Such costs are included in selling, general and administrative expenses in the consolidated
statements of operations.

Income Taxes:

Deferred taxes are provided for by the liability method wherein deferred tax assets are recognized for
deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are
recognized for taxable temporary differences. Temporary differences are the differences between the reported
amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when,
in the opinion of management, 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.

The Company applies the provisions of the Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) No. 740 - Income Taxes that provides a framework for accounting for uncertainty
in income taxes and provided a comprehensive model to recognize, measure, present, and disclose in its financial
statements uncertain tax positions taken or expected to be taken on a tax return. It initially recognizes tax positions
in the financial statements when it is more likely than not the position will be sustained upon examination by the tax
authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is
greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of
the position and all relevant facts. Application requires numerous estimates based on available information. The
Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized
tax positions and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information,
the Company may need to periodically adjust its recognized tax positions and tax benefits. These periodic
adjustments may have a material impact on its consolidated statements of operations.

F-9

The Company’s policy is to record estimated interest and penalties related to the underpayment of income

taxes as income tax expense in the consolidated statements of operations. There was no interest expense related to
the underpayment of estimated taxes during the year ended December 31, 2012 and 2011. There have been no
penalties in 2012 and 2011.

Research and Development Expenses:

The Company expenses all research and development costs as incurred.

Stock-Based Compensation:

The Company grants stock-based compensation to its employees and board of directors. Share-based

compensation arrangements may include the issuance of options to purchase common stock in the future or the
issuance of restricted stock, which generally are subject to vesting requirements. The Company records stock-based
compensation expense for all stock-based compensation granted after January 1, 2006 based on the grant-date fair
value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of
the award.

The Company estimates the grant-date fair value of stock-based compensation using the Black-Scholes

valuation model. Assumptions used to estimate compensation expense are determined as follows:

•

Expected term is determined using the contractual term and vesting period of the award;
Expected volatility of award grants made in the Company’s plan is measured using the weighted
average of historical daily changes in the market price of the Company’s common stock over the
period equal to the expected term of the award;
Expected dividend rate is determined based on expected dividends to be declared;
Risk-free interest rate is equivalent to the implied yield on zero-coupon U.S. Treasury bonds with a
maturity equal to the expected term of the awards; and
Forfeitures are based on the history of cancellations of awards granted and management’s analysis of
potential forfeitures.

Segments of Business:

Management has determined that its operations are comprised of one reportable segment: the sale of speed

detection and digital audio and video recording devices. For the year ended December 31, 2012 and 2011, sales by
geographic area were as follows:

Sales by geographic area:

United States of America ....................
Foreign ................................................

Year ended December 31,
2012

2011

16,587,042
1,031,066
$ 17,618,108

17,548,562
2,028,591
$ 19,577,153

Sales to customers outside of the United States are denominated in U.S. dollars. All Company assets are physically
located within the United States.

Recent Accounting Pronouncements:

New pronouncements issued but not effective until after December 31, 2012, are not expected to have a

material impact on our financial position, results of operation or liquidity.

NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject the Company to concentrations of credit risk consist of accounts

receivable. Sales to domestic customers are typically made on credit and the Company generally does not require
collateral while sales to international customers require payment before shipment or backing by an irrevocable letter
or credit. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an

F-10

allowance for estimated losses. Accounts are written off when deemed uncollectible and accounts receivable are
presented net of an allowance for doubtful accounts. The allowance for doubtful accounts totaled $70,193 and
$125,000 as of December 31, 2012 and December 31, 2011, respectively.

The Company sells primarily through a network of unaffiliated distributors for international sales and both

employee-based and independent sales agents for domestic sales. During 2012, the Company discontinued its use of
independent sales agents for domestic sales and currently only utilize employee-based domestic salesman. No
distributor/agents individually exceeded 10% total revenues, for the year ended December 31, 2012. Two
individual customer receivable balances exceeded 10% of total accounts receivable as of December 31, 2012, which
totaled $688,034 or 23% of total accounts receivable. Two distributor/agents individually exceeded 10% and in the
aggregate represented $6,110,091, or 31% of total revenues, for the year ended December 31, 2011. No customer
receivable balance exceeded 10% of total accounts receivable as of December 31, 2011. Following is a summary of
distributor/agents identified which individually exceeded 10% of total revenues for the years ended December 31,
2012 and 2011:

Distributor/Agent

Number 1

Number 2

Year ended December 31,

2012

2011

$1,697,412

$3,674,015

$1,186,197

$2,436,076

The Company purchases finished circuit boards and other proprietary component parts from suppliers
located in the United States and on a limited basis from Asia. Although the Company obtains certain of these
components from single source suppliers, management has located or is in process of locating alternative suppliers
to reduce the risk in most cases to supplier problems that could result in significant production delays. The
Company has not historically experienced any significant supply disruptions from any of its principal vendors, and
does not anticipate future supply disruptions. The Company acquires most of its components on a purchase order
basis and does not have long-term contracts with its suppliers.

The Company has entered into agreements with two unaffiliated companies (“Manufacturers”) to

development, license and manufacture certain products that the Company offers for sale to its customers. Currently,
these products represent less than 15% of the Company’s total revenue; however, revenue generated by these
products is expected to increase in the future to the extent that they may represent a significant portion of the
Company’s total revenue. These products can only be manufactured by the Manufacturers except in situations
where the Manufacturers are unable for any reason to supply the products. Backup proprietary documentation for
each product is required to be maintained offsite by each Manufacturer thereby allowing the Company to continue
production in such cases where the Manufacturers are unable to supply the product. The Manufacturers are located
in the United States and in Asia. Natural disasters, financial stress, bankruptcy and other factors may cause
conditions that would disrupt either Manufacturer’s ability to supply such products in quantities needed by the
Company. It would take time for management to locate and activate alternative suppliers to replace the
Manufacturers should it become necessary, which could result in significant production delays. The Company has
not historically experienced any significant supply disruptions from either of these Manufacturers, and does not
anticipate future supply disruptions.

NOTE 3. ACCOUNTS RECEIVABLE – ALLOWANCE FOR DOUBTFUL ACCOUNTS

The allowance for doubtful accounts receivable was comprised of the following for the years ended

December 31, 2012 and December 31, 2011:

Beginning balance ...................................................
Provision for bad debts ............................................
Charge-offs to allowance, net of recoveries ...........

Ending balance ........................................................

F-11

December 31,
2012
$125,000
—
(54,807)

December 31,
2011
$110,000
25,301
(10,301)

$ 70,193

$125,000

NOTE 4. INVENTORIES

Inventories consisted of the following at December 31, 2012 and December 31, 2011:

Subtotal ...........................................................
Reserve for excess and obsolete inventory .............

Total ................................................................

December 31,
2012
$ 2,475,857

145,622

5,050,572

December 31,
2011
$ 2,168,761
217,264
4,844,446

7,672,051
(377,330)
$ 7,294,721

7,230,471
(547,182)

$ 6,683,289

Finished goods inventory includes units held by potential customers and sales agents for test and evaluation

purposes. The cost of such units totaled $327,667 and $339,981 as of December 31, 2012 and December 31, 2011,
respectively.

NOTE 5. FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment consisted of the following at December 31, 2012 and December 31,

2011:

Office furniture, fixtures and equipment .................
Warehouse and production equipment ....................
Demonstration and tradeshow equipment ..............
Leasehold improvements ........................................
Website development .............................................
Other equipment ....................................................
Total cost..............................................................

Estimated
Useful Life
3-10 years
3-5 years
2-5 years
2-5 years
3 years
3 years

December 31,
2012
$2,055,668
1,249,382
781,799
209,556
11,178
85,297

December 31,
2011
$1,753,859
1,367,342
778,800
88,196
11,178
74,338

4,392,880

4,073,713

Less: accumulated depreciation and amortization ..

(3,454,087)

(3,212,827)

Net furniture, fixtures and equipment .....................

$ 938,793

$ 860,886

Depreciation and amortization of furniture fixtures and equipment aggregated $544,938 and $854,783 for the years
ended December 31, 2012 and 2011, respectively.

F-12

NOTE 6. INTANGIBLE ASSETS

Intangible assets consisted of the following at December 31, 2012 and 2011:

December 31, 2012
Accumulated
amortization

Net carrying
value

Gross value

December 31, 2011

Gross value

Accumulated
amortization

Net carrying
value

Amortized intangible assets:

Licenses ...................................
Patents and Trademarks ..........

$255,000
26,731

$255,000 $ —
16,431

10,300

$255,000
5,467

$230,536
1,685

$ 24,464
3,782

Unamortized intangible assets:

Patents and trademarks

pending .........................

201,229

—

201,229

198,556

—

198,556

Total ................................

$482,960

$265,300 $ 217,660

$459,023

$232,221

$226,802

Patents and trademarks pending will be amortized beginning at the time they are issued by the appropriate

authorities. If issuance of the final patent or trademark is denied, then the amount deferred will be immediately
charged to expense.

Amortization expense for the years ended December 31, 2012 and 2011 was $35,698 and $96,898,

respectively. Estimated amortization for intangible assets with definite lives for the next five years ending
December 31 and thereafter is as follows:

Year ending December 31:

2013 ............................................................................................
2014 ............................................................................................
2015 ............................................................................................
2016 .............................................................................................
2017 and thereafter.......................................................................

$8,910
7,521
—
—
—

$16,431

NOTE 7. SUBORDINATED NOTES PAYABLE AND CAPITAL LEASE OBLIGATIONS

Subordinated Notes Payable. Subordinated notes payable is comprised of the following:

Subordinated notes payable, at par ......................................................
Unamortized discount .........................................................................

$2,500,000
(96,378)

Total notes payable

Less: Current Maturities of long-term debt

2,403,622
—

December 31,
2012

December 31,
2011

$2,500,000
(142,711)

2,357,289
—

Subordinated notes payable, long-term

$2,403,622

$2,357,289

During the year ended December 31, 2011, the Company, in two separate transactions, borrowed an aggregate of
$2.5 million under two unsecured notes payable to a private, third-party lender. The loans were funded in May and
November 2011 and both are represented by promissory notes (the "Notes") that bear interest at the rate of 8% per
annum and are payable interest only on a monthly basis. The maturity date of the original Note in the principal
amount of $1,500,000 was extended from May 30, 2012 to May 30, 2013 in conjunction with the issuance of the
second Note during November 2011. Both Notes were due and payable in full on May 30, 2013 and could be
prepaid without penalty at any time. The Notes are subordinated to all existing and future senior indebtedness, as
such term is defined in the Notes.

F-13

The Company used a portion of the Notes proceeds to pay the outstanding borrowings under its line of

credit with a bank and such bank line of credit has been retired as of June 30, 2011. The remaining proceeds were
used for working capital purposes.

The Company granted the lender warrants (the "Warrants") exercisable to purchase a total of 56,250 shares

of its common stock at an exercise price of $8.00 per share (as modified) until November 30, 2013. The exercise
price for the Warrants exercisable to purchase 37,500 shares issued with the first Note was reduced from $12.00 per
share to $8.00 per share in consideration for the extension of the first Note’s maturity date. The Company paid fees
totaling $147,500 to an unaffiliated entity and issued warrants exercisable to purchase 13,750 shares of its Common
Stock on the same terms and conditions as the Warrants for its services relating to the transactions, including the
modification of the warrants issued pursuant to the first Note.

The Company allocated $236,726 of the proceeds of the Notes to additional paid-in-capital, which
represented the grant date fair value of the Warrant for 56,250 common shares issued to the lender and the warrant
for 13,750 shares issued to the unaffiliated third party who arranged the transactions. In addition, the cash fees paid
to the unaffiliated third party totaling $147,500 is included in the discount on the Notes. The modification of the
original Note that occurred during November 2011 was treated as an early extinguishment of the debt. Accordingly,
the remaining unamortized discount as of the date of modification $131,093 was charged off and reflected as a loss
on extinguishment of debt in the consolidated statement of operations in 2011.

On July 24, 2012, the Company entered into an agreement with the third party lender that extended the
maturity date of the Notes from May 30, 2013 to May 30, 2014. In connection with the extension, the Company
reduced the exercise price for the Warrants exercisable to purchase 56,250 shares previously granted to the lender
from $8.00 to $4.00 and extended their expiration date from November 30, 2013 to November 30, 2015. The
Company issued an unaffiliated third party a warrant exercisable to purchase 6,250 shares of Common Stock at a
price of $4.00 per share through November 30, 2015 for its services in connection with the extension of the maturity
dates of the Notes. Additionally, the Company reduced the exercise price of warrants it had issued to such firm in
May and November 2011 from $8.00 per share to $4.00 per share and extended their maturity dates to November
30, 2015. Such warrants are exercisable to purchase 13,750 shares of Common Stock. The Company allocated
$38,052 to additional paid in capital, which represented the grant date fair value of the new warrants issued to the
independent third party in July 2012 and the modification of the warrants for reducing the exercise price from $8.00
to $4.00 associated with extending the maturity date of the Note from May 30, 2013 to May 30, 2014. The
restructuring of the Note that occurred in July 2012 was treated as a modification of the debt and the remaining
unamortized discount of the note payable will be amortized to interest expense ratably over the modified terms of
the Notes. The discount amortized to interest expense totaled $84,384 and $110,425 for the years ended December
31, 2012, and 2011, respectively.

Capital Leases. Future minimum lease payments under non-cancelable capital leases having terms in

excess of one year are as follows:

Year ending December 31:

2013 .............................................................................................
2014 .............................................................................................
2015 ............................................................................................
2016 ............................................................................................
2017 and thereafter ......................................................................
Total future minimum lease payments ........................................
Less amount representing interest ...............................................
Present value of minimum lease payments .................................
Less current portion ....................................................................
Capital lease obligations, less current portion .............................

$ 80,529
80,529
48,520
—
—
209,578
22,503
187,075
66,087
$120,988

F-14

Assets under capital leases are included in furniture, fixtures and equipment as follows:

Office furniture, fixtures and equipment ........
Less: accumulated amortization .....................

December 31
2012

$234,933
(7,226)

Net furniture, fixtures and equipment ............

$227,707

NOTE 8 . ACCRUED EXPENSES

Accrued expenses consisted of the following at December 31, 2012 and December 31, 2011:

Accrued warranty expense ..................................................................
Accrued sales commissions ................................................................
Accrued payroll and related fringes ....................................................
Accrued insurance ..............................................................................
Accrued rent .......................................................................................
.........................................................................................
Other

December 31,
2012

$173,385
39,639
329,960

December 31,
2011

$211,421
64,782
305,328

60,149

61,355

66,287
124,104

7,222
183,152

$793,524

$833,260

Accrued warranty expense was comprised of the following for the years ended December 31, 2012 and 2011:

Beginning balance .........................................
Provision for warranty expense .....................
Charges applied to warranty reserve ..............

$211,421
296,830
(334,866)

2012

2011
$228,233
432,456
(449,268)

Ending balance… …………………………... $173,385

$211,421

NOTE 9. INCOME TAXES

The components of income tax (provision) benefit for the years ended December 31, 2012 and 2011 are as

follows:

Current taxes:
Federal ....................................................
State .........................................................

Total current taxes .......................................
Deferred tax (provision) benefit ...................

2012

2011

$ —
—

—
—

Income tax (provision) benefit .....................

$ —

F-15

A reconciliation of the income tax (provision) benefit at the statutory rate of 34% for the years ended

December 31, 2012 and 2011 to the Company’s effective tax rate is as follows:

U.S. Statutory tax rate .................................................
State taxes, net of Federal benefit ...............................
State tax credits ...........................................................
Federal Research and development tax credits ...........
Stock based compensation .........................................
Change in valuation reserve on deferred tax assets ....
Other, net ....................................................................

2012

34.0%
3.0%
1.8%
3.7%
(9.3)%
(29.2)%
(4.0)%

2011

34.0%
2.7%
2.3%
4.9%
(11.1)%
(36.5)%
3.7%

Income tax (provision) benefit ....................................

(0.0)%

Significant components of the Company’s deferred tax assets (liabilities) as of December 31, 2012 and

2011 are as follows:

Deferred tax assets:
Stock-based compensation ......................................
Start-up costs ............................................................
Inventory reserves ....................................................
Uniform capitalization of inventory costs ................
Allowance for doubtful accounts receivable ............
Other reserves ..........................................................
Equipment depreciation ..........................................
Accrued expenses ....................................................
Net operating loss carryforward ...............................
Research and development tax credit carryforward .
Alternative minimum tax credit carryforward ..........
State jobs credit carryforward ..................................
State research and development credit carryforward
Other ........................................................................

2012

2011

$ 1,270,000
165,000
138,000
—
25,000
5,000
125,000
313,000
2,850,000
1,085,000
90,000
264,000
203,000

10,000

$ 1,285,000
165,000
200,000
5,000
45,000
10,000
—
140,000
2,570,000
1,010,000
90,000
245,000
195,000
—

Total deferred tax assets ................................................
Valuation reserve .....................................................

6,543,000
(6,395,000)

5,960,000
(5,830,000)

Net deferred tax assets ..................................................
Deferred tax liabilities:
Domestic international sales company .....................
State taxes ................................................................
Equipment depreciation ...........................................

148,000

130,000

(138,000)
(10,000)
—

(105,000)
(10,000)
(15,000)

Net deferred tax assets (liability) ..................................

$ —

Net deferred tax asset (liability) are classified in our
consolidated balance sheets as follows:
Current .....................................................................
Non-current ..............................................................

$ —
$ —

F-16

The valuation allowance on deferred tax assets totaled $6,395,000 and $5,830,000 as of December 31, 2012
and December 31, 2011, respectively. We record the benefit we will derive in future accounting periods from tax
losses and credits and deductible temporary differences as “deferred tax assets,” which are included in the caption
“Deferred income taxes, net” on our consolidated balance sheets. In accordance with Accounting Standards
Codification (ASC) 740, “Income Taxes,” we record a valuation allowance to reduce the carrying value of our
deferred tax assets if, based on all available evidence, it is more likely than not that some or all of the deferred tax
assets will not be realized. At December 31, 2011, we had recorded a valuation allowance of $5,830,000 based on
our assessment of the realizability of our deferred tax assets at that date

The economic recession and its effect on state and local governmental budgets in particular remained weak in

2012 and 2011 and the Company incurred operating losses during this period. Law enforcement agencies are our
primary customer and are typically funded through state and local tax roles. The economic recession showed
improvement in 2012 and 2011 but the impact to state and local budgets are still uncertain at best. Despite the
improvement in general economic conditions and our ongoing cost containment efforts, we incurred additional
losses in 2012 and 2011 that placed us in a three year cumulative loss position at December 31, 2012 and 2011.
Accordingly, we determined there was not sufficient positive evidence regarding our potential for future profits to
outweigh the negative evidence of our three year cumulative loss position under the guidance provided in ASC
740. Therefore, we determined that our valuation allowance should be increased to $5,830,000 to fully reserve our
deferred tax assets at December 31, 2011. During 2012, we continued to incur operating losses which provides a
basis to continue to fully reserve our deferred tax assets as of December 31, 2012. Therefore, the valuation reserve
has been increased to $6,395,000 as of December 31, 2012 which provides a full reserve on all deferred tax assets.
We expect to continue to maintain a full valuation allowance until we determine that we can sustain a level of
profitability that demonstrates our ability to realize these assets. To the extent we determine that the realization of
some or all of these benefits is more likely than not based upon expected future taxable income, a portion or all of
the valuation allowance will be reversed. Such a reversal would be recorded as an income tax benefit and, for some
portion related to deductions for stock option exercises, an increase in shareholders' equity.

At December 31, 2012, the Company had available approximately $7,800,000 of net operating loss

carryforwards available to offset future taxable income generated. Such tax net operating loss carryforwards expire
between 2024 and 2032. In addition, the Company had research and development tax credit carryforwards totaling
$1,083,000 available as of December 31, 2012, which expire between 2023 and 2032.

The Internal Revenue Code contains provisions under Section 382 which limit a company’s ability to utilize
net operating loss carry-forwards in the event that it has experienced a more than 50% change in ownership over a
three-year period. Current estimates prepared by the Company indicate that due to ownership changes which have
occurred, approximately $765,000 of its net operating loss and $175,000 of its research and development tax credit
carryforwards are currently subject to an annual limitation of approximately $1,151,000, but may be further limited
by additional ownership changes which may occur in the future. As stated above, the net operating loss and research
and development credit carryforwards expire between 2023 and 2032, allowing the Company to potentially utilize
all of the limited net operating loss carry-forwards during the carryforward period.

As discussed in Note 1, "Summary of Significant Accounting Policies," tax positions are evaluated in a two-

step process. We first determine whether it is more likely than not that a tax position will be sustained upon
examination. If a tax position meets the more-likely-than-not recognition threshold, it is then measured to determine
the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of
benefit that is greater than 50% likely of being realized upon ultimate settlement. Management has identified no tax
positions taken that would meet or exceed these thresholds and therefore there are no gross interest, penalties and
unrecognized tax expense/benefits that are not expected to ultimately result in payment or receipt of cash in the
consolidated financial statements.

The Company’s federal and state income tax returns are closed for examination purposes by relevant statute
and by examination for 2008 and all prior tax years. The Company recently underwent an examination of its 2008
federal income tax return by the Internal Revenue Service. The examination process has been concluded with no
proposed adjustments.

The effective tax rate for the years ended December 31, 2012 and 2011 varied from the expected statutory rate

due to the Company continuing to provide a 100% valuation allowance on net deferred tax assets. The Company
determined that it was appropriate to continue the full valuation allowance on net deferred tax assets as of December
31, 2012 because of the current year operating losses.

F-17

NOTE 10. COMMITMENTS AND CONTINGENCIES

Operating Leases. We have several non-cancelable operating lease agreements for office space and

warehouse space that expire at various dates through April 2020. In September 2012, the Company entered into a
non-cancelable long term facility lease to combine all of their operations into one location effective November 2012.
We have also entered into month-to-month leases for equipment and facilities. Rent expense for the years ended
December 31, 2012 and 2011 was $405,234 and $383,530, respectively, related to these leases. The Company paid
a security deposit in conjunction with the new facility lease in September 2012 in the amount of $116,888. As
reflected in the table below, the Company has a rent holiday and discounted rent for the first 12 months of the new
facility lease which was effective November 1, 2012.

Year ending December 31:

$172,595

428,505
433,965
439,707
1,508,155
$2,982,927

License agreements. The Company has several license agreements whereby it has been assigned the rights
to certain licensed materials used in its products. Certain of these agreements require the Company to pay ongoing
royalties based on the number of products shipped containing the licensed material on a quarterly basis. Royalty
expense related to these agreements aggregated $35,785 and $34,905 for the years ended December 31, 2012 and
2011, respectively.

Supply and distribution agreement. The Company entered into a supply and distribution agreement on May
1, 2010 under which it was granted the exclusive worldwide right to sell and distribute a proprietary law
enforcement speed measurement device and derivatives to its customers. The term of the agreement was 42 months
after the date the supplier began full scale production of the product which commenced in August 2010 and final
certification of the product was obtained. The agreement had minimum purchase requirements of 1,000 units per
period over three commitment periods. On January 31, 2012, the supply and distribution agreement was amended
to reduce the minimum purchase commitment over the second and third years by 52% of the original commitment.
The Company agreed to release its world wide right to exclusively market the product to the law enforcement
community in exchange for the reduction in the purchase commitment.

After the initial term has expired, the parties may continue on a month-to-month basis and is terminable by

either party upon 30 days advance notice. The contract may be terminated earlier in case of material breach by
either party that is not cured within thirty days of notice of the breach.

The agreement contains required minimum order quantities and fixed prices per unit according to the

following schedule:

Minimum order commitment amount ($)

Commitment time period

March 2012 through February 2013 .............................
March 2012 through February 2014 .............................

Commitment
$846,240
846,240

Purchases
$705,200
—

Remaining
Commitment
$141,040
846,240

$1,692,480

$705,200

$987,280

The above table reflects the modified terms of the amended supply and distribution agreement. The

F-18

Litigation. The Company is subject to various legal proceedings arising from normal business operations.
Although there can be no assurances, based on the information currently available, management believes that it is
probable that the ultimate outcome of each of the actions will not have a material adverse effect on the consolidated
financial statements of the Company. However, an adverse outcome in certain of the actions could have a material
adverse effect on the financial results of the Company in the period in which it is recorded.

On June 8, 2009, we filed suit against Z3 in the U.S. District Court for the District of Kansas claiming breach

The trial of those claims began on June 25, 2012 and concluded with a jury verdict on July 3, 2012. The

F-19

401 (k) Plan. In July 2008, the Company amended and restated its 401(k) retirement savings plan. The
amended plan requires the Company to provide 100% matching contributions for employees who elect to contribute
up to 3% of their compensation to the plan and 50% matching contributions for employee’s elective deferrals on the
next 2% of their contributions. The Company has made matching contributions totaling $108,313 and $121,745 for
the years ended December 31, 2012 and 2011, respectively. Each participant is 100% vested at all times in employee
and employer matching contributions.

Stock Repurchase Program. During June 2008, our Board of Directors approved a program that authorized
the repurchase of up to $10 million of our common stock in the open market, or in privately negotiated transactions,
through July 1, 2010. Our Board of Directors approved an extension of this program to July 1, 2012. We made no
purchases under this program during the years ended December 31, 2012 and 2011. The Company has repurchased
63,518 shares at a total cost of $2,157,226 (average cost of $33.96 per share) under this program from inception to
December 31, 2012. This program was not extended and is now terminated.

NASDAQ Listing . On September 10, 2012, The Nasdaq Stock Market notified the company that it had
regained compliance with Nasdaq Listing Rule 5550(a)(2). Accordingly, the Company’s Common Stock will remain
listed on the Nasdaq Capital Market and continue to trade under the symbol DGLY. On September 13, 2011,
Nasdaq had notified the Company that its Common Stock failed to maintain a minimum bid price of $1.00 over the
previous 30 consecutive business days as required by such Listing Rule. Nasdaq then gave the Company two 180-
periods to achieve compliance with the Listing Rule. Nasdaq has determined that for the ten days from August 24,
2012 to September 7, 2012, the closing bid price was at $1.00 per share or greater and thus the Company had
achieved compliance with the Listing Rule.

NOTE 11. STOCKHOLDER’S EQUITY

Reverse Stock Split. The Company filed a Certificate of Change with the Nevada Secretary of State under

which the Company affected a one for eight reverse split of its issued and outstanding shares of common stock
effective August 24, 2012. As a result of the reverse stock split, every eight shares of the Company’s issued and
common stock were combined into one share of common stock. The reverse stock split reduced the number of
authorized shares of the Company’s common stock from 75,000,000 to 9,375,000 shares.

Immediately before the effectiveness of the reverse stock split the Company had 16,792,218 shares of
common stock issued and outstanding. Following the reverse split, the Company had 2,099,082 shares of common
stock issued and outstanding. The reverse stock split affects all shares of the Company’s common stock, including
common stock underlying stock options and warrants that are outstanding on the effective date of the reverse stock
split.

All references to shares and exercise prices of our common stock, warrants, stock options and restricted stock
(and associated dollar amounts) in the accompanying consolidated financial statements have been restated to present
such information on a post reverse split basis.

NOTE 12. STOCK-BASED COMPENSATION

The Company recorded pretax compensation expense related to the grant of stock options and restricted stock

issued of $521,427 and $839,232 for the years ended December 31, 2012 and 2011, respectively.

As of December 31, 2012, the Company has adopted five separate stock option and restricted stock plans: (i)
the 2005 Stock Option and Restricted Stock Plan (the “2005 Plan”), (ii) the 2006 Stock Option and Restricted Stock
Plan (the “2006 Plan”), (iii) the 2007 Stock Option and Restricted Stock Plan (the “2007 Plan”), (iv) the 2008 Stock
Option and Restricted Stock Plan (the “2008 Plan”) and (v) the 2011 Stock Option and Restricted Stock Plan (the
“2011 Plan”). These Plans permit the grant of stock options or restricted stock to its employees, non-employee
directors and others for up to a total of 875,000 shares of common stock. The Company believes that such awards
better align the interests of its employees with those of its shareholders. Option awards have been granted with an
exercise price equal to the market price of the Company’s stock at the date of grant with such option awards
generally vesting based on the completion of continuous service and having ten-year contractual terms. These
option awards provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company

F-20

has registered all shares of common stock that are issuable under its Plans with the SEC. A total of 89,357 options
remain available for grant under the various Plans as of December 31, 2012.

In addition to the Stock Option and Restricted Stock Plans described above, the Company has issued other
options outside of these Plans to non-employees for services rendered that are subject to the same general terms as
the Plans, of which 2,500 options are fully vested and remain outstanding as of December 31, 2012.

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation

model. The assumptions used for determining the grant-date fair value of options granted during the year ended
December 31, 2012 are reflected in the following table:

Expected term of the options in years

Expected volatility of Company stock

Expected dividends

Forfeiture rate

The following is a summary of stock options outstanding:

Options

Outstanding at January 1, 2012 ....................................................................
Granted ..............................................................................................
Exercised ...........................................................................................
Exercised and surrendered/cancelled (cashless exercise) ..................
Forfeited ............................................................................................

2-5 years

66%-73%

None

5%-75%

Weighted
Average
Exercise Price

$20.72
3.83

—
—
12.05

505,663
141,375
—
—
(94,388)

Outstanding at December 31, 2012..................................................

552,650

$17.87

Exercisable at December 31, 2012 ...............................................................

344,050

$23.70

Weighted-average fair value for options granted during the period at fair value

141,375

$1.32

The Plan’s allow for the cashless exercise of stock options. This provision allows the option holder to
surrender/cancel options with an intrinsic value equivalent to the purchase/exercise price of other options exercised.
There were no cashless exercises during the year ended December 31, 2012.

At December 31, 2012, the aggregate intrinsic value of options outstanding was approximately $11,725, the

aggregate intrinsic value of options exercisable was approximately $-0-, and there were no options exercised during
the year ended December 31, 2012.

As of December 31, 2012, the unamortized portion of stock compensation expense on all existing stock

options was $374,281, which will be recognized over the next forty-two months.

F-21

The following table summarizes the range of exercise prices and weighted average remaining contractual life

for outstanding and exercisable options under the Company’s option plans as of December 31, 2012:

Outstanding options

Exercisable options

Exercise price range

Number of
options

$0.01 to $3.99 ........................................................
$4.00 to $6.99 ........................................................
$7.00 to $9.99 ........................................................
$10.00 to $12.99 ....................................................
$13.00 to $15.99 ....................................................
$16.00 to $18.99 ....................................................
$19.00 to $29.99 ....................................................
$30.00 to $55.00 ....................................................

62,250
51,250
141,522
77,629
89,999
1,375
10,500
118,125

552,650

Weighted
average
remaining
contractual
life

Number
of options

Weighted
average
remaining
contractual
life

9,125

9.5 years
9.0 years
4.1 years
4.7 years
7.6 years

4.3 years

6.2 years
4.9 years

625
116,715
70,623
21,187
1,375
6,275
118,125

9.4 years
8.9 years
3.1 years
4.5 years
6.9 years
4.3 years
5.8 years
4.9 years

6.0 years

344,050

4.5 years
ears ears

Restricted stock grants. The Board of Directors has granted restricted stock awards under the Plans.

Restricted stock awards are valued on the date of grant and have no purchase price for the recipient. Restricted stock
awards typically vest over one to four years corresponding to anniversaries of the grant date. Under the Plans,
unvested shares of restricted stock awards may be forfeited upon the termination of service to or employment with
the Company, depending upon the circumstances of termination. Except for restrictions placed on the transferability
of restricted stock, holders of unvested restricted stock have full stockholder’s rights, including voting rights and the
right to receive cash dividends.

A summary of all restricted stock activity under the equity compensation plans for the year ended December

31, 2012 is as follows:

Nonvested balance, January 1, 2012 ...........................
Granted .......................................................................
Vested .........................................................................
Forfeited ......................................................................

Nonvested balance, December 31 2012 ......................

Restricted
stock

2,813
16,250
(8,126)
—

10,937

Weighted
average grant
date fair value
$16.72
3.52
5.75
—

$ 5.27

The Company estimated the fair market value of these restricted stock grants based on the closing market

price on the date of grant. As of December 31, 2012, there were $19,624 of total unrecognized compensation costs
related to all remaining non-vested restricted stock grants, which will be amortized over the next forty-two months
in accordance with the graduated vesting scale.

The nonvested balance of restricted stock vests as follows:

Year ended December 31,

2013 ............................................................................
2014 ............................................................................
2015 ............................................................................
2016 ............................................................................

Number
of shares

8,125
625
937
1,250

NOTE 13. COMMON STOCK PURCHASE WARRANTS

F-22

During the years ended December 31, 2012 and 2011, the Company issued common stock purchase warrants

(the “Warrants”) in conjunction with the issuance of the Notes (see Note 7). The Warrants are immediately
exercisable and allow the holders to purchase up to 81,250 shares of common stock at $4.00 to $4.40 per share after
modification. The Warrants expire on September 15, 2014 through November 30, 2015, allow for cashless exercise;
however, the holder does not have registration rights.

The fair value of the Warrants was estimated on the date of grant using a Black-Scholes option valuation
model. The assumptions used for determining the grant-date fair value of the Warrants granted are reflected in the
following table:

Expected term of the Warrants ........................................................

Expected volatility of Company stock ..............................................

Expected dividends ...........................................................................

Risk-free interest rate ........................................................................

Forfeiture rate ...................................................................................

23-30 months

66% - 68%

None

0.25% - 0.62%

A summary of all Warrant activity for the year ended December 31, 2012 is as follows:

Vested Balance, January 1, 2012 ..............................................................
Granted .....................................................................................................
Vested Balance, December 31, 2012 ........................................................

Warrants
70,000
11,250
81,250

Weighted average
exercise price

$ 4.00
$ 4.11
$ 4.02

The remaining unamortized grant date fair value of the Warrants to purchase 81,250 common shares
aggregated $96,378 as of December 31, 2012, which is amortized ratably to interest expense over the term of the
Notes.

NOTE 14. NET LOSS PER SHARE

The calculation of the weighted average number of shares outstanding and loss per share outstanding for the

years ended December 31, 2012 and 2011 are as follows:

Year ended December 31,
2011
2012

Numerator for basic and diluted income per share –

Net loss

$(1,970,989)

$(3,962,246)

Denominator for basic loss per share – weighted

average shares outstanding ....................................

2,029,109

2,018,979

Dilutive effect of shares issuable under stock

options and warrants outstanding ..........................

—

Denominator for diluted loss per share – adjusted

weighted average shares outstanding .....................

2,029,109

2,018,979

Net loss per share:

Basic .......................................................

Diluted ....................................................

$(0.97)
$(0.97)

$(1.96)
$(1.96)

Basic loss per share is based upon the weighted average number of common shares outstanding during the
period. All outstanding stock options to purchase common stock were considered antidilutive, as a result of their
exercise price being out of the money and the net loss incurred for the respective periods and, therefore, not included
in the computation of diluted loss per share.

F-23

NOTE 15. SUBSEQUENT EVENTS

On March 6, 2013, the Company loaned $65,000 to AfterMaster HD Audio, Inc. (“AfterMaster”) under a

10% convertible promissory note with principle and accrued interest due May 5, 2013. The note is convertible into
260,000 shares of common stock of AfterMaster’s parent company, Studio One Media, Inc. (“SOMD”) at the
Company’s discretion. The Company received an origination fee equivalent to 32,500 shares of SOMD restricted
common shares and a warrant to purchase 65,000 shares of SOMD at $0.25 per share which is immediately
exercisable and expires on March 5, 2018. The Company held 50,625 shares of SOMD restricted common stock as
of December 31, 2012 which was acquired for total consideration of $10,000. The Company’s CEO, President and
Chairman was appointed to serve as a member of the board of directors of SOMD effective January 29, 2013 and
resigned such position effective March 22, 2013.

SOMD is a publicly traded company (OTCBB: SOMD) and is engaged in the development and
commercialization of proprietary, audio and video technologies for professional and consumer use. SOMD’s
wholly-owned subsidiaries includes AfterMaster HD Audio, Inc. The Company’s management is considering
integrating some of AfterMaster’s technology into its products in the future.

*************************************

F-24