DSS, INC. - Quarter Report: 2012 September (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

   xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from________________to________________.

Indicate by check mark whether the registrant:

(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files) Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨      Accelerated filer ¨      Non-accelerated filer (Do not check if a smaller reporting company) ¨
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes ¨ No x

As of November 12, 2012, there were 21,705,967 shares of the registrant’s common stock, $0.02 par value, outstanding.

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

PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES

Consolidated Balance Sheets

As of

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30,

(Unaudited)

See accompanying notes.

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2012
(Unaudited)

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8.03 of Regulation S-X for smaller reporting companies. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and comprehensive loss and cash flows include all adjustments, consisting only of normal recurring items necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation.

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc.’s (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2011.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions. In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

Plan of Merger - On October 1, 2012, the Company entered into an Agreement and Plan of Merger ("Merger Agreement"), pursuant to which, once the merger commences, DSSIP, Inc., a wholly owned subsidiary of the Company ("Merger Sub"), will merge with and into Lexington Technology Group, Inc. ("Lexington"), with Lexington being the surviving corporation which will continue its existence as a wholly-owned subsidiary of the Company through an exchange of capital stock of Lexington for capital stock of the Company (the "Merger").

Earnings Per Common Share - The Company presents basic and diluted earnings per share. Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.

As of September 30, 2012 and 2011, there were up to 4,319,020 and 3,271,853, respectively, of shares potentially issuable under convertible debt agreements, options, warrants, restricted stock agreements and employment agreements that could potentially dilute basic earnings per share in the future. These shares were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company’s losses in the respective periods.

Concentration of Credit Risk - The Company maintains its cash in bank deposit accounts, which at times may exceed federally insured limits.  The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions. During the nine months ended September 30, 2012 and 2011, one customer accounted for 26% and 15%, respectively, of the Company’s consolidated revenue. As of September 30, 2012 and 2011, this customer accounted for 22% and 20%, respectively, of the Company’s trade accounts receivable balance. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

Conventional Convertible Debt -When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (“BCF"). Prior to the determination of the BCF, the proceeds from the debt instrument are first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants. The Company records a BCF as a debt discount pursuant to FASB ASC Topic 470-20. In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. The Company amortizes the discount to interest expense over the life of the debt using the effective interest method.

Derivative Instruments - The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate swap contracts to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Company has two interest rate swaps that change variable rates into fixed rates on a term loan and promissory note with RBS Citizens, N.A. These swaps qualify as Level 2 fair value financial instruments. These swap agreements are not held for trading purposes and the Company does not intend to sell the derivative swap financial instruments. The Company records the interest swap agreements on the balance sheet at fair value because the agreements qualify as cash flow hedges under accounting principles generally accepted in the United States of America. Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction. The valuations of the interest rate swaps have been derived from proprietary models of the bank based upon recognized financial principles and reasonable estimates about relevant future market conditions and may reflect certain other financial factors such as anticipated profit or hedging, transactional, and other costs. The notional amounts of the swaps decrease over the life of the agreements. The Company is exposed to a credit loss in the event of non-performance by the counter parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. The fair value of interest rate swap hedging liabilities as of September 30, 2012 amounted to $138,359 ($110,688 - December 31, 2011) and the net loss attributable to this cash flow hedge recorded during the nine months ended September 30, 2012 amounted to $27,671 ($3,678 gain - 2011).

Fair Value of Financial Instruments - Financial instruments include cash, which is a short term investment and its carrying amount is a reasonable estimate of fair value, interest rate swaps as discussed above, notes payable and a convertible note payable. Notes payable are valued based on rates currently available to financial institutions for debt with similar terms and remaining maturities. The carrying value approximates the fair value of these debt instruments as of September 30, 2012 and December 31, 2011. The convertible note payable is recorded at its face amount, net of an unamortized discount for a beneficial conversion feature and has an estimated fair value of approximately $1,082,000 ($663,000 - December 31, 2011) based on the underlying shares the note can be converted into at the trading price on September 30, 2012. Since the underlying shares are trading in an active, observable market, the fair value measurement qualifies as a Level 1 input.

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation.

Recent Accounting Pronouncements - In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.  This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS.  ASU 2011-04 is required to be applied prospectively in interim and annual periods beginning after December 15, 2011.   The adoption of ASU 2011-04 did not have a material impact on the consolidated financial statements.

In September 2011 the FASB issued ASU No. 2011-08, Intangibles – Goodwill and Other (Topic 350), Testing Goodwill for Impairment to allow entities an option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under that option, an entity no longer would be required to calculate the fair value of a reporting unit unless the entity determines, based on that qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments in this update are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of ASU 2011-08 did not have a material impact on the consolidated financial statements.

In June 2011 the Financial Accounting Standards Board issued Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income. This standard eliminates the option to report other comprehensive income and its components in the statement of changes in equity. The Company may elect to present items of net income and other comprehensive income in one continuous statement or in two consecutive statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two parts – net income and other comprehensive income – would need to be displayed under either alternative, and the statements would need to be presented with equal prominence as the other primary financial statements. This standard does not change 1) the items that constitute net income and other comprehensive income, 2) when an item of other comprehensive income must be reclassified to net income, or 3) the computation for earnings per share, which will continue to be based on net income. The adoption of ASU 2011-05 did not have a material impact on the consolidated financial statements. In December 2011, the FASB issued ASU 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This update indefinitely defers the provision of ASU 2011-05, “Presentation of Comprehensive Income,” that required entities to present reclassification adjustments out of accumulated other comprehensive income by component in the statement of operations. The effective date for this update follows the ASU 2011-05, which is fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating the impact of adopting ASU 2011-12 will have on the consolidated financial statements.

In December 2011, the FASB issued ASU 2011-11, “Disclosures About Offsetting Assets and Liabilities.” This update creates new disclosure requirements about the nature of an entity’s rights of offsetting and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements in this update are effective for annual reporting periods, and interim periods within those years, beginning on or after January 1, 2013. The Company is currently evaluating the impact this update will have on its disclosures.

Inventory consisted of the following:

Other intangible assets include patent application costs, which consist of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies, customer lists and non-compete agreements obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business. Patent application costs are capitalized and amortized over the estimated useful life of the patent, which generally approximates its legal life. The Company accounts for other intangible amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product. Costs incurred to renew or extend the term of recognized intangible assets, including patent annuities and fees, are expensed as incurred. To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material.

Other intangible assets are comprised of the following:

(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of September 30, 2012, the weighted average remaining useful life of these assets in service was approximately 11.75 years.

Amortization expense for the nine months ended September 30, 2012 amounted to $228,078 ($205,416 – 2011). Approximate expected amortization for each of the five succeeding fiscal years is as follows:

Revolving Credit Lines - The Company entered into a credit facility agreement with RBS Citizens, N.A. (“Citizens Bank”) in connection with the Company’s acquisition of Premier Packaging (“Premier”). As amended on July 26, 2011, the credit facility agreement provides Premier with a revolving credit line of up to $1,000,000.  The revolving line bears interest at 1 Month LIBOR plus 3.75% (3.97% as of September 30, 2012) and matures on May 31, 2013. As of September 30, 2012, the revolving line had a balance of $481,009 ($669,785 - December 31, 2011).

On May 12, 2011, in conjunction with the Company’s acquisition of ExtraDev, Inc. (“ExtraDev”), the Company assumed revolving credit lines and open credit card accounts totaling approximately $239,000, comprised of a $100,000 revolving line of credit with a bank at 4.75% with an outstanding balance of $63,000, a $100,000 revolving line of credit with a bank at 8.09% with an outstanding balance of $86,000, and various credits cards with an aggregate outstanding balance of approximately $90,000. All of the credit lines are secured by personal guarantees of the former ExtraDev owners. The line of credit with the $86,000 balance was paid in full during the year ended December 31, 2011 and the line of credit was closed. As of September 30, 2012, the balance of the revolving line of credit at 4.5% was $39,252 and outstanding balances on credit cards were $22,695, $61,947 in aggregate ($93,951 - December 31, 2011).

Short-Term Loan from Related Party - The Company issued a promissory note (the “DSS Note”) to Bzdick Properties, LLC (“Bzdick Properties”) in connection with the purchase of the Premier real estate, totaling $150,000. One of the members of Bzdick Properties is Robert Bzdick, who also serves as a director and chief operating officer of the Company. The DSS Note accrued interest at a rate of 9.5% per annum and permitted prepayment of principal without penalty. The DSS Note called for interest only payments during its term with a balloon payment due at the scheduled maturity date of March 31, 2012. The DSS Note was secured by a guaranty agreement running from Premier to Bzdick Properties and was subordinated to the Citizens Bank loan documents. The DSS Note was paid off in full on March 23, 2012 ($150,000 - December 31, 2011). Interest expense on the short-term loan from related party amounted to $3,240 for the nine months ended September 30, 2012.

Long-Term Debt - On December 30, 2011, the Company issued a $575,000 convertible note in order to refinance a traditional note payable that now matures on December 29, 2013, and carries an interest rate of 10% per annum. Interest is payable quarterly, in arrears. The convertible note can be converted at any time during the term at Lender’s option into a total of 260,180 shares of the Company’s common stock at a conversion price of $2.21 per share. In conjunction with the issuance of the convertible note, the Company determined a beneficial conversion feature existed amounting to approximately $88,000, which was recorded as a debt discount and will be amortized over the term of the note. The note is secured by all of the assets (excluding assets leased) of Secuprint, Inc., (“Secuprint”), a subsidiary of the Company, is subject to various events of default, and had a balance of $575,000 as of September 30, 2012 ($575,000 - December 31, 2011).

On February 12, 2010, in conjunction with the credit facility agreement with Citizens Bank, the Company entered into a term loan with Citizens Bank for $1,500,000.    As amended on July 26, 2011, the term loan now requires monthly principal payments of $25,000 through maturity of February 2015. Interest accrues at 1 Month LIBOR plus 3.75% (3.97% at September 30, 2012).  The Company entered into an interest rate swap agreement to lock into a 5.7% effective interest rate over the remaining life of the amended term loan. As of September 30, 2012, the balance of the term loan was $725,000 ($950,000 - December 31, 2011).

On June 29, 2011, the Company and Plastic Printing Professionals, Inc. (“P3”), a wholly owned subsidiary of the Company, entered into a Commercial Term Note (the “Note”) with Neil Neuman (“Neuman”) whereby the Company borrowed $650,000 from Neuman. The Note called for monthly payments of $13,585, an interest rate of 6.5% per annum, a term of forty-eight months and a final balloon payment of $100,000 on August 1, 2015. The proceeds from the Note were used to pay in full all sums owed by the Company under a Related Party Credit Agreement executed between the Company and Fagenson & Co., Inc., as agent for certain lenders, including Neuman, dated January 4, 2008. Upon such payment the Credit Agreement between the Company and Fagenson & Co., Inc. was terminated in its entirety. As of December 31, 2011, the Note had a balance of $599,462. On February 29, 2012, the Company entered into a Purchase, Amendment and Escrow Agreement (the “Purchase Agreement”) with Barry Honig (“Honig”), Neil Neuman (“Neuman”) and Grushko & Mittman, P.C. The Purchase Agreement provided, among other things, for the sale of the Note to Honig for a purchase price of $578,396, which was the outstanding principal balance on February 29, 2012. In connection with the sale and transfer of the Note to Honig, the Company agreed to amend certain terms of the Note pursuant to an allonge entered into on February 29, 2012 (the “Allonge”). Under the Purchase Agreement any security interest in the Note terminated at the closing of the purchase of the Note; accordingly, Honig did not possess a security interest in any assets of the Company as a result of his purchase of the Note. Pursuant to the Allonge, the maturity date of the Note was extended to July 1, 2013. Honig had the right to convert the principal and any interest due under the Note into shares of the Company’s common stock at a conversion price of $3.30 per share, subject to adjustment upon certain corporate events as set forth in the Allonge. In conjunction with this conversion option, the Company recorded a beneficial conversion feature of approximately $216,000, which was recorded as a discount to the debt.

During the first fiscal quarter of 2012, Honig exercised the conversion option on the Note. Pursuant to the conversion, the Company issued an aggregate of 175,710 shares of its common stock to Honig for full payment of Note and accrued interest amounting to $579,843. In conjunction with the conversion, the Company recorded a note discount amortization expense of the entire $216,000 of remaining unamortized debt discount expense during the first fiscal quarter of 2012.

Promissory Note - On August 30, 2011, the Company’s wholly owned subsidiary Premier purchased the packaging plant it occupies in Victor, New York for $1,500,000, which was partially financed with a $1,200,000 promissory note obtained by Premier from Citizens Bank (“Promissory Note”). The Promissory Note calls for monthly payments of principal and interest in the amount of $7,658, which includes interest, calculated as 1 month LIBOR plus 3.15% (3.37% at September 30, 2012). Concurrently with the transaction, the Company entered into an interest rate swap agreement to lock into a 5.865% effective interest rate for the life of the loan.  The Promissory Note matures in August 2021 at which time a balloon payment of the remaining principal balance of $919,677 is due. As of September 30, 2012, the Promissory Note had a balance of $1,176,463 ($1,192,914 - December 31, 2011).

Term Note - On October 8, 2010, the Company amended the Credit Facility Agreement with Citizens Bank to add a Standby Term Loan Note pursuant to which Citizens Bank will provide Premier with up to $450,000 towards the funding of eligible equipment purchases. In October 2011, the Standby Term Loan Note was converted into a Term Note payable in monthly installments of $887 plus interest over 5 years. As of September 30, 2012, the balance under this Term Note was $43,481 ($51,467 - December 31, 2011).

All of the Citizens Bank credit facilities are secured by all of the assets of Premier, and are also secured through cross guarantees by the Company and two of its other wholly owned subsidiaries, Plastic Printing Professionals, Inc. (“P3”) and Secuprint.

Under the Citizens Bank credit facilities, Premier is subject to various covenants including fixed charge coverage ratio, tangible net worth and current ratio covenants. In June 2012, Premier was notified that it was not in compliance with certain financial covenants as of December 31, 2011 and March 31, 2012, including a failure to maintain the required fixed charge coverage ratio and a disallowance of transfers from Premier to one of the Company’s other subsidiaries. In August 2012, the Company received a waiver as of December 31, 2011 and March 31, 2012 from Citizens Bank, relating to the above-mentioned financial covenants. Premier Packaging was in compliance with the covenants as of September 30, 2012.

Stock Issued in Private Placements - On February 13, 2012, the Company completed the sale of $3,000,000 of investment units (the “Units”) in a private placement. A total of 30 Units were sold, at a price of $100,000 per Unit. Each Unit consisted of (i) 32,258 shares of the Company’s common stock, and (ii) a five-year warrant to purchase up to 16,129 shares of the Company’s common stock at an exercise price of $3.10 per share. The private placement resulted in aggregate cash proceeds to the Company of $3,000,000. In connection with the private placement, the Company paid a placement agent fee of $210,000 and issued to the placement agent a five-year warrant to purchase up to an aggregate of 58,064 shares of Common Stock at an exercise price of $3.10. The placement agent warrant had a fair value of $177,000.

Stock Warrants - On February 20, 2012, the Company and ipCapital Group, Inc. (“ipCapital”) entered into an engagement letter (the “ipCapital Engagement Letter”) for the provision of certain IP strategic consulting services by ipCapital for the 2012 calendar year (the “Services”). The managing director and 42% owner of ipCapital, John Cronin, is also a director of the Company. Fees will range from $240,000 to $365,000 for services provided in 2012. In addition the Company issued ipCapital a five-year warrant (the “Warrant”) to purchase up to 100,000 shares of the Company’s common stock at an exercise price of $4.62 per share (the “Warrant Stock”). The Warrant vests and becomes exercisable to the extent of 33 1/3 percent of the Warrant Stock upon each of the first, second and third anniversary dates, respectively, of the Issuance Date. The warrant is valued using the Black Scholes Merton option pricing model at each reporting period through the earlier of the completion of services or the expiration of the service term. The warrant was valued at approximately $190,000 as of September 30, 2012. In addition, on February 20, 2012, the Company entered into a second consulting arrangement with ipCapital (the “ipCapital Consulting Agreement”) for which ipCapital will provide strategic advice to the Company’s senior management team on the development of the Company’s Digital Group infrastructure and cloud computing business strategy. The ipCapital Consulting Agreement has a three year term. As ipCapital’s sole source of compensation under the ipCapital Consulting Agreement, the Company issued ipCapital a five-year warrant (the “Consulting Warrant”) to purchase up to 200,000 shares of the Company’s common stock at an exercise price of $4.50 per share (the “Consulting Warrant Stock”). The Consulting Warrant vests and becomes exercisable to the extent of 33 1/3 percent of the Consulting Warrant Stock upon each of the first, second and third anniversary dates, respectively, of the Consulting Warrant Issuance Date. The warrant is valued using the Black Scholes-Merton option pricing model at each reporting period through the requisite service period, in this case the vesting period. The warrant was valued at approximately $386,000 as of September 30, 2012.

Also, on February 20, 2012, the Company entered into consulting arrangement with Century Media Group for the provision of investor relations services. As compensation Century Media Group will receive a fee of $10,000 per month for the one year term, plus the Company issued Century Media Group a 14-month warrant (the “Century Media Warrant”) to purchase up to 250,000 shares of the Company’s common stock at exercise prices of $4.50, $4.75, $5.00, $5.25 and $6.00 for each 50,000 shares subject to the Century Media Warrant. The Century Media Warrant vested in full on the date of issuance. The Company calculated the fair value of the warrant at approximately $248,000, using the Black Scholes-Merton option pricing model. Expense for consulting services is being recorded over the 12-month service term.

On July 30, 2012, the Company issued as compensation to a consultant a five-year warrant to purchase 45,000 shares of the Company's common stock at an exercise price of $4.00. One-third of the option vested on July 30, 2012, one-third of the option will vest on July 30, 2013, and the remaining one-third will vest on July 30, 2014. The Company valued the option at approximately $92,000 using the Black-Sholes-Merton option pricing model and will expense it in accordance with the service period.

During the nine months ended September 30, 2012, a total of 215,734 shares of common stock were issued by the Company upon the exercise of warrants in exchange for aggregate proceeds of approximately $609,000.

Restricted Stock - During the nine months ended September 30, 2012, the Company granted two restricted stock awards to an employee. The first award grants the employee 30,000 shares of common stock that vest ratably over four years and has a grant date fair value of $101,400. Expense related to the first grant is being recorded on a straight-line basis as shares vest. The second award grants the employee 100,000 shares of common stock that vest in four tranches upon reaching net sales goals. The grant date fair value of the second award amounted to $338,000. As of September 30, 2012, no expense was recorded for the second award as vesting was determined to be remote.

Stock Options - The Company records stock-based payment expense related to these options based on the grant date fair value in accordance with FASB ASC 718. During the nine months ended September 30, 2012, the Company issued options to purchase up to an aggregate of 40,000 shares of its common stock to its non-executive board members at an exercise price of $2.55 per share. The fair value of these options amounted to approximately $40,000 determined by utilizing the Black Scholes Merton option pricing model. On September 21, 2012, the Company issued options to purchase up to an aggregate of 280,000 shares of its common stock to certain of its employees and senior management at an exercise price of $4.26 per share that will vest upon the closing of the proposed merger, as described in Note 9. The grant date fair value of these options determined by utilizing the Black Scholes Merton option pricing model amounted to approximately $470,000. The Company believes vesting is likely and is recording of stock based compensation expense over the implicit service period.

Stock-Based Compensation - Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the nine months ended September 30, 2012, the Company had stock compensation expense of approximately $631,000 or $0.03 per share ($319,000; $0.02 per share - 2011).

As of September 30, 2012, there was approximately $1,342,000 of total unrecognized compensation costs (excluding $932,000 that vest upon the occurrence of certain events) related to options and restricted stock granted under the Company’s stock option plans, which the Company expects to recognize over the weighted average period of approximately one year.

Stock Option Plans - During the second quarter of 2012, a proposal to increase the number of shares under the 2004 Employee Stock Option Plan from 1,700,000 to 3,400,000 and a proposal to increase the number of shares under the 2004 Non-Executive Director Stock Option Plan from 200,000 to 500,000 was approved by the Company’s stockholders.

Legal Matters -On August 1, 2005, the Company commenced a suit in the European Court of First Instance in Luxembourg against the ECB alleging patent infringement by the ECB and claimed unspecified damages (the “ECB Litigation”). The Company brought the suit in the European Court of First Instance in Luxembourg.   The Company alleged that all Euro banknotes in circulation infringed the Company’s European Patent 0 455 750B1 (the “Patent”) which covered a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices.  The Court of First Instance in Luxembourg ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim. In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent.  Proceedings were commenced by the ECB before each of the national courts seeking revocation and declarations of invalidity of the Patent. On August 20, 2008, the Company entered into an agreement (the “Trebuchet Agreement”) with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with validity proceedings in eight European countries relating to the Patent. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the Trebuchet Agreement. In consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest in the Company's rights, title and interest in the Patent to Trebuchet which allowed Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise and to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. On July 7, 2011, Trebuchet and the Company entered into a series of related agreements and general releases wherein Trebuchet effectively ended its ongoing participation in the ECB Litigation, except for its continuing involvement in the final settlement of fees that may become payable as a result of the infringement case in The Netherlands described below. The Trebuchet Agreement executed in August 2008 will remain in full force and effect, in its entirety, until Trebuchet makes any and all final payments that may become due in connection with The Netherlands infringement case.

In a series of court decisions spanning from March 2007 through December 2010, the Patent was invalidated in each of the United Kingdom, Germany, France, The Netherlands, Belgium, Luxembourg, Austria and Italy. The Company did not further appeal these decisions.   On March 24, 2010 the Spanish Court ruled that the Patent was valid. The decision in Spain is currently under appeal by the ECB.

During the course of the litigation, the losing party in the ECB Litigation, in certain jurisdictions, was responsible for the prevailing party’s legal fees and disbursements. As of September30, 2012, the Company has recorded as accrued liabilities approximately €132,000 ($170,000) for the Germany case and approximately €175,000 ($225,000) for the Netherlands case for such fees. In addition, the ECB formally requested the Company to pay attorneys and court fees for the Court of First Instance case in Luxembourg in the amount of €93,752 ($121,000) as of September 30, 2012, which, unless the amount is settled will be subject to an assessment procedure that has not been initiated. The Company will accrue the assessed amount, if any, as soon as it is reasonably estimable.

On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V and Koninklijke Joh. Enschede B.V.  The Netherlands Court determined in December 2010 that the patent was invalid in The Netherlands, and the infringement case was terminated by Trebuchet. Trebuchet remains responsible for cost and fee reimbursements associated with the case when such amounts are determined and fixed by order of the Dutch Court.

On October 24, 2011 the Company initiated a law suit against Coupons.com Incorporated (“Coupons.com”). The suit was filed in the United States District Court, Western District of New York, located in Rochester, New York. Coupons.com is a Delaware corporation having its principal place of business located in Mountain View, California. In the Coupons.com suit, the Company alleges breach of contract, misappropriation of trade secrets, unfair competition and unjust enrichment, and is seeking in excess of $10 million in money damages from Coupons.com for those claims. In a motions decision rendered on August 20, 2012, the District Court judge dismissed the Company’s unfair competition and unjust enrichment claims. The Company’s breach of contract and misappropriation of trade secrets claims remain intact as of the date of this report.

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.

Merger Termination Fees –  Pursuant to the Merger Agreement the Company entered into on October 1, 2012, if the Merger agreement is terminated at any time prior to the closing of the Merger, as follows: (a) by mutual written consent of DSS, Merger Sub and Lexington; (b) by either DSS or Lexington if the closing has not occurred on or before March 15, 2013; (c) by either DSS or Lexington if any law enacted by a governmental authority prohibits the consummation of the Merger, or any governmental authority has issued an order or taken any other action which restrains, enjoins or otherwise prohibits the Merger; (d) by either DSS or Lexington if the other party’s stockholders do not approve the Merger, unless the failure to obtain approval is attributable to a failure on the part of such party seeking to terminate the Agreement; (e) by DSS if (i) the Lexington’s board of directors changes its recommendation for approval of the Merger, (ii) the board of directors of Lexington or any authorized committee has failed to present or recommend the approval of the Merger Agreement and the Merger to the stockholders, (iii) Lexington shall have entered or caused itself or its subsidiaries to enter, into any letter of intent, agreement in principle, term sheet, merger agreement, acquisition agreement or other similar agreement related to any Lexington Acquisition Proposal or (iv) Lexington shall have breached any term of the non-solicitation provision of the Merger Agreement; (f) by Lexington if (i) the DSS board of directors changes their recommendation for approval of the Merger, (ii) the board of directors of DSS or any authorized committee has failed to present or recommend the approval of the Merger Agreement and the Merger to the stockholders, (iii) DSS shall have entered or caused itself or its subsidiaries to enter, into any letter of intent, agreement in principle, term sheet, merger agreement, acquisition agreement or other similar agreement related to any DSS Acquisition Proposal or (iv) DSS shall have breached any term of the non-solicitation provision of the Merger Agreement; (g) by either party if the other party, or in the case of Lexington, DSS or Merger Sub, is in material breach of its obligations or representations or warranties under the Agreement; (h) by either DSS or Lexington if prior to obtaining stockholder approval such party determines to enter into a definitive agreement relating to a superior proposal; or (i) by Lexington, at any time, upon payment to DSS of a fee equal to $5,000,000. Under certain circumstances, if the Merger is terminated by either DSS or Lexington, then DSS shall pay to Lexington, a termination fee in cash equal to the sum of (i) $3,000,000 plus (ii) 5% of the consideration paid to all security holders of DSS in connection with a superior proposal in the same form as such consideration is paid to such security holders.

Contingent Litigation Payments – Pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family.  For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds.  For infringement matters involving certain foreign patents, the Company will be required to disburse 14% of the settlement proceeds.  These payments do not apply to licenses or royalties derived from patents that the Company has developed or obtained from persons other than the Wicker Family.  In addition, in May 2005, the Company entered into an agreement with its legal counsel in charge of the Company’s litigation with the European Central Bank which called for a $150,000 contingent payment to the legal counsel upon a successful ruling or settlement on the Company’s behalf in that litigation. As of September 30, 2012, there has been no settlement amounts related to these agreements.

On October 21, 2011, the Company entered into a contingency legal fee agreement with Nixon Peabody LLP (the “Contingency Agreement”), in connection with its law suit against Coupons.com. Under the Contingency Agreement, the Company would pay Nixon Peabody LLP 33 1/3% of any settlements or damages awards collected from Coupons.com in connection with the suit. Under the Contingency Agreement, the Company is responsible for payment of out-of-pocket charges and disbursements of Nixon Peabody LLP necessarily accrued during the prosecution of the suit.

Contingent Purchase Price -In December, 2008, the Company acquired substantially all of the assets of DPI of Rochester, LLC in which the Company guaranteed up to $50,000 to certain parties depending on whether certain conditions occurred within five years of the acquisition.   As of September 30, 2012, the Company considers the likelihood that the payment will be required as remote.

Facility Operating Lease - In July 2012, the Company entered into an amended facility lease at its current location that will accommodate the Company corporate offices as well as the Digital division. The commencement date of the amended lease was October 1, 2012. The amended facility lease will expire September 30, 2015, and future lease payments are expected to be approximately $39,000 in 2012, $157,000 in 2013, $169,000 in 2014 and $133,000 in 2015.

Supplemental cash flow information for the nine months ended September 30, 2012 and 2011 is approximately as follows:

The Company's businesses are organized, managed and internally reported as four operating segments.   In the second quarter of 2011, the Company acquired ExtraDev for its DSS Digital Group and the Company launched a new corporate identity and logo, along with a new website that grouped the Company under four distinct divisions. In conjunction with this, the Company determined that an expansion of its segment reporting to align with the new internal structure was appropriate. A summary of the four reportable segments follows:

Approximate information concerning the Company’s operations by reportable segment for the three and nine months ended September 30, 2012 and 2011 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:

Merger Agreement

On October 1, 2012, Document Security Systems, Inc., a New York corporation (“DSS”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) with DSSIP, Inc., a Delaware corporation and wholly-owned subsidiary of DSS (“Merger Sub”), and Lexington Technology Group, Inc., a Delaware corporation (“Lexington”), and Hudson Bay Master Fund Ltd., as representative of Lexington’s stockholders (“Lexington Representative”) solely for certain purposes (as described in the Merger Agreement), pursuant to which Merger Sub will merge with and into Lexington, with Lexington being the surviving corporation (the “Surviving Corporation”) and will continue its existence as a wholly-owned subsidiary of DSS through an exchange of capital stock of Lexington for capital stock of DSS (the “Merger”).

Lexington is a private intellectual property monetization company that acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the “Bascom Portfolio”). Lexington is focused on the economic benefits of intellectual property assets through acquiring or internally developing patents or other intellectual property assets (or interests therein) and then monetizing such assets through a variety of value enhancing initiatives, including, but not limited to: licensing, customized technology solutions (such as applications for medical electronic health records), strategic partnerships and litigation. Through its wholly-owned subsidiary Bascom Research, LLC (“Bascom Research”), Lexington currently develops software applications based on the Bascom Portfolio that are focused on applying computational and data structures to complex data sets in the medical field. Lexington has a strategic relationship with LinkSpace, LLC, a contextual search company, and a consulting agreement with Mednest LLC, a professional technology incubation advisor, to develop medical-related software applications in the RFID and electronic health record space. Lexington intends to attempt to enter into sponsored research agreements and partnerships with other companies and universities in order to further develop applications for the technology relating to the Bascom Portfolio. On October 3, 2012, Bascom Research initiated patent infringement lawsuits in the United States District Court for the Eastern District of Virginia against five companies, including Facebook, Inc. and LinkedIn Corporation, for unlawfully using systems that incorporate features claimed in patents owned by Bascom Research.

Pursuant to the terms of the Merger Agreement, upon completion of the Merger (the “Effective Time”) and subject to the Beneficial Ownership Condition (as defined below), each share of then-issued and outstanding common stock of Lexington, par value $0.0001 per share (“Lexington Common Stock”) and each share of then-issued and outstanding Series A Convertible Preferred Stock of Lexington, par value $0.0001 per share (“Lexington Preferred Stock”) (other than shares of Lexington Common Stock and Lexington Preferred Stock held in treasury or owned by DSS or any direct or indirect wholly owned subsidiary of DSS or Lexington that will be canceled and retired at the Effective Time) will be automatically converted into (i) the right to receive shares of DSS common stock, par value $0.02 per share (“DSS Common Stock”), (ii) Warrants (as described below), (iii) shares of DSS Common Stock to be held in escrow (as described below, the “Escrow Shares”) and, as applicable, shares of DSS’s Series A Convertible Preferred Stock (“DSS Preferred Stock”), determined by multiplying each of (x) 17,250,000 plus the number of Additional Shares (as defined below) and Exchanged Shares (as defined below), if any, (y) 4,859,894, and (z) 7,100,000 by a fraction, the numerator of which shall be one and the denominator of which shall be the sum of (A) the number of shares of Lexington Common Stock plus (B) the number of shares of Lexington Preferred Stock, in each case issued and outstanding immediately prior to the Effective Time (such fraction referred to as the “Common Stock Exchange Ratio“).

At the Effective Time of the Merger, DSS will issue to the holders of Lexington Common Stock and Lexington Preferred Stock (on a pro rata as-converted basis) an aggregate of 4,859,894 warrants to purchase an aggregate of 4,859,894 shares of DSS Common Stock with an exercise price of $4.80 per share and a term of five years commencing upon the closing of the Merger (the “Warrants”). As a condition to the closing of the Merger, DSS, Lexington Representative and American Stock Transfer & Trust Company, LLC, as escrow agent, will enter into an escrow agreement (the “Escrow Agreement”). Pursuant to the Escrow Agreement, at the Effective Time, DSS shall deposit the Escrow Shares into an escrow account to be released to the holders of Lexington Common Stock (pro rata on a fully-diluted basis as of the Effective Time) if and when the closing price per share of DSS Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of DSS Common Stock held in escrow shall be cancelled and returned to the treasury of DSS.

Upon the consummation of the Merger, only the holders of Lexington Preferred Stock who would, after giving effect to the Merger and receipt of the merger consideration, beneficially own more than 9.99% of DSS Common Stock (the “Beneficial Ownership Condition”) shall receive for each share of Lexington Preferred Stock they hold the same merger consideration as outlined above except that such holders shall receive a combination of DSS Common Stock and DSS Preferred Stock that is convertible into (or if the proposal to authorize DSS Preferred Stock is not approved by the stockholders, $.02 Warrants (as defined below) exercisable for) that number of shares of DSS Common Stock they would have received if they had been a holder of Lexington Common Stock immediately prior to the Effective Time in such amounts that would enable such holders, after giving effect to the Merger, to beneficially own no more than 9.99% of DSS Common Stock upon consummation of the Merger.

Those holders of Lexington Preferred Stock who do not exceed the Beneficial Ownership Condition and accordingly will not receive DSS Preferred Stock or $.02 Warrants (as defined below), will receive DSS Common Stock and the other types of merger consideration in exchange for their Lexington Preferred Stock based on the Common Stock Exchange Ratio. In the event DSS’s stockholders approve the issuance of the merger consideration, but do not approve the authorization of the DSS Preferred Stock, then the holders of Lexington Preferred Stock that satisfy the Beneficial Ownership Condition shall receive warrants to purchase DSS Common Stock with an exercise price of $0.02 per share (the “$.02 Warrants”). Each $.02 Warrant is exercisable at any time after the date of issuance for a period of ten years. If at any time between the three month anniversary of the issuance date and the expiration date, there is no effective registration statement registering the resale of the shares issuable under the Warrants, then the holder may elect to exercise the Warrants, or a portion thereof, by way of a cashless exercise. Except under certain circumstances, no holder may exercise its Warrants or $.02 Warrants if such exercise would result in such holder beneficially owning in excess of 9.99% of the number of shares of DSS common stock outstanding immediately after giving effect to the issuance of shares of common stock upon exercise of the Warrant. In addition, under certain circumstances, a holder of the Warrants will be entitled to participate in any distribution of DSS’s assets (or the right to acquire its assets) or any declared cash dividend, to the same extent such holder would have participated therein if such holder had held the shares of common stock acquirable upon complete exercise of the Warrants.

The DSS Preferred Stock will have the powers, preferences and privileges and other rights as will be set forth in a Certificate of Amendment to the Certificate of Incorporation of DSS to be filed by DSS subsequent to closing, which rights include, among other things, the right to participate in any dividends and distributions paid to common stockholders on an as-converted basis, pro rata with the holders of DSS Common Stock. Upon the occurrence of any Liquidation Event (as such term is defined in the Certificate of Amendment), after the payment of all debts and liabilities of DSS, any remaining assets shall be distributed pro rata to the holders of DSS Common Stock and DSS Preferred Stock on an as-converted basis. The DSS Preferred Stock will be non-voting, except as required by law and in certain defined instances, including in connection with a fundamental transaction. Each share of DSS Preferred Stock shall be initially convertible into one share of DSS Common Stock.

No fractional shares of DSS Common Stock or DSS Preferred Stock will be issued in connection with the Merger. Instead, each Lexington stockholder who would be otherwise entitled to receive a fractional share will receive from DSS, in lieu thereof, the next highest whole number shares of DSS Common Stock or DSS Preferred Stock, as applicable.

Immediately following the completion of the Merger, the former stockholders of Lexington are expected to own approximately 55% of the outstanding common and preferred stock of the combined company (on a fully-diluted basis including the escrow shares) and the current stockholders of DSS are expected to own approximately 45% of the outstanding common stock of the combined company (on a fully-diluted basis including the escrow shares) (without taking into account any shares of DSS Common Stock held by Lexington’s stockholders prior to the completion of the Merger). The shareholders of Lexington will hold the largest percentage of the voting shares on a dilutive basis after the completion of the Merger at 55% of the combined entity.  The percentages of ownership include the 7,100,000 shares held in escrow, which are eligible to be voted while in escrow.  If the escrow shares are terminated (which will be determined after 1 year of the deal being consummated), Lexington shareholders would own a 45%, with DSS shareholders owning 55%. Lexington shareholders will represent the larger minority voting interest in the combined entity at 45% compared to DSS’s organized group (consisting of management and the board) at 12%.  After the closing of the acquisition, senior management of the combined entity is expected to include five officers; the CEO, CIO and CTO from Lexington, and the CFO and COO from DSS, resulting in more members of senior management representing Lexington including the chief decision marker. Based on the aforementioned, and after taking in consideration all relevant facts and circumstances (which included, among others, the relative voting rights of the combined entity on a diluted basis, the larger minority voting interest, and the composition of the senior management), the Company came to a conclusion that, Lexington is the accounting acquirer, as it is defined in FASB Topic ASC 805 “Business Combinations.”

The Company intends to file a Form S-4 Registration Statement with the Securities and Exchange Commission (“SEC”) regarding the proposed Merger as soon as practicable. The Merger requires approval by the stockholders of both Lexington and DSS. The Company currently estimates that the Merger will be consummated during the first half of 2013.

The Company has incurred approximately $461,000 of professional fees associated with the Merger. These costs are expensed as incurred.

Private Placement

Concurrently with the execution of the Merger Agreement, on October 1, 2012, DSS entered into subscription agreements with certain accredited investors, pursuant to which DSS agreed to issue and sell to such investors in a private placement an aggregate of 833,651 shares of its common stock, at a purchase price of $3.30 per share, for an aggregate purchase price of $2,751,048 (the “Private Placement”). The Private Placement was completed on October 1, 2012. Lexington participated in the private placement and purchased an aggregate of 218,675 shares of DSS common stock, at a purchase price of $3.30 per share, for an aggregate purchase price of $721,628. Dawson James Securities, Inc. acted as the sole placement agent in connection with the Private Placement and received $250,095 in fees.

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 that could cause actual results to differ materially from the results anticipated in the forward-looking statements, including, without limitation, those contained in our Annual Report on Form 10-K for the year ended December 31, 2011, and as follows:

Overview

Document Security Systems, Inc. (referred to in this report as “Document Security Systems”, “Document Security,” “DSS,” “we,” “us,” “our” or “Company”) was formed in New York in 1984 and, in 2002, chose to strategically focus on becoming a developer and marketer of secure technologies. We specialize in fraud and counterfeit protection for all forms of printed documents and digital information. The Company holds numerous patents for optical deterrent technologies that provide protection of printed information from unauthorized scanning and copying. We operate three production facilities including a security and commercial printing facility, a packaging facility and a plastic card facility where we produce secure and non-secure documents for our customers. We license our anti-counterfeiting technologies to printers and brand-owners. In addition, we have a digital division which provides cloud computing services for its customers, including disaster recovery, back-up and data security services.

Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology. In 2006, the Company began a series of acquisitions designed to expand its ability to produce its products for end-user customers. In 2006, we acquired Plastic Printing Professionals, Inc., a privately held plastic cards manufacturer located in the San Francisco, California area, referred to herein as “P3” or the “DSS Plastics Group”. In 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, New York, referred to herein as “Secuprint” or “DSS Printing Group”. In 2010, the Company acquired Premier Packaging Corporation, referred to herein as “Premier”, “Premier Packaging” or “DSS Packaging Group”. Prior to the acquisition, Premier was a privately held packaging company located in Victor, New York.

In May 2011, we acquired ExtraDev, Inc. (“ExtraDev”), a privately held information technology and cloud computing company located in Rochester, New York. ExtraDev is also referred to herein as the “DSS Digital Group”.

In 2011, we rebranded as “DSS” and now do business in four operating segments as follows:

DSS Printing Group - Provides secure and commercial printing services for end-user customers along with technical support for the Company’s technology licensees. The division produces a wide array of printed materials such as security paper, vital records, prescription paper, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, brochures, direct mailing pieces, catalogs, and business cards. The division also provides the basis of research and development for the Company’s security printing technologies.

DSS Plastics Group - Manufactures laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, Radio Frequency Identification (RFID) and watermarks for printed plastic documents such as ID cards, event badges, and driver’s licenses.

DSS Packaging Group - Produces custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The division incorporates our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting.

DSS Digital Group - Provides data center centric solutions to businesses and governments delivered via the “cloud”. This division is also developing proprietary digital data security technologies based on the Company’s optical deterrent technologies.  

On October 1, 2012, Document Security Systems, Inc., a New York corporation (“DSS”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) with DSSIP, Inc., a Delaware corporation and wholly-owned subsidiary of DSS (“Merger Sub”), and Lexington Technology Group, Inc., a Delaware corporation (“Lexington”), and Hudson Bay Master Fund Ltd., as representative of Lexington’s stockholders (“Lexington Representative”) solely for certain purposes (as described in the Merger Agreement), pursuant to which Merger Sub will merge with and into Lexington, with Lexington being the surviving corporation (the “Surviving Corporation”) and will continue its existence as a wholly-owned subsidiary of DSS through an exchange of capital stock of Lexington for capital stock of DSS (the “Merger”).

Lexington is a private intellectual property monetization company that acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the “Bascom Portfolio”). Lexington is focused on the economic benefits of intellectual property assets through acquiring or internally developing patents or other intellectual property assets (or interests therein) and then monetizing such assets through a variety of value enhancing initiatives, including, but not limited to: licensing, customized technology solutions (such as applications for medical electronic health records), strategic partnerships and litigation. Through its wholly-owned subsidiary Bascom Research, LLC (“Bascom Research”), Lexington currently develops software applications based on the Bascom Portfolio that are focused on applying computational and data structures to complex data sets in the medical field. Lexington has a strategic relationship with LinkSpace, LLC, a contextual search company, and a consulting agreement with Mednest LLC, a professional technology incubation advisor, to develop medical-related software applications in the RFID and electronic health record space. Lexington intends to attempt to enter into sponsored research agreements and partnerships with other companies and universities in order to further develop applications for the technology relating to the Bascom Portfolio. On October 3, 2012, Bascom Research initiated patent infringement lawsuits in the United States District Court for the Eastern District of Virginia against five companies, including Facebook, Inc. and LinkedIn Corporation, for unlawfully using systems that incorporate features claimed in patents owned by Bascom Research.

Pursuant to the terms of the Merger Agreement, upon completion of the Merger (the “Effective Time”) and subject to the Beneficial Ownership Condition (as defined below), each share of then-issued and outstanding common stock of Lexington, par value $0.0001 per share (“Lexington Common Stock”) and each share of then-issued and outstanding Series A Convertible Preferred Stock of Lexington, par value $0.0001 per share (“Lexington Preferred Stock”) (other than shares of Lexington Common Stock and Lexington Preferred Stock held in treasury or owned by DSS or any direct or indirect wholly owned subsidiary of DSS or Lexington that will be canceled and retired at the Effective Time) will be automatically converted into (i) the right to receive shares of DSS common stock, par value $0.02 per share (“DSS Common Stock”), (ii) Warrants (as described below), (iii) shares of DSS Common Stock to be held in escrow (as described below, the “Escrow Shares”) and, as applicable, shares of DSS’s Series A Convertible Preferred Stock (“DSS Preferred Stock”), determined by multiplying each of (x) 17,250,000 plus the number of Additional Shares (as defined below) and Exchanged Shares (as defined below), if any, (y) 4,859,894, and (z) 7,100,000 by a fraction, the numerator of which shall be one and the denominator of which shall be the sum of (A) the number of shares of Lexington Common Stock plus (B) the number of shares of Lexington Preferred Stock, in each case issued and outstanding immediately prior to the Effective Time (such fraction referred to as the “Common Stock Exchange Ratio“).

At the Effective Time of the Merger, DSS will issue to the holders of Lexington Common Stock and Lexington Preferred Stock (on a pro rata as-converted basis) an aggregate of 4,859,894 warrants to purchase an aggregate of 4,859,894 shares of DSS Common Stock with an exercise price of $4.80 per share and a term of five years commencing upon the closing of the Merger (the “Warrants”). As a condition to the closing of the Merger, DSS, Lexington Representative and American Stock Transfer & Trust Company, LLC, as escrow agent, will enter into an escrow agreement (the “Escrow Agreement”). Pursuant to the Escrow Agreement, at the Effective Time, DSS shall deposit the Escrow Shares into an escrow account to be released to the holders of Lexington Common Stock (pro rata on a fully-diluted basis as of the Effective Time) if and when the closing price per share of DSS Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of DSS Common Stock held in escrow shall be cancelled and returned to the treasury of DSS.

Upon the consummation of the Merger, only the holders of Lexington Preferred Stock who would, after giving effect to the Merger and receipt of the merger consideration, beneficially own more than 9.99% of DSS Common Stock (the “Beneficial Ownership Condition”) shall receive for each share of Lexington Preferred Stock they hold the same merger consideration as outlined above except that such holders shall receive a combination of DSS Common Stock and DSS Preferred Stock that is convertible into (or if the proposal to authorize DSS Preferred Stock is not approved by the stockholders, $.02 Warrants (as defined below) exercisable for) that number of shares of DSS Common Stock they would have received if they had been a holder of Lexington Common Stock immediately prior to the Effective Time in such amounts that would enable such holders, after giving effect to the Merger, to beneficially own no more than 9.99% of DSS Common Stock upon consummation of the Merger.

Those holders of Lexington Preferred Stock who do not exceed the Beneficial Ownership Condition and accordingly will not receive DSS Preferred Stock or $.02 Warrants (as defined below), will receive DSS Common Stock and the other types of merger consideration in exchange for their Lexington Preferred Stock based on the Common Stock Exchange Ratio. In the event DSS’s stockholders approve the issuance of the merger consideration, but do not approve the authorization of the DSS Preferred Stock, then the holders of Lexington Preferred Stock that satisfy the Beneficial Ownership Condition shall receive warrants to purchase DSS Common Stock with an exercise price of $0.02 per share (the “$.02 Warrants”). Each $.02 Warrant is exercisable at any time after the date of issuance for a period of ten years. If at any time between the three month anniversary of the issuance date and the expiration date, there is no effective registration statement registering the resale of the shares issuable under the Warrants, then the holder may elect to exercise the Warrants, or a portion thereof, by way of a cashless exercise. Except under certain circumstances, no holder may exercise its Warrants or $.02 Warrants if such exercise would result in such holder beneficially owning in excess of 9.99% of the number of shares of DSS common stock outstanding immediately after giving effect to the issuance of shares of common stock upon exercise of the Warrant. In addition, under certain circumstances, a holder of the Warrants will be entitled to participate in any distribution of DSS’s assets (or the right to acquire its assets) or any declared cash dividend, to the same extent such holder would have participated therein if such holder had held the shares of common stock acquirable upon complete exercise of the Warrants.

The DSS Preferred Stock will have the powers, preferences and privileges and other rights as will be set forth in a Certificate of Amendment to the Certificate of Incorporation of DSS to be filed by DSS subsequent to closing, which rights include, among other things, the right to participate in any dividends and distributions paid to common stockholders on an as-converted basis, pro rata with the holders of DSS Common Stock. Upon the occurrence of any Liquidation Event (as such term is defined in the Certificate of Amendment), after the payment of all debts and liabilities of DSS, any remaining assets shall be distributed pro rata to the holders of DSS Common Stock and DSS Preferred Stock on an as-converted basis. The DSS Preferred Stock will be non-voting, except as required by law and in certain defined instances, including in connection with a fundamental transaction. Each share of DSS Preferred Stock shall be initially convertible into one share of DSS Common Stock.

No fractional shares of DSS Common Stock or DSS Preferred Stock will be issued in connection with the Merger. Instead, each Lexington stockholder who would be otherwise entitled to receive a fractional share will receive from DSS, in lieu thereof, the next highest whole number shares of DSS Common Stock or DSS Preferred Stock, as applicable.

Immediately following the completion of the Merger, the former stockholders of Lexington are expected to own approximately 55% of the outstanding common and preferred stock of the combined company (on a fully-diluted basis) and the current stockholders of DSS are expected to own approximately 45% of the outstanding common stock of the combined company (on a fully-diluted basis) (without taking into account any shares of DSS Common Stock held by Lexington’s stockholders prior to the completion of the Merger). The shareholders of Lexington will hold the largest percentage of the voting shares on a dilutive basis after the completion of the Merger at 55% of the combined entity.  The percentages of ownership include the 7,100,000 shares held in escrow, which are eligible to be voted while in escrow.  If the escrow shares are terminated (which will be determined after 1 year of the deal being consummated), Lexington shareholders would own a 45%, with DSS shareholders owning 55%. Lexington shareholders will represent the larger minority voting interest in the combined entity at 45% compared to DSS’s organized group (consisting of management and the board) at 12%.  After the closing of the acquisition, senior management of the combined entity is expected to include five officers; the CEO, CIO and CTO from Lexington, and the CFO and COO from DSS, resulting in more members of senior management representing Lexington including the chief decision marker. Based on the aforementioned, and after taking in consideration all relevant facts and circumstances (which included, among others, the relative voting rights of the combined entity on a diluted basis, the larger minority voting interest, and the composition of the senior management), the Company came to a conclusion that, Lexington is the accounting acquirer, as it is defined in FASB Topic ASC 805 “Business Combinations.”

We have expended significant effort and management attention on the proposed Merger transaction. There is no assurance that the transaction contemplated by the Merger Agreement will be consummated. If the Merger transaction is not consummated for any reason, our business and operations, as well as the market price of our stock and warrants may be adversely affected. For accounting purposes, based on our preliminary assessment, Lexington was identified as the “Acquirer”, as it is defined in FASB Topic ASC 805. As a result, in the post-combination consolidated financial statements, Lexington’s assets and liabilities will be presented at its pre-combination amounts, and our assets and liabilities will be recognized and measured in accordance with the guidance for business combinations in ASC 805. The Company intends to file a Form S-4 Registration Statement with the SEC regarding the proposed Merger as soon as practicable. The Merger requires approval by the stockholders of both Lexington and DSS, and is estimated to be consummated during the first half of 2013.

Results of Operations for the Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011

This discussion should be read in conjunction with the financial statements and footnotes contained in this quarterly report and in our Annual Report on Form 10-K for the year ended December 31, 2011.

Revenue

For the three months ended September 30, 2012, revenue was $4.2 million, an increase of $548,000, or 15% from the three months ended September 30, 2011. The revenue increase was primarily due to increases in packaging and licensing and digital solutions revenues. The Company’s packaging group saw increased order activity from its largest customers during the quarter while the Company’s licensing and digital solutions sales reflected increased usage of the Company’s security technology from its licensees. For the first nine months of 2012, revenue has increased 27% over the first nine months in 2011, primarily due to the 54% increase in the Company’s packaging group’s sales along with a 41% increase in revenue from the Company’s technology licensing and digital solutions groups, which was primarily the result of the Company’s acquisition of ExtraDev in May of 2011.

Cost of Revenue and Gross Profit

For the three months ended September 30, 2012, gross profit increased 20% to $1,523,000 as compared to the three months ended September 30, 2011. The increase in gross profit was primarily due a 98% increase in gross profits in the Company’s printing group, which benefited from a favorable product sales mix as the Company focused on higher margin projects, along with a 22% increase in gross profits in the Company’s packaging group.

For the first nine months of 2012, the Company’s gross profit has increased 36% over the first nine months of 2011. The Company saw a significant increase in gross profits from its printing groups as it has benefited from a lower cost structure and a more favorable product mix. In addition, each of the Company’s packaging and plastics groups realized gross profit gains as a result of their revenue gains. Finally, gross profits from licensing and digital solutions sales increased 25% primarily due to the addition of gross profits from the Company’s acquisition of ExtraDev, which occurred in May 2011.

Operating Expenses

Sales, general and administrative compensation costs, excluding stock base compensation, increased in 2012 as compared to 2011 primarily due to the addition of employees as a result of the Company’s acquisition of its cloud computing division in May 2011, offset by reductions of personnel in the Company’s printing and packaging divisions.

Professional fees during the three and nine months ended September 30, 2012 increased from the corresponding 2011 periods due to an increase in intellectual property consulting and investor relations costs, and approximately $461,000 of legal, accounting and consulting fees incurred in the third quarter of 2012 associated with the Company’s proposed merger with Lexington.

Sales and marketing costs during the three and nine months ended September 30, 2012 decreased from the corresponding periods of 2011, as the Company significantly decreased its marketing costs, including costs incurred during 2011 to redesign the Company’s logo, websites, sales collateral and trade-show booths, which did not re-occur in 2012.

Rent and utilities expenses in 2012 have decreased due to the elimination of rent at the Company’s packaging division as a result of that division’s purchase of its facility in August 2011, offset by an increase in rent due to the Company’s acquisition of ExtraDev in May 2011.

Other operating expenses consists primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses for the first nine months of 2012 include a one-time placement agent fee related to the placement of a convertible note and subsequent conversion in March 2012.

Research and development costs consist primarily of compensation costs for research personnel, third-party research costs, and consulting costs. During the three and nine months ended September 30, 2012, the Company’s research and development costs increased 110% and 162%, respectively, primarily due to payments and stock based compensation costs for warrants issued to ipCapital, a third party consulting firm assisting the Company with its goal of increasing its intellectual property portfolio of patents and trade secrets in the security field. The Company expects to continue to see a significant increase in research and develop costs over the next 12 to 18 months which the Company hopes will result in an increase in security product and licensing sales, and an increase in the value of its patent asset portfolio.

Stock based compensation includes expense charges for all stock based awards to employees, directors and consultants, except for stock based compensation allocated to research and development. Such awards include option grants, warrant grants, and restricted stock awards. Stock based compensation for the three months ended September 30, 2012 increased 72% from the three months ended September 30, 2011, primarily due to the estimated value of warrants issued in February 2012 to the Company’s investor relations provider and warrants issued to a consultant in July 2012.

Amortization of intangibles expense increases in 2012 compared to 2011 are due to the increase in the Company’s other intangible asset basis due to the acquisition of ExtraDev in May 2011.

Other Income and Expenses

Amortization of note discount On February 29, 2012, the Company entered into a convertible note. The holder of the note had the right to convert the principal and any interest due under the note into shares of the Company’s common stock at a conversion price of $3.30 per share. In conjunction with this conversion option, the Company recorded a beneficial conversion feature of approximately $216,000 which the Company will expense over the term of the note. In March 2012, the holder exercised the conversion option on the note. Pursuant to the conversion, the Company issued an aggregate of 175,710 shares of its common stock to the holder for full payment of note and accrued interest. In conjunction with the conversion, the Company recorded a note discount amortization expense of the entire $216,000 of remaining unamortized debt discount expense during the first quarter of 2012.

Change in fair value of derivative liability In late 2010, the Company issued various financial instruments to an investor in connection with a stock purchase agreement, which contained certain provisions that resulted in a derivative liability. On February 18, 2011 the Company entered into certain amendments with the investor for the purpose of modifying the terms of the financial instruments that among other things eliminated the provisions of the warrants that had created the derivative liabilities. As a result, the Company determined the fair value of the derivative liability as of the modification date of February 18, 2011 and recorded the change in fair value of the derivative liability since December 31, 2010 of $360,922 in the statement of operations.

Net Loss and Loss per Share

During the three months ended September 30, 2012, the Company had a net loss of $1,096,000, representing a 45% increase from the net loss during the three months ended September 30, 2011. The increase in net loss was significantly impacted by $461,000 of expenses incurred by the Company during the 2012 for legal, accounting and consulting costs associated with the Company’s proposed merger with LTG. Absent these costs, net loss would have been approximately $635,000 during the three months ended September 30, 2012, a 16% improvement from the three months ended September 30, 2011, and reflect the 20% increase in gross profits during the quarter along with a decrease in most operating expense categories.

During the nine months ended September 30, 2012, the Company had a net loss of $3,165,000 representing a 40% increase from the net loss during the nine months ended September 30, 2011. The increase in net loss was primarily due to three items: 1) $227,000 amortization of note discount expense recorded in the first quarter of 2012; 2) a $361,000 one-time other income recorded in the first quarter of 2011 due to a change in the fair value of a derivative liability; and 3) the $461,000 of expenses incurred by the Company during the third quarter of 2012 for legal, accounting and consulting costs associated with the Company’s proposed merger with LTG. These three items in aggregate amounted to $1,049,000. Absent these items, net loss during the first nine months of 2012 would have decreased approximately 7%.

LIQUIDITY AND CAPITAL RESOURCES

The Company has historically met its liquidity and capital requirements primarily through the private placement of equity securities and debt financings. As of September 30, 2012, the Company had cash of approximately $1.0 million. In addition, the Company had approximately $580,000 available to its Packaging and Digital division under revolving credit lines.

During the first nine months of 2012, the Company increased its cash position and reduced its debt by selling shares of its common stock and issuing shares of its common stock pursuant to debt conversions and warrant exercises. On February 13, 2012, the Company sold 967,740 shares of common stock for net proceeds of approximately $2,700,000 in a private placement of equity. On February 29, 2012, the Company entered into an agreement whereby an existing commercial term note in the original principal amount of $650,000 was sold and transferred to an investor for a purchase price of $578,396, the outstanding principal at the time of the sale. In connection with the sale and transfer of the commercial term note, the Company agreed to structure the note as a convertible note at a conversion price of $3.30 per share. In March 2012, the holder converted the full amount of the remaining indebtedness under the note, in exchange for 175,710 shares of the Company’s common stock, and the note was retired. In July 2012, the Company received approximately $500,000 from the exercise of warrants. In addition, in October 2012, the Company sold 833,651 shares of common stock for net proceeds of approximately $2,500,000 in a private placement of equity.

Operating Cash Flow – During the first nine months of 2012, the Company used approximately $2,080,000 of cash for operations, a 3% increase from the Company’s use of cash for operations during the first nine months of 2011, which generally reflect a difference in the timing of cash flows from accounts receivables and an increase in prepayments in 2012.

Investing Cash Flow - During the first nine months of 2012, the Company spent approximately $109,000 on equipment additions at its packaging and plastic divisions, and paid approximately $104,000 of legal and consulting costs which were capitalized as patent assets.

Financing Cash Flows - During the first nine months of 2012, the Company raised approximately $3.3 million from the sale of equity in a private placement, as described above, and from the exercise of warrants made by certain holders. In addition, the Company made scheduled debt and capitalized lease payments during the first nine months of 2012 of approximately $493,000 and paid down the balance of its packaging division’s revolving line of credit by approximately $221,000.

Future Capital Needs - As of September 30, 2012, the Company had cash of approximately $1.0 million and in October 2012, the Company received $2,500,000 from a private placement of its common shares. In addition, the Company had approximately $519,000 available to its Packaging division under a revolving credit line. The Company believes that its current cash, working capital and availability of funds under its credit line resources provide it sufficient resources in order to fund its operations and meet its obligations for at least the next twelve months. However, if expected revenues in the second half of 2012 do not materialize and if the Company cannot generate sufficient cash from its operations in the future, the Company may need to raise additional funds in order to fund its working capital needs and pursue its growth strategy. However, there is no guarantee we will be able to raise such funds if necessary.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.

Critical Accounting Policies and Estimates

As of September 30, 2012, our critical accounting policies and estimates have not changed materially from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2011.

ITEM 4 - CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of September 30, 2012. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, based on the material weaknesses discussed below, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act were recorded, processed, summarized, and reported within time periods specified in the Securities and Exchange Act Commission’s rules and forms and that our disclosure controls are not effectively designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

In connection with management’s assessment of our internal control over financial reporting described above, management has identified the following material weaknesses in the Company’s internal control over financial reporting as of September 30, 2012.

We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties. We have two people on staff that perform nearly all aspects of our external financial reporting process, including but not limited to access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the external financial statements. This creates certain incompatible duties and a lack of review over the financial reporting process that would likely fail to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures as filed with the Securities and Exchange Commission. Specifically, we determined that our controls over the preparation, review and monitoring of the financial statements were ineffective to provide reasonable assurance that financial disclosures agree with appropriate supporting detail, calculations or other documentation. These control deficiencies could potentially result in a material misstatement to our interim consolidated financial statements that may not be prevented or readily detected.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Plan for Remediation of Material Weaknesses

In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to continue to monitor and review our control environment and to evaluate whether cost effective solutions are available to remedy the identified material weaknesses by expanding the resources available to the financial reporting process.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over the financial reporting during our fiscal quarter ending June 30, 2012 that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting.

PART II
OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

None

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

There were no sales of unregistered equity securities which were not previously reported.

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4 – MINE SAFETY DISCLOSURES

None

ITEM 5 - OTHER INFORMATION

None

ITEM 6 - EXHIBITS

101 ** The following materials from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2012 formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, and (iv) related notes to these financial statements, tagged as blocks of text.

*Filed herewith.

**Furnished herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.