Digimarc (DMRC) 10-Q 2017 Q1 Quarterly report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2017

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period fromto

Commission File Number: 001-34108

DIGIMARC CORPORATION

(Exact name of registrant as specified in its charter)

Oregon	26-2828185
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

9405 SW Gemini Drive, Beaverton, Oregon 97008

(Address of principal executive offices) (Zip Code)

(503) 469-4800

(Registrant’s telephone number, including area code)

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 of 1934 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 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	☐	Accelerated filer	☒
Non-accelerated filer	☐  (Do not check if a smaller reporting company)	Smaller reporting company	☐
Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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 April 21, 2017, there were 10,697,735 shares of the registrant’s common stock, par value $0.001 per share, outstanding.

Table of Contents

PART I FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited):	3
	Consolidated Balance Sheets as of March 31, 2017 and December 31, 2016	3
	Consolidated Statements of Operations for the three months ended March 31, 2017 and 2016	4
	Consolidated Statements of Shareholders’ Equity for the three months ended March 31, 2017 and 2016	5
	Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	28
Item 4.	Controls and Procedures	28
PART II OTHER INFORMATION
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 6.	Exhibits	30
SIGNATURES		31

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

DIGIMARC CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(UNAUDITED)

	March 31,			December 31,
	2017			2016
ASSETS
Current assets:
Cash and cash equivalents	$	13,135		$	11,638
Marketable securities		43,050			44,496
Trade accounts receivable, net		3,804			5,078
Other current assets		1,625			1,695
Total current assets		61,614			62,907
Marketable securities		—			4,392
Property and equipment, net		3,767			3,570
Intangibles, net		6,399			6,422
Goodwill		1,114			1,114
Other assets		276			331
Total assets	$	73,170		$	78,736
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable and other accrued liabilities	$	1,398		$	1,523
Deferred revenue		2,448			2,923
Total current liabilities		3,846			4,446
Deferred rent and other long-term liabilities		1,066			956
Total liabilities		4,912			5,402
Commitments and contingencies (Note 12)
Shareholders’ equity:
Preferred stock (par value $0.001 per share, 2,500 authorized, 10 shares    issued and outstanding at March 31, 2017 and December 31, 2016)		50			50
Common stock (par value $0.001 per share, 50,000 authorized, 10,695 and    10,523 shares issued and outstanding at March 31, 2017 and December 31, 2016,    respectively)		11			11
Additional paid-in capital		122,152			120,985
Accumulated deficit		(53,955	)		(47,712	)
Total shareholders’ equity		68,258			73,334
Total liabilities and shareholders’ equity	$	73,170		$	78,736

The accompanying notes are an integral part of these consolidated financial statements.

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DIGIMARC CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(UNAUDITED)

	Three			Three
	Months			Months
	Ended			Ended
	March 31,			March 31,
	2017			2016
Revenue:
Service	$	3,696		$	3,250
Subscription		1,445			1,463
License		950			867
Total revenue		6,091			5,580
Cost of revenue:
Service		1,635			1,432
Subscription		556			662
License		118			96
Total cost of revenue		2,309			2,190
Gross profit		3,782			3,390
Operating expenses:
Sales and marketing		3,992			2,955
Research, development and engineering		3,459			3,305
General and administrative		2,385			2,170
Intellectual property		392			434
Total operating expenses		10,228			8,864
Operating loss		(6,446	)		(5,474	)
Other income, net		118			46
Loss before income taxes		(6,328	)		(5,428	)
Benefit (provision) for income taxes		110			(7	)
Net loss	$	(6,218	)	$	(5,435	)
Earnings (loss) per common share:
Loss per common share—basic	$	(0.61	)	$	(0.64	)
Loss per common share—diluted	$	(0.61	)	$	(0.64	)
Weighted average common shares outstanding—basic		10,161			8,533
Weighted average common shares outstanding—diluted		10,161			8,533

The accompanying notes are an integral part of these consolidated financial statements.

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DIGIMARC CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands)

(UNAUDITED)

													Retained
										Additional			Earnings			Total
	Preferred Stock				Common Stock					Paid-in			(Accumulated			Shareholders'
	Shares		Amount		Shares			Amount		Capital			Deficit)			Equity
BALANCE AT DECEMBER 31, 2015		10	$	50		8,919		$	9	$	77,439		$	(26,040	)	$	51,458
Exercise of stock options		—		—		15			—		145			—			145
Issuance of restricted common stock		—		—		162			—		—			—			—
Forfeiture of restricted common stock		—		—		(1	)		—		—			—			—
Purchase and retirement of common stock		—		—		(18	)		—		(520	)		—			(520	)
Stock-based compensation		—		—		—			—		1,315			—			1,315
Net loss		—		—		—			—		—			(5,435	)		(5,435	)
BALANCE AT MARCH 31, 2016		10	$	50		9,077		$	9	$	78,379		$	(31,475	)	$	46,963
BALANCE AT DECEMBER 31, 2016		10	$	50		10,523		$	11	$	120,985		$	(47,712	)	$	73,334
Exercise of stock options		—		—		19			—		177			—			177
Issuance of restricted common stock		—		—		178			—		—			—			—
Forfeiture of restricted common stock		—		—		(2	)		—		—			—			—
Purchase and retirement of common stock		—		—		(23	)		—		(583	)		—			(583	)
Stock-based compensation		—		—		—			—		1,573			(25	)		1,548
Net loss		—		—		—			—		—			(6,218	)		(6,218	)
BALANCE AT MARCH 31, 2017		10	$	50		10,695		$	11	$	122,152		$	(53,955	)	$	68,258

The accompanying notes are an integral part of these consolidated financial statements.

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DIGIMARC CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(UNAUDITED)

	Three			Three
	Months			Months
	Ended			Ended
	March 31,			March 31,
	2017			2016
Cash flows from operating activities:
Net loss	$	(6,218	)	$	(5,435	)
Adjustments to reconcile net loss to net cash used in    operating activities:
Depreciation, amortization and write-off of property and    equipment		299			339
Amortization and write-off of intangibles		257			290
Stock-based compensation		1,503			1,283
Changes in operating assets and liabilities:
Trade accounts receivable		1,274			2,320
Other current assets		70			91
Other assets		55			24
Accounts payable and other accrued liabilities		128			(663	)
Deferred revenue		(498	)		(457	)
Net cash used in operating activities		(3,130	)		(2,208	)
Cash flows from investing activities:
Purchase of property and equipment		(605	)		(490	)
Capitalized patent costs		(200	)		(217	)
Maturity of marketable securities		16,399			14,277
Purchase of marketable securities		(10,561	)		(6,081	)
Net cash provided by investing activities		5,033			7,489
Cash flows from financing activities:
Exercise of stock options		177			145
Purchase of common stock		(583	)		(520	)
Net cash used in financing activities		(406	)		(375	)
Net increase in cash and cash equivalents		1,497			4,906
Cash and cash equivalents at beginning of period		11,638			3,160
Cash and cash equivalents at end of period	$	13,135		$	8,066
Supplemental disclosure of cash flow information:
Cash paid for income taxes, net	$	13		$	6
Supplemental schedule of non-cash investing activities:
Property and equipment and patent costs in accounts payable	$	(120	)	$	(183	)
Stock-based compensation capitalized to software and patent    costs	$	45		$	32

The accompanying notes are an integral part of these consolidated financial statements.

6

DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(UNAUDITED)

1. Description of Business and Significant Accounting Policies

Description of Business

Digimarc Corporation (“Digimarc” or the “Company”), an Oregon corporation, enables governments and enterprises around the world to give digital identities to media and objects that computers can sense and recognize, and to which they can react. The Company has developed Digimarc Discover^®, Digimarc Barcode and the Intuitive Computing Platform^™ that are designed to optimize the identification of all consumer brand impressions, wherever and whenever they may appear, facilitating modern mobile-centric shopping. The platform includes means to embed “Digimarc Barcodes,” invisible and inaudible barcode-like information that is recognizable by smartphones, tablets, industrial scanners, and other computer interfaces into virtually all forms of media content, including consumer product packaging. Digimarc Barcodes have many applications, including facilitating remarkably faster scanning of products at retail checkout as well as improved engagement with smartphone-equipped consumers. The Digimarc Barcode is robust yet imperceptible by people in ordinary use, allowing for reliable, efficient, economical, globally scalable, automatic identification of media without visible computer codes like traditional barcodes.

Interim Consolidated Financial Statements

The Company has adhered to the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2016 in preparing the accompanying interim consolidated financial statements.

The accompanying interim consolidated financial statements have been prepared from the Company’s records without audit and, in management’s opinion, include all adjustments (consisting of only normal recurring adjustments) necessary to fairly reflect the financial condition and the results of operations for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted in accordance with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”).

These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, which was filed with the SEC on February 23, 2017. The results of operations for the interim periods presented in these consolidated financial statements are not necessarily indicative of the results for the full year.

Reclassifications

Certain prior period amounts in the accompanying consolidated financial statements and notes thereto have been reclassified to conform to current period presentation. These reclassifications had no material effect on the results of operations or financial position for any period presented.

Contingencies

The Company evaluates all pending or threatened contingencies or commitments, if any, that are reasonably likely to have a material adverse effect on the Company’s operations or financial position. The Company assesses the probability of an adverse outcome and determines if it is remote, reasonably possible or probable as defined in accordance with the provisions of ASC 450 “Contingencies.” If information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements, and the amount of the loss, or the range of probable loss can be reasonably estimated, then the loss is accrued and charged to operations. If no accrual is made for a loss contingency because one or both of the conditions pursuant to ASC 450 are not met, but the probability of an adverse outcome is at least reasonably possible, the Company will disclose the nature of the contingency and provide an estimate of the possible loss or range of loss, or state that such an estimate cannot be made.

7

Accounting Pronouncements Adopted

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09, “Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting (Topic 718).” ASU No. 2016-09 simplifies the accounting for share-based payment transactions, including accounting for income taxes, forfeitures, statutory tax withholding requirements, and classification in the statement of cash flows. The amendments in this update are effective for fiscal years beginning after December 31, 2016, and interim periods beginning in the first interim period within the year of adoption. Any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The Company adopted the provisions of this standard effective January 1, 2017. On adoption, deferred tax assets of $6,219 was recorded for previously unrecognized excess tax benefits as of December 31, 2016, which was offset by $6,219 of valuation allowance.Future excess tax benefits will be recognized in the income tax provision when realized and would be offset by any required valuation allowance.The Company will no longer apply a forfeiture rate to share-based payment awards and instead account for forfeitures when they occur. This policy election resulted in a $25 adjustment to opening retained earnings. The Company also provided employees the option to elect the minimum or the maximum statutory tax-withholding rate to be applied on the exercise or vesting of share-based awards. The adoption of the standard did not have a material impact on the Company’s financial condition, results of operations, cash flows and disclosures.

In January 2017, the FASB issued ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350).” ASU No. 2017-04 simplifies the subsequent measurement of goodwill by removing the second step of the two-step impairment test. The amendment requires an entity to perform its annual, or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The amendments in this update are effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 31, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The amendments in this update should be applied on a prospective basis.  The Company has elected to early adopt the amendments of this standard effectively January 1, 2017. The early adoption of this standard resulted in no impact on the Company’s financial condition, results of operations, cash flows and disclosures.

Accounting Pronouncements Issued But Not Yet Adopted

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASU No. 2014-09 provides specific guidance to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU No. 2015-14 to defer the effective date of the new revenue standard for public entities by one year to annual reporting periods beginning after December 31, 2017, and interim periods beginning in the first interim period within the year of adoption. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company has developed an implementation plan to adopt this new guidance.  As part of this plan, the Company is currently assessing the potential future impact of this standard on the Company’s financial condition, results of operations and disclosures.  Based on procedures performed to date, the impact of this standard on service and license revenues is not expected to have a material impact on the Company; however, the Company will continue to evaluate this assessment. The Company is not far enough along in the evaluation of the impact of the standard on subscription revenue to make any conclusions at this time. The guidance permits the use of either the retrospective or cumulative effect transition method. The Company plans to utilize the cumulative effect transition method and will adopt this standard effective January 1, 2018.

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842),” which supersedes Topic 840, Leases. ASU No. 2016-02 increases the transparency and comparability of organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This guidance requires that operating leases recognize a right-of-use asset and a lease liability measured at the present value of the lease payments in the statement of financial position, recognize a single lease cost allocated over the lease term on a generally straight-line basis, and classify all cash payments within operating activities in the statement of cash flows. The amendments in this update are effective for fiscal years beginning after December 31, 2018, and interim periods beginning in the first interim period within the year of adoption. Early adoption is permitted. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach, which includes a number of optional practical expedients that entities may elect to apply. While the Company is currently assessing the potential future impact of adopting this standard, the Company expects the primary impact will be the recognition, on a discounted basis, of our minimum commitments under non-cancelable operating leases on our consolidated balance sheets, resulting in the recording of right of use assets and lease obligations. The Company’s minimum commitments under non-cancelable operating leases are disclosed in Note 7 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

8

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows – Classification of Certain Cash Receipts and Cash Payments (Topic 230).” ASU No. 2016-15 adds or clarifies guidance on specific cash flow issues to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. The amendments in this update are effective for fiscal years beginning after December 31, 2017, and interim periods beginning in the first interim period within the year of adoption. Early adoption is permitted. Any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in this update are to be applied retrospectively to all periods presented but may be applied prospectively from the earliest date practicable if retrospective application would be impracticable. The Company is currently assessing the potential future impact of this standard on its cash flows and disclosures.

2. Fair Value of Financial Instruments

The estimated fair values of the Company’s financial instruments, which include cash equivalents, accounts receivable, accounts payable and other accrued liabilities approximate their carrying values due to the short-term nature of these instruments. The Company records marketable securities at amortized cost, which approximates fair value.

The Company’s fair value hierarchy for its cash equivalents and marketable securities as of March 31, 2017 and December 31, 2016, respectively, was as follows:

March 31, 2017	Level 1		Level 2		Level 3		Total
Money market securities	$	2,621	$	—	$	—	$	2,621
Commercial paper		—		18,718		—		18,718
Federal agency notes		—		17,223		—		17,223
Corporate notes		—		12,635		—		12,635
Pre-refunded municipal bonds (1)		—		3,114		—		3,114
U.S. treasuries		—		1,004		—		1,004
Total	$	2,621	$	52,694	$	—	$	55,315

December 31, 2016	Level 1		Level 2		Level 3		Total
Money market securities	$	1,218	$	—	$	—	$	1,218
Federal agency notes		—		16,810		—		16,810
Commercial paper		—		16,757		—		16,757
Corporate notes		—		15,753		—		15,753
Pre-refunded municipal bonds (1)		—		6,716		—		6,716
U.S. treasuries		—		2,515		—		2,515
Total	$	1,218	$	58,551	$	—	$	59,769

(1) Pre-refunded municipal bonds are collateralized by U.S. treasuries.

The fair value maturities of the Company’s cash equivalents and marketable securities as of March 31, 2017 are as follows:

	Maturities by Period
	Total		Lessthan 1 year		1-5 years		5 - 10 years		More than 10 years
Cash equivalents and marketable securities	$	55,315	$	55,315	$	—	$	—	$	—

The Company considers all highly liquid marketable securities with original maturities of 90 days or less at the date of acquisition to be cash equivalents. Cash equivalents include money market funds and commercial paper totaling $12,265 and $10,881 at March 31, 2017 and December 31, 2016, respectively. Cash equivalents are carried at cost or amortized cost, which approximates fair value.

3. Revenue Recognition

The Company derives its revenue primarily from professional services, subscriptions and licensing of its intellectual property:

• Service revenue consists primarily of software development and consulting services. The majority of service revenue arrangements are structured as time and materials consulting agreements.

• Subscription revenue includes Digimarc Discover, Digimarc Barcode and Guardian products and services, is generally recurring, paid in advance and recognized over the term of the subscription.

9

• License revenue originates primarily from licensing the Company’s intellectual property, where the Company receives license fees and/or royalties as its income stream.

Revenue is recognized in accordance with ASC 605 “Revenue Recognition” and ASC 985 “Software” when the following four criteria are met:

(i) persuasive evidence of an arrangement exists,

(ii) delivery has occurred,

(iii) the fee is fixed or determinable, and

(iv) collection is reasonably assured or probable.

Some customer arrangements encompass multiple deliverables, such as professional services, software licenses, and maintenance and support fees. For arrangements that include multiple deliverables, the Company identifies separate units of accounting at inception based on the consensus reached under ASC 605-25 “Multiple-Element Arrangements,” which provides that revenue arrangements with multiple deliverables should be divided into separate units of accounting if certain criteria are met. The Company applies ASC 985 to software deliverables when relevant. The consideration for the arrangements under ASC 605-25 is allocated to the separate units of accounting using the relative selling price method.

The relative selling price method allocates the consideration based on the Company’s specific assumptions rather than assumptions of a marketplace participant, and allocates any discount in the arrangement proportionally to each deliverable on the basis of each deliverable’s selling price.

Applicable revenue recognition criteria are considered separately for each separate unit of accounting as follows:

• Service revenue is generally determined based on time and materials. Revenue for development and consulting services is recognized as the services are performed. Billing for services rendered generally occurs within one month after the services are provided.

• Subscription revenue, which includes revenue from the sale of Digimarc Discover, Digimarc Barcode and Guardian products and services, is generally paid in advance and recognized over the term of the subscription, which is generally one to three years.

• License revenue is recognized when amounts owed to the Company have been earned, are fixed or determinable (within the Company’s normal 30 to 60 day payment terms), and collection is reasonably assured. If the payment terms extend beyond the normal 30 to 60 days, the fee may not be considered to be fixed or determinable, and the revenue would then be recognized when installments are due.

• The Company records revenue from certain license agreements upon cash receipt as a result of collectability not being reasonably assured.

• The Company’s standard payment terms for license arrangements are 30 to 60 days. Extended payment terms on patent license arrangements are not considered to be fixed or determinable if payments are due beyond the Company’s standard payment terms, primarily because of the risk of substantial modification present in the Company’s patent licensing business. As such, revenue on license arrangements with extended payment terms is recognized as fees become fixed or determinable.

Deferred revenue consists of billings in advance for professional services, subscriptions and licenses for which revenue has not been earned.

4. Segment Information

Geographic Information

The Company derives its revenue from a single reporting segment: media management solutions. Revenue is generated in this segment through development services, subscriptions and licensing of intellectual property. The Company markets its products in the U.S. and in non-U.S. countries through its sales and licensing personnel.

10

Revenue by geographic area, based upon the “bill-to” location, was as follows:

	Three		Three
	Months		Months
	Ended		Ended
	March 31,		March 31,
	2017		2016
Domestic	$	1,501	$	1,133
International (1)		4,590		4,447
Total	$	6,091	$	5,580

(1) Revenue from the Central Banks, consisting of a consortium of central banks around the world, is classified as international revenue. Reporting revenue by country for this customer is not practicable.

Major Customers

Customers who accounted for 10% or more of the Company’s revenue are as follows:

	Three			Three
	Months			Months
	Ended			Ended
	March 31,			March 31,
	2017			2016
Central Banks		62	%		63	%

Long-lived assets by geographical area

The Company’s long-lived assets are all domestic, domiciled in the U.S.

5. Stock-Based Compensation

Stock-based compensation includes expense charges for all stock-based awards to employees and directors. These awards include option grants and restricted stock awards.

Stock-based compensation expense related to internal labor is capitalized to software and patents based on direct labor hours charged to capitalized software and patent costs.

Determining Fair Value

Stock Options

The Company estimates the fair value of stock options granted using the Black-Scholes option valuation model. The fair value of stock options is determined on the date of the grant (measurement date), and is amortized on a straight-line method over the requisite service periods, which are generally the vesting periods.

There were no stock options granted during the three months ended March 31, 2017 and 2016.

Restricted Stock

The fair value of restricted stock awarded is based on the fair market value of the Company’s common stock on the date of the grant (measurement date), and is recognized over the vesting period of the award using the straight-line method.

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Stock-based Compensation

	Three		Three
	Months		Months
	Ended		Ended
	March 31,		March 31,
	2017		2016
Stock-based compensation:
Cost of revenue	$	176	$	173
Sales and marketing		368		212
Research, development and engineering		308		325
General and administrative		573		501
Intellectual property		78		72
Stock-based compensation expense		1,503		1,283
Capitalized to software and patent costs		45		32
Total stock-based compensation	$	1,548	$	1,315

The following table sets forth total unrecognized compensation cost related to non-vested stock-based awards granted under all equity compensation plans, including stock options and restricted stock:

	As of		As of
	March 31,		December 31,
	2017		2016
Total unrecognized compensation costs	$	12,620	$	9,728

Total unrecognized compensation costs will be adjusted for any future forfeitures.

The Company expects to recognize the unrecognized compensation costs as of March 31, 2017 for stock options and restricted stock over weighted average periods through March 2021 as follows:

	Stock	Restricted
	Options	Stock
Weighted average period	0.0 years	1.54 years

As of March 31, 2017, under all of the Company’s stock-based compensation plans, equity awards to purchase an additional 1,171 shares were authorized for future grants under the plans. The Company issues new shares upon option exercises.

Stock Option Activity

The following table reconciles the outstanding balance of stock options:

				Weighted		Weighted
				Average		Average		Aggregate
				Exercise		Grant Date		Intrinsic
Three months ended March 31, 2017:	Options			Price		Fair Value		Value
Outstanding at December 31, 2016		421		$	19.06	$	9.01
Granted		—			—		—
Exercised		(19	)		9.64		6.30
Forfeited or expired		—			—		—
Outstanding at March 31, 2017		402		$	19.49	$	9.13	$	3,307
Exercisable at March 31, 2017		402		$	19.49			$	3,307

The aggregate intrinsic value is based on the closing price of $27.00 per share of Digimarc common stock on March 31, 2017, which would have been received by the optionees had all of the options with exercise prices less than $27.00 per share been exercised on that date.

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Restricted Stock Activity

The following table reconciles the unvested balance of restricted stock:

				Weighted
				Average
	Number of			Grant Date
Three months ended March 31, 2017:	Shares			Fair Value
Unvested balance, December 31, 2016		385		$	26.28
Granted		178		$	25.15
Vested		(50	)	$	26.29
Forfeited		(2	)	$	18.25
Unvested balance, March 31, 2017		511		$	25.91

The following table indicates the fair value of all restricted stock awards that vested during the three months ended March 31, 2017 and 2016:

	Three		Three
	Months		Months
	Ended		Ended
	March 31,		March 31,
	2017		2016
Fair value of restricted stock awards vested	$	1,277	$	1,278

6. Earnings Per Common Share

The Company calculates basic and diluted earnings per common share in accordance with ASC 260 “Earnings Per Share,” using the two-class method because the Company’s unvested restricted stock is a participating security since these awards contain non-forfeitable rights to receive dividends. Under the two-class method, earnings are allocated to each class of common stock and participating security as if all of the earnings for the period had been distributed.

Basic earnings per common share excludes dilution and is calculated by dividing earnings to common shares by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share is calculated by dividing earnings to common shares by the weighted-average number of common shares, as adjusted for the potentially dilutive effect of stock options.

The following table reconciles earnings (loss) per common share for the three months ended March 31, 2017 and 2016:

	Three			Three
	Months			Months
	Ended			Ended
	March 31,			March 31,
	2017			2016
Basic Earnings (Loss) per Common Share:
Numerator:
Net loss	$	(6,218	)	$	(5,435	)
Distributed earnings to common shares		—			—
Distributed earnings to participating securities		—			—
Total distributed earnings		—			—
Undistributed loss allocable to common shares		(6,218	)		(5,435	)
Undistributed earnings allocable to participating    securities		—			—
Total undistributed loss		(6,218	)		(5,435	)
Loss to common shares—basic	$	(6,218	)	$	(5,435	)
Denominator
Weighted average common shares outstanding—    basic		10,161			8,533
Basic earnings (loss) per common share	$	(0.61	)	$	(0.64	)

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	Ended			Ended
	March 31,			March 31,
	2017			2016
Diluted Earnings (Loss) per Common Share:
Numerator:
Loss to common shares—basic	$	(6,218	)	$	(5,435	)
Undistributed earnings allocated to participating    securities		—			—
Undistributed earnings reallocated to participating    securities		—			—
Loss to common shares—diluted	$	(6,218	)	$	(5,435	)
Denominator
Weighted average common shares outstanding—    basic		10,161			8,533
Dilutive effect of stock options		—			—
Weighted average common shares outstanding—    dilutive		10,161			8,533
Diluted earnings (loss) per common share	$	(0.61	)	$	(0.64	)

There were 175 and 0 common stock equivalents related to stock options that were anti-dilutive and excluded from diluted earnings per common share calculations for the three months ended March 31, 2017 and 2016, respectively, because their exercise prices were higher than the average market price of the underlying common stock for the periods.

There were 119 and 207 common stock equivalents related to stock options that were anti-dilutive and excluded from diluted earnings per common share for the three months ended March 31, 2017 and 2016, respectively, as the Company incurred a net loss for the periods.

7. Trade Accounts Receivable

Trade Accounts Receivable

Trade accounts receivable are recorded at the invoiced amount.

	March 31,			December 31,
	2017			2016
Trade accounts receivable	$	3,819		$	5,093
Allowance for doubtful accounts		(15	)		(15	)
Trade accounts receivable, net	$	3,804		$	5,078
Unpaid deferred revenue included in trade accounts    receivable	$	507		$	2,245

Allowance for doubtful accounts

The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing trade accounts receivable. The Company determines the allowance based on historical write-off experience and current information. The Company reviews its allowance for doubtful accounts each reporting period. Account balances are charged against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

Unpaid deferred revenue

The unpaid deferred revenue that is included in trade accounts receivable is billed in accordance with the provisions of the contracts with the Company’s customers. Unpaid deferred revenue from the Company’s cash-basis customers is not included in trade accounts receivable nor deferred revenue.

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Major customers

Customers who accounted for 10% or more of trade accounts receivable, net are as follows:

	March 31,			December 31,
	2017			2016
Central Banks		60	%		57	%

8. Property and Equipment

Property and equipment are stated at cost. Repairs and maintenance are charged to expense when incurred.

Depreciation on property and equipment is calculated using the straight-line method over the estimated useful lives of the assets, generally two to ten years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life or the lease term.

	March 31,			December 31,
	2017			2016
Office furniture and fixtures	$	1,175		$	1,168
Software		2,472			2,146
Equipment		4,215			4,071
Leasehold improvements		1,614			1,617
Gross property and equipment		9,476			9,002
Less accumulated depreciation and amortization		(5,709	)		(5,432	)
Property and equipment, net	$	3,767		$	3,570

9. Intangibles

Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Amortization of capitalized patent costs associated with the application and award of patents in the U.S. and various other countries are capitalized and amortized on a straight-line basis over the term of the patents as determined at the award date, which varies depending on the pendency period of the application, generally approximating seventeen years.

Amortization of intangible assets acquired is calculated using the straight-line method over the estimated useful lives of the assets.

	Estimated Life	March 31,			December 31,
	(years)	2017			2016
Capitalized patent costs	17-20	$	7,444		$	7,281
Intangible assets acquired:
Purchased patents and intellectual property	3-10		250			250
Existing technology	5		1,560			1,560
Customer relationships	7		290			290
Backlog	2		760			760
Tradenames	3		290			290
Non-solicitation agreements	1		120			120
Gross intangible assets			10,714			10,551
Accumulated amortization			(4,315	)		(4,129	)
Intangibles, net		$	6,399		$	6,422

10. Joint Ventures and Related Party Transactions

In March 2012, Digimarc and Nielsen reduced the investments in their two joint ventures, TVaura LLC (in which Digimarc holds a 51% ownership interest) and TVaura Mobile LLC (in which Digimarc holds a 49% ownership interest), to minimal levels while assessing alternative approaches to achieving each of their goals in the emerging market opportunity of synchronized second screen television.

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In October 2015, Digimarc and Nielsen reactivated the TVaura Mobile LLC joint venture to develop solutions for programmers and advertisers to engage with consumers on second screens and otherwise provide enhanced flexibility to brand strategies targeting modern consumers. The enhanced cooperation represents another building block in developing the market for Digimarc Discover and Digimarc Barcode. Neither Digimarc nor Nielsen has contributed any capital to the joint venture upon reactivation.

As of March 31, 2017, both Digimarc and Nielsen continued to assess the market opportunities of the TVaura LLC joint venture.

Summarized financial information for the joint ventures has not been provided because the disclosures are immaterial to the Company’s filing. TVaura LLC and TVaura Mobile LLC had no revenue or expenses for the three months ended March 31, 2017 and 2016.

The Company’s investment in each joint venture was $0 as of March 31, 2017 and December 31, 2016.

11. Income Taxes

The benefit (provision) for income taxes for the three months ended March 31, 2017 and 2016 reflects current taxes, deferred taxes, and withholding taxes. The effective tax rate for the three months ended March 31, 2017 and 2016 was 2% and 0%, respectively. The valuation allowance against net deferred tax assets as of March 31, 2017 was $34,142, an increase of $9,254 from $24,888 as of December 31, 2016.

The Company adopted the provisions of ASU No. 2016-09 effective January 1, 2017. Deferred tax assets of $6,219 were recorded for previously unrecognized excess tax benefits as of December 31, 2016, which were offset by $6,219 of valuation allowance. Excess tax benefits of $179 were recognized in the provision for income taxes for the three month period ended March 31, 2017, which were offset by $179 of valuation allowance.

12. Commitments and Contingencies

Certain of the Company’s product license and services agreements include an indemnification provision for claims from third parties relating to the Company’s intellectual property. These indemnification provisions are accounted for in accordance with ASC 450 “Contingencies.” To date, there have been no claims made under such indemnification provisions.

The Company is subject from time to time to other legal proceedings and claims arising in the ordinary course of business. At this time, we do not believe that the resolution of any such matters will have a material adverse effect on our financial position, results of operations or cash flows.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements relating to future events or the future financial performance of Digimarc that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included in this Quarterly Report on Form 10-Q under the caption “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q. Readers are also urged to carefully review and consider the disclosures made in Part II, Item 1A (Risk Factors) of this Quarterly Report on Form 10-Q and in the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2016 filed on  February 23, 2017  (our “2016 Annual Report”), and other reports and filings made with the U.S. Securities and Exchange Commission (“SEC”).

Unless the context otherwise requires, references in this Quarterly Report on Form 10-Q to “Digimarc,” “we,” “our” and “us” refer to Digimarc Corporation.

All dollar amounts are in thousands except per share amounts or unless otherwise noted. Percentages within the following tables may not foot due to rounding.

Digimarc, Digimarc Discover and Guardian are registered trademarks of Digimarc Corporation. This Quarterly Report on Form 10-Q also includes trademarks and trade names owned by other parties, and all other such trademarks and trade names mentioned in this Quarterly Report on Form 10-Q are the property of their respective owners.

Overview

Digimarc Corporation, an Oregon corporation founded in 2008, enables governments and enterprises around the world to give digital identities to media and objects that computers can sense and recognize and to which they can react. We have developed Digimarc Discover^®, Digimarc Barcode and the Intuitive Computing Platform^™ that are designed to optimize the identification of all consumer brand impressions, wherever and whenever they may appear, facilitating modern mobile-centric shopping. The platform includes means to embed “Digimarc Barcodes,” invisible and inaudible barcode-like information that is recognizable by smartphones, tablets, industrial scanners, and other computer interfaces into virtually all forms of media content, including consumer product packaging. Digimarc Barcodes have many applications, including facilitating remarkably faster scanning of products at retail checkout as well as improved engagement with smartphone-equipped consumers. The Digimarc Barcode is robust yet imperceptible by people in ordinary use, allowing for reliable, efficient, economical, globally scalable, automatic identification of media without visible computer codes like traditional barcodes.

Our media identification and discovery innovations enable our business partners to create numerous applications across a wide range of media content, including solutions that:

• Improve the speed of retail checkout;

• Provide simple and intuitive mobile customer engagement experiences in stores;

• Quickly and reliably identify and effectively manage music, movies, television programming, digital images, e-publications, documents and other printed materials, especially in light of non-linear distribution over the Internet;

• Deter counterfeiting of money, media and goods, and piracy of e-publications, movies and music;

• Support new digital media distribution models and methods to monetize media content;

• Leverage the power of ubiquitous computing to instantly link consumers to a wealth of information and/or interactive experiences related to the media and objects they encounter each day;

• Provide consumers with more choice and access to media content when, where and how they want it;

• Enhance imagery and video by associating metadata or authenticating media content for government and commercial uses; and

• Better secure identity documents to enhance national security and combat identity theft and fraud.

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Our Intuitive Computing Platform has a proprietary foundation in signal processing innovation known as “digital watermarking,” which allows imperceptible digital information to be embedded in all forms of digitally designed, produced or distributed media content and many physical objects, including photographs, movies, music, television, personal identification documents, financial instruments, industrial parts and product packages. We refer to the embedded information as the Digimarc Barcode. This digital information can be detected and read by a wide range of computers, smartphones, tablets and other digital devices.

Our inventions allow our business partners and customers to provide persistent digital identities for virtually any media content that is digitally processed at some point during its lifecycle. Our technology can be applied to printed materials, video, audio, and images to supply a wide range of consumer engagement, media management and security solutions across multiple consumer and government industry sectors. Over the years our enabling software and business processes, and associated intellectual property portfolio have grown to encompass many related technologies.

We provide our solutions directly and through our business partners. Our inventions provide a powerful element of document security, giving rise to a long-term relationship with a consortium of central banks (the “Central Banks”), and many leading companies in the information technology industry. We and our business partners have successfully propagated the use of our technology in music, movies, television broadcasts, digital images, e-publications and printed materials. Digimarc Barcodes have been used in these applications to improve media rights and asset management, reduce piracy and counterfeiting losses, improve marketing programs, permit more efficient and effective distribution of valuable media content and enhance consumer entertainment and commercial experiences.

Digimarc Barcodes can be used to enhance all forms of media and are imperceptible to human senses, but quickly detected by computers, networks or other digital devices like smartphones and tablets. Unlike traditional barcodes and tags, our solution does not require publishers to give up valuable visual space in magazines and newspapers; nor does it impact the overall layout or aesthetics of the publication for readers. Digimarc Barcodes are imperceptible in normal use and do all that visible barcodes do, but perform better. Our Digimarc Discover platform delivers a range of rich media experiences to its readers on their smartphones or tablets across multiple media formats, including print, audio, video and packaging. Unique to the Digimarc Discover platform is its seamless multi-model use of various content identification technologies as needed, including Digimarc Barcode when present.

In January 2014, we introduced Digimarc Barcodes for use in consumer product packaging. These Digimarc Barcodes can contain the same information found in traditional universal product codes (“UPC”). The UPC information is invisibly repeated multiple times over the entire package surface. We partnered with Datalogic, a global leader in automatic data capture and industrial automation markets and producer of barcode readers, in introducing the Digimarc Barcode to the consumer product packaging market. The first retail scanner enabled was Datalogic’s Magellan^TM 9800i multi-plane imaging scanner. Since then additional scanner vendors and other channel partners have announced support for the Digimarc Barcode platform. Digimarc Barcodes can also connect mobile-enabled consumers directly from packaging to engaging mobile experiences such as additional product information, special offers, recommendations, reviews, social networks and more.

Our intellectual property contains many innovations in digital watermarking, content recognition (sometimes referred to as “fingerprinting”), digital rights management and related fields. To protect our inventions, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, we believe we have one of the world’s most extensive patent portfolios in digital watermarking and related fields, with approximately 1,100 U.S. and foreign patents and pending patent applications as of March 31, 2017. We continue to develop and broaden our portfolio in the fields of media identification and management technology and related applications and systems. We devote significant resources to developing and protecting our inventions and continuously seek to identify and evaluate potential licensees for our patents. The patents in our portfolio have a life of approximately 20 years from the effective filing date, and up to 17 years after the patent has been granted.

The market for patent licensing has become more challenging in recent years. As a result, we have shifted our focus from direct monetization via enforcement and licensing to facilitating progress toward the realization of our vision to enrich everyday living via pervasive, intuitive computing by;

• encouraging large scale adoption of our technologies by industry leaders;

• improving our financial performance by enhancing our competitive differentiation;

• increasing the scale and rate of growth of our products and services business; and

• laying a foundation for continuing innovation.

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For a discussion of activities and costs related to our research and development, see “Results of Operations –Summary – Research, development and engineering.”

Critical Accounting Policies and Estimates

Detailed information about our critical accounting policies and estimates is set forth in Part II, Item 7 of our 2016 Annual Report (“Management’s Discussion and Analysis of Financial Condition and Results of Operations”), under the caption “Critical Accounting Policies and Estimates,” which is incorporated by reference into this Quarterly Report on Form 10-Q.

Results of Operations

The following table presents statements of operations data for the periods indicated as a percentage of total revenue. Unless otherwise indicated, all references in this Management’s Discussion and Analysis of Financial Condition and Results of Operations to the three month period relate to the three month period ended March 31, 2017 and all changes discussed with respect to such periods reflect changes compared to the three month period ended March 31, 2016.

	Three			Three
	Months			Months
	Ended			Ended
	March 31,			March 31,
	2017			2016
	Percentagesare percent of total revenue
Revenue:
Service		61	%		58	%
Subscription		24			26
License		16			16
Total revenue		100			100
Cost of revenue:
Service		27			26
Subscription		9			12
License		2			2
Total cost of revenue		38			39
Gross profit		62			61
Operating expenses:
Sales and marketing		66			53
Research, development and    engineering		57			59
General and administrative		39			39
Intellectual property		6			8
Total operating expenses		168			159
Operating loss		(106	)		(98	)
Other income, net		2			1
Loss before income taxes		(104	)		(97	)
Benefit (provision) for income taxes		2			—
Net loss		(102	%)		(97	%)

Summary

Total revenue for the three month period increased 9% to $6.1 million, primarily as a result of higher service revenue.

Total operating expenses for the three month period increased 15% to $10.2 million, primarily reflecting higher investment in sales, marketing, and engineering as we continue to address important opportunities in market development and delivery of Digimarc Discover and Digimarc Barcode.

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Revenue

	Three			Three
	Months			Months
	Ended			Ended			Dollar			Percent
	March 31,			March 31,			Increase			Increase
	2017			2016			(Decrease)			(Decrease)
Revenue:
Service	$	3,696		$	3,250		$	446			14	%
Subscription		1,445			1,463			(18	)		(1	)%
License		950			867			83			10	%
Total	$	6,091		$	5,580		$	511			9	%
Revenue (as % of total revenue):
Service		61	%		58	%
Subscription		24	%		26	%
License		16	%		16	%
Total		100	%		100	%

Service. Service revenue consists primarily of software development and consulting services. The majority of service revenue arrangements are structured as time and materials consulting agreements. Most of our service revenue is derived from contracts with the Central Banks and government agency contractors. The agreements range from several months to several years in length, and our longer term contracts are subject to work plans that are reviewed and agreed upon at least annually. These contracts generally provide for billing hours worked at predetermined rates and, to a lesser extent, reimbursement for third party costs and services. Increases or decreases in the services provided under these contracts are generally subject to both volume and price changes. The volume of work is generally negotiated at least annually and can be modified as the customer’s needs change. We also have provisions in our longer term contracts that allow for specific hourly rate price increases on an annual basis to account for cost of living variables. Contracts with government agency contractors are generally shorter term in nature, less linear in billings and less predictable than our longer term contracts because the contracts with government agency contractors are subject to government budgets and funding.

The increase in service revenue for the three month period was primarily due to more program work with the Central Banks and with a government agency contractor.

Subscription. Subscription revenue includes Digimarc Discover, Digimarc Barcode and Guardian products and services, and is generally recurring in nature, paid in advance and recognized over the term of the subscription.

The decrease in subscription revenue for the three month period was primarily due to lower Guardian revenue, partially offset by higher Digimarc Discover and Digimarc Barcode revenue.

License. License revenue originates primarily from licensing our intellectual property, where we receive license fees and/or royalties as our income stream.

The increase in license revenue for the three month period was primarily due to higher royalty revenue.

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Revenue by Geography

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
Revenue by geography:
Domestic	$	1,501		$	1,133		$	368		32	%
International		4,590			4,447			143		3	%
Total	$	6,091		$	5,580		$	511		9	%
Revenue (as % of total revenue):
Domestic		25	%		20	%
International		75	%		80	%
Total		100	%		100	%

The increase in domestic revenue for the three month period was primarily the result of higher service revenue from a government agency contractor and higher royalty revenue from a domestic customer.

The increase in international revenue for the three month period was primarily due to more program work with the Central Banks.

Cost of Revenue

Service. Cost of service revenue primarily includes costs that are allocated from research, development and engineering, sales and marketing and intellectual property that relate directly to performing services under our customer contracts and direct costs of program delivery. Costs include:

• compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of our software developers, quality assurance personnel, product managers, business development managers and other personnel where we bill our customers for time and materials costs;

• payments to outside contractors that are billed to customers;

• charges for equipment directly used by customers;

• depreciation and other charges for machinery, equipment and software directly used by customers;

• travel costs directly attributable to service and development contracts; and

• charges for infrastructure and centralized costs of facilities and information technology.

Subscription. Cost of subscription revenue primarily includes:

• compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of operations personnel;

• cost of outside contractors that provide operational support;

• amortization of existing technology acquired in the acquisition of Attributor Corporation;

• Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers; and

• charges for infrastructure and centralized costs of facilities and information technology.

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License. Cost of license revenue primarily includes:

• amortization of capitalized patent costs; and

• amortization of patent maintenance fees.

Gross Profit

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
Gross Profit:
Service	$	2,061		$	1,818		$	243		13	%
Subscription		889			801			88		11	%
License		832			771			61		8	%
Total	$	3,782		$	3,390		$	392		12	%
Gross Profit (as % of related    revenue components):
Service		56	%		56	%
Subscription		62	%		55	%
License		88	%		89	%
Total		62	%		61	%

The increase in total gross profit was due primarily to higher service revenue and lower operations costs for our subscription products and services.

There was no change in service gross profit as a percentage of service revenue for the three month period.

The increase in subscription gross profit as a percentage of subscription revenue for the three month period was due primarily to lower operations costs.

The decrease in license gross profit as a percentage of license revenue was insignificant.

Operating Expenses

We allocate certain costs of research, development and engineering, sales and marketing, and intellectual property to cost of revenue when they relate directly to our customer contracts. We record all remaining, or “residual,” costs as sales and marketing, research, development and engineering, general and administrative, and intellectual property expenses.

Sales and marketing

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
Sales and marketing	$	3,992		$	2,955		$	1,037		35	%
Sales and marketing    (as % of total revenue)		66	%		53	%

Sales and marketing expenses consist primarily of:

• compensation, benefits, incentive compensation in the form of stock-based compensation and related costs of sales and marketing employees and product managers;

• travel and market research costs, and costs associated with marketing programs, such as trade shows, public relations and new product launches;

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• professional services and outside contractors for product and marketing initiatives; and

• charges for infrastructure and centralized costs of facilities and information technology.

The increase in sales and marketing expenses for the three month period was due primarily to:

• increased headcount and compensation-related expenses of $0.6 million;

• increased marketing and professional fees of $0.2 million related to market development activities; and

• increased travel expenses of $0.1 million.

Research, development and engineering

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
Research, development and    engineering	$	3,459		$	3,305		$	154		5	%
Research, development and    engineering (as % of total revenue)		57	%		59	%

Research, development and engineering expenses consist primarily of:

• compensation, benefits, incentive compensation in the form of stock-based compensation expense, recruiting and related costs of software and hardware developers and quality assurance personnel;

• payments to outside contractors;

• the purchase of materials and services for product development; and

• charges for infrastructure and centralized costs of facilities and information technology.

The increase in research, development and engineering for the three month period primarily resulted from increased headcount and compensation-related expenses of $0.2 million.

General and administrative

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
General and administrative	$	2,385		$	2,170		$	215		10	%
General and administrative (as %    of total revenue)		39	%		39	%

We incur general and administrative costs in the functional areas of finance, legal, human resources, executive and board of directors. Costs for facilities and information technology are also managed as part of the general and administrative processes and are allocated to this area as well as each of the areas in cost of revenue, sales and marketing, research, development and engineering and intellectual property.

General and administrative expenses consist primarily of:

• compensation, benefits and incentive compensation in the form of stock-based compensation expense and related costs of general and administrative personnel;

• third party and professional fees associated with legal, accounting and human resources;

23

• costs associated with being a public company; and

• charges for infrastructure and centralized costs of facilities and information technology.

The increase in general and administrative expenses for the three month period was primarily due to:

• increased professional fees of $0.1 million; and

• increased legal and accounting expenses of $0.1 million.

Intellectual property

	Three			Three
	Months			Months
	Ended			Ended			Dollar			Percent
	March 31,			March 31,			Increase			Increase
	2017			2016			(Decrease)			(Decrease)
Intellectual property	$	392		$	434		$	(42	)		(10	)%
Intellectual property (as %    of total revenue)		6	%		8	%

We incur intellectual property expenses that arise primarily from costs associated with documenting, applying for, and maintaining domestic and international patents and trademarks.

Gross expenditures for intellectual property costs, before reflecting the effect of capitalized patent costs, primarily consist of:

• compensation, benefits and incentive compensation in the form of stock-based compensation expense and related costs of attorneys and legal assistants;

• third party costs, including filing and governmental regulatory fees and fees for outside legal counsel and translation costs, each incurred in the patent process;

• consulting costs related to marketing our intellectual property portfolio;

• charges to write off previously capitalized patent costs for patent assets we abandon; and

• charges for infrastructure and centralized costs of facilities and information technology.

Intellectual property expenses can vary from period to period based on the level of capitalized patent activity.

The decrease in intellectual property expenses for the three month period was insignificant.

Stock-based compensation

	Three		Three
	Months		Months
	Ended		Ended		Dollar			Percent
	March 31,		March 31,		Increase			Increase
	2017		2016		(Decrease)			(Decrease)
Cost of revenue	$	176	$	173	$	3			2	%
Sales and marketing		368		212		156			74	%
Research, development and engineering		308		325		(17	)		(5	)%
General and administrative		573		501		72			14	%
Intellectual property		78		72		6			8	%
Total	$	1,503	$	1,283	$	220			17	%

The increase in stock-based compensation expense for the three month period was primarily due to increased headcount in sales and marketing.

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We anticipate incurring an additional $12,620 in stock-based compensation expense through March 2021 for awards outstanding as of March 31, 2017.

Other income, net

	Three			Three
	Months			Months
	Ended			Ended			Dollar		Percent
	March 31,			March 31,			Increase		Increase
	2017			2016			(Decrease)		(Decrease)
Other income, net	$	118		$	46			72		157	%
Other income, net (as % of    total revenue)		2	%		1	%

The increase in other income, net for the three month period was primarily due to higher interest income as a result of higher cash and investment balances, higher interest rates on cash and investments, and changes in foreign currency.

Income Taxes

The benefit (provision) for income taxes for the three month periods ended March 31, 2017 and 2016 reflects current taxes, deferred taxes, and withholding taxes. The effective tax rate for the three month periods ended March 31, 2017 and 2016 was 2% and 0%, respectively, because we have a full valuation allowance recorded against our deferred tax assets. The current year effective tax rate was not affected by our adoption of ASU No. 2016-09, because the excess tax benefit from stock-based compensation of $179 was offset by $179 of valuation allowance.

The valuation allowance against deferred tax assets as of March 31, 2017 was $34,142, an increase of $9,254 from $24,888 as of December 31, 2016. The adoption of ASU No. 2016-09 resulted in the recognition of deferred tax assets of $6,219 for previously unrecognized excess tax benefits as of December 31, 2016, which was offset by $6,219 of valuation allowance.

We continually assess the applicability of valuation allowance against our deferred tax assets. Based upon the positive and negative evidence available as of March 31, 2017, and largely due to the cumulative loss incurred by us over the last several years, which is considered a significant piece of negative evidence when assessing the realizability of deferred tax assets, a full valuation allowance is recorded against our deferred tax assets. We will not record tax benefits on any future losses until it is determined that those tax benefits will be realized. All future reversals of the valuation allowance would result in a tax benefit in the period recognized.

Liquidity and Capital Resources

	March 31,		December 31,
	2017		2016
Working capital	$	57,768	$	58,461
Current ratio (1)	16.0:1		14.1:1
Cash, cash equivalents and short-term    marketable securities	$	56,185	$	56,134
Long-term marketable securities	$	—	$	4,392
Total cash, cash equivalents and all    marketable securities	$	56,185	$	60,526

(1) The current ratio is calculated by dividing total current assets by total current liabilities.

The $4.3 million decrease in cash, cash equivalents and marketable securities resulted primarily from:

• cash used in operations;

• purchases of property and equipment and capitalized patent costs; and

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• purchases of common stock related to the vesting of restricted stock; partially offset by

• proceeds from stock option exercises.

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, marketable securities, and trade accounts receivable. We place our cash and cash equivalents with major banks and financial institutions and at times deposits may exceed insured limits. Marketable securities primarily include commercial paper, federal agency notes, corporate notes, pre-refunded municipal bonds and U.S. treasuries. Our investment policy requires our portfolio to be invested to ensure that the greater of $3 million or 7% of the invested funds will be available within 30 days’ notice.

Other than cash used for operating needs, which may include short-term marketable securities, our investment policy limits our credit exposure to any one financial institution or type of financial instrument by limiting the maximum of 5% of our cash and cash equivalents and marketable securities or $1 million, whichever is greater, to be invested in any one issuer except for the U.S. government, U.S. federal agencies and U.S. backed securities, which have no limits, at the time of purchase. Our investment policy also limits our credit exposure by limiting to a maximum of 40% of our cash and cash equivalents and marketable securities, or $15 million, whichever is greater, to be invested in any one industry category (e.g., financial or energy industries) at the time of purchase. As a result, we believe our credit risk associated with cash and investments to be minimal. A decline in the market value of any security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. To determine whether an impairment is other-than-temporary, we consider whether we have the ability and intent to hold the investment until a market price recovery and evidence indicating that the cost of the investment is recoverable outweighs evidence to the contrary. There have been no other-than-temporary impairments identified or recorded by us in the three month periods ended March 31, 2017 and 2016.

Operating Cash Flow

The components of operating cash flows were:

	Three			Three
	Months			Months
	Ended			Ended			Dollar			Percent
	March 31,			March 31,			Increase			Increase
	2017			2016			(Decrease)			(Decrease)
Net loss	$	(6,218	)	$	(5,435	)	$	(783	)		(14	)%
Non-cash items		2,059			1,912			147			8	%
Changes in operating assets and liabilities		1,029			1,315			(286	)		(22	)%
Net cash used in operating activities	$	(3,130	)	$	(2,208	)	$	(922	)		(42	)%

Cash flows used in operating activities for the three month period increased by $0.9 million, primarily as the result of a higher net loss and changes in operating assets and liabilities, partially offset by higher non-cash items. The higher net loss was primarily the result of higher operating expenses reflecting higher investment in sales, marketing, and engineering, partially offset by higher revenue.  The changes in operating assets and liabilities were primarily due to lower collections of accounts receivable, partially offset by higher accounts payable due to timing. The higher non-cash items were primarily the result of higher stock-based compensation due to increased headcount.

Cash flows provided by investing activities for the three month period decreased by $2.5 million from $7.5 million to $5.0 million, primarily as a result of higher net purchases of marketable securities.

Cash flows used in financing activities were relatively consistent for the three month period.

Future Cash Expectations

We believe that our current cash, cash equivalents, and short-term marketable securities balances will satisfy our projected working capital and capital expenditure requirements for at least the next 12 months. We have a $100 million shelf registration statement in place, of which $42,550 was allocated for sales of our common stock under our underwritten public offering in August 2016 and $30,000 was allocated for sales of our common stock under the Equity Distribution Agreement entered into in August 2014. The shelf registration statement expires in June 2017.

We may use similar or other financing means to raise working capital in the future, if necessary, to support continued investment in our growth initiatives. We may also raise capital in the future to fund acquisitions and/or investments in complementary

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businesses, technologies or product lines. If it becomes necessary to obtain additional financing, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms.

Off-Balance Sheet Arrangements

Other than the contractual obligations disclosed in our 2016 Annual Report, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Words such as “may,” “plan,” “should,” “could,” “expect,” “anticipate,” “intend,” “believe,” “project,” “forecast,” “estimate,” “continue,” and variations of such terms or similar expressions are intended to identify such forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements, or other statements made by us, are made based on our expectations and beliefs concerning future events impacting us, and are subject to uncertainties and factors (including those specified below), which are difficult to predict and, in many instances, are beyond our control. As a result, our actual results could differ materially from those expressed in or implied by any such forward-looking statements, and investors are cautioned not to place undue reliance on such statements. We believe that the following factors, among others (including those described in Item 1A. “Risk Factors” of our 2016 Annual Report), could affect our future performance and the liquidity and value of our securities and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us. Forward-looking statements include but are not limited to statements relating to:

• concentration of revenue with few customers comprising a large majority of the revenue;

• revenue trends and expectations;

• our future level of investment in our business, including investment in research, development and engineering of products and technology, development and protection of our intellectual property, sales growth initiatives and development of new market opportunities;

• our ability to improve margins;

• anticipated expenses, costs, margins, provision for income taxes and investment activities in the foreseeable future;

• anticipated tax benefits or reversals of a valuation allowance;

• anticipated effect of our early adoption of accounting pronouncements;

• anticipated revenue to be generated from current contracts, renewals, and as a result of new programs;

• variability of contracted arrangements;

• our profitability in future periods;

• business opportunities that could require that we seek additional financing;

• the size and growth of our markets;

• the existence of international growth opportunities and our future investment in such opportunities;

• the sources of our future revenue;

• our expected short-term and long-term liquidity positions;

• our capital expenditure and working capital requirements and our ability to fund our capital expenditure and working capital needs through cash flow from operations;

• capital market conditions, interest rate volatility and other limitations on the availability of capital, which could have an impact on our cost of capital and our ability to access the capital markets;

• our use of cash, cash equivalents and marketable securities in upcoming quarters;

• anticipated levels of backlog in future periods;

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• the success of our products, including Digimarc Discover, Digimarc Barcode, the Intuitive Computing Platform and Guardian;

• our ability to innovate and enhance our competitive differentiation;

• protection, development and monetization of our intellectual property portfolio;

• our plans and intentions with respect to our joint ventures; and

• the risks detailed in our filings with the Securities and Exchange Commission, including the risk factors set forth in Part I, Item 1A. “Risk Factors” of our 2016 Annual Report.

We believe that the risk factors specified above and the risk factors contained in Part I, Item 1A. “Risk Factors” of our 2016 Annual Report, among others, could affect our future performance and the liquidity and value of our securities and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us or on our behalf. Investors should understand that it is not possible to predict or identify all risk factors and that there may be other factors that may cause our actual results to differ materially from the forward-looking statements. All forward-looking statements made by us or by persons acting on our behalf apply only as of the date of this Quarterly Report on Form 10-Q. We do not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report on Form 10-Q.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

There have been no material changes in market risk from the disclosures provided in Part II, Item 7A of our 2016 Annual Report.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

We conducted an evaluation (pursuant to Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”)), under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q. These disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that this information is accumulated and communicated to management, including the principal executive and principal financial officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

Based on the evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.

Changes in Controls

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the three month period ended March 31, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION.

Item 1. Legal Proceedings.

We are subject from time to time to legal proceedings and claims arising in the ordinary course of business. At this time, we do not believe that the resolution of any such matters will have a material adverse effect on our financial position, results of operations or cash flows.

Item 1A. Risk Factors

Our business, financial condition, results of operations and cash flows may be affected by a number of factors. Detailed information about risk factors that may affect Digimarc’s actual results are set forth in Part I, Item 1A of our 2016 Annual Report. The risks and uncertainties described in our 2016 Annual Report are those risks of which we are aware and that we consider to be material to our business. If any of the risks and uncertainties develops into actual events, our business, financial condition, results of operations, or cash flows could be materially adversely affected. In that case, the trading price of our common stock could decline. As of March 31, 2017, there have been no material changes to the risk factors set forth in our 2016 Annual Report.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

We withhold (repurchase) shares of common stock in connection with the vesting of restricted shares.

The following table sets forth information regarding purchases of our equity securities during the three month period ended March 31, 2017:

							(d)
					(c)		Approximate
					Total number		dollar value
					of shares		of shares that
	(a)		(b)		purchased as		may yet be
	Total number		Average price		part of publicly		purchased
	of shares		paid per		announced plans		under the plans
Period	purchased (1)		share (1)		or programs		or programs
Month 1
January 1, 2017 to January 31, 2017		—	$	—		—	$	—
Month 2
February 1, 2017 to February 28, 2017		23,159	$	25.18		—	$	—
Month 3
March 1, 2017 to March 31, 2017		—	$	—		—	$	—
Total		23,159	$	25.18		—	$	—

(1) Fully vested shares of common stock withheld (purchased) by us in satisfaction of required withholding tax liability upon vesting of restricted stock.

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Item 6. Exhibits.

Exhibit Number	Exhibit Description
31.1	Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1	Section 1350 Certification of Chief Executive Officer
32.2	Section 1350 Certification of Chief Financial Officer
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

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SIGNATURES

Pursuant to the requirements 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.

Date: April 27, 2017	DIGIMARC CORPORATION
	By:	/s/ CHARLES BECK
		CHARLES BECK
		Chief Financial Officer
		(Duly Authorized Officer and Principal Financial and Accounting Officer)

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