UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2007 -------------------------------------------- | | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________________ to _______________________ COMMISSION FILE NUMBER 0-23970 FALCONSTOR SOFTWARE, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0216135 (State of Incorporation) (I.R.S. Employer Identification No.) 2 HUNTINGTON QUADRANGLE MELVILLE, NEW YORK 11747 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: 631-777-5188 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large Accelerated Filer |_| Accelerated Filer |X| Non-Accelerated Filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| The number of shares of Common Stock issued and outstanding as of July 25, 2007 was 50,527,050 and 49,661,850. 1FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES FORM 10-Q INDEX Page PART I. Financial Information 3 Item 1. Condensed Consolidated Financial Statements 3 Condensed Consolidated Balance Sheets at June 30, 2007 (unaudited) and December 31, 2006 3 Unaudited Condensed Consolidated Statements of Operations for the Three and six months ended June 30, 2007 and 2006 4 Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006 5 Notes to the Unaudited Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Item 3. Qualitative and Quantitative Disclosures about Market Risk 25 Item 4. Controls and Procedures 25 PART II. Other Information 26 Item 1. Legal Proceedings 26 Item 1A. Risk Factors 26 Item 4. Submission of Matters to a Vote of Security Holders 28 Item 5. Other Information 28 Item 6. Exhibits 29 2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS June 30, 2007 December 31, 2006 ------------- ----------------- ASSETS (unaudited) Current assets: Cash and cash equivalents ...................................... $ 26,225,644 $ 15,605,329 Marketable securities .......................................... 29,931,899 25,354,259 Accounts receivable, net of allowances of $7,185,360 and $6,016,298, respectively...................................... 20,506,847 24,134,257 Prepaid expenses and other current assets ...................... 2,044,561 1,244,937 ------------- ------------- Total current assets ....................................... 78,708,951 66,338,782 Property and equipment, net of accumulated depreciation of $11,879,963 and $10,221,780, respectively ..................... 7,107,128 5,960,317 Goodwill ......................................................... 3,512,796 3,512,796 Other intangible assets, net ..................................... 380,169 407,316 Other assets ..................................................... 2,028,606 2,011,433 ------------- ------------- Total assets ............................................... $ 91,737,650 $ 78,230,644 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ............................................... $ 1,700,825 $ 1,432,510 Accrued expenses ............................................... 5,288,812 6,505,536 Deferred revenue ............................................... 14,116,551 11,466,552 ------------- ------------- Total current liabilities ........................... 21,106,188 19,404,598 Other long-term liabilities ...................................... 133,184 137,317 Deferred revenue ................................................. 4,030,451 3,645,482 ------------- ------------- Total liabilities ................................... 25,269,823 23,187,397 Commitments and contingencies Stockholders' equity: Convertible preferred stock - $.001 par value, 2,000,000 shares authorized ............................................ -- -- Common stock - $.001 par value, 100,000,000 shares authorized, 50,480,810 and 49,085,539 shares issued, respectively and 49,615,610 and 48,220,339 shares outstanding, respectively .................................... 50,481 49,086 Additional paid-in capital ..................................... 109,983,633 99,282,308 Accumulated deficit ............................................ (37,208,864) (38,033,857) Common stock held in treasury, at cost (865,200 shares at both June 30, 2007 and December 31, 2006 ) ......... (5,780,163) (5,780,163) Accumulated other comprehensive loss, net ...................... (577,260) (474,127) ------------- ------------- Total stockholders' equity ................................. 66,467,827 55,043,247 ------------- ------------- Total liabilities and stockholders' equity ................. $ 91,737,650 $ 78,230,644 ============= ============= See accompanying notes to unaudited condensed consolidated financial statements. 3 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended June 30, Six Months Ended June 30, ------------------------------ ------------------------------ 2007 2006 2007 2006 ------------ ------------ ------------ ------------ Revenues: Software license revenue ................................... $ 11,980,480 $ 8,726,021 $ 22,417,985 $ 14,402,710 Maintenance revenue ........................................ 4,535,780 2,908,514 8,869,319 5,499,517 Software services and other revenue ........................ 1,234,284 1,033,692 2,803,918 1,974,320 ------------ ------------ ------------ ------------ 17,750,544 12,668,227 34,091,222 21,876,547 ------------ ------------ ------------ ------------ Operating expenses: Amortization of purchased and capitalized software .............................................. 24,286 101,333 49,822 253,055 Cost of maintenance, software services and other revenue ............................................... 2,462,050 2,320,065 5,206,338 4,304,662 Software development costs .............................. 5,341,481 4,905,137 10,857,666 9,512,240 Selling and marketing ................................... 7,500,433 5,686,742 14,469,184 10,590,747 General and administrative .............................. 1,922,723 1,390,140 3,860,503 2,711,434 ------------ ------------ ------------ ------------ 17,250,973 14,403,417 34,443,513 27,372,138 ------------ ------------ ------------ ------------ Operating income (loss) ............................. 499,571 (1,735,190) (352,291) (5,495,591) ------------ ------------ ------------ ------------ Interest and other income, net ............................. 594,376 384,009 1,093,747 670,660 ------------ ------------ ------------ ------------ Income (loss) before income taxes ................... 1,093,947 (1,351,181) 741,456 (4,824,931) Provision (benefit) for income taxes ....................... (285,621) (46,386) (83,537) 116,750 ------------ ------------ ------------ ------------ Net income (loss) ................................... $ 1,379,568 $ (1,304,795) $ 824,993 $ (4,941,681) ------------ ------------ ------------ ------------ Basic net income (loss) per share .......................... $ 0.03 $ (0.03) $ 0.02 $ (0.10) ============ ============ ============ ============ Diluted net income (loss) per share ........................ $ 0.03 $ (0.03) $ 0.02 $ (0.10) ============ ============ ============ ============ Weighted average basic shares outstanding ............................................. 49,378,812 48,047,291 48,988,778 48,026,914 ============ ============ ============ ============ Weighted average diluted shares outstanding ............................................. 53,007,181 48,047,291 50,802,963 48,026,914 ============ ============ ============ ============ See accompanying notes to unaudited condensed consolidated financial statements. 4 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Six Months Ended June 30, 2007 2006 ------------ ------------ Cash flows from operating activities: Net income (loss) ........................................................... $ 824,993 $ (4,941,681) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization ........................................... 1,813,510 1,828,762 Share-based payment compensation ........................................ 4,128,106 4,660,622 Loss on marketable securities ........................................... -- 28,855 Loss on foreign currency exchange ....................................... -- 41,670 Tax benefit from stock option exercises ................................. -- (10,467) Provision for returns and doubtful accounts ............................. 2,382,410 1,917,634 Changes in operating assets and liabilities: Accounts receivable ..................................................... 1,247,952 538,581 Prepaid expenses and other current assets ............................... (798,235) (89,291) Other assets ............................................................ (16,823) (134,275) Accounts payable ........................................................ 246,209 (24,756) Accrued expenses ........................................................ (1,278,200) 141,179 Deferred revenue ........................................................ 3,025,123 1,483,756 ------------ ------------ Net cash provided by operating activities ............................ 11,575,045 5,440,589 ------------ ------------ Cash flows from investing activities: Sale of marketable securities ............................................... 42,494,822 35,377,326 Purchase of marketable securities ........................................... (47,053,285) (43,209,250) Purchase of property and equipment .......................................... (2,797,221) (1,703,124) Purchase of software licenses ............................................... (15,000) (168,000) Purchase of intangible assets ............................................... (81,614) (121,533) ------------ ------------ Net cash used in investing activities ..................................... (7,452,298) (9,824,581) ------------ ------------ Cash flows from financing activities: Proceeds from exercise of stock options ..................................... 6,574,614 1,100,272 Payments made to acquire treasury stock ..................................... -- (1,671,572) Tax benefit from stock option exercises ..................................... -- 10,467 ------------ ------------ Net cash provided by (used in) financing activities ....................... 6,574,614 (560,833) ------------ ------------ Effect of exchange rate changes on cash and cash equivalents ................... (77,046) 59,332 ------------ ------------ Net increase (decrease) in cash and cash equivalents ........................... 10,620,315 (4,885,493) Cash and cash equivalents, beginning of period ................................. 15,605,329 18,796,973 ------------ ------------ Cash and cash equivalents, end of period ....................................... $ 26,225,644 $ 13,911,480 ============ ============ Cash paid for income taxes ..................................................... $ 264,213 $ 25,000 ============ ============ The Company did not pay any interest for the six months ended June 30, 2007 and 2006. See accompanying notes to unaudited condensed consolidated financial statements. 5 FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) THE COMPANY AND NATURE OF OPERATIONS FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures and sells network storage software solutions and provides the related maintenance, implementation and engineering services. (b) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (c) 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 more significant estimates include those related to revenue recognition, accounts receivable allowances, deferred income taxes and accounting for share-based compensation expense. Actual results could differ from those estimates. (d) UNAUDITED INTERIM FINANCIAL INFORMATION The accompanying unaudited interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements. In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at June 30, 2007, and the results of its operations for the three and six months ended June 30, 2007 and 2006. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year. (e) CASH EQUIVALENTS AND MARKETABLE SECURITIES The Company considers all highly liquid investments with 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 $13.7 million and $11.0 million at June 30, 2007 and December 31, 2006, respectively. Marketable securities at June 30, 2007 and December 31, 2006 amounted to $29.9 million and $25.4 million, respectively, and consisted of corporate bonds and government securities, which are classified as available-for-sale, and accordingly, unrealized gains and losses on marketable securities are reflected as a component of accumulated other comprehensive loss in stockholders' equity. 6 (f) REVENUE RECOGNITION The Company recognizes revenue from software licenses in accordance with Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION, as amended by SOP 98-4 and SOP 98-9, and related interpretations to determine the recognition of revenue. Accordingly, revenue for software licenses is recognized when persuasive evidence of an arrangement exists, the fee is fixed and determinable and the software is delivered and collection of the resulting receivable is deemed probable. Software delivered to a customer on a trial basis is not recognized as revenue until a permanent key code 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 maintenance, software service and other revenues. The Company provides an allowance for software product returns as a reduction of revenue, based upon historical experience and known or expected trends. Revenues associated with software implementation and software engineering services are recognized as the services are completed. Costs of providing these services are included in cost of maintenance, software services and other revenue. 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. The Company has transactions in which it purchases hardware and bundles this hardware with the Company's software and sells the bundled solution to its customer. Since the software is not essential for the functionality of the equipment included in the Company's bundled solutions, and both the hardware and software have stand alone value to the customer, a portion of the contractual fees is recognized as revenue when the software or hardware is delivered based on the relative fair value of the delivered element(s). For the three months ended June 30, 2007, the Company had two customers that together accounted for 40% of revenues, and two customers that together accounted for 25% of the accounts receivable balance at June 30, 2007. For the three months ended June 30, 2006, the Company had two customers that together accounted for 32% of revenues. (g) PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets (3 to 7 years). Depreciation expense was $857,074 and $767,739 for the three months ended June 30, 2007 and 2006, respectively. Depreciation expense was $1,658,183 and $1,504,257 for the six months ended June 30, 2007 and 2006, respectively. Leasehold improvements are amortized on a straight-line basis over the term of the respective leases or over their estimated useful lives, whichever is shorter. (h) 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 Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not amortized goodwill related to its acquisitions, but instead tests the balance for impairment. The Company's annual impairment assessment is performed as of December 31st of each year, and an assessment is made at other times if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. Identifiable intangible assets are amortized over a three-year period using the straight-line method. Amortization expense was $54,405 and $45,468 for the three months ended June 30, 2007 and 2006, respectively. Amortization expense was $108,760 and $90,648 for the six months ended June 30, 2007 and 2006, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of June 30, 2007 and December 31, 2006 are as follows: 7 June 30, December 31, 2007 2006 ----------- ----------- Patents: Gross carrying amount $ 1,104,706 $ 1,023,093 Accumulated amortization (724,537) (615,777) ----------- ----------- Net carrying amount $ 380,169 $ 407,316 =========== =========== (i) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY In accordance with the provisions of SFAS No. 86, ACCOUNTING FOR THE COSTS OF SOFTWARE TO BE SOLD, LEASED OR OTHERWISE MARKETED, costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company's product development process, technological feasibility is established upon completion of a working model. Amortization of software development costs is recorded at the greater of straight line over three years or the ratio of current revenue of the related products to total current and anticipated future revenue of these products. Purchased software technology of $148,756 and $183,578, net of accumulated amortization of $5,058,675 and $5,008,853 is included in other assets as of June 30, 2007 and December 31, 2006, respectively. Amortization expense was $24,286 and $101,333 for the three months ended June 30, 2007 and 2006, respectively and $49,822 and $253,055 for the six months ended June 30, 2007 and 2006, 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. (j) 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 recognizes interest and penalties accrued related to unrecognized tax benefits as part of income tax expense in its consolidated statements of operations. On January 1, 2007, the Company adopted FASB Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES, ("FIN 48"). FIN 48 is an interpretation of FASB Statement No. 109, ACCOUNTING FOR INCOME TAXES, and addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it meets the "more likely than not" threshold that the position will be sustained on examination by the taxing authority, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures. The adoption of FIN 48 did not result in any adjustment to the recognized benefits from the Company's uncertain tax positions. See footnote No. 6, "Income Taxes" for additional information. (k) 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. 8 (l) SHARE-BASED PAYMENTS Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), SHARE-BASED PAYMENT, which establishes the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Under the provisions of SFAS No. 123(R), share-based compensation expense 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) for awards expected to vest. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model. Stock option exercises and restricted stock awards are expected to be fulfilled with new shares of common stock. The Company accounts for stock option grants to non-employees in accordance with SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and EITF Issue No. 96-18, ACCOUNTING FOR EQUITY INSTRUMENTS THAT ARE ISSUED TO OTHER THAN EMPLOYEES FOR ACQUIRING, OR IN CONJUNCTION WITH SELLING, GOODS OR SERVICES, which require that the fair value of these instruments be recognized as an expense over the period in which the related services are rendered. (m) FINANCIAL INSTRUMENTS As of June 30, 2007 and December 31, 2006, 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. (n) 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. (o) EARNINGS PER SHARE (EPS) Basic EPS is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents. Due to the net loss for the three and six months ended June 30, 2006, all common stock equivalents were excluded from diluted net loss per share for the periods. As of June 30, 2007 potentially dilutive common stock equivalents included 9,856,588 stock options and shares of restricted stock outstanding. The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share ("EPS") computation: Three Months Ended June 30, 2007 Three Months Ended June 30, 2006 Net Income Shares Per Share Net Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ----------- ---------- ---------- ----------- ---------- -------- Basic EPS $ 1,379,568 49,378,812 $ 0.03 $(1,304,795) 48,047,291 $ (0.03) ========== ======== Effect of dilutive securities: Stock Options 3,628,369 -- ----------- ---------- ---------- ----------- ---------- -------- Diluted EPS $ 1,379,568 53,007,181 $ 0.03 $(1,304,795) 48,047,291 $ (0.03) =========== ========== ========== =========== ========== ======== 9 Six Months Ended June 30, 2007 Six Months Ended June 30, 2006 Net Income Shares Per Share Net Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ----------- ---------- ---------- ----------- ---------- -------- Basic EPS $ 824,993 48,988,778 $ 0.02 $(4,941,681) 48,026,914 $ (0.10) ========== ======== Effect of dilutive securities: Stock Options 1,814,185 -- ----------- ---------- ---------- ----------- ---------- -------- Diluted EPS $ 824,993 50,802,963 $ 0.02 $(4,941,681) 48,026,914 $ (0.10) =========== ========== ========== =========== ========== ======== (p) COMPREHENSIVE INCOME (LOSS) The Company's comprehensive income (loss) is as follows: Three Months Ended June 30, Six Months Ended June 30, 2007 2006 2007 2006 ---- ---- ---- ---- Net Income (loss) $ 1,379,568 $(1,304,795) $ 824,993 $(4,941,681) ----------- ----------- ----------- ----------- Other comprehensive income (loss): Foreign currency translation adjustments (83,667) 93,063 (124,879) 104,502 Unrealized gains (loss) on investments (4,719) (29,759) 19,177 (18,880) Benefit plan adjustment 2,569 -- 2,569 -- ----------- ----------- ----------- ----------- Other comprehensive income (loss) (85,817) 63,304 (103,133) 85,622 ----------- ----------- ----------- ----------- Comprehensive income (loss) $ 1,293,751 $(1,241,491) $ 721,860 $(4,856,059) =========== =========== =========== =========== (q) NEW ACCOUNTING PRONOUNCEMENTS In February 2007, the FASB issued SFAS No. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB STATEMENT NO. 115. SFAS No. 159 permits entities to choose to measure eligible items at fair value at specified election dates and to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of the provisions of SFAS No. 159 on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, FAIR VALUE Measurements to clarify the definition of fair value, establish a framework for measuring fair value and expand the disclosures on fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). SFAS No. 157 also stipulates that, as a market-based measurement, fair value should be determined based on the assumptions that market participants would use in pricing the asset or liability, and establishes a fair value hierarchy that distinguishes between (a) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (b) the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). SFAS No. 157 becomes effective for the Company in its fiscal year beginning January 1, 2008. The Company is currently evaluating the impact of the provisions of SFAS No. 157 on its consolidated financial statements. 10 (2) 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 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. 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 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. As of May 14, 2007, no additional options will be available for grant under 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 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. Initially, a maximum of 1,500,000 of the authorized but unissued or treasury shares of the common stock of the Company could 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. On May 8, 2007, the 2006 Plan was amended so that if, on July 1st of any calendar year in which the Plan is in effect (the "Calculation Date"), the number of shares of stock to which options may be granted is less than five percent (5%) of the number of outstanding shares of stock, then the number of shares of stock available for issuance under the Plan shall be increased so that the number equals five percent (5%) of the shares of stock outstanding. In no event shall the number of shares of stock subject to the Plan in the aggregate exceed twenty million shares, subject to adjustment as provided in the 2006 Plan. On July 1, 2007, the total number of outstanding shares of the Company's common stock totaled 49,615,610. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan thus increased by 2,170,731 shares to 2,480,781 shares available for issuance as of July 1, 2007. On May 8, 2007, the Company's stockholders approved the FalconStor Software, Inc. 2007 Outside Directors Equity Compensation Plan (the "2007 Plan"). The 2007 Plan is administered by the Board of Directors and provides for the issuance of up to 300,000 shares of Company common stock upon the vesting of options or upon the grant of shares with such restrictions as determined by the Board of Directors to the non-employee directors of the Company. 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. Shares of restricted stock have the terms and conditions set by the Board of Directors and are forfeitable until the terms of the grant have been satisfied. The following table summarizes stock option activity during the six months ended June 30, 2007: 11 Weighted Weighted Average Average Remaining Aggregate Number of Exercise Contractual Intrinsic Options Price Life (Years) Value ---------- ----------- ----------- ----------- Outstanding at December 31, 2006 10,835,975 $ 5.62 Granted 64,000 $ 8.75 Exercised (998,353) $ 4.13 Cancelled (97,467) $ 6.95 ---------- ----------- Outstanding at March 31, 2007 9,804,155 $ 5.77 6.45 $45,595,769 ---------- ----------- ----------- ----------- Granted 330,000 $ 11.07 Exercised (396,918) $ 6.16 Cancelled (132,149) $ 7.19 ---------- ----------- Outstanding at June 30, 2007 9,605,088 $ 5.91 6.30 $44,607,190 ========== =========== =========== =========== Options exercisable at June 30, 2007 7,096,560 $ 5.23 5.46 $37,642,505 ---------- ----------- ----------- ----------- Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended June 30, 2007 and 2006 was $2,446,812 and $304,157, respectively. The total cash received from stock option exercises for the six months ended June 30, 2007 and 2006 was $6,574,614 and $1,100,272, respectively. The total intrinsic value of stock options exercised during the three months ended June 30, 2007 and 2006 was $1,931,508 and $148,810, respectively. The total intrinsic value of stock options exercised during the six months ended June 30, 2007 and 2006 was $8,240,820 and $1,623,237, respectively. The Company recognized share-based compensation expense for awards issued under the Company's stock option plans in the following line items in the condensed consolidated statements of operations: Three Months Ended Three Months Ended June 30, June 30, 2007 2006 ---- ---- Cost of maintenance, software services and other revenue $ 224,454 $ 356,159 Software development costs 756,294 1,078,138 Selling and marketing 714,610 684,686 General and administrative 242,663 277,119 ---------- ---------- $1,938,021 $2,396,102 ========== ========== 12 Six Months Ended Six Months Ended June 30, June 30, 2007 2006 ---- ---- Cost of maintenance, software services and other revenue $ 509,303 $ 699,549 Software development costs 1,679,950 2,133,099 Selling and marketing 1,433,527 1,345,538 General and administrative 505,326 482,436 ---------- ---------- $4,128,106 $4,660,622 ========== ========== The Company did not recognize any tax benefits related to share-based compensation expense during the three and six months ended June 30, 2007. During the three and six months ended June 30, 2006, the Company recognized $10,467 of tax benefits related to share-based compensation expense. In 2006, the Company granted options to purchase 25,000 shares of common stock to certain non-employee consultants in exchange for professional services. During the three months ended June 30, 2007, the Company granted options to purchase 6,000 shares of common stock to certain non-employee consultants in exchange for professional services. The aggregate fair value of these options are determined using the Black-Scholes method as of each balance sheet date, and are being expensed over their respective period of services to be provided. The related cumulative aggregate expense totaled $58,370 through June 30, 2007, of which $19,607 and $40,455 were recognized during the three and six months ended June 30, 2007, respectively. In 2006, the Company granted 225,000 shares of restricted stock to certain officers and employees at an average fair value per share at date of grant of $7.06 per share. During the three months ended June 30, 2007, the Company granted 26,500 shares of restricted stock to certain Outside Directors and employees at a fair value per share at date of grant of $11.10 per share. As of June 30, 2007, no restricted shares have vested or been forfeited. There were no restricted shares issued or outstanding as of June 30, 2006. Options granted during both fiscal 2007 and 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%. The Company estimates expected volatility based primarily on historical daily price changes of the Company's stock and other factors. The risk-free interest rate is based on the United States treasury yield curve in effect at the time of grant. As of June 30, 2007 and 2006, there was approximately $9,848,541 and $12,152,329, respectively, of total unrecognized compensation cost related to the Company's unvested options and restricted shares granted under the Company's stock plans. In September 2003, the Company entered into a worldwide OEM agreement with a major technology company (the "OEM"), and granted to the OEM warrants to purchase 750,000 shares of the Company's common stock with an exercise price of $6.18 per share. A portion of the warrants were to vest annually subject to the OEM's achievement of pre-defined and mutually agreed upon sales objectives over a three-year period beginning June 1, 2004. As of June 1, 2007, none of the warrants had vested and the rights to exercise the warrants expired on such date. (3) SEGMENT REPORTING The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the three and six months ended June 30, 2007 and 2006, and the location of long-lived assets as of June 30, 2007 and December 31, 2006, are summarized as follows: 13 Three Months Ended June 30, Six Months Ended June 30, 2007 2006 2007 2006 ----------- ----------- ----------- ----------- United States $12,325,435 $ 8,603,774 $24,070,183 $14,898,771 Asia 2,174,322 2,117,520 4,060,086 3,499,868 Other international 3,250,787 1,946,933 5,960,953 3,477,908 ----------- ----------- ----------- ----------- Total revenues $17,750,544 $12,668,227 $34,091,222 $21,876,547 =========== =========== =========== =========== June 30, December 31, 2007 2006 ----------- ----------- Long-lived assets: United States $11,108,005 $10,113,633 Asia 1,612,252 1,498,534 Other international 308,442 279,695 ----------- ----------- Total long-lived assets $13,028,699 $11,891,862 =========== =========== (4) STOCK REPURCHASE PROGRAM On October 25, 2001, the Company announced that its Board of Directors authorized the repurchase of up to two million shares of the Company's outstanding common stock. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company's management. The terms of the stock repurchases will be determined by management based on market conditions. There were no stock repurchases during the three and six months ended June 30, 2007. During the three and six months ended June 30, 2006, the Company purchased 250,000 shares of its common stock in open market purchases for a total cost of $1,671,572. As of June 30, 2007, the Company had repurchased a total of 865,200 shares for $5,780,163. (5) COMMITMENTS AND CONTINGENCIES The Company has an operating lease covering its corporate office facility that expires in February 2012. The Company also has several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2007 through 2015. The following is a schedule of future minimum lease payments for all operating leases as of June 30, 2007: 2007 ................................................ $1,051,373 2008 ................................................ 1,895,160 2009 ................................................ 1,836,775 2010 ................................................ 1,472,522 2011 ................................................ 1,370,573 Thereafter .......................................... 718,740 ---------- $8,345,143 ========== 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, such matters are not expected to have a material adverse effect on our financial condition or operating results. 14 (6) INCOME TAXES For the three and six months ended June 30, 2007 and 2006, the Company's provision for income taxes consists of U.S. and foreign taxes in amounts necessary to align its year-to-date tax provision with the effective tax rate the Company expects to achieve for the full year. The provision includes U.S. federal alternative minimum taxes and state minimum taxes that are expected to be incurred primarily as a result of the limitations on the Company's ability to utilize net operating losses under the alternative minimum tax system and the non-deductibility of certain share-based compensation expense for income tax purposes that has been recognized for financial statement purposes and foreign taxes. During the six months ended June 30, 2007, the Company's income tax benefit of $83,537 includes discrete items for (i) $57,058 related to state income taxes incurred in periods prior to 2007, (ii) $120,000 related to a change in the Company's estimate of amounts due in certain foreign jurisdictions for periods prior to 2007, based upon the Company's evaluation of information obtained in 2007, and (iii) $0.3 million of benefit associated with disqualifying dispositions of incentive stock options. As of December 31, 2006, the Company reported deferred tax assets and a corresponding full valuation allowance, of $50.2 million. As of January 1, 2007, the Company revised the recorded amounts of certain deferred tax assets (and corresponding valuation allowance) to be $14.3 million, primarily due to the limitations on the Company's ability to utilize certain deferred tax assets relating to net operating losses acquired in the Company's 2001 reverse merger transaction. Through March 31, 2007, the Company maintained a full valuation allowance against its net deferred tax assets 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. As discussed above, the Company recognized $0.3 million of tax benefits associated with disqualifying dispositions of incentive stock options during the three and six months ended June 30, 2007 as a result of continued positive operating results and improved projections for taxable income. The Company believes that if positive evidence from its earnings trends continue in subsequent quarters, it is likely that the Company will recognize a significant portion of its deferred tax assets, through a reduction in its deferred tax valuation allowance in the near term. In determining the period in which related tax benefits are realized for book purposes, excess share-based payment deductions and deductions from discontinued operations included in net operating losses, are realized after regular net operating losses are exhausted. If the entire deferred tax asset were realized, approximately $6.0 million (related to the tax effects of excess compensation deductions from exercises of employee and consultant stock options) would be allocated to paid-in-capital, with the remainder reducing income tax expense. The Company's total unrecognized tax benefits as of January 1, 2007 were $4.4 million, which, if recognized, would affect the Company's effective tax rate. Total accrued interest and penalties as of January 1, 2007 were $22,193. During the three months ended June 30, 2007, there were no additional unrecognized tax benefits identified. The Company does not expect that its unrecognized tax benefits will significantly change within the next 12 months. The Company files a consolidated U.S. Income tax return and tax returns in various state and local jurisdictions. The returns filed in various state and local jurisdictions may be filed on a separate company, combined or consolidated basis depending on the legal requirements of the taxing jurisdiction. The Company's subsidiaries also file tax returns in various foreign jurisdictions. In addition to the U.S., the Company's major taxing jurisdictions include China, Japan, Taiwan, Korea, United Kingdom, Germany, France and Australia. There have not been any past tax examinations nor are there any current tax examinations in progress. Accordingly, as of January 1, 2007, the Company remains subject to examination in all tax jurisdictions for all periods since inception. 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS "BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS," "WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT. OVERVIEW Our results for the second quarter of 2007 showed solid growth from the same period in the prior year. Both our revenues and our gross margins increased. Revenues for the second quarter of 2007 increased 40% to $17.8 million compared with revenues of $ 12.7 million in the second quarter of 2006. Revenues from both our OEM partners and our resellers increased from the same period last year. Our revenues grew 9% from the previous quarter and were higher than our revenues in every quarter in the Company's history, other than the fourth quarter of 2006. We believe this shows continued momentum for our products and services. EMC Corporation accounted for 26% of our revenues, and Sun Microsystems accounted for 14% of our revenues, in the second quarter of 2007. We anticipate that each of these customers will account for 10% or more of our revenues during 2007. EMC has consistently contributed 20% or more of our revenues for a significant period of time. Sun's revenue contribution has fluctuated on a quarterly basis, but their announcement regarding their VTL strategy in the fourth quarter of 2006, and the announcement in April 2007 that Sun will carry our full product line, gives us reason to believe that their contribution to our revenues will remain at or above the 10% level. We continue to monitor our management structure to determine whether changes or additional resources will help to continue or to accelerate the positive momentum. We anticipate that we will need to add resources to our sales and marketing team to realize the full potential of our existing opportunities, to establish our visibility in the marketplace, and to generate additional business prospects. In addition to increased revenues, the other indicators we use to assess our performance and growth continued to be positive. We had net income of $1.4 million for the three months ended June 30, 2007. This positive result includes $1.9 million of share-based compensation expense related to SFAS No. 123(R). Cash flows from operations in the second quarter of 2007 were again positive. We continue to believe that our ability to fund our own growth internally bodes well for our long-term success. Deferred revenue at June 30, 2007 increased 63%, compared with the balance at June 30, 2006. We consider the continued growth of our deferred revenue as an important indicator of the success of our products. We believe that support and maintenance renewals, which comprise the majority of our deferred revenue, are expressions of satisfaction with our products and our support organization from our end users. Operating expenses increased by $2.8 million, or 20%, compared with the second quarter of 2006. Operating expenses include $1.9 million in share-based compensation expense for the second quarter of 2007, and $2.4 million in share-based compensation expense for the second quarter of 2006. We are pleased that our revenues, on both an absolute and a percentage basis, continue to grow at a higher rate than our expenses. 16 Our gross margins increased to 86% for the second quarter of 2007 from 81% for the second quarter of 2006. Share-based compensation expense within cost of maintenance, software services and other revenue was 1% of revenue in the second quarter of 2007 and 3% in the second quarter of 2006. We plan to continue adding research and development, sales and support personnel, both in the United States and worldwide, as necessary. We also plan to continue investing in infrastructure, including both equipment and property. We continue to operate the business with the goal of long-term growth. We believe that our ability to continue to refine our existing products and features and to introduce new products and features will be the primary driver of additional growth among existing resellers, OEMs and end users, and will drive our strategy to attempt to engage additional OEM partners and to expand the FalconStor product lines offered by these OEMs. RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED JUNE 30, 2007 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2006. Revenues for the three months ended June 30, 2007 increased 40% to $17.8 million compared with $12.7 million for the three months ended June 30, 2006. Our operating expenses increased 20% from $14.4 million for the three months ended June 30, 2006 to $17.3 million for the three months ended June 30, 2007. Included in our operating expenses for the three months ended June 30, 2007 and 2006 was $1.9 and $2.4 million, respectively, of share-based compensation expense in accordance with SFAS No. 123(R). Net income for the three months ended June 30, 2007 was $1.4 million compared with a net loss of $1.3 million for the three months ended June 30, 2006. The growth in revenues was due to significant increases in our software license and maintenance revenues as well as moderate increases in software services and other revenues. Revenue contribution from our OEM partners increased in absolute dollars and as a percentage of our total revenue for the quarter ended June 30, 2007 as compared with the same period in 2006. Revenue from resellers and distributors also increased in absolute dollars for the three months ended June 30, 2007 as compared with the same period in 2006. Expenses increased in all aspects of our business to support our continued growth. During the three months ended June 30, 2007, we continued to increase the number of employees and to invest in our infrastructure by increasing our capital expenditures particularly with purchases of equipment for support of our existing and future product lines. We increased the number of employees from 330 as of June 30, 2006 to 394 employees as of June 30, 2007. REVENUES SOFTWARE LICENSE REVENUE Software license revenue is comprised of software licenses sold through our OEMs, value-added resellers and distributors to end-users and, to a lesser extent, directly to end-users. These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing software licenses sold and the software and permanent key codes are delivered to the customer. We sometimes receive nonrefundable royalty advances and engineering fees from some of our OEM partners. These arrangements are evidenced by a signed customer contract, and the revenue is recognized when the software product master is delivered and accepted, and the engineering services, if any, have been performed. Software license revenue increased 37% from $8.7 million for the three months ended June 30, 2006 to $12.0 million for the three months ended June 30, 2007. Continued growth of market acceptance and increased demand for our products has resulted in increased sales from our OEM partners and were the primary drivers of the increase in software license revenue. Software license revenue increased from both our OEM partners and from our resellers. Revenue from our OEM partners increased as a percentage of total revenue. We expect our software license revenue to continue to grow in future periods. 17 MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenues are comprised of software maintenance and technical support, professional services primarily related to the implementation of our software, engineering services, and sales of computer hardware. Revenue derived from maintenance and technical support contracts is deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Revenue from engineering services is primarily related to customizing software product masters for some of our OEM partners. Revenue from engineering services is recognized in the period the services are completed. During the three months ended June 30, 2007 and 2006, we had transactions in which we purchased hardware and bundled this hardware with our software and sold this 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 46% to $5.8 million for the three months ended June 30, 2007 from $3.9 million for the three months ended June 30, 2006. 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 from our continued customer base and product offerings expansion, 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 $1.6 million from $2.9 million for the three months ended June 30, 2006 to $4.5 million for the three months ended June 30, 2007. Software services and other revenue increased approximately $0.2 million from $1.0 million for the three months ended June 30, 2006 to $1.2 million for the three months ended June 30, 2007. 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 June 30, 2007, we had $0.1 million of purchased software licenses, net of accumulated amortization of $5.1 million that are being amortized over three years. For the three months ended June 30, 2007, we recorded $24,000 of amortization related to these purchased software licenses. As of June 30, 2006, we had $0.3 million of purchased software licenses, net of accumulated amortization of $4.9 million and recorded approximately $100,000 of amortization for the three months ended June 30, 2006 related to these purchased software licenses. We will continue to evaluate third party software licenses and may make additional purchases from time to time, which would impact the amount we record as amortization expense in future periods. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense associated with SFAS No. 123(R). Cost of maintenance, software services and other revenues also includes the cost of hardware purchased that was resold. Cost of maintenance, software services and other revenues for the three months ended June 30, 2007 increased by 6% to $2.5 million compared with $2.3 million for the three months ended June 30, 2006. The increase in cost of maintenance, software services and other revenue was principally due to the increase in personnel and related costs for the three months ended June 30, 2007 as compared with the same period in 2006. As a result of our increased sales from maintenance and support contracts, we hired additional employees to provide technical support. Consequently, our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenues from these services also increase. Gross profit for the three months ended June 30, 2007 was $15.3 million or 86% of revenue compared with $10.2 million or 81% of revenue for the three months ended June 30, 2006. The increase in our gross margin was primarily due 18 to the increase of our revenue combined with our continued focus on our cost structure. Share-based compensation expense included in the cost of maintenance, software services and other revenue decreased in absolute dollars to $0.2 million from $0.4 million for the three months ended June 30, 2007 and 2006, respectively. Share-based compensation expense was equal to 1% and 3% of revenue for the three months ended June 30, 2007 and 2006, respectively. SOFTWARE DEVELOPMENT COSTS Software development costs consist primarily of personnel costs for product development personnel, share-based compensation expense associated with SFAS No. 123(R), and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 9% to $5.3 million for the three months ended June 30, 2007 from $4.9 million for the three months ended June 30, 2006. The major contributing factors to the increase in software development costs were higher salary costs and personnel related costs as a result of increased headcount to enhance and test our core network storage software product, as well as to develop new innovative features and options during the three months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in software development costs decreased in absolute dollars to $0.8 million from $1.1 million for the three months ended June 30, 2007 and 2006, respectively. Share-based compensation expense included in software development costs was equal to 4% and 9% of revenue for the three months ended June 30, 2007 and 2006, respectively. We intend to continue recruiting and hiring product development personnel to support our software development process. SELLING AND MARKETING Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense associated with 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 32% to $7.5 million for the three months ended June 30, 2007 from $5.7 million for the three months ended June 30, 2006. The increase in selling and marketing expenses was primarily due to (i) higher commissions paid as a result of our 40% increase in revenue, and (ii) higher salary costs and personnel related costs as a result of increased sales and marketing headcount during the three months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in selling and marketing remained consistent in absolute dollars at $0.7 million for both the three months ended June 30, 2007 and 2006. Share-based compensation expense included in selling and marketing expenses was equal to 4% and 5% of revenue for the three months ended June 30, 2007 and 2006, respectively. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our anticipated revenue growth. We anticipate that as we continue to grow sales, our sales and marketing expenses will continue to increase in support of such sales growth. GENERAL AND ADMINISTRATIVE General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense associated with 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 $1.9 million for the three months ended June 30, 2007 from $1.4 million for the three months ended June 30, 2006. The increase in general and administrative expenses was primarily due to (i) higher professional fees as a result of the implementation of FIN No. 48 and other tax related planning activities which commenced for fiscal year 2007, and (ii) increased compensation and personnel related costs as a result of increased headcount to support our general and administrative needs for the three months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in general and administrative decreased in absolute dollars to $0.2 million from $0.3 million for the three months ended June 30, 2007 and 2006, respectively. Share-based compensation expense included in general and administrative expenses was equal to 1% and 2% of revenue for the three months ended June 30, 2007 and 2006, respectively. Additionally, as our revenue and number of employees increase, our legal and professional fees and other general corporate overhead costs have increased and are likely to continue to increase. 19 INTEREST AND OTHER INCOME We invest our cash, cash equivalents and marketable securities in government securities and other low risk investments. Interest and other income increased to $0.6 million for the three months ended June 30, 2007 compared with $0.4 million for the three months ended June 30, 2006. This increase is primarily due to increased cash balance as of June 30, 2007 as compared with the same period in 2006, as well as increased interest rates, which resulted in a higher average cash balance invested at greater interest rates. INCOME TAXES For the three months ended June 30, 2007 and 2006, our provision for income taxes consisted of U.S. and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year. Our provision for income taxes for the three months ended June 30, 2007 consists primarily of foreign taxes and U.S. federal alternative minimum taxes and state minimum taxes that are expected to be incurred primarily as a result of the limitations on our ability to utilize net operating losses under the alternative minimum tax system, and the non-deductibility of certain share-based compensation expenses for income tax purposes that have been recognized for financial statement purposes and foreign taxes. For the three months ended June 30, 2007, we recorded an income tax benefit of $285,621, which includes approximately $0.3 million of tax benefits recognized associated with disqualifying dispositions of incentive stock options as a result of our continued positive operating results and improved projections for taxable income. We believe that if positive evidence from our earnings trends continue in subsequent quarters, it is likely we will recognize a significant portion of our deferred tax assets through a reduction in our deferred tax valuation allowance in the near term. RESULTS OF OPERATIONS - FOR THE SIX MONTHS ENDED JUNE 30, 2007 COMPARED WITH SIX MONTHS ENDED JUNE 30, 2006. Revenues for the six months ended June 30, 2007 increased 56% to $34.1 million compared with $21.9 million for the six months ended June 30, 2006. Our operating expenses increased 26% from $27.4 million for the six months ended June 30, 2006 to $34.4 million for the six months ended June 30, 2007. Included in our operating expenses for the six months ended June 30, 2007 and 2006 was $4.1 and $4.7 million, respectively, of share-based compensation expense related to stock-based compensation in accordance with SFAS No. 123(R). Net income for the six months ended June 30, 2007 was $0.8 million compared with a net loss of $4.9 million for the six months ended June 30, 2006. The growth in revenues was due to significant increases in our software license and maintenance revenues as well as moderate increases in software services and other revenues. Revenue contribution from our OEM partners increased in absolute dollars and as a percentage of our total revenue for the six months ended June 30, 2007 as compared with the same period in 2006. Revenue from resellers and distributors also increased in absolute dollars for the six months ended June 30, 2007 as compared with the same period in 2006. Expenses increased in all aspects of our business to support our continued growth. During the six months ended June 30, 2007, we continued to increase the number of employees and to invest in our infrastructure by increasing our capital expenditures particularly with purchases of equipment for support of our existing and future product lines. We increased the number of employees from 330 as of June 30, 2006 to 394 employees as of June 30, 2007. REVENUES SOFTWARE LICENSE REVENUE Software license revenue increased 56% from $14.4 million for the six months ended June 30, 2006 to $22.4 million for the six months ended June 30, 2007. Continued growth of market acceptance and increased demand for our products has resulted in increased sales from our OEM partners and were the primary drivers of the increase in software license revenue. Software license revenue increased from both our OEM partners and from our resellers. Revenue from our OEM partners increased as a percentage of total revenue. We expect our software license revenue to continue to grow in future periods. 20 MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Maintenance, software services and other revenue increased 56% to $11.7 million for the six months ended June 30, 2007 from $7.5 million for the six months ended June 30, 2006. 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 from our continued customer base and product offerings expansion, 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 $3.4 million from $5.5 million for the six months ended June 30, 2006 to $8.9 million for the six months ended June 30, 2007. Software services and other revenue increased approximately $0.8 million from $2 million for the six months ended June 30, 2006 to $2.8 million for the six months ended June 30, 2007. This increase is primarily due to the increase in hardware we bundled with our software. We expect maintenance, software services and other revenues to continue to increase. COST OF REVENUES AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE As of June 30, 2007, we had $0.1 million of purchased software licenses, net of accumulated amortization of $5.1 million that are being amortized over three years. For the six months ended June 30, 2007, we recorded $50,000 of amortization related to these purchased software licenses. As of June 30, 2006, we had $0.3 million of purchased software licenses, net of accumulated amortization of $4.9 million and recorded approximately $0.3 million of amortization for the six months ended June 30, 2006 related to these purchased software licenses. We will continue to evaluate third party software licenses and may make additional purchases from time to time, which would impact the amount we record as amortization expense in future periods. COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE Cost of maintenance, software services and other revenues for the six months ended June 30, 2007 increased by 21% to $5.2 million compared with $4.3 million for the six months ended June 30, 2006. The increase in cost of maintenance, software services and other revenue was primarily due to (i) the increased cost of hardware as a result of the increased number of transactions in which we bundled purchased hardware with our software and sold the bundled solution, and (ii) the increase in personnel and related costs for the six months ended June 30, 2007 as compared with the same period in 2006. As a result of our increased sales from maintenance and support contracts, we hired additional employees to provide technical support. Consequently, our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenues from these services also increase. Gross profit for the six months ended June 30, 2007 was $28.8 million or 85% of revenue compared with $17.3 million or 79% of revenue for the six months ended June 30, 2006. The increase in our gross margin was primarily due to the increase of our revenue combined with our continued focus on our cost structure. Share-based compensation expense included in the cost of maintenance, software services and other revenue decreased in absolute dollars to $0.5 million from $0.7 million for the six months ended June 30, 2007 and 2006, respectively. Share-based compensation expense was equal to 1% and 3% of revenue for the six months ended June 30, 2007 and 2006, respectively. SOFTWARE DEVELOPMENT COSTS Software development costs increased 14% to $10.9 million for the six months ended June 30, 2007 from $9.5 million for the six months ended June 30, 2006. The major contributing factors to the increase in software development costs were higher salary costs and personnel related costs as a result of increased headcount to enhance and test our core network storage software product, as well as to develop new innovative features and options during the six months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in software development costs decreased in absolute dollars to $1.7 million from $2.1 million for the six months ended June 30, 2007 and 2006, respectively. Share-based compensation expense included in software development costs was equal to 5% and 10% of 21 revenue for the six months ended June 30, 2007 and 2006, respectively. We intend to continue recruiting and hiring product development personnel to support our software development process. SELLING AND MARKETING Selling and marketing expenses increased 37% to $14.5 million for the six months ended June 30, 2007 from $10.6 million for the six months ended June 30, 2006. The increase in selling and marketing expenses was primarily due to (i) higher commissions paid as a result of our 56% increase in revenue and (ii) higher salary costs and personnel related costs as a result of increased sales and marketing headcount during the six months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in selling and marketing increased slightly in absolute dollars to $1.4 million from $1.3 million for the six months ended June 30, 2007 and 2006, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 4% and 6% of revenue for the six months ended June 30, 2007 and 2006, respectively. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our anticipated revenue growth. We anticipate that as we continue to grow sales, our sales and marketing expenses will continue to increase in support of such sales growth. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 42% to $3.9 million for the six months ended June 30, 2007 from $2.7 million for the six months ended June 30, 2006. The increase in general and administrative expenses was primarily due to (i) higher professional fees as a result of the implementation of FIN No. 48 and other tax related planning activities which commenced for fiscal year 2007, and (ii) increased compensation and personnel related costs as a result of increased headcount to support our general and administrative needs for the six months ended June 30, 2007 as compared with the same period in 2006. Share-based compensation expense included in general and administrative remained consistent in absolute dollars at $0.5 million for both the six months ended June 30, 2007 and 2006, respectively. Share-based compensation expense included in general and administrative expenses was equal to 1% and 2% of revenue for the six months ended June 30, 2007 and 2006, respectively. Additionally, as our revenue and number of employees increase, our legal and professional fees and other general corporate overhead costs have increased and are likely to continue to increase. 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 $1.1 million for the six months ended June 30, 2007 compared with $0.7 million for the six months ended June 30, 2006. This increase is primarily due to increased cash balance during the six months ended June 30, 2007 as compared with the same period in 2006, as well as increased interest rates, which resulted in a higher average cash balance invested at greater interest rates. INCOME TAXES For the six months ended June 30, 2007 and 2006, our provision for income taxes consists of U.S. and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective tax rate we expect to achieve for the full year. The provision includes U.S. federal alternative minimum taxes and state minimum taxes that are expected to be incurred primarily as a result of the limitations on our ability to utilize net operating losses under the alternative minimum tax system and the non-deductibility of certain share-based compensation expense for income tax purposes that has been recognized for financial statement purposes and foreign taxes. During the six months ended June 30, 2007, our income tax benefit of $83,537 includes discrete items for (i) $57,058 related to state income taxes incurred in periods prior to 2007, (ii) $120,000 related to a change in our estimate of amounts due in certain foreign jurisdictions for periods prior to 2007, based upon our evaluation of information obtained in 2007, and (iii) $0.3 million of benefit associated with disqualifying dispositions of incentive stock options as a result of our continued positive operating results and improved projections for taxable income. We believe that if positive evidence from our earnings trends continue in subsequent quarters, it is likely we will recognize a significant portion of our deferred tax assets through a reduction in our deferred tax valuation allowance in the near term. 22 CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our critical accounting policies and estimates are those related to revenue recognition, accounts receivable allowances, deferred income taxes and accounting for share-based compensation expense. REVENUE RECOGNITION. We recognize revenue in accordance with the provisions of Statement of Position 97-2, SOFTWARE REVENUE RECOGNITION, as amended. Software license revenue is recognized only when pervasive evidence of an arrangement exists and the fee is fixed and determinable, among other criteria. An arrangement is evidenced by a signed customer contract for nonrefundable royalty advances received from OEMs or a customer purchase order or a royalty report summarizing software licenses sold for each software license resold by an OEM, distributor or solution provider to an end user. The software license fees are fixed and determinable as our standard payment terms range from 30 to 90 days, depending on regional billing practices, and we have not provided any of our customers extended payment terms. When a customer licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance for its fair value based on the contractual maintenance renewal rate. ACCOUNTS RECEIVABLE. We review accounts receivable to determine which are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider historical return rates, specific past due accounts, analysis of our accounts receivable aging, customer payment terms, historical collections, write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. Historically, we have experienced a somewhat consistent level of write-offs and returns as a percentage of revenue due to our customer relationships, contract provisions and credit assessments. Changes in the product return rates, credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs, revenues and our general and administrative expenses. DEFERRED INCOME TAXES. Consistent with the provisions of Statement of Financial Accounting Standards No. 109, we regularly estimate our ability to recover deferred income taxes, and report such assets at the amount that is determined to be more-likely-than-not recoverable. This evaluation considers several factors, including an estimate of the likelihood of generating sufficient taxable income in future periods over which temporary differences reverse, the expected reversal of deferred tax liabilities, past and projected taxable income, and available tax planning strategies. As of June 30, 2007, based primarily upon our cumulative losses, a valuation allowance has been recorded against deferred tax assets to record such assets at an amount that we believe is more-likely-than-not recoverable. We believe that if positive evidence from our earnings trends continue in subsequent quarters, it is likely we will recognize a significant portion of our deferred tax assets through a reduction in our deferred tax valuation allowance in the near term. If the entire deferred tax assets were realized, approximately $6 million (related to the tax effects of excess compensation deductions from exercises of employee and consultant stock options) would be allocated to paid-in-capital with the remainder reducing income tax expense. ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to Unaudited Condensed Consolidated Financial Statements - Note (2) SHARE-BASED PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective method. We have used and expect to continue to use the Black-Scholes option-pricing model to compute the estimated fair value of share-based compensation expense. The Black-Scholes option-pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates. The assumptions used in computing the fair value of share-based compensation expense reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility based primarily on historical daily price changes of our stock and other factors. Additionally, we estimate forfeiture rates based primarily upon historical experiences, adjusted when appropriate for known events or expected trends. If other assumptions or estimates had been used, the share-based compensation expense that was recorded for the three and six months ended June 30, 2007 and 2006 could have been materially different. Furthermore, if different assumptions or estimates are used in future periods, share-based compensation expense could be materially impacted in the future. IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In February 2007, the FASB issued Statement of Financial Accounting Standard SFAS No. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL 23 LIABILITIES - INCLUDING AN AMENDMENT OF FASB STATEMENT NO. 115. SFAS No. 159 permits entities to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of the provisions of SFAS No. 159 on our consolidated financial position, results of operations or cash flows. In September 2006, the FASB issued SFAS No. 157, FAIR VALUE Measurements, to clarify the definition of fair value, establish a framework for measuring fair value and expand the disclosures on fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). SFAS No. 157 also stipulates that, as a market-based measurement, fair value should be determined based on the assumptions that market participants would use in pricing the asset or liability, and establishes a fair value hierarchy that distinguishes between (a) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (b) the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). SFAS No. 157 becomes effective for the Company in its fiscal year beginning January 1, 2008. We are currently evaluating the impact of the provisions of SFAS No. 157 on our consolidated financial position, results of operations or cash flows. LIQUIDITY AND CAPITAL RESOURCES Our total cash and cash equivalents and marketable securities balance as of June 30, 2007 increased by $15.2 million compared with December 31, 2006. Our cash and cash equivalents totaled $26.2 million and marketable securities totaled $29.9 million at June 30, 2007. As of December 31, 2006, we had approximately $15.6 million in cash and cash equivalents and $25.4 million in marketable securities. We continued to invest in our infrastructure to support our long-term growth during the six months ended June 30, 2007. We made investments in property and equipment and we increased the number of employees during the first half of 2007. As we continue to grow, we will continue to make investments in property and equipment and will need to continue to increase our headcount. In October 2001, our Board of Directors authorized the repurchase of up to two million shares of our outstanding common stock. Since October 2001, 865,200 shares have been repurchased at an aggregate purchase price of $5.8 million. We did not repurchase any shares during the three and six months ended June 30, 2007. During the three and six months ended June 30, 2006, we repurchased 250,000 shares at an aggregate purchase price of $1.7 million. Net cash provided by operating activities totaled $11.6 million for the six months ended June 30, 2007, compared with $5.4 million for the same period in 2006. Net cash provided by operating activities of $11.6 million was primarily derived from: (i) a decrease in accounts receivables of $3.6 million; (ii) an increase in deferred revenue of $3 million; (iii) non-cash charges of $1.8 million for depreciation and amortization; (iv) $4.1 million related to share-based compensation expense; and (v) our net income of $0.8 million for the six months ended June 30, 2007. These amounts were partially offset by: (i) a decrease in accrued expenses of $1.3 million; and (ii) an increase in prepaid and other assets of $0.8 million. The cash provided by operating activities for the six months ended June 30, 2006 was mainly comprised of: (i) a decrease in accounts receivable of $2.5 million; (ii) an increase in deferred revenue of $1.5 million; (iii) non-cash charges of $1.8 million for depreciation and amortization; (iv) an increase in accrued expenses of $0.1 million; and (iv) $4.7 million related to share-based compensation expense. These amounts were partially offset by: (i) our net loss of $4.9 million for the six months ended June 30, 2006; and (ii) an increase in other assets of $0.1 million. Net cash used in investing activities was $7.5 million for the six months ended June 30, 2007, was comprised of: (i) net purchases of marketable securities of $4.6 million; (ii) purchases of property and equipment of $2.8 million; and (iii) purchases of software licenses and intangible assets of $0.1 million. Net cash used in investing activities was $9.8 million for the six months ended June 30, 2006, was comprised of: (i) net purchases of marketable securities of $7.8 million; (ii) purchases of property and equipment of $1.7 million; and (iii) purchases of software licenses and intangible assets of $0.3 million. 24 Net cash provided from financing activities was $6.6 million for the six months ended June 30, 2007. We received proceeds from the exercise of stock options of $6.6 million. Net cash used in financing activities was $0.6 million for the six months ended June 30, 2006. It was comprised of purchases of treasury stock of $1.7 million partially offset by the proceeds from the exercise of stock options of $1.1 million. We currently do not have any debt and our only material cash commitments are related to our office leases. We have an operating lease covering our corporate office facility that expires in February 2012. We also have several operating leases related to offices in foreign countries. The expiration dates for these leases range from 2007 through 2015. Refer to Note 5 of the notes to our unaudited condensed consolidated financial statements. We believe that our current balance of cash, cash equivalents and marketable securities, and expected cash flows from operations will be sufficient to meet our cash requirements for at least the next twelve months. ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and marketable securities is subject to interest rate risks. We regularly assess these risks and have established policies and business practices to manage the market risk of our marketable securities. If interest rates were to change by 10% from the levels at June 30, 2007, the effect on our financial results would be insignificant. FOREIGN CURRENCY RISK. We have several offices outside the United States. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. The effect of foreign currency exchange rate fluctuations have not been material since our inception. If foreign currency exchange rates were to change by 10% from the levels at June 30, 2007, the effect on our other comprehensive income would be insignificant. We do not use derivative financial instruments to limit our foreign currency risk exposure. ITEM 4. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report, and, based on their evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. No changes in the Company's internal controls over financial reporting occurred during the quarter ended June 30, 2007, that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting. Disclosure controls and procedures are procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. 25 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, we believe that such matters will not have a material adverse effect on our financial condition or operating results. ITEM 1A. RISK FACTORS We are affected by risks specific to us as well as factors that affect all businesses operating in a global market. The significant factors known to us that could materially adversely affect our business, financial condition, or operating results are set forth in Item 1A to our Annual Report on Form 10-K for the year ended December 31, 2006 (the "2006 10-K"). The information below sets forth additional risk factors or risk factors that have had material changes since the 2006 10-K, and should be read in conjunction with Item 1A of the 2006 10-K. 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 quarter ended June 30, 2007, we had one customer who accounted for 26% of our revenues and one customer who accounted for 14% of our revenues. While we believe that we will continue to receive revenue from these customers, our agreements do not have any minimum sales requirements and we cannot guarantee continued revenue. If our contracts with either of these customers terminate, or if the volume of sales from these customers significantly declines, it would have a material adverse effect on our operating results. In addition, as of June 30, 2007, two customers accounted for a total of 25% of our outstanding receivables, 15% and 10%, respectively. While we currently have no reason to doubt 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. 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 first and second quarters of 2007, and we anticipate that our quarterly results for the remainder of 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; 26 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 trailing twelve months ended June 30, 2007, the closing market price of our common stock as quoted on the NASDAQ Global Market fluctuated between $6.06 and $12.10 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 variance in actual results as compared to financial estimates; 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 or addition 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. WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS, THE EXERCISE OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK, AND A SMALLER NUMBER OF RESTRICTED SHARES OF STOCK, THE VESTING OF WHICH WILL ALSO DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK. As of June 30, 2007, we had an aggregate of 9,856,588 outstanding options to purchase our common stock and outstanding restricted shares. If all of these outstanding options were exercised, and all of the outstanding restricted stock vested, the proceeds to the Company would average $5.76 per share. We also had 903,689 shares of our common stock reserved for issuance under our stock plans with respect to options (or restricted stock) that have not been granted (excluding an additional 2,170,731 shares of common stock reserved for issuance under the 2006 Plan as of July 1, 2007, see Note 2 to the financial statements.) On August 7, 2007, 66,000 of the restricted shares vested. The exercise of all of the outstanding options 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. 27 THE ABILITY TO CORRECTLY PREDICT OUR FUTURE EFFECTIVE TAX RATES COULD IMPACT OUR ABILITY TO ACCURATELY FORECAST FUTURE EARNINGS. We are subject to income taxes in both the United States and the various foreign jurisdictions in which we operate. Judgment is required in determining our provision for income taxes and there are many transactions and calculations where the tax determination may be uncertain. Our future effective tax rates could be affected by changes in our (i) earnings or losses; (ii) changes in the valuation of our deferred tax assets; (iii) changes in tax laws; and (iv) other factors. Our ability to correctly predict our future effective tax rates based upon these possible changes could significantly impact our forecasted earnings. 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company held its annual meeting of stockholders on May 8, 2007. 44,823,639 shares of Common Stock, 91% of the outstanding shares, were represented in person or by proxy. ReiJane Huai was elected to serve as a director of the Company for a term expiring in 2010 with 44,556,438 shares voted in favor, 267,201 shares withheld and 0 broker non-votes. Lawrence S. Dolin was elected to serve as a director of the Company for a term expiring in 2010 with 44,493,692 shares voted in favor, 329,947 shares withheld and 0 broker non-votes. The terms of office of Company directors Steven L. Bock, Patrick B. Carney, Steven R. Fischer, and Alan W. Kaufman did not expire prior to this annual meeting of stockholders and each remains a director of the Company. The amendment to the FalconStor Software, Inc., 2006 Incentive Stock Plan was approved with 19,734,009 shares voted in favor, 7,089,838 shares voted against, 62,846 shares abstained, and 17,936,946 broker non-votes. The Company's 2007 Outside Directors Equity Compensation Plan was approved with 23,557,476 shares voted in favor, 3,263,116 shares voted against, 66,101 shares abstained, and 17,936,946 broker non-votes. The selection of KPMG LLP as the independent registered public accounting firm for the Company was ratified with 44,680,339 shares voted in favor, 105,223 shares voted against, 38,017 shares abstained and 0 broker non-votes. ITEM 5. OTHER INFORMATION On August 6, 2007, the Company's Board of Directors approved amendments to the employment agreement between ReiJane Huai and the Company. These amendments were made as a result of recent guidance on Section 409(A) of the Internal Revenue Code provided by the Internal Revenue Service. The amendments do not have any impact on the value of payments that Mr. Huai may receive under the agreement. On August 6, 2007, the Company's Board of Directors approved amendments to the FalconStor Software, Inc., 2005 Key Executive Severance Protection Plan (the "Plan"). Most of these amendments were made as a result of recent guidance on Section 409(A) of the Internal Revenue Code provided by the Internal Revenue Service and do not result in any change in the amount payable to any participant in the Plan. One amendment provides that upon a Change of Control, as defined in the Plan, all restrictions on any shares of restricted Company stock held by any Participant shall automatically lapse. On August 6, 2007, the Company's Board of Directors approved an amendment to Section 9.1 of the Company By-Laws. The amendment was made to conform to a recent rule passed by the Securities and Exchange Commission that requires that all listed securities on the NASDAQ be eligible for a Direct Registration Program ("DRP") operated by a clearing agency registered under Section 17A of 28 the Exchange Act. The amendment provides for the issuance of the Company's stock to meet the requirements of NASDAQ's DRP. On August 7, 2007, the Compensation Committee of the Company's Board of Directors made grants of restricted shares of Company Common Stock to certain officers, including the Chief Financial Officer, the Vice President for Business Development and the Vice President and Co-Founder (the "Named Officers"). Each of the Named Officers received 28,000 restricted shares of stock which will vest in accordance with the Company's 2006 Incentive Stock Plan. ITEM 6. EXHIBITS 3.1 Amendment to By-laws of FalconStor Software, Inc., dated August 6, 2007. 10.1 Second Amended and Restated Employment Agreement, dated November 7, 2005 between Registrant and ReiJane Huai, as amended, August 6, 2007. 10.2 FalconStor Software, Inc., 2005 Key Executive Severance Protection Plan, as amended, August 6, 2007. 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). 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FALCONSTOR SOFTWARE, INC. /s/ James Weber -------------------------------------- James Weber Chief Financial Officer, Vice President and Treasurer (principal financial and accounting officer) August 8, 2007 30
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10-Q Filing
Falconstor Software (FALC) 10-Q2007 Q2 Quarterly report
Filed: 9 Aug 07, 12:00am