UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q /X/ QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006 --------------- /_/ TRANSITION REPORT PURSUANT 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 of Incorporation) (I.R.S. Employer Identification No.) 2 HUNTINGTON QUADRANGLE MELVILLE, NEW YORK 11747 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: 631-777-5188 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 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 --- --- The number of shares of Common Stock issued and outstanding as of April 21, 2006 was 48,689,502 and 48,139,902, which includes redeemable common shares. 1FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES FORM 10-Q INDEX Page PART I. Financial Information 3 Item 1. Consolidated Financial Statements 3 Condensed Consolidated Balance Sheets at March 31, 2006 (unaudited) and December 31, 2005 3 Unaudited Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005 4 Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005 5 Notes to the Unaudited Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Qualitative and Quantitative Disclosures about Market Risk 19 Item 4. Controls and Procedures 20 PART II. Other Information 20 Item 1. Legal Proceedings 20 Item 1A. Risk Factors 20 Item 6. Exhibits 28 2 PART I. FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS March 31, 2006 December 31, 2005 ------------------- -------------------- ASSETS (Unaudited) Current assets: Cash and cash equivalents ........................................... $ 22,276,669 $ 18,796,973 Marketable securities ............................................... 18,827,473 17,833,683 Accounts receivable, net of allowances of $4,306,243 and $3,846,882, respectively .......................................... 9,899,433 15,187,408 Prepaid expenses and other current assets ........................... 929,053 911,715 ------------ ------------ Total current assets .......................................... 51,932,628 52,729,779 Property and equipment, net of accumulated depreciation of $7,887,280 and $7,150,762, respectively ............................. 5,338,097 5,277,609 Goodwill ............................................................... 3,512,796 3,512,796 Other intangible assets, net ........................................... 259,674 216,864 Other assets ........................................................... 2,180,129 2,236,725 ------------ ------------ Total assets .................................................. $ 63,223,324 $ 63,973,773 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ..................................................... $ 949,761 $ 1,152,228 Accrued expenses ..................................................... 4,099,806 4,522,212 Deferred revenue ..................................................... 8,046,044 7,401,018 ------------ ------------ Total current liabilities ................................. 13,095,611 13,075,458 Deferred revenue ....................................................... 2,023,539 2,240,208 ------------ ------------ Total liabilities ......................................... 15,119,150 15,315,666 Commitments and contingencies Stockholders' equity: Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- -- Common stock - $.001 par value, 100,000,000 shares authorized, 48,689,502 and 48,441,614 shares issued, respectively and 48,139,902 and 47,892,014 shares outstanding, respectively .................. 48,690 48,442 Additional paid-in capital ........................................... 90,403,134 87,342,747 Accumulated deficit .................................................. (38,296,215) (34,659,329) Common stock held in treasury, at cost (549,600 shares ) ............. (3,632,930) (3,632,930) Accumulated other comprehensive loss ................................. (418,505) (440,823) ------------ ------------ Total stockholders' equity .................................... 48,104,174 48,658,107 ------------ ------------ Total liabilities and stockholders' equity .................... $ 63,223,324 $ 63,973,773 ============ ============ See accompanying notes to unaudited condensed consolidated financial statements. 3 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended March 31, 2006 2005 ------------ ------------ Revenues: Software license revenue ..................................... $ 5,676,689 $ 6,282,509 Maintenance revenue........................................... 2,591,003 1,530,174 Software services and other revenue .......................... 940,628 579,353 ------------ ------------ 9,208,320 8,392,036 ------------ ------------ Operating expenses: Amortization of purchased and capitalized software ......... 151,722 222,583 Cost of maintenance, software services and other revenue ... 1,984,597 1,327,217 Software development costs ................................. 4,607,103 2,667,391 Selling and marketing ...................................... 4,904,005 3,505,219 General and administrative ................................. 1,321,294 986,026 ------------ ------------ 12,968,721 8,708,436 ------------ ------------ Operating loss ........................................ (3,760,401) (316,400) ------------ ------------ Interest and other income .................................... 286,651 186,586 ------------ ------------ Loss before income taxes .............................. (3,473,750) (129,814) Provision for income taxes ................................... 163,136 4,015 ------------ ------------ Net loss .............................................. $ (3,636,886) $ (133,829) ------------ ------------ Basic and diluted net loss per share ......................... $ (0.08) $ (0.00) ============ ============ Weighted average basic and diluted shares outstanding ................................................ 48,006,309 47,528,874 ============ ============ See accompanying notes to unaudited condensed consolidated financial statements. 4 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Three Months Ended March 31, 2006 2005 ------------ ------------ Cash flows from operating activities: Net loss ......................................................... $ (3,636,886) $ (133,829) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization ................................ 925,207 869,972 Share-based payment compensation ............................. 2,264,520 -- Non-cash professional services ............................... -- (91,546) Realized loss on marketable securities ....................... 28,855 22,701 Provision for returns and doubtful accounts .................. 812,887 873,535 Changes in operating assets and liabilities: Accounts receivable .......................................... 4,476,931 (807,015) Prepaid expenses and other current assets .................... (16,290) (135,284) Other assets ................................................. 80,767 111,293 Accounts payable ............................................. (205,787) (73,384) Accrued expenses ............................................. (441,292) (400,308) Deferred revenue ............................................. 449,484 735,321 ------------ ------------ Net cash provided by operating activities .................. 4,738,396 971,456 ------------ ------------ Cash flows from investing activities: Sale of marketable securities .................................... 14,733,241 16,653,977 Purchase of marketable securities ................................ (15,745,007) (14,663,176) Purchase of property and equipment ............................... (774,704) (515,688) Purchase of software licenses .................................... (168,000) -- Purchase of intangible assets .................................... (87,990) (29,104) ------------ ------------ Net cash (used in) provided by investing activities ........ (2,042,460) 1,446,009 ------------ ------------ Cash flows from financing activities: Proceeds from exercise of stock options .......................... 796,115 361,950 Payments to acquire treasury stock ............................... -- (913,095) ------------ ------------ Net cash provided by (used in) financing activities ....... 796,115 (551,145) ------------ ------------ Effect of exchange rate changes on cash and cash equivalents ........ (12,355) (15,523) ------------ ------------ Net increase in cash and cash equivalents ........................... 3,479,696 1,850,797 Cash and cash equivalents, beginning of period ...................... 18,796,973 15,484,573 ------------ ------------ Cash and cash equivalents, end of period ............................ $ 22,276,669 $ 17,335,370 ============ ============ Cash paid for income taxes .......................................... $ 25,000 $ 6,294 ============ ============ The Company did not pay any interest expense for the three months ended March 31, 2006 and 2005. See accompanying notes to unaudited condensed consolidated financial statements. 5 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (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) UNAUDITED INTERIM FINANCIAL INFORMATION The unaudited interim consolidated financial statements of the Company as of March 31, 2006 and for the three months ended March 31, 2006 and 2005, included herein have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements. In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at March 31, 2006, and the results of its operations for the three months ended March 31, 2006 and 2005. (d) 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 $15.7 million and $12.4 million at March 31, 2006 and December 31, 2005, respectively. Marketable securities at March 31, 2006 and December 31, 2005 amounted to $18.8 million and $17.8 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. (e) 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 and 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 contract. 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 completed. 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 6 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. For the quarters ended March 31, 2006 and 2005, 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). For the three months ended March 31, 2006, the Company had one customer that accounted for 26% of revenues and one customer that accounted for 16% of the accounts receivable balance at March 31, 2006. (f) 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 (3 to 7 years). Depreciation expense was $736,518 and $585,130 for the three months ended March 31, 2006 and 2005, respectively. 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. (g) 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 instead tested the balance for impairment. The Company's annual impairment assessment is performed as of December 31st of each year, and at other times 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 $45,180 and $62,259 for the three months ended March 31, 2006 and 2005. The gross carrying amount and accumulated amortization of other intangible assets as of March 31, 2006 and December 31, 2005 are as follows: March 31, December 31, 2006 2005 ----------- ------------ Customer relationships and purchased technology: Gross carrying amount $ 216,850 $ 216,850 Accumulated amortization (216,850) (216,850) ----------- ------------ Net carrying amount $ - $ - =========== ============ Patents: Gross carrying amount $ 737,854 $ 649,864 Accumulated amortization (478,180) (433,000) ----------- ------------ Net carrying amount $ 259,674 $ 216,864 =========== ============ (h) SOFTWARE DEVELOPMENT COSTS AND PURCHASED 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. 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. Purchased software technology of $388,584 and $372,306, net of accumulated amortization of $4,798,417 and $4,646,694 is included in other assets in the balance sheets as of March 31, 2006 and December 31, 2005, respectively. 7 Amortization expense was $151,722 and $222,583 for the three months ended March 31, 2006 and 2005, 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. (i) 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. The Company provides a full valuation allowance against its deferred tax assets. (j) 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. (k) SHARE-BASED PAYMENTS Effective January 1, 2006, the Company adopted the provisions of Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 123(R), SHARE-BASED PAYMENT, which establishes the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Under the provisions of SFAS No. 123(R), share-based payment compensation is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the requisite employee service period (generally the vesting period). The Company adopted SFAS No. 123(R) using the modified prospective method and, as a result, periods prior to January 1, 2006 have not been restated. (l) FINANCIAL INSTRUMENTS As of March 31, 2006 and December 31, 2005, 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. (m) 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. (n) 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 the net loss for the three months ended March 31, 2006 and 2005, all common stock equivalents were excluded from diluted net loss per share for the periods. As of March 31, 2006, potentially dilutive common stock equivalents included 10,175,586 stock options outstanding and 750,000 warrants outstanding (such warrants become exercisable only if certain performance targets are met by the grantee). 8 (o) COMPREHENSIVE INCOME (LOSS) The Company's comprehensive income (loss) is as follows: Three Months Ended March 31, 2006 2005 ---- ---- Net loss $(3,636,886) $ (133,829) ----------- ----------- Other comprehensive income (loss): Foreign currency translation adjustments 11,439 (15,523) Unrealized gains on investments 10,879 6,155 ----------- ----------- Other comprehensive income (loss) 22,318 (9,368) ----------- ----------- Comprehensive loss $(3,614,568) $ (143,197) =========== =========== (p) 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, deferred income taxes and accounting for share-based payment compensation. Actual results could differ from those estimates. (q) NEW ACCOUNTING PRONOUNCEMENTS In February 2006, the FASB issued FASB Staff Position ("FSP") No. FAS 123(R)-4, CLASSIFICATION OF OPTIONS AND SIMILAR INSTRUMENTS ISSUED AS EMPLOYEE COMPENSATION THAT ALLOW FOR CASH SETTLEMENT UPON THE OCCURRENCE OF A CONTINGENT EVENT, which amends SFAS No. 123(R) to require that options issued with a cash settlement feature that can be exercised upon the occurrence of a contingent event that is outside the employee's control should not be classified as liabilities until it becomes probable that the event will occur. For companies that adopted SFAS No. 123(R) prior to the issuance of the FSP, application is required in the first reporting period beginning after February 3, 2006. Currently, the Company has no stock options outstanding with contingent cash settlement features, and as a result, the FSP will not impact the Company's consolidated financial statements. (r) RECLASSIFICATIONS Certain reclassifications have been made to prior years' consolidated financial statement presentations to conform to the current year's presentation. (2) SHARE-BASED PAYMENT ARRANGEMENTS 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 grant of options to purchase up to 14,162,296 shares of Company common stock 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. Exercise prices of non-qualified options granted must not be less than eighty percent of the fair value of the common stock on the date of grant, and have terms not greater than ten years. 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 is expensed over the periods the services are provided. The related expense amounted to $(91,546) for the three months ended March 31, 2005. These services were completed as of December 31, 2005. 9 On May 14, 2004, the Company adopted the 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 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. The following table summarizes stock option activity during the three months ended March 31, 2006: Weighted Weighted Average Average Remaining Aggregate Number of Exercise Contractual Intrinsic Options Price Life (Years) Value ------------ ----------- ------------- ------------ Outstanding at December 31, 2005 10,200,908 $ 5.22 Granted 284,000 $ 8.93 Exercised (247,888) $ 3.21 Canceled (61,434) $ 8.97 ------------ ----------- Outstanding at March 31, 2006 10,175,586 $ 5.35 6.89 $41,918,935 ============ =========== ============= ============ Options exercisable at March 31, 2006 6,903,249 $ 4.42 6.06 $34,901,576 ============ =========== ============= ============ Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended March 31, 2006 and 2005 was $796,115 and $361,950, respectively. The total intrinsic value of stock options exercised during the three months ended March 31, 2006 and 2005 was $1,474,427 and $1,127,236, respectively. The Company recognized share-based payment compensation for awards issued under the Company's stock option plans in the following line items in the consolidated statement of operations: Three Months Ended March 31, 2006 ---- Cost of maintenance software services and other revenue $ 343,390 Software development costs 1,054,961 Selling and marketing 660,852 General and administrative 205,317 ----------- Share-based payment $ 2,264,520 =========== The Company recognized no tax benefits related to share-based payment compensation during the three months ended March 31, 2006 due to the uncertainty about the recoverability of such benefits. For periods prior to January 1, 2006 the Company recorded compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to Accounting Principles Board ("APB") Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Since the exercise price for such 10 options was equal to the fair market value of the Company's stock at the date of grant, the stock options had no intrinsic value upon grant and, therefore, no expense was recorded in the consolidated statements of operations. Had the compensation cost of the Company's share-based payments been determined in accordance with SFAS No. 123, the Company's pro forma net income and net income per share for the three months ended March 31, 2005 would have been: Three Months Ended March 31, 2005 ---- Net loss as reported $ (133,829) Add share-based payment compensation expense included in reported net income, net of tax $ - Deduct total share-based payment compensation expense determined under fair-value-based method, net of tax $(2,656,988) ------------- Net loss - pro forma $ (2,790,817) ============= Basic and diluted net loss per common share-as reported $ .00 Basic and diluted net loss per common share-pro forma $ (.06) Under the modified prospective method, SFAS No. 123(R) applies to new awards and to awards outstanding on the effective date that are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service had not been rendered as of December 31, 2005 is recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS No. 123. Prior to the adoption of SFAS No. 123(R), the Company valued graded vesting awards based on the entire award for purposes of pro forma disclosure. The Company has elected to continue valuing awards based on the value of the entire award. The Company amortizes the fair value of all awards on a straight-line basis over the total vesting period. Cumulative compensation expense recognized at any date will at least equal the grant date fair value of the vested portion of the award at that time. The Company estimates the fair value of share-based payments using the Black-Scholes option pricing model. The Company believes that this valuation technique and the approach utilized to develop the underlying assumptions are appropriate in estimating the fair value of the Company's share-based payments granted during the three months ended March 31, 2006. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the employees who receive equity awards. The per share weighted average fair value of share-based payments granted during the three months ended March 31, 2006 and 2005 was $5.35 and $7.65, respectively. In addition to the exercise and grant date prices of the awards, certain weighted average assumptions that were used to estimate the fair value of share-based payment grants in the respective periods are listed in the table below: Three months ended March 31, 2006 2005 ---- ---- Expected dividend yield 0% 0% Expected volatility 60% 166% Risk-free interest rate 4.4-4.7% 3.5% Expected term (years) 6 5 Discount for post-vesting restrictions N/A N/A 11 Options granted during fiscal 2006 have exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, a vesting period of three years and an estimated forfeiture rate of 23%. All options granted through December 31, 2005 had exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, generally a vesting period of three years and an estimated forfeiture rate of 23%. The Company estimates expected volatility based primarily on historical daily price changes of the Company's stock and other factors. The risk-free interest rate is based on the United States ("U.S.") treasury yield curve in effect at the time of grant. The expected option term is the number of years that the Company estimates that options will be outstanding prior to exercise. The expected term of the awards issued after December 31, 2005 was determined using the "simplified method" prescribed in SEC Staff Accounting Bulletin ("SAB") No. 107. At March 31, 2006, total remaining unrecognized compensation cost related to unvested share-based payment arrangements was $11,693,029. That cost is expected to be recognized over a weighted average period of 1.3 years. 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 March 31, 2006, the Company had not generated any revenues from this OEM and accordingly no warrants had vested. (3) 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 three months ended March 31, 2006 and 2005 and the location of long-lived assets as of March 31, 2006 and December 31, 2005 are summarized as follows: Three Months Ended March 31, 2006 2005 ---- ---- United States $ 6,294,997 $ 5,760,793 Asia 1,382,348 1,383,320 Oher international 1,530,975 1,247,923 ----------- ----------- Total revenues $ 9,208,320 $ 8,392,036 =========== =========== March 31, December 31, 2006 2005 ---- ---- Long-lived assets: United States $ 9,574,121 $ 9,716,031 Asia 1,470,985 1,320,865 Other international 245,590 207,098 ----------- ----------- Total long-lived assets $11,290,696 $11,243,994 =========== =========== 12 (4) 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. There were no stock repurchases during the three months ended March 31, 2006. As of March 31, 2006, the Company had repurchased a total of 549,600 shares for $3,632,930. (5) COMMITMENTS AND CONTINGENCIES The Company has an operating lease covering its corporate 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 March 31, 2006: 2006........................................... $ 1,429,849 2007........................................... 1,565,008 2008........................................... 1,270,603 2009........................................... 1,275,263 2010........................................... 1,300,247 Thereafter..................................... 1,766,959 ------------ $ 8,607,929 =========== 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, such matters are not expected to have a material adverse effect on our financial condition or operating results. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" 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 Revenues for the first quarter of 2006 were disappointing. Nonetheless, we remain optimistic about our future prospects because other measures of our performance and potential growth remain strong. Revenues for the first quarter of 2006 increased only 10% to $9.2 million compared with revenues in the first quarter of 2005. This number is lower than we had expected. While revenues from our OEM partners were higher than the same period last year on both a percentage and an absolute dollar basis, revenues from our resellers declined. The decline in revenues from resellers was worldwide, but was concentrated in North America. A portion of the weakness in revenues from resellers can be attributed to normal seasonality in the information technology industry, but seasonality does not explain the whole story. We are reviewing our channel sales operations to determine why revenues fell short of our targets and what steps we can take to reverse the decline. Among other things, we are looking at whether we have dedicated, and have available, the proper resources to channel sales and whether the proper initiatives are in place. We anticipate that we will need to add resources to our sales and marketing team in order to realize the full potential of our existing opportunities, to establish our visibility in the marketplace, and to generate additional business prospects. As we expected, revenues from our VirtualTape Library software, grew at a higher rate in the first quarter of 2006 than our other products. Despite the lower than expected revenues, the other indicators we look to in order to assess our performance and growth continued to be positive. Cash from operations in the first quarter of 2006 totaled $4.7 million. This is the sixth consecutive quarter we have realized positive cash flows even as we have invested in personnel and infrastructure. We believe that our ability to fund our own growth bodes well for our long-term success. Deferred revenue at quarter end increased 4%, compared with the balance at December 31, 2005, and by 64% compared with the same period a year ago. We consider the continued growth of our deferred revenue as an important indicator of the success of our products. We believe that support and maintenance renewals, which comprise the majority of our deferred revenue, are expressions of satisfaction with our products and our support organization from our end users. We remain pleased with our ability to scale our business. Operating expenses increased by $1.6 million over the previous quarter. However, operating expenses for the first quarter of 2006 include $2.3 million in share-based compensation expense as required by accounting standards that went into effect on January 1, 2006. The sum of other operating expenses decreased from the fourth quarter of 2005. Operating expenses increased by $4.3 million from the first quarter of 2005. Of such increase, $2.3 million was attributable to share-based compensation expense. Our gross margins decreased from 82% for the fourth quarter of 2005 to 77% for the first quarter this year. Of such decline, 4% was attributable to share-based compensation expense. We plan to continue adding research and development, sales and support personnel, both in the United States and worldwide, as necessary. We also plan to continue investing in infrastructure, including both equipment and property. 14 We continue to operate the business with the goal of long term growth. We believe that our ability to continue to refine our existing products and features and to introduce new products and features will be the primary driver of additional growth among existing resellers, OEMs and end users, and will drive our strategy to attempt to engage additional OEM partners and to expand the FalconStor product lines offered by these OEMs. RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2006 COMPARED TO THE THREE MONTHS ENDED MARCH 31, 2005. Revenues for the three months ended March 31, 2006 increased 10% to $9.2 million compared with $8.4 million for the three months ended March 31, 2005. Our operating expenses increased 49% from $8.7 million for the three months ended March 31, 2005 to $13.0 million for the three months ended March 31, 2006. Included in our operating expenses for the three months ended March 31, 2006 was $2.3 million, of share-based payment compensation expense related to the implementation of SFAS 123(R) beginning January 1, 2006. For the three months ended March 31, 2005, there was no expense related to employee share-based payment compensation expense. Net loss for the three months ended March 31, 2006 was $3.6 million compared with a net loss of $0.1 million for the three months ended March 31, 2005. The increase in revenues was due to an increase in maintenance revenue and software services and other revenue partially offset by a decrease in software license revenue. Revenue contribution from our OEM partners increased in absolute dollars and as a percentage of our total revenue for the quarter ended March 31, 2006. Software license revenue from resellers and distributors decreased in absolute dollars. Expenses increased in all aspects of our business to support our growth. For the three months ended March 31, 2006, we increased the number of employees and continued to invest in our infrastructure by purchasing additional computers and equipment. We increased the number of employees from 223 employees as of March 31, 2005 to 308 employees as of March 31, 2006. 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 decreased 10% from $6.3 million for the three months ended March 31, 2005 to $5.7 million for the three months ended March 31, 2006. Although our software license revenue from our OEM partners increased, we experienced a decrease in software license revenue from our resellers and distributors. 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 the first quarter of 2006 and 2005, 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 fees 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 67% to $3.5 million for the three months ended March 31, 2006 from $2.1 million for the three months ended March 31, 2005. The major factor behind the increase in maintenance, software services and other revenue was an 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 15 our new customers purchase maintenance and support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $1.5 million for the three months ended March 31, 2005 to $2.6 million for the three months ended March 31, 2006. Growth in our professional services sales, which increased by $0.3 million for the three months ended March 31, 2006 compared with the three months ended March 31, 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. 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 March 31, 2006, we had $5.2 million of purchased software licenses that are being amortized over three years. For the three months ended March 31, 2006, we recorded $0.2 million of amortization related to these purchased software licenses. As of March 31, 2005, we had $4.9 million of purchased software licenses and recorded approximately $0.2 million of amortization for the three months ended March 31, 2005 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, training and share-based payment compensation expense associated with the implementation of SFAS 123(R). 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 three months ended March 31, 2006 increased by 50% to $2.0 million compared with $1.3 million for the three months ended March 31, 2005. The increase in cost of maintenance, software services and other revenue was principally due to $0.3 million of share-based payment compensation expense. There was no share-based payment compensation expense included in cost of maintenance, software services and other revenue for the three months ended March 31, 2005. Additionally, cost of maintenance, software services and other revenue increased 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. Our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenue increases. Gross profit for the three months ended March 31, 2006 was $7.1 million or 77% of revenue compared to $6.8 million or 82% of revenue for the three months ended March 31, 2005. The decrease in gross margin was mainly related to the share-based payment compensation included in cost of maintenance, software services and other revenue for the three months ended March 31, 2006. SOFTWARE DEVELOPMENT COSTS Software development costs consist primarily of personnel costs for product development personnel, share-based payment compensation expense associated with the implementation of SFAS 123(R), and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 73% to $4.6 million for the three months ended March 31, 2006 from $2.7 million for the three months ended March 31, 2005. The increase in software development costs was primarily due to $1.1 million of share-based payment compensation expense. There was no share-based payment compensation expense included in cost of maintenance, software services and other revenue for the three months ended March 31, 2005. The increase is also 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 16 to test and integrate our software with our OEM partners' products. We intend to continue recruiting and hiring product development personnel to support our software development process. SELLING AND MARKETING Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based payment compensation expense associated with the implementation of SFAS 123(R), 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 40% to $4.9 million for the three months ended March 31, 2006 from $3.5 million for the three months ended March 31, 2005. The increase in selling and marketing expenses was primarily due to $0.7 million of share-based payment compensation expense. There was no share-based payment compensation expense included in selling and marketing expenses for the three months ended March 31, 2005. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our anticipated revenue growth. We believe that to continue to grow sales, our sales and marketing expenses will continue to increase. GENERAL AND ADMINISTRATIVE General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based payment compensation expense associated with the implementation of SFAS 123(R), public company related costs, directors and officers insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased 34% to $1.3 million for the three months ended March 31, 2006 from $1.0 million for the three months ended March 31, 2005. The overall increase in general and administrative expenses was primarily due to $0.2 million of share-based payment compensation expense. There was no share-based payment compensation expense included in general and administrative expenses for the three months ended March 31, 2005. As our revenue and number of employees increase, our legal and professional fees and other general corporate overhead costs are likely to increase as well. 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 increased to $0.3 million for the three months ended March 31, 2006 compared to $0.2 million for the three months ended March 31, 2005. This increase is primarily due to a higher average cash balance and slightly higher interest rates. INCOME TAXES For the three months ended March 31, 2006, our provision for income taxes consisted of U.S. and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year. Our provision for income taxes for the three months ended March 31, 2006 consist primarily of foreign taxes and U.S. federal alternative minimum taxes and state minimum taxes that are expected to be incurred (despite our pre-tax book loss) primarily as a result of the limitations of our ability to utilize net operating losses and the non-deductibility of certain share-based payment compensation for income tax purposes that has been recognized for financial statement purposes. For the three months ended March 31, 2005, we did not record a tax benefit associated with the pre-tax loss incurred for the period due primarily to the uncertainty of recoverability of the related deferred tax assets. Accordingly, we provided a full valuation allowance against our net deferred tax assets. CRITICAL ACCOUNTING POLICIES Our critical accounting policies are those related to revenue recognition, accounts receivable allowances, deferred income taxes and accounting for share-based payment compensation. REVENUE RECOGNITION. 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 sold for each software license resold by an OEM, distributor or solution provider to an end user. The software license fees 17 are fixed and determinable as our standard payment terms 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 based on the contractual maintenance renewal rate. ACCOUNTS RECEIVABLE. 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. DEFERRED INCOME TAXES. 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 March 31, 2006, 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. ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to Unaudited Condensed Consolidated Financial Statements - Note (1K) SHARE-BASED PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective method. Through December 31, 2005, we accounted for our stock option plans under the intrinsic value method of Accounting Principles Board ("APB") Opinion No. 25, and as a result no compensation costs had been recognized in our historical consolidated statements of operations. We have used and expect to continue to use the Black-Scholes option-pricing model to compute the estimated fair value of stock-based awards. The Black-Scholes option pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates. The assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility based primarily on historical daily price changes of our stock and other factors. Additionally, we estimate forfeiture rates based primarily upon historical experiences, adjusted when appropriate for known events or expected trends. If other assumptions or estimates had been used, the share-based payment compensation expense that was recorded for the three months ended March 31, 2006 could have been materially different. Furthermore, if different assumptions or estimates are used in future periods, share-based payment compensation expense could be materially impacted in the future. Total compensation cost related to unvested share-based payment awards not yet recognized as of March 31, 2006 is $11,693,029. That cost is expected to be recognized over a weighted average period of 1.3 years. IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In February 2006, the FASB issued FASB Staff Position ("FSP") No. FAS 123(R)-4, CLASSIFICATION OF OPTIONS AND SIMILAR INSTRUMENTS ISSUED AS EMPLOYEE COMPENSATION THAT ALLOW FOR CASH SETTLEMENT UPON THE OCCURRENCE OF A CONTINGENT EVENT, which amends SFAS No. 123(R) to require that options issued with a cash settlement feature that can be exercised upon the occurrence of a contingent event that is outside the employee's control should not be classified as liabilities until it becomes probable that the event will occur. For companies that adopted SFAS No. 123(R) prior to the issuance of the FSP, application is required in the first reporting period beginning after February 3, 2006. Currently, the Company has no stock options outstanding with contingent cash settlement features, and as a result, the FSP will not impact the Company's consolidated financial statements. 18 LIQUIDITY AND CAPITAL RESOURCES Our total cash and cash equivalents and marketable securities balance as of March 31, 2006 increased by $4.5 million compared to December 31, 2005. Our cash and cash equivalents totaled $22.3 million and marketable securities totaled $18.8 million at March 31, 2006. As of March 31, 2005, we had approximately $17.3 million in cash and cash equivalents and $16.5 million in marketable securities. For the three months ended March 31, 2006 we generated positive cash flows. We continued to invest in our infrastructure to support our long-term growth during the three months ended March 31, 2006. We made investments in property and equipment and we increased the number of employees during the first quarter of 2006. 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 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. Net cash provided by operating activities totaled $4.7 million for the three months ended March 31, 2006, compared to $1.0 million for the three months ended March 31, 2005. Net cash provided by operating activities of $4.7 million was primarily derived from a decrease in net accounts receivable of $5.3 million, an increase in deferred revenue of $0.4 million and non-cash charges of $0.9 million for depreciation and amortization and $2.3 million related to stock option expense. These amounts were partially offset by our net loss of $3.6 million for the three months ended March 31, 2006, and decreases in accrued expenses and accounts payable totaling $0.6 million. The cash provided by operating activities for the three months ended March 31, 2005 was mainly comprised of our net loss of $0.1 million, and a decrease in accrued expense of $0.4 million offset by an increase in deferred revenue of $0.7 million and non-cash charges of $0.8 million. Net cash used in investing activities was $2.0 million for the three months ended March 31, 2006, due primarily to net purchases of marketable securities of $1.0 million, purchases of property and equipment of $0.8 million and purchases of software licenses and intangible assets of $0.3 million. Net cash provided by investing activities was $1.4 million for the three months ended March 31, 2005, due primarily to net sales of marketable securities of $2.0 million. This amount was partially offset by purchases of property and equipment of $0.5 million. Net cash provided by financing activities was $0.8 million for the three months ended March 31, 2006, which related to proceeds from the exercise of stock options. Net cash used in financing activities was $0.6 million for the three months ended March 31, 2005. This amount was primarily related to payments to acquire treasury stock of $0.9 million partially offset by proceeds from the exercise of stock options of $0.4 million. We currently do not have any debt and our only material cash commitments are related to our office leases. We have an operating lease covering our corporate office facility that expires in February, 2012. We also have several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2006 through 2012. Refer to Note 5 of the notes to our unaudited condensed consolidated financial statements. 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. ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and marketable securities 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. If interest rates were to change by 10% from the levels at March 31, 2006, the effect on our financial results would be insignificant. 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. If foreign currency exchange rates were to change by 10% from the levels at March 31, 2006, the effect on our other comprehensive income would be insignificant. We do not use derivative financial instruments to limit our foreign currency risk exposure. 19 ITEM 4. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report, and, based on their evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. No changes in the Company's internal controls over financial reporting occurred during the quarter ended March 31, 2006, that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting. Disclosure controls and procedures are procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. PART II. OTHER INFORMATION ITEM 1. 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 or operating results. ITEM 1A. RISK FACTORS We are affected by risks specific to us as well as factors that affect all businesses operating in a global market. The significant factors known to us that could materially adversely affect our business, financial condition, or operating results are set forth below, whether or not there has been a material change in any Risk Factor. 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 20 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. 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. 21 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. 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 quarter ended March 31, 2006, we had one customer who accounted for 26% of our revenues. While we believe that we will continue to receive revenue from this client, our agreement with this customer does not have any minimum sales requirements and we cannot guarantee continued revenue. If our contract with this customer is terminated, or if the volume of sales from this customer significantly declines, it would have a material adverse effect on our operating results. In addition, as of March 31, 2006, one customer accounted for a total of 16% of our outstanding receivables. While we currently have no reason to question the collectibility of this receivable, a business failure or reorganization by this customer could harm our ability to collect this receivable 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 22 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. 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. 23 Achieving our anticipated growth will depend on a number of factors, some of which include: 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 March 31, 2006, the closing market price of our common stock as quoted on the NASDAQ National Market System fluctuated between $5.23 and $9.78. 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; 24 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 ABILITY TO FORECAST EARNINGS IS LIMITED BY THE IMPACT OF ACCOUNTING REQUIREMENTS. The Financial Accounting Standards Board requires companies to recognize the fair value of stock options and other equity-based compensation to employees as compensation expense in the statement of operations. However, this expense, which, in accordance with accounting standards, we calculate based on the "Black-Scholes" model, is subject to factors beyond our control including the market price of our stock on a particular day and stock price "volatility." In addition, we do not know how many options our employees will exercise in any future period. These factors make it impossible for us to forecast accurately what the stock option and equity-based compensation expense will be in the future. Because we are unable to make accurate expense forecasts, we are unable to make accurate forecasts of future earnings. 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 March 31, 2006, we had outstanding options and warrants to purchase an aggregate of 10,925,586 shares of our common stock at a weighted average exercise price of $5.41 per share. We also have 783,748 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, 25 and the operations of our industry partners, remain susceptible to fire, floods, power loss, power shortages, telecommunications failures, break-ins and similar events. 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. 26 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 affect the amounts reported in the consolidated financial statements and the accompanying 27 notes. Note 1 to the Consolidated Financial Statements in this Report on Form 10-Q 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 6. EXHIBITS 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) 28 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FALCONSTOR SOFTWARE, INC. /s/ James Weber ---------------- James Weber Chief Financial Officer, Vice President and Treasurer (Chief Accounting Officer) May 9, 2006
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10-Q Filing
FalconStor Software (FALC) 10-Q2006 Q1 Quarterly report
Filed: 9 May 06, 12:00am