SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002.
OR
/ / TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from __________ to __________
Commission file number 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
125 Baylis Road 11747
Melville, New York (Zip code)
(Address of principal executive offices)
Registrant's telephone number, including area code: 631-777-5188
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001
par value
Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No __
Indicate by check mark if disclosure of delinquent filers pursuant
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Exchange Act Rule 12b-2). Yes |X| No __
Aggregate market value of Common Stock held by non-affiliates of the
Registrant as of June 30, 2002 was $90,962,009, which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers,
directors, and their affiliates. Such exclusion should not be deemed a
determination by Registrant that all such individuals are, in fact, affiliates
of the Registrant. The number of shares of Common Stock issued and outstanding
as of March 7, 2003 was 45,805,826 and 45,570,826, respectively.
Documents Incorporated by Reference:
The information required by Part III of Form 10-K will be
incorporated by reference to certain portions of a definitive proxy statement
which is expected to be filed by the Company pursuant to Regulation 14A within
120 days after the close of its fiscal year.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
PART I.
Item 1. Business............................................................3
Item 2. Properties.........................................................11
Item 3. Legal Proceedings..................................................11
Item 4. Submission of Matters to a Vote of Security Holders................11
PART II.
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters................................................12
Item 6. Selected Consolidated Financial Data...............................12
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..........................................14
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.........24
Item 8. Consolidated Financial Statements and Supplementary Data...........25
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure................................45
PART III.
Item 10. Directors and Executive Officers of the Registrant.................45
Item 11. Executive Compensation.............................................45
Item 12. Security Ownership of Certain Beneficial Owners and Management.....45
Item 13. Certain Relationships and Related Transactions.....................45
Item 14. Controls and Procedures............................................46
PART IV.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K....48
SIGNATURES...................................................................48
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PART I
Item 1. Business
OVERVIEW
FalconStor Software, Inc. ("FalconStor" or the "Company") is a provider of
network storage infrastructure software solutions and related maintenance,
implementation and engineering services. FalconStor's unique open software
approach to storage networking enables companies to embrace state-of-the-art
equipment (based on SCSI, Fibre Channel or iSCSI) from any storage manufacturer
without rendering their existing or legacy solutions obsolete. Several strategic
partners have recognized the industrial strength of FalconStor's flagship
software, IPStor(R), and utilized it to power their respective special purpose
storage appliances to perform Real Time Data Migration, Data Replication, and
other advanced storage services. IPStor leverages the high performance IP or FC
based network to help corporate IT aggregate storage capacity and contain the
run-away cost of administering mission-critical storage services such as
snapshot, backup, data replication, and other storage services. in a distributed
environment. Over 300 customers around the world have deployed IPStor in the
production environment to manage their storage infrastructure with minimal TCO
(Total Cost of Ownership) and optimal ROI (Return on Investment). FalconStor's
products have been certified by such industry leaders as Adaptec, Alacritech,
ATTO Technology, Bell Microproducts, Brocade, Cisco, Emulex, Fujitsu, Gadzoox,
Hitachi Data Systems, Hitachi Engineering Co., Ltd., IBM, Intel, LSI Logic,
McDATA Corporation, Microsoft, NEC, Novell, NS Solutions Corporation (subsidiary
of The Nippon Steel Corporation, Japan), Oracle, QLogic, Quantum|ATL,
StorageTek, SUN and Tivoli. FalconStor has agreements with original equipment
manufacturers ("OEMs") such as NEC, Runtop, Accton, ADTX, AnexTek Global, Inc.,
MTI, Dot Hill and Storage Engine, to incorporate FalconStor's IPStor technology
with such companies' products.
Network Peripherals Inc. ("NPI") was incorporated in California in March 1989
and reincorporated in Delaware in 1994. FalconStor, Inc. was incorporated in
Delaware in February 2000. On August 22, 2001, FalconStor, Inc. merged with NPI,
a publicly traded company, with NPI as the surviving corporation. Although NPI
acquired FalconStor, as a result of the transaction, FalconStor, Inc.
stockholders held a majority of the voting interests in the combined enterprise
after the merger. Accordingly, for accounting purposes, the acquisition was a
"reverse acquisition" and FalconStor, Inc. was the "accounting acquirer."
Further, as a result of NPI's decision on June 1, 2001 to discontinue its NuWave
and legacy business, at the time of the merger NPI was a non-operating public
shell with no continuing operations, and no intangible assets associated with
NPI were purchased by FalconStor. As a result, the transaction was accounted for
as a recapitalization of FalconStor and recorded based on the fair value of
NPI's net tangible assets acquired by FalconStor, with no goodwill or other
intangible assets being recognized. In connection with the merger, the name of
NPI was changed to FalconStor Software, Inc. For more information relating to
the merger, see Note 2 of Notes to Consolidated Financial Statements.
INDUSTRY BACKGROUND
The rapid growth of data-intensive business applications has increased the
amount of mission-critical enterprise data and consequently, the need for
dedicated storage. Enterprises are frequently discovering that their existing
storage infrastructure and resources have become over extended, inefficient and
increasingly congested with data traffic.
According to The Yankee Group, data continues to drive the need for better
management as storage doubles annually. Advanced storage network services are
crucial to storage area network (SAN) development, as they provide tools to
automate and simplify administrative tasks that help IT professionals move their
systems to a storage utility model. As service providers and enterprises move
forward in piloting and deploying production-level SANs, a number of storage
management segments will grow as companies are forced to find better ways to
manage storage. The Yankee Group predicts that storage management will continue
to grow as a crucial component of SAN adoption, and will increase by 2005 to a
$14.3 billion market. In addition, data management will continue to attract the
interests of IT executives. However, finding the right set of storage management
tools that meet specific enterprise requirements is still a challenge for many
enterprises.
These storage management challenges have led to the development of network
attached storage, or NAS, and storage area network, or SAN, systems, two
innovative ways of addressing the storage problem. These two storage systems do
not compete; both are needed by corporate data centers. NAS represents a quick
and simple solution to add general purpose, shareable, storage space to users
and groups and to some application servers that are not access-intensive. SAN
represents a way to separate the server and storage into two independently
managed systems, thereby simplifying the complexity of the overall IT
infrastructure. Fibre channel, or FC, a high-speed network connection system,
has emerged as a viable means to implement a SAN. However, a pure FC SAN alone
does not address all the problems in the areas of connectivity, storage
virtualization and storage services.
A large market opportunity is emerging for storage software that can
successfully address the shortcomings of current storage solutions. As SANs
continue to grow in popularity and complexity, innovative software products will
be required to improve management and to facilitate rapid transport of data
within an enterprise. Historically, no company could provide a single, managed,
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optimized, well-integrated, and well-connected network storage solution that
leverages all industry standard transport technology including Internet
Protocol/Internet Small Computer Systems Interface, or IP/iSCSI, and FC, and at
the same time, delivers advanced storage services offering both SAN and NAS
access.
There are many reasons enterprises are moving to a storage network model and/or
are adding a central data center with networked storage that works in concert
with direct attached storage at branch offices, including dramatically
simplified storage management, more efficient utilization of storage capacity,
high availability, and scalability, which result in two key benefits: lower
total cost of ownership (TCO), and higher return on investment (ROI).
PRODUCTS AND TECHNOLOGY
IPStor, FalconStor's flagship product, is a comprehensive set of state of the
art network storage infrastructure software solutions that delivers an open,
intelligent SAN/NAS infrastructure across heterogeneous environments by
providing advanced storage services for enterprise applications - optimizing
storage utilization, accelerating backup and recovery, maximizing performance
and ensuring business continuity.
The base software, running on a layer of standard, dedicated servers (the IPStor
Appliances), is responsible for aggregating and provisioning storage capacity
and services to application servers via all industry standard protocols with
speed, security, reliability, interoperability, and scalability.
IPStor offers Storage Consolidation, Business Continuity/Disaster Recovery, I/O
Performance Optimization and Backup/Recovery Acceleration services designed to
help enterprise data centers minimize total cost of ownership (TCO) and maximize
return on investment (ROI).
STORAGE CONSOLIDATION SOLUTIONS
IPStor's Storage Consolidation Solutions consolidate heterogeneous storage
environments, centralize storage management under one simple interface, maximize
storage capacity utilization, consolidate servers, and/or migrate data. IPStor's
Storage Consolidation Products include a Capacity-on-Demand Agent, a NAS Option,
the RealTime Data Migrator, a SANBridge option, a Storage Service Enabler
Option, as well as Storage Optimizers for Microsoft Exchange and Lotus
Notes/Domino.
CAPACITY-ON-DEMAND AGENT
The Capacity-on-Demand (COD) Agent is an automated capacity management solution
for heterogeneous storage environments that prevents systems from running out of
disk space through continuous monitoring of storage consumption and
availability. The COD Agent provides a customizable monitoring and action policy
with user-defined storage capacity thresholds. When thresholds are reached, the
COD Agent provides free disk space by performing one or more of the following
actions: compressing infrequently used files, relocating infrequently used files
to a different volume (an overflow storage pool), or expanding the capacity of
the file system. The three actions are performed in real time, without user
intervention or interruption to the business application.
NAS OPTION
IPStor's NAS Option is an easy way to add general purpose, shareable storage
space for Windows, Linux, and Unix users. IPStor's NAS Option provisions storage
via industry-standard file sharing protocols (SMB/CIFS and NFS) to Microsoft
Windows, Linux, and Unix clients. This provisioning allows users to share
folders and files regardless of the operating system. Furthermore, as the number
of users and amount of data grow, a NAS resource can be dynamically expanded
once its full capacity has been reached.
Distinctively different from today's typical NAS solution, IPStor allows both
NAS and SAN resources to be created from the same virtualized storage pool. This
innovative architecture simplifies administrative tasks because IPStor's
advanced storage services, such as Active-Active Failover (high availability),
Mirroring, Replication, Snapshot Copy, TimeMark, database-aware Snapshot Agents,
Zero-Impact Backup Enabler, and Serverless Backup Enabler, all work identically
for both SAN and NAS resources.
REALTIME DATA MIGRATOR
The IPStor RealTime Data Migrator is available from FalconStor as either a
software option to IPStor, or as a stand-alone appliance. It leverages an
existing SAN environment to transport data in real-time between similar and
dissimilar storage subsystems during storage upgrades, data center relocations,
and server consolidations, while maintaining full availability of application
servers. IPStor's RealTime Data Migrator is operating system independent,
therefore the same migration appliance can be used to migrate data within a
heterogeneous environment, significantly reducing overall IT expenses. The
IPStor RealTime Data Migrator will be generally available in Q2 2003.
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SANBRIDGE OPTION
IPStor's SANBridge Option enables IPStor appliances to share SAN Resources with
other IPStor appliances on Fibre Channel SANs. As a result of its protocol
flexibility, IPStor can provide SAN bridging capabilities with no distance
limitations. A local IPStor appliance can pass requests for data over IP to any
other IPStor appliance, gaining access to its storage resources, even if the
local host server is connected via Fibre Channel, SCSI, or IP. The IPStor
SANBridge Option provides the protocol conversion needed to bridge multiple
connection technologies.
STORAGE SERVICE ENABLER OPTION
IPStor's Storage Service Enabler Option enables customers to immediately add
enterprise class storage to new or existing SANs without bulk copying or the
need to virtualize existing data. Using this option, data centers can
immediately and transparently take advantage of IPStor's advanced storage
services (mirroring, snapshot, etc.) without any migration/copying, or
modification of data, and with minimal downtime. For Fibre Channel-based
storage, this transformation can be done without re-cabling; just rezoning. The
Storage Service Enabler option allows existing storage devices to be zoned or
cabled to an IPStor Appliance and quickly made available for use by host
servers.
STORAGE OPTIMIZER FOR MICROSOFT EXCHANGE
IPStor's Storage Optimizer for Exchange consolidates and moves older attachments
from primary data store to lower cost on-line disk storage, thereby reducing the
primary storage capacity requirements of Microsoft Exchange data stores. The
Storage Optimizer scans the Exchange information store for attachments to match
a given user-defined policy (age, size, type, etc.), and then migrates them to a
secondary storage pool. Migrated attachments remain virtually attached to the
original message and therefore can still be opened - which automatically
triggers a callback from the secondary data storage. Response time is nearly as
fast as if the attachment had never been migrated. The Storage Optimizer can
migrate attachments from aged e-mail messages, as well as consolidate them by
eliminating duplication. The Storage Optimizer also provides analytical tools
that let Administrators scan the information store to determine how much disk
space would be saved given a specific set of policies. The migration process
itself can be scheduled for specific times of day, to minimize impact on the
computing environment.
STORAGE OPTIMIZER FOR LOTUS/NOTES
The Storage Optimizer for Lotus Notes/Domino consolidates and moves older
attachments from primary database to lower cost on-line disk storage, thereby
reducing primary storage capacity requirements of Domino servers. The Storage
Optimizer scans the Lotus Notes database for attachments to match a given
user-defined policy (age, size, type, etc.), and then migrates them to a
secondary storage pool. Migrated attachments remain virtually attached to the
original message, and therefore can still be opened - which automatically
triggers a callback from the secondary data storage. Response time is nearly as
fast as if the attachment had never been migrated. The Storage Optimizer can
migrate attachments from aged e-mail messages, as well as consolidate them by
eliminating duplication. The Storage Optimizer for Lotus Notes/Domino also
provides analytical tools that let Administrators scan the information store to
determine how much disk space would be saved given a specific set of policies.
The migration process itself can be scheduled for specific times of day, to
minimize impact on the computing environment.
BUSINESS CONTINUITY / DISASTER RECOVERY STORAGE PRODUCTS
FalconStor Business Continuity | Disaster Recovery (BCDR) solutions share the
common goal of minimizing downtime.
IPStor Business Continuity Solutions, which include Active-Active Failover, Bare
Metal Recovery for Windows and Linux, DynaPath, NIC Express, TimeMark and
Message Recovery for Exchange, maintain continuous 24x7xforever data
availability and usability in the event of non-catastrophic unplanned or planned
hardware outages and software errors.
ACTIVE-ACTIVE FAILOVER OPTION
IPStor's Active-Active Failover Option provides enterprises with a highly
redundant storage solution offering 24x7 availability. IPStor can be deployed in
a two-node, active-active cluster configuration, where two IPStor Appliances are
configured to monitor each other. Should one fail, the other automatically
assumes the failed server's workload, ensuring no single point of failure.
The Active-Active Failover Option can also be used to facilitate software and
hardware maintenance and upgrades. Using the Java-based IPStor management
console, a forced failover can be triggered to temporarily take the IPStor
Appliances off-line for maintenance, one at a time, while providing the
Administrator the peace of mind that another server is there to keep the
application servers running without interruption.
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BARE METAL RECOVERY OPTION
IPStor Bare Metal Recovery (IBMR) maximizes system availability by reducing the
recovery time after a server, desktop, or notebook hard drive crash. IBMR
captures and stores the system's boot disk image on an IPStor-managed drive.
Upon local drive failure, instead of waiting for the installation of a
replacement hard drive, operating system (OS), and applications, the system can
access the stored image via the industry standard protocol PXE to boot the
system over the IP network. This process occurs seamlessly, without requiring a
recovery disk. Built on existing IP technology, IBMR extends remote boot
capabilities (traditionally performed within Fibre Channel SANs) to IP-based
networks. This allows users to leverage their existing networking infrastructure
without the need to invest in additional hardware.
IBMR saves mirrored boot images of Microsoft Windows, Sun Solaris, HP-UX, Linux,
and AIX application servers under one central repository and allows these
heterogeneous systems to be recovered immediately using the same process, thus
eliminating the need to manage separate solutions for each OS. IMBR will be
generally available in Q2 2003.
DYNAPATH AGENT
IPStor's DynaPath Agent ensures constant data availability across the SAN by
creating parallel active storage paths that transparently reroute application
server traffic to a redundant storage path without interruption in the event of
a storage network problem. Load balancing enhances peak performance of the SAN
by automatically distributing server traffic among the server's multiple storage
paths for higher throughput and to eliminate bottlenecks so that enterprises can
meet today's demands for 24x7 business continuity.
NIC EXPRESS PRODUCT LINE
FalconStor's NIC Express product line extends fault tolerance to the edges of
the network by providing advanced failover and load balancing functionality for
any server or workstation on the network. NIC Express intelligently re-routes
data traffic to another NIC in the event that a fault is detected in the path of
the primary NIC. This creates redundant data paths and enables companies to
build end-to-end fault tolerant networks. NIC Express also offers load balancing
of traffic across an array of two or more network connections to boost
bandwidth.
TIMEMARK OPTION
IPStor's TimeMark Option delivers a safeguard against "soft errors," (accidental
deletions, file corruptions, virus attacks, etc.), by providing granular instant
"roll-back" to a known-good point in time. TimeMark protects where high
availability (HA) configurations cannot, since in creating a redundant set of
data, HA configurations also create a duplicate set of soft errors by default.
TimeMark protects data from slip-ups, the butter fingers of employees,
unforeseen glitches during backup, and viruses.
The TimeMark Option also serves as an "undo button" for data processing.
Traditionally, when an administrator performed an operation on a data set, a
full backup would be required before each "dangerous" step, as a safety net. If
the step resulted in undesirable effects, the Administrator needed to restore
the data set and start the entire process again. Now, with IPStor's TimeMark
Option, Administrators can create TimeMarks-- point-in-time images of any SAN or
NAS virtual drive. Each TimeMark represents block-level changes, and therefore
does not require 100% redundant capacity. Restoring a drive back to its original
state is easily achieved with a few clicks in the IPStor management console.
MESSAGE RECOVERY FOR MICROSOFT EXCHANGE
IPStor Message Recovery for Microsoft Exchange (IMR) delivers scheduled
point-in-time copies of data volumes, which enables Administrators to quickly
locate and restore individual mailboxes from IPStor-managed disk storage to a
standalone file (in Outlook PST format), and then forward the file to the user
for simple and easy import to their Outlook client, or import back to the
message store. IMR will be generally available in Q2 2003.
Using IMR, Administrators can modify the identity of a recovery Exchange server
to emulate the Exchange server from which the mailbox is to be recovered. The
Exchange services are then started on the recovery server and the Administrator
can point-and-click to select the user's mail messages to be restored. Or, a
date range can be selected if a specific time range of messages needs to be
recovered. Restoring the entire mailbox is also an option.
IPStor Disaster Recovery Solutions enable rapid recommencement of business in
the event of catastrophic outages, i.e., severe data corruptions due to rolling
disasters and site-level failures, and include Asynchronous Mirroring over IP or
Fibre Channel, Synchronous Mirroring over IP, and Delta-based Replication over
IP.
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ASYNCHRONOUS MIRRORING OPTION
IPStor's Asynchronous Mirroring Option is ideal for environments consisting of
two storage systems located at geographically distant sites wherein the data
must be kept as closely synchronized as possible. It offers the ability to
define a near real-time mirror for any IPStor-managed disk (virtual or
service-enabled) over long distances between data centers and serves as an
effective tool for zero-downtime migration of data from older disks to newer
disks arrays.
To guard against site failure, Asynchronous Mirroring enables organizations to
locate a remote backup site miles from their production facility and to maintain
a near real-time mirror of crucial data there. At the same time, asynchronous
mirroring offers a performance advantage at the primary site since data is
committed to the local storage device without waiting for an acknowledgment from
the storage device (mirror) at the remote site.
SYNCHRONOUS MIRRORING OPTION
IPStor's Synchronous Mirroring Option protects against the consequences of
storage failure by providing fault-tolerance for virtual storage volumes. At the
same time, data throughput is improved. Data redundancy is provided by creating
a synchronous mirror of a virtual storage volume, and if a primary volume fails,
the IPStor Appliance continues to function using its mirrored copy. Mirroring is
done at the block level and can cross drive, vendor/brand, and interface (SCSI,
FC, etc.) boundaries. Furthermore, the failure protection of RAID storage
systems is greatly enhanced by IPStor's ability to mirror across cabinets, even
if they are from different vendors.
Once set up, mirrored virtual drives are active at all times, both for reading
and writing. During read operations, IPStor takes full advantage of the extra
drive to improve read performance. Data is read from the primary and the
mirrored drive to maximize throughput. During write operations, data is sent to
both the primary and the mirror drives simultaneously. If any read or write
failure is detected, the failed virtual drive is temporarily disabled, and the
surviving virtual drive becomes the primary drive. Throughout this process, the
application servers continue to run without interruption and at peak
performance.
DELTA-BASED REPLICATION OPTION
IPStor's Delta-based Replication Option provides an IP-based mechanism for data
replication from one site to another, for purposes such as off-site disaster
recovery, site migration, electronic vaulting, etc. Specifically designed to
defend against site failure by providing automated off-site data protection, the
Delta-based Replication Option provides fast remote data synchronization of
virtual storage volumes (SAN and/or NAS) from one IPStor Appliance to
another--across the street, across town, or across the globe. In case of a
catastrophic failure at the primary site, the Administrator can quickly redirect
application servers to access data from replicas located in the backup data
center.
Administrators can specify a variety of policies to control the replication
process, giving them a policy-driven mechanism for keeping an extra set of data
off-site for disaster protection. The atomic merge feature further protects data
from long-distance transmission problems and guarantees the integrity and
usability of replicated data by writing all replicated data to a reserved area
and only committing the data to the replica disk after all of the data from the
primary server has been received.
I/O PERFORMANCE OPTIMIZATION SOLUTIONS
IPStor's I/O Performance Optimization Solutions include HotZone and SafeCache
Options, which were developed specifically to maximize utilization of high-end
storage, increase overall storage performance, and minimize implementation costs
while allowing customers to leverage existing investments in IT infrastructure.
HOTZONE OPTION
IPStor's HotZone Option is an intelligent, policy-driven, disk-based staging
mechanism that automatically re-maps frequently used areas of one or more
virtual or service-enabled disks to higher performance storage devices such as
solid state disk(s) (SSDs). Using the IPStor management console, an
Administrator divides a given virtual or service-enabled disk into zones of
equal size (e.g., 32MB). This initiates the hot zoning process for the virtual
or service-enabled disk. IPStor will then automatically create HotZone storage
on the specified high performance disk(s) or SSDs. This HotZone storage is
itself divided into zones of a size equal to the size of the zones on the
virtual or service-enabled disk, and is provisioned to the virtual or
service-enabled disk.
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IPStor monitors reads/writes to each of the zones on the virtual or
service-enabled disk based on a specified interval of time (e.g., every 10
minutes, every day, etc.) and based on the statistics it has collected,
determines the most frequently accessed zones. Once they are identified, IPStor
re-maps the data from these "hot zones" to the HotZone storage--located on the
high performance disk or SSD--resulting in enhanced read/write performance for
the application accessing the storage. When IPStor determines that the
corresponding "hot zone" is no longer "hot", the data from the high performance
disk is moved back to its original zone on the virtual or service-enabled disk.
SAFECACHE OPTION
In a centralized storage environment in which a large set of database servers
share a smaller set of storage devices, data tends to be randomly accessed. In
environments such as these, IPStor's SafeCache Option, working in conjunction
with high-speed devices such as SSDs, should significantly improve performance.
Since SSDs are 100% immune to random access, IPStor SafeCache can write data
blocks sequentially to the persistent cache area and move them to the data disk
(random write) as a secondary operation once the writes have been acknowledged,
effectively accelerating the performance of the slower disks.
Using the IPStor management console, Administrators create a persistent cache
area from high performance disks and associate this cache area to an
IPStor-managed disk (virtual or service-enabled). Writes made to the
IPStor-managed disk are first written to its associated persistent cache area.
Because these writes are sequentially written and the persistent cache is most
likely an SSD (which by nature has zero seek time), the effective total elapsed
time for each write is reduced, no matter how random it was, resulting in an
increase in performance. The data written to the persistent cache is then
committed to the data disk as a separate process in the background. While SSDs
have a built-in power supply to minimize potential downtime, the persistent
cache can also be mirrored through IPStor for added protection.
BACKUP AND RECOVERY ACCELERATION PRODUCTS
IPStor's Backup and Recovery Acceleration Solutions provide customers with
optimal data protection through cutting-edge tape-based and disk-based backup
that work fast, with little or no impact to production servers, and deliver
rapid recovery when called upon. IPStor Backup and Recovery Acceleration
Solutions include options for Zero Impact Backup/Recovery, HyperTrac, and
Virtual Tape Library.
ZERO-IMPACT BACKUP/RECOVERY OPTION
IPStor's Zero-Impact Backup Option, used in conjunction with raw device backup
software, extends the concept of zero-impact backup by eliminating the need for
a dedicated backup server while also removing the application servers from
playing any role in backup and restore operations. With this option in place,
the data mover is the IPStor Server; it presides over control of the backups,
control of the tape library, and metadata organization on the backup tapes.
IPStor's Zero-Impact Backup Option is a highly cost-effective solution since
only one copy of the backup software is necessary, and the backup process,
licenses, and management are offloaded from the application servers. This lowers
TCO and offers simplified, centralized, and automated backup management.
Additional cost savings are generated by the elimination of backup agents; push
agents, etc., on each application server.
HYPERTRAC BACKUP ACCELERATOR
IPStor's HyperTrac Backup Accelerator dramatically increases the backup speed of
mission critical data while preserving the use of an enterprise's existing third
party backup software and dedicated backup server. With this solution, backups
are consolidated and offloaded not just from the LAN but from the application
servers, resulting in faster backups, simplified backup management, and
immediate and long-term cost-effectiveness.
IPStor's TimeMark Option (see IPStor Business Continuity Solutions) allows an
existing dedicated backup server to back up a TimeView - a mountable TimeMark
snapshot image - of a volume that can be concurrently in use by a host server.
The HyperTrac Backup Accelerator, which resides on the dedicated backup server,
communicates directly between the IPStor Server and the backup application and
automatically delivers TimeViews to the backup application for the purpose of
performing file-by-file or image backup of the data to tape at the speed of SAN.
When a backup is in progress, no backup traffic moves on the LAN, since the
TimeViews are delivered to the backup server via the SAN. The high degree of
separation between the backup server and the application servers provided by
IPStor's HyperTrac Backup Accelerator solution, eliminates any potential
interference, and thereby generates the highest possible backup speed.
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VIRTUAL TAPE LIBRARY
IPStor's Virtual Tape Library Option increases the speed and reliability of
existing backup and archiving applications by using IPStor-managed disks to
emulate tape libraries. With backup windows shrinking and rapid data restoration
more critical than ever, IPStor's Virtual Tape Library Option allows users to
take advantage of the speed of disk-based storage to back up and archive in
significantly less time. While delivering the same functionality as conventional
tape libraries, IPStor Virtual Tape Libraries maximize the reliability,
efficiency, and performance of backup systems by eliminating error-prone
mechanical components and removing physical tape drives and media from the
critical backup path. IPStor's Virtual Tape Library Option will be generally
available in Q2 2003.
MAINTENANCE, IMPLEMENTATION AND ENGINEERING SERVICES
FalconStor offers customers a variety of annual maintenance services which
entitle customers to periodic software updates and various levels of technical
support. Although the implementation of IPStor does not generally require the
assistance of FalconStor, the Company offers software implementation services if
requested from customers. FalconStor also offers customers software engineering
services if required.
BUSINESS STRATEGY
FalconStor intends to solidify its position as a leading network storage
software provider to enterprises and Internet Data Centers worldwide. FalconStor
intends to achieve this objective through the following strategies:
o Maintain a Leadership Position in Network Storage Software. FalconStor
intends to leverage its protocol-agnostic architecture to maintain a
leadership position in the network storage software market. The network
storage software market is defined by rapid change, and FalconStor plans
to continue to focus its research and development efforts to invent and to
bring to market innovative solutions.
o Increase Market Penetration and Brand Recognition. FalconStor plans to
promote its product and corporate awareness by:
o forming strategic partnerships with leading industry players;
o participating in industry events, conferences and trade shows; and
o initiating targeted promotions and public relations campaigns.
FalconStor believes that establishing a strong brand identity as a network
storage software solution provider is important to its future success.
o Establish a Global Presence. FalconStor believes that significant market
share can be achieved in Europe and Asia. FalconStor through its European
headquarters plans to expand its operational capabilities in Europe. In
addition, through its Asia headquarters, FalconStor believes that it is
developing a strong business presence in the Asia/Pacific Rim.
o Expand Technologies and Capabilities Through Strategic Acquisitions and
Alliances. FalconStor believes that opportunities exist to expand its
technological capabilities, product offerings and services through
acquisitions and strategic alliances. When evaluating potential
acquisitions and strategic alliances, FalconStor will focus on
transactions that enable it to acquire:
o important enabling technology;
o complementary applications;
o marketing, sales, customer and technological synergies; or
o key personnel.
As of the date of this filing, FalconStor has no agreements,
commitments or understanding with respect to any such acquisitions or strategic
alliances, which have not been consummated.
o Seek OEM Relationships With Industry Leaders. FalconStor intends to
continue to enter into original equipment manufacturer ("OEM") agreements
with strategic switch, storage, appliance and operating system vendors.
Besides accelerating overall marketing growth, the OEM relationships
should bolster FalconStor's product recognition, corporate credibility and
revenue stream.
9
SALES, MARKETING AND CUSTOMER SERVICE
FalconStor plans to continue to sell its products primarily through
relationships with OEMs, value-added resellers and distributors.
o Original Equipment Manufacturer Relationships. OEMs collaborate with
FalconStor to integrate FalconStor's products into their own product
offerings or resell FalconStor's products under their own label.
o Value-added Reseller and Distributor Relationships. FalconStor has
entered into value-added reseller and distributor agreements to help
sell its product in various geographic areas. FalconStor's
value-added resellers and distributors market the entire IPStor
product suite and receive a discount off list price on products
sold.
o Strategic Partners. FalconStor has entered into agreements with
strategic partners in which IPStor is adapted to the strategic
partner's special-purpose storage appliances to offer Real-Time Data
Migration, Data Replication, Storage Consolidation and other
services specifically for the partner's customers.
FalconStor's marketing department consists of marketing professionals dedicated
to advertising, public relations, marketing communications, events and channel
partner programs. FalconStor's marketing efforts focus on building brand
recognition and developing leads for the sales force.
FalconStor Professional Services personnel are also available to assist
customers and partners throughout the product life cycle of IPStor deployments.
The Professional Services team includes seasoned "Storage Architects" who can
assist in the assessment, planning/design, deployment, and testing phases of an
IPStor deployment project, and a Technical Support group for post-deployment
assistance and on-going trouble-shooting.
RESEARCH AND DEVELOPMENT
The network storage services industry is subject to rapid technological
advancements, changes in customer requirements, developing industry standards,
and regular new product introductions and enhancements. As a result,
FalconStor's success, in part, depends upon its ability to continue to improve
its existing solutions and to develop and introduce new products on a
cost-effective and timely basis. FalconStor believes that its continued
investment in research and development is critical to its ability to continue to
develop and introduce new and enhanced products addressing emerging market
needs. There can be no assurance that FalconStor will be able to successfully
develop new products to address new customer requirements and technological
changes, or that such products will achieve market acceptance. FalconStor's
research and development staff consisted of 64 employees as of December 31,
2002. Research and development expenses, primarily consisting of personnel
expenses were approximately $1.4 million, $5.3 million and $7.0 million in 2000,
2001 and 2002, respectively. FalconStor anticipates that research and
development expenses will increase in 2003.
COMPETITION
As the demand for network-based storage products and services increases, more
competitors will enter this high-growth market segment. Although there are
several companies attempting to fill specific needs for SCSI-IP connectivity,
Fibre Channel-IP connectivity and FC-SAN storage virtualization, FalconStor is
the only software-based solution capable of accommodating storage devices with
industry-standard interfaces and provisioning the virtualized resource over FC,
IP/iSCSI, NFS and CIFS with comprehensive storage services and end-to-end
manageability. However, some of FalconStor's product capabilities compete with a
number of companies with substantially greater financial resources, such as
Network Appliance, Inc., and Veritas Software Corporation. There is currently no
other known software company providing all of FC/IP-based connectivity,
virtualization, and storage services. FalconStor believes that the principal
competitive factors affecting its market include product features such as
scalability, data availability, ease of use, price, reliability,
hardware/platform neutrality, customer service and support.
FalconStor's success will depend largely on its ability to generate market
demand and awareness of the IPStor software suite and to develop additional or
enhanced products in a timely manner. FalconStor's success will also depend on
its ability to convince potential partners of the benefits of licensing its
software rather than competing technologies. FalconStor's future and existing
competitors could introduce products with superior features, scalability and
functionality at lower prices than FalconStor's products and could also bundle
existing or new products with other more established products in order to
compete with FalconStor. Increased competition could result in price reductions
and reduced gross margins, which could harm FalconStor's business.
10
INTELLECTUAL PROPERTY
FalconStor's success is dependent upon its proprietary technology. Currently,
the IPStor software suite is the core of its proprietary technology. FalconStor
currently has nine pending patent applications, two registered trademarks --
"FalconStor" and "IPStor" - and many pending trademark applications related to
FalconStor and the IPStor product.
FalconStor seeks to protect its proprietary rights and other intellectual
property through a combination of copyright, trademark and trade secret
protection, as well as through contractual protections such as proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position.
FalconStor generally enters into confidentiality or license agreements with its
employees, consultants and corporate partners, and generally controls access to
and distribution of its software, documentation and other proprietary
information. Despite FalconStor's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use its
products or technology. Monitoring unauthorized use of its products is
difficult, and there can be no assurance that the steps taken by FalconStor will
prevent misappropriation of its technology, particularly in foreign countries
whose laws may not protect its proprietary rights as fully as do the laws of the
United States.
MAJOR CUSTOMER
For the year ended December 31, 2002, FalconStor had one customer that accounted
for 16% of revenues. While the Company expects to derive future revenues from
such customer, the Company believes that the revenues it will receive from such
customer in 2003 will be less than the revenues it received from such customer
in 2002.
EMPLOYEES
As of December 31, 2002, FalconStor had 138 full-time employees, including 39 in
sales and marketing, 27 in service, 64 in research and development and eight in
general administration. FalconStor is not subject to any collective bargaining
agreements and believes its employee relations are good.
INTERNET ADDRESS AND AVAILABILITY OF FILINGS
FalconStor's internet address is www.falconstor.com.
FalconStor makes available free of charge on or through its Internet website,
FalconStor's annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed or furnished pursuant
to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended,
as soon as reasonably practicable after FalconStor electronically files such
material with, or furnishes it to, the Securities Exchange Commission.
FalconStor complied with this policy for every Securities Exchange Act of 1934
report filed on or after November 15, 2002.
Item 2. Properties
FalconStor's headquarters are located in an approximately 11,800 square foot
facility located in Melville, New York. Offices are also leased for development,
sales and marketing personnel, which total an aggregate of approximately 10,729
square feet in Euless, Texas; Le Chesnay, France; Taichung, Taiwan; Tokyo,
Japan; Beijing, China and Seoul, Korea. Initial lease terms range from one to
five years, with multiple renewal options.
Item 3. Legal Proceedings
There were no material legal proceedings pending or, to our knowledge,
threatened against us.
Item 4. Submission of Matters to a Vote of Security Holders
None.
11
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
MARKET INFORMATION
Since the merger with NPI on August 22, 2001, our Common Stock has
traded on The Nasdaq National Market ("Nasdaq") under the symbol
"FALC". Prior to August 22, 2001, the Common Stock of NPI traded on
Nasdaq under the symbol "NPIX". The following table sets forth the
range of high and low closing sales prices of our Common Stock for
the periods indicated as reported by Nasdaq:
2002 2001
------------------------ ----------------------
High Low High Low
---- --- ---- -----
Fourth Quarter $ 4.99 $ 3.61 $ 9.50 $ 5.85
Third Quarter $ 6.20 $ 4.08 $11.46 $ 7.34
Second Quarter $ 7.44 $ 4.02 $13.70 $ 6.00
First Quarter $11.97 $ 6.20 $ 9.25 $ 6.19
HOLDERS OF COMMON STOCK
We had approximately 233 holders of record of Common Stock as of
March 7, 2003. This does not reflect persons or entities whom hold
Common Stock in nominee or "street" name through various brokerage
firms.
DIVIDENDS
We have not paid any cash dividends on our Common Stock since
inception. We expect to reinvest any future earnings to finance
growth, and therefore do not intend to pay cash dividends in the
foreseeable future. Our board of directors will determine if we pay
any future cash dividends.
EQUITY COMPENSATION PLAN INFORMATION
The information required by this item will be our definitive proxy
materials to be filed with the Securities and Exchange Commission
and is incorporated in this Annual Report on Form 10-K by this
reference.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data with respect to our
consolidated balance sheets as of December 31, 2002, 2001 and 2000
and the related consolidated statements of operations for the years
ended December 31, 2002 and 2001 and the period from inception
(February 10, 2000) through December 31, 2000 have been derived from
our audited consolidated financial statements which are included
herein. The following selected consolidated financial data should be
read in conjunction with the consolidated financial statements and
the notes thereto and the information contained in Item 7,
"Management's Discussion and Analysis of Financial Condition and
Results of Operations."
12
Period from
inception
(February 10,
Year Ended Year Ended 2000) through
December 31, December 31, December 31,
2002 2001 2000
---- ---- ----
(In thousands, except per share data)
Consolidated Statements of Operations Data:
Revenues:
Software license revenue $ 8,667 $ 4,714 --
Software services and other revenue 1,962 878 143
-------- -------- --------
10,629 5,592 143
Operating expenses:
Cost of revenues 1,527 921 224
Software development costs 6,962 5,254 1,379
Selling and marketing 9,857 8,084 327
General and administrative 2,591 2,732 534
Impairment of prepaid royalty 483 -- --
-------- -------- --------
Total operating expenses 21,420 16,991 2,464
-------- -------- --------
Operating loss (21,420) (16,991) (2,464)
Interest and other income 1,585 1,365 225
Impairment of long-lived assets (2,300) -- --
-------- -------- --------
Loss before income taxes (22,135) (15,626) (2,239)
Provision for income taxes 37 22 --
-------- -------- --------
Net loss $(22,172) $(15,648) $ (2,239)
-------- -------- --------
Beneficial conversion feature attributable to
convertible preferred stock -- 3,896 --
-------- -------- --------
Net loss attributable to common shareholders $(22,172) $(19,544) $ (2,239)
======== ======== ========
Basic and diluted net loss per share $ (0.26) $ (0.40) $ (0.09)
======== ======== ========
Basic and diluted weighted average common
shares outstanding 45,233 35,264 24,383
======== ======== ========
December 31, December 31, December 31,
2002 2001 2000
---- ---- ----
(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents and marketable securities $51,102 $64,527 $ 7,727
Working capital 47,746 57,518 7,254
Total assets 64,710 74,471 8,594
Long-term obligations -- 283 --
Stockholders' equity 55,901 63,562 8,057
13
ITEM 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
FalconStor was incorporated in Delaware for the purpose of
developing, manufacturing and selling network storage infrastructure software
solutions and providing related maintenance, implementation and engineering
services. Our unique approach to storage networking enables companies to embrace
state-of-art equipment (based on SCSI, Fibre Channel or iSCSI) from any storage
manufacturer without rendering their existing or legacy solutions obsolete.
Several strategic partners have recognized the industrial strength of our
flagship software, IPStor(R), and utilized it to power their special purpose
storage appliances to perform Real Time Data Migration, Data Replication, and
other advanced storage services. IPStor leverages high performance IP or FC
based networks to help corporate IT aggregate storage capacity and contain the
run-away cost of administering mission-critical storage services such as
snapshot, backup, data replication, and other storage services, in a distributed
environment. Over 300 customers around the world have deployed IPStor in the
production environment to manage storage infrastructure with minimal TCO (Total
Cost of Ownership) and optimal ROI (Return on Investment).
From March 2000 through May 2001, we received net proceeds of
approximately $17.9 million from the sale of our preferred stock which converted
into approximately 20.2 million shares of our common stock. Our operations from
inception through the second quarter of 2001 were mainly comprised of the
development of our core network storage infrastructure software product. During
2000 and the first two quarters of 2001, we were in the development stage of
operations, and, as a result there were no significant revenues generated from
our planned principal operations. During the second quarter of 2001, we
completed the development of our principal product and released our software. We
began to earn our first significant revenues from software licenses in the third
quarter of 2001.
On August 22, 2001, we merged with NPI, a publicly traded company.
For more information relating to the merger with NPI, including the accounting
treatment, see note 2 to the audited consolidated financial statements.
On July 3, 2002, we acquired IP Metrics, a provider of intelligent
trunking software for mission-critical networks. For more information relating
to the acquisition of IP Metrics, including the accounting treatment, see note 2
to the audited consolidated financial statements.
Our critical accounting policies are those related to revenue
recognition. As described in note 1 to our consolidated financial statements, we
recognize revenue in accordance with the provisions of Statement of Position
97-2, Software Revenue Recognition, as amended. Software license revenue is
recognized only when pervasive evidence of an arrangement exists and the fee is
fixed and determinable, among other criteria. An arrangement is evidenced by a
signed customer contract for nonrefundable royalty advances received from OEMs
or a customer purchase order for each software license resold by an OEM,
distributor or solution provider to an end user. The software license fees are
fixed and determinable as our standard payment terms range from 30 to 90 days,
depending on regional billing practices, and we have not provided any of our
customers extended payment terms. When a customer licenses software together
with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.
14
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2002 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2001
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold
through our OEM's, value-added resellers and distributors to end users and, to a
lesser extent directly to the end user. These revenues are recognized when,
among other requirements, we receive a customer purchase order and the software
and permanent key codes are delivered to the customer. We also receive
nonrefundable royalty advances from some of our OEM partners. These arrangements
are evidenced by a signed customer contract, and the revenue is recognized when
the software product master is delivered and accepted.
Software license revenue increased 84% to $8.7 million in 2002 from
$4.7 million in 2001. The increase in software license revenue was partially due
to the release of our principal product at the end of the second quarter of
2001. Therefore in 2001, we only had two full quarters of software license
revenue compared to a full year of revenue in 2002. Another reason for the
increase in software license revenues was due to increased market acceptance of
our product as well as an increase in the number of our channel partners.
SOFTWARE SERVICES AND OTHER REVENUE
Software services and other revenues are comprised of software
maintenance and technical support, professional services primarily related to
the implementation of our software, engineering services, and to a lesser extent
sales of computer hardware. Revenue derived from maintenance and technical
support contracts is recognized ratably over the contractual maintenance term.
Professional services revenue is recognized in the period that the related
services are performed. Engineering services are primarily related to
customizing software product masters for some of our OEM partners. Revenue from
engineering services is recognized in the period the services are completed. In
2002, we had a limited number of transactions in which we purchased hardware and
bundled this hardware with our software and sold the bundled solution to our
customer. The associated revenue was recognized when the hardware was delivered
to the customer. Software services and other revenue increased 123% to $2.0
million in 2002 from $0.9 million in 2001. The primary reason for the increase
in service and other revenue is related to an increase in the number of our
maintenance and technical support contracts. Since our software was only
released at the end of the second quarter of 2001, we had limited maintenance
and technical support revenue in 2001.
COST OF REVENUES
Cost of revenues consists primarily of personnel and other costs
associated with providing software implementations, technical support under
maintenance contracts, and training, all associated with software services and
other revenue, above. Cost of revenues also includes the cost of the purchased
hardware, which is included in software services and other revenue, above. The
amortization of purchased software licenses and capitalized software development
costs, which is associated with software license revenue, is also included in
cost of revenues. The amortization of purchased licenses for existing software
products is recorded as software development expense until the modified product
is available for resale, and thereafter is recorded in cost of revenues.
Cost of revenues increased 66% to $1.5 million in 2002 from $0.9
million in 2001. The main reason for the increase in cost of revenues is due to
the increase in revenues. As a result of the increase in revenues, we required a
higher average number of employees to provide technical support under our
maintenance contracts and to help deploy our software. In addition, amortization
of purchased software licenses was $0.2 million in 2002 as compared with $23,643
of capitalized software in 2001. The hardware costs associated with hardware
revenue amounted to $0.2 million in 2002. There were no hardware costs in 2001.
Gross profit for the year ended December 31, 2002 was $9.1 million
or 86% compared with $4.7 million or 84% for the year ended December 31, 2001.
The increase in gross margin was due to the increase in software license
revenues, which have a higher gross margin than software services. The absolute
dollar increase in gross profit was due to the increase in total revenue
compared to the prior year.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for
product development personnel and other related costs associated with the
development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased 33% to $7.0 million
in 2002 from $5.3 million in 2001. The increase in software development costs
was partially due to an increase in development personnel. The increase in
employees was required to enhance and test our core network storage software
15
product, as well as to develop new innovative features and options. During 2002,
we released versions 3.0 and 3.5 of IPStor and began work on version 4.0.
Another reason for the increase is related to the amortization of purchased
software licenses that we further developed during the period. The amortization
of these licenses is recorded as software development expense until the modified
product is available for resale and then the expenses are recorded in cost of
revenues.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and
marketing personnel and related costs, travel, public relations expense,
marketing literature and promotions, commissions, trade show expenses, and the
costs associated with our foreign sales offices. Selling and marketing expenses
increased 22% to $9.9 million in 2002 from $8.1 million in 2001. This increase
in selling and marketing expenses was due to our product being released during
the end of the second quarter of 2001. As a result of this release, we expanded
our sales force to accommodate our revenue growth and we initiated our marketing
efforts to promote our product and create brand awareness. In addition, as a
result of the increase in revenues our commission expense increased.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related fees,
directors and officers insurance, legal and professional fees and other general
corporate overhead costs. General and administrative expenses decreased 5% to
$2.6 million in 2002 from $2.7 million in 2001. The decrease in general and
administrative expenses was due to a non-cash consulting expense for option
grants and higher legal fees in 2001. These amounts were partially offset by a
significant increase in premiums for directors and officers insurance in 2002.
INTEREST AND OTHER INCOME
Interest and other income increased 16% to $1.6 million in 2002 from
$1.4 million in 2001. This increase in interest income was due to higher average
cash, cash equivalent and marketable securities balances as a result of the
merger with NPI.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss
incurred from the period from inception (February 10, 2000) through December 30,
2002, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our development and now early stage operations.
Accordingly, we provided a full valuation allowance against our net deferred tax
assets.
IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, we entered into an agreement with Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2.8
million was paid to NSSI, of which $2.3 million was for the purchase of
convertible preferred stock of NSSI accounted for under the cost method, and
$0.5 million was for a non-refundable prepaid royalty recoupable against future
product sales of NSSI's product. Primarily due to the decline since May 2002 in
the market value of NSSI's common stock underlying the convertible preferred
stock significantly below the Company's cost, we have concluded the decline in
the fair value of our investment in NSSI's preferred stock is other than
temporary. Accordingly, in 2002 we recorded an impairment charge to write-off
our investment in NSSI preferred stock. In addition, due to the lack of market
acceptance of the NSSI product in its current state, we concluded that the
unrecouped prepaid royalty is not recoverable and it was written off. As a
result, in 2002, we recorded a $2.8 million charge for the impairment of
long-lived and other assets related to our NSSI agreement, of which $0.5 million
was an operating expense.
16
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2001 COMPARED TO THE
PERIOD FROM INCEPTION (FEBRUARY 10, 2000) THROUGH DECEMBER 31, 2000
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue was $4.7 million in 2001. For the period
from inception (February 10, 2000) through December 31, 2000 there was no
software license revenue since our principal product was not released until the
end of the second quarter of 2001.
SOFTWARE SERVICES AND OTHER REVENUE
Software services and other revenue increased to $0.9 million in
2001 from $0.1 million for the period from inception (February 10, 2000) through
December 31, 2000. The increase in software services and other revenue was due
to our principal product being released at the end of the second quarter of
2001. As a result, we earned software implementation revenues, engineering
services revenues related to customizing software product masters for our OEM
partners, and maintenance and technical support revenues associated with our
software license revenues. For the period from inception (February 10, 2000)
through December 31, 2000, software services and other revenues were related to
network consulting services.
COST OF REVENUES
Cost of revenues increased to $0.9 million in 2001 from $0.2 million
in 2000. The main reason for the increase in cost of revenues was due to the
increase in revenues. As a result of the increase in revenues, we increased our
average number of technical support and consulting employees.
Gross profit (loss) for the year ended December 31, 2001 was $4.7
million or 84% compared with ($80,000) or (56%) for the period from inception
(February 10, 2000) through December 31, 2000. The increase in gross margin was
due to the increase in software license revenues, which have a higher gross
margin than network consulting fees. In 2000, the cost of employee compensation
exceeded revenues earned.
SOFTWARE DEVELOPMENT COSTS
Software development costs were $5.3 million for the year ended
December 31, 2001 compared with $1.4 million for the period from inception
(February 10, 2000) through December 31, 2000. The $3.9 million increase from
the prior year was mainly due to an increase in development personnel. The
increase in employees was required to develop our initial core storage
networking infrastructure software product, as well as to develop new innovative
features and options.
SELLING AND MARKETING
Selling and marketing expenses increased from approximately $327,000
for the period from inception (February 10, 2000) through December 31, 2000 to
$8.1 million for the year ended December 31, 2001. This increase in selling and
marketing expenses was due to our product being released during the end of the
second quarter of 2001. As a result of this release, we expanded our sales force
to accommodate our revenue growth and we initiated our marketing efforts to
promote our product and to create brand awareness. Selling and marketing
expenses were limited in 2000 since our product had not yet been released.
GENERAL AND ADMINISTRATIVE
General and administrative expenses were $2.7 million for the year
ended December 31, 2001, an increase of approximately $2.2 million from the
period from inception (February 10, 2000) through December 31, 2000. The
increase in general and administrative expenses was due to increased salaries as
a result of increased personnel associated with building our basic corporate
infrastructure. Additionally, as a public company, in 2001 we began to incur
additional legal and professional fees and corporate directors and officers
insurance expense.
INTEREST AND OTHER INCOME
Interest and other income was $1.4 million for the year ended
December 31, 2001 compared with approximately $226,000 for the period from
inception (February 10, 2000) through December 31, 2000. The $1.2 million
increase in interest income was due to higher average cash, cash equivalent and
marketable securities balances as a result of the merger with NPI, as well as
the cash we raised from the issuance of Series C convertible preferred stock.
17
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss
incurred from the period from inception (February 10, 2000) through December 31,
2001, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our development and now early stage operations,
and accordingly, we provided a full valuation allowance against the deferred tax
asset.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents totaled $14.2 million and marketable
securities totaled $36.9 million at December 31, 2002. As of December 31, 2001,
we had $38.4 million in cash and cash equivalents and $26.2 million in
marketable securities. Net cash used in operating activities totaled $7.5
million for the year ended December 31, 2002. This was primarily a result of our
net loss of $11.5 million and an increase in accounts receivable and prepaid
expenses and other current assets, and a decrease in accounts payable. These
amounts were partially offset by non-cash charges of $5.3 million consisting of
depreciation and amortization, non-cash professional services expenses,
equity-based compensation and impairment of long-lived and other assets, in
addition to increases in deferred revenue and accrued expenses. Net cash used in
operating activities for the year ended December 31, 2001 was $10.1 million.
This was mainly attributable to our net loss of $10.1 million partially offset
by non-cash expenses of $1.5 million and increases in accounts payable, accrued
expenses and deferred revenue. The increase in net cash used was also
attributable to increases in accounts receivable and prepaid expenses and other
current assets. For the period from inception (February 10, 2000) through
December 31, 2000 the net cash used of $1.4 million was mainly attributable to
our net loss of $2.1 million partially offset by non-cash expenses of $0.2
million and increases in accounts payable, accrued expenses and deferred
revenue.
Net cash used in investing activities was $15.5 million in 2002, due
primarily to net purchases of marketable securities of $10.6 million, net cash
paid for acquisitions of $2.6 million, purchases of property and equipment of
$1.3 million and purchase of investments, software licenses and intangible
assets. Net cash provided by investing activities was $34.7 million for the year
ended December 31, 2001, due primarily to the $48.2 million of net cash acquired
from the merger with NPI. These amounts were partially offset by net purchases
of marketable securities of $7.4 million, $1.3 million in purchases of property
and equipment, $2.2 million related to the purchase of software licenses and a
$2.3 million investment in preferred stock of another entity which was
subsequently written off. See Note 9 of Notes to Consolidated Financial
Statements. For the period from inception (February 10, 2000) through December
31, 2000 the net cash used by investing activities of $0.9 million was
attributable to purchases of property and equipment of $0.6 million and
approximately $0.2 million in security deposits.
Net cash provided by financing activities was $0.9 million for the
year ended December 31, 2002, which was comprised of $1.1 million related to
proceeds from exercise of stock options offset by $0.2 million in payments to
acquire treasury stock. Net cash provided by financing activities was $7.0
million for the year ended December 31, 2001 which was comprised of $7.9 million
raised from our Series C preferred stock financing and approximately $0.3
million from the exercise of stock options. These amounts were partially offset
by the repurchase of treasury stock totaling $1.2 million. For the period from
inception (February 10, 2000) through December 31, 2000, cash provided by
financing activities was $10.0 million; primarily from the issuance of Series A
and B preferred stock.
For the year ended December 31, 2002 and 2001, we paid $2.1 million
and $0.8 million, respectively, related to discontinued operations.
As of December 31, 2002, we had $4.2 million of liabilities related
to the discontinued operations of NPI. See note 16 to the audited consolidated
financial statements.
In October 2001, our Board of Directors authorized the repurchase of
up to two million shares of our outstanding common stock, of which 235,000
shares were repurchased through December 31, 2002, at an aggregate purchase
price of $1.4 million.
In connection with our acquisition of IP Metrics in July 2002, we
are required to make cash payments to the former shareholders of IP Metrics,
which are contingent on the level of revenues from IP Metrics products for a
period of twenty-four months subsequent to the acquisition. As of December 31,
2002, the Company has accrued $0.2 million of additional purchase consideration
related to sales of IP Metrics products.
Our principal sources of liquidity are cash, cash equivalents and
marketable securities, which are expected to be used for general corporate
purposes, including expansion of operations and capital expenditures.
We believe that our current balance of cash, cash equivalents and
marketable securities, and expected cash flows from operations will be
sufficient to meet our cash requirements for at least the next twelve months.
18
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued Statement of Financial Accounting
Standards No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities" ("SFAS No. 146"), which is effective for exit or disposal activities
initiated after December 31, 2002. SFAS No. 146 applies to costs associated with
an exit activity (including restructuring costs) or with a disposal of
long-lived assets. Companies will be required to record an expense when a
liability for an exit or disposal activity is incurred and can be measured at
fair value. The Company does not expect the adoption of SFAS No. 146 to have a
material impact on its consolidated results of operations or financial position.
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." This interpretation expands the disclosures to be made
by a guarantor in its financial statements about its obligations under certain
guarantees and requires the guarantor to recognize a liability for the fair
value of an obligation assumed under a guarantee. FIN 45 clarifies the
requirements of SFAS No. 5, "Accounting for Contingencies," relating to
guarantees. In general, FIN 45 applies to contracts or indemnification
agreements that contingently require the guarantor to make payments to the
guaranteed party based on changes in a specified interest rate, security price,
foreign exchange rate or other variable that is related to an asset, liability,
or equity security of the guaranteed party, or failure of another party to
perform under an obligating agreement (performance guarantees). Certain
guarantee contracts are excluded from both the disclosure and recognition
requirements of this interpretation, including, among others, guarantees
relating to employee compensation, residual value guarantees under capital lease
arrangements, commercial letters of credit, loan commitments, subordinated
interests in a special purpose entity, and guarantees of a company's own future
performance. Other guarantees are subject to the disclosure requirements of FIN
45 but not to the recognition provisions and include, among others, a guarantee
accounted for as a derivative instrument under SFAS No. 133, and a guarantee
covering product performance, not product price. The disclosure requirements of
FIN 45 are effective for the Company as of December 31, 2002, and require
disclosure of the nature of the guarantee, the maximum potential amount of
future payments that the guarantor could be required to make under the
guarantee, and the current amount of the liability, if any, for the guarantor's
obligations under the guarantee. The recognition requirements of FIN 45 are to
be applied prospectively to guarantees issued or modified after December 31,
2002. Certain guarantees included in software license agreements that have been
entered into by the Company are disclosed in Note 11.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation--Transition and
Disclosure" ("SFAS No. 148"). SFAS No.148 amends SFAS No. 123, "Accounting for
Stock-Based Compensation," to provide alternative methods of transition for a
voluntary change to the fair value-based method of accounting for stock-based
employee compensation ("transition provisions"). In addition, SFAS No. 148
amends the disclosure requirements of Accounting Principals Board ("APB")
Opinion No. 28, Interim Financial Reporting, to require proforma disclosure in
interim financial statements by companies that elect to account for stock-based
compensation using the intrinsic value method prescribed in APB Opinion No. 25
("disclosure provisions"). The transition methods of SFAS No. 148 are effective
for financial statements for fiscal years ending after December 15, 2002. The
Company continues to use the intrinsic value method of accounting for
stock-based compensation. As a result, the transition provisions do not have an
effect on the Company's consolidated financial statements. The Company has
adopted the disclosure requirements of SFAS No. 148.
RISK FACTORS
WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR
MAINTAIN PROFITABILITY.
Due to the early stage of our product, we have had limited revenues
and a history of losses. For the years ended December 31, 2002 and 2001, we had
revenues of $10.6 million and $5.6 million, respectively. The increase in our
revenues from 2001 to 2002 is primarily due to the release of our principal
product at the end of the second quarter of 2001. For the period from inception
(February 10, 2000) through December 31, 2002 and for the year ended December
31, 2002, we had a net loss of $23.7 million and $11.5 million, respectively. We
have signed contracts with resellers and original equipment manufacturers, or
OEMs, and believe that as a result of these contracts, our revenues should
increase in the future. Our business model depends upon signing agreements with
additional OEM customers, further developing our reseller sales channel, and
expanding our direct sales force. Any difficulty in obtaining these OEM and
reseller customers or in attracting qualified sales personnel will hinder our
ability to generate additional revenues and achieve or maintain profitability.
19
FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.
Achieving our anticipated growth will depend on a number of factors,
some of which include:
o retention of key management, marketing and technical personnel;
o our ability to increase our customer base and to increase the sales of our
products; and
o competitive conditions in the storage networking infrastructure software
market.
We cannot assure you that the anticipated growth will be achieved.
The failure to achieve anticipated growth could harm our business, financial
condition and operating results.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE
INFRASTRUCTURE SOFTWARE MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING
REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
Due to the early stage of our product, we have only a limited
history from which to predict our revenue. This limited operating experience,
combined with the rapidly evolving nature of the network storage infrastructure
software market in which we sell our products and other factors that are beyond
our control, reduces our ability to accurately forecast our quarterly and annual
revenue. However, we use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
GLOBAL ECONOMIC CONDITIONS MAY CONTINUE TO ERODE, WHICH COULD RESULT IN
DECREASED REVENUES.
The macroeconomic environment and capital spending on information
technology have continued to erode, resulting in continued uncertainty in our
revenue expectations. The operating results of our business depend on the
overall demand for network storage infrastructure software. Because our sales
are primarily to major corporate customers whose businesses fluctuate with
general economic and business conditions, continued soft demand for network
storage infrastructure software caused by a weakening economy and budgetary
constraints may result in decreased revenues. Customers may continue to defer or
to reconsider purchasing our software if they continue to experience a lack of
growth in their business or if the general economy fails to significantly
improve, resulting in a lack of demand for our product.
THE MARKETS FOR STORAGE AREA NETWORKS, NETWORK ATTACHED STORAGE, AND DIRECT
ATTACHED STORAGE ARE NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO
NOT DEVELOP AS WE EXPECT.
The rapid adoption of Storage Area Networks (SAN), Network Attached
Storage (NAS), and Direct Attached Storage (DAS) storage solutions is critical
to our future success. The markets for SAN, NAS and DAS solutions are still
unproven, making it difficult to predict their potential sizes or future growth
rates. Most potential customers have made substantial investments in their
current storage networking infrastructure, and they may elect to remain with
current network architectures or to adopt new architecture, in limited stages or
over extended periods of time. We are uncertain whether a viable market for our
products will develop or be sustainable. If these markets fail to develop, or
develop more slowly than we expect, our business, financial condition and
results of operations would be adversely affected.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, OUR OPERATING RESULTS MAY
SUFFER.
The network storage infrastructure software market continues to
evolve and as a result there is continuing demand for new products. Accordingly,
we may need to develop and manufacture new products that address additional
network storage infrastructure software market segments and emerging
technologies to remain competitive in the data storage software industry. We are
uncertain whether we will successfully qualify new network storage
infrastructure software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking infrastructure software products. Any failure to address
additional market segments could harm our business, financial condition and
operating results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN, NAS or DAS storage
system. All components of these systems must comply with the same industry
standards in order to operate together efficiently. We depend on companies that
provide other components of these systems to conform to industry standards. Some
industry standards may not be widely adopted or implemented uniformly, and
20
competing standards may emerge that may be preferred by OEM customers or end
users. If other providers of components do not support the same industry
standards as we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.
OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.
Our IPStor platform is complex and is designed to be deployed in
large and complex networks. Many of our customers have unique infrastructures,
which may require additional professional services in order for our software to
work within their infrastructure. Because our products are critical to the
networks of our customers, any significant interruption in their service as a
result of defects in our product within our customers' networks could result in
lost profits or damage to our customers. These problems could cause us to incur
significant service and warranty costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require
that each of our products undergo an extensive qualification process, which
involves interoperability testing of our product in the OEM's system as well as
rigorous reliability testing. This qualification of a product by an OEM does not
assure any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including sales, marketing and management efforts, toward
qualifying our products with OEMs in anticipation of sales to them. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND
INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage infrastructure software market is intensely
competitive even during periods when demand is stable. Some of our current and
potential competitors have longer operating histories, significantly greater
resources, broader name recognition and a larger installed base of customers
than we have. Those competitors and other potential competitors may be able to
establish or to expand network storage infrastructure software offerings more
quickly, adapt to new technologies and customer requirements faster, and take
advantage of acquisition and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us;
or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business, may
enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive
prices before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
21
o our customers canceling, rescheduling or deferring significant orders for
our products, particularly in anticipation of new products or enhancements
from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
OUR BOARD OF DIRECTORS MAY SELECTIVELY RELEASE SHARES OF OUR COMMON STOCK FROM
LOCK-UP RESTRICTIONS.
Currently, approximately 1.9 million shares of our common stock are
subject to contractual lock-up restrictions expiring on April 30, 2003, and
approximately 26.8 million shares of our common stock are subject to contractual
lock-up restrictions expiring on April 30, 2004. Our board of directors may, in
its sole discretion, release any or all of the shares of our common stock from
lock-up restrictions at any time with or without notice. Any release of such
shares from lock-up restrictions may be applied on a proportionate or selective
basis. If the release is selectively applied, the stockholders whose shares are
not released will be forced to hold such shares while other stockholders may
sell. In addition, the release of any of such shares could depress our stock
price. Our board of directors has agreed to a phased release of up to
approximately 2.0 million shares between November 1, 2002 and April 1, 2004,
from the shares that are subject to contractual lock-up restrictions expiring on
April 30, 2004.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and
may be volatile in the future. For example, during the year ended December 31,
2002, the market price of our common stock as quoted on the NASDAQ National
Market System fluctuated between $3.61 and $11.97. The market price of our
common stock may be significantly affected by the following factors:
o actual or anticipated fluctuations in our operating results;
o failure to meet financial estimates;
o changes in market valuations of other technology companies,
particularly those in the storage networking infrastructure
software market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures
or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Finally, we have entered into change of
control agreements with certain executives.
22
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS, THE EXERCISE OF WHICH WOULD
DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK.
As of December 31, 2002, we have outstanding options to purchase an
aggregate of 9,387,579 shares of our common stock at a weighted average exercise
price of $3.55 per share.
The exercise of all of the outstanding options would dilute the
then-existing stockholders' percentage ownership of common stock, and any sales
in the public market of the common stock issuable upon such exercise could
adversely affect prevailing market prices for the common stock. Moreover, the
terms upon which we would be able to obtain additional equity capital could be
adversely affected because the holders of such securities can be expected to
exercise or convert them at a time when we would, in all likelihood, be able to
obtain any needed capital on terms more favorable than those provided by such
securities.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.
Our success is dependent upon our proprietary technology. Currently,
the IPStor software suite is the core of our proprietary technology. We have
nine pending patent applications and multiple pending trademark applications
related to our IPStor product. We cannot predict whether we will receive patents
for our pending or future patent applications, and any patents that we own or
that are issued to us may be invalidated, circumvented or challenged. In
addition, the laws of certain countries in which we sell and manufacture our
products, including various countries in Asia, may not protect our products and
intellectual property rights to the same extent as the laws of the United
States.
We also rely on trade secret, copyright and trademark laws, as well as
the confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
OUR TECHNOLOGY MAY BE SUBJECT TO INFRINGEMENT CLAIMS THAT COULD HARM OUR
BUSINESS.
We may become subject to litigation regarding infringement claims
alleged by third parties. If an action is commenced against us, our management
may have to devote substantial attention and resources to defend these claims.
An unfavorable result for the Company could have a material adverse effect on
our business, financial condition and operating results and could limit our
ability to use our intellectual property.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United
States involving patents, trademarks and other intellectual property rights.
Legal proceedings could subject us to significant liability for damages or
invalidate our intellectual property rights. Any litigation, regardless of its
outcome, would likely be time consuming and expensive to resolve and would
divert management's time and attention. Any potential intellectual property
litigation against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual
property;
o obtain from the owner of the infringed intellectual property right
a license to sell or use the relevant technology or trademark,
which license may not be available on reasonable terms, or at all;
or
o redesign those products that use infringing intellectual property
or cease to use an infringing product or trademark.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key
employees, many of whom would be extremely difficult to replace. We do not have
key person life insurance on any of our personnel Worldwide competition for
skilled employees in the network storage infrastructure software industry is
extremely intense. If we are unable to retain existing employees or to hire and
integrate new employees, our business, financial condition and operating results
could suffer. In addition, companies whose employees accept positions with
competitors often claim that the competitors have engaged in unfair hiring
practices. We may be the subject of such claims in the future as we seek to hire
qualified personnel and could incur substantial costs defending ourselves
against those claims.
23
NETWORK PERIPHERALS INC. HAS LIABILITIES AND ONGOING OBLIGATIONS TO CERTAIN
CUSTOMERS AND SUPPLIERS AS A RESULT OF THE WINDING DOWN OF ITS BUSINESS.
Network Peripherals Inc. had existing agreements with certain suppliers
and customers. NPI may have liabilities to certain existing customers and
suppliers as a result of the termination of these agreements. We cannot be sure
that our efforts to remove all such liability will be successful.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies
or their assets. Integration of the acquired products, technologies and
businesses, could divert management's time and resources. Further, we may not be
able to properly integrate the acquired products, technologies or businesses,
with our existing products and operations, train, retain and motivate personnel
from the acquired businesses, or combine potentially different corporate
cultures. If we are unable to fully integrate the acquired products,
technologies or businesses, or train, retain and motivate personnel from the
acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
LONG TERM CHARACTER OF INVESTMENTS.
We made an investment in Network-1 Security Solutions, Inc., and were
required to record an impairment charge of $2.3 million from this investment in
the year ended December 31, 2002. Despite this loss, we may continue to make
equity investments in other entities (although we have no agreements,
commitments or understandings with respect to equity investments other than our
investment in Network-1 Security Solutions, Inc.). Our present and future equity
investments may never appreciate in value, and are subject to normal risks
associated with equity investments in businesses. These investments may involve
technology risks as well as commercialization risks and market risks. As a
result, we may be required to write down some or all of these investments in the
future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities.
FOREIGN CURRENCY RISK. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
24
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements Page
Independent Auditors' Report............................................26
Consolidated Balance Sheets as of December 31, 2002 and 2001............27
Consolidated Statements of Operations for the years ended December 31,
2002 and 2001 and for the period from inception (February 10, 2000)
through December 31, 2000.............................................28
Consolidated Statements of Stockholders' Equity and Comprehensive
Loss for the years ended December 31, 2002 and 2001 and for the
period from inception (February 10, 2000) through December 31, 2000...29
Consolidated Statements of Cash Flows for the years ended December
31, 2002 and 2001 and for the period from inception
(February 10, 2000) through December 31, 2000..........................30
Notes to Consolidated Financial Statements..............................32
25
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
FalconStor Software, Inc.:
We have audited the accompanying consolidated balance sheets of
FalconStor Software, Inc. and subsidiaries as of December 31, 2002 and 2001, and
the related consolidated statements of operations, stockholders' equity and
comprehensive loss, and cash flows for each of the years in the two-year period
ended December 31, 2002 and the period from inception (February 10, 2000)
through December 31, 2000. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of FalconStor
Software, Inc. and subsidiaries as of December 31, 2002 and 2001, and the
results of their operations and their cash flows for each of the years in the
two-year period ended December 31, 2002 and the period from inception (February
10, 2000) through December 31, 2000, in conformity with accounting principles
generally accepted in the United States of America.
/s/ KPMG LLP
Melville, New York
January 28, 2003, except for note 16, which is
as of February 26, 2003
26
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
-----------------------------
2002 2001
-------------- -------------
Assets
Current assets:
Cash and cash equivalents ................................................ $ 14,191,075 $ 38,370,937
Marketable securities .................................................... 36,910,448 26,156,180
Accounts receivable, net ................................................. 4,285,892 2,539,987
Prepaid expenses and other current assets ................................ 1,167,174 1,077,017
------------ ------------
Total current assets ............................................ 56,554,589 68,144,121
Property and equipment, net ................................................. 2,068,001 1,605,396
Investments ................................................................. -- 2,300,062
Goodwill .................................................................... 3,301,599 --
Other intangible assets, net ................................................ 309,491 --
Other assets ................................................................ 2,476,306 2,421,376
------------ ------------
Total assets .................................................... $ 64,709,986 $ 74,470,955
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 437,088 $ 544,998
Accrued expenses ......................................................... 1,987,651 1,588,723
Deferred revenue ......................................................... 2,182,729 357,912
Liabilities of discontinued operations ................................... 4,201,465 8,134,322
------------ ------------
Total current liabilities ....................................... 8,808,933 10,625,955
------------ ------------
Long-term liabilities of discontinued operations ........................ -- 283,428
------------ ------------
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
45,527,590 and 45,049,379 shares issued, respectively 45,528 45,049
Additional paid-in capital ............................................... 81,423,661 77,991,996
Deferred compensation .................................................... (471,445) (1,026,674)
Accumulated deficit ...................................................... (23,694,634) (12,151,469)
Common stock held in treasury, at cost (235,000 and 190,000 shares,
respectively)
(1,435,130) (1,220,730)
Accumulated other comprehensive income (loss) ............................ 33,073 (76,600)
------------ ------------
Total stockholders' equity ...................................... 55,901,053 63,561,572
------------ ------------
Total liabilities and stockholders' equity ...................... $ 64,709,986 $ 74,470,955
============ ============
See accompanying notes to consolidated financial statements.
27
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Period from
Year Ended Year Ended Inception (February
December 31, December 31, 10, 2000) through
2002 2001 December 31, 2000
------------ ------------- ------------------
Revenues:
Software license revenue ............................................. $ 8,666,583 $ 4,713,909 $ --
Software services and other revenue .................................. 1,962,309 877,820 143,294
------------ ------------ ------------
10,628,892 5,591,729 143,294
------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized software ................... 218,191 23,643 --
Cost of software services and other revenue .......................... 1,309,139 897,145 223,689
Software development costs ........................................... 6,961,769 5,253,842 1,379,260
Selling and marketing ................................................ 9,856,496 8,084,588 327,142
General and administrative ........................................... 2,591,430 2,731,551 534,473
Impairment of prepaid royalty ........................................ 482,715 -- --
------------ ------------ ------------
21,419,740 16,990,769 2,464,564
------------ ------------ ------------
Operating loss ............................................... (10,790,848) (11,399,040) (2,321,270)
------------ ------------ ------------
Interest and other income ............................................... 1,585,351 1,364,780 225,551
Impairment of long-lived assets ......................................... (2,300,062) -- --
------------ ------------ ------------
Loss before income taxes ....................................... (11,505,559) (10,034,260) (2,095,719)
Provision for income taxes ............................................. 37,606 21,490 --
------------ ------------ ------------
Net loss ....................................................... $(11,543,165) $(10,055,750) $ (2,095,719)
------------ ------------ ------------
Beneficial conversion feature attributable
to convertible preferred stock ....................................... -- 3,896,287 --
------------ ------------ ------------
Net loss attributable to common
shareholders ......................................................... $(11,543,165) $(13,952,037) $ (2,095,719)
============ ============ ============
Basic and diluted net loss per share attributable to common shareholders $ (0.26) $ (0.40) $ (0.09)
============ ============ ============
Basic and diluted weighted average common
shares outstanding ................................................... 45,232,595 35,264,277 24,383,166
============ ============ ============
See accompanying notes to consolidated financial statements.
28
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
Series A Series B Series C
convertible convertible convertible Additional
preferred preferred preferred Common paid-in Deferred
stock stock stock stock capital compensation
----------------------------------------------------------------------------------------
Balance at inception
(February 10, 2000) $ - $ - $ - $ - $ - $ -
Issuance of 10,900,016 shares
of common stock - - - 10,900 44,100 -
Issuance of 3,000,000 shares of
Series A preferred stock 3,000 - - - 2,973,329 -
Issuance of 4,900,000 shares of
Series B preferred stock - 4,900 - - 6,992,216 -
Increase of stock options and
common stock to
non-employees - - - - 118,647 -
Deferred compensation - - - - 496,960 (496,960)
Amortization of deferred
compensation - - - - - 27,609
Net loss - - - - - -
Foreign currency translation
adjustment - - - - - -
-------------------------------------------------------------------------------------------
Balance, December 31, 2000 $ 3,000 $ 4,900 $ - $ 10,900 $ 10,625,252 $ (469,351)
Issuance of 3,193,678 shares of
Series C preferred stock - - 3,194 - 7,929,141 -
Issuance of stock options and
common stock to
non-employees - - - - 450,802 -
Exercise of stock options - - - 593 254,273 -
Deferred compensation - - - - 1,028,640 (1,028,640)
Amortization of deferred
compensation - - - - - 471,317
Net loss - - - - - -
Conversion of preferred stock
into common stock (3,000) (4,900) (3,194) 20,207 (9,113) -
Issuance of common stock in
connection with NPI merger - - - 13,349 57,713,001 -
Acquisition of treasury stock - - - - - -
Net unrealized gain on
marketable securities - - - - - -
Foreign currency translation
adjustment - - - - - -
------------------------------------ ------------------------------------------------------
Balance, December 31, 2001 $ - $ - $ - $45,049 $ 77,991,996 $ (1,026,674)
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
Accumulated
other
compre- Total Compre-
Accumulated Treasury hensive stockholders' hensive
Deficit stock loss equity loss
------------------------------------------------------------------------------------------------
Balance at inception
(February 10, 2000) $ - $ - $ - $ - $ -
Issuance of 10,900,016 shares
of common stock - - - 55,000 -
Issuance of 3,000,000 shares of
Series A preferred stock - - - 2,976,329 -
Issuance of 4,900,000 shares of
Series B preferred stock - - - 6,997,116 -
Increase of stock options and
common stock to
non-employees - - - 118,647 -
Deferred compensation - - - - -
Amortization of deferred
compensation - - - 27,609 -
Net loss (2,095,719) - - (2,095,719) (2,095,719)
Foreign currency translation
adjustment - (22,005) (22,005) (22,005)
---------------------------------------------------------------------------------------------
Balance, December 31, 2000 (2,095,719) $ - $ (22,005) $ 8,056,977 $ (2,117,724)
====================
Issuance of 3,193,678 shares of
Series C preferred stock - - - 7,932,335 -
Issuance of stock options and
common stock to
non-employees - - - 450,802 -
Exercise of stock options - - - 254,866 -
Deferred compensation - - - - -
Amortization of deferred
compensation - - - 471,317 -
Net loss (10,055,750) - - (10,055,750) (10,055,750)
Conversion of preferred stock
into common stock - - - - -
Issuance of common stock in
connection with NPI merger - - - 57,726,350 -
Acquisition of treasury stock - (1,220,730) - (1,220,730) -
Net unrealized gain on
marketable securities - 4,533 4,533 4,533
Foreign currency translation
adjustment - (59,128) (59,128) (59,128)
---------------------------------------------------------------------------------------------
Balance, December 31, 2001 $ (12,151,469) $ (1,220,730) $ (76,600) $ 63,561,572 $ (10,110,345)
=============================================================================================
Series A Series B Series C
convertible convertible convertible Additional
preferred preferred preferred Common paid-in Deferred
stock stock stock stock capital compensation
----------------------------------------------------------------------------------------
Issuance of stock options to
non-employees - - - - 32,890 -
Compensation expense for
accelerated vesting of
stock options - - - - 231,415 -
Exercise of stock options - - - 479 1,112,970 -
Amortization of deferred
compensation and option
forteitures - - - - (95,610) 555,229
Net loss - - - - - -
Acquisiton of treasury stock - - - - - -
Adjustments to the fair value
of the net tangible assets
acquired in the NPI merger - - - - 2,150,000 -
Net unrealized gain on
marketable services - - - - - -
Foreign currency translation
adjustment - - - - - -
--------------------------------------------------------------------------------------------
Balance, December 31, 2002 $ - $ - $ - $ 45,528 $ 81,423,661 $ (471,445)
============================================================================================
Accumulated
other
compre- Total Compre-
Accumulated Treasury hensive stockholders' hensive
Deficit stock loss equity loss
------------------------------------------------------------------------------------------------
Issuance of stock options to
non-employees - - - 32,890 -
Compensation expense for - - - 231,415 -
accelerated vesting of
stock options
Exercise of stock options - - - 1,113,449 -
Amortization of deferred
compensation and option
forteitures - - - 451,619 -
Net loss (11,543,165) - - (11,543,165) (11,543,165)
Acquisiton of treasury stock - (214,400) - (214,400) -
Adjustments to the fair value
of the net tangible assets
acquired in the NPI merger - - - 2,150,000 -
Net unrealized gain on
marketable services - - 90,904 90.904 90,904
Foreign currency translation
adjustment - - 18,769 18,769 18,769
-------------- ----------- --------- ------------ -------------
Balance, December 31, 2002 $(23,694,634) $(1,435,130) $ 33,073 $ 55,901,053 $ (11,433,492)
============== =========== ========= ============ =============
See accompanying notes to consolidated financial statements.
29
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Period from
Inception (February
Year Ended Year Ended 10, 2000) through
December 31, 2002 December 31, 2001 December 31, 2000
----------------- ----------------- -----------------
Cash flows from operating activities:
Net loss ........................................................ $(11,543,165) $(10,055,750) $ (2,095,719)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ............................. 1,747,380 617,277 50,905
Non-cash professional services expenses ................... 32,890 450,802 118,647
Equity-based compensation expense ......................... 691,034 471,317 27,609
Impairment of long-lived and other assets ................. 2,782,777 -- --
Changes in operating assets and liabilities, net of effects of
acquisitions:
Accounts receivable, net .................................. (1,728,305) (2,524,173) (15,814)
Prepaid expenses and other current assets ................. (571,635) (1,029,022) (47,995)
Other assets .............................................. (9,119) -- --
Accounts payable .......................................... (121,685) 407,633 137,365
Accrued expenses .......................................... 55,868 1,321,774 266,949
Deferred revenue .......................................... 1,175,735 224,912 133,000
------------ ------------ ------------
Net cash used in operating activities .................. (7,488,225) (10,115,230) (1,425,053)
------------ ------------ ------------
Cash flows from investing activities:
Purchase of marketable securities ............................... (39,507,257) (9,312,973) --
Sale of marketable securities ................................... 28,843,893 1,868,430 --
Purchase of investment .......................................... (75,000) (2,300,062) --
Purchase of property and equipment .............................. (1,272,104) (1,340,583) (634,106)
Purchase of software licenses ................................... (800,000) (2,240,000) --
Purchase of intangible assets ................................... (145,534) -- --
Net cash acquired from acquisition of NPI ....................... -- 48,208,649 --
Net cash paid for acquisition of IP Metrics ..................... (2,381,726) -- --
Net cash paid for acquisition of FarmStor ....................... (169,640) -- --
Security deposits ............................................... (35,802) (210,166) (220,099)
------------ ------------ ------------
Net cash (used in) provided by investing activities .......... (15,543,170) 34,673,295 (854,205)
------------ ------------ ------------
Cash flows from financing activities:
Net proceeds from issuance of preferred stock ................... -- 7,932,335 9,973,445
Proceeds from exercise of stock options ......................... 1,113,449 254,866 --
Proceeds from issuance of common stock .......................... -- -- 55,000
Payments to acquire treasury stock .............................. (214,400) (1,220,730) --
------------ ------------ ------------
Net cash provided by financing activities .................... 899,049 6,966,471 10,028,445
------------ ------------ ------------
Cash flows from discontinued operations:
Payments of liabilities of discontinued operations ........... (2,066,285) (821,653) --
------------ ------------ ------------
Effect of exchange rate changes on cash ............................ 18,769 (59,128) (22,005)
------------ ------------ ------------
Net (decrease) increase in cash and cash equivalents .............. (24,179,862) 30,643,755 7,727,182
Cash and cash equivalents, beginning of period ..................... 38,370,937 7,727,182 --
------------ ------------ ------------
Cash and cash equivalents, end of period .......................... $ 14,191,075 $ 38,370,937 $ 7,727,182
============ ============ ============
30
Supplemental disclosures of cash flow information:
In connection with the merger with NPI (note 2), additional paid-in capital
increased as follows:
Cash acquired -- 57,091,647
Marketable securities acquired -- 18,707,104
Merger related costs -- (8,882,998)
Fair value of property and equipment acquired -- 50,000
Fair value of accounts receivable acquired -- 92,000
Liabilities of discontinued operations assumed 2,150,000 (9,331,403)
------------ ------------
Increase in additional paid-in capital $ 2,150,000 $ 57,726,350
============ ============
Cash paid for income taxes $ 34,082 $ -- $ --
============ ============= ===========
The Company did not pay any interest expense for the period from inception
(February 10, 2000) through December 31, 2002.
See accompanying notes to consolidated financial statements.
31
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2002
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) THE COMPANY AND NATURE OF OPERATIONS
FalconStor Software, Inc., a Delaware Corporation (the "Company"),
develops, manufactures and sells network storage infrastructure software
solutions and provides the related maintenance, implementation and engineering
services.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c) CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$13.6 million and $38.3 million at December 31, 2002 and 2001, respectively.
Marketable securities at December 31, 2002 and 2001 amounted to $36.9 million
and $26.2 million, respectively, and consisted of corporate bonds and government
securities, which are classified as available for sale, and accordingly,
unrealized gains and losses on marketable securities are reflected as a
component of stockholders' equity.
(d) REVENUE RECOGNITION
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, Software Revenue Recognition. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable and the software is
delivered, provided no significant obligations remain and collection of the
resulting receivable is deemed probable. Software delivered to a customer on a
trial basis is not recognized as revenue until a permanent key is delivered to
the customer. When a customer licenses software together with the purchase of
maintenance, the Company allocates a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate. Software
maintenance fees are deferred and recognized as revenue ratably over the term of
the contract. The cost of providing technical support is included in cost of
revenues.
Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Network consulting
services, which are billed on a time and material basis, are also recognized as
revenue when the services are performed. Costs of providing these services are
included in cost of revenues.
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided the reseller a non-exclusive software license to install the Company's
software on certain hardware or to resell the Company's software in exchange for
royalty payments based on the number of products distributed by the OEM or
distributor. Nonrefundable advances received by the Company from an OEM for
royalties are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.
In 2002, the Company had a limited number of transactions in which it
purchased hardware and bundled this hardware with the Company's software and
sold the bundled solution to its customer. The associated revenue was recognized
when the hardware was delivered to the customer.
(e) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years).
32
(f) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Other intangible assets mainly represent customer
relationships and purchased technology. Consistent with SFAS 142, Goodwill and
Other Intangible Assets, the Company has not amortized goodwill related to its
acquisitions, but instead tested the balance for impairment. Identifiable
intangible assets are amortized over a three-year period using the straight-line
method. Amortization expense was $52,892 in 2002.
(g) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility in
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $31,524 and $23,643 was
amortized in 2002 and 2001, respectively. Amortization of software development
costs is recorded at the greater of straight line over three years or the ratio
of current revenue of the related products to total current and anticipated
future revenue of these products.
In 2002 and 2001, the Company purchased software technology for $800,000
and $2,240,000, respectively, which is included in other assets in the balance
sheets. Amortization expense was $867,499 and $248,889 in 2002 and 2001,
respectively.
(h) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(i) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of the asset may
not be recoverable. If the sum of the expected future cash flows, undiscounted
and without interest, is less than the carrying amount of the asset, an
impairment loss is recognized as the amount by which the carrying amount of the
asset exceeds its fair value.
(j) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations including FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to
account for its fixed-plan stock options. Under this method, compensation
expense is recorded on the date of grant only if the current market price of the
underlying stock exceeded the exercise price. SFAS No. 123, Accounting for
Stock-Based Compensation, established accounting and disclosure requirements
using a fair-value-based method of accounting for stock-based employee
compensation plans. As allowed by SFAS No. 123, the Company has elected to
continue to apply the intrinsic-value-based method of accounting described
above, and has adopted only the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:
2002 2001 2000
---- ---- ----
Net loss attributable to common shareholders-as reported $ (11,543,165) $ (13,952,037) $ (2,095,719)
Add stock-based employee compensation expense included
in reported net income, net of tax $ 691,034 $ 471,317 $ 27,609
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax $ (5,830,622) $ (3,394,894) $ (188,070)
-------------- -------------- --------------
33
Net loss - pro forma $ (16,682,753) $ (16,875,614) $ (2,256,180)
============== ============= =============
Basic net loss per common share-as reported $ (0.26) $ (0.40) $ (0.09)
Basic net loss per common share- pro forma $ (0.37) $ (0.48) $ (0.09)
The per share weighted average fair value of stock options granted during
2002, 2001 and 2000 was $2.29, $4.08 and $0.32, respectively, on the date of
grant using the Black-Scholes option-pricing method with the following weighted
average assumptions: 2002 - expected dividend yield of 0%, risk free interest
rate of 3%, expected stock volatility of 44% and an expected option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees; 2001 - expected dividend yield of
0%, risk free interest rate of 3%, expected stock volatility of 118% and an
expected option life of three years for options granted to employees of the
Company, and an option life of ten years for options granted to non-employees;
2000 - expected dividend yield of 0%, risk free interest rate of 6%, expected
stock volatility of 60% and an expected option life of five years for options
granted to employees of the Company, and an option life of ten years for options
granted to non-employees.
(k) FINANCIAL INSTRUMENTS
As of December 31, 2002 and 2001, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.
(l) STOCK SPLIT
In July 2000, the Company's Board of Directors declared a five-for-one
stock split to be effected in the form of a common stock dividend. For purposes
of the accompanying consolidated financial statements, all share and per share
information have been adjusted for the stock split.
(m) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.
(n) EARNINGS PER SHARE (EPS)
Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the periods presented, all common stock
equivalents were excluded from diluted net loss per share. As of December 31,
2002 and 2001, potentially dilutive common stock equivalents included 9,387,579
and 7,274,717 stock options outstanding, respectively. As of December 31, 2000,
potentially dilutive common stock equivalents included 4,735,027 stock options
outstanding and 17,902,078 shares issuable upon the conversion of convertible
preferred stock.
(o) COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) includes the Company's net loss, foreign
currency translation adjustments, and unrealized gains on marketable securities.
(p) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
(q) NEW ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, "Accounting for Costs Associated with Exit or Disposal Activities"
("SFAS No. 146"), which is effective for exit or disposal activities initiated
after December 31, 2002. SFAS No. 146 applies to costs associated with an exit
activity (including restructuring costs) or with a disposal of long-lived
34
assets. Companies will be required to record an expense when a liability for an
exit or disposal activity is incurred and can be measured at fair value. The
Company does not expect the adoption of SFAS No. 146 to have a material impact
on its consolidated results of operations or financial position.
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." This interpretation expands the disclosures to be made
by a guarantor in its financial statements about its obligations under certain
guarantees and requires the guarantor to recognize a liability for the fair
value of an obligation assumed under a guarantee. FIN 45 clarifies the
requirements of SFAS No. 5, "Accounting for Contingencies," relating to
guarantees. In general, FIN 45 applies to contracts or indemnification
agreements that contingently require the guarantor to make payments to the
guaranteed party based on changes in a specified interest rate, security price,
foreign exchange rate or other variable that is related to an asset, liability,
or equity security of the guaranteed party, or failure of another party to
perform under an obligating agreement (performance guarantees). Certain
guarantee contracts are excluded from both the disclosure and recognition
requirements of this interpretation, including, among others, guarantees
relating to employee compensation, residual value guarantees under capital lease
arrangements, commercial letters of credit, loan commitments, subordinated
interests in a special purpose entity, and guarantees of a company's own future
performance. Other guarantees are subject to the disclosure requirements of FIN
45 but not to the recognition provisions and include, among others, a guarantee
accounted for as a derivative instrument under SFAS No. 133, and a guarantee
covering product performance, not product price. The disclosure requirements of
FIN 45 are effective for the Company as of December 31, 2002, and require
disclosure of the nature of the guarantee, the maximum potential amount of
future payments that the guarantor could be required to make under the
guarantee, and the current amount of the liability, if any, for the guarantor's
obligations under the guarantee. The recognition requirements of FIN 45 are to
be applied prospectively to guarantees issued or modified after December 31,
2002. Certain guarantees included in software license agreements that have been
entered into by the Company are disclosed in Note 11.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation--Transition and
Disclosure" ("SFAS No. 148"). SFAS No.148 amends SFAS No. 123, "Accounting for
Stock-Based Compensation," to provide alternative methods of transition for a
voluntary change to the fair value-based method of accounting for stock-based
employee compensation ("transition provisions"). In addition, SFAS No. 148
amends the disclosure requirements of Accounting Principals Board ("APB")
Opinion No. 28, Interim Financial Reporting, to require proforma disclosure in
interim financial statements by companies that elect to account for stock-based
compensation using the intrinsic value method prescribed in APB Opinion No. 25
("disclosure provisions"). The transition methods of SFAS No. 148 are effective
for financial statements for fiscal years ending after December 15, 2002. The
Company continues to use the intrinsic value method of accounting for
stock-based compensation. As a result, the transition provisions do not have an
effect on the Company's consolidated financial statements. The Company has
adopted the disclosure requirements of SFAS No. 148.
(r) RECLASSIFICATIONS
Certain reclassifications have been made to prior year's consolidated
financial statements to conform to the current year's presentation.
(2) ACQUISITIONS
On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned
subsidiary of the Company, acquired all of the common stock of IP Metrics
Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for
mission-critical networks, for $2,432,419 in cash plus payments contingent on
the level of revenues from IP Metrics' products and services for a period of
twenty-four months. The acquisition was accounted for under the purchase method
and the results of IP Metrics are included with those of the Company from the
date of acquisition.
The fair value of the net tangible liabilities of IP Metrics assumed was
$898,306. The Company purchased certain intangible assets, including customer
relationships and purchased technology with a fair value of $216,851. These
intangible assets are being amortized under the straight-line method over an
estimated useful life of 3 years, the expected period of benefit. The purchase
price in excess of the fair value of the net tangible and intangible assets
acquired and liabilities assumed by the Company amounted to $3,113,874 and has
been recorded as goodwill.
On November 12, 2002, FalconStor AC, Inc., acquired all of the common
stock of FarmStor, a software sales organization in the Republic of Korea for
$180,000 in cash. The fair value of the net tangible liabilities of FarmStor
assumed was $7,725. The purchase price in excess of the fair value of the net
35
tangible assets acquired and liabilities assumed by the Company amounted to
$187,725 and has been recorded as goodwill.
On August 22, 2001, pursuant to an Agreement and Plan of Merger and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor") merged
with Network Peripherals Inc. ("NPI"), with NPI as the surviving corporation.
Under the terms of the Merger Agreement, all of FalconStor's preferred shares
were converted into common shares and the stockholders of FalconStor received
0.721858 shares of NPI common stock for each share of FalconStor common stock
that they held. Although NPI acquired FalconStor, as a result of the
transaction, FalconStor stockholders held a majority of the voting interests in
the combined enterprise after the merger. Accordingly, for accounting purposes,
the acquisition was a "reverse acquisition" and FalconStor was the "accounting
acquirer." Further, as a result of NPI's decision on June 1, 2001 to discontinue
its NuWave and legacy business, at the time of the merger NPI was a
non-operating public shell with no continuing operations, and no intangible
assets associated with NPI were purchased by FalconStor. As a result, the
transaction was accounted for as a recapitalization of FalconStor and recorded
based on the fair value of NPI's net tangible assets acquired by FalconStor,
with no goodwill or other intangible assets being recognized. Costs incurred by
FalconStor directly related to the transaction, amounting to $8,882,998, were
charged to additional paid-in capital. The conversion of all of FalconStor's
preferred stock into common stock resulted in an additional 20,207,460 shares of
common stock outstanding and, for accounting purposes, the merger resulted in
the issuance of 13,348,605 common shares to NPI's pre-merger shareholders. In
connection with the merger, the name of NPI was changed to FalconStor Software,
Inc.
The following unaudited pro forma consolidated financial information gives
effect to the above described acquisitions of IP Metrics and FarmStor and merger
with NPI, as if they had occurred at the beginning of the respective periods by
consolidating the continuing results of operations of the Company, IP Metrics,
FarmStor and NPI for the years ended December 31, 2002 and 2001.
Year Ended Year Ended
December 31, 2002 December 31, 2001
----------------- -----------------
Revenues................................................. $ 11,089,570 $ 6,066,159
Net Loss from continuing operations...................... (11,972,835) (10,294,191)
Basic and diluted net loss from continuing operations per
share................................................... $ (0.26) $ (0.23)
Weighted average basic and diluted shares outstanding..... 45,232,595 43,822,013
The pro forma statements are provided for illustrative purposes only and
do not represent what the actual consolidated results of operations would have
been had the merger occurred on the dates assumed, nor are they necessarily
indicative of future results of operations.
(3) PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
December 31, December 31, Useful
2002 2001 lives
------------- ------------ -------
Computer hardware and software $ 2,913,989 $1,641,975 3 years
Furniture and equipment 276,179 321,391 5-7 years
Leasehold improvements 124,115 61,323
----------- ----------
3,314,283 2,024,689
Less accumulated depreciation (1,246,282) (419,293)
------------ ----------
$ 2,068,001 $1,605,396
Depreciation expense was $826,989, $368,388 and $50,905 in 2002, 2001 and 2000,
respectively.
36
(4) MARKETABLE SECURITIES
The Company accounts for its short-term investments in accordance with
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 establishes
the accounting and reporting requirements for all debt securities and for
investments in equity securities that have a readily determinable fair market
value. All short-term marketable securities must be classified as one of the
following: held-to-maturity, available-for-sale or trading securities. The
Company's short-term investments consist of available-for-sale securities, which
are carried at fair value, with unrealized gains and losses reported as a
separate component of stockholders' equity. Unrealized gains and losses are
computed on the basis of the specific identification method. Realized gains,
realized losses and declines in value judged to be other-than-temporary, are
included in other income. The cost of available-for-sale securities sold are
based on the specific identification method and interest earned is included in
interest and other income.
The carrying value and fair values of the Company's marketable securities
as of December 31, 2002 and 2001 are as follows:
Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
------------ ------------- ----------- -----------
Available-for-sales securities:
December 31, 2002 $ 36,910,448 $ 36,815,011 $ 95,437 $ -
December 31, 2001 $ 26,156,180 $ 26,151,647 $ 4,533 $ -
Marketable securities at December 31, 2002 and 2001 consist of corporate
bonds and government securities.
(5) ACCRUED EXPENSES
Accrued expenses are comprised of the following:
2002 2001
----------- ------------
Accrued compensation $ 826,721 $ 532,060
Accrued consulting and professional fees 327,416 395,491
Accrued marketing and promotion 170,282 304,631
Other accrued expenses 441,654 356,541
Accrued IP Metrics contingent purchase price 221,578 --
------------ -----------
$ 1,987,651 $ 1,588,723
============ ===========
(6) INCOME TAXES
The provision for income taxes for the years ended December 31, 2002 and
2001 are comprised solely of foreign income taxes. The tax effects of temporary
differences that give rise to the Company's deferred tax assets (liabilities) as
of December 31, 2002 and 2001 are as follows:
2002 2001
---- ----
U.S. net operating loss carryforwards (FalconStor) $ 8,285,700 $ 4,750,000
U.S. net operating loss carryforwards (NPI) 31,756,000 31,756,000
Start-up costs not currently deductible for taxes 1,014,200 708,600
Depreciation (47,200) (53,000)
Compensation 412,800 580,700
Tax credit carryforwards 704,900 345,600
Liabilities of discontinued operations 2,667,400 3,535,400
Deferred revenue 783,300 150,500
Impairment of investment 966,000 --
Identifiable intangible assets (71,000) --
Other 367,800 157,300
-------------- -----------
46,839,900 41,931,100
Valuation allowance (46,839,900) (41,931,100)
--------------- ------------
$ -- $ --
=============== ============
The difference between the provision for income taxes computed at the
Federal statutory rate and the reported amount of tax expense attributable to
loss before income taxes for the years ended December 31, 2002 and 2001 and for
the period from inception (February 10, 2000) through December 31, 2000 are as
follows:
37
2002 2001 2000
---- ---- ----
Tax recovery at Federal statutory rate $ (3,911,900) $ (3,411,700) $ (712,500)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit (788,400) (819,400) (147,300)
Non-deductible expenses 41,400 34,600 34,700
Compensation 389,800 -- --
Foreign tax credit (125,800) (21,490) 18,400
Net effect of foreign operations 75,700 (610) --
Research and development credit (233,500) (345,600) --
Increase in valuation allowance 4,590,300 4,585,690 806,700
------------- -------------- ------------
$ 37,600 $ 21,490 $ --
============= ============== =============
Income (loss) before provision for income taxes for the years ended
December 31, 2002 and 2001 is as follows:
2002 2001
-------------- -------------
Domestic loss $ (11,393,000) $ (10,099,000)
Foreign income (loss) (113,000) 65,000
-------------- -------------
$ (11,506,000) $ (10,034,000)
============== =============
As of December 31, 2002, the Company has U.S. net operating loss
carryforwards of approximately $19,726,000, which expire from 2020 through 2022.
In addition, as of the date of the merger, NPI had U.S. net operating loss
carryforwards of $93,400,000 that start to expire in December, 2012. At December
31, 2002 and 2001, the Company has established a valuation allowance against its
net deferred tax assets due to the Company's pre-tax losses and the resulting
likelihood that the deferred tax asset is not realizable. Due to the Company's
various equity transactions, which resulted in a change of control, the
utilization of certain tax loss carryforwards is subject to annual limitations
imposed by the Internal Revenue Code Section 382. NPI experienced such ownership
change as a result of the merger. As such, the Company's ability to use its NOL
carryforwards to offset taxable income in the future may be significantly
limited. If the entire deferred tax asset were realized, $5,225,500 would be
allocated to paid-in capital with the remainder reducing income tax expense. Of
the amount allocable to paid in capital, $3,880,500 related to the tax effect of
the deductions that will result from payments of the liabilities of discontinued
operations and the balance, $1,345,000 related to the effect of compensation
deductions from exercises of employee and consultants stock options.
(7) STOCKHOLDERS' EQUITY
Upon the incorporation of the Company on February 10, 2000, the Company
issued 10,827,831 shares of its common stock for proceeds of $30,000.
In November 2000, in connection with a consulting agreement, the Company,
in addition to agreeing to pay a monthly consulting fee, sold 72,185 shares of
restricted common stock to a consultant for $25,000 ($0.35 per share). The
consultant's rights vested for 23,821 shares on each of November 1, 2001 and
2002 and an additional 24,543 shares will vest on November 1, 2003. As of March
31, 2001, the services related to this consulting agreement were fully
performed. The excess of the fair value of the common stock over $0.35 of
$122,000 and $32,000 in 2001 and 2000, respectively, was recorded as cumulative
consulting expense in each period up until the services were fully performed.
38
In March 2000, the Company issued 3,000,000 shares of its Series A
convertible preferred stock ("Series A") at $1.00 per share for net proceeds of
$2,976,329. While outstanding, each share of Series A was convertible, at the
option of the holder, into five shares of common stock. The holders of Series A
were entitled to receive cumulative cash dividends at the same rate as dividends
were paid with respect to the common stock. The Series A was not redeemable at
the option of the holder and had a liquidation preference equal to the greater
of $1.00 per share plus all accumulated unpaid dividends, or the amount that the
Series A holders would have received had they converted all Series A into shares
of common stock.
In September 2000, the Company issued 4,900,000 shares of its Series B
convertible preferred stock ("Series B") at $1.43 per share for net proceeds of
$6,997,116. While outstanding each share of Series B was convertible, at the
option of the holder, into two shares of common stock. The holders of Series B
were entitled to receive cumulative cash dividends at the same rate as dividends
were paid with respect to the common stock. The Series B was not redeemable at
the option of the holder and had a liquidation preference equal to the greater
of the amount that the Series B holders would have received had they converted
all Series B into shares of common stock, or the aggregate purchase price paid
for the Series B plus all accumulated unpaid dividends.
On May 4, 2001, the Company issued 3,193,678 shares of its Series C
preferred stock ("Series C") at 2.55 per share for net proceeds of $7,932,335.
While outstanding, each share of Series C was convertible, at the option of the
holder, into one share of common stock. The Series C automatically converted
into common stock upon the consummation of a merger or consolidation of the
Company with or into another company. The holders of Series C were entitled to
receive cumulative cash dividends at the same rate as dividends were paid with
respect to the common stock. The Series C was not redeemable at the option of
the holder and had a liquidation preference equal to the greater of $2.55 per
share plus all accumulated unpaid dividends, or the amount that the Series C
holders would have received had they converted all Series C into shares of
common stock.
The issuance of the Series C preferred stock resulted in a beneficial
conversion feature, which was recorded as a preferred stock dividend in the
second quarter of 2001, since the Series C preferred stock was convertible at
issuance. The beneficial conversion feature of $3,896,287 was calculated on the
date of issuance, based on the difference between the fair value of the
Company's common stock which would be issued upon conversion of the preferred
stock and the amount paid for the preferred stock.
In connection with the Company's merger with NPI in August 2001, all of
FalconStor's preferred stock was converted into common stock which resulted in
an additional 20,207,460 shares of common stock outstanding and, for accounting
purposes, the merger resulted in the issuance of 13,348,605 common shares to
NPI's pre-merger shareholders.
(8) STOCK OPTION PLANS
As of May 1, 2000, the Company adopted the FalconStor Software, Inc., 2000
Stock Option Plan (the "Plan"). The Plan is administered by the Board of
Directors and, as amended, provides for the issuance of up to 10,662,296 options
to employees, consultants and non-employee directors. Options may be incentive
("ISO") or non-qualified. Exercise prices of ISOs granted must be at least equal
to the fair value of the common stock on the date of grant, and have terms not
greater than ten years, except those to an employee who owns stock with greater
than 10% of the voting power of all classes of stock of the Company, in which
case they must have an option price at least 110% of the fair value of the
stock, and expire no later than five years from the date of grant.
Certain of the options granted to employees had exercise prices less than
the fair value of the common stock on the date of grant, which resulted in
deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively.
The amortization of deferred compensation amounted to $459,619, $471,317 and
$27,609 in 2002, 2001 and 2000, respectively.
The Company granted options to purchase an aggregate of 10,000, 25,546 and
203,563 shares of common stock to certain non-employee consultants in exchange
for professional services received during 2002, 2001 and 2000, respectively. The
aggregate fair value of these options as determined using the fair value method
under SFAS No. 123, amounted to $32,890, $328,802 and $86,647 in 2002, 2001 and
2000, respectively.
In February 2002, the Company accelerated the vesting of stock options of
one employee upon his death. Compensation costs of $231,415 were recorded based
on the intrinsic value of the options on the date of acceleration.
As of December 31, 2002, there were outstanding vested options to purchase
802,167 common shares under several of the former NPI stock option plans. The
Company does not intend to grant any additional options under these plans except
for the 1994 Outside Directors Stock Option Plan which, as amended, has 500,000
shares authorized for issuance upon the exercise of options, of which options to
purchase 260,000 shares were outstanding as of December 31, 2002.
39
Stock option activity for the periods indicated is as follows:
Weighted
average
Number of exercise
Options price
----------- ------------
Outstanding at February 10, 2000 (inception) ... --
Granted ........................................ 4,735,027 $ 0.35
Exercised ...................................... --
Canceled ....................................... --
---------
Outstanding at December 31, 2000 ............... 4,735,027 $ 0.35
Granted ........................................ 2,591,451 $ 5.37
Assumed in connection with NPI acquisition .... 1,717,040 $ 10.78
Exercised ...................................... (593,297) $ 0.43
Canceled ....................................... (1,175,504) $ 8.46
----------
Outstanding at December 31, 2001 ............... 7,274,717 $ 3.28
Granted ........................................ 3,088,500 $ 4.60
Exercised ...................................... (478,038) $ 2.32
Canceled ....................................... (497,600) $ 7.53
----------
Outstanding at December 31, 2002 ............... 9,387,579 $ 3.55
==========
Vested at December 31, 2000 .................... -- $ --
==========
Vested at December 31, 2001 .................... 2,177,265 $ 4.49
==========
Vested at December 31, 2002 .................... 3,829,793 $ 3.21
==========
Options available for grant at December 31, 2002 1,718,173
==========
The following table summarizes information about stock options outstanding
at December 31, 2002:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted Average
Remaining Weighted Weighted
Range of Number Contractual Average Exercise Number Average Exercise
Exercise Price Outstanding Life (Years) Price Outstanding Price
-------------- ----------- ------------ ----- ----------- -----
$ 0.35 4,204,347 7.5 $ 0.35 2,552,420 $ 0.35
$ 1.01 54,249 8.0 $ 1.01 15,556 $ 1.01
$ 4.04 - $ 4.50 1,567,500 9.5 $ 4.05 125,000 $ 4.20
$ 4.94 - $ 5.25 1,563,427 9.0 $ 5.08 86,667 $ 4.94
$ 6.20 981,519 8.5 $ 6.20 320,782 $ 6.20
$ 7.63 - $ 9.72 370,923 8.0 $ 8.78 226,447 $ 8.26
$10.95 - $14.63 605,614 8.0 $12.23 462,921 $12.63
$15.00 - $25.69 40,000 7.0 $18.66 40,000 $18.66
--------- ---------
9,387,579 3,829,793
========= =========
(9) IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, the Company entered into an agreement with Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2,800,062
was paid to NSSI, of which $2,300,062 was for the purchase of convertible
preferred stock accounted for under the cost method and $500,000 was for a
40
non-refundable prepaid royalty recoupable against future product sales of NSSI's
product. If the preferred stock were converted into common stock it would
represent an approximate 16% ownership in NSSI. Primarily due to the decline
since May, 2002 in the market value of NSSI's common stock underlying the
convertible preferred stock to a value which is significantly below the
Company's cost, the Company has concluded the decline in the fair value of its
investment in NSSI's preferred stock is other than temporary. Accordingly, in
2002 the Company recorded an impairment charge of $2,300,062 to write-off its
investment in NSSI. In addition, due to the lack of market acceptance of the
NSSI product in its current state, the unrecouped prepaid royalty is not
recoverable and in 2002 the Company recorded an impairment charge of $482,715 to
write off this prepaid royalty.
(10) NET LIABILITIES OF DISCONTINUED OPERATIONS
As of December 31, 2002, the Company consummated the wind down of NPI's
discontinued operations, including the termination of all of NPI's former
employees. Liabilities of NPI's discontinued operations at December 31, 2002
totaled $4.2 million and consisted of warranty related liabilities, foreign
income taxes, severance related payments, professional fees and other related
liabilities, including estimated settlement costs for disputes. See note 16.
(11) COMMITMENTS
The Company has an operating lease covering its primary office facility
that expires in July, 2007. The Company also has several operating leases
related to a domestic office and offices in foreign countries. The expiration
date for these leases ranges from 2003 through 2004. The following is a schedule
of future minimum lease payments for these operating leases as of December 31,
2002:
Year ending December 31,
2003................................................. $ 498,011
2004................................................. 336,493
2005................................................. 269,968
2006................................................. 303,919
2007................................................. 150,429
-----------
$ 1,558,820
===========
These leases require the Company to pay its proportionate share of real
estate taxes and other common charges. Total rent expense for operating leases
was $596,578, $381,260 and $68,571 for the years ended December 31, 2002 and
2001 and the period from inception (February 10, 2000) through December 31,
2000, respectively.
The Company typically provides its customers a warranty on its software
products for a period of not more than 90 days. Such warranties are accounted
for in accordance with SFAS No. 5, "Accounting for Contingencies." To date, the
Company has not incurred any costs related to warranty obligations.
Under the terms of substantially all of its software license agreements,
the Company has agreed to indemnify its customers for all costs and damages
arising from claims against such customers based on, among other things,
allegations that the Company's software infringes the intellectual property
rights of a third party. In most cases, in the event of an infringement claim,
the Company retains the right to (i) procure for the customer the right to
continue using the software; (ii) replace or modify the software to eliminate
the infringement while providing substantially equivalent functionality; or
(iii) if neither (i) nor (ii) can be reasonably achieved, the Company may
terminate the license agreement and refund to the customer a pro-rata portion of
the license fee paid to the Company. Such indemnification provisions are
accounted for in accordance with SFAS No. 5. Through December 31, 2002, there
have not been any claims under such indemnification provisions.
(12) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases will be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. As of December 31, 2002, the Company
repurchased a total of 235,000 shares for $1,435,130.
41
(13) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the years ended
December 31, 2002 and 2001 and the period from inception (February 10, 2000) to
December 31, 2000 and the location of long-lived assets as of December 31, 2002,
2001 and 2000 are summarized as follows:
2002 2001 2000
------------------------------------------------
Revenues:
United States $ 6,629,147 $ 1,755,823 $ 143,294
Asia and other international $ 3,999,745 $ 3,835,906 $ --
-------------------------------------------------
Total revenues $ 10,628,892 $ 5,591,729 $ 143,294
=================================================
Long-lived assets (includes all non-current assets):
United States $ 7,655,900 $ 5,963,235 $ 764,056
Asia and other international $ 499,497 $ 363,599 $ 39,244
-------------------------------------------------
Total long-lived assets $ 8,155,397 $ 6,326,834 $ 803,300
=================================================
For the year ended December 31, 2002, the Company had one customer that
accounted for 16% of revenues. For the year ended December 31, 2001, the Company
had one customer that accounted for 13% of revenues. For the period from
inception (February 10, 2000) through December 31, 2000, the Company had one
customer that accounted for 64% of revenues.
(14) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR DOUBTFUL ACCOUNTS
Balance at Balance at
Beginning of Additions charged End of
Period Ended, Period to Expense Deductions Period
------------- ------ ---------- ---------- ------
December 31, 2002 $ 128,138 $ 570,762 $ 182,540 $ 516,360
December 31, 2001 $ -- $ 128,138 $ -- $ 128,138
December 31, 2000 $ -- $ -- $ -- $ --
(15) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of selected quarterly financial data for the
years ended December 31, 2002 and 2001 and the period from inception (February
10, 2000) through December 31, 2000:
Fiscal Quarter
First Second Third Fourth
----- ------ ----- ------
2002
Revenue $ 1,980,842 $ 2,376,618 $ 2,855,522 $ 3,415,910
=============== ============ ============= =============
Net loss $ (2,581,385) $ (2,464,671) $ (3,562,455)$ (2,934,654)
=============== ============ ============= =============
Basic and diluted net
loss per share $ (0.06) $ (0.05) $ (0.08) $ (0.06)
=============== ============ ============= =============
Basic and diluted
weighted average common
shares outstanding 45,184,257 45,238,657 45,239,977 45,266,504
=============== ============ ============= =============
42
2001
Revenue $ -- $ 43,400 $ 2,521,887 $ 3,026,442
=============== ============ ============= =============
Net loss $ (2,912,168) $ (4,448,424) $ (1,443,657)$ (1,251,501)
=============== ============ ============= =============
Basic and diluted net
loss per share $ (0.10) $ (0.15) $ (0.04) $ (0.03)
=============== ============ ============= =============
Basic and diluted
weighted average common
shares outstanding 28,802,095 30,333,760 37,004,055 44,723,121
=============== ============ ============= =============
2000
Revenue $ -- $ -- $ 68,350 $ 74,944
=============== ============ ============= =============
Net loss $ (51,474) $ (155,744) $ (489,388)$ (1,399,113)
=============== ============ ============= =============
Basic and diluted net
loss per share $ (0.004) $ (0.01) $ (0.02) $ (0.05)
=============== ============ ============= =============
Basic and diluted
weighted average common
shares outstanding 13,037,600 21,655,701 21,655,701 28,700,094
=============== ============ ============= =============
The sum of the quarterly net loss per share amounts do not always equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each such period.
43
(16) SUBSEQUENT EVENTS
On February 14, 2003, the Company reached a settlement related to a claim
associated with the liabilities of discontinued operations. The Company paid
$2,850,000 in settlement of this claim. As a result of the resolution of all
known significant contingent liabilities related to NPI's discontinued
operations, $2,150,000, representing the excess of the remaining liabilities for
discontinued operations as of December 31, 2002 over the amounts estimated to be
paid, has been reflected as a reduction of liabilities of discontinued
operations and an increase in additional paid in capital in the accompanying
balance sheet as of December 31, 2002 since this liability was related to the
merger with NPI, which was accounted for as a recapitalization.
44
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
For information relating to the change in the Company's independent
public accountants, please see the Form 8-K filed by the Company on
September 6, 2001 which is incorporated herein by reference.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information called for by Part III, Item 10, regarding the Registrant's
directors will be included in our Proxy Statement relating to our
annual meeting of stockholders scheduled to be held in May 2003, and is
incorporated herein by reference. The information appears in the Proxy
Statement under the captions "Election of Directors" and "Management."
The Proxy Statement will be filed within 120 days of December 31, 2002,
our year-end.
ITEM 11. EXECUTIVE COMPENSATION
Information called for by Part III, Item 11, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2003, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
caption "Executive Compensation." The Proxy Statement will be filed
within 120 days of December 31, 2002, our year-end.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information called for by Part III, Item 12, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2003, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
captions "Beneficial Ownership of Shares" and "Equity Compensation Plan
Information." The Proxy Statement will be filed within 120 days of
December 31, 2002, our year-end.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding our relationships and related transactions will
be included in our Proxy Statement relating to our annual meeting of
stockholders scheduled to be held in May 2003, and is incorporated by
reference. The information appears in the Proxy Statement under the
caption "Certain Relationships and Related Transactions." The Proxy
Statement will be filed within 120 days of December 31, 2002, our
year-end.
45
ITEM 14. CONTROLS AND PROCEDURES
QUARTERLY EVALUATION OF THE COMPANY'S DISCLOSURE CONTROLS AND INTERNAL
CONTROLS. Within the 90 days prior to the date of this Annual Report
on Form 10-K, the Company evaluated the effectiveness of the design
and operation of its "disclosure controls and procedures" (Disclosure
Controls), and its "internal controls and procedures for financial
reporting" (Internal Controls). This evaluation (the "Controls
Evaluation") was done under the supervision and with the participation
of management, including our Chief Executive Officer (CEO) and Chief
Financial Officer (CFO). Rules adopted by the SEC require that in this
section of the Annual Report we present the conclusions of the CEO and
the CFO about the effectiveness of our Disclosure Controls and
Internal Controls based on and as of the date of the Controls
Evaluation.
DISCLOSURE CONTROLS AND INTERNAL CONTROLS. Disclosure Controls are
procedures that are designed with the objective of ensuring that
information required to be disclosed in our reports filed under the
Securities Exchange Act of 1934 ("Exchange Act"), such as this Annual
Report, is recorded, processed, summarized and reported within the
time periods specified in the Securities and Exchange Commission's
("SEC") rules and forms. Disclosure Controls are also designed with
the objective of ensuring that such information is accumulated and
communicated to our management, including the CEO and CFO, as
appropriate to allow timely decisions regarding required disclosure.
Internal Controls are procedures which are designed with the objective
of providing reasonable assurance that (1) our transactions are
properly authorized; (2) our assets are safeguarded against
unauthorized or improper use; and (3) our transactions are properly
recorded and reported, all to permit the preparation of our financial
statements in conformity with generally accepted accounting
principles.
LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS. The Company's
management, including the CEO and CFO, does not expect that our
Disclosure Controls or our Internal Controls will prevent all errors
and all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that
the objectives of the control system are met. Further, the design of a
control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative
to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, with the Company
have been detected. These inherent limitations include the realities
that judgments in decision-making can be faulty, and that breakdowns
can occur because of simple error or mistake. Additionally, controls
can be circumvented by the individual acts of some persons, by
collusion of two or more people, or by management override of the
control. The design of any system of controls also is based in part
upon certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving
its stated goals under all potential future conditions; over time,
controls may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a cost-effective
control system, misstatements due to error or fraud may occur and not
be detected.
CHANGES IN CONTROLS. In accordance with SEC requirements, the CEO and
CFO note that, since the date of the Controls Evaluation to the date
of this Annual Report, there have been no significant changes in
Internal Controls or in other factors that could significantly affect
Internal Controls, including any corrective actions with regard to
significant deficiencies and material weaknesses.
CONCLUSIONS. Based upon the Controls Evaluation, our CEO and CFO have
concluded that, subject to the limitations noted above, our Disclosure
Controls are effective to ensure that material information relating to
the Company and its subsidiaries is made known to management,
including the CEO and CFO, particularly during the period when our
periodic reports are being prepared, and that our Internal Controls
are effective to provide reasonable assurance that our financial
statements are fairly presented in conformity with generally accepted
accounting principles.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The information required by subsections (a)(1) and (a)(2) of this item
are included in the response to Item 8 of Part II of this annual
report on Form 10-K.
(b) Reports on Form 8-K
On October 25, 2002, we filed a Form 8-K under Item 5.
46
(c)
2.1 Agreement and Plan of Merger and Reorganization, dated as of
May 4, 2001, among FalconStor, Inc., Network Peripherals Inc.
and Empire Acquisition Corp, incorporated herein by reference
to Annex A to the Registrant's joint proxy/prospectus on Form
S-4, filed May 11, 2001.
3.1 Restated Certificate of Incorporation, incorporated herein by
reference to Exhibit 3.1 to the Registrant's registration
statement on Form S-1 (File no. 33-79350), filed on April 28,
1994.
3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the
Registrant's quarterly report on form 10-Q for the period
ended March 31, 2000, filed on May 10, 2000.
3.3 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.3 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 1998, filed on March 22, 1999.
3.4 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.4 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 2001, filed on March 27, 2002.
4.1 *2000 Stock Option Plan, as amended May 17, 2002.
4.2 *1994 Outside Directors Stock Plan, as amended May 17, 2002.
10.1 Agreement of Lease between Reckson Operating Partnership, L.P.
and FalconStor.net, Inc. dated July, 2000, incorporated herein
by reference to Exhibit 10.1 to the Registrant's annual report
on Form 10-K for the year ended December 31, 2001, filed on
March 27, 2002.
10.2 First Lease Modification and Extension Agreement between
Reckson Operating Partnership, L.P. and FalconStor, Inc. dated
May 25, 2001, incorporated herein by reference to Exhibit 10.2
to the Registrant's annual report on Form 10-K for the year
ended December 31, 2001, filed on March 27, 2002.
10.3 ReiJane Huai Employment Agreement, dated September 1, 2001
between Registrant and ReiJane Huai, incorporated herein by
reference to Exhibit 10.3 to the Registrant's annual report on
Form 10-K for the year ended December 31, 2001, filed on March
27, 2002.
10.4 Change of Control Agreement dated December 10, 2001 between
the Registrant and ReiJane Huai, incorporated herein by
reference to Exhibit 10.4 to the Registrant's annual report on
Form 10-K for the year ended December 31, 2001, filed on March
27, 2002.
10.5 Change of Control Agreement dated December 7, 2001 between the
Registrant and Wayne Lam, incorporated herein by reference to
Exhibit 10.5 to the Registrant's annual report on Form 10-K
for the year ended December 31, 2001, filed on March 27, 2002.
10.6 Change of Control Agreement dated December 10, 2001 between
the Registrant and Jacob Ferng, incorporated herein by
reference to Exhibit 10.6 to the Registrant's annual report on
Form 10-K for the year ended December 31, 2001, filed on March
27, 2002.
21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC,
Inc.
23.1 *Consent of KPMG LLP.
99.1 *Certification of the Chief Executive Officer
99.2 *Certification of the Chief Financial Officer
*- filed herewith.
47
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has signed this report by the undersigned,
thereunto duly authorized in Melville, State of New York on March 14, 2003.
FALCONSTOR SOFTWARE, INC.
By: /s/ ReiJane Huai Date: March 14, 2003
-----------------------------------------
ReiJane Huai, President, Chief Executive
Officer of FalconStor Software, Inc.
POWER OF ATTORNEY
FalconStor Software, Inc. and each of the undersigned do hereby appoint
ReiJane Huai and Jacob Ferng, and each of them severally, its or his true and
lawful attorney to execute on behalf of FalconStor Software, Inc. and the
undersigned any and all amendments to this Annual Report on Form 10-K and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission; each of such attorneys
shall have the power to act hereunder with or without the other.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
By: /s/ ReiJane Huai March 14, 2003
----------------------------------------------------- --------------
ReiJane Huai, President, Chief Executive Officer and Date
Chairman of the Board
(Principal Executive Officer)
By: /s/ Jacob Ferng March 14, 2003
----------------------------------------------------- ---------------
Jacob Ferng, Chief Financial Officer, Vice President Date
and Secretary
(Principal Accounting Officer)
By: /s/ Lawrence S. Dolin March 14, 2003
----------------------------------------------------- ---------------
Lawrence S. Dolin, Director Date
By: /s/ Steven R. Fischer March 14, 2003
----------------------------------------------------- ---------------
Steven R. Fischer, Director Date
By: /s/ Steven H. Owings March 14, 2003
----------------------------------------------------- ---------------
Steven H. Owings, Director Date
48
Certifications
I, ReiJane Huai, certify that:
1. I have reviewed this annual report on form 10-K of FalconStor
Software, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this annual report (the "Evaluation Date");
and
c) presented in this annual report our conclusion about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which would adversely affect the registrants
ability to record, process, summarize and report financial
data and have identified for the registrant's auditors any
material weakness in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether or not there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: March 14, 2003 /s/ ReiJane Huai
-------------------------
ReiJane Huai
Chief Executive Officer
I, Jacob Ferng, certify that:
1. I have reviewed this annual report on Form 10-K of FalconStor
Software, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this annual report (the "Evaluation Date");
and
c) presented in this annual report our conclusion about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which would adversely affect the registrants
ability to record, process, summarize and report financial
data and have identified for the registrant's auditors any
material weakness in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether or not there were significant changes in
internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
/s/ Jacob Ferng
Date: March 14, 2003 -------------------------
Jacob Ferng
Chief Financial Officer
