DSS, INC. - Quarter Report: 2006 September (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE

COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

1-32146

Commission file number

DOCUMENT SECURITY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

New York		16-1229730
(State of incorporation)		(IRS Employer Identification Number)

28 Main Street East, Suite 1525

Rochester, NY 14614

(Address of principal executive office)

(585) 325-3610

(Registrant's telephone number)

Indicate by check mark whether the registrant:

(1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 o

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. (Check one):

Large accelerated filer o	Accelerated filer o	Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes o No x

Applicable only to corporate issuers

As of November 10, 2006 (the most recent practicable date), there were 12,926,989 shares of the issuer's Common Stock, $0.02 par value per share, outstanding.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes o No x

DOCUMENT SECURITY SYSTEMS, INC. FORM 10-Q TABLE OF CONTENTS

PART I FINANCIAL INFORMATION
Item 1	Financial Statements
	Consolidated Balance Sheets	F-1
	Consolidated Statements of Operations	F-2
	Consolidated Statements of Cash Flows	F-3
	Notes to Financial Statements	F-4
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	1
Item 3	Quantitative and Qualitative Disclosures about Market Risk	11
Item 4	Controls and Procedures	11

PART II OTHER INFORMATION
Item 1 Item 1a	Legal Proceedings Risk Factors	12
3Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	13
Item 3	Defaults upon Senior Securities	20
Item 4	Submission of Matters to a Vote of Security Holders	20
Item 5	Other Information	20
Item 6	Exhibits	20

SIGNATURES

PART I

FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

	September 30,			December 31,
	2006			2005
	(unaudited)			(audited)
ASSETS

Current assets:
Cash and cash equivalents	$	1,520,360		$	3,953,482
Accounts receivable, net of allowance
of $25,000 ($13,000 -2005)		719,941			164,726
Inventory		249,438			148,804
Prepaid expenses and other current assets		124,974			225,114

Total current assets		2,614,713			4,492,126

Restricted cash		—			240,000
Fixed assets, net		623,700			451,195
Other assets		159,862			229,050
Goodwill		1,396,734			711,785
Other intangible assets, net		4,994,754			4,208,962

Total Assets	$	9,789,763		$	10,333,118

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable	$	1,298,827		$	547,512
Accrued expenses & other current liabilities		229,692			212,559
Deferred revenue		595,783			—
Current portion of capital lease obligations		34,817			33,374
Current portion of long-term debt		—			50,891

Total current liabilities		2,159,119			844,336

Long-term debt		—			167,309
Long-term capital lease obligations		58,784			84,931


Commitments and contingencies (See Note 8)

Stockholders' equity
Common stock, $.02 par value;
200,000,000 shares authorized,
12,926,989 shares issued and outstanding (12,698,872 in 2005)		258,540			253,977
Additional paid-in capital		23,114,276			21,377,996
Accumulated deficit		(15,800,956	)		(12,395,431	)

Total stockholders' equity		7,571,860			9,236,542

Total Liabilities and Stockholders' Equity	$	9,789,763		$	10,333,118

See accompanying notes.

F-1

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations
(unaudited)


	Three Months Ended						Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2006			2005			2006			2005
Revenue, net
Security products & printing	$	849,264		$	222,158		$	2,608,619		$	864,352
Royalties		246,528			28,251			343,223			51,600
Legal products		167,518			122,714			483,983			381,445
Total Revenue		1,263,310			373,123			3,435,825			1,297,397

Costs of revenue
Security products & printing		581,370			123,936			1,665,325			475,285
Legal products		86,355			62,713			267,240			196,960
Total costs of revenue		667,725			186,649			1,932,565			672,245

Gross profit		595,585			186,474			1,503,260			625,152

Operating expenses:
Selling, general and administrative expenses		1,435,016			674,018			3,919,925			1,956,675
Research and development		93,693			79,165			262,577			239,750
Amortization of intangibles		275,714			135,000			763,989			270,000

Operating expenses		1,804,423			888,183			4,946,491			2,466,425

Operating loss		(1,208,838	)		(701,709	)		(3,443,231	)		(1,841,273	)

Other income (expense):
Interest income		7,200			29,797			51,338			67,222
Interest expense		(2,788	)		(6,494	)		(13,632	)		(20,543	)

Loss before income taxes		(1,204,426	)		(678,406	)		(3,405,525	)		(1,794,594	)

Income taxes		—			—			—			—

Net loss	$	(1,204,426	)	$	(678,406	)	$	(3,405,525	)	$	(1,794,594	)

Net loss per share, basic and diluted	$	(0.09	)	$	(0.06	)	$	(0.26	)	$	(0.15	)

Weighted average common shares outstanding, basic and diluted		12,920,315			12,285,029			12,868,887			11,856,511

See accompanying notes.

F-2

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
For the Nine Months Ended September 30,



	2006			2005
	(unaudited)			(unaudited)
Cash flows from operating activities:
Net loss	$	(3,405,525	)	$	(1,794,594	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization expense		927,635			404,960
Stock based compensation		591,684			29,521
(Increase) decrease in assets:
Accounts receivable		(389,229	)		235,226
Inventory		(30,487	)		(77,176	)
Prepaid expenses and other assets		(20,541	)		(73,238	)
Increase in liabilities:
Accounts payable and accrued expenses		234,719			58,179
Deferred revenue		595,783			—

Net cash used by operating activities		(1,495,961	)		(1,217,122	)

Cash flows from investing activities:
Purchase of fixed assets		(78,204	)		(83,941	)
Acquisition		(1,301,670	)		—
Purchase of other intangible assets		(453,542	)		(185,283	)

Net cash used by investing activities		(1,833,416	)		(269,224	)

Cash flows from financing activities:
Repayment of long-term debt		(218,200	)		(35,663	)
Decrease in restricted cash		240,000			51,000
Repayment of capital lease obligations		(24,704	)		(22,714	)
Issuance of common stock, net		899,159			2,555,664

Net cash provided by financing activities		896,255			2,548,287

Net increase (decrease) in cash and cash equivalents		(2,433,122	)		1,061,941
Cash and cash equivalents beginning of period		3,953,482			2,657,865

Cash and cash equivalents end of period	$	1,520,360		$	3,719,806

See accompanying notes.

F-3

DOCUMENT SECURITY SYSTEMS, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

(Unaudited)

1. Basis of Presentation and Significant Accounting Policies

Document Security Systems, Inc. (the “Company”), a New York corporation, operates in the market for secured documents and solutions. The Company licenses its patented technology and sells products that use its patented optical anti-scanning, anti-counterfeiting technologies. The Company’s customers include governments, law enforcement agencies, security printers, check and forms printers and corporations. In addition, the Company, through its consolidated subsidiaries, operates a retail printing operation and sells supplies to the legal industry.

Interim Financial Statements

The consolidated financial statements include the accounts of Document Security Systems, Inc and its wholly owned subsidiaries (collectively, the “Company”) after elimination of intercompany transactions, profits, and balances. The consolidated financial statements have been prepared from the Company’s records without audit and, in management’s opinion, include all adjustments (consisting of only normal recurring adjustments) necessary to fairly reflect the financial condition and the results for the periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted under the Securities and Exchange Commission’s rules and regulations.

These consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2005. The results of operations for the interim periods presented in these consolidated financial statements are not necessarily indicative of the results expected for the year ended December 31, 2006.

Reclassifications

Certain prior period amounts in the accompanying consolidated financial statements and notes thereto have been reclassified to current period presentation. These classifications had no effect on the results of operations for the period presented. These reclassifications include the reclassification of state business fees from income tax to selling, general and administrative and amortization of intangibles from selling, general and administrative to a separate line on the statement of operations.

Use of Estimates

The preparation of consolidated financial statements in accordance with U.S. generally accepted accounting principles requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Certain of the Company’s accounting policies require higher degrees of judgment than others in their application. These include impairments and estimation of useful lives of long-lived assets, inventory valuation, reserves for uncollectible accounts receivable, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

F-4

Share-Based Payments

Prior to January 1, 2006, the Company accounted for stock option awards granted under the Company’s Stock Incentive Plans in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, (“APB 25”) and related Interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”, (“SFAS 123”). Share-based employee compensation expense was not recognized in the Company’s consolidated statements of operations prior to January 1, 2006, as all stock option awards granted had an exercise price equal to or greater than the market value of the common stock on the date of the grant, except for modifications of stock option awards, which triggered compensation expense in accordance with provisions of FASB FIN 44 -“Accounting for Certain Transactions Involving Stock Compensation”. As permitted by SFAS 123, the Company reported pro-forma disclosures presenting results and earnings per share as if the Company had used the fair value recognition provisions of SFAS 123 in the Notes to Consolidated Financial Statements. Stock-based compensation related to non-employees were accounted for based on the fair value of the related stock or options in accordance with SFAS 123 and its interpretations.

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment”, (“SFAS 123(R)”) using the modified prospective transition method. See Note 5 for further detail on the impact of SFAS 123(R) to the Company’s consolidated financial statements.

Revenue Recognition

Sales of custom document security products amd printing, retail printing and legal products are recognized when a product or service is delivered, shipped or provided to the customer and all material conditions relating to the sale have been substantially performed. We also enter into arrangements under which we provide hosted software applications. We recognize revenue for these arrangements based on the provisions of EITF No. 00-3, Application of AICPA SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware ("EITF 00-3"), and the provisions of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by SAB No. 104, when there is persuasive evidence of an arrangement, collection of the resulting receivable is probable, the fee is fixed or determinable and acceptance has occurred. Our revenues related to these arrangements consist of system implementation service fees and software subscription fees. We have determined that the system implementation services represent set-up services that do not qualify as separate units of accounting from the software subscriptions as the customer would not purchase these services without the purchase of the software subscription. As a result, we recognize system implementation fees ratably over a period of time from when the core system implementation services are completed and accepted by the customer over the remaining customer relationship life, which we have determined is the contractual life of the customer's subscription agreement. We recognize software subscription fees, which typically commence upon completion of the related system implementation, ratably over the applicable subscription period. Amounts billed and/or collected prior to satisfying our revenue recognition policy are reflected as deferred revenue.

We recognize revenue from technology licenses once all the following criteria for revenue recognition have been met: (1) persuasive evidence of an agreement exists; (2) the right and ability to use the product or technology has been rendered; (3) the fee is fixed and determinable and not subject to refund or adjustment; and (4) collection of the amounts due is reasonably assured.

F-5

2. Inventory

Inventory consisted of the following:

	September 30,		December 31,
	2006		2005
	(unaudited)		(audited)

Finished Goods	$	178,745	$	148,804
Materials		70,693		-

	$	249,438	$	148,804

3. Goodwill and Other Intangible Assets

Other Intangible Assets -

Other intangible assets are comprised of the following:

				September 30,		December 31,
	Useful Life			2006		2005
Royalty rights		5 years		$	90,000	$	90,000
Other Intangibles		5 years			666,300		41,000
Patent and contractual rights		Varied (1	)		5,556,052		4,634,071
					6,312,352		4,765,071
Less accumulated amortization					1,317,598		556,109

Net carrying value				$	4,994,754	$	4,208,962

(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of September 30, 2006 the weighted average expected useful life of these assets was 6.7 years.

F-6

Goodwill - In accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets" (SFAS 142), the Company performs an annual fair value test of its recorded goodwill for its reporting units using a discounted cash flow and capitalization of earnings approach. During the first quarter of 2006, the Company recorded a preliminary estimate of goodwill of $942,000 associated with its acquisition of the assets of Plastic Printing Professionals. During the second quarter of 2006, the Company revised its estimate of goodwill associated with this acquisition to $685,000. As of September 30, 2006, the Company’s goodwill of $1,397,000 consists of $81,000 attributable to the legal segment and $1,316,000 attributable to the document security and production segment. The Company plans to conduct annual impairment tests in the fourth quarter of each year, unless impairment indicators exist at an earlier date.

4. Acquisition

On February 7, 2006, the Company acquired substantially all of the assets of Plastic Printing Professionals, Inc. ("P3") for $1.25 million in cash, 18,704 shares of the Company’s Common Stock valued at $250,000 and the assumption of certain liabilities. The cash portion of the purchase price was paid using the Company’s cash on hand. P3 is a security printer specializing in plastic cards containing security technologies. P3 has 25 full-time employees and had sales of approximately $2.7 million in 2005. Commencing on February 7, 2006, the results of P3’s operations are included in the consolidated financial statements of the Company. The Company accounted for the acquisition as a business combination under FASB 141 “Business Combinations”. During the quarter ended June 30, 2006, the Company revised its allocations from its preliminary estimates based upon the receipt of a valuation report that resulted in an increase in the amount allocated to acquired intangibles and a corresponding decrease in the amount allocated to goodwill of $225,000. The purchase price has been allocated based on the estimated fair market value of the assets acquired and liabilities assumed as follows:

Accounts receivable	$	166,000
Inventory & pre-paid assets		83,000
Fixed assets		258,000
Identified intangible assets		625,000
Goodwill		685,000
Total Assets	$	1,817,000
Liabilities Assumed	$	(265,000	)
Total Purchase Price	$	1,552,000

Set forth below is the unaudited pro forma revenue, operating loss, net loss and loss per share of the Company as if P3 had been acquired by the Company as of January 1, 2005:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Revenue	$	1,263,310		$	994,185		$	3,685,931		$	3,237,348
Operating Loss		(1,208,838	)		(687,444	)		(3,448,001	)		(1,796,714	)
Net Loss		(1,204,426	)		(664,141	)		(3,409,849	)		(1,750,035	)
Basic and diluted loss per share		(0.09	)		(0.05	)		(0.26	)		(0.15	)

F-7

5. Stock Based Compensation

In December 2004, the Financial Accounting Standards Board issued SFAS 123R, Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes SFAS 123, Accounting for Stock Based Compensation, and Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees (“APB 25) and its related implementation guidance. On January 1, 2006, the Company adopted the provisions of SFAS 123R using the modified prospective transition method. Under this method, the Company is required to record compensation expense for all stock based awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding as of the beginning of the adoption and prior periods have not been restated. Under SFAS 123R, compensation expense related to stock based payments are recorded over the requisite service period based on the grant date fair value of the awards.

Prior to the adoption of SFAS 123R, the Company accounted for employee stock options using the intrinsic value method in accordance with APB 25. Accordingly, no compensation expense was recognized for stock options issued to employees as long as the exercise price was greater than or equal to the market value of the Common Stock at the date of grant. In accordance with SFAS 123, the Company disclosed the summary of pro forma effects to reported net loss as if the Company had elected to recognize compensation costs based on the fair value of the awards at the grant date.

The Company has adopted the 2004 Employees' Stock Option Plan (the "2004 Plan") to provide for the grant of options, restricted stock and other forms of equity to employees, including executive officers, and consultants. A total of 1,200,000 shares of Common Stock are authorized to be issued under the 2004 Plan. Under the terms of the 2004 Plan, options granted thereunder may be designated as options which qualify for incentive stock option treatment ("ISOs") under Section 422A of the Internal Revenue Code, or options which do not so qualify ("Non-ISOs"). The 2004 Plan is administered by the Compensation Committee of the Company’s Board of Directors. The Compensation Committee has the discretion to determine the eligible employees to whom, and the times and the price at which, options will be granted; whether such options shall be ISOs or Non-ISOs; the periods during which each option will be exercisable; and the number of shares subject to each option. The Compensation Committee has full authority to interpret the 2004 Plan and to establish and amend rules and regulations relating thereto.

The Company also adopted The Non-Executive Director Stock Option Plan (the "Director Plan"), which provides for options for up to 100,000 shares to non-executive directors and advisors. Under the terms of the Director Plan, an option to purchase (a) 5,000 shares of our common stock shall be granted to each non-executive director upon joining the Board of Directors and (b) 5,000 shares of our common stock shall be granted to each non-executive director thereafter on January 2^nd of each year; provided that any non-executive director who has not served as a director for the entire year immediately prior to January 2nd shall receive a pro rata number of options based on the time the director has served in such capacity during the previous year.

The exercise price for options granted under the Director Plan is 100% of the fair market value of the Common Stock on the date of grant. Until otherwise provided in the Director Plan, the exercise price of options granted under the Director Plan must be paid at the time of exercise, either in cash, by delivery of shares of the common stock of the Company or by a combination of each. The term of each option commences on the date it is granted and unless terminated sooner as provided in the Director Plan, expires five years from the date of grant. Neither the Board nor the Compensation Committee has discretion to determine which non-executive director or advisory board member will receive options or the number of shares subject to the option, the term of the option or the exercisability of the option. However, the Compensation Committee will make all determinations of the interpretation of the Director Plan. Options granted under the Director Plan are not qualified for incentive stock option treatment.

F-8

The compensation cost that has been charged against income for options granted under the plans was approximately $21,000 and $63,000 for the three-month and nine-month periods, respectively, ended September 30, 2006. The impact of these expenses to basic and diluted earnings per share was less than $0.01 during those periods. The adoption of SFAS 123R did not have an impact on cash flows from operating or financing activities. For stock options issued as non-ISO’s a tax deduction is not allowed until the options are exercised. The amount of this deduction will be the difference between the fair value of the Company’s Common Stock and the exercise price at the date of exercise. Accordingly, there is a deferred tax asset recorded for the tax effect of the financial statement expense recorded. The tax effect of the income tax deduction in excess of the financial statement expense will be recorded as an increase to additional paid-in capital. Due to the uncertainty of the Company’s ability to generate sufficient taxable income in the future to utilize the tax benefits of the options granted, the Company has recorded a valuation allowance to reduce gross deferred tax asset to zero. As a result for the periods ended September 30, 2006, there is no income tax expense impact from recording the fair value of options granted. No tax deduction is allowed for stock options issued and exercised as ISO’s.

In December 2005, the Company approved an acceleration of all unvested options at that time. Pursuant to this, the Company recorded stock based compensation expense based on the intrinsic value of in-the-money options and our estimate of the benefit of the modification to the Company's employees and officers. As of that date, our estimate of the benefit was $78,000, which was recorded as stock based compensation expense. As of September 30, 2006, there remained an additional $252,000 of potential expense that would be recorded if actual forfeiture results differ from management's estimates.

The fair value of each option award is estimated on the date of grant utilizing the Black Scholes Option Pricing Model that uses the assumptions noted in the following table.


	Nine Months Ended September 30,
	2006			2005
Volatility		42.6	%		55	%
Expected option term		3 years			4 years
Risk-free interest rate		4.4	%		4.1	%
Expected dividend yield		0	%		0	%

F-9

A summary of the status of the options granted under the 2004 Plan and the Director Plan, respectively, is presented below:

	2004 Employee Plan						Non-Executive Director Plan


	Number of Options		Weighted Average Exercise Price		Weighted Average Life Remaining		Number of Options		Weighted Average Exercise Price		Weighted Average Life Remaining
					(years)						(years)
Outstanding at December 31, 2005		277,000		8.05				36,250		5.47
Granted		—						20,000		12.65
Exercised		—						—		-
Canceled		50,000		10.19				—		-
Outstanding at September 30, 2006:		227,000		7.58				56,250		8.02
Exercisable at September 30, 2006:		217,000		7.67				36,250		5.47

Aggregate Intrinsic Value of outstanding options at September 30, 2006	$	519,830				3.8	$	159,500				3.3
Aggregate Intrinsic Value of exercisable options at September 30, 2006	$	477,400				3.9	$	159,500				2.8

The weighted-average grant date fair value of options granted during the six-month period ended September 30, 2006 was $4.24 ($2.99 during the nine-month period ended September 30, 2005). There were no options exercised during the nine-month periods ended September 30, 2006 or 2005, respectively.

The following table summarizes the status of the Company’s non-vested options under the its stock option plans:

	Number of Non-vested		Weighted- Average
	Shares		Grant Date
	Subject to Options		Fair Value
Non-vested as of December 31, 2005		10,000	$	3.68
Non-vested granted- nine month period ended September 30, 2006		20,000	$	4.24
Vested - nine month period ended September 30, 2006		—	$	—
Forfeited - nine month period ended September 30, 2006		—	$	—

Non-vested as of September 30, 2006		30,000	$	4.05

As of September 30, 2006, there was approximately $25,000 of total unrecognized compensation cost related to non-vested options granted under the Non-Executive Director plan. That cost will be recognized over a weighted average period of one year. The total fair value of shares that vested during the nine-month period ended September 30, 2006 was $0 ($450,000 during the nine-month period ended September 30, 2005).

F-10

Pro-Forma Stock Compensation Expense:

For the quarterly and nine-month periods ended September 30, 2005, the Company applied the intrinsic value method of accounting for stock options as prescribed by APB 25. Since all options granted during the quarterly and nine-month periods ended September 30, 2005 had an exercise price equal to the closing market price of the underlying common stock on the grant date, no compensation expense was recognized. If compensation expense had been recognized based on the estimated fair value of each option granted in accordance with the provisions of SFAS 123 as amended by Statement of Financial Accounting Standard 148, our net loss and net loss per share would have been reduced to the following pro-forma amounts (in thousands, except per share amounts):

	September 30, 2005
	Three months						Nine months
	ended						ended
	$ Amount			$ Per share			$ Amount			$ Per share
Net loss, as reported	$	(678,406	)	$	(0.06	)	$	(1,794,594	)	$	(0.15	)
Fair value method compensation expense, net of tax		(224,473	)		(0.02	)		(449,693	)		(0.04	)
Net loss, pro-forma	$	(902,879	)	$	(0.08	)	$	(2,244,287	)	$	(0.19	)

Restricted Stock- Restricted common stock is issued for services to be rendered and may not be sold, transferred or pledged for such period as determined by our Compensation Committee. Restricted stock compensation cost is measured as the stock’s fair value based on the market price at the date of grant. The restricted shares issued reduce the amount available under our stock option plans. We recognize compensation cost only on restricted shares that will ultimately vest. We estimate the number of shares that will ultimately vest at each grant date based on our historical experience and adjust compensation cost and the carrying amount of unearned compensation based on changes in those estimates over time. Restricted stock compensation cost is recognized ratably over the requisite service period which approximates the vesting period. An employee may not sell or otherwise transfer unvested shares and, in the event that employment is terminated prior to the end of the vesting period, any unvested shares are surrendered to us. We have no obligation to repurchase restricted stock.

On June 26, 2006, the Company granted 65,000 in restricted stock to recently hired employees, including 50,000 to its new President. The restricted shares vest over 3 years beginning on the grant date. The company will recognize compensation costs associated with these restricted shares of approximately $700,000 over the vesting periods of which $58,000 was recognized during the third quarter of 2006.

The following is a summary with respect to restricted stock outstanding at September 30, 2006:

			Weighted- average
			grant-date
	Shares		fair value per share

Restricted shares outstanding, December 31, 2005		—	$	—
Restricted shares granted		65,000		10.77
Restricted shares vested		—		—
Restricted shares forfeited		—		—
Restricted shares outstanding, September 30, 2006		65,000	$	10.77

F-11

6. Stockholders Equity

Stock Issued for Acquisition -In February 2006, the Company issued 18,704 of its Common Stock plus additional costs related to the acquisition of substantially all of the assets of Plastic Printing Professionals (See Note 4). The value of the shares of Common Stock was determined based upon the average closing price of the shares of the Company’s Common Stock on the American Stock Exchange on for 10 trading days immediately prior to February 7, 2006 of $13.36 per share.

Stock Warrants -During the first nine months of 2006, the Company received approximately $900,000 in proceeds from the exercise of warrants.

On June 16, 2006, the Company issued to International Barcode Corporation (d/b/a Barcode Technology)(“BTI”), a warrant to purchase 500,000 shares of the Company's common stock, $0.02 par value per share, at a price of $10.00 per share vesting over approximately one year and with an expiration date of June 16, 2007. The fair value of the warrants amounted to $890,000 utilizing Black Scholes pricing model. This value is being recognized as the warrants vests. During the three months and nine months ended September 30, 2006, the Company has recognized approximately $223,000 and $445,000, respectively, of expense related to these warrants. The warrants were issued in conjunction with an agreement that provides BTI with the exclusive right to market, sell and manufacture DSS technologies, products and processes for all security-related applications for government and commercial use in China.

The following is a summary with respect to warrants outstanding at September 30, 2006:

	2006
			Weighted
			Average
			Exercise
	Warrants		Price

Warrants outstanding at January 1, 2006		296,783	$	4.12

Granted		500,000	$	10.00
Exercised		204,597	$	4.49
Lapsed		—	$	—

Warrants outstanding at September 30, 2006		592,186	$	8.96

				10.6

F-12

The following table summarizes the warrants outstanding and exercisable as of September 30, 2006:

	Warrants Outstanding						Warrants Exercisable

Range of Exercise Prices	Number of Shares		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price		Number of Shares		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price


$2.00-$4.99		59,375		1.5	$	2.38		59,375		1.5	$	2.38
$5.00-$7.75		32,811		2.2	$	5.00		32,811		2.2	$	5.00
$7.76-$10.00		500,000		0.7	$	10.00		250,000		0.7	$	10.00
		592,186						342,186

7. Loss per Share

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares, outstanding for the period. Diluted earnings per share is computed by including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive. As of September 30, 2006, there were 875,436 (580,969 as of September 30, 2005) stock options and warrants outstanding with exercise prices below the average share price for the period that would have been included in the calculation of diluted earnings per share had the Company generated net income.

8. Commitments and Contingencies

In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s litigation with the European Central Bank (“ECB”) which capped the fees for all matters associated with that litigation at $500,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation. The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable. As described above, in March 2006, the Company was countersued by the ECB in several European national courts seeking revocation of the Company’s patents. Through September 30, 2006, the Company has been billed approximately $500,000 for legal costs associated with these aforementioned countersuits. It was the Company’s belief that the costs of defending these countersuits would be fully covered under the litigation cap it had previously negotiated with its legal counsel, However, given the potentially significant costs associated with these countersuits, the Company determined that additional reimbursements to its legal counsel was warranted. As such, on November 14, 2006 the Company entered into an agreement with its legal counsel in which the Company will issue approximately 47,000 shares of its common stock for payment of the approximately $500,000 of bills currently residing in accounts payable relating to the ECB countersuits. In addition, the Company will have the right to pay all future legal fees incurred by its lead legal counsel related to the countersuits with shares of its common stock. In addition to these payments, the Company will be responsible for certain third party fees and expenses associated with the countersuits. Depending of the duration of these cases and any appeals, these third party costs may be significant and could be material to the Company’s financial condition.

F-13

In addition, if the ECB is successful in its claims of invalidity against the Company’s patent, it may materially affect the Company’s financial condition, including the potential requirement to pay all of the ECB’s legal fees associated with the suit, and the Company’s ability to market certain of its technology.

On June 29, 2006, the Company received notice of favorable summary judgment from the State of New York Supreme Court in the case of “Frank LaLoggia v. Document Security Systems, Inc”. The Court ruled in favor of the Company and dismissed all claims against the Company. The Company will continue to pursue its counterclaim against Mr. LaLoggia which was not dismissed by the Court.

In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.

9. Supplemental Cash Flow Information

During the nine months ended September 30, 2006, the Company issued 18,704 shares of Common Stock valued at $250,000 in conjunction with the acquisition of the assets of P3 (See Note 4).

10. Subsequent Event

On November 14, 2006, the Company entered into an agreement with its legal counsel regarding the European Central Bank countersuit in which the Company will issue approximately 47,000 shares of its common stock for payment of approximately $500,000 of legal bills currently residing in accounts payable. In addition, per the agreement, the Company has the right to pay all future legal fees incurred by its lead legal counsel related to countersuits initiated by the European Central Bank with shares of its common stock. Under the agreement, the Company will be responsible for third party fees associated with the countersuit litigation. (See Note 8)

F-14

11. Segment Information

The Company's businesses are organized, managed and internally reported as four operating segments. Three of these operating segments, Document Security Systems, Plastic Printing Professionals and Patrick Printing, respectively, are engaged in various aspects of developing and applying printing technologies and procedures to produce, or allow others to produce, documents with a wide range of features, including the Company’s patented technologies and trade secrets. Consistent with the Company’s strategic initiative to increase its focus on servicing the end-user of secure documents, the Company has reorganized Patrick Printing, which was formerly considered a separate reportable segment, to concentrate its internal printing capabilities for these end-users. While Patrick Printing continues to offset its costs and utilize its capacity with retail copying and printing work, the Company determined that it was appropriate to aggregate this segment with its other document production and security companies because of the similarities in the nature of their products and production and sales processes and types of customers. Thus, for the purposes of providing segment information, these three operating segments have been aggregated into one reportable segment in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 131- “Disclosures about Segments of an Enterprise and Related Information”. Prior period amounts have been reclassified to reflect the change in reporting segments and all inter-company transactions are eliminated. A summary of the two segments is as follows:

Document Security and Production	License, manufacture and sale of document security technologies and secure printed products at its Document Security Systems, Plastic Printing Professionals and Patrick Printing divisions. Also, includes revenues from copying services and residual royalties from motion picture operations.

Legal Supplies	Sale of specialty legal supplies to lawyers and law firms located throughout the United States as Legalstore.com.

Approximate information concerning the operations by reportable segment for the three and nine months ended September 30, 2006 and 2005 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:

			Document
	Legal		Security &
3 months ended September 30, 2006:	Supplies		Production			Corporate			Total
Revenues from external customers	$	168,000	$	1,095,000		$	-			1,263,000
Depreciation and amortization		3,000		301,000			16,000			320,000
Segment profit or (loss)		13,000		(789,000	)		(428,000	)		(1,204,000	)

3 months ended September 30, 2005:
Revenues from external customers	$	122,000	$	251,000		$	-		373,000
Depreciation and amortization		1,000		157,000			22,000		180,000
Segment profit or (loss)		12,000		(394,000	)		(296,000	)	(678,000	)


					Document
		Legal			Security &
9 months ended September 30, 2006:		Supplies			Production			Corporate		Total
Revenues from external customers	$	484,000		$	2,952,000		$	-		3,436,000
Depreciation and amortization		9,000			847,000			72,000		928,000
Segment profit or (loss)		(18,000	)		(1,933,000	)		(1,455,000	)	(3,406,000	)

9 months ended September 30, 2005:
Revenues from external customers	$	381,000		$	916,000		$	-		1,297,000
Depreciation and amortization		4,000			335,000			66,000		405,000
Segment profit or (loss)		50,000			(789,000	)		(1,056,000	)	(1,795,000	)

F-15

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, including, without limitation, those contained in our Form 10-KSB for the year ended December 31, 2005 and those described herein that could cause actual results to differ materially from the results anticipated in the forward-looking statements.

Overview

We are a supplier of advanced optical anti-scanning, anti-counterfeiting, and verification technologies and products for all forms of printed media. We provide document security technology to security printers, corporations and governments worldwide. Our technology can be used in securing sensitive and critical documents such as currency, automobile titles, spare parts forms for the aerospace industry, psychological examinations, gift certificates, permits, checks, licenses, receipts, prescription and medical forms, engineering schematics, ID cards, labels, original music, coupons, homeland security manuals, consumer product and pharmaceutical packaging, tickets, and school transcripts. In addition, we sell legal supplies on the Internet at a non-core division.

Generally, we generate revenue from our document security and production business in three ways. We produce document security products for the end-user market including pre-packaged security paper. We license our patented technology to security printers so that they can provide their customers with anti-counterfeiting capabilities, and finally, we design, produce and consult for customized anti-counterfeiting solutions for corporate and government customers, including custom documents printed on paper, plastic or various other materials or delivered via electronic means.

Security Paper: Our primary product for the end-user market is AuthentiGuard Security Paper. AuthentiGuard Security Paper is a paper which reveals hidden warning words, logos or images when a clear plastic viewer is placed over the paper or when the paper is faxed, copied, scanned or re-imaged in any form. The hidden words appear on the duplicate copy or the computer digital file and essentially prevent important documents from ever being counterfeited. We market and sell our Security Paper primarily through two major paper distributors: Boise White Paper and PaperlinX Limited. Since 2005, Boise markets our Security Paper under its Boise Beware brand name in North America, primarily through its commercial paper sales group, and in OfficeMax and CopyMax stores. In late 2005, we entered into an agreement with PaperlinX to market and sell our Security Paper under the name SecurelinX in Europe, Australia and New Zealand. The initial orders under this agreement were shipped during the second quarter of 2006. In addition, our licensee, PyroTech, has the marketing rights to manufacture and sell our Security Paper in the continent of Africa. We retain the rights to sell the same Security Paper direct to end users anywhere in the world. Pricing for the Security Paper is determined on mark-up from cost.

Currently, our Security Paper is manufactured and stored for us by a third-party printer which has sufficient capacity to meet the foreseeable demand for this product. We are seeking to increase profit margins by developing manufacturing capabilities through strategic mergers and acquisitions that will allow us to service larger and a wider range of potential customers while eliminating a layer of costs by reducing our reliance on third-party printers.

Technology Licensing: We license our anti-counterfeiting technology and trade secrets through licensing arrangements with security printers. We seek licensees that have a broad customer base that can benefit from our technologies. Licensees generally pay on a usage basis royalties to us based on the revenue of each job in which our technologies are used.

In addition, we believe that some of our technologies are being used on an un-authorized basis. By aggressively defending our intellectual property rights, we believe that we will be able to secure a potentially significant amount of additional and ongoing revenue by securing licensing agreements with those persons, companies or governments that we believe are infringing our patents. We also anticipate that we may be required to pursue litigation in some cases and that we will need to spend a significant amount of money and time on these matters.

Custom Document Security Solutions and Production: Our technology portfolio allows us to create custom secure documents that are unique to the industry. We target end-users such as governments, agencies and corporations which require anti-counterfeiting and authentication features in a wide range of documents and vital records such as driver’s licenses, birth certificates, receipts, manuals and identification materials and corporations creating entertainment tickets, coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods.

In February of 2006, we acquired San Francisco-based Plastic Printing Professionals, Inc. ("P3"), a privately held, security printer specializing in plastic cards containing security technologies. P3's primary focus is manufacturing composite, laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, DNA and a patent pending watermark technology. P3's products are marketed through an extensive dealer network that covers North America, Europe and South America. Its product and client list includes the Grammy Awards, the Country Music Association awards, Super Bowl media cards, ID cards for major airports and Latin American driver’s licenses.

During 2006, we expanded our marketing efforts to the end-user of custom secure documents. Whereas in the past, we typically sought to license our technology to the printer of the end-user, we have determined that significant advantages exist in the market if we are able to own the end-user relationship from the design phase through the production phase. Therefore, we have shifted our focus to utilize more of our internal printing capabilities towards the custom security document market.

In March 2006, we entered into a license with a major international bank to provide a technology for the Internet delivery of secure, verifiable documents that can be transmitted and printed over the Internet using a customized web-hosting site for the securitization process. This is the first application of a covert method we developed for producing secure documents, such as financial instruments, at multiple locations. The three-year agreement includes implementation and initial set-up fees for the bank's website, as well as annual licensing and maintenance fees and was put into service in August of 2006.

Currently, we primarily outsource the production of our custom security print orders to strategic printing vendors. The acquisition of P3 marked the initial execution of our strategy to expand our manufacturing capabilities through acquisitions or strategic alliances in order to service our custom security printing business.

Legal Supplies: We also own and operate Legalstore.com, an Internet company which sells legal supplies and, documents, including security paper and products for the users of legal documents and supplies, including the legal, medical and educational fields . While not a component of our core business strategy, we seek to maximize the revenue and profitability of this operation..

Results of Operations for the Three and Nine Months Ended September 30, 2006

The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-KSB for the year ended December 31, 2005.

The following discussion also includes a non-GAAP financial measure which has been reconciled to the most comparable GAAP financial measure of net loss. Our management believes that this performance measure is a relevant indicator of the Company’s financial performance.

Summary

	Three Months Ended September 30,2006						Nine Months Ended September 30,2006
	$			% change vs. 3 months ended September 30, 2005			$			% change vs. 9 months ended September 30, 2005
Revenue, net		1,264,000			239	%		3,436,000			165	%

Costs of revenue		668,000			257	%		1,933,000			188	%

Gross profit		596,000			220	%		1,503,000			140	%

Total Operating Expenses		1,804,000			103	%		4,946,000			101	%

Operating loss		(1,208,000	)		72	%		(3,443,000	)		87	%

Other income (expense):
Interest income		7,000			-77	%		51,000			-24	%
Interest expense		(3,000	)		-50	%		(14,000	)		-33	%

Loss before income taxes		(1,204,000	)		78	%		(3,406,000	)		90	%

Income taxes		0			-			0			-
Net loss		(1,204,000	)		78	%		(3,406,000	)		90	%

Revenue

For the three and nine month periods ended September 30, 2006, total revenue increased 239% and 165% from the same periods ended September 30, 2005, respectively. The increases in total revenue resulted primarily from increases in royalty revenue from the licensing of the Company’s patented technology, and from increases in sales of security products and documents from the Company’s acquisition during the first quarter of 2006 of Plastic Printing Professionals, a manufacturer of secure plastic cards and documents.

In addition, not reflected in the results above are deferred revenues of approximately $596,000 which represent payments the Company has received for technology licenses and certain of its on-demand products for which revenue recognition is deferred over the terms of the license or service. During the third quarter of 2006, the Company received $500,000 from one major technology licensee as described below.

During the three and nine month periods ended September 30, 2006, the Company continued its efforts to increase the market for its technologies and products by developing sales and marketing channels by a combination of expanding its internal sales and marketing resources and widening its list of partners and distributors. The following chart summarizes significant new contracts and business development agreements entered into by the Company during 2006 that are expected to drive revenue growth for the remainder of 2006 and 2007:

Renewed and extended the historical licensing agreement with R.R. Donnelley & Sons Company, the largest printer in North America. A three-year contract, the renewed agreement includes royalties on the usage of DSS's SecureScan(tm) technology and began producing significant revenue for the Company during the third quarter of 2006.

Signed a letter of agreement with The Ergonomic Group (EGI) for the exclusive, limited right to use and market DSS's extensive portfolio of security technologies in the high technology, aerospace, financial and healthcare industries. The agreement guarantees that the Company will receive a minimum of $1,000,000 of which $500,000 was received in the third quarter of 2006 and $500,000 is due in the fourth quarter of 2006. Ergonomics Group is a shareholder of the Company with holdings of less than 5% of the outstanding shares of the Company.

Agreed to provide TransTech Systems, Inc. the exclusive distributions rights of DSS technology when used for large format event identification badges and cards. TransTech is a leading distributor in the ID badge and access control markets and services a network of over 700 security products dealers throughout the United States.

Signed a licensing contract with Nampak Flexible, a division of Nampak Limited ("Nampak") who is a leading flexible packaging manufacturer in South Africa. The agreement is Company's first licensing agreement with a packaging business and is a royalty-based contract for one-year with automatic annual renewals for an additional four years.

Signed an exclusive marketing agreement with Assa Abloy HID Global ("HID") to market DSS’s select technologies to enhance the security of HID's contactless smartcards and proximity cards. Assa Abloy HID, is owned by parent ASSA ABLOY (ASZAF.PK) which is headquartered in Stockholm, Sweden. ASSA ABLOY is the world's leading manufacturer and supplier of locking and security access solutions.

Signed a two-year licensing agreement with Banknote Corporation of America (BCA), a major high security printer in the United States for a variety of secure documents, such as checks, stamps, identification.

Signed licensing agreement with The Reynolds and Reynolds Company (NYSE: REY), a leading software and services provider for the automotive retailing market in the United States and Canada for the protection of checks and forms.

Signed an exclusive licensing agreement with Barcode Technology (BTI) to market and produce DSS's technology, both independently and in combination with BTI's technology in China.

Signed a two-year agreement with ProdoSafe Security Solutions, Turkey's largest supplier of anti-counterfeiting technology. With its recently awarded contracts, ProdoSafe will apply DSS's technology in two metropolitan areas in Turkey.

	Three Months Ended September 30,2006					Nine Months Ended September 30,2006
	$		% change vs. 3 months ended September 30, 2005			$		% change vs. 9 months ended September 30, 2005
Revenue, net
Security Products & Printing	$	849,000		282	%	$	2,609,000		202	%
Royalties		247,000		782	%		343,000		560	%
Legal products		168,000		37	%		484,000		27	%
Total Revenue		1,264,000		239	%		3,436,000		165	%

Security Products & Printing

For the three and nine month periods ended September 30, 2006, Document Security and Production sales increased 282% and 200%, respectively compared with the same periods of 2005. The increases in revenues in the category of $627,000 and $1,724,000, respectively for the 2006 periods were primarily due to the inclusion of $593,000 and $1,665,000, respectively, of sales from the Company’s P3 division (“P3”), which was acquired on February 7, 2006.

Royalties

During the third quarter of 2006 and for the nine-months ended September 30, 2006, the substantial increase in the Company’s royalty revenue was primarily a result of its recent license agreements with RR Donnelly and The Ergonomics Group. In addition, the Company received approximately $585,000 in license royalty pre-payments during the third quarter for which revenue recognition is deferred over the terms of the license or service.

Legal Products

Revenue from our legal supplies business, Legalstore.com, grew 38% and 27% during the third quarter and first nine months of 2006, respectively, compared with those periods of 2005. While we view our legal supplies business segment as a non-core part of our company, we have experienced steady growth in its operations as it continues to expand its product catalog and customer reach through various keyword advertising campaigns and trade shows..

Cost of Sales and Gross Profit

	Three Months Ended September 30,2006					Nine Months Ended September 30,2006
			% change vs. 3 months ended September 30, 2005					% change vs. 9 months ended September 30, 2005

Costs of revenue
Security Products & Printing	$	582,000		349	%	$	1,667,000		251	%
Legal products		86,000		50	%		266,000		35	%
Total cost of sales		668,000		257	%		1,933,000		188	%

Gross profit
Security Products & Printing		267,000		189	%		942,000		142	%
Royalties		247,000		782	%		343,000		560	%
Legal products		82,000		25	%		218,000		18	%
Total gross profit		596,000		220	%		1,503,000		140	%

	Three Months Ended September 30,2006						Nine Months Ended September 30,2006
				% change vs. 3 months ended September 30, 2005						% change vs. 9 months ended September 30, 2005
Gross profit percentage:		47	%		-5	%		44	%		-9	%

Gross Profit

During the third quarter of 2006, gross profit increased 220% to $596,000 which was primarily the result of increases in both document security & production profits and royalties profits. The increase in the document security and production category during the 2006 quarter included $246,000 in gross profit derived from the Company’s P3 division which was acquired in 2006.

During the first nine months of 2006, the gross profit increased by 140% as compared with the first nine months of 2005. The increase of $878,000 in gross profit included $631,000 from P3.

The gross profit percentage decrease during the first nine months of 2006 reflects the impact of P3’s gross profit margin of approximately 37% which was consistent with its historical gross profit margin, but is less than the document security category’s historical profit margin. However, the gross profit of 47% realized by the Company during the third quarter of 2006 reflects a 12% increase over the year to date through June 30, 2006 gross profit margin of 42% which reflects the positive effect of the increase in license royalty revenue earned during the third quarter.

Operating expenses

	Three Months Ended September 30,2006					Nine Months Ended September 30,2006
	$		% change vs. 3 months ended September 30, 2005			$		% change vs. 9 months ended September 30, 2005

Selling, general and administrative
Compensation	$	541,000		105	%	$	1,434,000		105	%
Stock based payments		311,000		3010	%		592,000		1873	%
Professional Fees		212,000		36	%		945,000		77	%
Sales and marketing		128,000		2	%		399,000		19	%
Depreciation and amortization		18,000		-18	%		74,000		16	%
Other		224,000		131	%		475,000		60	%
Research and development		94,000		19	%		263,000		10	%
Amortization of intangibles		276,000		104	%		764,000		183	%

Total Operating Expenses		1,804,000		103	%		4,946,000		101	%

Selling, General and Administrative

The Company’s selling, general and administrative costs increases generally reflect increases to the size of our organization as the result of the Company’s acquisition of P3 and increases in executive management, sales and operations personnel integral to the company’s sales growth strategy.

SG&A Compensation costs increases for non-production personnel that the Company has experienced in 2006 to date are primarily due to the addition of executive management, sales, and operations personnel, as well as the addition of executive and administrative personnel at P3. Of the $277,000 and $752,000 increase in compensation expense during the third quarter and first nine months of 2006, respectively, $147,000 and $344,000 stem from P3 which was acquired in February of 2006. The Company believes that it has obtained appropriate levels of staffing for its near term forecasted business levels and that future staffing additions will be concentrated on sales, marketing and operations to coincide with expected revenue growth.

Stock based payments during the first nine months of 2006 include approximately $445,000 of expense recognized for the issuance of warrants to International Barcode Corporation (d/b/a Barcode Technology) (“BTI”) in consideration for a cross-marketing relationship that enables the Company to expedite its entry into the Chinese market for secure documents, and $63,000 associated with annual option grants to the non-executive members of our Board of Directors. The Company will continue to incur approximately $223,000 in expense per quarter for the next two quarters associated with the grant of the BTI warrants based on the estimated value of the warrants on the grant date using the Black-Scholes option valuation model. These warrants have an exercise price of $10.00 and do not include a non-cash exercise provision. Therefore, the exercise of these warrants, if ever, would result in the receipt of $5,000,000 by the Company.

Professional fees include legal, accounting, shareholder services, investor relations, and consulting costs. Consulting fees ($74,000 and $215,000 for three and nine month periods ended September 30, 2006, respectively), are primarily directed towards efforts to help the Company develop market opportunities with government and large multinational corporations, and intellectual property management, legal fees ($53,000 and $266,000 for three and nine month periods ended September 30, 2006, respectively) and accounting fees ($23,000 and $138,000 for three and nine month periods ended September 30, 2006, respectively) are generally associated with the Company’s corporate governance and reporting compliance requirements. In addition, legal fees include costs associated with certain legal matters regarding Adlertech and F. Laloggia, respectively- (See Part II -Legal Proceedings). These legal costs do not include costs associated with the application and defense of our patents which the company capitalizes and amortizes over the expected life of the patent. (See Part I -Financial Information -Note 8)

Sales and marketing expenses increases in 2006 have been the result of investments in resources to expand its sales and marketing efforts in order to increase customer awareness and understanding of the Company technologies and solutions. The Company expects to continue to increase its sales and marketing efforts in correlation with expected revenue growth.

Other expenses are primarily rent and utilities, office supplies, IT support, and insurance costs. Increases in 2006 reflect costs associated with a larger organization including higher rent and utility costs associated with the addition of P3.

Research and Development

We continue to invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consist primarily of compensation costs for our four persons who spend all or at least half of their time on developing new technologies or developing new uses for our existing technology. In addition, we incur costs for the use of third party printers’ facilities to test our technologies on equipment that we do not have access to internally. We expect that our research and development costs will continue at current levels for the foreseeable future.

Amortization of intangibles

Commencing in the second quarter of 2005, we began to amortize the costs associated with the patents that we acquired in 2005 and the legal costs associated with the development and defense of our patents, including the costs associated with our suit against the European Central Bank for patent infringement. In addition, we amortize our acquired intangibles from business combinations. A significant portion of these assets were acquired by the issuance of equity in the company. Our amortizable asset base at September 30, 2006 was approximately $6.5 million and will generate approximately $900,000 in annual amortization expense during the next 6 years. The Company reviews these assets for impairment annually. If an impairment, such as unfavorable ruling in the Company’s patent infringement lawsuits or an assessment of non-commerciability of certain of its patents, then the Company would write-off a portion of these assets, which could be a significant expense in the period incurred.

In addition, the Company has $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined.

Net loss and loss per share

	Three Months Ended September 30,2006						Nine Months Ended September 30,2006
	$			% change vs. 3 months ended September 30, 2005			$			% change vs. 9 months ended September 30, 2005


Net loss		(1,204,000	)		78	%		(3,406,000	)		90	%

Net loss per share, basic and diluted		(0.09	)		69	%		(0.26	)		75	%

Weighted average common shares outstanding, basic and diluted		12,920,315			5	%		12,868,887			9	%

During the third quarter and first nine months of 2006, the Company continued to experience net losses. While we have experienced growth in our sales and gross profits, these increases have not offset our increases in our operating expenses, especially significant increases in amortization expense, stock based compensation, compensation and professional fees.

Our basic and diluted loss per share has increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding in 2006 compared to 2005. Our shares have increased as we have issued our common shares for warrants exercised, for an acquisition and for the purchase of patent assets.

Non-GAAP Financial Performance Measure

The following adjusted Earnings before interest, taxes, depreciation, amortization and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because the Company’s management believes it to be a relevant measure of the performance of the Company. The Adjusted EBITDA is used by the Company’s management to measure its core operating performance without certain non-cash expenditures. The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP measure is presented below.

Adjusted EBITDA

	Three Months Ended September 30,2006						Nine Months Ended September 30,2006
	$			% change vs. 3 months ended September 30, 2005			$			% change vs. 9 months ended September 30, 2005

Net Loss	$	(1,204,000	)		78	%	$	(3,405,000	)		90	%
Add back:
Depreciation		45,000			0	%		163,000			21	%
Amortization of Intangibles		276,000			104	%		764,000			183	%
Stock based payments		311,000			3010	%		592,000			1873	%
Interest Income		(7,000	)		-77	%		(51,000	)		-24	%
Interest Expense		3,000			-50	%		14,000			-33	%
Income Taxes		—						—

Adjusted EBITDA		(576,000	)		13	%		(1,923,000	)		37	%

As described above, Adjusted EBITDA is a non-GAAP measurement of financial performance that the Company believes is relevant to the understanding of the Company’s financial results. While net loss increased 78% and 90%, respectively, during the third quarter and nine months ended September 30, 2006, Adjusted EBITDA deficits increased only 13% and 37%, respectively, for the same periods. These results reflect that the increases in sales and gross profits have outpaced increases in the Company’s core operating expenses, (core operating expenses are compensation, professional fees, sales and marketing, other and research and development costs) which increased 65% and 68%, respectively, during the three and nine months ended September 30, 2006 compared to 2005 levels.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s cash flows and other key indicators of liquidity are summarized as follows:

	Nine Months Ended
	September 30,			September 30,
	2006			2005			%
	(unaudited)			(unaudited)			Change
Cash flows from:

Operating activities	$	(1,496,000	)	$	(1,217,000	)		-23	%
Investing activities		(1,833,000	)		(269,000	)		-581	%
Financing activities		896,000			2,548,000			-65	%
Working capital (a)		456,000			3,648,000			-88	%
Current ratio (a)		1.21	x		5.32	x		-77	%

During the third quarter of 2006, the Company’s significantly reduced its use of cash for operations to a breakeven level. The significant improvement reflects the favorable impact of a $500,000 licensing revenue prepayment received during the quarter and also reflects increases in revenue and gross profits that have outpaced core operating expenses as described above. The Company expects that due to recent license agreements and the expected continued revenue growth that the Company will continue to experience improvement in it operating cash flows during the remainder of 2006 and into 2007.

During 2006, the Company has used significant amount of its cash for the acquisition of P3, a producer of plastic printed cards in San Francisco, California and to invest in its patent portfolio, including the payment of legal costs associated with patent applications and the defense of our patents, which includes payments to cover third party experts fees and other fees associated with the Company’s case with the European Central Bank.

During its early stages of development, the Company has benefited by its ability to use its common stock to pay for investments in patents and contractual rights which we may not have otherwise been able to obtain had we been required to pay in cash. The use of equity for investments allowed us to retain cash needed for operations during the early stages of our business without sacrificing the investments needed to secure our competitiveness in the future. As the Company grows and emerges from the early stages of its development and achieves consistent cash flows from operations, it expects it will be able to finance a larger portion of its investments with its own cash resources.

During 2006 and 2005, the Company has partially offset its uses of cash for operations and investments with cash received from our warrant holders who paid approximately $900,000 $2,566,000, respectively, from the exercise of warrants. During the third quarter of 2006, the Company paid off a term loan of $189,000 that released $240,000 of cash that was restricted as collateral for the loan. As of September 30, 2006, the Company has approximately 342,000 warrants outstanding and exercisable that, if exercised, would produce approximately $2.8 million in cash proceeds to the Company and which would significantly improve the Company’s cash position.

At September 30, 2006, the Company had cash and cash equivalents of approximately $1,520,000. The Company’s working capital as was approximately $456,000 which was 88% lower than working capital at September 30, 2005. The Company’s working capital position is adversely affected by approximately $525,000 in accounts payable that is related to legal costs associated with the countersuits by the European Central Bank in response to our lawsuit with the European Central Bank. In November, 2006, the Company agreed to issue shares of its common stock to pay for the $525,000. As a result, the Company’s working capital position after taking into account this transaction would have been approximately $1,000,000 as of September 30, 2006. (See Item 1- Financial Statements -Note 8).

The Company’s liquidity could be affected if the Company is not successful in its infringement lawsuit against the European Central Bank, or the countersuit for validity made by the European Central Bank against the Company. As discussed above (Item 1- Financial Statements -Note 8) due to the potential require that the Company pay a significant portion of the ECB’s legal costs upon a negative ruling. The Company estimates that these costs could be substantial and the payment of these amounts could adversely affect the Company’s financial position and would likely require the Company to raise additional funds, which may not be on terms favorable to the Company.

Furthermore, in order to support our existing and proposed operations, we may need additional financing. We currently have outstanding, exercisable warrants to purchase our common stock with exercise prices below the current market price as of November 1, 2006 that can generate approximately $305,000 in cash financing for the Company. There is no assurance that all or any of the warrants will be exercised.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our market risk exposures are related to our cash, cash equivalents and investments. We invest our excess cash in certificates of deposits with maturities of 90 days or less. Changes in interest rates affect the investment income we earn and therefore impact our cash flows and results of operations.

We mitigate our foreign currency risks principally by contracting primarily in U.S. dollars. For the nine months ended September 30, 2006, all of our billings, were denominated in our functional currency, which is the U.S. dollar.

ITEM 4 - CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our principal executive officer and principal accounting officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our principal executive officer and principal accounting officer have concluded that as of that date, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and forms, and to provide reasonable assurance that information required to be disclosed by the Corporation in such reports is accumulated and communicated to the Corporation’s management, including its principal executive officer and principal accounting officer, as appropriate to allow timely decisions regarding required disclosure.

During the quarter ended September 30, 2006, the Company implemented an ERP (Enterprise Reporting Program) system to streamline its accounting and sales reporting capabilities and to incorporate the daily activities of its newly acquired P3 division. The program went live on July 1, 2006 and management expects the system will materially affect the Corporation’s internal controls over financial reporting, especially in regards to controls related to its newly acquired P3 division. Specifically, the new system will eliminate redundant controls due to the consolidation of subsidiary ledgers and the cash disbursements and cash receipts processes. There were no other changes in the Corporation’s “internal control over financial reporting” (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

PART II

OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

There were no significant developments during the first nine months of 2006 in connection with our litigation against Adler Technologies and Andrew McTagger. This litigation is described in our Form 10-KSB Annual Report for the year ended December 31, 2005.

On June 29, 2006, Document Security Systems, Inc. the Supreme Court of the State of New York (the “Court”) ruled in favor of DSS’s motion for summary judgment in the case of “Frank LaLoggia v. Document Security Systems, Inc”. In its ruling, the Court dismissed all of Mr. LaLoggia’s claims against DSS. DSS will continue to pursue its counterclaim against Mr. LaLoggia. This litigation is described in our Form 10-KSB Annual Report for the year ended December 31, 2005.

On August 1, 2005, we commenced a suit against the European Central Bank alleging patent infringement by the European Central Bank and have claimed unspecified damages. We brought the suit in European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe our European Patent 455750B1, which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. We will seek all remedies available to us under the law. In November 2005, the European Central Bank filed its answer to our complaint asserting mostly procedural and jurisdictional arguments. The ECB contended that it could not be sued for patent infringement, but rather each individual country that comprises the ECB should be sued on an individual nation-by-nation basis. We responded to the European Central Bank’s answer in late December 2005. On March 24, 2006, we received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European Court of First Instance) seeking the invalidation of the Patent. Claims to invalidity in each of the Netherlands, Belgium, France, Spain, Germany, and Austria were subsequently served. The main basis of the ECB’s claim is the existence of prior art. A second basis is that the scope of the Patent was extended in prosecution which in Europe is a ground of invalidity. If the ECB is successful, it may materially affect us, our financial condition, and our ability to market certain technology. On October 27, 2006 both parties exchanged Expert Reports in the United Kingdom proceedings which is expected to go to trial in January 2007.

ITEM 1a - RISK FACTORS

An investment in our securities is subject to numerous risks, including the Risk Factors described below. Our business, operating results or financial condition could be materially adversely affected by any of the following risks. The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also materially affect our business. The trading price of our Common Stock could decline due to any of these risks. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Form 10-Q, including our financial statements and related notes.

We have a limited operating history with our business model, which limits the information available to you to evaluate our business.

Since our inception in 1984, we have accumulated deficits from historical operations of approximately $15,800,000 at September 30, 2006. In 2002, we changed our business model and chose to strategically focus on becoming a developer and marketer of secure technologies for all forms of print media. We have continued to incur losses since we began our new business model. Also, we have limited operating and financial information relating to this new business to evaluate our performance and future prospects. Due to the change in our business model, we do not view our historical financials as being a good indication of our future. We face the risks and difficulties of a company going into a new business including the uncertainties of market acceptance, competition, cost increases and delays in achieving business objectives. There can be no assurance that we will succeed in addressing any or all of these risks, and the failure to do so could have a material adverse effect on our business, financial condition and operating results.

Current litigation may affect our technology rights and plan of operation.

On August 1, 2005, we filed a patent infringement suit in the European Court of First Instance against the European Central Bank (“ECB”) alleging that the Euro banknotes infringe our European Patent No 0455750B1 (the “Patent”). On October 20, 2005, the ECB challenged the venue of the lawsuit to which we formally responded to the court in December, 2005. The ECB contended that it could not be sued for patent infringement, but rather each individual country that comprises the ECB should be sued on an individual nation-by-nation basis. On March 24, 2006, we received notice that the ECB has filed a separate counter claim in the United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European Court of First Instance) seeking the invalidation of the Patent. Claims to invalidity in each of the Netherlands, Belgium, France, Spain, Germany and Austria were subsequently served. The main basis of the ECB’s claim is the existence of prior art. A second basis is that the scope of the Patent was extended in prosecution which in Europe is a ground of invalidity. If the ECB is successful, it may materially affect us, our financial condition, and our ability to market certain technology. For more information regarding this litigation see Item 1- Legal Proceedings.

On January 31, 2003, we commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. And Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. And Andrew Mctaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which our company has an interest. We commenced this action alleging various causes of action against Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach of the duty of good faith and fair dealing and various business torts. Adler distributes and supplies anti-counterfeit currency devices and McTaggert is a principal of, and the primary contact at, Adler. Adler had entered into several agreements with Thomas M. Wicker Enterprises and Document Security Consultants, both of which we acquired in 2002. These agreements, generally, authorized Adler to manufacture in Canada our “Checkmate^®” patented system for verifying the authenticity of currency and documents. Other agreements were entered into between the parties and Thomas Wicker regarding other technology owned by Wicker and assigned to us including “Archangel,” an anti-copy technology, and “Blockade,” which creates a wave pattern on documents when they are reproduced or scanned. It is our contention that Adler has breached these agreements, failed to make an appropriate accounting, and may have exceeded the scope of its license. Adler has denied the material allegations of the complaint and has counterclaimed against our company, claiming Adler owns or co-owns or has a license to use certain technologies of ours, including several U.S. patents. If Adler is successful, it may materially affect us, our financial condition, and our ability to market certain technology.

If we lose our current infringement litigation we may be liable for significant legal costs of our counterparts.

We have been able to mitigate the cash outlays that we have been required to make for legal costs of our current infringement litigation against the European Central Bank by negotiating legal fee caps and using shares of our common stock for payments. However, if we receive an adverse ruling in any of our infringement or related cases against the European Central Bank, we will likely be responsible for a large portion of the legal costs that were expended by the European Central Bank which would likely be significant. The payment of these amounts could adversely affect the Company’s financial position and would likely require the Company to raise additional funds, which may not be on terms favorable to the Company.

If we are unable to adequately protect our intellectual property, our competitive advantage may disappear.

Our success will be determined in part by our ability to obtain United States and foreign patent protection for our technology and to preserve our trade secrets. Because of the substantial length of time and expense associated with developing new document security technology, we place considerable importance on patent and trade secret protection. Our ability to compete and the ability of our business to grow could suffer if these rights are not adequately protected. There can be no assurance that our patent applications will result in patents being issued or that current or additional patents will afford protection against competitors. We also rely on trade secrets that are not patented. No guarantee can be given that others will not independently develop substantially equivalent proprietary information or techniques, or otherwise gain access to our proprietary technology.

We may face intellectual property infringement or other claims against us, our customers, or our intellectual property rights that could be costly to defend and result in our loss of significant rights.

Although we have received U.S. Patents and a European Patent with respect to certain technologies of ours, there can be no assurance that these patents will afford us any meaningful protection. We intend to rely primarily on a combination of patent protection, trade secrets, technical measures, copyright protection and nondisclosure agreements with our employees to establish and protect the ideas, concepts and documentation of software and trade secrets developed by us. Such methods may not afford complete protection, and there can be no assurance that third parties will not independently develop such technology or obtain access to the software we have developed. Although we believe that our use of the technology and products we developed and other trade secrets used in our operations does not infringe upon the rights of others, our use of the technology and trade secrets we developed may infringe upon the patents or intellectual property rights of others. In the event of infringement, we could, under certain circumstances, be required to obtain a license or modify aspects of the technology and trade secrets we developed or refrain from using same. We may not have the necessary financial resources to defend any infringement claim made against us or be able to successfully terminate any infringement in a timely manner, upon acceptable terms and conditions or at all. Failure to do any of the foregoing could have a material adverse effect on us. Moreover, if the patents, technology or trade secrets we developed or use in our business are deemed to infringe upon the rights of others, we could, under certain circumstances, become liable for damages, which could have a material adverse effect on us. As we continue to market our products, we could encounter patent barriers that are not known today. A patent search will not disclose applications that are currently pending in the United States Patent Office; and there may be one or more such pending applications that would take precedence over our applications.

Furthermore, since the date of invention (and not the date of application) governs under U.S. patent law, future applications could be filed by another party, which would preempt our position. While we have taken and continue to take steps to become aware of related technical developments, there can be no assurance that we will not encounter an unfavorable patent situation. Other parties may assert intellectual property infringement claims against us or our customers, and our products may infringe the intellectual property rights of third parties. Other parties may also assert that our intellectual property rights are invalid, which could result in significant expenditures by us to refute such assertions. If we become involved in litigation, we could lose our proprietary rights, be subject to damages and incur substantial unexpected operating expenses. Intellectual property litigation is expensive and time-consuming, even if the claims are subsequently proven unfounded, and could divert management's attention from our business. If there is a successful claim of infringement, we may not be able to develop non-infringing technology or enter into royalty or license agreements on acceptable terms, if at all. If we are unsuccessful in defending claims that our intellectual property rights are invalid, we may not be able to enter into royalty or license agreements on acceptable terms, if at all. This could prohibit us from providing our products and services to customers.

If our products and services do not achieve market acceptance, we may not achieve our revenue and net income goals in the time prescribed or at all.

We are at the early stage of introducing our document security technology and products to the market. If we are unable to operate our business as contemplated by our business model or if the assumptions underlying our business model prove to be unfounded, we could fail to achieve our revenue and net income goals within the time we have projected, or at all, which could have a material adverse effect on our business. As a result, the value of your investment could be significantly reduced or completely lost.

We cannot assure you that a sufficient number of such companies will demand our products or services or other document security products. In addition, we cannot predict the rate of market's acceptance of our document security solutions. Failure to maintain a significant customer base may have a material adverse effect on our business.

The results of our research and development efforts are uncertain and there can be no assurance of the commercial success of our products.

We believe that we will need to continue to incur research and development expenditures to remain competitive. The products we currently are developing or may develop in the future may not be technologically successful. In addition, the length of our product development cycle may be greater than we originally expect and we may experience delays in future product development. If our resulting products are not technologically successful, they may not achieve market acceptance or compete effectively with our competitors' products.

Changes in document security technology and standards could render our applications and services obsolete.

The market for document security products, applications, and services is fast moving and evolving. Identification and authentication technology is constantly changing as we and our competitors introduce new products, applications, and services, and retire old ones as customer requirements quickly develop and change. In addition, the standards for document security are continuing to evolve. If any segments of our market adopt technologies or standards that are inconsistent with our applications and technology, sales to those market segments could decline.

The market in which we operate is highly competitive, and we may not be able to compete effectively, especially against established industry competitors with greater market presence and financial resources.

Our market is highly competitive and characterized by rapid technological change and product innovations. Our competitors may have advantages over us because of their longer operating histories, more established products, greater name recognition, larger customer bases, and greater financial, technical and marketing resources. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, and devote greater resources to the promotion and sale of their products. Competition may also force us to decrease the price of our products and services. We cannot assure you that we will be successful in developing and introducing new technology on a timely basis, new products with enhanced features, or that these products, if introduced, will enable us to establish selling prices and gross margins at profitable levels. Although several potential competitors have expressed an interest to us in forming marketing alliances, there can be no assurance that we will undertake such efforts or if undertaken, such efforts will prove profitable.

Our growth strategy depends, in part, on our acquiring complementary businesses and assets and expanding our existing operations to include manufacturing capabilities, which we may be unable to do.

Our growth strategy is based, in part, on our ability to acquire businesses and assets that are complimentary to our existing operations and expanding our operations to include manufacturing capabilities. We may also seek to acquire other businesses. The success of this acquisition strategy will depend, in part, on our ability to accomplish the following:

identify suitable businesses or assets to buy;

complete the purchase of those businesses on terms acceptable to us;

complete the acquisition in the time frame we expect; and

improve the results of operations of the businesses that we buy and successfully integrate their operations into our own.

There can be no assurance that we will be successful in pursuing any or all of these steps. Our failure to implement our acquisition strategy could have an adverse effect on other aspects of our business strategy and our business in general. We may not be able to find appropriate acquisition candidates, acquire those candidates that we find or integrate acquired businesses effectively or profitably.

Our acquisition program and strategy may lead us to contemplate acquisitions of companies in bankruptcy, which entail additional risks and uncertainties. Such risks and uncertainties include, without limitation, that, before assets may be acquired, customers may leave in search of more stable providers and vendors may terminate key relationships. Also, assets are generally acquired on an “as is” basis, with no recourse to the seller if the assets are not as valuable as may be represented. Finally, while bankrupt companies may be acquired for comparatively little money, the cost of continuing the operations may significantly exceed expectations.

We have in the past used, and may continue to use, our Common Stock as payment for all or a portion of the purchase price for acquisitions. If we issue significant amounts of our Common Stock for such acquisitions, this could result in substantial dilution of the equity interests of our stockholders.

If we fail to retain our key personnel and attract and retain additional qualified personnel, we might not be able to pursue our growth strategy.

Our future success depends upon the continued service of our executive officers and other key sales and research personnel who possess longstanding industry relationships and technical knowledge of our products and operations. The loss of any of our key employees, in particular, Patrick White, our Chief Executive Officer and Chief Financial Officer; Peter Ettinger, our President; Thomas Wicker, our Vice-President of Research and Development; and David Wicker, our Vice-President of Operations, could negatively impact our ability to pursue our growth strategy and conduct operations. Although we believe that our relationship with these individuals is positive, there can be no assurance that the services of these individuals will continue to be available to us in the future. We have extended our employment agreements with Patrick White to June 2009. We have also extended our employment agreements with Thomas Wicker and David Wicker to June 2007. There can be no assurance that these persons will continue to agree to be employed by us after such dates. Our employment agreement with Peter Ettinger has an expiration date of June, 2009.

We intend to hire a Chief Financial Officer for our company and believe that our ability to obtain a qualified Chief Financial Officer is material to our future success. We also must continue to hire other highly qualified individuals. Our failure to attract, train and retain management and technical personnel could adversely affect our company's ability to grow and to develop new products or product enhancements now and in the future.

If we do not successfully expand our sales force, we may be unable to increase our revenues.

We must expand the size of our marketing activities and sales force to increase revenues. We continue to evaluate various methods of expanding our marketing activities, including the use of outside marketing consultants and representatives and expanding our in-house marketing capabilities. Going forward, we anticipate an increasing percentage of our revenues to come from the licensing of our newer technologies, where profit margins are significantly higher than those provided by Security Paper. If we are unable to hire or retain qualified sales personnel, if newly hired personnel fail to develop the necessary skills to be productive, or if they reach productivity more slowly than anticipated, our ability to increase our revenues and grow could be compromised. The challenge of attracting, training and retaining qualified candidates may make it difficult to meet our sales growth targets. Further, we may not generate sufficient sales to offset the increased expense resulting from expanding our sales force or we may be unable to manage a larger sales force.

Future growth in our business could make it difficult to manage our resources.

Our anticipated business expansion could place a significant strain on our management, administrative and financial resources. Significant growth in our business may require us to implement additional operating, product development and financial controls, improve coordination among marketing, product development and finance functions, increase capital expenditures and hire additional personnel. There can be no assurance that we will be able to successfully manage any substantial expansion of our business, including attracting and retaining qualified personnel. Any failure to properly manage our future growth could negatively impact our business and operating results.

We cannot predict our future capital needs and we may not be able to secure additional financing.

We may need to raise additional funds in the future to fund more aggressive expansion of our business, complete the development, testing and marketing of our products, or make strategic acquisitions or investments. We may require additional equity or debt financings, collaborative arrangements with corporate partners or funds from other sources for these purposes. No assurance can be given that these funds will be available for us to finance our development on acceptable terms, if at all. Such additional financings may involve substantial dilution of our stockholders or may require that we relinquish rights to certain of our technologies or products. In addition, we may experience operational difficulties and delays due to working capital restrictions. If adequate funds are not available from operations or additional sources of financing, we may have to delay or scale back our growth plans.

Risks Related to Our Stock

Provisions of our certificate of incorporation and agreements could delay or prevent a change in control of our company.

Certain provisions of our certificate of incorporation may discourage, delay, or prevent a merger or acquisition that a shareholder may consider favorable. These provisions include:

the authority of the Board of Directors to issue preferred stock; and

a prohibition on cumulative voting in the election of directors.

We have a large number of authorized but unissued shares of common stock, which our management may issue without further stockholder approval, thereby causing dilution of your holdings of our common stock.

As of September 30, 2006, there are 186,132,575 million shares of authorized but unissued shares of our common stock. Our management will continue to have broad discretion to issue shares of our common stock in a range of transactions, including capital-raising transactions, mergers, acquisitions, for anti-takeover purposes, and in other transactions, without obtaining stockholder approval, unless stockholder approval is required for a particular transaction under the rules of the American Stock Exchange, New York law, or other applicable laws. We currently have no specific plans to issue shares of our common stock for any purpose. However, if our management determines to issue shares of our common stock from the large pool of such authorized but unissued shares for any purpose in the future without obtaining stockholder approval, your ownership position would be diluted without your further ability to vote on that transaction.

The exercise of our outstanding options and warrants may depress our stock price.

As of September 30, 2006, there were outstanding stock options and warrants to purchase an aggregate of 875,436 shares of our Common Stock at exercise prices ranging from $2.00 to $12.65 per share, most of which are immediately exercisable. To the extent that these securities are exercised, dilution to our shareholders will occur. Moreover, the terms upon which we will be able to obtain additional equity capital may be adversely affected, since the holders of these 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 to us than the exercise and conversion terms provided by those securities.

Sales of these shares in the public market, or the perception that future sales of these shares could occur, could have the effect of lowering the market price of our common stock below current levels and make it more difficult for us and our shareholders to sell our equity securities in the future.

Sale or the availability for sale of shares of common stock by stockholders could cause the market price of our common stock to decline and could impair our ability to raise capital through an offering of additional equity securities.

We do not intend to pay cash dividends.

We do not intend to declare or pay cash dividends on our common stock in the foreseeable future. We anticipate that we will retain any earnings and other cash resources for investment in our business. The payment of dividends on our common stock is subject to the discretion of our Board of Directors and will depend on our operations, financial position, financial requirements, general business conditions, restrictions imposed by financing arrangements, if any, legal restrictions on the payment of dividends and other factors that our Board of Directors deems relevant.

ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On February 7, 2006, the Company issued 18,704 shares of the Company’s Common Stock valued at $250,000 in connection with an acquisition. The shares issued in the transaction were not registered under the Securities Act of 1933.

We did not purchase any shares of our common stock during the nine months ended September 30, 2006.

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5 - OTHER INFORMATION

None

ITEM 6 - EXHIBITS

The Exhibits listed below designated by an * are incorporated by reference to the filings by Document Security Systems, Inc. under the Securities Act of 1933 or the Securities and Exchange Act of 1934, as indicated. All other exhibits are filed herewith.

(a) Exhibits

Item 3.1

Articles of Organization, as amended (incorporated by reference to exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY on Form S-18).*

Item 3.2

By-laws, as amended (incorporation by reference to exhibit 3.2 to the Company's Registration Statement No. 2-98684-NY on Form S-18).*

Item 31.1

Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act

Item 31.2

Certifications of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes Oxley Act

Item 32.1

Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes Oxley Act

Item 32.2

Certification of principal Accounting Officer Pursuant to Section 906 of the Sarbanes Oxley Act

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.


	DOCUMENT SECURITY SYSTEMS, INC.

November 14, 2006	By:	/s/ Patrick White
		Patrick White
		President, Chief Executive Officer and
		Acting Chief Financial Officer



November 14, 2006	By:	/s/ Philip Jones
		Philip Jones
		Controller/Principal Accounting Officer