In this report, the terms "ISC8 Inc.," "ISC8," "Irvine Sensors," "Irvine Sensors Corporation," "Company," "we," "us" and "our" refer to ISC8 Inc. ("ISC8") and its subsidiaries.

Introduction

The following information should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto in Part I, Item 1 of this Quarterly Report on Form 10-Q ("Quarterly Report"), and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended September 30, 2012.

Overview

We are engaged in the design, development, manufacture and sale of a family of security products, consisting of cyber security solutions for government and commercial applications, secure memory products, some of which utilize technologies that we have pioneered for 3-D stacking of semiconductors, Systems in a Package (or SIP), and anti-tamper systems. In our government systems portfolio, we utilize technologies such as high-speed processor assemblies and miniaturized vision systems and sensors. In addition, we offer custom stacked solutions for other customer specific systems in package applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or other prime contractors. We generally use contract manufacturers to produce our products or their subassemblies. Our current operations are located in California, Texas, and Italy with other employees and consultants in various other locations globally. Our operation in Italy was acquired in connection with our acquisition of certain software assets of Bivio in October 2012, described below.

As of December 30, 2012, we had approximately $31.4 million of debt, exclusive of debt discounts, and approximately $3.6 million of accounts payable and accrued expenses.

Acquisition of Bivio Software

On October 12, 2012, pursuant to the terms of the Foreclosure Sale Agreement between the Company and GF Acquisition Co. 2012, LLC ("GFAC") dated October 4, 2012 (the "Foreclosure Sale Agreement"), the Company acquired substantially all of the assets of the NetFalcon and Network Content Control System Business (the "Bivio Software") of Bivio Networks, Inc. and certain of its subsidiaries (collectively, "Bivio"), an international provider of cyber security solutions and products. The purchase price of those assets (the "Acquisition") was $600,000 payable in cash to GFAC, and the issuance to GFAC of a warrant to purchase capital stock of the Company. In addition, the Company assumed certain liabilities, including accounts payable, contractual obligations, reclamation obligations and other liabilities related to Bivio Software.

Critical Accounting Estimates

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results are the same as those disclosed in our Form 10-K for the fiscal year ended September 30, 2012 filed with the SEC on December 28, 2012.

Results of Continuing Operations

The following discussions relate to the Company's results of continuing operations after reclassifying the operations of our Thermal Imaging Business as a discontinued operation due to its sale on January 31, 2012.

Total Revenues. Our total revenues are generally derived from sales of specialized chips, modules, stacked chip products and amounts realized or realizable from funded research and development contracts, largely from U.S. government agencies and other government contractors. Our total revenues decreased in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 and changed in composition as shown in the following table and discussed more fully below.

13-Week Comparisons                               Total Revenues
13 weeks ended January 1, 2012                   $      1,297,000
Dollar decrease in current comparable 13 weeks           (422,000 )

13 weeks ended December 30, 2012                 $        875,000
Percentage decrease in current 13 weeks                     (33%)

The decrease in our total revenues in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 was primarily the result of a $676,000 decrease in funded research and development revenue. This decrease in total revenues was partially offset by a $254,000 increase in product sales related to our 3-D stacking business as well as our cyber business. We believe the decrease in revenues derived from funded research and development contracts in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 was substantially related to our current inability to obtain contracts under the Small Business Innovation Research ("SBIR") program. Our inability to receive grants under the SBA could materially adversely affect our business, results of operations and financial condition. We are unable to ascertain what future effects the U.S. defense budget timing may have on our total revenues for the balance of the fiscal year ended September 30, 2013 ("Fiscal 2013") and beyond. We are promoting sales of our other recently introduced products, which if achieved we believe could still become a material contributor to our total revenues in the final reporting period of Fiscal 2013. However we are not certain that such outcome will materialize during Fiscal 2013 or at all.

Cost of Revenues. Cost of revenues includes wages and related benefits of our personnel, as well as subcontractor, independent consultant and vendor expenses directly incurred in the manufacture of products sold or in the performance of funded research and development contracts, plus related overhead expenses and, in the case of funded research and development contracts, such other indirect expenses as are permitted to be charged pursuant to the relevant contracts. The comparison of cost of revenues for the 13-week period ended December 30, 2012 and January 1, 2012 is shown in the following table and discussed more fully below:

                                                                                    Percentage of
13-Week Comparisons                                          Cost of Revenues       Total Revenues
13 weeks ended January 1, 2012                              $          961,000                   74 %
Dollar decrease in current comparable 13 weeks                       (332,000)

13 weeks ended December 30, 2012                            $          629,000                   72 %
Percentage decrease in current 13 weeks                                  (35%)

The decrease in absolute dollar cost of revenues in the 13-week period ending December 30, 2012 compared to the 13-week period ended January 1, 2012 is largely the result of comparatively low contract material costs and other direct costs relative to funded research and development revenue. Additionally, we experienced an increase in product sales, which have lower costs of revenue as compared to our funded research and development revenue.

General and Administrative Expense. General and administrative expense largely consists of wages and related benefits for our executive, financial, administrative and marketing staff, as well as professional fees, primarily legal and accounting fees and costs, plus various fixed costs such as rent, utilities and telephone. The comparison of general and administrative expense for the 13-week period ended December 30, 2012 and January 1, 2012 is shown in the following table and discussed more fully below:

                                                              General and
                                                             Administrative       Percentage of
13-Week Comparisons                                             Expense           Total Revenue
13 weeks ended January 1, 2012                              $      2,551,000                 197 %
Dollar increase in current comparable 13 weeks                       376,000

13 weeks ended December 30, 2012                            $      2,927,000                 335 %
Percentage increase in current 13 weeks                                  15%

The increase in absolute dollars of general and administrative expense in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 consisted of a combination of increased stock-based compensation expense, marketing and legal fees, severance expenses, as well as facilities expense related to cyber development in Texas. This was partially offset by a decrease in travel, bid and proposal fees, professional fees, and stockholder-related expenses.

Research and Development Expense. Research and development expense primarily consists of wages and related benefits for our research and development staff, independent contractor consulting fees and subcontractor and vendor expenses directly incurred in support of internally funded research and development projects, plus associated overhead expenses. Research and development expense for the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012 is shown in the following table and discussed more fully below:

                                                  Research and
                                                  Development         Percentage of
13-Week Comparisons                                 Expense           Total Revenue
13 weeks ended January 1, 2012                   $    1,831,000                  141 %
Dollar increase in current comparable 13 weeks          613,000

13 weeks ended December 30, 2012                 $    2,444,000                  279 %
Percentage increase in current 13 weeks                      33 %

The changes in research and development expense in the 13-week period ended December 30, 2012 as compared to the 13-week period ended January 1, 2012, are largely related to the development expenses of our Texas-based cyber security office, which we opened and commenced staffing in April 2011. Many of those expenses relate to hiring of highly-skilled development and support staff, software licensing expenses, consulting fees and various operating leases of facilities and equipment to support product development. We also signed a joint development agreement with Cavium, Inc. to provide design and engineering services. We expect to continue to allocate significant resources to the development of our cyber security products in future periods, which may result in further increases in research and development expense as compared to prior fiscal periods. However, no assurances can be given that we will capitalize on our research and development initiatives.

Interest Expense. Our interest expense for the 13-week period ended December 30, 2012, compared to the 13-week period ended January 1, 2012, increased as shown in the following table and discussed more fully below:

13-Week Comparisons                               Interest Expense
13 weeks ended January 1, 2012                   $        1,669,000
Dollar increase in current comparable 13 weeks              318,000

13 weeks ended December 30, 2012                 $        1,987,000
Percentage increase in current 13 weeks                          19 %

The increase in interest expense in the 13 weeks ended December 30, 2012 as compared to January 1, 2012 was attributable primarily to interest and amortization of debt discounts and financing related costs as a result of our capital structure and continued fund raising efforts.

Change in Fair Value of Derivative Liability. We recorded a substantial decrease in the change in fair value of derivative liability for the 13 week period ended December 30, 2012, as compared to the 13-week period ended January 1, 2012. This is shown in the following table and discussed more fully below:

                                                  Change in Fair Value of
13-Week Comparisons                                Derivative Liability
13 weeks ended January 1, 2012                   $              (2,310,000 )
Dollar decrease in current comparable 13 weeks                 (7,257,000)

13 weeks ended December 30, 2012                 $               4,947,000
Percentage decrease in current 13 weeks                               (314 %)

The Company revalued its derivatives as of December 30, 2012 and recorded a decrease in their fair value of approximately $4.9 million for the 13-week period, mainly as a result of quarterly valuations based on a decrease of our stock price from last quarter. Given the price volatility of our common stock, we anticipate that there could be additional substantial change in fair value of derivative liability expense that we will be required to record in future reporting periods, unless and until the Subordinated Notes are converted into, and/or the warrants are exercised for the purchase of common stock pursuant to their respective terms. Although no assurances can be given, in the event of such conversion or exercise, the derivative liability associated with these instruments would be eliminated.

Net Loss from Continuing Operations. Our net loss from continuing operations decreased in the 13-week period ended December 30, 2012, compared to the 13-week period ended January 1, 2012, as shown in the following table and discussed more fully below:

                                                     Net Loss
                                                  from Continuing
13-Week Comparisons                                 Operations
13 weeks ended January 1, 2012                   $     (8,027,000)
Dollar decrease in current comparable 13 weeks         (5,863,000)

13 weeks ended December 30, 2012                 $     (2,164,000)
Percentage decrease for current 13 weeks                      (73% )

The decrease in net loss from continuing operations in the 13-week period ended December 30, 2012 compared to the 13-week period ended January 1, 2012 was largely due to a change in fair value of derivative instruments, a non cash item, discussed above which mainly related to lower stock prices during the current period, offset in part by an increase total cost and expenses and interest expenses in the comparable periods.

Liquidity and Capital Resources

Our liquidity in terms of both cash and cash equivalents decreased in the first
13 weeks of Fiscal 2012, largely as a result of losses generated from continuing
operations, partially offset by an increase in product sales. As a result, we
continued to have a working capital deficit for the current period as shown in
the following table and discussed more fully below:

                                                                 Cash and            Working Capital
                                                             Cash Equivalents           (Deficit)
September 30, 2012                                          $        1,738,000      $     (10,091,000 )
Dollar decrease as of December 30, 2012                            (1,311,000)            (5,906,000)

December 30, 2012                                           $          427,000      $     (15,997,000 )
Percentage decrease as of December 30, 2012                               (75% )                (59%)

The $1.3 million use of cash during the 13-week period ended December 30, 2012 is a result of the following components: cash used in operating activities of $4.9 million, cash used in investing activities of $0.6 million, and cash provided by financing activities of $4.2 million. Cash used in operating activities was a result of the $2.2 million net loss from continuing operations and $4.9 million change in fair value of derivative liability, partially offset by $1.7 million in non-cash interest expense, and other less significant factors related to various timing and cash deployment effects. Cash used in investing activities was a result of $0.6 million related to acquisition related costs, and property and equipment expenditures. Cash provided by financing activities was a result of $4.2 million in proceeds from the issuance of the 2012 Notes. The proceeds from financing were the primary source of improvement in our working capital for the current period.

As of December 30, 2012 we have used a significant portion of the cash obtained from both from the Thermal Imaging Sale, the Revolving Credit Facility and 2012 Notes to fund our operations, and have been unable to maintain positive cash flow during the 13-week period due to insufficient revenues. To continue to fund anticipated operating expenses and satisfy indebtedness, we will have to seek additional financing, and no assurances can be given that such financing would be available on a timely basis, on terms that are acceptable, or at all. Failure to do so and meet the repayment or other obligations of our existing debt could result in default and acceleration of debt maturity, which could materially adversely affect our business, and financial condition, and threaten our viability as a going concern.

At December 30, 2012, our funded backlog was approximately $1.3 million. Although no assurances can be given, we anticipate that a substantial portion of our funded backlog at December 30, 2012 will result in revenue recognized in the next twelve months. In addition, our government research and development contracts and product purchase orders typically include unfunded backlog, which is funded when the previously funded amounts have been expended or product delivery schedules are released. As of December 30, 2012, our total backlog, including unfunded portions, was approximately $1.4 million.

Contracts with government agencies may be suspended or terminated by the government at any time, subject to certain conditions. Similar termination provisions are typically included in agreements with prime contractors. While we have only experienced a small number of contract terminations, none of which were recent, we cannot assure you that we will not experience suspensions or terminations in the future. Any such termination, if material, could cause a disruption of our revenue stream, materially adversely affect our liquidity and results of operations and result in employee layoffs.

Off-Balance Sheet Arrangements

Our conventional operating leases are either immaterial to our financial statements or do not contain the types of guarantees, retained interests or contingent obligations that would require their disclosures as an "off-balance sheet arrangement" pursuant to Regulation S-K Item 303(a)(4). As of December 30, 2012 and September 30, 2012, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Contractual Obligations and Commitments

Debt. At December 30, 2012, we had approximately $31.4 million of debt, exclusive of discounts, which consisted of (i) a Senior Secured Revolving Credit Facility, in the original principal amount of $5.0 million; (ii) Senior Subordinated Convertible Notes with an aggregate principal balance of approximately $5.4 million.; (iii) Senior Subordinated Notes with an aggregate principal balance of approximately $4.9 million, and (iv) Subordinated Secured Convertible Notes with an aggregate principal balance of approximately $16.1 million. Each of these instruments are described more fully below.

Senior Secured Revolving Credit Facility

In December 2011, we entered into a Loan and Security Agreement (the "Loan Agreement") with Partners for Growth, L.P. ("PFG") pursuant to which we obtained the two-year, $5.0 million line of credit (the "Revolving Credit Facility"). Upon execution of the Loan Agreement, we borrowed the entire $5.0 million available thereunder and used approximately $1.9 million of that Revolving Credit Facility to repay the Secured Promissory Note. We used the remaining proceeds of the Revolving Credit Facility, less expenses thereof, for general working capital purposes.

The maturity date for the Revolving Credit Facility is December 14, 2013 (the "Maturity Date"). Interest on the Revolving Credit Facility accrues at the rate of 12% per annum. Interest on the Revolving Credit Facility is payable monthly on the third business day of each month for interest accrued during the prior month, and the remaining balance is payable on the Maturity Date. Each of Costa Brava and Griffin, individually and collectively, jointly and severally, have unconditionally guaranteed repayment to PFG of $2.0 million of our monetary obligations under the Loan Agreement.

To secure the payment of all of our obligations under the Revolving Credit Facility when due, we granted to PFG a first position, continuing security interest in substantially all of our assets, including substantially all of our intellectual property, subject to the commitment by PFG to release any security interests in the assets of the Thermal Imaging Business that we sold. That sale was consummated on January 31, 2012, and PFG subsequently released the related security interests. In addition, Costa Brava, Griffin and certain other of our existing creditors have agreed that, while any obligations remain outstanding by us to PFG, their respective security interests in and liens on our assets shall be subordinated and junior to those of PFG.

Senior Subordinated Convertible Notes

Effective as of September 28, 2012, the Company issued and sold to The Griffin Fund LP Senior Subordinated Secured Convertible Promissory Notes due November 30, 2012 in the aggregate principal amount of $1.2 million (the "2012 Notes"). The 2012 Notes are convertible at $0.12 per share, or the price of shares sold by the Company to one or more investors and raising gross proceeds to the Company of at least $1.0 million. During the 13 week period ended December 30, 2012 the Company issued $4,210,000 of 2012 Notes.

Payment in cash of an amount equal to all outstanding principal and accrued, but unpaid interest on the 2012 Notes was initially due November 30, 2012. The 2012 Notes were amended effective November 30, 2012 to change the maturity date of the 2012 Notes to March 31, 2013 (the "Maturity Date").

Subsequent to December 30, 2012, the Company authorized the issuance of Senior Subordinated Convertible Promissory Notes (the "2013 Notes") that are a part of a series of notes, along with the 2012 Notes, in the aggregate amount of $10 million. As additional consideration for the purchase of the 2013 Notes, the Company shall issue shares of its common stock to each investor with a value equal to 25% of the principal amount of the 2013 Notes purchased by such investor. The 2012 Notes previously issued were cancelled and exchanged by each investor for 2013 Notes. The maturity date of the 2013 Notes is the earlier of 6 months after issuance, or the closing of a debt or equity financing resulting in gross proceeds to the Company in excess of $5 million (a "Qualified Financing"). Further, within fifteen (15) business days after the closing of a Qualified Financing, each investor may convert the outstanding principal and interest under their 2013 Note into the securities issued in the Qualified Financing, on the same terms and conditions as the other investors in the Qualified Financing. As of February 6, 2013 the Company has issued $7.4 million of the $10 million aggregate amount of these series of Notes.

Senior Subordinated Notes

In March 2011, the Company issued and sold to two accredited investors, Costa Brava Partnership III L.P. ("Costa Brava") and The Griffin Fund LP ("Griffin") 12% Senior Subordinated Secured Promissory Notes due March 2013 (the "Senior Subordinated Notes") in the aggregate principal amount of $4.0 million. In July 2011, the Senior Subordinated Notes were amended to permit the holders to demand repayment any time on or after July 16, 2012, in partial consideration for permitting the issuance of additional Subordinated Secured Convertible Promissory Notes as discussed below. Because of this demand, the Senior Subordinated Notes have been classified as current obligations in the Company's Consolidated Balance Sheet as of December 30, 2012.

The Senior Subordinated Notes bear interest at a rate of 12% per annum paid by adding the amount of such interest to the outstanding principal amount of the Senior Subordinated Notes as "paid-in-kind" ("PIK") interest. As a result of the addition of such interest, the outstanding principal amount of the Senior Subordinated Notes at December 30, 2012 was $4.9 million.

The Senior Subordinated Notes are secured by substantially all of the assets of the Company pursuant to Security Agreements dated March 16, 2011 and March 31, 2011 between the Company and Costa Brava as representative of the Senior Subordinated Note holders, but the liens securing the Senior Subordinated Notes are subordinate to the liens securing the indebtedness of the Company to PFG under the Revolving Credit Facility.

Subordinated Secured Convertible Notes

In December 2010, the Company entered into a Securities Purchase Agreement with Costa Brava and Griffin, pursuant to which the Company issued and sold to Costa Brava and Griffin 12% Subordinated Secured Convertible Notes due December 23, 2015 (the "Subordinated Notes") in the aggregate principal amount of $7.8 million and sold in a subsequent closing in March 2011 additional Subordinated Notes to Costa Brava and Griffin for an aggregate purchase price of $1.2 million. In July 2011, the Company sold additional Subordinated Notes to five accredited investors, including Costa Brava and Griffin, in the aggregate principal amount of $5,000,000. In addition, holders of existing notes with a principal balance of $1.1 million converted their Bridge Notes into Subordinated Notes during Fiscal 2011.

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