FALCONSTOR SOFTWARE INC - Quarter Report: 2003 September (Form 10-Q)

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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

For the quarterly period ended September 30, 2003
--------------------------------------------

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

For the transition period from _______________ to ________________________

Commission File Number 0-23970

FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer Identification No.)

125 Baylis Road
Melville, New York 11747
(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code: 631-777-5188

Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes /X/ No / /

Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act). Yes /X/ No / /

The number of shares of Common Stock issued and outstanding as of November 4,
2003 was 46,314,393, which includes redeemable common shares.

-1-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

Page

PART I. Financial Information 3

Item 1. Consolidated Financial Statements 3

Consolidated Balance Sheets at September 30, 2003
(unaudited) and December 31, 2002 3

Unaudited Consolidated Statements of Operations for the
three and nine months ended September 30, 2003 and 2002 4

Unaudited Consolidated Statements of Cash Flows for the nine
months ended September 30, 2003 and 2002 5

Notes to the Unaudited Condensed Consolidated
Financial Statements 6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 14

Item 3. Qualitative and Quantitative Disclosures about Market Risk 26

Item 4. Controls and Procedures 26

PART II. Other Information 27

Item 2. Changes in Securities and Use of Proceeds 27

Item 6. Exhibits and Reports on Form 8-K 27

-2-

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

September 30, 2003 December 31, 2002
------------------ -----------------
Assets (unaudited)
Current assets:
Cash and cash equivalents ................................................ $ 10,129,645 $ 14,191,075
Marketable securities .................................................... 29,973,451 36,910,448
Accounts receivable, net
of allowances of $1,284,067 and
$813,645, respectively.................................................. 5,379,276 4,285,892
Prepaid expenses and other current assets ................................ 1,374,743 1,167,174
------------ ------------

Total current assets ............................................ 46,857,115 56,554,589

Property and equipment, net ................................................. 3,203,477 2,068,001
Goodwill .................................................................... 3,315,315 3,301,599
Other intangible assets, net ................................................ 365,732 309,491
Other assets ................................................................ 3,472,734 2,476,306
------------ ------------

Total assets .................................................... $ 57,214,373 $ 64,709,986
============ ============

Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 637,359 $ 437,088
Accrued expenses ......................................................... 2,305,705 1,987,651
Deferred revenue ......................................................... 2,035,875 2,182,729
Liabilities of discontinued operations ................................... -- 4,201,465
------------ ------------

Total current liabilities ....................................... 4,978,939 8,808,933
------------ ------------

Commitments

Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
46,455,672 and 45,527,590 shares issued, respectively.................. 46,456 45,528
Additional paid-in capital ............................................... 82,819,903 81,423,661
Deferred compensation .................................................... (123,838) (471,445)
Accumulated deficit ...................................................... (28,906,610) (23,694,634)
Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,435,130)
Accumulated other comprehensive (loss) gain .............................. (165,347) 33,073
------------ ------------

Total stockholders' equity ...................................... 52,235,434 55,901,053
------------ ------------

Total liabilities and stockholders' equity ...................... $ 57,214,373 $ 64,709,986
============ ============

See accompanying notes to unaudited consolidated financial statements.

-3-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ----------------------------
2003 2002 2003 2002
----------- ------------ ------------- ------------

Revenues:
Software license revenue ..................................... $ 2,878,448 $ 2,311,811 $ 8,589,186 $ 6,045,034
Software services and other revenue .......................... 1,204,169 543,711 3,263,215 1,167,948
------------ ------------ ------------ ------------
4,082,617 2,855,522 11,852,401 7,212,982

Operating expenses:
Amortization of purchased and capitalized
software................................................. 358,798 230,659 981,337 648,921
Cost of software services and other revenue ............... 620,359 302,351 1,804,015 900,260
Software development costs ................................ 1,821,442 1,604,412 5,105,196 4,719,102
Selling and marketing ..................................... 2,706,326 2,473,844 7,893,247 7,329,336
General and administrative ................................ 736,774 644,094 2,127,593 1,899,118
Impairment of prepaid royalty ............................. -- 482,715 -- 482,715
------------ ------------ ------------ ------------
6,243,699 5,738,075 17,911,388 15,979,452
------------ ------------ ------------ ------------
Operating loss .................................... (2,161,082) (2,882,553) (6,058,987) (8,766,470)
------------ ------------ ------------ ------------

Interest and other income .................................... 270,075 405,033 867,914 1,242,894
Impairment of long-lived assets .............................. -- (1,084,935) -- (1,084,935)
------------ ------------ ------------ ------------

Loss before income taxes ............................ (1,891,007) (3,562,455) (5,191,073) (8,608,511)

Provision for income taxes ................................... 3,191 -- 20,903 --
------------ ------------ ------------ ------------

Net loss ............................................ $ (1,894,198) $ (3,562,455) $ (5,211,976) $ (8,608,511)
------------ ------------ ------------ ------------

Basic and diluted net loss per share ......................... $ (0.04) $ (0.08) $ (0.11) $ (0.19)
============ ============ ============ ============

Weighted average basic and diluted shares
outstanding ............................................... 46,134,816 45,239,977 45,830,216 45,221,168
============ ============ ============ ============

See accompanying notes to unaudited consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended
September 30,
2003 2002
------------- -------------
Cash flows from operating activities:
Net loss ........................................................ $ (5,211,976) $ (8,608,511)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ............................. 2,059,840 1,235,048
Non-cash professional services expenses ................... 47,315 30,278
Equity-based compensation expense ......................... 347,607 575,173
Impairment of long-lived and other assets ................. -- 1,567,650
Changes in operating assets and liabilities, net of effects of
acquisitions:
Accounts receivable, net .................................. (1,093,384) (880,593)
Prepaid expenses and other current assets ................. (207,569) (431,579)
Other assets .............................................. (145,412) (5,179)
Accounts payable .......................................... 200,271 (324,094)
Accrued expenses .......................................... 341,468 101,179
Deferred revenue .......................................... (146,854) 653,014
------------ ------------

Net cash used in operating activities .................. (3,808,694) (6,087,614)
------------ ------------

Cash flows from investing activities:
Sale of marketable securities ................................... 14,850,965 16,898,656
Purchase of marketable securities ............................... (8,113,555) (17,267,619)
Purchase of investment .......................................... (137,710) (75,000)
Purchase of property and equipment .............................. (2,128,364) (935,241)
Purchase of software licenses ................................... (1,171,000) (600,000)
Purchase of intangible assets ................................... (165,499) (93,401)
Security deposit ................................................ (500,000) --
Net cash paid for acquisition of IP Metrics ..................... (287,130) (2,365,374)
------------ ------------

Net cash provided by (used in) investing activities .......... 2,347,707 (4,437,979)
------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options ......................... 433,010 1,099,139
Payments to acquire treasury stock .............................. -- (214,400)
------------ ------------

Net cash provided by financing activities .................... 433,010 884,739
------------ ------------

Cash flows from discontinued operations:
Payments of liabilities of discontinued operations .............. (3,034,620) (1,964,172)
------------ ------------

Effect of exchange rate changes on cash ............................ 1,167 9,811
------------ ------------

Net decrease in cash and cash equivalents .......................... (4,061,430) (11,595,215)
Cash and cash equivalents, beginning of period ..................... 14,191,075 38,370,937
------------ ------------
Cash and cash equivalents, end of period ........................... $ 10,129,645 $ 26,775,722
============ ============

The Company did not pay any interest expense or income taxes for the nine months
ended September 30, 2003 and 2002.

See accompanying notes to unaudited consolidated financial statements.

-5-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) THE COMPANY AND NATURE OF OPERATIONS

FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops,
manufactures and sells network storage 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.

The unaudited interim consolidated financial statements of the Company as of
and for the three and nine months ended September 30, 2003 and 2002, included
herein have been prepared, without audit, pursuant to the rules and regulations
of the Securities and Exchange Commission ("SEC"). Certain information and note
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to such rules and regulations relating
to interim financial statements.

In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at September 30, 2003 and the results of its operations for the
three months and nine months ended September 30, 2003 and 2002.

(d) CASH EQUIVALENTS AND MARKETABLE SECURITIES

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$9.0 million at September 30, 2003. Marketable securities at September 30, 2003
amounted to approximately $30.0 million and consisted of corporate bonds and
government securities, which are classified as available for sale, and
accordingly, unrealized gains and losses on marketable securities are reflected
as a component of accumulated other comprehensive (loss) gain in stockholders'
equity.

(e) REVENUE RECOGNITION

The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, and the software is
delivered and collection of the resulting receivable is deemed probable.
Software delivered to a customer on a trial basis is not recognized as revenue
until a permanent key 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. 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 to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company

-6-

from an OEM 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.

For the nine months ended September 30, 2003, the Company had a limited
number of transactions in which it purchased hardware and bundled this hardware
with the Company's software and sold the bundled solution to its customer. Since
the software is not essential for the functionality of the equipment included in
the Company's bundled solutions, and both the hardware and software have stand
alone value to the customer, a portion of the contractual fees is recognized as
revenue when the software or hardware is delivered based on the relative fair
value of the delivered element(s).

(f) PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years).

(g) GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and identifiable intangible assets acquired in business
combinations. Consistent with Statement of Financial Accounting Standards
("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not
amortized goodwill related to its acquisitions, but has instead tested the
balance for impairment. Identifiable intangible assets are amortized over a
three-year period using the straight-line method. Amortization expense was
$42,643 and $4,473 for the three months ended September 30, 2003 and 2002,
respectively, and $109,258 and $6,429 for the nine months ended September 30,
2003 and 2002, respectively. The gross carrying amount and accumulated
amortization of other intangible assets as of September 30, 2003 and December
31, 2002 are as follows:

September 30, December 31,
2003 2002
------------- ------------
Customer relationships and purchased technology:

Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (90,354) (36,142)
--------- ---------

Net carrying amount $ 126,496 $ 180,708
========= =========

Patents and trademarks:

Gross carrying amount $ 311,033 $ 145,534
Accumulated amortization (71,797) (16,751)
--------- ---------

Net carrying amount $ 239,236 $ 128,783
========= =========

(h) 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 at
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $7,881 was amortized for the
three months ended September 30, 2003 and 2002, and $23,643 was amortized for
the nine months ended September 30, 2003 and 2002. Amortization of software
development costs is recorded at the greater of straight line over three years
or the ratio of current revenue of the related products to total current and
anticipated future revenue of these products.

Purchased software technology of $2,136,917 and $1,923,611, net of
accumulated amortization of $2,074,083 and $1,116,389, is included in other
assets in the balance sheets as of September 30, 2003 and December 31, 2002,

-7-

respectively. Amortization expense was $350,917 and $222,778 for the three
months ended September 30, 2003 and 2002, respectively, and $957,694 and
$625,279 for the nine months ended September 30, 2003 and 2002, respectively.

(i) INCOME TAXES

Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.

(j) LONG-LIVED ASSETS

The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. If the sum of the expected future cash flows, undiscounted and
without interest, is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.

(k) 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 Financial
Accounting Standards Board ("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:

Three months ended, Nine months ended
------------------- -----------------
September 30 September 30
------------ ---------------
2003 2002 2003 2002
---- ---- ---- ----
Net loss as reported $ (1,894,198) $ (3,562,455) $ (5,211,976) $ (8,608,511)

Add stock-based employee compensation expense 115,861 115,868 347,607 575,173
included in reported net income, net of tax

Deduct total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of tax (1,736,751) (1,253,836) (4,742,578) (3,384,788)
------------ ------------ ------------ ------------
Net loss - pro forma $ (3,515,088) $ (4,700,423) $ (9,606,947) $(11,418,126)
============ ============ ============ ============
Basic net loss per common share-as reported $ (.04) $ (.08) $ (.11) $ (.19)
Basic net loss per common share-pro forma $ (.08) $ (.10) $ (.21) $ (.25)

The per share weighted average fair value of stock options granted was
$4.59 for the three months ended September 30, 2003 and $3.11 and $2.17 for the
nine months ended September 30, 2003 and 2002, respectively, on the date of
grant using the Black-Scholes option pricing method with the following weighted
average assumptions: 2003--expected dividend yield of 0%, risk free interest

-8-

rate of 3%, expected stock volatility of 68% 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; 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.

(l) FINANCIAL INSTRUMENTS

As of September 30, 2003 and December 31, 2002, 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.

(m) FOREIGN CURRENCY

Assets and liabilities of foreign operations are translated from the
functional currency to the U.S. dollar 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 component of accumulated
other comprehensive (loss) gain in 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 September 30,
2003, potentially dilutive common stock equivalents included 8,710,867 stock
options and 750,000 warrants outstanding.

(o) COMPREHENSIVE LOSS

Comprehensive loss amounted to $2,026,200 and $3,429,401 for the three
months ended September 30, 2003 and 2002, respectively, and $5,410,396 and
$8,449,509 for the nine months ended September 30, 2003 and 2002, respectively.
Comprehensive loss includes the Company's net loss, foreign currency translation
adjustments of $55,969 and $(16,359) for the three months ended September 30,
2003 and 2002, respectively, and $1,167 and $9,811 for the nine months ended
September 30, 2003 and 2002, respectively. Additionally, comprehensive loss
includes the Company's unrealized gains/(losses) on marketable securities of
$(183,571) and $149,413 for the three months ended September 30, 2003 and 2002,
respectively, and $(199,587) and $149,191 for the nine months ended September
30, 2003 and 2002, respectively.

(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 November 2002, the Emerging Issue Task Force ("EITF") reached a
consensus on EITF Issue No. 00-21, ACCOUNTING FOR REVENUE ARRANGEMENTS WITH
MULTIPLE DELIVERABLES. The Issue addresses the accounting for arrangements that
may involve the delivery or performance of multiple revenue-generating
activities and how to determine whether such an arrangement involving multiple
deliverables contains more than one unit of accounting for purposes of revenue
recognition. The guidance in this issue is effective for revenue arrangements
entered into in quarters beginning after June 15, 2003. Accordingly, the Company
adopted EITF Issue No. 00-21 effective July 1, 2003. The adoption of EITF Issue
No. 00-21 did not have a material impact on our results of operations, financial
position or cash flows.

In December 2002, the FASB issued SFAS No. 148, ACCOUNTING FOR
STOCK-BASED COMPENSATION--TRANSITION AND DISCLOSURE. 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

-9-

accounting for stock-based employee compensation ("transition provisions"). In
addition, SFAS No. 148 amends the disclosure requirements of 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. The FASB recently indicated that they
will require stock-based employee compensation to be recorded as a charge to
earnings beginning in 2004. The Company will continue to monitor the progress of
the FASB on the issuance of this standard as well as evaluate its position with
respect to current guidance.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity. SFAS
No. 150 establishes standards for how a company classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify certain financial instruments as a liability
(or as an asset in some circumstances). SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. The adoption of SFAS No. 150 did not have an impact on the Company's
consolidated financial statements.

In July 2003, the EITF reached a consensus on Issue 03-5, Applicability
of AICPA SOP 97-2 to Non-Software Deliverables. The consensus was reached that
SOP 97-2 is applicable to non-software deliverables if they are included in an
arrangement that contains software that is essential to the non-software
deliverables' functionality. This consensus is to be applied to fiscal periods
beginning after August 13, 2003, and is not expected to have a material impact
on the Company's consolidated financial statements.

(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. As of September 30, 2003, the Company made contingent
acquisition payments totaling $287,130 related to the sale of IP Metrics'
products and services and accrued an additional $16,527 of incurred but unpaid
contingent consideration.

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 $216,850. 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 $3,127,590 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
tangible assets acquired and liabilities assumed by the Company amounted to
$187,725 and has been recorded as goodwill.

The following unaudited pro forma consolidated financial information
gives effect to the above described acquisitions of IP Metrics and FarmStor, as
if they had occurred at the beginning of the period by consolidating the
continuing results of operations of the Company, IP Metrics and FarmStor for the
three and nine months ended September 30, 2002.

-10-

Three months Nine months
Ended Ended
September 30, 2002 September 30, 2002
------------------ ------------------

Revenues $ 2,855,522 $ 7,673,660
Net loss from continuing operations (3,571,171) (9,008,643)

Basic and diluted net loss from continuing operations per share $ (0.08) $ (0.20)

Weighted average basic and diluted shares outstanding 45,239,977 45,221,168

The pro forma information is provided for illustrative purposes only and
does not represent what the actual consolidated results of operations would have
been had the acquisitions occurred on the date assumed, nor is it necessarily
indicative of future results of operations.

(3) SEGMENT REPORTING

The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the three and nine
months ended September 30, 2003 and September 30, 2002 and the location of
long-lived assets as of September 30, 2003 and December 31, 2002 are summarized
as follows:

Three months ended Nine months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----

United States $ 2,397,445 $ 1,673,411 $ 6,878,237 $ 4,166,703
Asia and other international 1,685,172 1,182,111 4,974,164 3,046,279
----------- ----------- ----------- -----------

Total revenues $ 4,082,617 $ 2,855,522 $11,852,401 $ 7,212,982
=========== =========== =========== ===========

September 30, December 31,
2003 2002
---------- ----------

Long-lived assets (includes all non-current assets):

United States $ 9,520,696 $ 7,655,900
Asia and other international 836,562 499,497
----------- -----------

Total long-lived assets $10,357,258 $ 8,155,397
=========== ===========

-11-

(4) STOCK REPURCHASE PROGRAM

On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases 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 September 30, 2003, the Company
repurchased a total of 235,000 shares for $1,435,130. The Company did not
repurchase any shares during the nine months ended September 30, 2003.

(5) COMMITMENTS

The Company has entered into an operating lease effective November 1,
2003 covering its new primary office facility that expires in February, 2012.
The Company also has several operating leases related to domestic offices and
offices in foreign countries. The expiration dates for these leases range from
2003 through 2007. The following is a schedule of future minimum lease payments
for these operating leases (which includes the operating lease effective
November 1, 2003) as of September 30, 2003:

2003 (remaining 3 months)........ $ 188,022
2004............................. 778,068
2005............................. 1,080,696
2006............................. 1,375,952
2007............................. 1,238,841
2008............................. 1,121,064
Thereafter....................... 3,778,261
-----------
$ 9,560,904
===========

(6) EQUITY

In September, 2003, the Company entered into a worldwide OEM agreement
with a major technology company (the "OEM"), and issued warrants to the OEM to
purchase Company common stock. The Company issued to the OEM warrants to
purchase 750,000 shares of the Company's common stock with an exercise price of
$6.18 per share. A portion of the warrants will vest annually subject to the
OEM's achievement of pre-defined and mutually agreed upon sales objectives over
a three-year period. If the OEM generates cumulative revenues to the Company in
the mid-eight figure dollar range from reselling the Company's products then all
the warrants granted will vest. Any warrants that do not vest by the end of the
three-year period will expire. If and when it is probable the warrants will
vest, the then fair value of the warrants earned will be recorded as a reduction
of revenue. Subsequently, each quarter the Company will apply variable
accounting to adjust such amount to reflect the fair value of the warrants until
they vest. The Company expects to begin deriving revenues from sales by the OEM
in 2004.

On May 15, 2003, the Company's stockholders approved an amendment to the
Company's 2000 Stock Option Plan to increase the number of shares of common
stock reserved for issuance thereunder by 2,000,000 from 10,662,296 to
12,662,296.

(7) 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
nonrefundable 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 to a value which

-12-

was significantly below the Company's cost, the Company concluded the decline in
the fair value of its investment in NSSI's preferred stock was other than
temporary. Accordingly, in September 2002 the Company recorded an impairment
charge of $1,084,935 to write down its investment in NSSI to fair value. In
addition, due to the lack of market acceptance of the NSSI product in its then
current state, the unrecouped prepaid royalty was not recoverable and in 2002
the Company recorded an impairment charge of $482,715 to write off this prepaid
royalty.

(8) LIABILITIES OF DISCONTINUED OPERATIONS

On February 14, 2003, the Company settled a claim associated with the
liabilities of discontinued operations for a payment of $2,850,000. As of
September 30, 2003 all significant contingent liabilities related to the
discontinued operations of NPI have been resolved and paid. As a result, the
excess of the remaining liabilities for discontinued operations over the amounts
paid of $916,844 has been reflected as an increase to additional paid-in-capital
in the accompanying balance sheet as of September 30, 2003 since this liability
was related to the merger with NPI, which was accounted for as a
recapitalization.

-13-

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

THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.

OVERVIEW

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 IPStor(R)
software 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. Hundreds
of 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).

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 accompanying unaudited consolidated financial statements.

Our main critical accounting policies are those related to revenue
recognition. As described in note 1 to our unaudited 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 payments 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.

We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for the
uncollectible accounts, we consider specific past due accounts, analysis of our
accounts receivable aging, customer payment terms, historical collections and
write-offs, changes in customer demand and relationships, concentrations of
credit risk and customer credit worthiness. Historically, we have experienced a
low level of write-offs given our customer relationships, contract provisions
and credit assessments. Changes in the credit worthiness of customers, general
economic conditions and other factors may impact the level of future write-offs
and our general and administrative expenses.

-14-

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 2002.

REVENUES

Overall, revenues increased 43% from $2.9 million for the three months
ended September 30, 2002 to $4.1 million for the three months ended September
30, 2003.

SOFTWARE LICENSE REVENUE

Software license revenue is comprised of software licenses sold through
our OEMs, value-added resellers and distributors to end-users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order and the software and
permanent key codes are delivered to the customer. We also receive nonrefundable
advances and engineering fees from some of our OEM partners. These arrangements
are evidenced by a signed customer contract, and the revenue is recognized when
the software product master is delivered and accepted, and the engineering
services, if any, have been performed.

Software license revenue increased 25% from $2.3 million for the three
months ended September 30, 2002 to $2.9 million for the three months ended
September 30, 2003. 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 OEM and 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. Revenue from engineering services is
primarily related to customizing software product masters for some of our OEM
partners. Revenue from engineering services is recognized in the period the
services are completed. For the three months ended September 30, 2003, 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 and software were delivered
to the customer. Software services and other revenue increased 121% to $1.2
million for the three months ended September 30, 2003 compared to $0.5 million
for the three months ended September 30, 2002. One reason for the increase in
software services and other revenue was an increase in the number of our
maintenance and technical support contracts. This increase in maintenance and
support contracts was directly related to the increase in our software license
customers that have elected to purchase maintenance. Maintenance revenue
increased from $0.4 million for the three months ended September 30, 2002, to
$0.6 million for the three months ended September 30, 2003. The Company also had
hardware sales of approximately $0.3 million for the three months ended
September 30, 2003 that contributed to the increase in software services and
other revenue. For the three months ended September 30, 2002, we had minimal
sales of hardware. Additionally, for the three months ended September 30, 2003,
our revenues from professional services increased to $0.3 million compared to
$0.1 million for the three months ended September 30, 2002. This increase in
professional services revenue was related to the increase in our software
license customers that elected to purchase related professional services.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

Amortization of purchased and capitalized software increased from $0.2
million for the three months ended September 30, 2002 to $0.4 million for the
three months ended September 30, 2003. The Company did not capitalize any
software development costs until our initial product reached technological
feasibility in March 2001. At that point, we capitalized $0.1 million of
software development costs, which are being amortized 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. Amortization of
capitalized software was $7,881 for both the three months ended September 30,
2003 and 2002. As of September 30, 2003, we had $4.2 million of purchased
software licenses that are being amortized over three years. For the three
months ended September 30, 2003, we recorded $350,917 of amortization related to

-15-

these purchased software licenses. As of September 30, 2002, we had $2.8 million
of purchased software licenses and recorded $222,778 of amortization for the
three months ended September 30, 2002 related to these purchased software
licenses.

COST OF SOFTWARE SERVICES AND OTHER REVENUE

Cost of software services and other revenue consists primarily of
personnel and other costs associated with providing software implementations,
technical support under maintenance contracts, and training. Cost of software
services and other revenues also includes the cost of hardware purchased for
resale. Cost of software services and other revenues for the three months ended
September 30, 2003 increased by 105% to $620,359 compared to $302,351 for the
three months ended September 30, 2002. The increase in cost of software services
and other revenue was primarily related to $0.2 million of hardware costs
associated with hardware revenue. For the three months ended September 30, 2002,
we had minimal sales of hardware. The increase was also due to an increase in
personnel. As a result of our increase in revenues, we required a higher number
of employees to provide technical support under our maintenance contracts and
help to deploy our software.

Gross profit for the three months ended September 30, 2003 was $3.1
million or 76% of revenues compared to $2.3 million or 81% of revenues for the
three months ended September 30, 2002. The increase in gross profit was directly
related to the increase in revenues. The decrease in gross margins was due to
the increase in amortization of purchased software licenses and also partially
related to lower margins on hardware sales.

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 14% to $1.8 million
for the three months ended September 30, 2003 compared to $1.6 million for the
three months ended September 30, 2002. The increase in software development
costs was due to an increase in development personnel and an increase in
depreciation related to additional computer hardware. This increase in personnel
and hardware was required to enhance and test our software, as well as to
develop new innovative features and options.

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 9% to $2.7 million for the three months ended September 30, 2003 from
$2.5 million for the three months ended September 30, 2002. This increase in
selling and marketing expenses was partially due to increased salary expense as
we increased our headcount to support our revenue growth. Additionally, as a
result of the increase in revenues our commission expense also increased.

GENERAL AND ADMINISTRATIVE

General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related costs,
directors and officers insurance, legal and professional fees, and other general
corporate overhead costs. General and administrative expenses increased 14% to
$736,774 for the three months ended September 30, 2003 from $644,094 for the
three months ended September 30, 2002. The primary reason for the increase in
general and administrative expense was due to higher premiums for our directors
and officers insurance.

INTEREST AND OTHER INCOME

Interest and other income decreased 33% to $0.3 million for the three
months ended September 30, 2003 from $0.4 million for the three months ended
September 30, 2002. This decrease in interest income was due to lower interest
rates and lower average cash and cash equivalent balances.

-16-

IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

In September 2002, we recorded an impairment charge to write-down our
investment in Network-1 Security Solutions, Inc. ("NSSI") to its then fair
value. In addition, due to the lack of market acceptance of the NSSI product, we
also wrote off our non-refundable prepaid royalty, which was recoupable against
future sales of NSSI's product. As a result, we recorded a $1.6 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.

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 September
30, 2003, 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. Our income tax provision consists of tax liabilities
related to our foreign subsidiaries.

RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO
THE NINE MONTHS ENDED SEPTEMBER 30, 2002.

REVENUES

Overall, revenues increased 64% from $7.2 million for the nine months
ended September 30, 2002 to $11.9 million for the nine months ended September
30, 2003.

SOFTWARE LICENSE REVENUE

Software license revenue increased 42% from $6.0 million for the nine
months ended September 30, 2002 to $8.6 million for the nine months ended
September 30, 2003. 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 OEM and channel partners.

SOFTWARE SERVICES AND OTHER REVENUE

Software services and other revenue increased 179% to $3.3 million for
the nine months ended September 30, 2003 compared to $1.2 million for the nine
months ended September 30, 2002. This increase resulted in part from an increase
in the number of maintenance and technical support contracts which was directly
related to the increase in our software license customers that elected to
purchase maintenance. Maintenance revenue increased from $1.0 million for the
nine months ended September 30, 2002, to $1.7 million for the nine months ended
September 30, 2003. Another reason for the increase in software services and
other revenue was the sale of approximately $1.0 million of hardware in the nine
months ended September 30, 2003. For the nine months ended September 30, 2002,
we had minimal sales of hardware. Additionally, for the nine months ended
September 30, 2003, our revenues from professional services increased to $0.6
million compared to $0.2 million for the nine months ended September 30, 2002.
This increase in professional services revenue was related to the increase in
our software license customers that elected to purchase related professional
services.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

Amortization of purchased and capitalized software increased from $0.6
million for the nine months ended September 30, 2002 to $1.0 million for the
nine months ended September 30, 2003. Amortization of capitalized software was
$23,643 for both the nine months ended September 30, 2003 and 2002,
respectively. Amortization of purchased software was $957,694 and $625,278 for
the nine months ended September 30, 2003 and 2002, respectively. The increase in
amortization of purchased software was due to an increase in the number of
purchased software licenses.

COST OF SOFTWARE SERVICES AND OTHER REVENUE

Cost of software services and other revenues for the nine months ended
September 30, 2003 increased 100% to $1,804,015 compared to $900,260 for the
nine months ended September 30, 2002. The increase in cost of software services
and other revenues is primarily related to $0.7 million of hardware costs
associated with hardware revenue. For the nine months ended September 30, 2002,

-17-

we had minimal sales of hardware. The increase is also due to an increase in
personnel. As a result of our increase in revenues, we required a higher number
of employees to provide technical support under our maintenance contracts and to
help deploy our software.

Gross profit for the nine months ended September 30, 2003 was $9.1
million or 76% of revenues compared to $5.7 million or 79% of revenues for the
nine months ended September 30, 2002. The increase in gross profit was directly
related to the increase in revenues. The decrease in gross margins was due to
the increase in amortization of purchased software licenses and partially
related to lower margins on hardware sales.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 8% to $5.1 million for the nine
months ended September 30, 2003 compared to $4.7 million for the nine months
ended September 30, 2002. The increase in software development costs was due to
an increase in development personnel and an increase in depreciation related to
additional computer hardware. This increase in personnel and hardware was
required to enhance and test our software, as well as to develop new innovative
features and options.

SELLING AND MARKETING

Selling and marketing expenses increased 8% to $7.9 million for the
nine months ended September 30, 2003 from $7.3 million for the nine months ended
September 30, 2002. This increase in selling and marketing expenses was
partially due to increased salary expense as we increased our headcount to
support our revenue growth. Additionally, as a result of the increase in
revenues, our commission expense also increased.

GENERAL AND ADMINISTRATIVE

General and administrative expenses increased 12% to $2.1 million for the nine
months ended September 30, 2003 from $1.9 million for the nine months ended
September 30, 2002. The increase in general and administrative expenses was
primarily due to significantly higher premiums for our directors and officers
insurance for 2002-2003 compared to 2001-2002.

INTEREST AND OTHER INCOME

Interest and other income decreased 30% to $0.9 million for the nine
months ended September 30, 2003 from $1.2 million for the nine months ended
September 30, 2002. This decrease in interest income was due to lower interest
rates and lower average cash and cash equivalent balances.

IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

In September 2002, we recorded an impairment charge to write-down our
investment in NSSI to its then fair value. In addition, due to the lack of
market acceptance of the NSSI product, we also wrote off our non-refundable
prepaid royalty, which was recoupable against future sales of NSSI's product. As
a result, we recorded a $1.6 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.

INCOME TAXES

-18-

LIQUIDITY AND CAPITAL RESOURCES

Our cash and cash equivalents totaled $10.1 million and marketable
securities were $30.0 million at September 30, 2003. As of September 30, 2002,
we had approximately $26.8 million in cash and cash equivalents and $26.7
million in marketable securities. Net cash used in operating activities was $3.8
million for the nine months ended September 30, 2003. This was primarily a
result of our net loss of $5.2 million, and increases in accounts receivable,
prepaid and other current assets and other assets, and a decrease in deferred
revenue. These amounts were partially offset by non-cash charges of $2.5 million
consisting of depreciation and amortization, non-cash professional services
expenses, and equity-based compensation. Additional offsetting amounts include
increases in accounts payable and accrued expenses. Net cash used in operating
activities for the nine months ended September 30, 2002 was $6.1 million. The
cash used in operating activities for the nine months ended September 30, 2002
was mainly comprised of the Company's net loss of $8.6 million, and an increase
in accounts receivables, prepaid expenses and other current assets and a
decrease in accounts payable. These amounts were partially offset by non-cash
expenses of $3.4 million, and an increase in deferred revenue of $0.7 million.

Net cash provided by investing activities was $2.3 million for the nine
months ended September 30, 2003, due primarily to net sales of marketable
securities of $6.7 million. This amount was offset by purchases of property and
equipment of $2.1 million, purchases of software licenses of $1.2 million,
purchases of intangible assets and investments of $0.2 million, a security
deposit related to our new office space of $0.5 million and cash paid for
acquisition of IP Metrics of $0.3 million. Net cash used in investing activities
was $4.4 million for the nine months ended September 30, 2002, primarily due to
$2.4 million paid in connection with the acquisition of IP Metrics, $0.4 million
in net purchases of marketable securities, $0.9 million in purchases of property
and equipment, and $0.6 million in purchases of software licenses.

Net cash provided by financing activities was $0.4 million for the nine
months ended September 30, 2003. This amount was related to the proceeds
received from the exercise of stock options. Net cash provided by financing
activities was $0.9 million for the nine months ended September 30, 2002. This
amount was comprised of $1.1 million from proceeds related to the exercise of
stock options offset by payments to acquire treasury stock of $0.2 million.

For the nine months ended September 30, 2003 and 2002, we paid $3.0
million and $2.0 million, respectively, related to liabilities of discontinued
operations. See note 8 to the accompanying unaudited 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 September 30, 2003, at an aggregate purchase price of
$1.4 million. We did not repurchase any shares during the nine months ended
September 30, 2003.

In connection with our acquisition of IP Metrics in July 2002, we must
make cash payments to the former shareholders of IP Metrics, contingent on the
level of revenues from IP Metrics' products for a period of twenty-four months
subsequent to the acquisition. As of September 30, 2003, the Company had
incurred $0.3 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.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In November 2002, the EITF reached a consensus on EITF Issue No. 00-21,
Accounting for Revenue Arrangements with Multiple Deliverables. The Issue
addresses the accounting for arrangements that may involve the delivery or
performance of multiple revenue-generating activities and how to determine
whether such an arrangement involving multiple deliverables contains more than

-19-

one unit of accounting for purposes of revenue recognition. The guidance in this
issue is effective for revenue arrangements entered into in quarters beginning
after June 15, 2003. Accordingly, we adopted EITF Issue No. 00-21 effective July
1, 2003. The adoption of EITF Issue No. 00-21 did not have a material impact on
our results of operations, financial position or cash flows.

In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION--TRANSITION AND
DISCLOSURE. 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 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. We continue to use the intrinsic value method of
accounting for stock-based compensation. As a result, the transition provisions
do not have an effect on our consolidated financial statements. We have adopted
the disclosure requirements of SFAS No. 148. The FASB recently indicated that
they will require stock-based employee compensation to be recorded as a charge
to earnings beginning in 2004. We will continue to monitor the progress of the
FASB on the issuance of this standard as well as evaluate our position with
respect to current guidance.

In May 2003, the FASB issued SFAS No. 150, ACCOUNTING FOR CERTAIN
FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. SFAS
No. 150 establishes standards for how a company classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify certain financial instruments as a liability
(or as an asset in some circumstances). SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. The adoption of SFAS No. 150 did not have an impact on our consolidated
financial statements.

In July 2003, the EITF reached a consensus on Issue 03-5, APPLICABILITY
OF AICPA SOP 97-2 TO NON-SOFTWARE DELIVERABLES. The consensus was reached that
SOP 97-2 is applicable to non-software deliverables if they are included in an
arrangement that contains software that is essential to the non-software
deliverables' functionality. This consensus is to be applied to fiscal periods
beginning after August 13, 2003, and is not expected to have a material impact
on our consolidated financial statements.

RISK FACTORS

WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR
MAINTAIN PROFITABILITY.

We have had limited revenues and a history of losses. For the year ended
December 31, 2002 and the nine months ended September 30, 2003, we had revenues
of $10.6 million and $11.9 million, respectively. For the period from inception
(February 10, 2000) through September 30, 2003 and for the nine months ended
September 30, 2003, we had net losses of $28.9 million and $5.2 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, although we are unable to predict
whether we will be profitable. Our business model depends upon signing
agreements with additional OEM customers, further developing our reseller sales
channel, and expanding our 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.

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;

-20-

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.

WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.

During the third quarter of 2003, we signed a lease for new office
space that commences on November 1, 2003 and continues through February, 2012.
The new lease obligations are substantially greater than our prior lease
obligations. This commitment could impact our ability to achieve or to maintain
profitability. In addition, our current lease continues through 2007. While we
are actively attempting to sublease the office space we are vacating , there is
no guarantee that we will be able to find subtenants for the space or that any
subtenants will pay rent equal to our continuing obligations. If we are unable
to find subtenants or to receive rents equal to our obligations, it could impact
our ability to achieve or to maintain profitability.

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.

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.

CONTINUING REDUCED CAPITAL SPENDING COULD RESULT IN DECREASED REVENUES.

Capital spending on information technology has remained at low levels,
resulting in continued uncertainty in our revenue expectations. The operating
results of our business depend in part on the overall demand for network storage
infrastructure software. Because our sales are primarily to major corporate
customers, continued soft demand for network storage infrastructure software
caused by budgetary constraints may result in decreased revenues. Customers may
continue to defer or to reconsider purchasing our software, 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

-21-

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
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.

WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.

Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage infrastructure software market and in other markets. The OEM
customers and resellers may choose to focus their sales efforts on other
products in the network storage infrastructure software market or other markets.
This would likely result in lower revenues to us and would impede our ability to
grow our business.

ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.

As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.

-22-

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;

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 25.5 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 previously 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. As of September 30, 2003,
approximately 1,087,000 shares of the approximately 2.0 million shares have been
released from the lock-up restrictions pursuant to the phased released. As of
November 14, 2003 the Board agreed to release the remaining approximately
930,000 shares from the lock-up restriction effective immediately.

-23-

OUR STOCK PRICE MAY BE VOLATILE

The market price of our common stock has been volatile in the past and
may be volatile in the future. For example, during the past twelve months ended
September 30, 2003, the market price of our common stock as quoted on the NASDAQ
National Market System fluctuated between $3.43 and $7.50. 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.

WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.

As of September 30, 2003, we had outstanding options and warrants to
purchase an aggregate of 9,460,867 shares of our common stock at a weighted
average exercise price of $3.73 per share. We also have 2,850,071 shares
reserved for issuance under our stock option plans with respect to options that
have not been granted.

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.

-24-

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
fourteen 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 that action. 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.

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

-25-

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.

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 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities.

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.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report, and,
based on their evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. No changes in the Company's internal controls over financial
reporting occurred during the quarter ended September 30, 2003 that have
materially affected, or are reasonably likely to materially affect, the
Company's internal controls over financial reporting.

Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the Securities and Exchange Commission's
rules and forms. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by us in the reports that we file under the Exchange Act is
accumulated and communicated to our management, including our principal
executive officer and principal financial officer, as appropriate to allow
timely decisions regarding required disclosure.

-26-

PART II. OTHER INFORMATION

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

In September, 2003 we granted warrants to purchase 750,000 shares of
common stock at an exercise price of $6.18 per share in connection with a
world-wide OEM agreement with a major technology company. The warrants were
granted under the exemption provided by Section 4(2) of the Securities Act of
1933, as amended. For further information related to the foregoing, please see
Note 6 of Notes to Unaudited Consolidated Financial Statements.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

31.1 Rule 15d-14(a) Certification of Chief Executive Officer

31.2 Rule 15d-14(a) Certification of Chief Financial Officer

32.1 Section 1350 Certification of Chief Executive Officer

32.2 Section 1350 Certification of Chief Financial Officer

99.1 Agreement of Lease

(b) Reports on Form 8-K

On July 24, 2003, we filed a Form 8-K under Item 9.

-27-

SIGNATURES

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

FALCONSTOR SOFTWARE, INC.

/s/ Jacob Ferng
---------------
Jacob Ferng
Chief Financial Officer and Vice President
(Principal Accounting Officer)

November 14, 2003

-28-