SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2006. OR |_| TRANSITION REPORT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission file number 0-23970 FALCONSTOR SOFTWARE, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0216135 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2 HUNTINGTON QUADRANGLE, SUITE 2S01 11747 MELVILLE, NEW YORK (Zip code) (Address of principal executive offices) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 631-777-5188 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common Stock, $.001 par value Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes |_| No |X| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X| Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large Accelerated Filer |_| Accelerated Filer |X| Non-Accelerated Filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|Aggregate market value of Common Stock held by non-affiliates of the Registrant as of June 30, 2006 was $173,209,810 which value, solely for the purposes of this calculation excludes shares held by Registrant's officers and directors. Such exclusion should not be deemed a determination by Registrant that all such individuals are, in fact, affiliates of the Registrant. The number of shares of Common Stock issued and outstanding as of February 21, 2007 was 49,129,542 and 48,264,342, respectively. DOCUMENTS INCORPORATED BY REFERENCE: The information required by Part III of Form 10-K will be incorporated by reference to certain portions of a definitive proxy statement which is expected to be filed by the Company pursuant to Regulation 14A within 120 days after the close of its fiscal year. 2 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES 2006 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Page PART I. Item 1. Business........................................................ 4 Item 1A. Risk Factors.................................................... 10 Item 1B. Unresolved Staff Comments....................................... 19 Item 2. Properties...................................................... 19 Item 3. Legal Proceedings............................................... 19 Item 4. Submission of Matters to a Vote of Security Holders............. 19 PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............................................. 20 Item 6. Selected Consolidated Financial Data............................ 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................... 24 Item 7A. Qualitative and Quantitative Disclosures About Market Risk...... 34 Item 8. Financial Statements and Supplementary Data..................... 36 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............................. 59 Item 9A. Controls and Procedures......................................... 59 Item 9B. Other Information............................................... 59 PART III. Item 10. Directors and Executive Officers of the Registrant.............. 59 Item 11. Executive Compensation.......................................... 60 Item 12. Security Ownership of Certain Beneficial Owners and Management.. 60 Item 13. Certain Relationships and Related Transactions.................. 60 Item 14. Principal Accountant Fees and Services.......................... 60 PART IV. Item 15. Exhibits and Financial Statement Schedules...................... 61 SIGNATURES................................................................. 63 3 PART I ITEM 1. BUSINESS OVERVIEW FalconStor Software, Inc. ("FalconStor", the "Company", "we", "our" or "us") is a leader in disk-based data protection solutions that maximize business continuity and data center efficiency within all IT infrastructures, integrating seamlessly to ensure rapid data recovery while simplifying storage management. FalconStor's comprehensive data protection solutions, developed on a single platform, IPStor(R), include award-winning, easy-to-deploy storage virtualization, Continuous Data Protection (CDP), VirtualTape Library (VTL) with Single Instance Repository (SIR), and Replication software solutions and related implementation, maintenance, and engineering services. In addition, FalconStor's PrimeVaultSM services provide customers with a safe secondary location to which they can replicate their data securely and cost-effectively for rapid recovery and archiving. From the Fortune 1000 to small and medium-size businesses, customers across a vast range of industries worldwide have implemented FalconStor solutions in their production IT environments in order to meet their most stringent recovery time objectives (RTO) and recovery point objectives (RPO), as well as to manage their storage infrastructures with minimal total cost of ownership (TCO) and optimal return on investment (ROI). The FalconStor IPStor data protection platform is designed to empower IT administrators and end users to recover data easily to any point in time in the event of hardware failure, data corruption, deletion, or catastrophic site-level disaster, allowing rollback or failover to a known-good, immediately useable state. To ensure that businesses maintain reliable access to their vital applications, and to facilitate accurate data restoration while concurrently minimizing downtime, the uniquely application-aware FalconStor solutions are engineered to work seamlessly with database, email, and file systems so that redundant sets of active data are generated with transactional and point-in-time integrity. Because this eliminates the need for the time-consuming consistency checks that traditionally create long periods of downtime during a recovery process, business productivity is measurably enhanced. Designed to contain escalating costs, FalconStor solutions enable companies to aggregate heterogeneous, distributed storage capacity and centralize administration of both storage resources and business-critical data services such as backup, snapshot, replication, and migration. Companies benefit from lower administrative overhead, elimination of storage over-provisioning, boundless scalability, and the ability to make cost-effective storage allocation and purchasing decisions. Moreover, FalconStor's commitment to an open software-based approach to storage networking entails any-to-any connectivity via native support for industry standards (including Fibre Channel, iSCSI, SCSI, CIFS, NFS, and emerging standards such as InfiniBand) and delivers unified support for multiple storage architectures (SAN, NAS, and DAS). As a result, FalconStor solutions provide companies of any size and complexity with the freedom to leverage the high performance of IP/iSCSI-, Fibre Channel or InfiniBand-based networks and to implement their choice of state-of-the-art equipment, based on any standard protocol from any storage manufacturer, without rendering their existing or future investments obsolete. Recognizing the strong value proposition of FalconStor's proven, cutting-edge technology, multiple Tier-1 partners utilize FalconStor's innovative software products - including CDP, VTL, Network Storage Server (NSS) and DiskSafe(TM)-to power their storage appliances and bundled solutions. FalconStor's products have been certified by such industry leaders as Adaptec, Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Engenio Information Technologies, EMC, Emulex, Fujitsu, Gadzoox, Hewlett Packard, Hitachi Data Systems, Hitachi Engineering Co., Ltd., Huawei, Huawei-3COM, IBM, Intel, LSI Logic, Brocade Corporation, Microsoft, NEC, Network Appliance, Nexsan, Novell, NS Solutions Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, Pillar Data, QLogic, Quantum, Sony, Sun Microsystems, Voltaire, and VMware. Further validation of FalconStor solutions comes from the agreements FalconStor has with many Tier-1 original equipment manufacturers (OEMs) and others to integrate FalconStor technology with those companies' products. In the past year, many of our OEM partners have renewed contracts and pursued a visible market presence with FalconStor, leveraging both brands for market presence. FalconStor was incorporated in Delaware as Network Peripherals, Inc., in 1994. Pursuant to a merger with FalconStor, Inc., in 2001, the former business of 4 Network Peripherals, Inc., was discontinued, and the newly re-named FalconStor Software, Inc., continued the storage software business started in 2000 by FalconStor, Inc. FalconStor's headquarters are located at 2 Huntington Quadrangle, Suite 2S01, Melville, NY 11747. The Company also maintains offices throughout Europe and Asia. PRODUCTS AND TECHNOLOGY The FalconStor IPStor platform is a network infrastructure software platform that provides the most reliable and complete disk-based platform for delivering data protection solutions. FalconStor data protection solutions accelerate or eliminate the backup window which allows users to recover data in 30 minutes, anytime, anywhere, with 100% data integrity. FalconStor offers the following core products: VTL with SIR for de-duplications, CDP, NSS and Replication for disaster recovery and remote branch office protection. The IPStor platform and subsequent solutions share several key technologies that foster seamless integration and offer a competitive edge. o ONE INDEPENDENT, OPEN PLATFORM - Built on the IPStor storage virtualization platform, FalconStor's solutions are completely independent of any storage or connectivity, delivering comprehensive data protection. o RAPID RECOVERY - Unique to FalconStor is the ability to return a file, full system, or entire array to service in 30 minutes and, in some cases, 5 minutes or less. This is due to the application-aware snapshot ability of TimeMark(R) technology as well as bare metal recovery capabilities. o AFFORDABLE, SCALABLE PROTECTION FROM THE DATA CENTER TO THE REMOTE OFFICE - FalconStor data protection technology scales from the data center to the remote office or single user laptop. FalconStor and its partners have deployed solutions as small as a 2TB desktop network storage server and as large as multiple-petabyte architectures. FalconStor's MicroScan(TM) technology eliminates redundant data across the network. This eliminates 70%-90% of the bandwidth requirements, making disk based protection for remote or disaster recovery sites highly affordable and practical. FalconStor's data protection solutions address the full spectrum of data protection business problems, from the need to accelerate backup to the need to recover data after a disaster. Customers today are facing massive data growth, often exceeding 60% a year. Backup windows have not only shrunk; for many organizations they have disappeared altogether. Traditional backup has also been plagued with media and hardware failures. These are issues addressed by FalconStor VTL. In addition, the time to recover is also shrinking, so companies need more recovery points and times, rather than the once a day offered by daily backup. For this they turn to the FalconStor CDP solution. To improve the day-to-day management they face with the explosive storage growth, customers use the FalconStor NSS to virtualize, provision, and protect their data. And for protecting remote office data and disasters, FalconStor has built a highly efficient Replication solution that integrates with VTL, CDP, and NSS. Because all of these solutions are built from a single platform, IPStor, deployment is simplified and businesses benefit from the peace of mind that FalconStor solutions work together in an easily managed and highly efficient fashion, with high data availability and rapid recovery always paramount. FalconStor sells its solutions as software only or pre-installed on FalconStor-supplied hardware appliances. Software only solutions are available as pre-packaged Software Appliance Kits or from an itemized price list in the forms of Enterprise, Standard, and Express Editions. SOFTWARE PRODUCTS NETWORK STORAGE SERVER (NSS) FalconStor's flagship product, NSS powered by IPStor, provides advanced storage networking and best-in-class business continuity/disaster recovery (BC/DR) functionality to all segments of the enterprise, small and medium-size business (SMB), and small office/home office (SOHO) markets. NSS is comprised of an extensive set of state-of-the-art network storage services designed to deliver rapid data recovery and an open, unified SAN and NAS infrastructure across heterogeneous environments. NSS aggregates storage capacity, provisioning, and services to application servers via all industry-standard protocols with speed, security, reliability, interoperability, and scalability. 5 VIRTUALTAPE LIBRARY (VTL) FalconStor VTL is the industry-leading, revolutionary backup/recovery solution that saves money and time by using disk to emulate an extensive range of physical tape libraries. Integrating seamlessly with existing backup software and policies, and with FalconStor CDP solutions, VTL enhances backup reliability, speed, availability, and recoverability, while consolidating management of backup resources. VTL backup to disk-based virtual tape ensures backup/restore success by eliminating the media/mechanical errors and manual intervention traditionally associated with tape backup. Remote offsite replication of virtual tapes provides disaster protection, while automated data export to physical tape is supported for archiving purposes. Software-based encryption technology prevents unauthorized access to data exported to physical tapes and in transit during replication, without imposing any overhead on the backup process. VTL is fast and easy to deploy--comparable to adding a new tape drive or library to an existing backup environment. In 2006 FalconStor introduced the Single Instance Repository (SIR) as a de-duplication enhancement to VTL. Because backup by nature copies data over and over again, de-duplication minimizes storage and bandwidth needs. By eliminating duplicate copies, VTL with SIR allows customers to keep more data online, longer. Instead of a month of data on disk for recovery, they can now keep several months or more. CONTINUOUS DATA PROTECTION (CDP) CDP solutions maintain 24x7x365 availability and usability of data in the event of an unplanned hardware failure, deletion, or software error, or planned downtime. Combining application-aware TimeMark snapshots and continuous journaling functions, CDP enables customers to recover data to any point in time. CDP eliminates the backup window entirely, by enabling customers to use the CDP copy as the target for the backup software. REPLICATION FalconStor Replication provides rapid, reliable recovery in the event of catastrophic site failure, such as a fire, power outage, or flood in the main data center. Disk-to-disk disaster recovery solutions become more affordable and available to customers of all sizes. Customer benchmarks have indicated that FalconStor Replication technology can eliminate 70% to 90% of the redundant data typically replicated by other solutions. When combined with VTL or CDP, Replication technology delivers a highly efficient remote office protection solution. DISKSAFE(TM)AND FILESAFE(TM) FalconStor DiskSafe and FileSafe are host-resident software tools that protect DAS-based application servers and end user desktops or laptops, as well as servers using third-party storage networks, by enabling them to replicate entire local disks (DiskSafe) or individual files and directories (FileSafe) to CDP-managed storage for automated backup, off-site data storage, and rapid, user-initiated data recovery. DiskSafe technology captures the information necessary to boot the designated machine in the event of a virus or spyware attack, application malfunction, or hard disk crash. DiskSafe and FileSafe are integral components of FalconStor's CDP solutions, facilitating the transfer of replicated data over the network to a centralized FalconStor data management appliance for both redundant nearline storage and remote disaster recovery (DR) purposes. APPLICATION-AWARE SNAPSHOT AGENTS FalconStor Snapshot Agents automate and minimize quiesce time during data replication, backup, and other snapshot-based operations to ensure transactional integrity and point-in-time consistency of databases and messaging stores for fast time-to-recovery. Snapshot Agents are available for IBM(R) DB2(R) UDB, Informix(R), Microsoft(R) SQL Server, Oracle(R), Pervasive.SQL(R), Sybase(R), IBM Lotus Notes(R)/Domino, Microsoft(R) Exchange, Microsoft(R) VSS, Novell(R) GroupWise(R), VMWare(R), and many file systems. OFFSITE, ONLINE DATA PROTECTION FACILITY PrimeVaultSM by FalconStor is an offsite, online data protection service for organizations that either do not have their own disaster recovery sites or wish to replicate their data to an additional site for a supplementary layer of redundancy. PrimeVault grants small, medium, and large businesses the ability to protect and archive their data to a secure facility at an affordable and predetermined price based on individualized needs. By cutting the costs of deploying and maintaining an alternate site, PrimeVault makes alternate sites practical for most, if not all businesses. PrimeVault services are sold directly to FalconStor customers or through partners. 6 PrimeVault offerings include: o Rapid 24x7x365 data recovery with maximum BC/DR capabilities o Immediate BC/DR solution deployment o Cost-effective, flexible pricing o Minimal upfront IT investment and operating overhead o Rapid deployment and compliance with minimal implementation costs o Seamless scalability of offsite data storage as business expands o Offsite replication of virtual tapes o Data export from virtual to physical tapes with offsite archiving for compliance or other purposes o End-to-end security o Encryption for data replication, virtual tapes, and data storage o Closed-circuit video surveillance 24x7x365 o Encrypted, multi-point verified access to facility BUSINESS STRATEGY FalconStor intends to maintain its position as a leading provider of disk-based data protection solutions serving enterprises and SMBs worldwide. FalconStor intends to achieve this objective through the following strategies: DISK-BASED DATA PROTECTION LEADERSHIP FalconStor intends to continue to leverage the protocol-agnostic, unified architecture, and robust data protection technology of its solutions to maintain a leadership position in the enterprise disk-based data protection software market. The disk-based data protection market is rapidly growing. IDC forecasts the VTL market will reach $1.2B by 2011, a 30% CAGR. Polls by Gartner at their customer summits show CDP to be adopted by 17% to 19% of the customers in 2007. FalconStor plans to continue its leadership in this market through its deep commitment to research and development and continued rapid technology innovation. EXPAND PRODUCT OFFERINGS In the spring of 2006, FalconStor released CDP, complementing the already successful TimeMark snapshot technology. This along with the Continuous Replication delivers a remote data center and remote branch office offering. For the SMB market, FalconStor released Express versions of our products, sold by our OEM partners and also used by our enterprise customers for remote office data protection. In addition, FalconStor introduced SIR de-duplication technology as an enhancement to its VTL offering for improved storage and network efficiency. We expect many VTL solutions to be sold with this critical functionality. FalconStor also enhanced its VTL with optimized scalability to meet the needs of the largest enterprises. In 2006 the largest VTL cluster managed 1.5PB of storage. As our customers grow, we expect their requirement for scalability to grow as well. EXPAND CORPORATE VISIBILITY In late 2006, FalconStor made significant steps in increasing its market presence and awareness. First, we invested in experienced marketing staff. A new Chief Marketing Officer was hired along with additional staff for product and partner marketing. Second, we increased our engagement with the press and analyst community to bring our comprehensive disk based data protection message to the market. This broad effort will continue throughout 2007, as we hone our message and market deliverables. We are relying significantly on our success with customers and partners throughout the world. Third, we increased our investment in our partners, both OEMs and channel, for joint marketing and field engagement. EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND ALLIANCES. FalconStor believes that opportunities may exist to expand its technological capabilities, product offerings, and services whether through acquisitions of 7 businesses or software technology, or through strategic alliances. FalconStor will focus on opportunities that enable it to acquire or to license: o Important enabling technology; o Complementary applications; o Marketing, sales, customer and technological synergies; and/or o Key personnel. SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to continue to enter into OEM agreements with strategic switch, storage, appliance, and operating system vendors. Besides accelerating overall market growth, the OEM relationships should continue to bolster FalconStor's product recognition, corporate credibility, and revenue stream. EXPAND INSIDE AND FIELD SALES ORGANIZATION FalconStor intends to expand its worldwide sales force in 2007. Field sales expansion should provide increased coverage for end user opportunities and partners. FalconStor is increasing its investment in partners with additional training, lead generation and market development. Inside sales has been added for lead generation and incremental revenue opportunities for current end users and mid-size businesses. IDENTIFY AND NURTURE NEW GROWTH DRIVERS FalconStor has made key investments in several areas, from which we expect growth in the coming years. We believe we are uniquely positioned to take advantage of the rapid storage growth in China. OEM relationships with Huawei-3com and a major telecommunications equipment provider, and joint development with Chinese Academy of Sciences for remote data protection services, will continue to expand this market. InfiniBand is a new promising protocol used by the High Performance Computing market. We are in early stages with customers, but potentially leading this market in tying in the large InfiniBand clusters to traditional Fibre Channel SANs. Our non-disruptive approach protects our customer's investments, while delivering speeds over 1GBs. As the Inifiband clusters proliferate, we believe we will lead in managing the storage with our partners. We expect the PrimeVault Service Provider Channel to expand in 2007, by bringing online several large network service providers. Similar to the Chinese Academy of Sciences, these offerings will be for disaster recovery for large institutions and primary data protection for small and mid size businesses. SALES, MARKETING AND CUSTOMER SERVICE FalconStor plans to continue to sell its products primarily through original equipment manufacturers (OEMs), value-added resellers (VARs, also sometimes called "solution providers"), and distributors. OEM RELATIONSHIPS. OEMs collaborate with FalconStor to integrate FalconStor technology into their own product offerings or to resell FalconStor technology under their own label. VAR AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered into VAR and distributor agreements to help sell its product in various geographic areas. FalconStor's VARs and distributors market various FalconStor products and receive a discount off of the list price on products sold. STORAGE APPLIANCES. FalconStor has agreements with strategic partners to adapt FalconStor products for use in the strategic partners' special-purpose storage appliances. DIRECT SALES TO END USERS. In a limited number of circumstances, FalconStor has entered into software license agreements directly with end users. FalconStor's marketing efforts focus on building brand recognition among customers, partners, analysts, and the media, and developing qualified leads for the sales force. 8 FalconStor Professional Services personnel are also available to assist customers and partners throughout the life cycle of FalconStor solution deployments. The Professional Services team includes experienced Storage Architects (expert field engineers) who can assist in the assessment, planning/design, deployment, and testing phases of a deployment project, and a Technical Support group for post-deployment assistance and ongoing support. COMPETITION As the demand for data protection and network-based storage products and services increases, more competitors will enter this high-growth market segment. Although there are several companies attempting to offer unified storage services or data protection, FalconStor believes it is the only software-based solution provider capable of comprehensive data protection. We believe the IPStor platform and its integrated services of virtualization, VTL, CDP, Replication for remote offices and data centers is unique to the industry. Although some of FalconStor's products provide capabilities that put them in competition with products from a number of companies with substantially greater financial resources, FalconStor is not aware of any other software company providing unified data protection storage services running on a standard Linux-, Windows- or Solaris-based appliance. FalconStor believes that the principal competitive factors affecting its marketability include product features such as scalability, data availability, ease of use, price, reliability, hardware/platform neutrality, customer service, and support. Additionally, as more partners offer appliances that integrate FalconStor products, the Company has experienced competitive pressures from smaller, niche players in the industry. However, FalconStor believes these competitors currently do not offer the depth or breadth of storage services delivered by FalconStor, nor do they possess the experience and technological innovation needed to develop and deliver reliable, fully integrated, and proven storage services. As FalconStor continues its move into the non-enterprise storage market, the products and services offered by its partners may compete with existing or new products and services offered by current and new entrants to the market. FalconStor's future and existing competitors could conceivably introduce products with superior features, scalability, and functionality at lower prices than FalconStor's products and could also bundle existing or new products with other more established products to compete with FalconStor. Increased competition could result in price reductions and reduced gross margins, which could harm FalconStor's business. FalconStor's success will depend largely on its ability to generate market demand and awareness of its products and to develop additional or enhanced products in a timely manner. FalconStor's success will also depend on its ability to convince potential partners of the benefits of licensing its software rather than that of competing technologies. INTELLECTUAL PROPERTY FalconStor's success is dependent in part upon its proprietary technology. Currently, the IPStor software suite forms the core of this proprietary technology. FalconStor currently has six patents and numerous pending patent applications; and multiple registered trademarks - including "FalconStor," "FalconStor Software" and "IPStor" - and many pending trademark applications related to FalconStor and its products. FalconStor seeks to protect its proprietary rights and other intellectual property through a combination of copyright, trademark and trade secret protection, as well as through contractual protections such as proprietary information agreements and nondisclosure agreements. The technological and creative skills of its personnel, new product developments, frequent product enhancements and reliable product maintenance are essential to establishing and maintaining a technology leadership position. FalconStor generally enters into confidentiality or license agreements with its employees, consultants, and corporate partners, and generally controls access to and distribution of its software, documentation, and other proprietary information. Despite FalconStor's efforts to protect its proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use its products or technology. Monitoring unauthorized use of its products is difficult, and there can be no assurance that the steps FalconStor has taken will prevent misappropriation of its technology, particularly in foreign countries where laws may not protect its proprietary rights as fully as do the laws of the United States. 9 MAJOR CUSTOMERS For the year ended December 31, 2006, FalconStor had one customer that accounted for 27% of revenues. For the year ended December 31, 2005, FalconStor had two customers that together accounted for 31% of revenues. For the year ended December 31, 2004, FalconStor had one customer that accounted for 16% of revenues. As of December 31, 2006, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 30% of the accounts receivable balance. As of December 31, 2005, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 28% of the accounts receivable balance. EMPLOYEES As of December 31, 2006, FalconStor had 340 full-time employees, consisting of 167 in research and development, 95 in sales and marketing, 59 in service, and 19 in general administration. FalconStor is not subject to any collective bargaining agreements and believes its employee relations are good. INTERNET ADDRESS AND AVAILABILITY OF FILINGS FalconStor's internet address is WWW.FALCONSTOR.COM. FalconStor makes available free of charge, on or through its Internet website, FalconStor's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after FalconStor electronically files such material with, or furnishes it to, the SEC. FalconStor complied with this policy for every Securities Exchange Act of 1934, as amended, report filed during the year ended December 31, 2006. 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 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. 10 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. THE MARKET FOR InfiniBand SOLUTIONS IS NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT. The rapid adoption of InfiniBand solutions is important to our future success. The market for InfiniBand solutions 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 offer products for the small/medium business (SMB) and small office/home office (SOHO) markets. Our products may not be 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. THE MARKET FOR OUR PRIMEVAULTSM SERVICES IS COMPETITIVE AND IT IS UNCERTAIN WHETHER WE WILL ATTRACT ENOUGH CUSTOMERS TO PROVIDE AN ADEQUATE RETURN ON INVESTMENT. We have continued to make investments in infrastructure and in operating, sales and marketing personnel for our PrimeVault disaster recovery, data backup, and VTL replication services. The market for these services is competitive with a number of vendors offering similar services. Despite what we believe are competitive advantages offered by our PrimeVault services based on our proprietary IPStor and VTL families of software, there can be no assurance that we will be able to attract enough customers, or earn enough revenues, to cover our investment in PrimeVault services or to provide an adequate return on that investment. 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. 11 OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION. Our IPStor platform, including VirtualTape Library, is complex and is designed to be deployed in large and complex networks. Many of our customers have unique infrastructures, which may require additional professional services in order for our software to work within their infrastructures. Because our products are critical to the networks of our customers, any significant interruption in their service as a result of defects in our product could result in damage to our customers. These problems could cause us to incur significant service and engineering costs, divert engineering personnel from product development efforts and significantly impair our ability to maintain existing customer relationships and attract new customers. In addition, a product liability claim, whether successful or not, would likely be time consuming and expensive to resolve and would divert management time and attention. Further, if we are unable to fix the errors or other problems that may be identified in full deployment, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer. Our other products may also contain errors or defects. If we are unable to fix the errors or other problems that may be discovered, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer. 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. In addition, in certain instances, we install our software onto third party hardware for resale to end users. 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. OUR OEM CUSTOMERS ARE NOT OBLIGATED TO CONTINUE TO SELL OUR PRODUCTS. We have no control over the shipping dates or volumes of systems incorporation of our product that our OEM customers ship and they have no obligation to ship systems incorporating our software applications. Our OEM customers also have no obligation to recommend or offer our software applications exclusively or at all, and they have no minimum sales requirements. These OEMs also could choose to develop their own data protection and network storage software internally, or to license software from our competitors, and incorporate those products into their systems instead of our software applications. The OEMs that we do business with also compete with one another. If one of our OEMs views our arrangement with another OEM as competing with its products, it may decide to stop doing business with us. Any material decrease in the volume of sales generated by OEMs with whom we do business, as a result of these factors or otherwise, would have a material adverse effect on our revenues and results of operations in future periods. 12 THE FAILURE OF OUR RESELLERS TO EFFECTIVELY SELL OUR SOFTWARE APPLICATIONS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR REVENUES AND RESULTS OF OPERATIONS. We rely significantly on our value-added resellers, systems integrators and corporate resellers, which we collectively refer to as resellers, for the marketing and distribution of our software applications and services. However, our agreements with resellers are generally not exclusive, are generally renewable annually and in many cases may be terminated by either party without cause. Many of our resellers carry software applications that are competitive with ours. These resellers may give a higher priority to other software applications, including those of our competitors, or may not continue to carry our software applications at all. If a number of resellers were to discontinue or reduce the sales of our products, or were to promote our competitors' products in lieu of our applications, it would have a material adverse effect on our future revenues. Events or occurrences of this nature could seriously harm our sales and results of operations. In addition, we expect that a significant portion of our sales growth will depend upon our ability to identify and attract new reseller partners. The use of resellers is an integral part of our distribution network. We believe that our competitors also use reseller arrangements. Our competitors may be more successful in attracting reseller partners and could enter into exclusive relationships with resellers that make it difficult to expand our reseller network. Any failure on our part to expand our network of resellers could impair our ability to grow revenues in the future. WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A SIGNIFICANT PORTION OF OUR RECEIVABLES IS CONCENTRATED WITH TWO CUSTOMERS. We tend to have one or more customers account for 10% or more of our revenues during each fiscal quarter. For the year ended December 31, 2006, we had one customer who accounted for 27% of our revenues. While we believe that we will continue to receive revenue from this client, our agreements do not have any minimum sales requirements and we cannot guarantee continued revenue. If our contract with this customer terminates, 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 December 31, 2006, two customers accounted for a total of 30% of our outstanding receivables, 21% and 9%, respectively. While we currently have no reason to question the collectibility of these receivables, a business failure or reorganization by either of these customers could harm our ability to collect these receivables and could damage our cash flow. THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR RESPONDING TO TRENDS. Certain of our OEM customers do not report license revenue to us until sixty days or more after the end of the quarter in which the software was licensed. There is thus a delay before we learn whether licensing revenue from these OEMs has met, exceeded, or fallen short of 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 from one of our other OEM partners, there will be a delay in our ability to determine whether this is an anomaly or a part of a trend. However, we must use our forecasted revenue to establish our expense budget. Most of our expenses are fixed in the short term or incurred in advance of anticipated revenue. As a result, we may not be able to decrease our expenses in a timely manner to offset any shortfall in revenue or to increase our sales, marketing or support headcounts to take advantage of positive developments. 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 13 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 have had an impact on our revenues. If additional OEM customers are acquired, the acquiring entity 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. OUR ABILITY TO SELL OUR SOFTWARE APPLICATIONS IS HIGHLY DEPENDENT ON THE QUALITY OF OUR SERVICES OFFERINGS, AND OUR FAILURE TO OFFER HIGH QUALITY SUPPORT AND PROFESSIONAL SERVICES WOULD HAVE A MATERIAL ADVERSE AFFECT ON OUR SALES OF SOFTWARE APPLICATIONS AND RESULTS OF OPERATIONS. Our services include the assessment and design of solutions to meet our customers' storage management requirements and the efficient installation and deployment of our software applications based on specified business objectives. Further, once our software applications are deployed, our customers depend on us to resolve issues relating to our software applications. A high level of service is critical for the successful marketing and sale of our software. If we or our partners do not effectively install or deploy our applications, or succeed in helping our customers quickly resolve post-deployment issues, it would adversely affect our ability to sell software products to existing customers and could harm our reputation with potential customers. As a result, our failure to maintain high quality support and professional services would have a material adverse effect on our sales of software applications and results of operations. FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING RESULTS. Achieving our anticipated growth will depend on a number of factors, some of which include: o retention of key management, marketing and technical personnel; 14 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 the market for our software is primarily 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. Historically, information technology spending has been higher in the fourth and second quarters of each calendar year, and somewhat slower in the other quarters, particularly the first quarter. Our quarterly results reflected this seasonality in 2006, and we anticipate that our quarterly results for 2007 will show the effects of seasonality as well. Our future performance will depend on many factors, including: o the timing of securing software license contracts and the delivery of software and related revenue recognition; o the seasonality of information technology, including network storage products, spending; o the average unit selling price of our products; o existing or new competitors introducing better products at competitive prices before we do; o our ability to manage successfully the complex and difficult process of qualifying our products with our customers; o new products or enhancements from us or our competitors; o import or export restrictions on our proprietary technology; and o personnel changes. Many of our expenses are relatively fixed and difficult to reduce or modify. As a result, the fixed nature of our expenses will magnify any adverse effect of a decrease in revenue on our operating results. OUR STOCK PRICE MAY BE VOLATILE The market price of our common stock has been volatile in the past and may be volatile in the future. For example, during the past twelve months ended December 31, 2006, the closing market price of our common stock as quoted on the NASDAQ Global Market fluctuated between $6.06 and $9.78 per share and subsequent to December 31, 2006 the closing market price had a high of $11.23 per share. 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; 15 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 share-based payment 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. These factors include 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 unknowns make it difficult for us to forecast accurately what the stock option and equity-based compensation expense will be in the future. Because of these factors, our ability to make accurate forecasts of future earnings is compromised. THE AMOUNT OF INCOME TAXES WE HAVE TO PAY MAY INCREASE. We currently have net operating loss carryforwards which reduce the amount of income taxes that we are required to pay. The availability of these net operating losses are limited. If we generate taxable income in the future in excess of our ability to utilize our net operating losses, the amount of income tax we pay will likely increase significantly. 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, RESTRICTED SHARES AND WARRANTS, THE EXERCISE OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK. As of December 31, 2006, we had an aggregate of 11,810,975 outstanding options and outstanding restricted shares and warrants to purchase our common stock. The weighted average exercise price of the outstanding options and warrants is $5.65 per share. We also have 794,573 shares of our common stock reserved for issuance under our stock plans with respect to options (or restricted stock) that have not been granted. The exercise of all of the outstanding options and warrants and/or the grant and exercise of additional options or restricted stock 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. 16 OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER, TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS In August, 2003, our business was interrupted due to a large scale blackout in the northeastern United States. While our headquarters facilities contain redundant power supplies and generators, our domestic and foreign operations, and the operations of our industry partners, remain susceptible to fire, floods, power loss, power shortages, telecommunications failures, break-ins and similar events. 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. Certain of our products are subject to various levels of export restrictions. These export restrictions 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 six patents issued, we have received a notice of allowance for one patent, and we have 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. 17 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. 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. 18 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 notes. Note 1 to the Consolidated Financial Statements in this Report on Form 10-K describes the significant accounting policies essential to preparing our financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual future results may differ materially from these estimates. We evaluate, on an ongoing basis, our estimates and assumptions. LONG TERM CHARACTER OF INVESTMENTS Our present and future equity investments may never appreciate in value, and are subject to normal risks associated with equity investments in businesses. These investments may involve technology risks as well as commercialization risks and market risks. As a result, we may be required to write down some or all of these investments in the future. UNKNOWN FACTORS Additional risks and uncertainties of which we are unaware or which currently we deem immaterial also may become important factors that affect us. ITEM 1B. UNRESOLVED STAFF COMMENTS None ITEM 2. PROPERTIES FalconStor's headquarters are located in an approximately 45,000 square foot facility located in Melville, New York. Offices are also leased for development, sales and marketing personnel, which total an aggregate of approximately 44,000 square feet in Le Chesnay, France; Taipei and Taichung, Taiwan; Tokyo, Japan; Beijing, Shenzhen and Shanghai, China; Munich, Germany; Seoul, Korea; Kuala Lumpur, Malaysia; and North Sydney, Australia. Initial lease terms range from one to eight years, with multiple renewal options. ITEM 3. LEGAL PROCEEDINGS We are subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, we believe that such matters will not have a material adverse effect on our financial condition, results of operations, cash flows or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 19 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION Our Common Stock is listed on The Nasdaq Global Market ("Nasdaq") under the symbol "FALC". The following table sets forth the range of high and low closing sales prices of our Common Stock for the periods indicated as reported by Nasdaq: 2006 2005 -------------- -------------- High Low High Low ----- ----- ----- ----- Fourth Quarter $8.83 $7.25 $8.02 $5.81 Third Quarter $7.95 $6.06 $6.87 $5.66 Second Quarter $9.25 $6.15 $7.43 $5.23 First Quarter $9.78 $7.54 $9.67 $5.78 HOLDERS OF COMMON STOCK We had approximately 178 holders of record of Common Stock as of February 21, 2007. This does not reflect persons or entities whom hold Common Stock in nominee or "street" name through various brokerage firms. DIVIDENDS We have not paid any cash dividends on our common stock since inception. We expect to reinvest any future earnings to finance growth, and therefore do not intend to pay cash dividends in the foreseeable future. Our board of directors may determine to pay future cash dividends if it determines that dividends are an appropriate use of Company capital. EQUITY COMPENSATION PLAN INFORMATION The Company currently does not have any equity compensation plans not approved by security holders. Number of Securities to be Weighted - Number of Securities Issued upon Average exercise Remaining Available for Exercise of Price of Future Issuance Under Outstanding Outstanding Equity Compensation Plans Options, Warrans Options, Warrants (Excluding Securities and Rights (1) and Rights (1) Reflected in Column (a)(1) Plan Category (a) (b) (c) ------------- ---------------- ----------------- --------------------------- Equity compensation plans approved by security holders 10,835,975 $ 5.62 794,573 (1) As of December 31, 2006 COMMON STOCK PERFORMANCE: The following graph compares, for each of the periods indicated, the percentage change in the Company's cumulative total stockholder return on the Company's Common Stock with the cumulative total return of a) an index consisting of Computer Software and Services companies, a peer group index, and b) the Russell 3000 Index, a broad equity market index. 20 FALCONSTOR SOFTWARE, INC. COMPARATIVE CUMULATIVE TOTAL RETURN ASSUMES $100 INVESTED ON DEC. 31, 2001 ASSUMES DIVIDEND REINVESTED FISCAL YEAR ENDING DECEMBER 31, 2006 Fiscal Year Ending ------------------ 2001 2002 2003 2004 2005 2006 ---- ---- ---- ---- ---- ---- FALCONSTOR SOFTWARE, INC. 100.00 42.83 96.74 105.63 81.57 95.47 COREDATA GROUP INDEX 100.00 68.11 88.07 96.72 96.96 112.58 RUSSELL 3000 INDEX 100.00 77.19 99.37 109.39 114.06 129.80 There can be no assurance that the Common Stock's performance will continue with the same or similar trends depicted in the graph above. ITEM 6. SELECTED FINANCIAL DATA The selected financial data appearing below have been derived from our audited consolidated financial statements, and should be read in conjunction with these consolidated financial statements and the notes thereto and the information contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." 21 CONSOLIDATED STATEMENTS OF OPERATIONS DATA: Year Ended Year Ended Year Ended Year Ended Year Ended December 31, December 31, December 31, December 31, December 31, 2006 2005 2004 2003 2002 ------------------------------------------------------------------- (In thousands, except per share data) Revenues: Software license revenue ................................. $ 38,317 $ 29,544 $ 21,488 $ 12,251 $ 8,667 Maintenance revenue ...................................... 12,475 7,594 4,443 2,473 1,297 Software services and other revenue ...................... 4,274 3,826 2,778 2,220 665 -------- -------- -------- -------- -------- 55,066 40,964 28,709 16,944 10,629 -------- -------- -------- -------- -------- Operating expenses: Amortization of purchased and capitalized software ..... 362 782 1,394 1,394 899 Cost of maintenance, software services and other revenue 9,048 6,114 4,150 2,580 1,309 Software development costs ............................. 20,022 12,039 9,050 7,068 6,281 Selling and marketing .................................. 23,713 16,109 14,277 10,967 9,856 General and administrative ............................. 5,828 4,213 5,109 2,878 2,592 Litigation settlement .................................. 799 -- 1,300 -- -- Lease abandonment charge ............................... -- -- -- 550 -- Impairment of prepaid royalty .......................... -- -- -- -- 483 -------- -------- -------- -------- -------- 59,772 39,257 35,280 25,437 21,420 -------- -------- -------- -------- -------- Operating income (loss) .............................. (4,706) 1,707 (6,571) (8,493) (10,791) -------- -------- -------- -------- -------- Interest and other income ................................ 1,650 705 714 1,122 1,585 Impairment of long-lived assets .......................... -- -- -- 35 (2,300) -------- -------- -------- -------- -------- Income (loss) before income taxes .................... (3,056) 2,412 (5,857) (7,336) (11,506) Provision for income taxes ............................... 319 119 32 33 37 -------- -------- -------- -------- -------- Net income (loss) .................................... $ (3,375) $ 2,293 $ (5,889) $ (7,369) $(11,543) ======== ======== ======== ======== ======== Basic net income (loss) per share ........................ $ (0.07) $ 0.05 $ (0.13) $ (0.16) $ (0.26) ======== ======== ======== ======== ======== Diluted net income (loss) per share ...................... $ (0.07) $ 0.05 $ (0.13) $ (0.16) $ (0.26) ======== ======== ======== ======== ======== Basic weighted average common shares outstanding ......... 48,045 47,662 46,967 45,968 45,233 ======== ======== ======== ======== ======== Diluted weighted average common shares outstanding ....... 48,045 50,776 46,967 45,968 45,233 ======== ======== ======== ======== ======== 22 CONSOLIDATED BALANCE SHEET DATA: December 31, December 31, December 31, December 31, December 31, 2006 2005 2004 2003 2002 -------------------------------------------------------------------- (In thousands) Cash and cash equivalents and marketable securities $40,960 $36,631 $33,973 $36,685 $51,102 Working capital 46,934 39,730 36,452 39,527 47,746 Total assets 78,231 63,974 56,074 56,493 64,710 Long-term obligations 3,783 2,316 1,290 396 -- Stockholders' equity 55,043 48,658 46,364 50,556 55,901 23 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS "BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS," "WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT. OVERVIEW We were pleased with our continued revenue growth in 2006. Our revenues for the full year increased to $55.1 million from $41.0 million in 2005. This is a thirty-four percent year over year increase in revenues. This increase was driven by sales of our core products. We reached our revenue target for the year even though revenues from certain areas in which we had anticipated seeing growth, such as iSCSI and the SMB/SOHO market, were not significant contributors to our revenue. We believe that our ability to grow our revenues by thirty four percent even without significant contributions from these areas shows the strength of our core products. We believe we are on the right track and we anticipate further revenue growth in 2007. We had a net loss of $3.4 million in 2006. Due to a change in accounting rules, it is difficult to compare this result with results in prior years. New accounting rules that went into effect for us in 2006 required us to include in our consolidated financial statements an expense for the grant date fair value of share-based compensation for the first time. This expense -- which relates to stock options and restricted stock we grant to employees as part of our incentive compensation plan -- totaled $9.4 million in 2006. As it has been in the past, our focus will continue to be on managing our business with a view towards long-term success and growth. In 2006, we continued to invest in research and development and other areas to build on our momentum, to design new products, and to enhance our existing products to position the Company for future growth. We will continue to invest in these areas in 2007 and we anticipate that our research and development and sales and marketing expenses will increase in 2007. To continue to create industry-leading, cutting-edge network storage solutions, we hired additional software development engineers and quality assurance engineers. These software engineers design and test the software products that are or will be sold by our OEM partners and resellers. Continuing to deliver new and enhanced products to meet the demands of the storage market is necessary if we are to remain competitive and to continue our growth. We also increased our sales force and our technical support team. An increased sales force should expand the market exposure for our products. The expanded technical support team responds to questions and technical issues from end users of our products and from our resellers and OEM partners. Providing top notch technical support to these groups enhances our ability to continue to make sales. End users who are satisfied with our technical support are more likely to order additional products from us. Resellers and OEM partners who are happy with our technical support, and whose end users are satisfied, will be more likely to recommend our current products and less likely to consider other providers for future products. The key factors we look to for our future business prospects continue to be our sales pipeline, our ability to establish and expand relationships with key industry OEMs and resellers, sales by our OEM partners, additional orders from resellers, growth in deferred revenue, re-orders from existing customers, and the growth of the overall market for storage solutions. Gross margins are also a key factor in evidencing the scalability of our business. Our sales "pipeline" consists of inquiries from end users and resellers for possible purchases of our products. Our overall sales pipeline steadily increased for each quarter of 2006 compared with the same quarter in 2005. OEM relationships continue to be important to us for two main reasons: 24 First, sales by our OEM partners contribute to our revenues. Overall, product licenses to OEMs accounted for approximately forty two percent of our revenues in 2006. One OEM customer accounted for twenty seven percent of our revenues. We anticipate that OEMs will account for over forty percent of our revenues in 2007. We expect that at least one OEM will account for at least ten percent of our revenues in 2007. Accordingly, the loss of this customer would have a material adverse effect on our business. Second, having our products selected by respected, established industry leaders signals to customers, resellers and other potential OEM partners that our products are quality products that add value to their enterprise. Before licensing software, OEM partners typically undertake broad reviews of many of the competing software solutions available. The choice of our products by major industry participants validates both the design and the capabilities of the products and our product roadmaps. In 2006, we renewed and extended our OEM agreement with EMC Corporation, to 2013. EMC also launched a new range of products that incorporate our VTL technology. In 2006 we also extended our strategic relationship with Sun Microsystems by entering into a joint development agreement. Sun's next generation open systems virtual tape solution will incorporate FalconStor's VTL technology. In 2006, we entered into OEM agreements with other companies, including companies in Asia and companies focused on the SMB market, as discussed below. We also renewed or extended agreements with existing OEM partners. We will continue to seek additional OEM opportunities in the future. We do everything we can to assure that our products meet the needs of our OEM partners and their customers. However, we cannot control decisions by our OEM partners to change their product or marketing mix in ways that impact sales of products licensed by the OEMs from us. Over our history, we have entered into OEM agreements with two Tier-1 OEM companies, and with another significant company in the computer, networking and communications products business, only to see those OEM partners change their strategies and make significant reductions in their commitments to the products that incorporate our technology. Many enterprises look to value added resellers or solution providers to assist them in making their information technology purchases. These resellers typically review an enterprise's needs and suggest a hardware, software, or combined hardware and software solution to fulfill the enterprise's requirements. As service providers to companies, resellers' reputations are dependent on satisfying their customers' needs efficiently and effectively. Resellers have wide choices in fulfilling their customers' needs. If resellers determine that a product they have been providing to their customers is not functioning as promised, or is not providing adequate return on investment, or if the customers are not satisfied with the level of support they are receiving from the suppliers, the resellers will move quickly to offer different solutions to their customers. Additional sales by resellers are therefore an important indicator of our business prospects. Sales from our resellers in the United States fell below our expectations in 2006. Increasing sales from resellers is an area of focus for us. Steps we have taken to increase sales from resellers include the addition of sales, marketing and support personnel focused on those accounts. We also have instituted, and we will be instituting further, support, training and incentive programs intended to increase sales by our resellers. In 2006, we signed agreements with new resellers worldwide. We also terminated relationships with resellers who we believed were not properly selling our products. We will continue to enter into relationships with resellers and to discontinue relationships with resellers with whom we are not satisfied. Our deferred revenues consist primarily of amounts attributable to future support and maintenance of our products. The level of deferred revenue is an important indicator of our success. Maintenance and support for our products is sold for fixed periods of time. Maintenance and support agreements are typically for one year, although some agreements are for terms in excess of one year. If we do not deliver the support needed by end users of our products or by our OEM partners and resellers, then they will not renew their maintenance and support agreements. If end users stop using our products, they also will not renew their maintenance and support agreements. An increase in deferred revenues thus indicates growth in our installed base and end user and OEM satisfaction with our products and our maintenance and support services. Our deferred revenue increased to $15.1 million as of December 31, 2006, compared with $9.6 million as of December 31, 2005. We expect deferred revenue to continue to grow in 2007. The level of re-orders from existing end users of our products is another measure of customer satisfaction. Information technology professionals will only order additional products and services for their companies if they determine that the products have reduced total cost of ownership and have provided a good 25 return on investment. Re-orders are thus an indication that our products are delivering as promised and that our support is meeting the end user's needs. In 2006, many end users ordered additional copies of our products, or additional products or ordered additional options. If re-orders decline, it would indicate that future sales might also decline. As the percentage of our revenues from OEMs increases, our ability to gauge re-orders decreases because our OEM partners typically do not provide us with information identifying the end user for each order. Consolidation in the network storage market continued in 2006. The consolidation did not have a significant impact on our revenue. The storage solutions market continues to grow. In addition to growth based on demand for storage server consolidation and replication, there was growth in backup acceleration. We expect each of these areas to continue growing in 2007. In the fourth quarter of 2005, we announced the launch of our PrimeVault disaster recovery, services. These services are based on our IPStor and VirtualTape Library (VTL) software and provide a means for us to leverage our successes with those products to increase our customer base to include end users who do not have the resources - either technical or financial - to undertake a full implementation of our products. Initially, we intended to offer these services directly to end users and through resellers. In 2006, we modified our approach to PrimeVault so that we would no longer be the primary provider of the services. Instead, we now license the PrimeVault services to third parties for resale to end users. Payment to us is based on either a revenue share or a fee based on the amount of storage managed by the third party. PrimeVault services did not provide significant revenue in 2006, but we anticipate an increase in revenue in 2007. In 2005 and the beginning of 2006, we launched initiatives in the small/medium business (SMB) and small office/home office (SOHO) markets. In early 2006, we signed an OEM agreement with a leading computer, networking and communications products manufacturer to offer an entry-level data storage and protection appliance, powered by a version of IPStor optimized to run on a System-on-Chip ("SOC") platform ("IPStor Express"), targeting the SMB/SOHO market. Shortly after the launch of the product, the OEM partner announce a major strategic review of its operations and decided to scale back its commitment to this product line. As a result of this change in strategy, revenues from our SMB/SOHO product line were lower than expected and were not significant. We continue to believe that these non-enterprise markets are another growth area for storage software and in 2006 we signed agreements with OEM companies, both in the United States and abroad, whose product lines target these markets. While we expect revenue growth in 2007 from our SMB/SOHO products, it is too early to estimate whether revenues from these markets will be significant contributors to our revenues in 2007. Another area of focus for us in 2006, and one that will remain an area of focus in 2007, was the China market. In 2006, we signed an agreement with Hangzhou Huawei-3Com Technology Co. Ltd, a leading global manufacturer of IP network solutions, to expand our strategic partnership in IP Network Storage to include joint R&D activities in China and a multi-year, multi-million dollar commitment. In 2006, we also signed an OEM agreement with a Chinese company that is a leader in telecommunications networks. In early 2007, we signed a joint development and research agreement with the Computer Network Information Center, Chinese Academy of Sciences (CNIC, CAS) to establish a laboratory to develop data protection and remote disaster recovery solutions for the Chinese government and enterprises with the goal of providing our PrimeVault data protection services throughout China. As we had anticipated, we saw the greatest increase in revenues from our VirtualTape Library software. We expect this growth to continue, if not accelerate, in 2007, as our OEM partners introduce new products and as we introduce additional features and functionality for the product. The continued decline in prices for disk storage, and the continuing need for rapid back up, disaster recovery and regulatory compliance, should contribute to this growth. Another important measure of our business is gross margin. Among other things, gross margin measures our ability to scale our business. Unlike manufacturers of hardware, our incremental cost for each additional unit of software licensed is a small percentage of the software license revenue. Thus, our gross margins tend to increase as our software license revenue increases. We incur research and development expenses before the product is offered for licensing. These expenses consist primarily of personnel costs for engineering and testing, but also include other items such as the cost of hardware and software used in development. We also have expenses for software support, sales and marketing, and general and administrative functions. 26 Our gross margins for 2006 were 83%. Due to the change in accounting rules regarding share-based compensation (as discussed above), a direct comparison with our gross margins in 2005 is not meaningful. The impact of the equity-based compensation expense on gross margin in 2006 was equivalent to 2%. We believe that our gross margin in 2006 demonstrates that we were successful in our ability to scale our business. We believe the change in accounting rules also makes any comparison of expenses in 2006 and 2005 not meaningful. Nonetheless, we are pleased with our ability to contain the increase of expenses in 2006. Excluding share-based compensation expense, our expenses grew at a lower rate than our revenues. We will continue to invest in infrastructure and personnel to maintain and enhance our leading edge designs and to support our customers, but we will continue to do so in a controlled, cost-effective manner. One additional factor that we expect to continue to affect our revenues on a quarterly, but not annual, basis, is the seasonality of the information technology business. Historically, information technology spending has been higher in the fourth and second quarters of each calendar year, and somewhat slower in the other quarters, particularly the first quarter. Our quarterly results reflected this seasonality in 2006, and we anticipate that our quarterly results for 2007 will show the effects of seasonality as well. As discussed above, the new accounting rules relating to share-based compensation expense had a negative impact on our earnings in 2006. Both before the rules became effective, and during 2006, we weighed the impact of the changes on our consolidated financial statements against the impact of discontinuing the grant of equity-based compensation to our worldwide workforce. We decided that we will continue to apply the criteria and the methodology we have used in the past to determine grants of stock options or other equity-based compensation to our employees. We believe that the opportunity to participate in the growth of our Company is an important motivating factor for our current employees and a valuable recruiting tool for new employees. For the management of our business and the review of our progress, we will continue to look to our results before share-based compensation expense. We will use these non-GAAP financial measures in making operating decisions because they measure the results of our day to day operations and because they provide a more consistent basis for evaluating and comparing our results across different periods. Our critical accounting policies are those related to revenue recognition, accounts receivable allowances, accounting for share-based compensation and deferred income taxes. As described in note 1 to our consolidated financial statements, we recognize revenue in accordance with the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended. Software license revenue is recognized only when pervasive evidence of an arrangement exists and the fee is fixed and determinable, among other criteria. An arrangement is evidenced by a signed customer contract for nonrefundable royalty advances received from OEMs or a customer purchase order or a royalty report summarizing software licenses resold by an OEM, distributor or solution provider to an end user. The software license fees are fixed and determinable as our standard payment terms generally range from 30 to 90 days, depending on regional billing practices. When a customer licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance for its fair value. We review accounts receivable to determine which are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider historical return rates, specific past due accounts, analysis of our accounts receivable aging, customer payment terms, historical collections, write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. Historically, we have experienced a somewhat consistent level of write-offs and returns as a percentage of revenue due to our customer relationships, contract provisions and credit assessments. Changes in the product return rates, credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs, revenues and our general and administrative expenses. With the adoption of SFAS No. 123(R) on January 1, 2006, the Company is required to record the fair value of share-based compensation awards as an expense. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and expected term assumptions require a greater level of judgment. We estimate expected stock-price volatility based primarily on a simple average historical volatility of the underlying stock over a period equal to the expected term of the option, but also consider whether other factors are present that indicate that exclusive reliance on historical volatility may not be a reliable indicator of expected volatility. With regard to our estimate of expected term, as adequate information with respect to historical share option exercise experience is not available, we primarily consider the vesting term and original contractual term of the options granted. 27 Consistent with the provisions of Statement of Financial Accounting Standards No. 109, we regularly estimate our ability to recover deferred income taxes, and report such assets at the amount that is determined to be more-likely-than-not recoverable. This evaluation considers several factors, including an estimate of the likelihood of generating sufficient taxable income in future periods over which temporary differences reverse, the expected reversal of deferred tax liabilities, past and projected taxable income, and available tax planning strategies. As of December 31, 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. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2006 COMPARED TO THE YEAR ENDED DECEMBER 31, 2005 Revenues for the year ended December 31, 2006 increased 34% to $55.1 million compared with $41.0 million for the year ended December 31, 2005. Our operating expenses increased 52% from $39.3 million in 2005 to $59.8 million in 2006. Included in our operating expenses for the year ended December 31, 2006 was $9.4 million of share-based payment compensation expense related to the implementation of SFAS No. 123(R) beginning January 1, 2006. For the year ended December 31, 2005, there was insignificant share-based payment compensation expense. Net loss for the year ended December 31, 2006 was $3.4 million compared with net income of $2.3 million for the year ended December 31, 2005. The increase in revenues was mainly due to an increase in (i) demand for our network storage solution software (ii) maintenance revenue from new and existing customers and (iii) sales from our resellers and OEM partners. Revenue contribution from our OEM partners increased in absolute dollars and as a percentage of our total revenue for the year ended December 31, 2006. Revenue from resellers and distributors also increased in absolute dollars. Expenses increased in all aspects of our business to support our growth. For the year ended December 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 279 as of December 31, 2005 to 340 as of December 31, 2006. Included in our results for the year ended December 31, 2006 is a litigation settlement charge of $0.8 million relating to a contingent purchase price dispute associated with an acquisition we made in 2002. REVENUES SOFTWARE LICENSE REVENUE Software license revenue is comprised of software licenses sold through our OEMs, value-added resellers and distributors to end users and, to a lesser extent, directly to end users. These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing software licenses sold and the software and permanent key codes are delivered to the customer. We sometimes receive nonrefundable royalty advances and engineering fees from some of our OEM partners. These arrangements are evidenced by a signed customer contract, and the revenue is recognized when the software product master is delivered and accepted, and the engineering services, if any, have been performed. Software license revenue increased 30% to $38.3 million in 2006 from $29.5 million in 2005. Increased market acceptance and demand for our product and increased sales from our resellers and OEM partners were the primary drivers of the increase in software license revenue. Revenue from our OEM partners increased as a percentage of total revenue. We expect our software license revenue to continue to grow and the percentage of future software license revenue derived from our OEM partners to increase. MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenues are comprised of software maintenance and technical support, professional services primarily related to the implementation of our software, engineering services, and sales of computer hardware. Revenue derived from maintenance and technical support contracts is deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Revenue from engineering services is primarily related to customizing software product masters for some of our OEM partners. Revenue 28 from engineering services is recognized in the period the services are completed. In 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 47% to $16.7 million in 2006 from $11.4 million in 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 our new customers purchase maintenance and support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $7.6 million for the year ended December 31, 2005 to $12.5 million for the year ended December 31, 2006. Software services and other revenue increased from $3.8 million in 2005 to $4.3 million in 2006. The increase in software services and other revenue was partially attributable to our hardware sales which increased from $2.3 million in 2005 to $2.6 million in 2006. This increase was the result of an increase in demand from our customers for bundled solutions. Growth in our professional services sales, which increased from $1.5 million in 2005 to $1.7 million in 2006, 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 December 31, 2006 and 2005, we had $5.2 million and $5.0 million, respectively, of purchased software licenses that are being amortized over three years. For the year ended December 31, 2006, we recorded $0.4 million of amortization related to these purchased software licenses. For the year ended December 31, 2005, we recorded $0.8 million of amortization related to these purchased software licenses. We will continue to evaluate third party software licenses and may make additional purchases, which would result in an increase in amortization expense. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues consists primarily of personnel costs, other costs associated with providing software implementations, technical support under maintenance contracts and training, and share-based payment compensation expense associated with the implementation of SFAS No. 123(R). Cost of maintenance, software services and other revenues also includes the cost of hardware that was resold. Cost of maintenance, software services and other revenues for the year ended December 31, 2006 increased by 48% to $9.0 million compared with $6.1 million for the year ended December 31, 2005. The increase in cost of maintenance, software services and other revenue was partially due to $1.3 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 year ended December 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. Additionally, due to an increase in hardware sales, our associated hardware costs increased from $1.5 million for the year ended December 31, 2005 to $1.8 million for the year ended December 31, 2006. Our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenue increases. Gross profit for the year ended December 31, 2006 was $45.7 million or 83% of revenues compared with $34.1 million or 83% of revenues for the year ended December 31, 2005. Gross margin remained consistent despite the inclusion of share-based payment compensation expense in the cost of maintenance, software services and other revenue for the year ended December 31, 2006. Share-based payment compensation expense was equal to 2% of revenue for the year ended December 31, 2006. 29 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 No. 123(R), and costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 66% to $20.0 million in 2006 from $12.0 million in 2005. The major contributing factor to the increase in software development costs was $4.3 million of share-based payment compensation expense. There was no share-based payment compensation expense included in software development costs for the year ended December 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 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 costs, share-based payment compensation expense associated with the implementation of SFAS No. 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 47% to $23.7 million in 2006 from $16.1 million in 2005. The increase in selling and marketing expenses was partially due to $2.8 million of share-based payment compensation expense. There was insignificant share-based payment compensation expense included in selling and marketing expenses for the year ended December 31, 2005. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our revenue growth. As a result of the increase in revenue and interest in our software, our commission expense and travel expenses also increased. 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 No. 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 38% to $5.8 million in 2006 from $4.2 million in 2005. The major contributing factor to the increase in general and administrative expenses was $0.9 million of share-based payment compensation expense. There was no share-based payment compensation expense included in general and administrative expense for the year ended December 31, 2005. Additionally, as our revenue and number of employees increase, our legal and professional fees and other general corporate overheard costs have increased and are likely to continue to increase. LITIGATION SETTLEMENT CHARGE In January 2007, we resolved claims brought against us by two former shareholders of IP Metrics, Inc. ("IP Metrics"). When we purchased IP Metrics in July 2002, part of the contractual consideration was payments to be made in 2003 and 2004 to the former IP Metrics shareholders based on sales of IP Metrics products and/or payments to be made if certain events occurred. We made payments to all four former shareholders in 2003 and 2004. Two of the former shareholders alleged that they were entitled to additional payments based on the alleged occurrence of certain contingent events and they brought an action against us. This action was resolved in January, 2007 without any admission of liability, by the payment of an additional $0.8 million to the two former shareholders. This amount was recorded as an operating expense as of December 31, 2006. All claims in the lawsuit have now been dismissed. INTEREST AND OTHER INCOME We invest our cash, cash equivalents and marketable securities in government securities and other low risk investments. Interest and other income increased to $1.7 million for the year ended December 31, 2006 compared with $0.7 million for the year ended December 31, 2005. This increase is primarily due to a higher average cash balance and higher interest rates. 30 INCOME TAXES We did not record a tax benefit associated with our pre-tax loss incurred for the year ended December 31, 2006, as we deemed that it was uncertain that the related deferred tax assets would be realized based on our cumulative losses incurred since inception and our limited period of profitability. For the year ended December 31, 2005, our pre-tax income was substantially offset by available net operating losses. Our income tax provision for 2006 and 2005 consists of taxes related to alternative minimum taxes, state income taxes, and taxes from our foreign subsidiaries. In 2007, in the event that we continue to generate taxable income and our forecasts indicate that it is more-likely-than-not that we will recover a portion of our deferred tax assets in the future, we will likely reverse a portion of our deferred tax asset valuation allowance. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2005 COMPARED TO THE YEAR ENDED DECEMBER 31, 2004 REVENUES SOFTWARE LICENSE REVENUE Software license revenue increased 37% to $29.5 million in 2005 from $21.5 million in 2004. Increased market acceptance and demand for our product and increased sales from our OEM partners were the primary drivers of the increase in software license revenue. Software license revenue increased from both our OEM partners and from our resellers. Revenue from our OEM partners increased as a percentage of total revenue. MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenue increased 58% to $11.4 million in 2005 from $7.2 million in 2004. The major factor behind the increase in maintenance, software services and other revenue was the increase in the number of maintenance and technical support contracts we sold. As we are in business longer, and as we license more software, we expect these revenues will continue to increase. The majority of our new customers purchase maintenance and support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $4.4 million for the year ended December 31, 2004 to $7.6 million for the year ended December 31, 2005. Software services and other revenue increased from $2.8 million in 2004 to $3.8 million in 2005. The increase in software services and other revenue was partially attributable to our hardware sales which increased from $1.5 million in 2004 to $2.3 million in 2005. This increase was the result of an increase in demand from our customers for bundled solutions. Growth in our professional services sales, which increased from $1.3 million in 2004 to $1.5 million in 2005, also contributed to the increase in software services and other revenues. This increase in professional services revenue was related to the increase in our software license customers who elected to purchase professional services. COST OF REVENUES AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE As of December 31, 2005 and 2004, we had $5.0 million and $4.9 million, respectively, of purchased software licenses that are being amortized over three years. For the year ended December 31, 2005, we recorded $0.8 million of amortization related to these purchased software licenses. For the year ended December 31, 2004 amortization was $1.4 million. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues for the year ended December 31, 2005 increased by 47% to $6.1 million compared with $4.2 million for the year ended December 31, 2004. The increase in cost of maintenance, software services and other revenue was principally due to an increase in personnel. As a result of our increased sales of maintenance and support contracts and professional services, we hired additional employees to provide technical support and to implement our software. Additionally, due to an increase in hardware sales, our associated hardware costs increased from $1.0 million for the year ended December 31, 2004 to $1.5 million for the year ended December 31, 2005. 31 Gross profit for the year ended December 31, 2005 was $34.1 million or 83% of revenues compared with $23.2 million or 81% of revenues for the year ended December 31, 2004. The increase in gross profit and gross margin was directly related to the increase in revenues. Additionally, the increased percentage of revenue from our OEM partners in 2005 contributed to the increase in gross margins since revenues from our OEM partners typically have higher gross margins. SOFTWARE DEVELOPMENT COSTS Software development costs increased 33% to $12.0 million in 2005 from $9.1 million in 2004. The increase in software development costs was primarily due to an increase in employees required to enhance and test our core network storage software product, as well as to develop new innovative features and options. In addition, we required additional employees to test and integrate our software with our OEM partners' products. SELLING AND MARKETING Selling and marketing expenses increased 13% to $16.1 million in 2005 from $14.3 million in 2004. As a result of the increase in revenue and interest in our software, our commission expense and travel expenses increased. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our revenue growth. GENERAL AND ADMINISTRATIVE General and administrative expenses decreased 18% to $4.2 million in 2005 from $5.1 million in 2004. The overall decrease in general and administrative expenses was primarily due to a decrease in legal expenses. For the year ended December 31, 2004 we had $1.0 million in legal expenses attributable to litigation related to alleged patent infringement. LITIGATION SETTLEMENT CHARGE During the third quarter of 2004, we resolved claims relating to alleged patent infringement brought by Dot Hill and by Crossroads against us in the United States District Court for the Western District of Texas. Pursuant to the terms of the Settlement Agreement between Crossroads and us, we, without admission of infringement, made a one-time payment of $1.3 million and granted to Crossroads licenses to certain of our technology in exchange for a worldwide, perpetual license to the technology underlying the Crossroads' patents at issue in the litigation. All claims against us by both Dot Hill and Crossroads have now been dismissed. INTEREST AND OTHER INCOME Interest and other income remained consistent at $0.7 million. Interest income increased from $0.7 million to $1.0 million due to a higher average cash balance and slightly higher interest rates. Additionally, interest and other income for the year ended December 31, 2005, includes an out-of-period charge of approximately $0.2 million to recognize investment losses realized in prior years. INCOME TAXES For the year ended December 31, 2005, our pre-tax income was substantially offset by available net operating losses. For the year ended December 31, 2004, we did not record a tax benefit associated with the pre-tax loss incurred, as we deemed that it was uncertain that the related deferred tax assets would be realized based on our cumulative losses incurred since inception and our limited period of profitability. Accordingly, we provided a full valuation allowance against our net deferred tax assets. Our income tax provision for 2005 and 2004 consists of tax expenses related to alternative minimum taxes, state income taxes, and taxes from our foreign subsidiaries. LIQUIDITY AND CAPITAL RESOURCES Our total cash and cash equivalents and marketable securities balance as of December 31, 2006 increased by $4.3 million compared with December 31, 2005. Our cash and cash equivalents totaled $15.6 million and marketable securities totaled $25.4 million at December 31, 2006. As of December 31, 2005, we had $18.8 million in cash and cash equivalents and $17.8 million in marketable securities. 32 In 2006, we made investments in our infrastructure to support our long-term growth. We increased the total number of employees in 2006 and made investments in property and equipment to support our growth. As we continue to grow, we will continue to make investments in property and equipment and will need to continue to increase our headcount. In the past, we have also used cash to purchase software licenses and to make acquisitions. We will continue to evaluate potential software license purchases and acquisitions and if the right opportunity presents itself we may continue to use our cash for these purposes. However, as of the date of this filing, we have no agreements, commitments or understandings with respect to any such acquisitions. We currently do not have any debt and our only significant commitments are related to our office leases. In connection with our acquisition of IP Metrics in July 2002, we were required to make cash payments to the former shareholders of IP Metrics, which were contingent on the level of revenues from IP Metrics products for a period of twenty-four months through June 30, 2004. In 2004, we made payments to the former shareholders of IP Metrics totaling $214,009. In 2006, we recorded a litigation settlement expense of $0.8 million relating to a contingent purchase price dispute with two former shareholders of IP Metrics. This settlement was paid out in the first quarter of 2007. In October 2001, our Board of Directors authorized the repurchase of up to two million shares of our outstanding common stock. Since October 2001, 865,200 shares have been repurchased at an aggregate purchase price of $5.8 million including 315,600 shares repurchased in 2006 at an aggregate purchase price of $2.1 million. Net cash provided by operating activities totaled $8.2 million for the year ended December 31, 2006, compared with net cash provided by operating activities of $6.5 million for the year ended December 31, 2005 and net cash used in operating activities of $1.1 million for the year ended December 31, 2004. The increase in net cash provided by operating activities was primarily due to an increase in non-cash charges of $9.4 million related to share-based payment compensation expense. There was insiginificant share-based payment compensation expense for the years ended December 31, 2005 and 2004. Also contributing to the increase in net cash provided by operating activities was an increase in our deferred revenues, which increased to $5.5 million compared with $4.2 million in 2005 and $2.8 million in 2004, as well as, an increase in accrued expenses and other liabilities which increased to $2.0 million compared with $1.1 million in 2005 and $0.8 million in 2004. These amounts were partially offset by increases in our net accounts receivable balances of $8.9 million in 2006, $4.9 million in 2005 and $3.2 million in 2004. The increases in our accounts receivable balances are due to our continued revenue growth. Net cash used in investing activities was $11.8 million in 2006 compared with net cash used in investing activities of $2.8 million in 2005 and net cash provided by investing activities of $6.3 million in 2004. Included in investing activities for each year are the sales and purchases of our marketable securities. These represent the sales, maturities and reinvesting of our marketable securities. The net cash used in investing activities from the net purchase of securities was $7.5 million in 2006 and the net cash provided by investing activities from the net sale of securities was $0.6 million for 2005 and $9.5 million in 2004. These amounts will fluctuate from year to year depending on the maturity dates of our marketable securities. The cash used to purchase property and equipment was $3.7 million, $3.2 million and $2.8 million in 2006, 2005 and 2004, respectively. The cash used to purchase software licenses was $0.2 million in 2006 and $0.1 million in both 2005 and 2004. We continually evaluate potential software licenses and we may continue to make similar investments if we find opportunities that would benefit our business. Net cash provided by financing activities was $0.4 million in 2006, $24,385 in 2005, and $1.8 million in 2004. We received proceeds from the exercise of stock options of $2.5 million in 2006, $1.9 million in 2005 and $2.0 million in 2004. We made payments of $2.1 million in 2006, $1.9 million in 2005 and $0.3 million in 2004 to acquire treasury stock. The Company's only significant commitments relate to its operating leases. The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2007 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2006: 33 Year ending december 31 2007............................................................. $1,875,673 2008............................................................. 1,372,384 2009............................................................. 1,365,163 2010............................................................. 1,331,877 2011............................................................. 1,367,538 Thereafter....................................................... 708,120 ---------- $8,020,755 ========== We believe that our current balance of cash, cash equivalents and marketable securities, and expected cash flows from operations will be sufficient to meet our cash requirements for at least the next twelve months. IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS - an amendment of FASB Statements No. 87, 88, 106 and 132(R) ("SFAS 158"). SFAS 158 requires that employers recognize the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. SFAS No. 158 also requires additional disclosures in the notes to financial statements. The Company adopted SFAS No. 158, effective December 31, 2006, and recorded an adjustment to accumulated other comprehensive income. In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS ("SFAS 157"), which defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. Adoption is required as of the beginning of the first fiscal year that begins after November 15, 2007. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. Management is evaluating the impact the adoption of this statement will have on the Company's consolidated financial statements. In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No. 108, CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB No. 108") to provide guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Under SAB No. 108, companies should evaluate a misstatement based on its impact on the current year income statement, as well as the cumulative effect of correcting such misstatements that existed in prior years existing in the current year's ending balance sheet. The Company adopted SAB No. 108 for the year ended December 31, 2006 with no impact to the Company's consolidated financial statements. In June 2006, the FASB issued FASB Interpretation No. ("FIN") 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES - an Interpretation of SFAS No. 109, which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, ACCOUNTING FOR INCOME TAXES. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Any change in the net assets or liabilities recognized as a result of adopting the provisions of FIN 48 would be recorded as an adjustment to the opening balance of retained earnings. FIN 48 is effective for the Company as of January 1, 2007. Management is currently evaluating the impact, if any, the adoption of FIN 48 will have on the Company's consolidated financial statements. ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and marketable securities which aggregated to $41.0 million as of December 31, 2006, 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. 34 FOREIGN CURRENCY RISK. We have several offices outside the United States. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. The effect of foreign currency exchange rate fluctuations have not been material since our inception. We do not use derivative financial instruments to limit our foreign currency risk exposure. We do not believe that our results would be materially affected by a 10% change in interest or foreign exchange rates. 35 ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Page Reports of Independent Registered Public Accounting Firm .................... 37 Consolidated Balance Sheets as of December 31, 2006 and 2005 ................ 39 Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004 .......................................... 40 Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) for the years Ended December 31, 2006, 2005 and 2004 ........ 41 Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 .......................................... 42 Notes to Consolidated Financial Statements................................... 43 36 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders FalconStor Software, Inc.: We have audited the accompanying consolidated balance sheets of FalconStor Software, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FalconStor Software, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. As discussed in Notes 1 (k) and 8 to the accompanying consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), "SHARED-BASED PAYMENT", as of January 1, 2006. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of FalconStor Software, Inc.'s internal control over financial reporting as of December 31, 2006, based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report, dated March 14, 2007, expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP Melville, New York March 14, 2007 37 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders FalconStor Software, Inc.: We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that FalconStor Software, Inc. and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by COSO. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006, and our report, dated March 14, 2007, expressed an unqualified opinion on those consolidated financial statements. As discussed in our report, dated March 14, 2007, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004), "SHARED-BASED PAYMENT", as of January 1, 2006. /s/ KPMG LLP Melville, New York March 14, 2007 38 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2006 2005 ------------ ------------ Assets Current assets: Cash and cash equivalents .............................................................. $ 15,605,329 $ 18,796,973 Marketable securities .................................................................. 25,354,259 17,833,683 Accounts receivable, net of allowances of $6,016,298 and $3,846,882, respectively ............................................................. 24,134,257 15,187,408 Prepaid expenses and other current assets .............................................. 1,244,937 911,715 ------------ ------------ Total current assets ............................................................... 66,338,782 52,729,779 Property and equipment, net of accumulated depreciation of $10,221,780 and $7,150,762, respectively ............................................... 5,960,317 5,277,609 Goodwill ................................................................................. 3,512,796 3,512,796 Other intangible assets, net ............................................................. 407,316 216,864 Other assets, net ........................................................................ 2,011,433 2,236,725 ------------ ------------ Total assets ......................................................................... $ 78,230,644 $ 63,973,773 ============ ============ Liabilities and Stockholders' Equity Current liabilities: Accounts payable ....................................................................... $ 1,432,510 $ 1,152,228 Accrued expenses ....................................................................... 6,505,536 4,446,559 Deferred revenue ....................................................................... 11,466,552 7,401,018 ------------ ------------ Total current liabilities ............................................................ 19,404,598 12,999,805 Other long-term liabilities .............................................................. 137,317 75,653 Deferred revenue ......................................................................... 3,645,482 2,240,208 ------------ ------------ Total liabilities .................................................................... 23,187,397 15,315,666 ------------ ------------ Commitments and Contingencies Stockholders' equity: Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued ............ -- -- Common stock - $.001 par value, 100,000,000 shares authorized, 49,085,539 and 48,441,614 shares issued, respectively and 48,220,339 and 47,892,014 shares outstanding, respectively..................................... 49,086 48,442 Additional paid-in capital ............................................................. 99,282,308 87,342,747 Accumulated deficit .................................................................... (38,033,857) (34,659,329) Common stock held in treasury, at cost (865,200 and 549,600 shares, respectively).......................................................................... (5,780,163) (3,632,930) Accumulated other comprehensive loss, net .............................................. (474,127) (440,823) ------------ ------------ Total stockholders' equity ......................................................... 55,043,247 48,658,107 ------------ ------------ Total liabilities and stockholders' equity ......................................... $ 78,230,644 $ 63,973,773 ============ ============ See accompanying notes to consolidated financial statements. 39 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 2006 2005 2004 --------------------------------------------------------- Revenues: Software license revenue ..................................... $ 38,317,352 $ 29,544,467 $ 21,487,866 Maintenance revenue .......................................... 12,475,342 7,593,804 4,442,724 Software services and other revenue .......................... 4,273,334 3,825,832 2,778,088 ------------ ------------ ------------ 55,066,028 40,964,103 28,708,678 ------------ ------------ ------------ Operating expenses: Amortization of purchased and capitalized software ................................................... 362,159 781,500 1,393,908 Cost of maintenance, software services and other revenue .......................................... 9,048,354 6,114,112 4,150,309 Software development costs ................................... 20,021,899 12,039,488 9,050,092 Selling and marketing ........................................ 23,712,488 16,109,440 14,277,167 General and administrative ................................... 5,828,150 4,212,769 5,108,516 Litigation settlement ........................................ 799,317 -- 1,300,000 ------------ ------------ ------------ 59,772,367 39,257,309 35,279,992 ------------ ------------ ------------ Operating income (loss) .................................. (4,706,339) 1,706,794 (6,571,314) ------------ ------------ ------------ Interest and other income, net ................................. 1,650,284 705,063 714,412 ------------ ------------ ------------ Income (loss) before income taxes ........................ (3,056,055) 2,411,857 (5,856,902) Provision for income taxes ..................................... 318,473 118,750 31,945 ------------ ------------ ------------ Net income (loss) ........................................ $ (3,374,528) $ 2,293,107 $ (5,888,847) ------------ ------------ ------------ Basic net income (loss) per share .............................. $ (0.07) $ 0.05 $ (0.13) ============ ============ ============ Diluted net income (loss) per share ............................ $ (0.07) $ 0.05 $ (0.13) ============ ============ ============ Basic weighted average common shares outstanding .................................................. 48,044,946 47,662,446 46,967,422 ============ ============ ============ Diluted weighted average common shares outstanding .................................................. 48,044,946 50,776,396 46,967,422 ============ ============ ============ See accompanying notes to consolidated financial statements. 40 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) Additional Deferred Common paid-in compen- Accumulated stock capital sation deficit ------------ ------------ ------------ ------------ Balance, December 31, 2003 $ 46,745 $ 83,277,981 $ (7,969) $(31,063,589) Issuance of stock options to non-employees -- 87,023 -- -- Exercise of stock options 1,024 2,035,736 -- -- Amortization of deferred compensation -- -- 7,969 -- Net loss -- -- -- (5,888,847) Acquisition of treasury stock -- -- -- -- Change in unrealized losses on marketable securities, net -- -- -- -- Foreign currency translation adjustment -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2004 $ 47,769 $ 85,400,740 $ -- $(36,952,436) Issuance of stock options to non-employees -- (32,860) -- -- Exercise of stock options, including tax benefit 673 1,974,867 -- -- Net income -- -- -- 2,293,107 Acquisition of treasury stock -- -- -- -- Change in unrealized losses on marketable securities, net -- -- -- -- Foreign currency translation adjustment -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2005 $ 48,442 $ 87,342,747 $ -- $(34,659,329) Exercise of stock options, including tax benefit 644 2,546,407 -- -- Issuance of stock options to non-employees -- 17,914 -- -- Share-based compensation -- 9,375,240 -- -- Net loss -- -- -- (3,374,528) Acquisition of treasury stock -- -- -- -- Adjustment to initially apply SFAS No. 158, net of tax (Note 11) -- -- -- -- Change in unrealized losses on marketable securities, net -- -- -- -- Foreign currency translation adjustment -- -- -- -- ------------ ------------ ------------ ------------ Balance, December 31, 2006 $ 49,086 $ 99,282,308 $ -- $(38,033,857) ------------ ------------ ------------ ------------ Accumulated other compre- hensive Total Compre- Treasury income stockholders' hensive stock (loss) equity income (loss) ------------ ------------ ------------ ------------ Balance, December 31, 2003 $ (1,435,130) $ (262,489) $ 50,555,549 Issuance of stock options to non-employees -- -- 87,023 -- Exercise of stock options -- -- 2,036,760 -- Amortization of deferred compensation -- -- 7,969 -- Net loss -- -- (5,888,847) (5,888,847) Acquisition of treasury stock (279,645) -- (279,645) -- Change in unrealized losses on marketable securities, net -- (148,849) (148,849) (148,849) Foreign currency translation adjustment -- (6,010) (6,010) (6,010) ------------ ------------ ------------ ------------ Balance, December 31, 2004 $ (1,714,775) $ (417,348) $ 46,363,950 $ (6,043,706) ============ Issuance of stock options to non-employees -- -- (32,860) -- Exercise of stock options, including tax benefit -- -- 1,975,540 -- Net income -- -- 2,293,107 2,293,107 Acquisition of treasury stock (1,918,155) -- (1,918,155) -- Change in unrealized losses on marketable securities, net -- 218,523 218,523 218,523 Foreign currency translation adjustment -- (241,998) (241,998) (241,998) ------------ ------------ ------------ ------------ Balance, December 31, 2005 $ (3,632,930) $ (440,823) $ 48,658,107 $ 2,269,632 ============ Exercise of stock options, including tax benefit -- -- 2,547,051 -- Issuance of stock options to non-employees -- -- 17,914 -- Share-based compensation -- -- 9,375,240 Net loss -- -- (3,374,528) (3,374,528) Acquisition of treasury stock (2,147,233) -- (2,147,233) -- Adjustment to initially apply SFAS No. 158, net of tax (Note 11) -- (87,482) (87,482) -- Change in unrealized losses on marketable securities, net -- 25,800 25,800 25,800 Foreign currency translation adjustment -- 28,378 28,378 28,378 ------------ ------------ ------------ ------------ Balance, December 31, 2006 $ (5,780,163) $ (474,127) $ 55,043,247 $ (3,320,350) ------------ ------------ ------------ ------------ See accompanying notes to consolidated financial statements. 41 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2006 2005 2004 -------------------------------------------------------- Cash flows from operating activities: Net income (loss) .............................................. $ (3,374,528) $ 2,293,107 $ (5,888,847) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization .............................. 3,581,451 3,505,562 3,656,212 Share-based payment employee compensation................... 9,375,240 -- 7,969 Non-cash professional services expenses .................... 17,914 (32,860) 87,023 Realized loss on marketable securities ..................... 28,854 270,026 17,795 Realized gain on sale of cost method investment ............................................... (3,112) -- -- Realized gain on sale of warrants .......................... (38,378) -- -- Tax benefit from stock option exercise ..................... (45,895) 33,000 -- Provision for returns and doubtful accounts ................ 4,765,148 4,340,102 3,296,275 Changes in operating assets and liabilities: Accounts receivable ........................................ (13,704,152) (9,274,971) (6,456,175) Prepaid expenses and other current assets .................. (326,695) (291,693) 636,208 Other assets ............................................... 122,098 (50,401) (251,038) Accounts payable ........................................... 254,211 354,471 259,128 Accrued expenses and other liabilities ..................... 2,018,002 1,104,416 791,498 Deferred revenue ........................................... 5,492,625 4,234,918 2,789,987 ------------ ------------ ------------ Net cash provided by (used in) operating activities ............................................. 8,162,783 6,485,677 (1,053,965) ------------ ------------ ------------ Cash flows from investing activities: Purchase of marketable securities .............................. (78,776,443) (61,264,424) (33,897,295) Sale of marketable securities .................................. 71,252,813 61,867,854 43,441,277 Sale of cost method investment ................................. 96,755 -- -- Purchase of cost method investment ............................. (198,117) -- -- Purchase of warrants ........................................... (635,000) -- -- Sale of warrants ............................................... 673,378 -- -- Purchase of property and equipment ............................. (3,693,756) (3,161,383) (2,842,792) Purchase of software licenses .................................. (173,431) (108,000) (50,000) Purchase of intangible assets .................................. (373,229) (126,241) (131,392) Net cash paid for acquisition of IP Metrics .................... -- -- (214,009) Security deposits .............................................. (2,062) -- (4,500) ------------ ------------ ------------ Net cash (used in) provided by investing activities ................................................. (11,829,092) (2,792,194) 6,301,289 ------------ ------------ ------------ Cash flows from financing activities: Proceeds from exercise of stock options ........................ 2,501,156 1,942,540 2,036,760 Payments to acquire treasury stock ............................. (2,147,233) (1,918,155) (279,645) Tax benefit from stock option exercise ......................... 45,895 -- -- ------------ ------------ ------------ Net cash provided by financing activities .................... 399,818 24,385 1,757,115 ------------ ------------ ------------ Effect of exchange rate changes .................................. 74,847 (405,468) (6,010) ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents.............. (3,191,644) 3,312,400 6,998,429 Cash and cash equivalents, beginning of year ..................... 18,796,973 15,484,573 8,486,144 ------------ ------------ ------------ Cash and cash equivalents, end of year ........................... $ 15,605,329 $ 18,796,973 $ 15,484,573 ============ ============ ============ Cash paid for income taxes ....................................... $ 79,501 $ 21,583 $ 24,554 ============ ============ ============ The Company did not pay any interest for the three years ended December 31, 2006. See accompanying notes to consolidated financial statements. 42 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2006 (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) 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, share-based payment compensation and deferred income taxes. Actual results could differ from those estimates. (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 $11.0 million and $12.4 million at December 31, 2006 and 2005, respectively. Marketable securities at December 31, 2006 and 2005 amounted to $25.4 million and $17.8 million, respectively, and consisted of corporate bonds, government securities and certificate of deposits, 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, 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 performed. Costs of providing these services are included in cost of revenues. 43 The Company has entered into various distribution, licensing and joint promotion agreements with OEMs and distributors, whereby the Company has provided to the reseller a non-exclusive software license to install the Company's software on certain hardware or to resell the Company's software in exchange for payments based on the products distributed by the OEM or distributor. Nonrefundable advances and engineering fees received by the Company from an OEM are recorded as deferred revenue and recognized as revenue when related software engineering services, if any, are complete and the software product master is delivered and accepted. For the years ended December 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). (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). 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 does not amortize goodwill, but has instead tested the balance for impairment annually on December 31st of each year, and more frequently if events or changes in circumstances indicate that goodwill may be impaired. Identifiable intangible assets are amortized over a three-year period using the straight-line method. Amortization expense was $182,777, $216,997 and $220,712 for 2006, 2005 and 2004, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of December 31, 2006 and December 31, 2005 are as follows: December 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 $ 1,023,093 $ 649,864 Accumulated amortization (615,777) (433,000) ----------- ----------- Net carrying amount $ 407,316 $ 216,864 =========== =========== (H) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY Costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company's product development process, technological feasibility is established upon completion of a working model. The Company did not capitalize any software development costs until its initial product reached technological feasibility at the end of March 2001. The Company previously capitalized $94,570 of software development costs which were fully amortized as of the first quarter of 2004. 44 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 $183,578 and $372,306, net of accumulated amortization of $5,008,853 and $4,646,694, is included in other assets in the balance sheets as of December 31, 2006 and December 31, 2005, respectively. Amortization expense was $362,159, $781,500 and $1,386,027 for the years ended December 31, 2006, 2005 and 2004, respectively. Amortization of purchased software technology is recorded at the greater of the straight line basis over the products estimated remaining life or the ratio of current period revenue of the related products to total current and anticipated future revenue of these products. As of December 31, 2006, amortization expense on existing identifiable intangible assets and purchased software technology will be $295,433, $223,482, and $71,979 for the years ended December 31, 2007, 2008 and 2009, respectively. Such assets will be fully amortized at December 31, 2009. (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 Statement of Financial Accounting Standards No. 123 (R) (Revised 2004), "SHARE-BASED PAYMENT" (SFAS No. 123(R)), 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. The adoption of this pronouncement resulted in increased compensation expense of $9.4 million, which caused net income to decrease by the same amount or $0.20 per share for the year ended December 31, 2006, as well as cash flows from financing activities increasing by $45,895 while cash flows from operating activities decreased by the same amount for the year ended December 31, 2006. Prior to the adoption of SFAS No. 123 (R), the Company accounted for stock-based compensation using the intrinsic-value based method under Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations, and provided applicable pro-forma disclosures required by Statement of Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION. Accordingly, prior to 2006, the Company recorded employee stock-based compensation expense only if, on the date of grant, the market price of the underlying stock on the date of grant exceeded the exercise price. (L) FINANCIAL INSTRUMENTS As of December 31, 2006 and 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. 45 (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 net losses for the years ended December 31, 2006 and 2004, all common stock equivalents for these periods were excluded from diluted net loss per share. As of December 31, 2006, 2005 and 2004, potentially dilutive common stock equivalents included 11,060,975, 10,200,908 and 8,973,358 stock options and shares of restricted stock outstanding, respectively. As of December 31, 2006, 2005 and 2004, potentially dilutive common stock equivalents also included 750,000 warrants outstanding. The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share ("EPS") computation: Year Ended December 31, 2006 Year Ended December 31, 2005 Net Income Shares Per Share Net Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ------------ ---------- ----------- ----------- ---------- ----------- Basic EPS $(3,374,528) 48,044,946 $ (0.07) $ 2,293,107 47,662,446 $ 0.05 =========== =========== Effect of dilutive securities: Stock Options and Restricted Stock -- 3,113,950 ----------- ----------- ----------- ----------- ----------- ----------- Diluted EPS $(3,374,528) 48,044,946 $ (0.07) $ 2,293,107 50,776,396 $ 0.05 =========== =========== =========== =========== =========== =========== Year Ended December 31, 2004 Net Income Shares Per Share (Numerator) (Denominator) Amount ----------- ---------- ----------- Basic EPS $(5,888,847) 46,967,422 $ (0.13) =========== Effect of dilutive securities: Stock Options and Restricted Stock -- ----------- ----------- ----------- Diluted EPS $(5,888,847) 46,967,422 $ (0.13) =========== =========== =========== (O) COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) includes the Company's net income (loss), foreign currency translation adjustments and unrealized losses on marketable securities, net of tax. Components of accumulated other comprehensive income (loss) were comprised of foreign currency translation adjustment losses of $363,163 and $391,540 as of December 31, 2006 and 2005, respectively, unrealized losses on marketable securities of $23,482 and $49,283, net of tax as of December 31, 2006 and 2005, respectively and unrecognized pension adjustments of $87,482, net of tax as of December 31, 2006. (P) NEW ACCOUNTING PRONOUNCEMENTS In September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS - an amendment of FASB Statements No. 87, 88, 106 and 132(R) ("SFAS 158"). SFAS 158 requires that employers recognize the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. SFAS No. 158 also requires additional disclosures in the notes to financial statements. The Company adopted SFAS No. 158, effective December 31, 2006, and recorded a $87,482 adjustment to other comprehensive income. In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS ("SFAS 157"), which defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. Adoption is required as of the beginning of the first fiscal year that begins after November 15, 2007. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. Management is evaluating the impact the adoption of this statement will have on the Company's consolidated financial statements. 46 In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No. 108, CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB No. 108") to provide guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Under SAB No. 108, companies should evaluate a misstatement based on its impact on the current year income statement, as well as the cumulative effect of correcting such misstatements that existed in prior years existing in the current year's ending balance sheet. The Company adopted SAB No. 108 for the year ended December 31, 2006 with no impact to the Company's consolidated financial statements. In June 2006, the FASB issued FASB Interpretation No. ("FIN") 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES - an Interpretation of SFAS No. 109, which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, ACCOUNTING FOR INCOME TAXES. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Any change in the net assets or liabilities recognized as a result of adopting the provisions of FIN 48 would be recorded as an adjustment to the opening balance of retained earnings. FIN 48 is effective for the Company as of January 1, 2007. Management is currently evaluating the impact, if any, the adoption of FIN 48 will have on the Company's consolidated financial statements. (Q) RECLASSIFICATIONS Certain reclassifications have been made to prior years' consolidated financial statement presentations to conform to the current year's presentation. (2) ACQUISITION On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned subsidiary of the Company, acquired all of the common stock of IP Metrics Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for mission-critical networks, for $2,432,419 in cash plus payments contingent on the level of revenues from IP Metrics' products and services for a period of twenty-four months. The acquisition was accounted for under the purchase method and the results of IP Metrics are included with those of the Company from the date of acquisition. As of December 31, 2004, the Company made aggregate contingent acquisition payments totaling $501,139 related to the sale of IP Metrics' products and services. In 2006, the Company recorded a litigation settlement expense of $0.8 million relating to a contingent purchase price dispute with two former shareholders of IP Metrics. (3) PROPERTY AND EQUIPMENT Property and equipment consist of the following: December 31, December 31, 2006 2005 -------------------------------- Computer hardware and software $ 14,845,319 $ 11,410,607 Furniture and equipment 511,184 501,861 Leasehold improvements 812,586 502,895 Automobile 13,008 13,008 ------------ ------------ 16,182,097 12,428,371 Less accumulated depreciation (10,221,780) (7,150,762) ------------ ------------ $ 5,960,317 $ 5,277,609 ============ ============ Depreciation expense was $3,071,018, $2,452,737, and $2,041,592 in 2006, 2005, and 2004, respectively. 47 (4) MARKETABLE SECURITIES The Company's investments consist of available-for-sale securities, which are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Unrealized gains and losses are computed on the specific identification method. Realized gains, realized losses and declines in value judged to be other-than-temporary, are included in interest and other income, net. The cost of available-for-sale securities sold are based on the specific identification method and interest earned is included in interest and other income. The cost and fair values of the Company's available-for-sale marketable securities as of December 31, 2006, are as follows: Aggregate Cost Unrealized Unrealized Fair Value Basis Gains Losses ----------- ----------- ----------- ----------- Auction rate securities $10,900,000 $10,900,000 $ -- $ -- Government securities 12,956,804 12,978,952 -- 22,148 Corporate bonds 997,455 998,789 -- 1,334 Certificate of deposit 500,000 500,000 -- -- ----------- ----------- ----------- ----------- $25,354,259 $25,377,741 $ -- $ 23,482 =========== =========== =========== =========== As of December 31, 2006 there are two corporate bonds and twelve government securities that are in an unrealized loss position. Based on the credit ratings of these securities and the timing of their respective maturities, there is no reason to believe the Company will be unable to collect all amounts due according to the contractual terms of these securities. Unrealized losses on the Company's available-for-sales securities have not been determined to be other-than-temporary due principally to the Company's intent and ability to hold these securities for a period of time sufficient to recover the value of the investments. The cost and fair values of the Company's available-for-sale marketable securities as of December 31, 2005, are as follows: Aggregate Cost Unrealized Unrealized Fair Value Basis Gains Losses ----------- ----------- ----------- ----------- Auction rate securities $10,098,031 $10,098,031 $ -- $ -- Government securities 6,394,262 6,431,432 -- 37,170 Corporate bonds 1,341,390 1,353,503 -- 12,113 ----------- ----------- ----------- ----------- $17,833,683 $17,882,966 $ -- $ 49,283 =========== =========== =========== =========== The cost basis and fair value of available-for-sale securities by contractual maturity as of December 31, 2006, were as follows: Fair Cost Value ----------- ----------- Due within one year $23,328,950 $23,308,021 Due between one and two years 2,048,791 2,046,238 ----------- ----------- $25,377,741 $25,354,259 =========== =========== (5) ACCRUED EXPENSES Accrued expenses are comprised of the following: 48 December 31, December 31, 2006 2005 ---------------------------- Accrued compensation $ 2,267,222 $ 1,517,115 Accrued consulting and professional fees 606,702 598,674 Accrued marketing and promotion 220,419 229,675 Other accrued expenses 1,052,536 1,245,873 Accrued income taxes 247,376 24,000 Accrued other taxes 256,989 295,119 Accrued litigation settlement fee 1,100,000 -- Accrued hardware purchases 314,101 38,946 Accrued and deferred rent 440,191 497,157 ------------ ------------ $ 6,505,536 $ 4,446,559 ============ ============ 6) INCOME TAXES The provision for income taxes for the years ended December 31, 2006 and 2005 is comprised of Federal Alternative Minimum Tax, state income taxes and foreign income taxes. The tax effects of temporary differences that give rise to the Company's deferred tax assets (liabilities) as of December 31, 2006 and 2005 are as follows: 2006 2005 ------------ ------------ U.S. Federal net operating loss carryforwards (FalconStor) $ 7,420,767 $ 11,123,022 U.S. Federal net operating loss carryforwards (NPI) 31,711,302 31,711,302 Foreign net operating loss carryforwards 1,484,416 941,369 State net operating loss carryforwards 722,234 1,065,636 Start-up costs not currently deductible for taxes -- 90,100 Depreciation (37,943) (358,207) Compensation 375,922 348,562 Tax credit carryforwards 2,421,810 1,866,248 Alternative minimum tax carryforward 222,684 23,007 Deferred revenue 1,056,016 650,555 Capital loss carryforward 850,134 847,901 Lease abandonment charge 34,369 77,327 Allowance for receivables 2,258,062 1,440,036 Patent 189,889 99,194 Other 8,065 11,636 Share-based payment compensation 1,529,144 -- ------------ ------------ 50,246,871 49,937,688 Valuation allowance (50,246,871) (49,937,688) ------------ ------------ $ -- $ -- ============ ============ The difference between the provision for income taxes computed at the Federal statutory rate and the reported amount of tax expense attributable to income (loss) before income taxes for the years ended December 31, 2006, 2005 and 2004, are as follows: 49 2006 2005 2004 ----------- ----------- ----------- Tax at Federal statutory rate $(1,066,688) $ 820,031 $(1,991,300) Increase (reduction) in income taxes resulting from: State and local taxes, net of Federal income tax benefit 62,711 885,733 809,345 Non-deductible expenses 355,144 302,207 47,600 Compensation -- -- 2,700 Share-based payment compensation 1,170,364 -- -- Foreign tax credit -- -- (6,100) Net effect of foreign operations 36,279 128,150 164,800 Research and development credit (568,520) (433,013) (360,100) AMT tax 199,677 23,007 -- Change in valuation allowance 129,506 (1,607,365) 1,365,000 ----------- ----------- ----------- $ 318,473 $ 118,750 $ 31,945 =========== =========== =========== 2006 2005 2004 -------- -------- -------- Federal $239,411 $ 55,887 $ -- State and local 22,862 1,113 -- Foreign 56,200 61,750 31,945 -------- -------- -------- $318,473 $118,750 $ 31,945 ======== ======== ======== Income (loss) before provision for income taxes for the years ended December 31, 2006, 2005 and 2004 are as follows: 2006 2005 2004 ----------- ----------- ----------- Domestic income (loss) $(1,599,446) $ 4,390,212 $(5,465,902) Foreign loss (1,456,609) (1,978,355) (391,000) ----------- ----------- ----------- $(3,056,055) $ 2,411,857 $(5,856,902) =========== =========== =========== As of December 31, 2006, the Company had U.S. Federal net operating loss carryforwards of approximately $21,825,800 which expire from 2020 through 2025. In August 2001, the Company was a party to a reverse merger with Network Peripherals, Inc. ("NPI"). As of the date of the merger, NPI had U.S. Federal net operating loss carryforwards of $93,268,500 that start to expire in December, 2012. As of December 31, 2006, the Company had state net operating loss carryforwards of approximately $13,657,200 which expire from 2007 through 2025. As of December 31, 2006, the Company had foreign net operating loss carryforwards of approximately $4,719,700. At December 31, 2006 and 2005, the Company established a valuation allowance to reduce its deferred tax assets to an amount that is more-likely-than-not realizable due to the Company's prior history of pre-tax losses and uncertainty about the timing of and ability to generate taxable income in the future. Due to the Company's various equity transactions, which resulted in a change of control, the utilization of certain tax loss carryforwards is subject to annual limitations imposed by Internal Revenue Code Section 382. NPI experienced such an ownership change as a result of the merger. As such, the Company's ability to use its NOL carryforwards to offset taxable income in the future may be significantly limited. If the entire deferred tax asset were realized, $4,631,900 would be allocated to paid-in-capital with the remainder reducing income tax expense. Of the amount allocable to paid-in-capital, $2,340,600 relates to the tax effect of the deductions for payments of liabilities of discontinued operations in connection with the reverse merger and the remainder of $2,291,300 relates to the tax effects of excess compensation deductions from exercises of employee and consultant stock options. In determining the period in which related tax benefits are realized for book purposes, excess share-based payment deductions and deduction from discontinued operations included in net operating losses are realized after regular net operating losses are exhausted. (7) STOCKHOLDERS' EQUITY In September, 2003 the Company entered into a worldwide OEM agreement with a major technology company (the "OEM"), and granted 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 50 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. Through December 31, 2006, the Company had not generated any revenues from this OEM and accordingly no warrants had vested. (8) SHARE-BASED PAYMENT ARRANGEMENTS As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000 Stock Option Plan (the "2000 Plan"). The 2000 Plan is administered by the Compensation Committee of the Board of Directors and, as amended, 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. ISOs granted must have exercise prices 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. Non-qualified options granted must have exercise prices not 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. All options granted under the 2000 Plan must be granted before May 1, 2010. 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 $32,860 and $87,023 in 2005 and 2004, respectively. These services were completed as of December 31, 2005. On May 14, 2004, the Company adopted the FalconStor Software, Inc. 2004 Outside Directors Stock Option Plan (the "2004 Plan"). The 2004 Plan is administered by the Compensation Committee of 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. On May 17, 2006, the Company adopted the FalconStor Software, Inc. 2006 Incentive Stock Plan (the "2006 Plan"). The 2006 Plan is administered by the Compensation Committee of the Board of Directors and provides for the grant of incentive and nonqualified stock options, and restricted stock, to employees, officers, consultants and advisors of the Company. A maximum of 1,500,000 of the authorized but unissued or treasury shares of the common stock of the Company may be issued upon the grant of restricted stock or upon the exercise of options granted under the 2006 Plan. 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 not greater than ten years. All options and shares of restricted stock granted under the 2006 Plan must be granted within ten years of the adoption of the 2006 Plan. A summary of the Company's stock option activity for 2006 is as follows: 51 Weighted Weighted Average Average Remaining Aggregate Number of Exercise Contractual Intrinsic Options Price Life (Years) Value ------------ ------------ ------------ ------------ Options Outstanding at December 31, 2005 10,062,745 $ 5.29 ============ ============ Granted 2,086,150 $ 7.26 Exercised (643,925) $ 3.88 Canceled (668,995) $ 7.45 ------------ ------------ Options Outstanding at December 31, 2006 10,835,975 $ 5.62 6.55 $ 33,360,990 ============ ============ ============ ============ Options Exercisable at December 31, 2006 7,530,233 $ 4.89 5.62 $ 28,695,438 ============ ============ ============ ============ Options Expected to Vest at December 31, 2006 3,001,271 $ 7.25 8.72 $ 4,199,665 ------------ ------------ ------------ ------------ Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the years ended December 31, 2006, 2005 and 2004 was $2,501,156, $1,942,540 and $2,031,903, respectively. The total intrinsic value of stock options exercised during the year ended December 31, 2006, was $2,697,850. The Company realized 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: Year Ended December 31, 2006 ---------- Cost of maintenance software services and other revenue $1,342,970 Software development costs 4,331,902 Selling and marketing 2,803,585 General and administrative 914,697 ---------- $9,393,154 ========== The Company recognized $45,895 of tax benefits related to share-based payment compensation during the year ended December 31, 2006. In 2006, the Company granted options to purchase an aggregate of 25,000 shares of common stock to certain non-employee consultants in exchange for professional services. The aggregate fair value of these options as determined using the Black-Scholes method, $161,230 as of December 31, 2006, is being expensed over the periods the services are provided. The related expense amounted to $17,914 during the year ended December 31, 2006. In 2006, the Company granted 225,000 shares of restricted stock at an average fair value per share at date of grant of $7.06 per share. There were no restricted shares issued or outstanding as of December 31, 2005. As of December 31, 2006 no restricted shares have been vested or forfeited. 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 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. 52 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 years ended December 31, 2005 and 2004 would have been: Year Ended Year Ended December 30, December 31, 2005 2004 ------------ ------------ Net Income (loss) as reported $ 2,293,107 $ (5,888,847) Add share-based payment compensation expense included in reported net income (loss), net of tax $ -- $ 7,969 Deduct total share-based payment compensation expense determined under fair-value-based method, net of tax $ (8,565,701) $ (8,268,471) ------------ ------------ Net loss - pro forma $ (6,272,594) $(14,149,349) ============ ============ Basic and diluted net income (loss) per common share-as reported $ 0.05 $ (0.13) Basic and diluted net loss per common share-pro forma $ (0.13) $ (0.30) 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 with graded vesting, based on the value of the entire award. The Company allocates the fair value of all awards on a straight-line basis over the 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 year ended December 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 years ended December 31, 2006, 2005 and 2004 was $4.32, $4.52 and $6.55, 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: Year ended December 31, 2006 2005 2004 ---- ---- ---- Expected dividend yield 0% 0% 0% Expected volatility 57 - 60% 61 - 65% 166 - 176% Risk-free interest rate 4.4 - 5.1% 3.7 - 4.6% 3.5% Expected term (years) 6 6 5 Discount for post-vesting N/A N/A N/A restrictions 53 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 volatility of the Company's stock and other factors, if applicable. The risk-free interest rate is based on the United States 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. As of December 31, 2006, there was approximately $11,433,934 of total unrecognized compensation cost related to the Company's unvested options and restricted shares granted under the Company's stock plans. The unrecognized compensation cost is expected to be recognized over a weighted-average period of 2.23 years. As of December 31, 2006, the Company has 12,605,548 shares of common stock reserved for issuance upon the exercise of options, restricted shares and warrants. (9) LITIGATION SETTLEMENT CHARGES In January 2007, we resolved claims brought against us by two former shareholders of IP Metrics, Inc. ("IP Metrics"). When we purchased IP Metrics in July 2002, part of the contractual consideration was payments to be made in 2003 and 2004 to the former IP Metrics shareholders based on sales of IP Metrics products, and/or payments to be made if certain events occurred. We made payments to all four former shareholders in 2003 and 2004. Two of the former shareholders alleged that they were entitled to additional payments based on the alleged occurrence of certain contingent events and they brought an action against us. This action was resolved in January, 2007 without any admission of liability, by the payment of an additional $0.8 million to the two former shareholders. This amount was recorded as an operating expense as of December 31, 2006. All claims in the lawsuit have now been dismissed. During the third quarter of 2004, the Company resolved claims relating to alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill") and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company. Pursuant to the terms of the Settlement Agreement between the Company and Crossroads, the Company, without admission of infringement, made a one-time payment of $1.3 million and granted to Crossroads licenses to certain Company technology in exchange for a worldwide, perpetual license to the technology underlying the Crossroads patents at issue in the litigation. All claims against the Company by both Dot Hill and Crossroads were dismissed. (10) COMMITMENTS AND CONTINGENCIES The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2007 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2006: Year Ending December 31, 2007.............................................................. $1,875,673 2008.............................................................. 1,372,384 2009.............................................................. 1,365,163 2010.............................................................. 1,331,877 2011.............................................................. 1,367,538 Thereafter........................................................ 708,120 ---------- $8,020,755 ========== 54 These leases require the Company to pay its proportionate share of real estate taxes and other common charges. Total rent expense for operating leases was $1,945,991, $1,461,051, and $1,103,008 for the years ended December 31, 2006, 2005 and 2004, respectively. The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with SFAS No. 5, ACCOUNTING FOR CONTINGENCIES. To date, the Company has not incurred any costs related to warranty obligations. Under the terms of substantially all of its software license agreements, the Company has agreed to indemnify its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company's software infringes the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with SFAS No. 5. Except for the alleged patent infringement claim discussed in note 9, through December 31, 2006, there have not been any claims under such indemnification provisions. The Company is subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, the Company believes that such matters will not have a material adverse effect on its financial condition or liquidity. The Company expenses legal costs related to contingencies when incurred. In November, 2005, the Company entered into a second Amended and Restated Employment Agreement ("Employment Agreement") with ReiJane Huai. Pursuant to the Employment Agreement, the Company agreed to employ Mr. Huai as President and Chief Executive Officer of the Company until December 31, 2007, at an annual salary of $275,000. The Employment Agreement also provides for the payment of annual bonuses to Mr. Huai based on the Company's operating income (as defined) and for certain other contingent benefits set forth in the Employment Agreement. On December 1, 2005, the Company adopted the 2005 FalconStor Software, Inc., Key Executive Severance Protection Plan ("Severance Plan"). Pursuant to the Severance Plan, the Company's Chief Financial Officer and certain other key executives are entitled to receive certain contingent benefits, as set forth in the Severance Plan, including lump sum payments and acceleration of stock option vesting, each in certain circumstances. (11) EMPLOYEE BENEFIT PLANS DEFINED CONTRIBUTION PLAN Effective July 2002, the Company established a voluntary savings and defined contribution plan (the "Plan") under Section 401(k) of the Internal Revenue Code. This Plan covers all U.S. employees meeting certain eligibility requirements and allows participants to contribute a portion of their annual compensation. Employees are 100% vested in their own contributions. For the years ended December 31, 2006, 2005 and 2004, the Company did not make any contributions to the Plan. DEFINED BENEFIT PLAN The Company has a defined benefit plan covering employees in Taiwan. On December 31, 2006, the Company adopted the provisions of FASB statement No. 158, EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS, AN AMENDMENT OF FASB STATEMENTS NO. 87, 88, 106, AND 132(R) ("SFAS No. 158"), which required the Company to recognize the funded status of its defined benefit plan in the accompanying consolidated balance sheet at December 31, 2006, with the corresponding adjustment to accumulated other comprehensive income, net of tax. Therefore, as a result of adopting the provisions of SFAS No. 158, the Company increased other non-current liabilities and accumulated other comprehensive income by $87,482 as of December 31, 2006. The adjustment to accumulated other comprehensive income upon adoption represents the net unrecognized actuarial losses, which were previously netted against the funded 55 status in the Company's consolidated balance sheet in accordance with the provision of SFAS No. 87. These amounts will be recognized subsequently as net periodic pension cost. Actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income and will be recognized subsequently as a component of net periodic pension cost on the same basis as the amounts recognized in accumulated other comprehensive income upon adoption of SFAS No. 158. Included in accumulated other comprehensive loss at December 31, 2006 are the following amounts, net of tax, that have not yet been recognized in net periodic pension cost: unrecognized transition obligation of $63,120, and unrecognized actuarial losses of $24,362. The transition obligation and actuarial loss included in accumulated other comprehensive loss and expected to be recognized in net periodic pension cost for the year ended December 31, 2007, is $5,260 and $740, respectively. Pension information for the year ended December 31, 2006 is as follows: Accumulated benefit obligation $108,418 ======== Changes in projected benefit obligation: Projected benefit obligation at beginning of year 120,457 Interest cost 4,216 Actuarial (gain)/loss 31,320 Benefits paid -- Service cost 1,129 -------- Projected benefit obligation at end of year $157,122 ======== Changes in plan assets: Fair value of plan assets at beginning of year 5,780 Actual return on plan assets 28 Benefits paid -- Employer contributions 13,763 -------- Fair value of plan assets at end of year $ 19,571 ======== Funded status $137,551 ======== Components of net periodic pension cost: Interest cost $ 4,253 Expected return on plan assets 204 Amortization of net loss 5,306 Service cost 1,139 -------- Net periodic pension cost $ 10,902 ======== The company makes contributions to the plan so that minimum contribution requirements, as determined by government regulations, are met. The Company does not anticipate a contribution to this plan in 2007. Benefit payments of approximately $58,000 are expected to be paid in 2012 through 2016. (12) STOCK REPURCHASE PROGRAM On October 25, 2001, the Company announced that its Board of Directors authorized the repurchase of up to two million shares of the Company's outstanding common stock. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company's management. The terms of the stock repurchases will be determined by management based on market conditions. During the year ended December 31, 2006, the Company purchased 315,600 shares of its common stock in open market purchases for a total cost of $2,147,233. As of December 31, 2006, the Company had repurchased a total of 865,200 shares for $5,780,163. 56 (13) SEGMENT REPORTING AND CONCENTRATIONS The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the years ended December 31, 2006, 2005 and 2004, and the location of long-lived assets as of December 31, 2006, 2005 and 2004, are summarized as follows: 2006 2005 2004 ----------------------------------------- Revenues: United States $37,461,247 $28,300,822 $18,140,465 Asia 8,352,382 6,535,128 5,821,902 Other international 9,252,399 6,128,153 4,746,311 ----------- ----------- ----------- Total Revenues $55,066,028 $40,964,103 $28,708,678 =========== =========== =========== Long-lived assets (includes all non-current assets): United States $10,113,633 $ 9,716,031 $ 9,929,214 Asia 1,498,534 1,320,865 950,387 Other international 279,695 207,098 322,544 ----------- ----------- ----------- Total long-lived assets $11,891,862 $11,243,994 $11,202,145 =========== =========== =========== For the year ended December 31, 2006, the Company had one customer that accounted for a total of 27% of revenues. For the year ended December 31, 2005, the Company had two customers that together accounted for a total of 31% of revenues. For the year ended December 31, 2004, the Company had one customer that accounted for 16% of revenues. As of December 31, 2006, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 30% of the accounts receivable balance. As of December 31, 2005, the Company had two customers with accounts receivable balances greater than 5% of gross accounts receivable, which in the aggregate were 28% of the accounts receivable balance. (14) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL ACCOUNTS Balance at Balance at Beginning of Additions charged End of Period ended Period To Expense Deductions Period - ----------------- ---------- ---------- ---------- ---------- December 31, 2006 $3,846,882 $4,765,148 $2,595,732 $6,016,298 December 31, 2005 $2,551,616 $4,340,102 $3,044,836 $3,846,882 December 31, 2004 $1,837,934 $3,296,275 $2,582,593 $2,551,616 57 (15) QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of selected quarterly financial data for the years ended December 31, 2006 and 2005: Fiscal Quarter First Second Third Fourth - ------------------------ ------------ ------------ ------------ ------------ 2006 Revenue $ 9,208,320 $ 12,668,227 $ 12,966,111 $ 20,223,370 ============ ============ ============ ============ Net income (loss) $ (3,636,886) $ (1,304,795) $ (1,258,371) $ 2,825,524 ============ ============ ============ ============ Basic net income (loss) per share $ (0.08) $ (0.03) $ (0.03) $ 0.06 ============ ============ ============ ============ Diluted net income (loss) per share $ (0.08) $ (0.03) $ (0.03) $ 0.06 ============ ============ ============ ============ Basic weighted average common shares outstanding 48,006,309 48,047,291 47,990,558 48,134,809 ============ ============ ============ ============ Diluted weighted average common shares outstanding 48,006,309 48,047,291 47,990,558 50,370,514 ============ ============ ============ ============ 2005 Revenue $ 8,392,036 $ 9,495,587 $ 10,056,665 $ 13,019,815 ============ ============ ============ ============ Net income (loss) (a) $ (133,829) $ 288,105 $ 482,879 $ 1,655,952 ============ ============ ============ ============ Basic net income (loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03 ============ ============ ============ ============ Diluted net income (loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03 ============ ============ ============ ============ Basic weighted average common shares outstanding 47,528,874 47,594,072 47,720,496 47,802,694 ============ ============ ============ ============ Diluted weighted average common shares outstanding 47,528,874 50,623,983 50,531,012 50,958,553 ============ ============ ============ ============ (a) Net income for the year ended December 31, 2005, includes an out-of-period charge of approximately $0.2 million to recognize investment losses realized in prior years. Such charge was not considered material to any period. The sum of the quarterly net loss per share amounts do not always equal the annual amount reported, as per share amounts are computed independently for each quarter and the annual period based on the weighted average common shares outstanding in each such period. 58 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES The Company maintains "disclosure controls and procedures," as such term is defined in Rules 13a-15e and 15d-15e of the Securities and Exchange Act of 1934, as amended (the "Exchange Act"), that are designed to ensure that information required to be disclosed in its reports, pursuant to the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to its management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding the required disclosures. In designing and evaluating the disclosure controls and procedures, management has recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. The Company's Chief Executive Officer (its principal executive officer) and Chief Financial Officer (its principal finance officer and principal accounting officer) have evaluated the effectiveness of its "disclosure controls and procedures" as of the end of the period covered by this Annual Report on Form 10-K. Based on their evaluation, the principal executive officer and principal financial officer concluded that its disclosure controls and procedures are effective. INTERNAL CONTROL OVER FINANCIAL REPORTING MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. To evaluate the effectiveness of the Company's internal control over financial reporting, the Company's management uses the Integrated Framework adopted by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). The Company's management has assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2006, using the COSO framework. The Company's management has determined that the Company's internal control over financial reporting is effective as of that date. KPMG LLP, the registered public accounting firm that has audited the Company's consolidated financial statements included in this report, has issued their attestation report on management's assessment of the Company's internal control over financial reporting, which is included herein. ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information called for by Part III, Item 10, regarding the Registrant's directors will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2007, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions "Election of Directors", "Management", "Executive Compensation", "Section 16 (a) Beneficial Ownership Reporting Compliance", and "Committees of the Board of Directors." The Proxy Statement will be filed within 120 days of December 31, 2006, our year-end. 59 ITEM 11. EXECUTIVE COMPENSATION Information called for by Part III, Item 11, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2007, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions "Executive Compensation", "Director Compensation", "Compensation Committee Interlocks and Insider Participation", Compensation Committee Report" and "Committees of the Board of Directors." The Proxy Statement will be filed within 120 days of December 31, 2006, our year-end. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding Securities Authorized for Issuance Under Equity Compensation Plans is included in Item 5 and is incorporated herein by reference. All other information called for by Part III, Item 12, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2007, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Beneficial Ownership of Shares." The Proxy Statement will be filed within 120 days of December 31, 2006, our year-end. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding our relationships and related transactions will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2007, and is incorporated by reference. The information appears in the Proxy Statement under the caption "Certain Relationships and Related Transactions." The Proxy Statement will be filed within 120 days of December 31, 2006, our year-end. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information called for by Part III, Item 14, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2007, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Principal Accountant Fees and Services." The Proxy Statement will be filed within 120 days of December 31, 2006, our year-end. 60 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES The information required by subsections (a)(1) and (a)(2) of this item are included in the response to Item 8 of Part II of this annual report on Form 10-K. (b) Exhibits 2.1 Agreement and Plan of Merger and Reorganization, dated as of May 4, 2001, among FalconStor, Inc., Network Peripherals Inc., and Empire Acquisition Corp, incorporated herein by reference to Annex A to the Registrant's joint proxy/prospectus on Form S-4, filed May 11, 2001. 3.1 Restated Certificate of Incorporation, incorporated herein by reference to Exhibit 3.1 to the Registrant's registration statement on Form S-1 (File no. 33-79350), filed on April 28, 1994. 3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the Registrant's quarterly report on form 10-Q for the period ended March 31, 2000, filed on May 10, 2000. 3.3 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.3 to the Registrant's annual report on Form 10-K for the year ended December 31, 1998, filed on March 22, 1999. 3.4 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.4 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002. 4.1 2000 Stock Option Plan, incorporated herein by reference to Exhibit 4.1 of the Registrant's registration statement on Form S-8, filed on September 21, 2001. 4.2 2000 Stock Option Plan, as amended May 15, 2003, incorporated herein by reference to Exhibit 99 to the Registrant's quarterly report on Form 10-Q for the period ended June 30, 2003, filed on August 14, 2003. 4.3 2000 Stock Option Plan, as amended May 14, 2004, incorporated herein by reference to Exhibit 4.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2004, filed on March 16, 2005. 4.4 1994 Outside Directors Stock Plan, as amended May 17, 2002 incorporated herein by reference to Exhibit 4.2 to the Registrant's annual report on Form 10-K for the year ended December 31, 2002, filed on March 17, 2003. 4.5 2004 Outside Directors Stock Option Plan, incorporated herein by reference to Exhibit 4.5 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2004, filed on March 16, 2005. 4.6 2006 Incentive Stock Plan incorporated herein by reference to Exhibit 99.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2006, filed on August 8, 2006. 10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and FalconStor Software, Inc., dated August, 2003, incorporated herein by reference to Exhibit 99.1 to the Registrant's quarterly report on Form 10-Q for the period ended September 30, 2003, filed on November 14, 2003. 61 10.2 Second Amended and Restated Employment Agreement, dated November 7, 2005 between Registrant and ReiJane Huai, incorporated herein by reference to Exhibit 10.1 to the Registrant's quarterly report on Form 10-Q for the period ended September 30, 2005, filed on November 8, 2005. 10.3 Amended and Restated FalconStor Software, Inc., 2005 Key Executive Severance Protection Plan, incorporated herein by reference to Exhibit 10.3 to Registrant's annual report on Form 10-K for the year ended December 31, 2005, filed on March 15, 2006. 21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC, Inc., FalconStor Software (Korea), Inc. 23.1 *Consent of KPMG LLP 31.1 *Certification of the Chief Executive Officer 31.2 *Certification of the Chief Financial Officer 32.1 *Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) 32.2 *Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) *- filed herewith. 62 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has signed this report by the undersigned, thereunto duly authorized in Melville, State of New York on March 15, 2006. FALCONSTOR SOFTWARE, INC. By: /S/ REIJANE HUAI Date: March 14, 2007 --------------------------------------------- ReiJane Huai, President, Chief Executive Officer of FalconStor Software, Inc. POWER OF ATTORNEY FalconStor Software, Inc. and each of the undersigned do hereby appoint ReiJane Huai and James Weber, and each of them severally, its or his true and lawful attorney to execute on behalf of FalconStor Software, Inc. and the undersigned any and all amendments to this Annual Report on Form 10-K and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission; each of such attorneys shall have the power to act hereunder with or without the other. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By: /S/ Reijane Huai March 14, 2007 --------------------------------------------- ------------------------- Reijane Huai, President, Chief Executive Date Officer and Chairman of the Board (Principal Executive Officer) By: /S/ James Weber March 14, 2007 ------------------------------------------- ------------------------- James Weber, Chief Financial Officer, Date Vice President and Treasurer (Principal Financial Officer and Principal Accounting Officer) By: /S/ Steven L. Bock March 14, 2007 ------------------------------------------- ------------------------- Steven L. Bock, Director Date By: /S/ Patrick B. Carney March 14, 2007 ------------------------------------------- ------------------------- Patrick B. Carney, Director Date By: /S/ Lawrence S. Dolin March 14, 2007 ------------------------------------------- ------------------------- Lawrence S. Dolin, Director Date By: /S/ Steven R. Fischer March 14, 2007 ------------------------------------------- ------------------------- Steven R. Fischer, Director Date By: /S/ Alan W. Kaufman March 14, 2007 ------------------------------------------- ------------------------- Alan W. Kaufman, Director Date 63
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10-K Filing
Falconstor Software (FALC) 10-K2006 FY Annual report
Filed: 15 Mar 07, 12:00am