SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005. OR |_| TRANSITION REPORT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission file number 0-23970 FALCONSTOR SOFTWARE, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0216135 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2 HUNTINGTON QUADRANGLE, SUITE 2S01 11747 MELVILLE, NEW YORK (Zip code) (Address of principal executive offices) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 631-777-5188 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common Stock, $.001 par value Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes |_| No |X| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X| 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 |X| No |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large Accelerated Filer |_| Accelerated Filer |X| Non-Accelerated Filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| Aggregate market value of Common Stock held by non-affiliates of the Registrant as of June 30, 2005 was $158,217,433 which value, solely for the purposes of this calculation excludes shares held by Registrant's officers and directors. Such exclusion should not be deemed a determination by Registrant that all such individuals are, in fact, affiliates of the Registrant. The number of shares of Common Stock issued and outstanding as of February 21, 2006 was 48,565,923 and 48,016,323, respectively. DOCUMENTS INCORPORATED BY REFERENCE: The information required by Part III of Form 10-K will be incorporated by reference to certain portions of a definitive proxy statement which is expected to be filed by the Company pursuant to Regulation 14A within 120 days after the close of its fiscal year. 1FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES 2005 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Page PART I. Item 1. Business........................................................ 3 Item 1A. Risk Factors.................................................... 9 Item 1B. Unresolved Staff Comments....................................... 17 Item 2. Properties...................................................... 17 Item 3. Legal Proceedings............................................... 17 Item 4. Submission of Matters to a Vote of Security Holders............. 17 PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............................................. 18 Item 6. Selected Consolidated Financial Data............................ 19 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................... 22 Item 7A. Qualitative and Quantitative Disclosures About Market Risk...... 33 Item 8. Financial Statements and Supplementary Data..................... 34 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............................. 56 Item 9A. Controls and Procedures......................................... 56 Item 9B. Other Information............................................... 56 PART III. Item 10. Directors and Executive Officers of the Registrant.............. 56 Item 11. Executive Compensation.......................................... 57 Item 12. Security Ownership of Certain Beneficial Owners and Management.. 57 Item 13. Certain Relationships and Related Transactions.................. 57 Item 14. Principal Accountant Fees and Services.......................... 57 PART IV. Item 15. Exhibits and Financial Statement Schedules ..................... 58 SIGNATURES................................................................ 60 2 PART I ITEM 1. BUSINESS OVERVIEW FalconStor Software, Inc. ("FalconStor") is a premier developer of adaptive data protection solutions that maximize business continuity and data center efficiency within all IT infrastructures, integrating seamlessly to ensure rapid data recovery while simplifying storage management. FalconStor's comprehensive offerings include award-winning, easy-to-deploy storage virtualization, continuous data protection (CDP), virtual tape library (VTL), and disaster recovery (DR) software solutions and related implementation, maintenance, and engineering services. In addition, FalconStor recently launched its PrimeVaultSM offsite data protection center, which provides customers with a safe secondary location to which they can replicate their data securely and cost-effectively for rapid recovery and archiving. From the Fortune 1000 to small and medium-size businesses, customers across a vast range of industries worldwide have implemented FalconStor solutions in their production IT environments in order to meet their most stringent recovery time objectives (RTO) and recovery point objectives (RPO), as well as to manage their storage infrastructures with minimal total cost of ownership (TCO) and optimal return on investment (ROI). FalconStor technology empowers IT administrators and end users to recover data easily to any point in time in the event of hardware failure, data corruption, deletion, or catastrophic site-level disaster, allowing rollback or failover to a known-good, immediately useable state. To ensure that businesses maintain reliable access to their vital applications, and to facilitate accurate data restoration while concurrently minimizing downtime, the uniquely application-aware FalconStor solutions are engineered to work seamlessly with database, email, and file systems so that redundant sets of active data are generated with transactional and point-in-time integrity. Because this eliminates the need for the time-consuming consistency checks that traditionally create long periods of downtime during a recovery process, business productivity is measurably enhanced. Designed to contain escalating costs, FalconStor solutions enable companies to aggregate heterogeneous, distributed storage capacity and centralize administration of both storage resources and business-critical data services such as backup, snapshot, replication, and migration. Companies benefit from lower administrative overhead, elimination of storage over-provisioning, boundless scalability, and the ability to make cost-effective storage allocation and purchasing decisions. Moreover, FalconStor's commitment to an open software-based approach to storage networking entails any-to-any connectivity via native support for industry standards (including Fibre Channel, iSCSI, SCSI, CIFS, NFS, and emerging standards such as Infiniband) and delivers unified support for multiple storage architectures (SAN, NAS, and DAS). As a result, FalconStor solutions provide companies of any size and complexity with the freedom to leverage the high performance of IP/iSCSI- and Fibre Channel-based networks and to implement their choice of state-of-the-art equipment, based on any standard protocol from any storage manufacturer, without rendering their existing and future environments obsolete. Recognizing the strong value proposition of FalconStor's proven, cutting-edge technology, multiple Tier-1 partners utilize FalconStor's innovative software products - including IPStor(R), VirtualTape Library, and DiskSafe(TM) - to power their special-purpose storage appliances and bundled solutions. FalconStor's products have been certified by such industry leaders as Adaptec, Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Engenio Information Technologies, EMC, Emulex, Fujitsu, Gadzoox, Hewlett Packard, Hitachi Data Systems, Hitachi Engineering Co., Ltd., Huawei-3COM, IBM, Intel, LSI Logic, McData Corporation, Microsoft, NEC, Network Appliance, Novell, NS Solutions Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, QLogic, Quantum, Sony, SUN Microsystems, and VMware. Further validation of the best-in-class status of Falconstor's solutions, comes from the agreements Falconstor has with many Tier-1 original equipment manufacturers (OEMs) and others to integrate FalconStor's technology with those companies' products. 3 FalconStor was incorporated in Delaware as Network Peripherals, Inc., in 1994. Pursuant to a merger with FalconStor, Inc., in 2001, the former business of Network Peripherals, Inc., was discontinued, and the newly re-named FalconStor Software, Inc., continued the storage software business started in 2000 by FalconStor, Inc. FalconStor's headquarters are located at 2 Huntington Quadrangle, Suite 2S01, Melville, NY 11747. The Company also maintains offices throughout Europe and Asia. PRODUCTS AND TECHNOLOGY FalconStor's flexible product portfolio facilitates the simple, cost-effective creation of customized data protection solutions that adapt to changing requirements during the entire data lifecycle. FalconStor's innovative approach goes beyond mere backup to address additional elements of the data protection workflow: nearline storage; offsite storage; archiving; and, most importantly, recovery. Because FalconStor's products are engineered from the ground up, they are extraordinarily integrated and scalable; businesses benefit from peace of mind that FalconStor solutions work together in an easily managed and highly efficient fashion, with high data availability and rapid recovery always paramount. SOFTWARE PRODUCTS IPSTOR(R) FalconStor's flagship product, IPStor software - available in an Enterprise Edition, a Standard Edition, and an Express Edition - provides advanced storage networking and best-in-class business continuity/disaster recovery (BCDR) functionality to all segments of the enterprise, small and medium-size business (SMB), and small office/home office (SOHO) markets. IPStor software is comprised of an extensive set of state-of-the-art network storage services designed to deliver rapid data recovery and an open, unified SAN and NAS infrastructure across heterogeneous environments. IPStor software aggregates storage capacity, provisioning, and services to application servers via all industry-standard protocols with speed, security, reliability, interoperability, and scalability. o IPStor continuous data protection (CDP) solutions maintain 24x7x365 availability and usability of data in the event of an unplanned hardware failure, deletion, or software error, or planned downtime. o IPStor disaster recovery (DR) solutions provide rapid, reliable recovery in the event of catastrophic site failure, such as a fire, power outage, or flood in the main data center. o IPStor virtualization solutions enable enterprise data centers to consolidate heterogeneous storage environments and servers, and to centralize storage management under one simple interface. VIRTUALTAPE LIBRARY (VTL) FalconStor VirtualTape Library is the industry-leading, revolutionary backup/recovery solution that saves money and time by using disk to emulate an extensive range of physical tape libraries. Integrating seamlessly with existing backup software and policies, and with FalconStor CDP solutions, VTL enhances backup reliability, speed, availability, and recoverability while consolidating management of backup resources. VTL backup to disk-based virtual tape ensures backup/restore success by eliminating the media/mechanical errors and manual intervention traditionally associated with tape backup. Remote offsite replication of virtual tapes provides disaster protection, while automated data export to physical tape is supported for archiving purposes. Software-based encryption technology prevents unauthorized access to data exported to physical tapes and in transit during replication, without imposing any overhead on the backup process. VTL is fast and easy to deploy--comparable to adding a new tape drive or library to an existing backup environment. DISKSAFE(TM) AND FILESAFE(TM) FalconStor DiskSafe and FalconStor FileSafe are host-resident software tools that protect DAS-based application servers and end user desktops or laptops, as well as servers using third-party storage networks, by enabling them to replicate their entire local disks (DiskSafe) or individual files and directories (FileSafe) to IPStor-managed storage for automated backup and off-site data storage and rapid, user-initiated data recovery. Moreover, DiskSafe technology captures the information necessary to easily boot the designated machine in the event of a virus or spyware attack, application malfunction, or hard disk crash. DiskSafe and FileSafe are integral components of FalconStor's CDP solutions, 4 facilitating the transfer of replicated data over an IP or Fibre Channel network to a centralized FalconStor data management appliance for both redundant nearline storage and remote disaster recovery purposes. APPLICATION-AWARE SNAPSHOT AGENTS FalconStor Snapshot Agents automate and minimize quiesce time during data replication, backup, and other snapshot-based operations to ensure transactional integrity and point-in-time consistency of databases and messaging stores for fast time-to-recovery (TTR). Snapshot Agents are available for IBM(R) DB2(R) UDB, Informix(R), Microsoft(R) SQL Server, Oracle(R), Pervasive.SQL(R), Sybase(R), IBM Lotus Notes(R)/Domino, Microsoft(R) Exchange, Microsoft(R) VSS, Novell(R) GroupWise(R), VMWare(R), and many file systems. SOFTWARE APPLIANCE KITS (SAKS) Addressing one of the fastest growing segments of the storage industry, SMBs and the SOHO market, FalconStor has entered into agreements with resellers and with OEMs to develop software kits for storage appliances that combine specific IPStor, VirtualTape Library, and DiskSafe functionality with third party hardware to create cost-effective, turnkey storage solutions that are easy to deploy and maintain. Currently, FalconStor's resellers and/or OEM partners offer the following storage appliances: o VIRTUALTAPE LIBRARY BACKUP|RECOVERY APPLIANCES use disk to enhance the reliability, speed, and availability of backups while consolidating the management and provisioning of backup resources - without changing existing tape backup software and procedures. With backup windows shrinking and rapid data restoration more critical than ever, VirtualTape Library appliances allow users to utilize disk storage to emulate multiple tape libraries concurrently and to accelerate backup/restore speed across IP/iSCSI and Fibre Channel networks. o ISCSI STORAGE/CDP APPLIANCES leverage the industry-standard iSCSI protocol and an existing IP network to create a reliable networked storage solution for small or remote offices, as well as small data centers, at an affordable price. These appliances work in conjunction with DiskSafe and FileSafe to aggregate and provision storage capacity and provide services that deliver rapid recovery, continuous data protection, and disaster recovery capabilities across networked and direct-attached storage environments. o REALTIME DATA MIGRATION APPLIANCES deliver zero-downtime data migration by leveraging an existing storage network to transport data between different vendors' storage subsystems without requiring reconfiguration or shutting down of production servers. OFFSITE, ONLINE DATA PROTECTION FACILITY PRIMEVAULTSM BY FALCONSTOR is an offsite, online data protection service for organizations, that either do not have their own disaster recovery sites or wish to replicate their data to an additional site for a supplementary layer of redundancy. PrimeVault grants small, medium, and large businesses the power to protect and to archive their data at a secure facility at an affordable and predetermined price based on individualized needs. By cutting the costs of deploying and maintaining an alternate site by half to three-quarters, PrimeVault makes alternate sites practical for most, if not all businesses. PrimeVault offerings include: o Rapid 24x7x365 data recovery with maximum business continuity/disaster recovery (BCDR) capability o Immediate BCDR solution deployment - Cost-effective, flexible pricing - Minimal up-front IT investment and operating overhead - No need to build and staff a dedicated DR center - No need to buy software and hardware for a DR center o Rapid compliance solution deployment while minimizing implementation costs 5 o Seamless scalability of offsite data storage as business expands o Offsite replication of virtual tapes o Data export from virtual to physical tapes with offsite archiving for compliance or other purposes o End-to-end security - Encryption for data replication, virtual tapes, and data storage - Closed-circuit video surveillance 24x7x365 - Encrypted, multi-point verified access to facility PrimeVault also offers: o Managed storage with the benefit of advanced IPStor storage services, including mirroring, continuous data replication and snapshots. o Co-location BUSINESS STRATEGY FalconStor intends to maintain its position as a leading network storage software provider to enterprises worldwide and intends to continue its expansion into the non-enterprise storage market by offering a diverse range of products for use in the small/medium business (SMB) and small office/home office (SOHO) markets. FalconStor intends to achieve these objectives through the following strategies: o MAINTAIN A LEADERSHIP POSITION IN ENTERPRISE NETWORK STORAGE SOFTWARE. FalconStor intends to continue to leverage the protocol-agnostic, unified architecture, and robust data protection technology of its solutions to maintain a leadership position in the enterprise network storage software market. The network storage software market is defined by rapid change, and FalconStor plans to continue to focus its research and development efforts on continuing to invent innovative solutions and bringing them to market quickly. o EXPAND PRODUCT OFFERINGS. In 2005, FalconStor offered additional data protection options and enhancements for its software, including continuous data protection for nonstop data protection and immediate granular data recovery; Adaptive Replication with intelligent, automated throttling capabilities to maximize efficient usage of bandwidth during remote replication of data; VTL Encryption to safeguard data on physical tapes and in transit during replication of virtual tapes; and Automated Tape Caching for simple, seamless integration with existing tape libraries. FalconStor intends to continue to expand its data protection solution offerings across all market segments. o INCREASE MARKET PENETRATION AND BRAND RECOGNITION. FalconStor believes that establishing a strong brand identity as a premier provider of data protection solutions is important to its future success. FalconStor plans to continue to promote corporate and product awareness by investing in activities which have been shown to deliver positive results, such as: o Engaging an experienced, storage-focused PR agency; o Advertising in strategic storage publications and online media; o Hosting solution-focused end user and partner seminars in partnership with industry trade groups and leading analysts; o Forming strategic partnerships with leading industry players; o Participating in industry-specific events, conferences and trade shows; and o Continuing targeted promotions and PR campaigns. 6 o ESTABLISH A GLOBAL PRESENCE. Because FalconStor believes that significant market share can be achieved in Europe and Asia, FalconStor plans to continue expansion of its operational capabilities and promotional activities in these regions to build on current successes. In addition, FalconStor believes that it is developing a strong business presence and positive reputation in Europe and the Asia/Pacific Rim. o EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND ALLIANCES. FalconStor believes that opportunities may exist to expand its technological capabilities, product offerings and services through acquisitions of businesses or software technology and through strategic alliances. When evaluating potential acquisitions and strategic alliances, FalconStor will focus on transactions that enable it to acquire: o Important enabling technology; o Complementary applications; o Marketing, sales, customer and technological synergies; and/or o Key personnel. o SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to continue to enter into OEM agreements with strategic switch, storage, appliance and operating system vendors. Besides accelerating overall market growth, the OEM relationships should continue to bolster FalconStor's product recognition, corporate credibility, and revenue stream. o OFFER PRODUCTS AND SERVICES TO THE SMB AND SOHO MARKETS. FalconStor is working with industry partners to offer storage solutions or services to the SMB and SOHO markets. These solutions and services include special-purpose appliances and applications, as well as hosted storage and DR services via FalconStor's PrimeVault services. SALES, MARKETING AND CUSTOMER SERVICE FalconStor plans to continue to sell its products primarily through original equipment manufacturers (OEMs), value-added resellers (VARs, also sometimes called "solution providers"), and distributors. o OEM RELATIONSHIPS. OEMs collaborate with FalconStor to integrate FalconStor's products into their own product offerings or to resell FalconStor's products under their own label. o VAR AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered into VAR and distributor agreements to help sell its product in various geographic areas. FalconStor's VARs and distributors market various FalconStor products and receive a discount off of the list price on products sold. o STORAGE APPLIANCES. FalconStor has agreements with strategic partners to adapt FalconStor products for use in the strategic partners' special-purpose storage appliances. o DIRECT SALES TO END USERS. In a limited number of circumstances, FalconStor has entered into software license agreements directly with end users. FalconStor's marketing efforts focus on building brand recognition amongst customers, partners, analysts, and the media, and developing qualified leads for the sales force. FalconStor Professional Services personnel are also available to assist customers and partners throughout the product life cycle of FalconStor solution deployments. The Professional Services team includes experienced Storage Architects 7 (expert field engineers) who can assist in the assessment, planning/design, deployment, and testing phases of a deployment project, and a Technical Support group for post-deployment assistance and ongoing support. COMPETITION As the demand for network-based storage products and services increases, more competitors will enter this high-growth market segment. Although there are several companies attempting to offer unified storage services to application hosts attached to iSCSI, Fibre Channel, CIFS, and NFS networks, FalconStor believes it is the only software-based solution provider capable of accommodating storage devices with industry-standard interfaces and provisioning the virtualized resource over IP/iSCSI, Fibre Channel, NFS, and CIFS with comprehensive storage services and simple end-to-end manageability. Although some of FalconStor's products provide capabilities that put them in competition with products from a number of companies with substantially greater financial resources, FalconStor is not aware of any other software company providing unified storage services running on a standard Linux-, Windows- or Solaris-based appliance. FalconStor believes that the principal competitive factors affecting its market include product features such as scalability, data availability, ease of use, price, reliability, hardware/platform neutrality, customer service, and support. Additionally, as more partners offer appliances that integrate FalconStor products, the Company has experienced competitive pressures from smaller, niche players in the industry. However, FalconStor believes these competitors currently do not offer the depth or breadth of storage services delivered by FalconStor, nor do they possess the experience and technological innovation needed to develop and deliver reliable, fully integrated, and proven storage services. As FalconStor continues its move into the non-enterprise storage market, the products and services offered by its partners may compete with existing or new products and services offered by current and new entrants to the market. FalconStor's success will depend largely on its ability to generate market demand and awareness of its products and to develop additional or enhanced products in a timely manner. FalconStor's success will also depend on its ability to convince potential partners of the benefits of licensing its software rather than competing technologies. FalconStor's future and existing competitors could introduce products with superior features, scalability and functionality at lower prices than FalconStor's products and could also bundle existing or new products with other more established products to compete with FalconStor. Increased competition could result in price reductions and reduced gross margins, which could harm FalconStor's business. INTELLECTUAL PROPERTY FalconStor's success is dependent in part upon its proprietary technology. Currently, the IPStor software suite forms the core of this proprietary technology. FalconStor currently has one patent and numerous pending patent applications; and multiple registered trademarks - including "FalconStor," "FalconStor Software" and "IPStor" - and many pending trademark applications related to FalconStor and its products. FalconStor seeks to protect its proprietary rights and other intellectual property through a combination of copyright, trademark and trade secret protection, as well as through contractual protections such as proprietary information agreements and nondisclosure agreements. The technological and creative skills of its personnel, new product developments, frequent product enhancements and reliable product maintenance are essential to establishing and maintaining a technology leadership position. FalconStor generally enters into confidentiality or license agreements with its employees, consultants, and corporate partners, and generally controls access to and distribution of its software, documentation, and other proprietary information. Despite FalconStor's efforts to protect its proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use its products or technology. Monitoring unauthorized use of its products is difficult, and there can be no assurance that the steps FalconStor has taken will prevent misappropriation of its technology, particularly in foreign countries where laws may not protect its proprietary rights as fully as do the laws of the United States. 8 MAJOR CUSTOMERS For the year ended December 31, 2005, FalconStor had two customers that together accounted for 31% of revenues. For the year ended December 31, 2004, FalconStor had one customer that accounted for 16% of revenues. For the year ended December 31, 2003, FalconStor did not have any customers that accounted for over 10% of revenues. As of December 31, 2005, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 28% of the accounts receivable balance. As of December 31, 2004, the Company had three customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 33% of the accounts receivable balance. EMPLOYEES As of December 31, 2005, FalconStor had 279 full-time employees, consisting of 139 in research and development, 74 in sales and marketing, 49 in service, and 17 in general administration. FalconStor is not subject to any collective bargaining agreements and believes its employee relations are good. INTERNET ADDRESS AND AVAILABILITY OF FILINGS FalconStor's internet address is WWW.FALCONSTOR.COM. FalconStor makes available free of charge, on or through its Internet website, FalconStor's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after FalconStor electronically files such material with, or furnishes it to, the SEC. FalconStor complied with this policy for every Securities Exchange Act of 1934 report filed during the year ended December 31, 2005. ITEM 1A. RISK FACTORS DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE MARKET AND OUR RELIANCE ON OUR PARTNERS, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES. The rapidly evolving nature of the network storage software market in which we sell our products, the degrees of effort and success of our partners' sales and marketing efforts, and other factors that are beyond our control, reduce our ability to accurately forecast our quarterly and annual revenue. However, we must use our forecasted revenue to establish our expense budget. Most of our expenses are fixed in the short term or incurred in advance of anticipated revenue. As a result, we may not be able to decrease our expenses in a timely manner to offset any shortfall in revenue. THE MARKET FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE EXPECT. The continued adoption of Storage Area Networks (SAN) and Network Attached Storage (NAS) solutions is critical to our future success. The markets for SAN and NAS solutions are still maturing, making it difficult to predict their potential sizes or future growth rates. If these markets develop more slowly than we expect, our business, financial condition and results of operations would be adversely affected. THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS STILL MATURING, AND OUR BUSINESS WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT. The continued adoption of disk-based backup solutions, such as our VirtualTape Library software, is critical to our future success. The market for disk-based backup solutions is still maturing, making it difficult to predict its potential size or future growth rate. If this market develops more slowly than we expect, our business, financial condition and results of operations would be adversely affected. 9 THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT. The rapid adoption of IP-based Storage Area Networks (SAN) is important to our future success. The market for IP-based SANs is still unproven, making it difficult to predict the potential size or future growth rate. We are uncertain whether a viable market for our products will develop or be sustainable. If this market fails to develop, or develops more slowly than we expect, our business, financial condition and results of operations would be adversely affected. WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS AND SMALL OFFICE/HOME OFFICE MARKETS. We have announced plans to offer products for the small/medium business (SMB) and small office/home office (SOHO) markets. We may not be able to design or offer products attractive to the SMB and the SOHO markets, or to reach agreements with OEMs and resellers with significant presences in the SMB and SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will not be able to recoup the expenses associated with our efforts in these markets and our ability to grow revenues could suffer. IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER. The network storage software market continues to evolve and as a result there is continuing demand for new products. Accordingly, we may need to develop and manufacture new products that address additional network storage software market segments and emerging technologies to remain competitive in the data storage software industry. We are uncertain whether we will successfully qualify new network storage software products with our customers by meeting customer performance and quality specifications or quickly achieve high volume production of storage networking software products. Any failure to address additional market segments could harm our business, financial condition and operating results. OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY CUSTOMERS IN OUR MARKETS. Our current products are only one part of a storage system. All components of these systems must comply with the same industry standards in order to operate together efficiently. We depend on companies that provide other components of these systems to conform to industry standards. Some industry standards may not be widely adopted or implemented uniformly, and competing standards may emerge that may be preferred by OEM customers or end users. If other providers of components do not support the same industry standards as we do, or if competing standards emerge, our products may not achieve market acceptance, which would adversely affect our business. OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION. Our IPStor platform is complex and is designed to be deployed in large and complex networks. Many of our customers have unique infrastructures, which may require additional professional services in order for our software to work within their infrastructures. Because our products are critical to the networks of our customers, any significant interruption in their service as a result of defects in our product could result in damage to our customers. These problems could cause us to incur significant service and engineering costs, divert engineering personnel from product development efforts and significantly impair our ability to maintain existing customer relationships and attract new customers. In addition, a product liability claim, whether successful or not, would likely be time consuming and expensive to resolve and would divert management time and attention. Further, if we are unable to fix the errors or other problems that may be identified in full deployment, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer. Our other products may also contain errors or defects. If we are unable to fix the errors or other problems that may be discovered, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer. 10 FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES. We have entered into agreements with resellers and OEM partners to develop storage appliances that combine certain aspects of IPStor or VTL functionality with third party hardware to create single purpose turnkey solutions that are designed to be easy to deploy. If the storage appliances are not easy to deploy or do not integrate smoothly with end user systems, the basic premise behind the appliances will not be met and sales would suffer. OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES. Prior to offering our products for sale, our OEM customers typically require that each of our products undergo an extensive qualification process, which involves interoperability testing of our product in the OEM's system as well as rigorous reliability testing. This qualification of a product by an OEM does not assure any sales of the product to the OEM. Despite this uncertainty, we devote substantial resources, including engineering, sales, marketing and management efforts, toward qualifying our products with OEMs in anticipation of sales to them. If we are unsuccessful or delayed in qualifying any products with an OEM, such failure or delay would preclude or delay sales of that product to the OEM, which may impede our ability to grow our business. WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES. Almost all of our sales come from sales to end users of our products by our OEM customers and by our resellers. These OEM customers and resellers have limited resources and sales forces and sell many different products, both in the network storage software market and in other markets. The OEM customers and resellers may choose to focus their sales efforts on other products in the network storage software market or other markets. The OEM customers might also choose not to continue to develop or to market products which include our products. This would likely result in lower revenues to us and would impede our ability to grow our business. WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR RECEIVABLES ARE CONCENTRATED WITH TWO CUSTOMERS. We tend to have one or more customers account for 10% or more of our revenues during each fiscal quarter. For the year ended December 31, 2005, we had two customers who together accounted for 31% of our revenues. While we believe that we will continue to receive revenue from these clients, our agreements with these clients do not have any minimum sales requirements and we cannot guarantee continued revenue. If our contracts with these partners are terminated, or if the volume of sales from these clients significantly declines, it would have a material adverse effect on our operating results. In addition, as of December 31, 2005, two customers accounted for a total of 28% of our outstanding receivables. While we currently have no reason to question the collectibility of these receivables, a business failure or reorganization by these customers could harm our ability to collect these receivables and could damage our cash flow. THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR RESPONDING TO TRENDS. Certain of our OEM customers do not report license revenue to us until sixty days or more after the end of the quarter in which the software was licensed. There will thus be a delay before we learn whether licensing revenue from these OEMs has met, exceeded, or fallen short of our expectations. The reporting schedule from these OEMs also means that our ability to respond to trends in the market could be harmed as well. For example, if, in a particular quarter, we see a significant increase or decrease in revenue from our channel sales or one of our other OEM partners, there will be a delay in our ability to determine whether this is an anomaly or a part of a trend. However, we must use our forecasted revenue to establish our expense budget. Most of our expenses are fixed in the short term or incurred in advance of anticipated revenue. As a result, we may not be able to decrease our expenses in a timely manner to offset any shortfall in revenue or to increase our sales, marketing or support headcounts to take advantage of positive developments. 11 ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR PRODUCTS. As part of our sales channel, we license our software to OEMs and other partners who install our software on their own hardware or on the hardware of other third parties. If the hardware does not function properly or causes damage to customers' systems, we could lose sales to future customers, even though our software functions properly. Problems with our partners' hardware could negatively impact our business. WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH STRATEGIC INDUSTRY PARTNERS. Part of our strategy is to partner with major third-party software and hardware vendors who integrate our products into their offerings and/or market our products to others. These strategic partners often have customer or distribution networks to which we otherwise would not have access or the development of which would take up large amounts of our time and other resources. There is intense competition to establish relationships with these strategic partners. Some of our agreements with our OEM customers grant to the OEMs limited exclusivity rights to portions of our products for periods of time. This could result in lost sales opportunities for us with other customers or could cause other potential OEM partners to consider or select software from our competitors for their storage solutions. In addition, the desire for product differentiation could cause potential OEM partners to select software from our competitors. We cannot guarantee that our current strategic partners, or those companies with whom we may partner in the future, will continue to be our partners for any period of time. If our software were to be replaced in an OEM solution by competing software, or if our software is not selected by OEMs for future solutions, it would likely result in lower revenues to us and would impede our ability to grow our business. CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGIC RELATIONSHIPS. In the past, companies with whom we have OEM relationships have been acquired by other companies. These acquisitions caused disruptions in the sales and marketing of our products and in 2005, acquisitions of two of our OEM partners had an impact on our revenues. If additional OEM customers are acquired, the new parents might choose to stop offering solutions containing our software. Even if the solutions continued to be offered, there might be a loss of focus and sales momentum as the companies are integrated. THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS. The network storage software market is intensely competitive even during periods when demand is stable. Some of our current and potential competitors have longer operating histories, significantly greater resources, broader name recognition and a larger installed base of customers than we have. Those competitors and other potential competitors may be able to establish or to expand network storage software offerings more quickly, adapt to new technologies and customer requirements faster, and take advantage of acquisition and other opportunities more readily. Our competitors also may: o consolidate or establish strategic relationships among themselves to lower their product costs or to otherwise compete more effectively against us; or o bundle their products with other products to increase demand for their products. In addition, some OEMs with whom we do business, or hope to do business, may enter the market directly and rapidly capture market share. If we fail to compete successfully against current or future competitors, our business, financial condition and operating results may suffer. FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING RESULTS. Achieving our anticipated growth will depend on a number of factors, some of which include: 12 o retention of key management, marketing and technical personnel; o our ability to increase our customer base and to increase the sales of our products; and o competitive conditions in the network storage infrastructure software market. We cannot assure you that the anticipated growth will be achieved. The failure to achieve anticipated growth could harm our business, financial condition and operating results. OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS. The operating results of our business depend in part on the overall demand for network storage software. Because our sales are primarily to major corporate customers, any softness in demand for network storage software may result in decreased revenues. OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. Our previous results are not necessarily indicative of our future performance and our future quarterly results may fluctuate significantly. Our future performance will depend on many factors, including: o the timing of securing software license contracts and the delivery of software and related revenue recognition; o the seasonality of information technology, including network storage products, spending; o the average unit selling price of our products; o existing or new competitors introducing better products at competitive prices before we do; o our ability to manage successfully the complex and difficult process of qualifying our products with our customers; o new products or enhancements from us or our competitors; o import or export restrictions on our proprietary technology; and o personnel changes. Many of our expenses are relatively fixed and difficult to reduce or modify. As a result, the fixed nature of our expenses will magnify any adverse effect of a decrease in revenue on our operating results. OUR STOCK PRICE MAY BE VOLATILE The market price of our common stock has been volatile in the past and may be volatile in the future. For example, during the past twelve months ended December 31, 2005, the closing market price of our common stock as quoted on the NASDAQ National Market System fluctuated between $5.23 and $9.67. The market price of our common stock may be significantly affected by the following factors: o actual or anticipated fluctuations in our operating results; o failure to meet financial estimates; 13 o changes in market valuations of other technology companies, particularly those in the network storage software market; o announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments; o loss of one or more key OEM customers; and o departures of key personnel. The stock market has experienced extreme volatility that often has been unrelated to the performance of particular companies. These market fluctuations may cause our stock price to fall regardless of our performance. OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE. The Financial Accounting Standards Board ("FASB") has required companies to recognize the fair value of stock options and other equity-based compensation to employees as compensation expense in the statement of operations. We must implement this FASB standard effective in the first quarter of 2006. While we are still evaluating the impact of this requirement, there will be a negative impact on our results of operations. WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY. Our Board of Directors has the authority, without further action by the stockholders, to issue up to 2,000,000 shares of preferred stock on such terms and with such rights, preferences and designations, including, without limitation restricting dividends on our common stock, dilution of the voting power of our common stock and impairing the liquidation rights of the holders of our common stock, as the Board may determine without any vote of the stockholders. Issuance of such preferred stock, depending upon the rights, preferences and designations thereof may have the effect of delaying, deterring or preventing a change in control. In addition, certain "anti-takeover" provisions of the Delaware General Corporation Law, among other things, may restrict the ability of our stockholders to authorize a merger, business combination or change of control. Further, we have entered into change of control agreements with certain executives, which may also have the effect of delaying, deterring or preventing a change in control. WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK. As of December 31, 2005, we had outstanding options and warrants to purchase an aggregate of 10,950,908 shares of our common stock at a weighted average exercise price of $5.29 per share. We also have 1,006,314 shares of our common stock reserved for issuance under our stock option plans with respect to options that have not been granted. The exercise of all of the outstanding options and warrants and/or the grant and exercise of additional options would dilute the then-existing stockholders' percentage ownership of common stock, and any sales in the public market of the common stock issuable upon such exercise could adversely affect prevailing market prices for the common stock. Moreover, the terms upon which we would be able to obtain additional equity capital could be adversely affected because the holders of such securities can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms more favorable than those provided by such securities. OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER, TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS In August, 2003, our business was interrupted due to a large scale blackout in the northeastern United States. While our headquarters facilities contain redundant power supplies and generators, our domestic and foreign operations, and the operations of our industry partners, remain susceptible to fire, floods, power loss, power shortages, telecommunications failures, break-ins and similar events. 14 Any interruption in power supply or telecommunications would be particularly disruptive to our PrimeVault backup and disaster recovery operations. If PrimeVault customers are unable to access their data, confidence in our ability to provide disaster recovery and backup services will be damaged which will impair our ability to retain existing customers, to gain new customers and to expand our operations. Terrorist actions domestically or abroad could lead to business disruptions or to cancellations of customer orders or a general decrease in corporate spending on information technology, or could have direct impact on our marketing, administrative or financial functions and our financial condition could suffer. UNITED STATES GOVERNMENT EXPORT RESTRICTIONS COULD IMPEDE OUR ABILITY TO SELL OUR SOFTWARE TO CERTAIN END USERS. Certain of our products include the ability for the end user to encrypt data. The United States, through the Bureau of Industry Security, places restrictions on the export of certain encryption technology. These restrictions may include: the requirement to have a license to export the technology; the requirement to have software licenses approved before export is allowed; and outright bans on the licensing of certain encryption technology to particular end users or to all end users in a particular country. If we are subject to restrictions on our ability to license products to certain end users, this could negatively impact our business. THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR OPERATING RESULTS. We sell our products worldwide. Accordingly, our operating results could be materially adversely affected by various factors including regulatory, political, or economic conditions in a specific country or region, trade protection measures and other regulatory requirements, and acts of terrorism and international conflicts. Our international sales are denominated primarily in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in foreign markets. Additional risks inherent in our international business activities generally include, among others, longer accounts receivable payment cycles, difficulties in managing international operations, decreased flexibility in matching workforce to needs as compared with the U.S., and potentially adverse tax consequences. Such factors could materially adversely affect our future international sales and, consequently, our operating results. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER. Our success is dependent upon our proprietary technology. Currently, the IPStor software suite is the core of our proprietary technology. We have one patent issued, and multiple pending patent applications, numerous trademarks registered and multiple pending trademark applications related to our products. We cannot predict whether we will receive patents for our pending or future patent applications, and any patents that we own or that are issued to us may be invalidated, circumvented or challenged. In addition, the laws of certain countries in which we sell and manufacture our products, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States. We also rely on trade secret, copyright and trademark laws, as well as the confidentiality and other restrictions contained in our respective sales contracts and confidentiality agreements to protect our proprietary rights. These legal protections afford only limited protection. OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS. In recent years, there has been significant litigation in the United States involving patents, trademarks and other intellectual property rights. 15 We were already subject to one action, which alleged that our technology infringed on patents held by a third party. While we settled this litigation, the fees and expenses of the litigation as well as the litigation settlement were expensive and the litigation diverted management's time and attention. Any additional litigation, regardless of its outcome, would likely be time consuming and expensive to resolve and would divert management's time and attention and might subject us to significant liability for damages or invalidate our intellectual property rights. Any potential intellectual property litigation against us could force us to take specific actions, including: o cease selling our products that use the challenged intellectual property; o obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology or trademark, which license may not be available on reasonable terms, or at all; or o redesign those products that use infringing intellectual property or cease to use an infringing product or trademark. DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION. Many of our products are designed to include software or other intellectual property licensed from third parties, including "Open Source" software. At least one intellectual property rights holder has alleged that it holds the rights to software traditionally viewed as Open Source. It may be necessary in the future to seek or renew licenses relating to various aspects of these products. There can be no assurance that the necessary licenses would be available on acceptable terms, if at all. The inability to obtain certain licenses or other rights or to obtain such licenses or rights on favorable terms, or the need to engage in litigation regarding these matters, could have a material adverse effect on our business, operating results, and financial condition. Moreover, the inclusion in our products of software or other intellectual property licensed from third parties on a nonexclusive basis could limit our ability to protect our proprietary rights in our products. THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS. Our success depends upon the continued contributions of our key employees, many of whom would be extremely difficult to replace. We do not have key person life insurance on any of our personnel. Worldwide competition for skilled employees in the network storage software industry is extremely intense. If we are unable to retain existing employees or to hire and integrate new employees, our business, financial condition and operating results could suffer. In addition, companies whose employees accept positions with competitors often claim that the competitors have engaged in unfair hiring practices. We may be the subject of such claims in the future as we seek to hire qualified personnel and could incur substantial costs defending ourselves against those claims. WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM, OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS. We have made, and may continue to make, acquisitions of other companies or their assets. Integration of the acquired products, technologies and businesses, could divert management's time and resources. Further, we may not be able to properly integrate the acquired products, technologies or businesses, with our existing products and operations, train, retain and motivate personnel from the acquired businesses, or combine potentially different corporate cultures. If we are unable to fully integrate the acquired products, technologies or businesses, or train, retain and motivate personnel from the acquired businesses, we may not receive the intended benefits of the acquisitions, which could harm our business, operating results and financial condition. IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR FUTURE PERIODS COULD BE MATERIALLY AFFECTED. The preparation of consolidated financial statements and related disclosure in accordance with generally accepted account principles requires management to establish policies that contain estimates and assumptions that 16 affect the amounts reported in the consolidated financial statements and the accompanying notes. Note 1 to the Consolidated Financial Statements in this Report on Form 10-K describes the significant accounting policies essential to preparing our financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual future results may differ materially from these estimates. We evaluate, on an ongoing basis, our estimates and assumptions. LONG TERM CHARACTER OF INVESTMENTS Our present and future equity investments may never appreciate in value, and are subject to normal risks associated with equity investments in businesses. These investments may involve technology risks as well as commercialization risks and market risks. As a result, we may be required to write down some or all of these investments in the future. UNKNOWN FACTORS Additional risks and uncertainties of which we are unaware or which currently we deem immaterial also may become important factors that affect us. ITEM 1B. UNRESOLVED STAFF COMMENTS None ITEM 2. PROPERTIES FalconStor's headquarters are located in an approximately 45,000 square foot facility located in Melville, New York. Offices are also leased for development, sales and marketing personnel, which total an aggregate of approximately 33,000 square feet in Le Chesnay, France; Taichung, Taiwan; Tokyo, Japan; Beijing and Shanghai, China; Munich, Germany; Seoul, Korea; and North Sydney, Australia. Initial lease terms range from one to eight years, with multiple renewal options. ITEM 3. LEGAL PROCEEDINGS We are subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, we believe that such matters will not have a material adverse effect on our financial condition, results of operations, cash flows or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 17 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION Our Common Stock is listed on The Nasdaq National Market ("Nasdaq") under the symbol "FALC". The following table sets forth the range of high and low closing sales prices of our Common Stock for the periods indicated as reported by Nasdaq: 2005 2004 ------------------- ------------------- High Low High Low ---- --- ---- --- Fourth Quarter $ 8.02 $ 5.81 $ 9.57 $ 6.21 Third Quarter $ 6.87 $ 5.66 $ 7.85 $ 5.13 Second Quarter $ 7.43 $ 5.23 $ 8.35 $ 6.15 First Quarter $ 9.67 $ 5.78 $ 10.15 $ 6.57 HOLDERS OF COMMON STOCK We had approximately 182 holders of record of Common Stock as of February 21, 2006. This does not reflect persons or entities whom hold Common Stock in nominee or "street" name through various brokerage firms. DIVIDENDS We have not paid any cash dividends on our common stock since inception. We expect to reinvest any future earnings to finance growth, and therefore do not intend to pay cash dividends in the foreseeable future. Our board of directors may determine to pay future cash dividends if it determines that dividends are an appropriate use of Company capital. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Shares of common stock repurchased during the quarter ended December 31, 2005: Total Number of Maximum Number Shares Purchased of Shares that May Total Number of Average Price as Part of Publicly Yet Be Purchased Shares Purchased Paid per Share Announced Plan Under the Plan November, 2005 8,000 $7.50 8,000 1,492,400 December, 2005 42,000 $7.49 42,000 1,450,400 Total 50,000 $7.49 50,000 1,450,400 18 The Company's Board of Directors approved a program, effective October 24, 2001, to repurchase up to two million shares of the Company's common stock. The program has no expiration date. ITEM 6. SELECTED FINANCIAL DATA The selected financial data appearing below have been derived from our audited consolidated financial statements, and should be read in conjunction with these consolidated financial statements and the notes thereto and the information contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." 19 CONSOLIDATED STATEMENTS OF OPERATIONS DATA: Year Ended Year Ended Year Ended Year Ended Year Ended December 31, December 31, December 31, December 31, December 31, 2005 2004 2003 2002 2001 ----------------------------------------------------------------------- (In thousands, except per share data) Revenues: Software license revenue ............. $ 29,544 $ 21,488 $ 12,251 $ 8,667 $ 4,714 Maintenance revenue .................. 7,594 4,443 2,473 1,297 17 Software services and other revenue .. 3,826 2,778 2,220 665 861 -------- -------- -------- -------- -------- 40,964 28,709 16,944 10,629 5,592 -------- -------- -------- -------- -------- Operating expenses: Amortization of purchased and capitalized software ........................... 782 1,394 1,394 899 273 Cost of maintenance, software services and other revenue ...................... 6,114 4,150 2,580 1,309 897 Software development costs .............................. 12,039 9,050 7,068 6,281 5,004 Selling and marketing .............. 16,109 14,277 10,967 9,856 8,085 General and administrative ......... 4,213 5,109 2,878 2,592 2,732 Litigation settlement .............. -- 1,300 -- -- -- Lease abandonment charge ........... -- -- 550 -- -- Impairment of prepaid royalty ...... -- -- -- 483 -- -------- -------- -------- -------- -------- 39,257 35,280 25,437 21,420 16,991 -------- -------- -------- -------- -------- Operating income (loss) .......... 1,707 (6,571) (8,493) (10,791) (11,399) -------- -------- -------- -------- -------- Interest and other income ............ 705 714 1,122 1,585 1,365 Impairment of long-lived assets ...... -- -- 35 (2,300) -- -------- -------- -------- -------- -------- Income (loss) before income ...... 2,412 (5,857) (7,336) (11,506) (10,034) Provision for income taxes ........... 119 32 33 37 22 -------- -------- -------- -------- -------- Net income (loss) ................ $ 2,293 $ (5,889) $ (7,369) $(11,543) $(10,056) -------- -------- -------- -------- -------- Beneficial conversion feature attributable to convertible preferred stock .................... -- -- -- -- 3,896 -------- -------- -------- -------- -------- Net income (loss) attributable to common shareholders ................ $ 2,293 $ (5,889) $ (7,369) $(11,543) $(13,952) ======== ======== ======== ======== ======== Basic net income (loss) per share attributable to common shareholders $ 0.05 $ (0.13) $ (0.16) $ (0.26) $ (0.40) ======== ======== ======== ======== ======== Diluted net income (loss) per share attributable to common shareholders $ 0.05 $ (0.13) $ (0.16) $ (0.26) $ (0.40) ======== ======== ======== ======== ======== Basic weighted average common shares outstanding ................. 47,662 46,967 45,968 45,233 35,264 ======== ======== ======== ======== ======== Diluted weighted average common shares outstanding ................. 50,776 46,967 45,968 45,233 35,264 ======== ======== ======== ======== ======== 20 CONSOLIDATED BALANCE SHEET DATA: December 31, December 31, December 31, December 31, December 31, 2005 2004 2003 2002 2001 ------------------------------------------------------------------------ (In thousands) Cash and cash equivalents and marketable securities $36,631 $33,973 $36,685 $51,102 $64,527 Working capital 39,654 36,452 39,527 47,746 57,518 Total assets 63,974 56,074 56,493 64,710 74,471 Long-term obligations 2,240 1,290 396 -- 283 Stockholders' equity 48,658 46,364 50,556 55,901 63,562 21 ITEM 7. 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" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS "BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS," "WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT. OVERVIEW Fiscal 2005 was a year of continued growth and profitability. Our revenues for the full year increased to $41.0 million from $28.7 million in 2004. We are pleased that we were profitable for a full year for the first time. As it has been in the past, our focus will continue to be on managing our business with a view towards long-term success and growth. In 2005 we continued to invest in research and development and other areas to build on our momentum, to design new products, and to enhance our existing products to position the Company for future growth. We will continue to invest in these areas in 2006 and we anticipate that our research and development and sales and marketing expenses will increase in 2006. To continue to create industry-leading, cutting-edge network storage solutions, we hired additional software development engineers and quality assurance engineers. These software engineers design and test the software products that are or will be sold by our OEM partners and resellers. Continuing to deliver new and enhanced products to meet the demands of the storage market is necessary for us to remain competitive and to continue our growth. It is important to our success that our products meet the needs of end users and that our products are - and are viewed by the market to be - innovative. In 2005 our products continued to receive recognition for their features, quality and innovation from several respected, independent, industry publications and organizations. This recognition helps us gain access to additional customers and assists us in closing sales. We also increased our sales force and our technical support team. An increased sales force should expand the market exposure for our products. The expanded technical support team responds to questions and technical issues from end users of our products and from our resellers and OEM partners. Providing top notch technical support to these groups enhances our ability to continue to make sales. End users who are satisfied with our technical support are more likely to order additional products from us. Resellers and OEM partners who are happy with our technical support, and whose end users are satisfied, will be more likely to recommend our current products and less likely to consider other providers for future products. In the fourth quarter of 2005, we announced the launch of our PrimeVault disaster recovery, archiving and hosting services. These services are based on our IPStor and VirtualTape Library (VTL) software and provide a means for us to leverage our successes with those products to increase our customer base to include end users who do not have the resources - either technical or financial - - to undertake a full implementation of our products. The key factors we look to for our future business prospects continue to be our sales pipeline, our ability to establish and expand relationships with key industry OEMs and resellers, sales by our OEM partners, additional orders from resellers, growth in deferred revenue, re-orders from existing customers, and the growth of the overall market for storage solutions. Gross margins are also a key factor in evidencing the growth of our business. Our sales "pipeline" consists of inquiries from end users and resellers for possible purchases of our products. Our overall sales pipeline steadily increased for each quarter of 2005 compared with the same quarter in 2004. 22 OEM relationships are important to us for two main reasons. First, sales by our OEM partners contribute to our revenues. Second, having our products selected by respected, established industry leaders signals to customers, resellers and other potential OEM partners that our products are quality products that add value to their enterprise. Before licensing software, OEM partners typically undertake broad reviews of many of the competing software solutions available. The choice of our products by major industry participants validates both the design and the capabilities of the products and our product roadmaps. Overall, product licenses to OEMs accounted for approximately forty percent of our revenues in 2005. Two OEM customers each accounted for over ten percent of our revenues. We anticipate that OEMs will account for over forty percent of our revenues in 2006. We expect that at least one OEM will account for at least ten percent of our revenues in 2006. Accordingly, the loss of this customer would have a material adverse effect on our business. In 2005, we signed a new agreement for our VTL product with a Tier-1 OEM. This OEM released a solution using our VTL in the fourth quarter of 2005. Due to the timing of the royalty reports from this OEM, the revenue will be recorded on a one quarter lag. As a result of this lag, we did not have any revenue from this OEM in 2005, but we expect to start generating revenue in 2006. In 2005, we signed a number of agreements with international OEMs for our IPStor, VTL and iSCSI Storage Server products. One of these agreements is with a major IP Networking solution provider based in Hangzhou, China to offer turn-key iSCSI solutions. We also renewed agreements with existing OEM partners. We will continue to seek additional OEM opportunities in the future. We do everything we can to assure that our products meet the needs of our OEM partners and their customers. However, we cannot control decisions by our OEM partners to change their product or marketing mix in ways that impact sales of products licensed by the OEMs from us. Many enterprises look to value added resellers or solution providers to assist them in making their information technology purchases. These resellers typically review an enterprise's needs and suggest a hardware, software, or combined hardware and software solution to fulfill the enterprise's requirements. As service providers to companies, resellers' reputations are dependent on satisfying their customers' needs efficiently and effectively. Resellers have wide choices in fulfilling their customers' needs. If resellers determine that a product they have been providing to their customers is not functioning as promised, or is not providing adequate return on investment, or if the customers are complaining about the level of support they are receiving from the suppliers, the resellers will move quickly to offer different solutions to their customers. Additional sales by resellers are therefore an important indicator of our business prospects. We saw growth in the sales by most of our significant resellers in 2005 and expect that this growth will continue in 2006. We have established strong relationships with many premier resellers. In 2005, we signed agreements with new resellers worldwide. We also terminated relationships with resellers who we believed were not properly selling our products. We will continue to enter into relationships with resellers and to discontinue relationships with resellers with whom we are not satisfied. Our deferred revenues consist primarily of amounts received attributable to future support and maintenance of our products. The level of deferred revenue is an important indicator of our success. Maintenance and support for our products is sold for fixed periods of time. Maintenance and support agreements are typically for one year, although some agreements are for terms in excess of one year. If we do not deliver the support needed by end users of our products or by our OEM partners and resellers, then they will not renew their maintenance and support agreements. If end users stop using our products, they also will not renew their maintenance and support agreements. An increase in deferred revenues thus indicates growth in our installed base and end user and OEM satisfaction with our maintenance and support services. Our deferred revenue increased to $9.6 million as of December 31, 2005, compared with $5.4 million as of December 31, 2004. We expect deferred revenue to continue to grow in 2006. The level of re-orders from existing end users of our products is another measure of customer satisfaction. Information technology professionals will only order additional products and services for their companies if they determine that the products have reduced total cost of ownership and have provided a good return on investment. Re-orders are thus an indication that our products are delivering as promised and that our support is meeting the end user's needs. In 2005, many end users ordered additional copies of our products, or additional products or ordered additional options. If re-orders decline, it would indicate 23 that future sales might also decline. As the percentage of our revenues from OEMs increases, our ability to gauge re-orders decreases because our OEM partners typically do not provide us with information identifying the end user for each order. Consolidation in the network storage market had an adverse impact on our revenues in 2005. During 2005, two of our OEM partners were purchased by other companies. In one case, the uncertainty caused by the impending purchase and the subsequent consolidation of the businesses caused a loss of focus on sales by the two companies. In the other case, after the acquisition, the acquirer undertook a lengthy review of which solutions would be offered by the combined entity. This review caused a near halt in sales of solutions incorporating our product. We are pleased that both acquirers have decided to continue to offer solutions incorporating our products. The storage solutions market continues to grow. In addition to growth based on demand for storage server consolidation and replication, there was growth in backup acceleration. We expect each of these areas to continue growing in 2006. We have new initiatives in the small/medium business (SMB) and small office/home office (SOHO) markets. We did not receive significant revenue from these markets in 2005, but we believe that these non-enterprise markets are another growth area for storage software. In early 2006, we signed an OEM agreement with a leading computer, networking and communications products manufacturer to offer an entry-level data storage and protection appliance, powered by a version of IPStor optimized to run on a System-on-Chip ("SOC") platform ("IPStor Express"), targeting the SMB/SOHO market. The launch is scheduled for the first quarter of 2006. It is too early to estimate whether revenues from these markets will be significant contributors to our revenues in 2006. As we had anticipated, we saw the greatest increase in revenues from our VirtualTape Library software. We expect this growth to continue, if not accelerate, in 2006, as our new OEM continues it sales and as we introduce additional features and functionality for the product. The continued decline in prices for disk storage, and the continuing need for rapid back up, disaster recovery and regulatory compliance, should contribute to this growth. Market acceptance of IP-based Storage Area Networks, primarily using iSCSI, continued in 2005. Previously, most SANs had been based on fibre-channel. However, this portion of the storage software market has not been a significant contributor to our revenues. Our expectations regarding the size of the revenue contribution from this market in 2005 were impacted negatively, in part, by sales from our Tier 1 OEM partner that were lower than we had anticipated. In 2006, we plan to work with this partner to enhance the product line to help to grow sales. In addition, we have signed agreements with international OEMs to market these products. We plan to continue to tap into the growth in this market through sales of our products by other strategic partners. Another important measure of our business is gross margin. Among other things, gross margin measures our ability to scale our business. Unlike manufacturers of hardware, our incremental cost for each additional unit of software licensed is a small percentage of the software license revenue. Thus, our gross margins tend to increase as our software license revenue increases. We incur research and development expenses before the product is offered for licensing. These expenses consist primarily of personnel costs for engineering and testing, but also include other items such as the cost of hardware and software used in development. We also have expenses for software support, sales and marketing, and general and administrative functions. Our gross margin increased on a full year basis to 83% compared with 81% in 2004. We believe this demonstrates that we were successful in our ability to scale our business. We are pleased with our ability to contain the increase of expenses in 2005. We will continue to invest in infrastructure and personnel to maintain and enhance our leading edge designs and to support our customers, but we will continue to do so in a controlled, cost-effective manner. One additional factor that we expect to continue to affect our revenues on a quarterly, but not annual, basis, is the seasonality of the information technology business. Historically, information technology spending has been higher in the fourth and second quarters of each calendar year, and somewhat slower in the other quarters, particularly the first quarter. Our quarterly results reflected this seasonality in 2005, and we anticipate that our quarterly results for 2006 will show the effects of seasonality as well. 24 As described in note 1 to our consolidated financial statements, beginning with the first quarter of 2006, we will be required by Statement of Financial Accounting Standards No. 123(R), Share Based Payment, to expense the grant date fair value of stock options and other equity based compensation to employees and non-employees in our financial statements. We are currently evaluating the impact that the adoption of this statement will have on our consolidated financial statements, but there will be a negative impact on our reported results of operations. Notwithstanding this change to our financial statements, we will continue to apply the criteria and the methodology we have used in the past to determine grants of stock options or other equity-based compensation to our employees. We believe that the opportunity to participate in the growth of our Company is an important motivating factor for our current employees and a valuable recruiting tool for new employees. For the management of our business and the review of our progress, we will continue to look to our results before stock option expense. We will use these non-GAAP financial measures in making operating decisions because they measure the results of our day to day operations and because they provide a more consistent basis for evaluating and comparing our results across different periods. Our critical accounting policies are those related to revenue recognition, accounts receivable allowances and deferred income taxes. As described in note 1 to our consolidated financial statements, we recognize revenue in accordance with the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended. Software license revenue is recognized only when pervasive evidence of an arrangement exists and the fee is fixed and determinable, among other criteria. An arrangement is evidenced by a signed customer contract for nonrefundable royalty advances received from OEMs or a customer purchase order or a royalty report summarizing software licenses resold by an OEM, distributor or solution provider to an end user. The software license fees are fixed and determinable as our standard payment terms generally range from 30 to 90 days, depending on regional billing practices, and we have not provided any of our customers extended payment terms. When a customer licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance for its fair value. We review accounts receivable to determine which are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider historical return rates, specific past due accounts, analysis of our accounts receivable aging, customer payment terms, historical collections, write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. Historically, we have experienced a somewhat consistent level of write-offs and returns as a percentage of revenue due to our customer relationships, contract provisions and credit assessments. Changes in the product return rates, credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs, revenues and our general and administrative expenses. Consistent with the provisions of Statement of Financial Accounting Standards No. 109, we regularly estimate our ability to recover deferred income taxes, and report such assets at the amount that is determined to be more-likely-than-not recoverable. This evaluation considers several factors, including an estimate of the likelihood of generating sufficient taxable income in future periods over which temporary differences reverse, the expected reversal of deferred tax liabilities, past and projected taxable income, and available tax planning strategies. As of December 31, 2005, based primarily upon our cumulative losses, a valuation allowance has been recorded against our deferred tax assets. In the event that evidence becomes available in the future to indicate that our deferred taxes will likely be recoverable (e.g., taxable income generated in and projected for future periods), our estimate of the recoverability of deferred taxes may change, resulting in a reversal of all or a portion of such valuation allowance. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2005 COMPARED TO THE YEAR ENDED DECEMBER 31, 2004 Revenues for the year ended December 31, 2005 increased 43% to $41.0 million compared to $28.7 million for the year ended December 31, 2004. Our operating expenses increased 11% from $35.3 million in 2004 to $39.3 million in 2005. Net income for the year ended December 31, 2005 was $2.3 million compared with a net loss of $5.9 million for the year ended December 31, 2004. The 25 increase in revenues was mainly due to an increase in (i) demand for our network storage solution software and (ii) sales from our OEM partners. Revenue contribution from our OEM partners increased in absolute dollars and as a percentage of our total revenue for the year ended December 31, 2005. Revenue from resellers and distributors also increased in absolute dollars. Expenses increased in cost of maintenance, software services and other revenue, software development, and selling and marketing to support our growth. For the year ended December 31, 2005, we increased the number of employees and continued to invest in infrastructure by purchasing additional computers and equipment. We increased the number of employees from 217 employees as of December 31, 2004 to 279 employees as of December 31, 2005. Included in our results for the year ended December 31, 2004 are a litigation settlement charge of $1.3 million and legal fees of $1.0 million, each associated with litigation relating to patent infringement that was resolved in the third quarter of 2004. REVENUES SOFTWARE LICENSE REVENUE Software license revenue is comprised of software licenses sold through our OEMs, value-added resellers and distributors to end users and, to a lesser extent, directly to end users. These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing software licenses sold and the software and permanent key codes are delivered to the customer. We sometimes receive nonrefundable royalty advances and engineering fees from some of our OEM partners. These arrangements are evidenced by a signed customer contract, and the revenue is recognized when the software product master is delivered and accepted, and the engineering services, if any, have been performed. Software license revenue increased 37% to $29.5 million in 2005 from $21.5 million in 2004. Increased market acceptance and demand for our product and increased sales from our OEM partners were the primary drivers of the increase in software license revenue. Software license revenue increased from both our OEM partners and from our resellers. Revenue from our OEM partners increased as a percentage of total revenue. We expect our software license revenue to continue to grow and the percentage of future software license revenue derived from our OEM partners to increase. MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenues are comprised of software maintenance and technical support, professional services primarily related to the implementation of our software, engineering services, and sales of computer hardware. Revenue derived from maintenance and technical support contracts is deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Revenue from engineering services is primarily related to customizing software product masters for some of our OEM partners. Revenue from engineering services is recognized in the period the services are completed. In 2005 and 2004, we had a limited number of transactions in which we purchased hardware and bundled this hardware with our software and sold the bundled solution to our customer. A portion of the contractual fee is recognized as revenue when the hardware or software is delivered to the customer based on the relative fair value of the delivered element(s). Maintenance, software services and other revenue increased 58% to $11.4 million in 2005 from $7.2 million in 2004. The major factor behind the increase in maintenance, software services and other revenue was the increase in the number of maintenance and technical support contracts we sold. As we are in business longer, and as we license more software, we expect these revenues will continue to increase. The majority of our new customers purchase maintenance and support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $4.4 million for the year ended December 31, 2004 to $7.6 million for the year ended December 31, 2005. Software services and other revenue increased from $2.8 million in 2004 to $3.8 million in 2005. The increase in software services and other revenue was partially attributable to our hardware sales which increased from $1.5 million in 2004 to $2.3 million in 2005. This increase was the result of an increase in demand from our customers for bundled solutions. Growth in our professional services sales, which increased from $1.3 million in 2004 to $1.5 million in 2005, also contributed to the increase in software services and other revenues. This increase in professional services revenue was related to the increase in our software license customers who elected to purchase professional services. We expect maintenance, software services and other revenues to continue to increase. 26 COST OF REVENUES AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE To remain successful in the network storage solutions market, we must continually upgrade our software by enhancing the existing features of our products and by adding new features and products. We often evaluate whether to develop these new offerings in-house or whether we can achieve a greater return on investment by purchasing or licensing software from third parties. Based on our evaluations, we have purchased or licensed various software for resale since 2001. As of December 31, 2005 and 2004, we had $5.0 million and $4.9 million, respectively, of purchased software licenses that are being amortized over three years. For the year ended December 31, 2005, we recorded $0.8 million of amortization related to these purchased software licenses. For the year ended December 31, 2004, we recorded $1.4 million of amortization related to these purchased software licenses. We will continue to evaluate third party software licenses and may make additional purchases, which would result in an increase in amortization expense. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, and training. Cost of maintenance, software services and other revenues also includes the cost of hardware purchased that was resold. Cost of maintenance, software services and other revenues for the year ended December 31, 2005 increased by 47% to $6.1 million compared to $4.2 million for the year ended December 31, 2004. The increase in cost of maintenance, software services and other revenue was principally due to an increase in personnel. As a result of our increased sales of maintenance and support contracts and professional services, we hired additional employees to provide technical support and to implement our software. Additionally, due to an increase in hardware sales, our associated hardware costs increased from $1.0 million for the year ended December 31, 2004 to $1.5 million for the year ended December 31, 2005. Our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenue increases. Gross profit for the year ended December 31, 2005 was $34.1 million or 83% of revenues compared to $23.2 million or 81% of revenues for the year ended December 31, 2004. The increase in gross profit and gross margin was directly related to the increase in revenues. Additionally, the increased percentage of revenue from our OEM partners in 2005 contributed to the increase in gross margins since revenues from our OEM partners typically have higher gross margins. SOFTWARE DEVELOPMENT COSTS Software development costs consist primarily of personnel costs for product development personnel and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 33% to $12.0 million in 2005 from $9.1 million in 2004. The increase in software development costs was primarily due to an increase in employees required to enhance and test our core network storage software product, as well as to develop new innovative features and options. In addition, we required additional employees to test and integrate our software with our OEM partners' products. We intend to continue recruiting and hiring product development personnel to support our development process. SELLING AND MARKETING Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses increased 13% to $16.1 million in 2005 from $14.3 million in 2004. As a result of the increase in revenue and interest in our software, our commission expense and travel expenses increased. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our revenue growth. We believe that to continue to grow sales, our sales and marketing expenses will continue to increase. 27 GENERAL AND ADMINISTRATIVE General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related costs, directors and officers insurance, legal and professional fees and other general corporate overhead costs. General and administrative expenses decreased 18% to $4.2 million in 2005 from $5.1 million in 2004. The overall decrease in general and administrative expenses was primarily due to a decrease in legal expenses. For the year ended December 31, 2004 we had $1.0 million in legal expenses attributable to litigation related to alleged patent infringement. LITIGATION SETTLEMENT CHARGE During the third quarter of 2004, we resolved claims relating to alleged patent infringement brought by Dot Hill and by Crossroads against us in the United States District Court for the Western District of Texas. Pursuant to the terms of the Settlement Agreement between Crossroads and us, we, without admission of infringement, made a one-time payment of $1.3 million and granted to Crossroads licenses to certain of our technology in exchange for a worldwide, perpetual license to the technology underlying the Crossroads' patents at issue in the litigation. All claims against us by both Dot Hill and Crossroads have now been dismissed. INTEREST AND OTHER INCOME We invest our cash, cash equivalents and marketable securities in government securities and other low risk investments. Interest and other income remained consistent at $0.7 million. Interest income increased from $0.7 million to $1.0 million due to a higher average cash balance and slightly higher interest rates. Additionally, interest and other income for the year ended December 31, 2005, includes an out-of-period charge of approximately $0.2 million to recognize investment losses realized in prior years. INCOME TAXES We did not record a tax benefit associated with the pre-tax results incurred from the period from inception (February 10, 2000) through December 31, 2005, as we deemed that it was uncertain that the related deferred tax assets would be realized based on our cumulative losses incurred since inception and our limited period of profitability. Accordingly, we provided a full valuation allowance against our net deferred tax assets. Our income tax provision consists of tax expenses related to alternative minimum taxes and taxes from our foreign subsidiaries. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2004 COMPARED TO THE YEAR ENDED DECEMBER 31, 2003 REVENUES SOFTWARE LICENSE REVENUE Software license revenue increased 75% to $21.5 million in 2004 from $12.3 million in 2003. Increased market acceptance and demand for our product, the introduction of our new products and the successful launch by one of our OEMs of a solution powered by our product were the primary drivers of the increase in software license revenue. Software license revenue increased from both our OEM partners and from our resellers. Revenue from our OEM partners increased as a percentage of total revenue. MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenue increased 54% to $7.2 million in 2004 from $4.7 million in 2003. The major factor contributing to the increase in maintenance, software services and other revenue was the increase in the number of maintenance and technical support contracts we sold. As we are in business longer, and as we license more software, we expect these revenues will continue to increase. The majority of our new customers purchase maintenance and 28 support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $2.5 million for the year ended December 31, 2003 to $4.4 million for the year ended December 31, 2004. Software services and other revenue increased to $2.8 million from $2.2 million in 2003. Growth in our professional services revenue, which increased from $0.9 million in 2003 to $1.3 million in 2004, partially contributed to the increase in software services and other revenues. This increase in professional services revenue was related to the increase in our software license customers that elected to purchase professional services. Additionally, our hardware sales increased from $1.3 million in 2003 to $1.5 million in 2004. This increase was the result of an increase in demand from our customers for bundled solutions. COST OF REVENUES AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE As of December 31, 2004 and 2003, we had $4.9 million of purchased software licenses that are being amortized over three years. For the years ended December 31, 2004 and 2003, we recorded $1.4 million of amortization related to these purchased software licenses. Amortization of capitalized software was $7,881 and $31,523 for the years ended December 31, 2004 and 2003, respectively. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues for the year ended December 31, 2004 increased by 61% to $4.2 million compared to $2.6 million for the year ended December 31, 2003. The increase in cost of maintenance, software services and other revenue was principally due to an increase in personnel. As a result of our increased sales of maintenance and support contracts and professional services, we required a higher number of employees to provide technical support and to implement our software. Gross profit for the year ended December 31, 2004 was $23.2 million or 81% of revenues compared to $13.0 million or 77% of revenues for the year ended December 31, 2003. The increase in gross profit and gross margin was directly related to the increase in revenues relative to the increase in expenses. As our software license revenues increase, the associated costs as a percentage of those revenues tend to decrease. Additionally, the increased percentage of revenue from our OEM partners in 2004 contributed to the increase in gross margin since revenues from our OEM partners have higher gross margins. SOFTWARE DEVELOPMENT COSTS Software development costs increased 28% to $9.1 million in 2004 from $7.1 million in 2003. The increase in software development costs was primarily due to an increase in employees required to enhance and test our network storage software products, as well as to develop new innovative features and options. In addition, as we entered into agreements with new OEM partners, we required additional employees to test and integrate our software with our OEM partners' products. At the end of 2003, we also opened a development office in China to assist in our development work. SELLING AND MARKETING Selling and marketing expenses increased 30% to $14.3 million in 2004 from $11.0 million in 2003. As a result of the increase in revenue and interest in our software, our commission expense and travel expenses increased. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our revenue growth. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 77% to $5.1 million in 2004 from $2.9 million in 2003. The increase in general and administrative expenses was partially due to a $1.0 million increase in legal expense attributable to litigation relating to alleged patent infringement with Dot Hill Systems Corporation ("Dot Hill") and Crossroads Systems (Texas), Inc. ("Crossroads"). 29 Expenses of $0.8 million for the year ended December 31, 2004, related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and an increase in the number of employees also contributed to the increase in general and administrative expenses. INTEREST AND OTHER INCOME Interest and other income decreased 36% to $0.7 million in 2004 from $1.1 million in 2003. This decrease in interest income was due to lower interest rates and lower average cash, cash equivalent and marketable securities balances. INCOME TAXES We did not record a tax benefit associated with the pre-tax loss incurred from the period from inception (February 10, 2000) through December 31, 2004, as we deemed that it was more likely than not that the deferred tax assets will not be realized based on our early stage of operations. Accordingly, we provided a full valuation allowance against our net deferred tax assets. Our income tax provision consists of tax liabilities related to our foreign subsidiaries. LEASE ABANDONMENT CHARGE In November 2003, we relocated our headquarters to a larger facility to accommodate our future growth. As a result of this relocation, we vacated our previous office space and recorded a charge for the estimated loss we expected to incur on the remaining lease obligation. The charge of $0.6 million included the remaining lease rental obligation reduced by cash flows we expected to generate from an agreement to sub-lease the facility as well as the write off of leasehold improvements at our previous facility. LIQUIDITY AND CAPITAL RESOURCES Our total cash and cash equivalents and marketable securities balance as of December 31, 2005 increased by $2.7 million compared to December 31, 2004. Our cash and cash equivalents totaled $18.8 million and marketable securities totaled $17.8 million at December 31, 2005. As of December 31, 2004, we had $15.5 million in cash and cash equivalents and $18.5 million in marketable securities. In 2005, we made investments in our infrastructure to support our long-term growth. We increased the total number of employees in 2005 and made investments in property and equipment to support our growth. As we continue to grow, we will continue to make investments in property and equipment and will need to continue to increase our headcount. In the past, we have also used cash to purchase software licenses and to make acquisitions. We will continue to evaluate potential software license purchases and acquisitions and if the right opportunity presents itself we may continue to use our cash for these purposes. However, as of the date of this filing, we have no agreements, commitments or understandings with respect to any such acquisitions. We currently do not have any debt and our only significant commitments are related to our office leases. In connection with our acquisition of IP Metrics in July 2002, we were required to make cash payments to the former shareholders of IP Metrics, which were contingent on the level of revenues from IP Metrics products for a period of twenty-four months through June 30, 2004. In 2004, we made payments to the former shareholders of IP Metrics totaling $214,009. We believe we have no further payment obligations. In October 2001, our Board of Directors authorized the repurchase of up to two million shares of our outstanding common stock. Since October 2001, 549,600 shares have been repurchased at an aggregate purchase price of $3.6 million including 272,500 shares repurchased in 2005 at an aggregate purchase price of $1.9 million. Net cash provided by operating activities totaled $6.5 million for the year ended December 31, 2005, compared with net cash used in operating activities of $1.1 million for the year ended December 31, 2004 and $5.9 million for the year ended December 31, 2003. The positive trend in our cash provided by operating activities is mainly due to the improvement in our net results which resulted in net income of $2.3 million for the year ended December 31, 2005, 30 compared with a net loss of $5.9 million for the year ended December 31, 2004 and $7.4 million for the year ended December 31, 2003. In addition to our net income for 2005 and our decrease in net loss for 2004 and 2003, our deferred revenues increased by $4.2 million in 2005 compared to $2.8 million in 2004 and $0.4 million in 2003. The increase in our deferred revenue is the result of an increase in our maintenance contracts, which are deferred and recognized as revenue ratably over the term of the contract. This amount was partially offset by increases in our net accounts receivable balances of $4.9 million in 2005, $3.2 million in 2004 and $2.8 million in 2003. The increases in our accounts receivable balances are due to our revenue growth. We expect cash provided by operating activities to continue to increase as we anticipate our net income will increase. Net cash used in investing activities was $2.8 million in 2005 compared to net cash provided by investing activities of $6.3 million in 2004 and $2.5 million in 2003. Included in investing activities for each year are the sales and purchases of our marketable securities. These represent the sales, maturities and reinvesting of our marketable securities. The net cash provided by investing activities from the net sale of securities was $0.6 million, $9.5 million and $8.5 million in 2005, 2004 and 2003, respectively. These amounts will fluctuate from year to year depending on the maturity dates of our marketable securities. The cash used to purchase property and equipment was $3.2 million, $2.8 million and $3.0 million in 2005, 2004 and 2003, respectively. The cash used to purchase software licenses was $0.1 million in 2005 and 2004 and $1.8 million in 2003. We continually evaluate potential software licenses and we may continue to make similar investments if we find opportunities that would benefit our business. Net cash provided by financing activities was $24,385 in 2005, $1.8 million in 2004 and $0.9 million in 2003. We received proceeds from the exercise of stock options of $1.9 million in 2005, $2.0 million in 2004 and $0.9 million in 2003. We made payments of $1.9 million in 2005 and $0.3 million in 2004 to acquire treasury stock. The Company's only significant commitments relate to its operating leases. The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2006 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2005: Year ending December 31 ----------------------- 2006...................................................... $ 1,915,879 2007...................................................... 1,433,153 2008...................................................... 1,220,435 2009...................................................... 1,254,067 2010...................................................... 1,288,708 Thereafter................................................ 1,699,218 ----------- $ 8,811,460 =========== We believe that our current balance of cash, cash equivalents and marketable securities, and expected cash flows from operations will be sufficient to meet our cash requirements for at least the next twelve months. IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment ("SFAS 123R"), which revises SFAS 123. SFAS 123R also supersedes APB 25 and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R eliminates the alternative to account for employee stock options under APB 25 and requires the fair value of all share-based payments to employees (including stock options) be recognized in the income statement, generally over the vesting period. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107, which provides additional implementation guidance for SFAS 123R. Among other things, SAB 107 provides guidance on share-based payment valuations, income statement classification and presentation, capitalization of costs and related income tax accounting. 31 SFAS 123R provides for adoption using either the modified prospective or modified retrospective transition method. We will adopt SFAS 123R on January 1, 2006, using the modified prospective transition method in which compensation cost is recognized beginning January 1, 2006 for all share-based payments granted on or after that date and for all awards granted to employees prior to January 1, 2006 that remain unvested on that date. We expect to continue to use the Black-Scholes-Merton option pricing model to determine the fair value of stock option awards. Adoption of SFAS 123R's fair value method will have an effect on our results of operations. The future impact of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted. However, had SFAS 123R been adopted in prior periods, the effect would have approximated the SFAS 123 pro forma amounts disclosed in footnote 1(j) to our accompanying consolidated financial statements. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as currently required. We have historically not realized significant tax benefits associated with tax deductions for stock-based compensation. Further, those amounts cannot be estimated for future periods (because they depend on, among other things, when employees will exercise the stock options and the market price of the Corporation's common stock at the time of exercise). In June 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR CORRECTIONS - a replacement of APB Opinion No. 20 and FASB Statement No. 3 ("SFAS 154"). SFAS 154 replaces APB Opinion No. 20, ACCOUNTING CHANGES ("APB 20"), and SFAS No. 3, REPORTING ACCOUNTING CHANGES IN INTERIM FINANCIAL STATEMENTS. SFAS 154 requires retrospective application to prior periods' financial statements of a voluntary change in accounting principle unless it is impracticable to determine either the period-specific effects or the cumulative effects of the change. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income in the period of the change the cumulative effect of changing to the new accounting principle. This standard generally will not apply with respect to the adoption of new accounting standards, as new accounting standards usually include specific transition provisions, and will not override transition provisions contained in new or existing accounting literature. SFAS 154 is effective for fiscal years beginning after December 15, 2005, and early adoption is permitted for accounting changes and error corrections made in years beginning after the date that SFAS 154 was issued. The Company does not expect that the adoption of SFAS 154 on January 1, 2006 will have a significant effect on its financials condition or results of operations. On December 21, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109, ACCOUNTING FOR INCOME TAXES, TO THE TAX DEDUCTION ON QUALIFIED PRODUCTION ACTIVITIES PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1") and FASB Staff Position No. FAS 109-2, ACCOUNTING AND DISCLOSURE GUIDANCE FOR THE FOREIGN EARNINGS REPATRIATION PROVISION WITHIN THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states that the tax deduction for domestic manufacturing activities from this legislation should be accounted for as a "special deduction" and reduce tax expense in the period(s) the amounts are deductible on the tax return, not as an adjustment of recorded deferred tax assets and liabilities. FSP No. 109-2 gives a company additional time to evaluate the effects of the legislation on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109. The Company has determined that it will not repatriate any undistributed foreign earnings under the new tax legislation and, therefore, the legislation as it relates to undistributed foreign earnings will not have an affect on the Company's consolidated financial statements. 32 ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and marketable securities which aggregated to $36.6 million as of December 31, 2005, is subject to interest rate risks. We regularly assess these risks and have established policies and business practices to manage the market risk of our marketable securities. FOREIGN CURRENCY RISK. We have several offices outside the United States. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. The effect of foreign currency exchange rate fluctuations have not been material since our inception. We do not use derivative financial instruments to limit our foreign currency risk exposure. We do not believe that our results would be materially affected by a 10% change in interest or foreign exchange rates. 33 ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Page Reports of Independent Registered Public Accounting Firm ........... 35 Consolidated Balance Sheets as of December 31, 2005 and 2004 ....... 37 Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003 ................................. 38 Consolidated Statements of Stockholders' Equity and Comprehensive Loss for the years ended December 31, 2005, 2004 and 2003 ........ 39 Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003 ................................. 40 Notes to Consolidated Financial Statements ......................... 41 34 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders FalconStor Software, Inc.: We have audited the accompanying consolidated balance sheets of FalconStor Software, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FalconStor Software, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of FalconStor Software, Inc.'s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report, dated March 15, 2006, expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP Melville, New York March 15, 2006 35 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders FalconStor Software, Inc.: We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that FalconStor Software, Inc. and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by COSO. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated, March 15, 2006, expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Melville, New York March 15, 2006 36 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, ------------ 2005 2004 ------------ ------------ ASSETS Current assets: Cash and cash equivalents ................................................ $ 18,796,973 $ 15,484,573 Marketable securities .................................................... 17,833,683 18,488,616 Accounts receivable, net of allowances of $3,846,882 and $2,551,616, respectively ............................................... 15,187,408 10,269,822 Prepaid expenses and other current assets ................................ 911,715 629,036 ------------ ------------ Total current assets ............................................... 52,729,779 44,872,047 Property and equipment, net of accumulated depreciation of $7,150,762 and $4,698,025, respectively ................................... 5,277,609 4,662,269 Goodwill .................................................................... 3,512,796 3,512,796 Other intangible assets, net ................................................ 216,864 307,620 Other assets, net ........................................................... 2,236,725 2,719,460 ------------ ------------ Total assets ....................................................... $ 63,973,773 $ 56,074,192 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable .......................................................... $ 1,152,228 $ 821,433 Accrued expenses .......................................................... 4,522,212 3,501,034 Deferred revenue .......................................................... 7,401,018 4,097,279 ------------ ------------ Total current liabilities .......................................... 13,075,458 8,419,746 Deferred revenue ............................................................ 2,240,208 1,290,496 ------------ ------------ Total liabilities .................................................. 15,315,666 9,710,242 ------------ ------------ Commitments and Contingencies Stockholders' equity: Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued -- -- Common stock - $.001 par value, 100,000,000 shares authorized, 48,441,614 and 47,768,755 shares issued, respectively and 47,892,014 and 47,491,655 shares outstanding, respectively ....................... 48,442 47,769 Additional paid-in capital ................................................ 87,342,747 85,400,740 Accumulated deficit ....................................................... (34,659,329) (36,952,436) Common stock held in treasury, at cost (549,600 and 277,100 shares, respectively) .......................................................... (3,632,930) (1,714,775) Accumulated other comprehensive loss, net ................................. (440,823) (417,348) ------------ ------------ Total stockholders' equity ......................................... 48,658,107 46,363,950 ------------ ------------ Total liabilities and stockholders' equity ......................... $ 63,973,773 $ 56,074,192 ============ ============ See accompanying notes to consolidated financial statements. 37 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 2005 2004 2003 ------------ ------------ ------------ Revenues: Software license revenue ................ $ 29,544,467 $ 21,487,866 $ 12,250,616 Maintenance revenue ..................... 7,593,804 4,442,724 2,473,504 Software services and other revenue ..... 3,825,832 2,778,088 2,220,015 ------------ ------------ ------------ 40,964,103 28,708,678 16,944,135 ------------ ------------ ------------ Operating expenses: Amortization of purchased and capitalized software ............................. 781,500 1,393,908 1,394,301 Cost of maintenance, software services and other revenue .................... 6,114,112 4,150,309 2,580,141 Software development costs .............. 12,039,488 9,050,092 7,067,605 Selling and marketing ................... 16,109,440 14,277,167 10,966,548 General and administrative .............. 4,212,769 5,108,516 2,878,192 Litigation settlement ................... -- 1,300,000 -- Lease abandonment charge ................ -- -- 550,162 ------------ ------------ ------------ 39,257,309 35,279,992 25,436,949 ------------ ------------ ------------ Operating income (loss) ............ 1,706,794 (6,571,314) (8,492,814) ------------ ------------ ------------ Interest and other income, net ............ 705,063 714,412 1,121,391 Other ..................................... -- -- 35,000 ------------ ------------ ------------ Income (loss) before income taxes .. 2,411,857 (5,856,902) (7,336,423) Provision for income taxes ............... 118,750 31,945 32,532 ------------ ------------ ------------ Net income (loss) .................. $ 2,293,107 $ (5,888,847) $ (7,368,955) ------------ ------------ ------------ Basic net income (loss) per share ........ $ 0.05 $ (0.13) $ (0.16) ============ ============ ============ Diluted net income (loss) per share ...... $ 0.05 $ (0.13) $ (0.16) ============ ============ ============ Basic weighted average common shares outstanding ............................. 47,662,446 46,967,422 45,967,830 ============ ============ ============ Diluted weighted average common shares outstanding ............................. 50,776,396 46,967,422 45,967,830 ============ ============ ============ See accompanying notes to consolidated financial statements. 38 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) Additional Common paid-in Deferred Accumulated stock capital compensation deficit ------------ ------------ ------------ ------------ Balance, December 31, 2002 .. $ 45,528 $ 81,423,661 $ (471,445) $(23,694,634) Issuance of stock options to non-employees ............. -- 86,875 -- -- Exercise of stock options ... 1,217 850,600 -- -- Amortization of deferred compensation .............. -- -- 463,476 -- Net loss .................... -- -- -- (7,368,955) Adjustment to the fair value of the net tangible assets acquired in the NPI merger -- 916,845 -- -- Change in unrealized loss on marketable securities, net -- -- -- -- Foreign currency translation adjustment ................ -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2003 .. $ 46,745 $ 83,277,981 $ (7,969) $(31,063,589) Issuance of stock options to non-employees ............. -- 87,023 -- -- Exercise of stock options ... 1,024 2,035,736 -- -- Amortization of deferred compensation .............. -- -- 7,969 -- Net loss .................... -- -- -- (5,888,847) Acquisition of treasury stock -- -- -- -- Change in unrealized loss on marketable securities, net -- -- -- -- Foreign currency translation adjustment ................ -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2004 .. $ 47,769 $ 85,400,740 $ -- $(36,952,436) Issuance of stock options to non-employees ............. -- (32,860) -- -- Exercise of stock options, including tax benefit ..... 673 1,974,867 -- -- Amortization of deferred compensation .............. -- -- -- -- Net income .................. -- -- -- 2,293,107 Acquisition of treasury stock -- -- -- -- Change in unrealized loss on marketable securities, net -- -- -- -- Foreign currency translation adjustment ................ -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2005 .. $ 48,442 $ 87,342,747 $ -- $(34,659,329) ------------ ------------ ------------ ------------ Accumulated other comprehensive Total Comprehensive Treasury income stockholders' income stock (loss) equity (loss) ------------ ------------- ------------- ------------- Balance, December 31, 2002 .. $ (1,435,130) $ 33,073 $ 55,901,053 Issuance of stock options to non-employees ............. -- -- 86,875 -- Exercise of stock options ... -- -- 851,817 -- Amortization of deferred compensation .............. -- -- 463,476 -- Net loss .................... -- -- (7,368,955) (7,368,955) Adjustment to the fair value of the net tangible assets acquired in the NPI merger -- -- 916,845 -- Change in unrealized loss on marketable securities, net -- (214,394) (214,394) (214,394) Foreign currency translation adjustment ................ -- (81,168) (81,168) (81,168) ------------ ------------ ------------ ------------ Balance, December 31, 2003 .. $ (1,435,130) $ (262,489) $ 50,555,549 $ (7,664,517) ============ Issuance of stock options to non-employees ............. -- -- 87,023 -- Exercise of stock options ... -- -- 2,036,760 -- Amortization of deferred compensation .............. -- -- 7,969 -- Net loss .................... -- -- (5,888,847) (5,888,847) Acquisition of treasury stock (279,645) -- (279,645) -- Change in unrealized loss on marketable securities, net -- (148,849) (148,849) (148,849) Foreign currency translation adjustment ................ -- (6,010) (6,010) (6,010) ------------ ------------ ------------ ------------ Balance, December 31, 2004 .. $ (1,714,775) $ (417,348) $ 46,363,950 $ (6,043,706) ============ Issuance of stock options to non-employees ............. -- -- (32,860) -- Exercise of stock options, including tax benefit ..... -- -- 1,975,540 -- Amortization of deferred compensation .............. -- -- -- -- Net income .................. -- -- 2,293,107 2,293,107 Acquisition of treasury stock (1,918,155) -- (1,918,155) -- Change in unrealized loss on marketable securities, net -- 218,523 218,523 218,523 Foreign currency translation adjustment ................ -- (241,998) (241,998) (241,998) ------------ ------------ ------------ ------------ Balance, December 31, 2005 .. $ (3,632,930) $ (440,823) $ 48,658,107 $ 2,269,632 ------------ ------------ ------------ ------------ See accompanying notes to consolidated financial statements. 39 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2005 2004 2003 ---------------------------------------------- Cash flows from operating activities: Net income (loss) ................................ $ 2,293,107 $ (5,888,847) $ (7,368,955) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization ................ 3,505,562 3,656,212 2,759,030 Non-cash professional services expenses ...... (32,860) 87,023 86,875 Realized loss on marketable securities ....... 270,026 17,795 -- Tax benefit from stock option exercise ....... 33,000 -- -- Equity-based compensation expense ............ -- 7,969 463,476 Provision for returns and doubtful accounts .. 4,340,102 3,296,275 1,700,100 Changes in operating assets and liabilities: Accounts receivable .......................... (9,274,971) (6,456,175) (4,524,130) Prepaid expenses and other current assets .... (291,693) 636,208 (137,115) Other assets ................................. (50,401) (251,038) (227,711) Accounts payable ............................. 354,471 259,128 125,217 Accrued expenses ............................. 1,104,416 791,498 761,827 Deferred revenue ............................. 4,234,918 2,789,987 415,059 ------------ ------------ ------------ Net cash provided by (used in) operating activities ............................... 6,485,677 (1,053,965) (5,946,327) ------------ ------------ ------------ Cash flows from investing activities: Purchase of marketable securities ................ (61,264,424) (33,897,295) (8,537,284) Sale of marketable securities .................... 61,867,854 43,441,277 17,034,096 Purchase of investments .......................... -- -- (137,710) Purchase of property and equipment ............... (3,161,383) (2,842,792) (2,998,908) Purchase of software licenses .................... (108,000) (50,000) (1,821,000) Purchase of intangible assets .................... (126,241) (131,392) (246,697) Net cash paid for acquisition of IP Metrics ...... -- (214,009) (287,130) Security deposits ................................ -- (4,500) (500,000) ------------ ------------ ------------ Net cash provided by (used in) investing activities ................................... (2,792,194) 6,301,289 2,505,367 ------------ ------------ ------------ Cash flows from financing activities: Proceeds from exercise of stock options .......... 1,942,540 2,036,760 851,817 Payments to acquire treasury stock ............... (1,918,155) (279,645) -- ------------ ------------ ------------ Net cash provided by financing activities ...... 24,385 1,757,115 851,817 ------------ ------------ ------------ Cash flows from discontinued operations (all operating activities in 2003): Payments of liabilities of discontinued operations ................................... -- -- (3,034,620) ------------ ------------ ------------ Effect of exchange rate changes ..................... (405,468) (6,010) (81,168) ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents 3,312,400 6,998,429 (5,704,931) Cash and cash equivalents, beginning of year ........ 15,484,573 8,486,144 14,191,075 ------------ ------------ ------------ Cash and cash equivalents, end of year .............. $ 18,796,973 $ 15,484,573 $ 8,486,144 ============ ============ ============ Increase in additional paid-in capital resulting from an adjustment to reduce the fair value of the liabilities of discontinued operations assumed in the merger with NPI (Note 2) ...................... $ -- $ -- $ 916,845 ============ ============ ============ Cash paid for income taxes .......................... $ 21,583 $ 24,554 $ 48,351 ============ ============ ============ The Company did not pay any interest expense for the three years ended December 31, 2005. See accompanying notes to consolidated financial statements. 40 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2005 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) THE COMPANY AND NATURE OF OPERATIONS FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures and sells network storage software solutions and provides the related maintenance, implementation and engineering services. (B) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (C) CASH EQUIVALENTS AND MARKETABLE SECURITIES The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents, consisting of money market funds and commercial paper, amounted to approximately $12.4 million and $10.9 million at December 31, 2005 and 2004, respectively. Marketable securities at December 31, 2005 and 2004 amounted to $17.8 million and $18.5 million, respectively, and consisted of corporate bonds and government securities, which are classified as available for sale, and accordingly, unrealized gains and losses on marketable securities are reflected as a component of accumulated other comprehensive loss in stockholders' equity. (D) REVENUE RECOGNITION The Company recognizes revenue from software licenses in accordance with Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly, revenue for software licenses is recognized when persuasive evidence of an arrangement exists, the fee is fixed and determinable, the software is delivered and collection of the resulting receivable is deemed probable. Software delivered to a customer on a trial basis is not recognized as revenue until a permanent key is delivered to the customer. Reseller customers typically send the Company a purchase order only when they have an end user identified. When a customer licenses software together with the purchase of maintenance, the Company allocates a portion of the fee to maintenance for its fair value. Software maintenance fees are deferred and recognized as revenue ratably over the term of the arrangement. The long-term portion of deferred revenue relates to maintenance contracts with terms in excess of one year. The cost of providing technical support is included in cost of revenues. The Company provides an allowance for software product returns as a reduction of revenue, based upon historical experience and known or expected trends. Revenues associated with software implementation and software engineering services are recognized as the services are performed. Costs of providing these services are included in cost of revenues. The Company has entered into various distribution, licensing and joint promotion agreements with OEMs and distributors, whereby the Company has provided to the reseller a non-exclusive software license to install the Company's software on certain hardware or to resell the Company's software in exchange for payments based on the products distributed by the OEM or distributor. Nonrefundable advances and engineering fees received by the Company from an OEM are recorded as deferred revenue and recognized as revenue when related software engineering services are complete, if any, and the software product master is delivered and accepted. 41 For the years ended December 31, 2005 and 2004, the Company had a limited number of transactions in which it purchased hardware and bundled this hardware with the Company's software and sold the bundled solution to its customer. Since the software is not essential for the functionality of the equipment included in the Company's bundled solutions, and both the hardware and software have stand alone value to the customer, a portion of the contractual fees is recognized as revenue when the software or hardware is delivered based on the relative fair value of the delivered element(s). (E) PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets (generally between 3 to 7 years). Leasehold improvements are amortized on a straight-line basis over the term of the respective leases or over their estimated useful lives, whichever is shorter. (F) GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill represents the excess of the purchase price over the estimated fair value of net tangible and identifiable intangible assets acquired in business combinations. Consistent with Statement of Financial Accounting Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not amortized goodwill related to its acquisitions, but has instead tested the balance for impairment. The Company's annual impairment assessment is performed on December 31st of each year, and additionally if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. Identifiable intangible assets are amortized over a three-year period using the straight-line method. Amortization expense was $216,997, $220,712 and $159,248 for 2005, 2004 and 2003, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of December 31, 2005 and December 31, 2004 are as follows: December 31, December 31, 2005 2004 ------------ ------------ Customer relationships and purchased technology: Gross carrying amount .......................... $ 216,850 $ 216,850 Accumulated amortization ....................... (216,850) (180,708) --------- --------- Net carrying amount .......................... $ -- $ 36,142 ========= ========= Patents: Gross carrying amount .......................... $ 649,864 $ 523,623 Accumulated amortization ....................... (433,000) (252,145) --------- --------- Net carrying amount .......................... $ 216,864 $ 271,478 ========= ========= (G) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY Costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company's product development process, technological feasibility is established upon completion of a working model. The Company did not capitalize any software development costs until its initial product reached technological feasibility at the end of March 2001. Until such product was released, the Company capitalized $94,570 of software development costs, of which $7,881 and $31,523 was amortized for the years ended December 31, 2004 and 2003, respectively. Software development costs were fully amortized as of the first quarter of 2004. Amortization of software development costs is recorded at the greater of straight line over three years or the ratio of current revenue of the related products to total current and anticipated future revenue of these products. 42 Purchased software technology of $372,306 and $1,045,806, net of accumulated amortization of $4,646,694 and $3,865,194, is included in other assets in the balance sheets as of December 31, 2005 and December 31, 2004, respectively. Amortization expense was $781,500, $1,386,027 and 1,362,778 for the years ended December 31, 2005, 2004 and 2003, respectively. Amortization of purchased software technology is recorded at the greater of the straight line basis over the products estimated remaining life or the ratio of current period revenue of the related products to total current and anticipated future revenue of these products. As of December 31, 2005, amortization expense on existing identifiable intangible assets and purchased software technology will be $443,457, $104,451, and $41,262 for the years ended December 31, 2006, 2007 and 2008, respectively. Such assets will be fully amortized at December 31, 2008. (H) INCOME TAXES Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (I) LONG-LIVED ASSETS The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the sum of the expected future cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value. (J) ACCOUNTING FOR STOCK-BASED COMPENSATION The Company applies the intrinsic-value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations including FASB Interpretation No. 44, ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB OPINION NO. 25 to account for its fixed-plan stock options. Under this method, compensation expense is recorded only if on the date of grant the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123. Had the Company determined stock-based compensation cost based upon the fair value method under SFAS No. 123, the Company's pro forma net loss and diluted net loss per share would have been adjusted to the pro forma amounts indicated below: 2005 2004 2003 ------------ ------------ ------------ Net income (loss) as reported ........................ $ 2,293,107 $ (5,888,847) $ (7,368,955) Add stock-based employee compensation expense included in reported net loss, net of tax ............... -- 7,969 463,476 Deduct total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax ............................. (8,565,701) (8,268,471) (4,930,656) ------------ ------------ ------------ Net loss - pro forma ................................. $ (6,272,594) $(14,149,349) $(11,836,135) ============ ============ ============ Diluted net income (loss) per common share-as reported $ 0.05 $ (0.13) $ (0.16) Diluted net loss per common share-pro forma .......... $ (0.13) $ (0.30) $ (0.26) 43 The per share weighted average fair value of stock options granted during 2005, 2004 and 2003 was $4.52, $6.55 and $5.60, respectively, on the date of grant using the Black-Scholes option-pricing method with the following weighted average assumptions: 2005 - expected dividend yield of 0%, risk free interest rate ranging from 3.7% to 4.6%, expected stock volatility ranging from 61% to 65% and an expected option life of six years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees; 2004 - expected dividend yield of 0%, risk free interest rate of 3.5%, expected stock volatility ranging from 166% to 176% and an expected option life of five years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees; 2003 - expected dividend yield of 0%, risk free interest rate of 3%, expected stock volatility ranging from 68% to 153% and an expected option life of five years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees; (K) FINANCIAL INSTRUMENTS As of December 31, 2005 and 2004, the fair value of the Company's financial instruments including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximates book value due to the short maturity of these instruments. (L) FOREIGN CURRENCY Assets and liabilities of foreign operations are translated at rates of exchange at the end of the period, while results of operations are translated at average exchange rates in effect for the period. Unrealized gains and losses from the translation of foreign assets and liabilities are classified as a separate component of stockholders' equity. Realized gains and losses from foreign currency transactions are included in the statements of operations within interest and other income, net. Such amounts have historically not been material. (M) EARNINGS PER SHARE (EPS) Basic EPS is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents. Due to net losses for the years ended December 31, 2004 and 2003, all common stock equivalents for these periods were excluded from diluted net loss per share. As of December 31, 2005, 2004 and 2003, potentially dilutive common stock equivalents included 10,200,908, 8,973,358 and 9,860,425 stock options outstanding, respectively. As of December 31, 2005, 2004 and 2003, potentially dilutive common stock equivalents also included 750,000 warrants outstanding. The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share ("EPS") computation: 44 Twelve Months Ended December 31, 2005 Twelve Months Ended December 31, 2004 Net Income Shares Per Share Net Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ----------- ------------- ----------- ----------- ------------- ------------ Basic EPS ......... $ 2,293,107 47,662,446 $ 0.05 $(5,888,847) 46,967,422 $ (0.13) ----------- ----------- ----------- ----------- ----------- ------------ Effect of dilutive securities: Stock Options 3,113,950 -- Diluted EPS $ 2,293,107 50,776,396 $ 0.05 $(5,888,847) 46,967,422 $ (0.13) =========== =========== =========== =========== =========== ============ Twelve Months Ended December 31, 2003 Net Income Shares Per Share (Numerator) (Denominator) Amount ----------- ------------- ----------- Basic EPS ......... $(7,368,955) 45,967,830 $ (0.16) ----------- ----------- ----------- Effect of dilutive securities: Stock Options -- Diluted EPS $(7,368,955) 45,967,830 $ (0.16) =========== =========== =========== (N) COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) includes the Company's net income (loss), foreign currency translation adjustments and unrealized losses on marketable securities. Components of comprehensive income (loss) were comprised of foreign currency translation adjustment losses of $391,540 and $149,542 as of December 31, 2005 and 2004, respectively and unrealized losses on marketable securities of $49,283 and $267,806 as of December 31, 2005 and 2004, respectively. (O) USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company's significant estimates include those related to revenue recognition, accounts receivable allowances and deferred income taxes. Actual results could differ from those estimates. (P) NEW ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued SFAS No. 123 (Revised 2004), SHARE-BASED PAYMENT ("SFAS 123R"), which revises SFAS 123. SFAS 123R also supersedes APB 25 and amends SFAS No. 95, STATEMENT OF CASH FLOWS. SFAS 123R eliminates the alternative to account for employee stock options under APB 25 and requires the fair value of all share-based payments to employees (including stock options) be recognized in the income statement, generally over the vesting period. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107, which provides additional implementation guidance for SFAS 123R. Among other things, SAB 107 provides guidance on share-based payment valuations, income statement classification and presentation, capitalization of costs and related income tax accounting. SFAS 123R provides for adoption using either the modified prospective or modified retrospective transition method. The Company will adopt SFAS 123R on January 1, 2006, using the modified prospective transition method in which compensation cost is recognized beginning January 1, 2006 for all share-based payments granted on or after that date and for all awards granted to employees prior to January 1, 2006 that remain unvested on that date. Adoption of SFAS 123R's fair value method will have an effect on the Company's results of operations. The future impact of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted. However, had SFAS 123R been adopted in prior periods, the effect would have approximated the SFAS 123 pro forma amounts disclosed in footnote 1(j). SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as currently required. The Company has historically not realized significant benefits associated with tax deductions for stock-based compensation. Further, those amounts cannot be estimated for future periods (because they depend on, among other things, when employees will exercise the stock options and the market price of the Company's common stock at the time of exercise). In June 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR CORRECTIONS - a replacement of APB Opinion No. 20 and FASB Statement No. 3 ("SFAS 154"). SFAS 154 replaces APB Opinion No. 20, ACCOUNTING CHANGES ("APB 20"), and SFAS No. 3, REPORTING ACCOUNTING CHANGES IN INTERIM FINANCIAL 45 STATEMENTS. SFAS 154 requires retrospective application to prior periods' financial statements of a voluntary change in accounting principle unless it is impracticable to determine either the period-specific effects or the cumulative effects of the change. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income in the period of the change the cumulative effect of changing to the new accounting principle. This standard generally will not apply with respect to the adoption of new accounting standards, as new accounting standards usually include specific transition provisions, and will not override transition provisions contained in new or existing accounting literature. SFAS 154 is effective for fiscal years beginning after December 15, 2005, and early adoption is permitted for accounting changes and error corrections made in years beginning after the date that SFAS 154 was issued. The Company does not expect that the adoption of SFAS 154 on January 1, 2006 will have a significant effect on its financial condition or results of operations. On December 21, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109, ACCOUNTING FOR INCOME TAXES, TO THE TAX DEDUCTION ON QUALIFIED PRODUCTION ACTIVITIES PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1") and FASB Staff Position No. FAS 109-2, ACCOUNTING AND DISCLOSURE GUIDANCE FOR THE FOREIGN EARNINGS REPATRIATION PROVISION WITHIN THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states that the tax deduction for domestic manufacturing activities from this legislation should be accounted for as a "special deduction" and reduce tax expense in the period(s) the amounts are deductible on the tax return, not as an adjustment of recorded deferred tax assets and liabilities. FSP No. 109-2 gives a company additional time to evaluate the effects of the legislation on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109. The Company has determined that it will not repatriate any undistributed foreign earnings under the new tax legislation and, therefore, the legislation as it relates to undistributed foreign earnings will not have an affect on the Company's consolidated financial statements. (Q) RECLASSIFICATIONS Certain reclassifications have been made to prior years' consolidated financial statement presentations to conform to the current year's presentation. (2) ACQUISITIONS On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned subsidiary of the Company, acquired all of the common stock of IP Metrics Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for mission-critical networks, for $2,432,419 in cash plus payments contingent on the level of revenues from IP Metrics' products and services for a period of twenty-four months. The acquisition was accounted for under the purchase method and the results of IP Metrics are included with those of the Company from the date of acquisition. As of December 31, 2004, the Company made final aggregate contingent acquisition payments totaling $501,139 related to the sale of IP Metrics' products and services. Contingent consideration incurred through December 31, 2004 in excess of the amount accrued at the time of acquisition was $211,197, of which $146,154 and $65,043 was added to goodwill in 2004 and 2003, respectively. The fair value of the net tangible liabilities of IP Metrics assumed was $898,305, including $289,942 of accrued contingent consideration recorded at the time of acquisition. The Company purchased certain intangible assets, including customer relationships and purchased technology with a fair value of $216,850. These intangible assets are being amortized under the straight-line method over an estimated useful life of 3 years, the expected period of benefit. The purchase price in excess of the fair value of the net tangible and intangible assets acquired and liabilities assumed by the Company amounted to $3,325,071 and has been recorded as goodwill. On August 22, 2001, pursuant to an Agreement and Plan of Merger and Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged with Network Peripherals, Inc. ("NPI"), with NPI as the surviving corporation. Although NPI acquired FalconStor, as a result of the transaction, FalconStor stockholders held a majority of the voting interests in the combined enterprise 46 after the merger. Accordingly, for accounting purposes, the acquisition was a "reverse acquisition" and FalconStor was the "accounting acquirer." The transaction was accounted for as a recapitalization of FalconStor and recorded based on the fair value of NPI's net tangible assets acquired by FalconStor, with no goodwill or other intangible assets being recognized. At the time of the merger, NPI had no continuing operations and, thus, any post-merger transactions related to NPI have been classified as discontinued operations. In connection with the merger, the name of NPI was changed to FalconStor Software, Inc. (3) PROPERTY AND EQUIPMENT Property and equipment consist of the following: December 31, December 31, 2005 2004 ------------ ------------ Computer hardware and software $ 11,410,607 $ 8,542,374 Furniture and equipment 501,861 503,819 Leasehold improvements 502,895 314,101 Automobile 13,008 -- ------------ ------------ 12,428,371 9,360,294 Less accumulated depreciation (7,150,762) (4,698,025) ------------ ------------ $ 5,277,609 $ 4,662,269 ============ ============ Depreciation expense was $2,452,737, $2,041,592, and $1,205,839 in 2005, 2004, and 2003, respectively. (4) MARKETABLE SECURITIES The Company's investments consist of available-for-sale securities, which are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Unrealized gains and losses are computed on the specific identification method. Realized gains, realized losses and declines in value judged to be other-than-temporary, are included in other income. The cost of available-for-sale securities sold are based on the specific identification method and interest earned is included in interest and other income. The cost and fair values of the Company's available-for-sale marketable securities as of December 31, 2005, are as follows: Aggregate Cost Unrealized Unrealized Fair Value Basis Gains Losses ----------- ----------- ----------- ----------- Auction rate securities $10,098,031 $10,098,031 $ -- $ -- Government securities 6,394,262 6,431,432 -- 37,170 Corporate bonds 1,341,390 1,353,503 -- 12,113 ----------- ----------- ----------- ----------- $17,833,683 $17,882,966 $ -- $ 49,283 =========== =========== =========== =========== As of December 31, 2005 there are 3 corporate bonds and 2 government securities which are in an unrealized loss position. Based on the credit ratings of these securities and the timing of their respective maturities, there is no reason to believe the Company will be unable to collect all amounts due according to the contractual terms of these securities. Unrealized losses on the Company's available-for-sales securities have not been determined to be other-than-temporary due principally to the Company's intent and ability to hold these securities for a period of time sufficient to recover the value of the investments. 47 The cost and fair values of the Company's available-for-sale marketable securities as of December 31, 2004, are as follows: Aggregate Cost Unrealized Unrealized Fair Value Basis Gains Losses ----------- ----------- ----------- ----------- Auction rate securities $ 8,960,511 $ 8,960,511 $ -- $ -- Government securities 6,901,663 6,920,615 -- 18,952 Corporate bonds 2,626,442 2,875,296 -- 248,854 ----------- ----------- ----------- ----------- $18,488,616 $18,756,422 $ -- $ 267,806 =========== =========== =========== =========== The cost basis and fair value of available-for-sale securities by contractual maturity as of December 31, 2005, were as follows: Fair Cost Value ----------- ----------- Due within one year $15,866,571 $15,838,499 Due between one and two years 2,016,395 1,995,184 ----------- ----------- $17,882,966 $17,833,683 =========== =========== (5) ACCRUED EXPENSES Accrued expenses are comprised of the following: December 31, December 31, 2005 2004 ------------ ------------ Accrued compensation $1,517,115 $1,088,656 Accrued consulting and professional fees 598,674 899,678 Accrued marketing and promotion 229,675 193,592 Other accrued expenses 1,640,645 770,821 Accrued hardware purchases 38,946 73,252 Accrued and deferred rent 497,157 475,035 ---------- ---------- $4,522,212 $3,501,034 ========== ========== 6) INCOME TAXES The provision for income taxes for the year ended December 31, 2005 is comprised of Federal Alternative Minimum Tax, state income taxes and foreign income taxes. The provision for income taxes for the year ended December 31, 2004 is comprised solely of foreign income taxes. The tax effects of temporary differences that give rise to the Company's deferred tax assets (liabilities) as of December 31, 2005 and 2004 are as follows: 48 2005 2004 ------------ ------------ U.S. Federal net operating loss carryforwards (FalconStor) $ 11,123,022 $ 11,664,300 U.S. Federal net operating loss carryforwards (NPI) 31,711,302 31,711,100 Foreign net operating loss carryforwards 941,369 335,100 State net operating loss carryforwards 1,065,636 1,715,300 Start-up costs not currently deductible for taxes 90,100 271,300 Depreciation (358,207) (584,300) Compensation 348,562 361,300 Tax credit carryforwards 1,889,255 1,433,200 Deferred revenue 650,555 1,977,400 Capital loss carryforward 847,901 883,400 Lease abandonment charge 77,327 111,800 Allowance for receivables 1,440,036 995,100 Patent 99,194 113,500 Other 11,636 8,100 ------------ ------------ 49,937,688 50,996,600 Valuation allowance (49,937,688) (50,996,600) ------------ ------------ $ -- $ -- ============ ============ The difference between the provision for income taxes computed at the Federal statutory rate and the reported amount of tax expense attributable to loss before income taxes for the years ended December 31, 2005, 2004 and 2003, are as follows: 2005 2004 2003 ----------- ----------- ----------- Tax recovery at Federal statutory rate $ 820,031 $(1,991,300) $(2,494,400) Increase (reduction) in income taxes resulting from: State and local taxes, net of Federal income tax benefit 885,733 809,300 (318,000) Non-deductible expenses 302,207 47,600 41,900 Compensation -- 2,700 157,600 Foreign tax credit -- (6,100) (90,000) Net effect of foreign operations 128,150 164,800 (900) Research and development credit (433,013) (360,100) (272,200) Increase (decrease) in valuation allowance (1,584,358) 1,365,000 3,008,600 ----------- ----------- ----------- $ 118,750 $ 31,900 $ 32,600 =========== =========== =========== The components of the Company's current income tax provision for the years ended December 31, 2005, 2004 and 2003 are as follows: 2005 2004 2003 -------- -------- -------- Federal $ 55,887 $ -- $ -- State and local 1,113 -- -- Foreign 61,750 31,900 32,600 -------- -------- -------- $118,750 $ 31,900 $ 32,600 ======== ======== ======== Income (loss) before provision for income taxes for the years ended December 31, 2005, 2004 and 2003 are as follows: 2005 2004 2003 ----------- ----------- ----------- Domestic income (loss) $ 4,390,212 $(5,466,000) $(7,434,000) Foreign income (loss) (1,978,355) (391,000) 98,000 ----------- ----------- ----------- $ 2,411,857 $(5,857,000) $(7,336,000) =========== =========== =========== 49 As of December 31, 2005, the Company had U.S. Federal net operating loss carryforwards of approximately $32,714,800 which expire from 2020 through 2025. In addition, as of the date of the merger described in Note 2, NPI had U.S. Federal net operating loss carryforwards of $93,268,500 that starts to expire in December, 2012. As of December 31, 2005, the Company had state net operating loss carryforwards of approximately $20,682,000 which expire starting in 2007 through 2025. As of December 31, 2005, the Company had foreign net operating loss carryforwards of approximately $3,083,600. At December 31, 2005 and 2004, the Company established a valuation allowance against its deferred tax assets to an amount that is more-likely-than-not realizable due to the Company's prior history of pre-tax losses and uncertainty about the timing of and ability to generate taxable income in the future. Due to the Company's various equity transactions, which resulted in a change of control, the utilization of certain tax loss carryforwards is subject to annual limitations imposed by Internal Revenue Code Section 382. NPI experienced such an ownership change as a result of the merger. As such, the Company's ability to use its NOL carryforwards to offset taxable income in the future may be significantly limited. If the entire deferred tax asset were realized, $4,628,100 would be allocated to paid-in-capital with the remainder reducing income tax expense. Of the amount allocable to paid-in-capital, $2,336,800 related to the tax effect of the deductions for payments of the liabilities of discontinued operations and the balance of $2,291,300 related to the tax effect of compensation deductions from exercises of employee and consultant stock options. (7) STOCKHOLDERS' EQUITY In September, 2003, the Company entered into a worldwide OEM agreement with a major technology company (the "OEM"), and granted to the OEM warrants to purchase 750,000 shares of the Company's common stock with an exercise price of $6.18 per share. A portion of the warrants may vest annually subject to the OEM's achievement of pre-defined and mutually agreed upon sales objectives over a three-year period beginning June 1, 2004. If the OEM generates cumulative revenues to the Company in the mid-eight figure dollar range from reselling the Company's products then all the warrants granted will vest. Any warrants that do not vest by the end of the three-year period will expire. If and when it is probable that all or a portion of the warrants will vest, the then fair value of the warrants earned will be recorded as a reduction of revenue. Subsequently, each quarter the Company will apply variable accounting to adjust such amount to reflect the fair value of the warrants until they vest. As of December 31, 2005, the Company had not generated any revenues from this OEM and accordingly no warrants had vested. (8) STOCK OPTION PLANS As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000 Stock Option Plan (the "Plan"). The Plan is administered by the Board of Directors and, as amended, currently provides for the issuance of up to 14,162,296 options to employees, consultants and non-employee directors. Options may be incentive ("ISO") or non-qualified. Exercise prices of ISOs granted must be at least equal to the fair value of the common stock on the date of grant, and have terms not greater than ten years, except those to an employee who owns stock with greater than 10% of the voting power of all classes of stock of the Company, in which case they must have an option price at least 110% of the fair value of the stock, and expire no later than five years from the date of grant. Certain of the options granted to employees had exercise prices less than the fair value of the common stock on the date of grant, which resulted in deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively. The amortization of deferred compensation amounted to $7,969 and $463,476 in 2004 and 2003, respectively. Deferred compensation was fully amortized as of the first quarter of 2004. The Company granted options to purchase an aggregate of 50,000 shares of common stock to certain non-employee consultants in exchange for professional services during 2002. The aggregate fair value of these options as determined using the fair value method under SFAS No. 123, is being expensed over the periods the services are provided. The related expense amounted to $32,860, $87,023 and $86,875 in 2005, 2004 and 2003, respectively. These services have been completed as of December 31, 2005. On May 14, 2004 the Company adopted a 2004 Outside Directors Stock Option Plan (the "2004 Plan"). The 2004 Plan is administered by the Board of Directors and provides for the granting of options to non-employee directors of the 50 Company to purchase up to 300,000 shares of Company common stock. Exercise prices of the options must be equal to the fair market value of the common stock on the date of grant. Options granted have terms of ten years. All options granted under the 2004 Plan must be granted within three years of the adoption of the 2004 Plan. Stock option activity for the periods indicated is as follows: Weighted average Number of exercise Options Price ----------- -------- Outstanding at December 31, 2002 ................... 9,387,579 $ 3.55 Granted ............................................ 2,678,300 $ 7.01 Exercised .......................................... (1,224,833) $ .70 Canceled ........................................... (980,621) $ 9.19 ---------- Outstanding at December 31, 2003 ................... 9,860,425 $ 4.29 ---------- Granted ............................................ 1,227,000 $ 6.91 Exercised .......................................... (1,023,425) $ 1.99 Canceled ........................................... (1,090,642) $ 6.01 ---------- Outstanding at December 31, 2004 ................... 8,973,358 $ 4.71 ---------- Granted ............................................ 2,226,500 $ 7.31 Exercised .......................................... (465,110) $ 4.02 Canceled ........................................... (533,840) $ 6.38 ---------- Outstanding at December 31, 2005 ................... 10,200,908 $ 5.22 ========== Vested at December 31, 2003 ........................ 4,950,046 $ 2.47 ========== Vested at December 31, 2004 ........................ 5,521,469 $ 3.60 ========== Vested at December 31, 2005 ........................ 6,735,403 $ 4.19 ========== Options available for grant at December 31, 2005 ... 1,006,314 ========== During 2003, one employee paid for the exercise price of certain options with 7,094 shares of common stock that were held greater than six months. Such shares which had a market value of $28,744 were retired. The following table summarizes information about stock options outstanding at December 31, 2005: Options Outstanding Options Exercisable ------------------------------------------------------- ----------------------------------- Weighted - Average Weighted Range of Number Remaining Contractual Average Exercise Number Weighted - Average Exercise Prices Outstanding Life (Years) Price Exercisable Exercise Price - --------------- ----------- --------------------- ---------------- ----------- ------------------ $0.35 - $1.01 2,208,913 4.53 $ 0.35 2,208,913 $ 0.35 $3.95 - $4.04 1,124,610 6.85 $ 4.03 1,097,750 $ 4.04 $5.07 - $5.86 1,775,341 6.87 $ 5.27 1,432,252 $ 5.20 $6.01 - $6.90 1,956,570 8.08 $ 6.35 763,307 $ 6.25 $7.35 - $8.43 2,673,200 8.51 $ 8.11 839,587 $ 8.24 $8.74 - $9.72 318,624 6.99 $ 9.09 249,944 $ 9.18 $10.95 143,650 4.31 $ 10.95 143,650 $ 10.95 ----------- ----------- 10,200,908 6.99 $ 5.22 6,735,403 $ 4.19 ----------- ----------- 51 (9) LEASE ABANDONMENT CHARGE In November 2003, the Company relocated its headquarters to a larger facility. As a result of this relocation, the Company vacated its previous office space and recorded a lease abandonment charge of $550,162 for the estimated loss expected to be incurred on the remaining lease obligation through July 2007. The charge included the remaining lease rental obligation reduced by cash flows the Company expects to generate from an agreement to sub-lease the facility, as well as the write-off of leasehold improvements at the Company's previous facility. As of December 31, 2005, the remaining amounts due of $137,429 associated with this charge were included in accrued expenses. (10) LITIGATION SETTLEMENT CHARGE During the third quarter of 2004, the Company resolved claims relating to alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill") and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company. Pursuant to the terms of the Settlement Agreement between the Company and Crossroads, the Company, without admission of infringement, made a one-time payment of $1.3 million and granted to Crossroads licenses to certain Company technology in exchange for a worldwide, perpetual license to the technology underlying the Crossroads patents at issue in the litigation. All claims against the Company by both Dot Hill and Crossroads were dismissed. (11) LIABILITIES OF DISCONTINUED OPERATIONS Liabilities of NPI's discontinued operations at December 31, 2002 totaled $4.2 million and consisted of warranty related liabilities, foreign income taxes, severance related payments, professional fees and other related liabilities, including estimated settlement costs for disputes. As of December 31, 2002, the Company had reduced liabilities of discontinued operations and increased additional paid-in-capital by $2,150,000 for its then estimate of the excess of the remaining liabilities for discontinued operations over the amounts estimated to be paid. On February 14, 2003, the Company settled a claim associated with the liabilities of discontinued operations for $2,850,000. As of December 31, 2003 all significant contingent liabilities related to the discontinued operations of NPI were resolved and paid. As a result, on December 31, 2003 the excess of the remaining liabilities for discontinued operations over the amounts paid of $916,845 was reflected as an increase to additional paid-in-capital since this liability was related to the merger with NPI, which was accounted for as a recapitalization. (12) COMMITMENTS AND CONTINGENCIES The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2005 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2005: Year ending December 31, ------------------------ 2006...................................................... $ 1,915,879 2007...................................................... 1,433,153 2008...................................................... 1,220,435 2009...................................................... 1,254,067 2010...................................................... 1,288,708 Thereafter................................................ 1,699,218 ----------- $ 8,811,460 =========== 52 These leases require the Company to pay its proportionate share of real estate taxes and other common charges. Total rent expense for operating leases was $1,461,051, $1,103,008, and $673,949 for the years ended December 31, 2005, 2004 and 2003, respectively. The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with SFAS No. 5, ACCOUNTING FOR CONTINGENCIES. To date, the Company has not incurred any costs related to warranty obligations. Under the terms of substantially all of its software license agreements, the Company has agreed to indemnify its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company's software infringes the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with SFAS No. 5. Except for the alleged patent infringement claim discussed in note 10, through December 31, 2005, there have not been any claims under such indemnification provisions. The Company is subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, the Company believes that such matters will not have a material adverse effect on its financial condition or liquidity. In November, 2005, the Company entered into a second Amended and Restated Employment Agreement ("Employment Agreement") with ReiJane Huai. Pursuant to the Employment Agreement, the Company agreed to employ Mr. Huai as President and Chief Executive Officer of the Company until December 31, 2007, at an annual salary of $275,000. The Employment Agreement also provides for the payment of annual bonuses to Mr. Huai based on the Company's operating income (as defined) and for certain other contingent benefits set forth in the Employment Agreement. On December 1, 2005, the Company adopted the 2005 FalconStor Software, Inc., Key Executive Severance Protection Plan ("Severance Plan"). Pursuant to the Severance Plan, the Company's Chief Executive Officer, Chief Financial Officer and certain other key executives are entitled to receive certain contingent benefits, as set forth in the Severance Plan, including lump sum payments and acceleration of stock option vesting, each in certain circumstances. (13) EMPLOYEE BENEFIT DEFINED CONTRIBUTION PLAN Effective July 2002, the Company established a voluntary savings and defined contribution plan (the "Plan") under Section 401(k) of the Internal Revenue Code. This Plan covers all U.S. employees meeting certain eligibility requirements and allows participants to contribute a portion of their annual compensation. Employees are 100% vested in their own contributions. For the years ended December 31, 2005, 2004 and 2003, the Company did not make any contributions to the Plan. (14) STOCK REPURCHASE PROGRAM On October 25, 2001, the Company announced that its Board of Directors authorized the repurchase of up to two million shares of the Company's outstanding common stock. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company's management. The terms of the stock repurchases will be determined by management based on market conditions. During the year ended December 31, 2005, the Company purchased 272,500 shares of its common stock in open market purchases for a total cost of $1,918,155. As of December 31, 2005, the Company had repurchased a total of 549,600 shares for $3,632,930. 53 (15) SEGMENT REPORTING The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the years ended December 31, 2005, 2004 and 2003 and the location of long-lived assets as of December 31, 2005, 2004 and 2003 are summarized as follows: 2005 2004 2003 ----------- ----------- ----------- Revenues: United States $28,300,822 $18,140,465 $ 9,834,526 Asia 6,535,128 5,821,902 3,580,741 Other international 6,128,153 4,746,311 3,528,868 ----------- ----------- ----------- Total Revenues $40,964,103 $28,708,678 $16,944,135 =========== =========== =========== Long-lived assets (includes all non-current assets): United States $ 9,716,031 $ 9,929,214 $10,329,876 Asia 1,320,865 950,387 760,148 Other international 207,098 322,544 334,576 ----------- ----------- ----------- Total long-lived assets $11,243,994 $11,202,145 $11,424,600 =========== =========== =========== For the year ended December 31, 2005, the Company had two customers that together accounted for a total of 31% of revenues. For the year ended December 31, 2004, the Company had one customer that accounted for 16% of revenues. For the year ended December 31, 2003, the Company did not have any customers that accounted for over 10% of revenues. As of December 31, 2005, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 28% of the accounts receivable balance. As of December 31, 2004, the Company had three customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 33% of the accounts receivable balance. (16) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL ACCOUNTS Balance at Additions Balance at Beginning of Charged End of Period Ended, Period to Expense Deductions Period - ----------------- ------------- ------------- ------------- ------------- December 31, 2005 $ 2,551,616 $ 4,340,102 $ 3,044,836 $ 3,846,882 December 31, 2004 $ 1,837,934 $ 3,296,275 $ 2,582,593 $ 2,551,616 December 31, 2003 $ 813,645 $ 1,700,100 $ 675,811 $ 1,837,934 (17) QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of selected quarterly financial data for the years ended December 31, 2005 and 2004: 54 Fiscal Quarter First Second Third Fourth ------------ ------------ ------------ ------------ 2005 Revenue $ 8,392,036 $ 9,495,587 $ 10,056,665 $ 13,019,815 ============ ============ ============ ============ Net income (loss) (a) $ (133,829) $ 288,105 $ 482,879 $ 1,655,952 ============ ============ ============ ============ Basic net income (loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03 ============ ============ ============ ============ Diluted net income (loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03 ============ ============ ============ ============ Basic weighted average common shares outstanding 47,528,874 47,594,072 47,720,496 47,802,694 ============ ============ ============ ============ Diluted weighted average common shares outstanding 47,528,874 50,623,983 50,531,012 50,958,553 ============ ============ ============ ============ (a) Net income for the year ended December 31, 2005, includes an out-of-period charge of approximately $0.2 million to recognize investment losses realized in prior years. Such charge was not considered material to any period. 2004 Revenue $ 5,258,798 $ 6,483,137 $ 7,469,999 $ 9,496,744 ============ ============ ============ ============ Net income (loss) $ (2,221,507) $ (1,713,091) $ (2,293,083) $ 338,834 ============ ============ ============ ============ Basic net income (loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01 ============ ============ ============ ============ Diluted net income (loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01 ============ ============ ============ ============ Basic weighted average common shares outstanding 46,638,740 46,859,326 47,054,294 47,307,612 ============ ============ ============ ============ Diluted weighted average common shares outstanding 46,638,740 46,859,326 47,054,294 51,249,985 ============ ============ ============ ============ The sum of the quarterly net loss per share amounts do not always equal the annual amount reported, as per share amounts are computed independently for each quarter and the annual period based on the weighted average common shares outstanding in each such period. 55 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES. DISCLOSURE CONTROLS AND PROCEDURES The Company maintains "disclosure controls and procedures," as such term is defined in Rules 13a-15e and 15d-15e of the Securities and Exchange Act of 1934, as amended (the "Exchange Act"), that are designed to ensure that information required to be disclosed in its reports, pursuant to the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to its management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding the required disclosures. In designing and evaluating the disclosure controls and procedures, management has recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. The Company's Chief Executive Officer (its principal executive officer) and Chief Financial Officer (its principal finance officer and principal accounting officer) have evaluated the effectiveness of its "disclosure controls and procedures" as of the end of the period covered by this Annual Report on Form 10-K. Based on their evaluation, the principal executive officer and principal financial officer concluded that its disclosure controls and procedures are effective. INTERNAL CONTROL OVER FINANCIAL REPORTING MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. To evaluate the effectiveness of the Company's internal control over financial reporting, the Company's management uses the Integrated Framework adopted by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). The Company's management has assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, using the COSO framework. The Company's management has determined that the Company's internal control over financial reporting is effective as of that date. KPMG LLP, the registered public accounting firm that has audited the Company's consolidated financial statements included in this report has issued their attestation report on management's assessment of the Company's internal control over financial reporting, which is included herein. ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information called for by Part III, Item 10, regarding the Registrant's directors will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2006, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions 56 "Election of Directors", "Management" and "Committees of the Board of Directors." The Proxy Statement will be filed within 120 days of December 31, 2005, our year-end. ITEM 11. EXECUTIVE COMPENSATION Information called for by Part III, Item 11, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2006, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Executive Compensation." The Proxy Statement will be filed within 120 days of December 31, 2005, our year-end. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information called for by Part III, Item 12, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2006, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions "Beneficial Ownership of Shares" and "Equity Compensation Plan Information." The Proxy Statement will be filed within 120 days of December 31, 2005, our year-end. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding our relationships and related transactions will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2006, and is incorporated by reference. The information appears in the Proxy Statement under the caption "Certain Relationships and Related Transactions." The Proxy Statement will be filed within 120 days of December 31, 2005, our year-end. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information called for by Part III, Item 14, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2006, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Principal Accountant Fees and Services." The Proxy Statement will be filed within 120 days of December 31, 2005, our year-end. 57 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES The information required by subsections (a)(1) and (a)(2) of this item are included in the response to Item 8 of Part II of this annual report on Form 10-K. (b) Exhibits 2.1 Agreement and Plan of Merger and Reorganization, dated as of May 4, 2001, among FalconStor, Inc., Network Peripherals Inc., and Empire Acquisition Corp, incorporated herein by reference to Annex A to the Registrant's joint proxy/prospectus on Form S-4, filed May 11, 2001. 3.1 Restated Certificate of Incorporation, incorporated herein by reference to Exhibit 3.1 to the Registrant's registration statement on Form S-1 (File no. 33-79350), filed on April 28, 1994. 3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the Registrant's quarterly report on form 10-Q for the period ended March 31, 2000, filed on May 10, 2000. 3.3 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.3 to the Registrant's annual report on Form 10-K for the year ended December 31, 1998, filed on March 22, 1999. 3.4 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.4 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002. 4.1 2000 Stock Option Plan, incorporated herein by reference to Exhibit 4.1 of the Registrant's registration statement on Form S-8, filed on September 21, 2001. 4.2 2000 Stock Option Plan, as amended May 15, 2003, incorporated herein by reference to Exhibit 99 to the Registrant's quarterly report on Form 10-Q for the period ended June 30, 2003, filed on August 14, 2003. 4.3 2000 Stock Option Plan, as amended May 14, 2004, incorporated herein by reference to Exhibit 4.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2004, filed on March 16, 2005. 4.4 1994 Outside Directors Stock Plan, as amended May 17, 2002 incorporated herein by reference to Exhibit 4.2 to the Registrant's annual report on Form 10-K for the year ended December 31, 2002, filed on March 17, 2003. 4.5 2004 Outside Directors Stock Option Plan, incorporated herein by reference to Exhibit 4.5 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2004, filed on March 16, 2005. 10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and FalconStor Software, Inc., dated August, 2003, incorporated herein by reference to Exhibit 99.1 to the Registrant's quarterly report on Form 10-Q for the period ended September 30, 2003, filed on November 14, 2003. 10.2 Second Amended and Restated Employment Agreement, dated November 7, 2005 between Registrant and ReiJane Huai, incorporated herein by reference to Exhibit 10.1 to the 58 Registrant's quarterly report on Form 10-Q for the period ended September 30, 2005, filed on November 8, 2005. 10.3 *Amended and Restated FalconStor Software, Inc., 2005 Key Executive Severance Protection Plan. 21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC, Inc., FalconStor Software (Korea), Inc. 23.1 *Consent of KPMG LLP. 31.1 *Certification of the Chief Executive Officer 31.2 *Certification of the Chief Financial Officer 32.1 *Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) 32.2 *Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) *- filed herewith. 59 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has signed this report by the undersigned, thereunto duly authorized in Melville, State of New York on March 15, 2006. FALCONSTOR SOFTWARE, INC. By: /s/ Reijane Huai Date: March 15, 2006 --------------------------------------------- ReiJane Huai, President, Chief Executive Officer of FalconStor Software, Inc. POWER OF ATTORNEY FalconStor Software, Inc. and each of the undersigned do hereby appoint ReiJane Huai and James Weber, and each of them severally, its or his true and lawful attorney to execute on behalf of FalconStor Software, Inc. and the undersigned any and all amendments to this Annual Report on Form 10-K and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission; each of such attorneys shall have the power to act hereunder with or without the other. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By: /s/ ReiJane Huai March 15, 2006 ---------------------------------------------------- -------------- Reijane Huai, President, Chief Executive Officer and Date Chairman of the Board (Principal Executive Officer) By: /s/ James Weber March 15, 2006 ---------------------------------------------------- -------------- James Weber, Chief Financial Officer, Date Vice President and Treasurer (Principal Financial Officer and Principal Accounting Officer) By: /s/ Steven L. Bock March 15, 2006 ---------------------------------------------------- -------------- Steven L. Bock, Director Date By: /s/ Patrick B. Carney March 15, 2006 ---------------------------------------------------- -------------- Patrick B. Carney, Director Date By: /s/ Lawrence S. Dolin March 15, 2006 ---------------------------------------------------- -------------- Lawrence S. Dolin, Director Date By: /s/ Steven R. Fischer March 15, 2006 ---------------------------------------------------- -------------- Steven R. Fischer, Director Date By: /s/ Alan W. Kaufman March 15, 2006 ---------------------------------------------------- -------------- Alan W. Kaufman, Director Date 60
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10-K Filing
FalconStor Software (FALC) 10-K2005 FY Annual report
Filed: 15 Mar 06, 12:00am