FALCONSTOR SOFTWARE INC - Annual Report: 2004 (Form 10-K)

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, 2004.

/ / 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.)

2 Huntington Quadrangle, Suite 2S01 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, 2004 was $182,607,166 which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers and
directors. 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 February 21, 2005 was
47,798,909 and 47,521,809, 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.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

2004 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

Page

PART I.

Item 1. Business.............................................................4
Item 2. Properties..........................................................10
Item 3. Legal Proceedings...................................................10
Item 4. Submission of Matters to a Vote of Security Holders.................10

PART II.

Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters.................................................11
Item 6. Selected Consolidated Financial Data................................11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations...........................................14
Item 7A. Qualitative and Quantitative Disclosures About Market Risk..........32
Item 8. Consolidated Financial Statements and Supplementary Data............33
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................................56
Item 9A. Controls and Procedures.............................................56
Item 9B. Other Information...................................................56

PART III.

Item 10. Directors and Executive Officers of the Registrant..................56
Item 11. Executive Compensation..............................................57
Item 12. Security Ownership of Certain Beneficial Owners and Management......57
Item 13. Certain Relationships and Related Transactions......................57
Item 14. Principal Accountant Fees and Services..............................57

PART IV.

Item 15. Exhibits, Financial Statement Schedules ............................58

SIGNATURES....................................................................60

PART I

ITEM 1. BUSINESS

OVERVIEW

FalconStor Software, Inc. ("FalconStor" or the "Company") provides network
storage 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 have utilized it to power their special purpose storage appliances to
deliver a variety of storage related services including Real Time Data
Migration, Continuous Data Replication, Continuous Data Protection, Virtual Tape
Library backup, and other advanced storage services. IPStor leverages the high
performance IP- or FC- based network to help corporate IT departments aggregate
storage capacity and contain the escalating cost of administering
business-critical storage services such as snapshot, backup, data replication,
and other storage services in a distributed environment. Over 500 customers
around the world have deployed FalconStor solutions in production environments
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, Engenio Information Technologies, Emulex,
Fujitsu, Gadzoox, Hewlett Packard, Hitachi Data Systems, Hitachi Engineering
Co., Ltd., IBM, Intel, LSI Logic, McData Corporation, Microsoft, NEC, Network
Appliance, Novell, NS Solutions Corporation (subsidiary of The Nippon Steel
Corporation, Japan), Oracle, QLogic, Quantum, Sony, StorageTek, SUN and Tivoli.
FalconStor has agreements with original equipment manufacturers ("OEMs")
including Accton, Acer, Inc., AXIOMTEK, Copan Systems, Evesham Technology,
MaXXan, NEC, Next IT, Runtop StorageTek, Systex Corp. and others to incorporate
FalconStor's technology with such companies' products.

INDUSTRY BACKGROUND

According to storage industry experts, escalating disaster recovery
requirements, increasing government regulations, and the growing focus on cost
management, efficiency and return on investment, are key spending factors
driving the overall growth of the IT storage market for the next several years.
Consolidation of storage systems on a common platform has consistently been
cited as the biggest spending driver by a number of industry analysts. In fact,
enterprises are buying new Storage Area Network (SAN) capacity from their
preferred vendors to handle data moved off other platforms. Moreover, companies
of all sizes (small/medium businesses, as well as large enterprises) have
indicated that regulations such as HIPAA are forcing them to adopt new
data-retention systems and procedures, which are also driving storage spending.

TheInfoPro (TIP), a technology research network, investigates the storage market
every six months by conducting hundreds of in-depth interviews with storage
professionals from Fortune 1000, mid-market and European enterprises. This
bi-annual study of the Storage Networking & Storage Management markets gathers
data on budgeted technology implementations, future spending plans, capacity
changes and business drivers behind the storage deployments. TIP has been
studying the Networked Storage market since 2002 and the two studies released in
2004 provide a "grass roots" perspective of FalconStor's core markets.

The IT professionals at Fortune 1000 companies interviewed for the survey
indicated that they are expecting SAN growth of 50% in 2005. Expected Network
Attached Storage (NAS) growth also remains strong, having doubled in 2004 to an
average of 44 Terabytes, with planned growth of 51% in 2005.

What is driving Networked Storage growth? IT and storage professionals cited
several factors:

- A STRONG MOVE AWAY FROM DIRECT ATTACHED STORAGE (DAS). Fortune 1000
companies are moving all servers to a Networked Storage environment and
the same move is beginning to happen with mid-market companies as well.

- ORGANIC GROWTH OF DATABASES AND APPLICATIONS. Business-critical
applications such as Oracle and SAP, as well as e-mail systems
including Microsoft Exchange and Lotus/Notes Domino, all continue to
grow substantially year over year. In addition Application Development
to enhance the infrastructure requires more capacity.

- INFORMATION LIFECYCLE MANAGEMENT. New and demanding Government
regulations, especially as they relate to archiving, e-mail management,
and data replication to remote locations, are driving storage
investments and additional capacity requirements.

- EASE OF MANAGEMENT. Most companies can not effectively perform data
back up procedures if the storage is not networked.

A move to Tiered Storage is underfoot with high performing, Fibre Channel SANs
augmented by:

- Mid-tier Fibre Channel SANs

- IP-based SANs

- Serial ATA Disk Drives

- NAS

- Content Addressed Storage

TheInfoPro created an industry standard "Technology Heat Index" based on the
current and planned usage of over forty different storage networking and storage
management technologies, prioritizing them based on near term spending.

According to TheInfoPro research, although there was huge interest in Serial ATA
technologies in 2003, only a small number of companies actually deployed and
used these technologies. By the middle of 2004, usage of ATA drives increased
nearly 40%. Initially, ATA had been used as a staging media before backing up to
tape. As the early adopters became more comfortable with the usage
characteristics, including improved performance and greater reliability, they
began to plan other uses for the technology such as replication, as well as
using it as a medium for less mission critical data.

The move to Serial ATAs along with IP SANs, gives IT storage professionals
options and the ability to store data based on importance and usage. Fifty one
percent of surveyed IT professionals are in the midst of server consolidation.
In addition, 70% of respondents cited server virtualization as already in use or
under consideration. Previously the infrastructure costs, notably HBAs and
switches, had been a limiting factor in deploying additional server assets on
the SAN. Now with the confluence of tiered storage, server consolidation and
server virtualization, enterprises can deploy and manage more servers, and
therefore more data, in a networked storage environment.

The study also showed the continued impact of regulations and business
continuance as evidenced by the high scores for Archiving, e-mail management,
and Remote Replication in the survey, which is reflective of the growing need
for Information Lifecycle Management (ILM) solutions. IT and Storage
professionals are actively seeking an "ILM engine" that would allow them to
develop a data lifecycle strategy which can set policy on data types and
seamlessly move data through storage tiers based on characteristics that
include: Security, Quality of Service (QoS), Replication and Disaster Recovery
needs, as well as Access Patterns.

The functionality required by IT and storage professionals in an effective ILM
solution include: Data Mobility, Categorization, and Classification Tools
designed to seamlessly transfer and protect data between tiers of storage.

TheInfoPro also reported that Fortune 1000 users have, on average, 138TB and
22TB of SAN and NAS capacity, respectively. As expected, the numbers are
different for users in the small to medium-sized enterprise (SME) market. SME
respondents reported an average of 91TB on SAN and 4TB on NAS. Furthermore, NAS
capacity at SMEs is expected to grow 102% on average, while SAN capacity is
expected to grow 43% on average. (TheInfoPro characterizes SMEs as companies
with revenues between $600 million and $1 billion.)

Storage Resource Management and Storage Network Management software continue to
gain adoption on a worldwide basis. Businesses of all sizes, from the small and
medium to the large enterprise, are proactively seeking solutions that enable
them to preserve and optimize their existing IT investments, while concurrently

providing the storage-related services required to meet data retention
regulations, establish information lifecycle management and business continuance
strategies, and deploy end-to-end data protection methods.

PRODUCTS AND TECHNOLOGY

IPStor Enterprise Edition (IPStor), FalconStor's flagship product, is the
foundation on which all FalconStor solutions are built. IPStor Enterprise
Edition is comprised of a comprehensive set of state of the art network storage
software designed to deliver an open, intelligent SAN/NAS infrastructure across
heterogeneous environments. FalconStor has also developed and currently offers
turnkey, IPStor-powered network storage appliances, which are available and
supported by major OEMs, as well as system integrators and resellers worldwide.

SOFTWARE SOLUTIONS

FalconStor software solutions deliver the advanced services needed to optimize
the protection, availability and storage of enterprise data, in addition to
maximizing performance and availability of enterprise applications. FalconStor
solutions have been specifically designed to help enterprise data centers
minimize total cost of ownership (TCO) and maximize return on investment (ROI).

The base IPStor software, running on either a layer of stand-alone or a pair of
clustered Linux/Solaris 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.

o IPStor solutions developed to deliver continuous PROTECTION of
corporate data maintain 24x7 availability and usability of data in the
event of non-catastrophic unplanned or planned hardware outage, or
software error. These solutions also reduce the risk of data loss due
to a site failure, media error, robotic failure, or human error, and
allow data to be recovered quickly and accurately.

o IPStor solutions developed to deliver continuous AVAILABILITY of
corporate data maintained via network attached storage or direct
attached storage enable rapid recommencement of business in the event
of catastrophic outages, such as, a flood in the main data center.

o IPStor solutions developed to optimize STORAGE increase overall storage
performance to maximize return on existing investments in IT
infrastructure, cost effectively migrate data, based on policy, between
heterogeneous storage subsystems, and eliminate system outages caused
by insufficient storage space.

o IPStor solutions developed to help enterprise data centers minimize
total cost of ownership and maximize return on investment consolidate
heterogeneous storage environments and servers, and centralize storage
management under one simple interface.

STORAGE APPLIANCES

Addressing one of the fastest growing segments of the storage industry,
small/medium businesses (SMBs), FalconStor has entered into agreements with
resellers and with OEMs to develop "storage appliances" that combine specific
IPStor functionality with third party hardware to create cost effective, turnkey
storage solutions that are easy to deploy and maintain. Currently, FalconStor's
resellers and/or OEM partners offer the following storage appliances:

o REALTIME DATA MIGRATION APPLIANCES use a Fibre Channel SAN to transport
data across different vendors' storage subsystems without reconfiguring
or shutting down the host.

o VIRTUALTAPE LIBRARY/VIRTUAL DISK ISCSI AND FIBRE CHANNEL APPLIANCES use
disk to enhance the reliability, speed, and availability of backups,
while consolidating the management and provisioning of backup resources
without changing existing tape backup software and procedures. With
backup windows shrinking and rapid data restoration more critical than
ever, the VirtualTape Library Appliance allows users to utilize disk
storage to emulate multiple tape libraries concurrently and to
accelerate backup/restore speed.

o ISCSI STORAGE APPLIANCES leverage the industry standard iSCSI protocol
and an existing IP network to create a reliable SAN solution for small
or remote offices, as well as small data centers, at an affordable
price. These appliances aggregate and provision storage capacity and
provide services that deliver rapid recovery, continuous data
protection and disaster recovery capabilities.

BUSINESS STRATEGY

FalconStor intends to continue its position as a leading network storage
software provider to enterprises worldwide. FalconStor also intends to enter the
non-enterprise storage market by offering products for use in the Small/Medium
Business (SMB) and Small Office/Home Office (SOHO) markets. FalconStor intends
to achieve these objectives 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 EXPAND PRODUCT OFFERINGS. During the past year, FalconStor offered
additional options for its IPStor software. In addition, FalconStor
expanded its offerings of storage appliances consisting of third-party
hardware loaded with IPStor functionality. FalconStor intends to
continue to expand the options available for IPStor and to offer
additional storage appliances.

o INCREASE MARKET PENETRATION AND BRAND RECOGNITION. FalconStor plans to
promote its products and corporate awareness by:

o forming strategic partnerships with leading industry players;

o participating in industry events, conferences and trade shows; and

o continuing 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 of businesses or software technology 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; and/or

o key personnel.

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.

o OFFER PRODUCTS AND SERVICES TO THE SMB AND SOHO MARKETS. FalconStor
intends to work with industry partners so that these partners can offer
storage solutions or services to the SMB and SOHO markets. These
solutions and services may take the form of special purpose appliances
or applications, or hosted storage.

SALES, MARKETING AND CUSTOMER SERVICE

FalconStor plans to continue to sell its products primarily through agreements
with OEMs, value-added resellers (sometimes called "solution providers") 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 various FalconStor products and
receive a discount off list price on products sold.

o STORAGE APPLIANCES. FalconStor has entered into agreements with
strategic partners in which various FalconStor products are adapted to
the strategic partner's special-purpose storage appliances to provide
various services to end users.

o DIRECT SALES TO END USERS. In a limited number of circumstances,
FalconStor has entered into software license agreements directly with
end users for FalconStor's products.

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 storage software 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 existing solutions and to
develop and introduce new products on a cost-effective and timely basis.
FalconStor believes its continued investment in research and development is
critical to its ability to continue to provide new and enhanced products
addressing emerging market needs. There can be no assurance that FalconStor will
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 105 employees as of
December 31, 2004. Research and development expenses, primarily consisting of
personnel expenses, were approximately $6.3 million, $7.1 million and $9.1
million in 2002, 2003 and 2004, respectively. FalconStor anticipates that
research and development expenses will increase in 2005.

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 offer unified storage services to application
hosts attached to CIFS, NFS, iSCSI and Fibre Channel (FC) networks, FalconStor
believes it 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 products from a number of companies with substantially greater
financial resources, such as Network Appliance, Inc., and Veritas Software
Corporation. FalconStor is not aware of any other software company providing
unified storage services running on a standard Linux or Solaris based appliance.
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.

Additionally, as more partners offer appliances, the Company has experienced
competitive pressures from smaller, niche players in the industry. However,
FalconStor believes these potential competitors currently do not offer the depth
or breadth of storage services delivered by FalconStor, nor do they possess the
experience and technological innovation needed to develop and deliver reliable,
fully integrated, and proven storage services.

As FalconStor moves into the non-enterprise storage market, the products and
services offered by its partners may compete with existing or new products and
services offered by current and new entrants to the market.

FalconStor's success will depend largely on its ability to generate market
demand and awareness of its products 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 to compete with FalconStor.
Increased competition could result in price reductions and reduced gross
margins, which could harm FalconStor's business.

INTELLECTUAL PROPERTY

FalconStor's success is dependent in part upon its proprietary technology.
Currently, the IPStor software suite is the core of its proprietary technology.
FalconStor currently has one patent and numerous pending patent applications,
nine registered trademarks - including "FalconStor," "FalconStor Software" and
"IPStor" - and many pending trademark applications related to FalconStor and its
products.

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
where laws may not protect its proprietary rights as fully as do the laws of the
United States.

MAJOR CUSTOMERS

For the year ended December 31, 2004, FalconStor had one customer that accounted
for 16% of revenues. For the year ended December 31, 2003 FalconStor did not
have any customers that accounted for over 10% of revenues. For the year ended
December 31, 2002, FalconStor had one customer that accounted for 16% of
revenues. As of December 31, 2004, the Company had three customers with accounts
receivable balances greater than 5% of gross accounts receivable, which in the
aggregate were 30% of the accounts receivable balance. As of December 31, 2003,
the Company had two customers with accounts receivable balances greater than 5%
of gross accounts receivable, which in the aggregate were 11% of the accounts
receivable balance.

EMPLOYEES

As of December 31, 2004, FalconStor had 217 full-time employees, consisting of
61 in sales and marketing, 38 in service, 105 in research and development and 13
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 soon as reasonably practicable
after FalconStor electronically files such material with, or furnishes it to,
the SEC. FalconStor complied with this policy for every Securities Exchange Act
of 1934 report filed during the year ended December 31, 2004.

ITEM 2. PROPERTIES

FalconStor's headquarters are located in an approximately 45,000 square foot
facility located in Melville, New York, of which 34,000 square feet is currently
being utilized. Offices are also leased for development, sales and marketing
personnel, which total an aggregate of approximately 24,500 square feet in Le
Chesnay, France; Taichung, Taiwan; Tokyo, Japan; Beijing and Shanghai, China;
Munich, Germany; and Seoul, Korea. Initial lease terms range from one to eight
years, with multiple renewal options.

ITEM 3. LEGAL PROCEEDINGS

We are subject to various legal proceedings and claims, asserted or unasserted,
which arise in the ordinary course of business. While the outcome of any such
matters cannot be predicted with certainty, we believe that such matters will
not have a material adverse effect on our financial condition or liquidity.

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

None

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

MARKET INFORMATION

Our Common Stock is listed on The Nasdaq National Market ("Nasdaq")
under the symbol "FALC". 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:

2004 2003
--------------------- ------------------
High Low High Low
---- --- ---- -----
Fourth Quarter $ 9.57 $ 6.21 $ 9.15 $ 6.11
Third Quarter $ 7.85 $ 5.13 $ 6.89 $ 4.54
Second Quarter $ 8.35 $ 6.15 $ 7.11 $ 3.56
First Quarter $10.15 $ 6.57 $ 4.57 $ 3.47

HOLDERS OF COMMON STOCK

We had approximately 184 holders of record of Common Stock as of
February 21, 2005. 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 may determine to pay
future cash dividends if it determines that dividends are an
appropriate use of Company capital.

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data with respect to our
consolidated balance sheets as of December 31, 2004, 2003, 2002,
2001 and 2000 and the related consolidated statements of operations
data for the years ended December 31, 2004, 2003, 2002 and 2001 and
the period from inception (February 10, 2000) through December 31,
2000 have been derived from our audited consolidated financial
statements. 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."

CONSOLIDATED STATEMENTS OF OPERATIONS DATA:

PERIOD FROM
INCEPTION (FEBRUARY
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED 10, 2000) THROUGH
DECEMBER 31, DECEMBER 31, DECEMBER 31 DECEMBER 31, DECEMBER 31,
2004 2003 2002 2001 2000
-------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)

Revenues:
Software license revenue ............................... $ 21,488 $ 12,251 $ 8,667 $ 4,714 $ --
Maintenance revenue .................................... 4,443 2,473 1,297 17 --
Software services and other revenue .................... 2,778 2,220 665 861 143
-------- -------- -------- -------- --------
28,709 16,944 10,629 5,592 143
-------- -------- -------- -------- --------

Operating expenses:
Amortization of purchased and capitalized software ..... 1,394 1,394 899 273 --
Cost of maintenance, software services and other revenue 4,150 2,580 1,309 897 224
Software development costs ............................. 9,050 7,068 6,281 5,004 1,379
Selling and marketing .................................. 14,277 10,967 9,856 8,085 327
General and administrative ............................. 5,109 2,878 2,592 2,732 534
Litigation settlement .................................. 1,300 -- -- -- --
Lease abandonment charge ............................... -- 550 -- -- --
Impairment of prepaid royalty .......................... -- -- 483 -- --
-------- -------- -------- -------- --------
35,280 25,437 21,420 16,991 2,464
-------- -------- -------- -------- --------
Operating loss .............................. (6,571) (8,493) (10,791) (11,399) (2,321)
-------- -------- -------- -------- --------

Interest and other income .............................. 714 1,122 1,585 1,365 225
Impairment of long-lived assets ........................ -- 35 (2,300) -- --
-------- -------- -------- -------- --------

Loss before income taxes ............................... (5,857) (7,336) (11,506) (10,034) (2,096)

Provision for income taxes ............................ 32 33 37 22 --
-------- -------- -------- -------- --------

Net loss ............................................... $ (5,889) $ (7,369) $(11,543) $(10,056) $ (2,096)
-------- -------- -------- -------- --------

Beneficial conversion feature
attributable to convertible preferred
stock ....................................... -- -- -- 3,896 --
-------- -------- -------- -------- --------

Net loss attributable to common
shareholders ......................................... $ (5,889) $ (7,369) $(11,543) $(13,952) $ (2,096)
======== ======== ======== ======== ========

Basic and diluted net loss per share
attributable to common shareholders ............. $ (0.13) $ (0.16) $ (0.26) $ (0.40) $ (0.09)
======== ======== ======== ======== ========

Basic and diluted weighted average
common shares outstanding ................... 46,967 45,968 45,233 35,264 24,383
======== ======== ======== ======== ========

CONSOLIDATED BALANCE SHEET DATA:

DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
2004 2003 2002 2001 2000
-------------------------------------------------------------------------
(IN THOUSANDS)

Cash and cash equivalents and
marketable securities $33,973 $36,685 $51,102 $64,527 $ 7,727

Working capital 36,452 39,527 47,746 57,518 7,254

Total assets 56,074 56,493 64,710 74,471 8,594

Long-term obligations 1,290 396 -- 283 --

Stockholders' equity 46,364 50,556 55,901 63,562 8,057

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

In 2004, we continued our growth and we had our first profitable
quarter. Our revenues for the full year increased to $28.7 million from $16.9
million in 2003. We are pleased that we were profitable in the fourth quarter of
2004. However, our focus will continue to be on managing our business with a
view towards long-term success and growth. To this end, in 2004 we continued to
invest in research and development and other areas to position the Company for
future growth. We will continue to invest in these areas in 2005 and anticipate
that our research and development expenses will increase in 2005.

To continue to create industry-leading cutting-edge network storage
solutions, we hired additional software development engineers and quality
assurance engineers. These software engineers design and test the software
products that are or will be sold by our OEM partners and resellers. Continuing
to deliver products to meet the demands of the storage market is necessary for
us to remain competitive and to continue our growth.

It is important to our success that our products meet the needs of end
users and that our products are - and are viewed by the market to be -
innovative. In 2004, our products received recognition for their quality and
innovation from several respected, independent, industry publications and
organizations. This recognition helps us gain access to additional customers and
assists us in closing sales.

We also increased our sales force and our technical support team. An
increased sales force should expand the market exposure for our products. The
expanded technical support team responds to questions and technical issues from
end users of our products and from our resellers and OEM partners. Providing top
notch technical support to these groups enhances our ability to continue to make
sales. End users who are satisfied with our technical support are more likely to
order additional products from us. Resellers and OEM partners who are happy with
our technical support, and whose end users are satisfied, will be more likely to
recommend our current products and less likely to consider other providers for
future products.

The key factors we look to for our future business prospects continue
to be our sales pipeline, our ability to establish and expand relationships with
key industry OEMs and resellers, sales by our OEM partners, additional orders
from resellers, growth in deferred revenue, re-orders from existing customers,
and the growth of the overall market for storage solutions. Gross margins are
also a key factor in evidencing the growth of our business.

Our sales "pipeline" consists of inquiries from end users and resellers
for possible purchases of our products. Our overall sales pipeline steadily
increased for each quarter of 2004 compared with the same quarter in 2003.

OEM relationships are important to us for two main reasons. First,
sales by our OEM partners contribute to our revenues. Second, having our
products selected by respected, established industry leaders signals to
potential customers, resellers and other potential OEM partners that our
products are quality products that add value to their enterprise. Before
licensing software, OEM partners typically undertake broad reviews of all of the
competing software solutions available. The choice of IPStor by major industry
participants validates the design and the capabilities of our products.

Overall, product licenses to OEMs accounted for approximately thirty
percent of our revenues in 2004. One OEM customer accounted for over ten percent
of our revenues. We anticipate that OEMs will account for thirty to forty

percent of our revenues in 2005. We expect that at least one OEM will account
for at least ten percent of our revenues in 2005. Accordingly, the loss of this
customer would have a material adverse effect on our business.

In 2004, we signed a new agreement for our iSCSI Server for Windows
Storage Server 2003 (WSS2003) powered by IPStor with a Tier 1 OEM. This product,
which is private-labeled by the OEM, began shipping towards the end of 2004. In
addition, a Tier 1 OEM with whom we signed an agreement in 2003 began shipping a
private-labeled storage solution utilizing our VirtualTape Library software in
the second quarter of 2004. During the fourth quarter of 2004, we also signed an
agreement with an OEM partner for non-enterprise storage solutions.

These OEM relationships are in addition to the OEM partnerships we
already had with CNT, Maxxan and StorageTek, among others. We will continue to
seek additional OEM opportunities in the future.

We were disappointed that an OEM with whom we signed an agreement in
2003 did not launch their solution as planned in 2004. This decision, which we
were informed by the OEM was not related to any problems with our software,
caused us to have lower than expected revenues for 2004. We do everything we can
to assure that our products meet the needs of our OEM partners and their
customers. However, we cannot control decisions by our OEM partners to change
their product or marketing mix in ways that impact sales of products licensed by
the OEMs from us.

Many enterprises look to value added resellers or solution providers to
assist them in making their information technology purchases. These resellers
typically review an enterprise's needs and suggest a hardware, software, or
combined hardware and software solution to fulfill the enterprise's
requirements. Resellers have wide choices in fulfilling their customers' needs.
We have established strong relationships with many premier resellers. In 2004,
we signed agreements with many new resellers worldwide. We also terminated
relationships with several resellers who we believed were not properly selling
our products. We will continue to enter into relationships with resellers and to
discontinue relationships with resellers with whom we are not satisfied.

As service providers to companies, resellers' reputations are dependent
on satisfying their customers' needs efficiently and effectively. If resellers
determine that a product they have been providing to their customers is not
functioning as promised or is not providing adequate return on investment, or if
the customers are complaining about the level of support they are receiving from
the suppliers, the resellers will move quickly to offer different solutions to
their customers. Additional sales by resellers are therefore an important
indicator of our business prospects. We saw growth in the sales by most of our
significant resellers in 2004 and expect that this growth will continue in 2005.

Our deferred revenues consist primarily of revenue attributable to
support and maintenance of our products. The level of deferred revenue is an
important indicator of our success. Maintenance and support for our products is
sold for fixed periods of time. Maintenance and support agreements are typically
for one year, although some agreements are for terms in excess of one year. If
we do not deliver the support needed by end users of our products or by our OEM
partners and resellers, then they will not renew their maintenance and support
agreements. If end users stop using our products, they also will not renew their
maintenance and support agreements. An increase in deferred revenues thus
indicates growth in our installed base and end user and OEM satisfaction with
our maintenance and support services. Our deferred revenue increased to $5.4
million as of December 31, 2004, compared with $2.6 million as of December 31,
2003. We expect deferred revenue to continue to grow in 2005.

The level of re-orders from existing end users of our products is
another measure of customer satisfaction. Information technology professionals
will only order additional products and services for their companies if they
determine that the products have reduced total cost of ownership and have
provided a good return on investment. Re-orders are thus an indication that our
products are delivering as promised and that our support is meeting the end
user's needs. In 2004, many end users ordered additional copies of IPStor,
additional products or ordered additional options. If re-orders decline, it
would indicate that future sales might also decline. As the percentage of our
revenues from OEMs increases, the analytical value of re-orders decreases
because our OEM partners typically do not provide us with information
identifying the end user for each order.

The storage solutions market continues to grow. (Please see the
discussion on page 4.) As we predicted last year, in addition to growth based on
demand for storage server consolidation and replication, there was growth in
backup acceleration. We expect each of these areas to continue growing in 2005.
In addition, we have announced new initiatives in the small/medium business
(SMB) and small office/home office (SOHO) markets. We believe that these
non-enterprise markets are another growth area for storage software.

One area of particular growth in 2004 that we expect to continue, if
not accelerate, in 2005, was in VirtualTape Library software. Prices for disk
storage continue to fall, and the need for rapid back up, disaster recovery and
regulatory compliance continues to grow.

As we expected, 2004 saw the beginning of market acceptance of IP-based
Storage Area Networks, primarily using iSCSI. Previously, most SANs had been
based on fibre-channel. In addition to the solution offered by our Tier 1 OEM
partner, we plan to continue to tap into the growth in this market through sales
of our products by other strategic partners.

Another important measure of our business is gross margin. Among other
things, gross margin measures our ability to scale our business. Unlike
manufacturers of hardware, our incremental cost for each additional unit of
software licensed is a small percentage of the software license revenue. Thus,
our gross margins tend to increase as our software license revenue increases. We
incur research and development expenses before the product is offered for
licensing. These expenses consist primarily of personnel costs for engineering
and testing, but also include other items such as the cost of hardware and
software used in development. We also have expenses for sales and marketing, and
general and administrative functions.

Our gross margin continued to increase in 2004, ending at 86% for the
fourth quarter of 2004, compared with 77% for the fourth quarter of 2003. This
demonstrates that we were successful in containing the growth of our costs even
as our revenue increased.

We are pleased with our ability to contain the growth of expenses in
2004. There were two large expense items in 2004 which we had not anticipated.
First, we were subject to a claim that some of our products infringed a patent
issued to a third party. While we denied, and continue to deny, that, if the
subject patent is valid, our products infringe the patent, the defense and
settlement of the claim was expensive. As part of the settlement, we made a
one-time payment of $1.3 million. In addition, we incurred over $1 million in
related legal expenses. The need to defend our products against these types of
claims could result in higher expenses in the future.

Second, we incurred significant expenses related to compliance with the
provisions of the Sarbanes-Oxley Act of 2002. This Act requires, among other
things, an annual review of "internal controls" by the Company and our auditors.
The costs associated with this review, including the cost of an outside
consultant and the cost of the review by our auditors, approximated $0.8 million
in 2004. While we believe these costs will be reduced in the future, there will
be continuing costs related to compliance with the Act in 2005 and beyond.

One additional factor that we expect to affect our revenues on a
quarterly, but not annual, basis, is the seasonality of the information
technology business. Historically, information technology spending has been
higher in the fourth and second quarters of each calendar year, and somewhat
slower in the other quarters, particularly the first quarter. Our quarterly
results were impacted by this seasonality in 2004, and we anticipate that our
quarterly results for 2005 will be affected as well.

Our critical accounting policies are those related to revenue
recognition and accounts receivable allowances. 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
or a royalty report summarizing software licenses sold for each software license
resold by an OEM, distributor or solution provider to an end user. The software
license fees are fixed and determinable as our standard payment terms range from
30 to 90 days, depending on regional billing practices, and we have not provided
any of our customers extended payment terms. When a customer licenses software
together with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.

We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer

relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2004 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2003

Revenues for the year ended December 31, 2004 increased 69% to $28.7
million compared to $16.9 million for the year ended December 31, 2003. Our
operating expenses increased 39% from $25.4 million in 2003 to $35.3 million in
2004. Net loss decreased 20% from $7.4 million in 2003 to $5.9 million in 2004.
The increase in revenues was mainly due to an increase in demand for our network
storage solution software, the introduction of our new products and the
successful launch by one of our OEMs of a solution powered by our product.
Revenue contribution from our OEM partners increased in absolute dollars and as
a percentage of our total revenue for the year ended December 31, 2004. Revenue
from resellers and distributors also increased in absolute dollars. Expenses
increased in all aspects of our business to support our growth. In November,
2003 we moved our headquarters to a larger facility and, for the year ended
December 31, 2004, we increased the number of employees and continued to invest
in infrastructure by purchasing additional computers and equipment. We increased
the number of employees from 178 employees as of December 31, 2003 to 217
employees as of December 31, 2004. Included in our results for the year ended
December 31, 2004 is a litigation settlement charge of $1.3 million and legal
fees of $1.0 million, each associated with litigation relating to patent
infringement that was resolved in the third quarter of 2004, as well as $0.8
million of costs related to compliance with the Sarbanes-Oxley Act of 2002.

REVENUES

SOFTWARE LICENSE REVENUE

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

Software license revenue increased 75% to $21.5 million in 2004 from
$12.3 million in 2003. Increased market acceptance and demand for our product,
the introduction of our new products and the successful launch by one of our
OEMs of a solution powered by our product were the primary drivers of the
increase in software license revenue. Software license revenue increased from
both our OEM partners and from our resellers. Revenue from our OEM partners
increased as a percentage of total revenue. We expect our software license
revenue to continue to grow and the percentage of future software license
revenue derived from our OEM partners to increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenues are comprised of
software maintenance and technical support, professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Revenue derived from maintenance and technical support
contracts is deferred and recognized ratably over the contractual maintenance
term. Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In 2004 and 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 a customer. A portion of the contractual fee is recognized

as revenue when the hardware or software is delivered to the customer based on
the relative fair value of the delivered element(s). Through December 31, 2004,
the software and hardware in bundled solutions have been delivered to the
customer in the same quarter. Maintenance, software services and other revenue
increased 54% to $7.2 million in 2004 from $4.7 million in 2003.

The major factor contributing to the increase in maintenance, software
services and other revenue was the increase in the number of maintenance and
technical support contracts we sold. As we are in business longer, and as we
license more software, we expect these revenues will continue to increase. The
majority of our new customers purchase maintenance and support and most
customers renew their maintenance and support after their initial contracts
expire. Maintenance revenue increased from $2.5 million for the year ended
December 31, 2003 to $4.4 million for the year ended December 31, 2004. Growth
in our professional services revenue, which increased from $0.9 million in 2003
to $1.3 million in 2004, also contributed to the increase in software services
and other revenues. This increase in professional services revenue was related
to the increase in our software license customers that elected to purchase
professional services. Additionally, our hardware sales increased from $1.3
million in 2003 to $1.5 million in 2004. This increase was the result of an
increase in demand from our customers for bundled solutions. We expect
maintenance, software services and other revenues to continue to increase.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations, we have purchased or licensed various software for resale since
2001. As of December 31, 2004 and 2003, we had $4.9 million of purchased
software licenses that are being amortized over three years. For the years ended
December 31, 2004 and 2003, we recorded $1.4 million of amortization related to
these purchased software licenses. We will continue to evaluate third party
software licenses and may make additional purchases, which would result in an
increase in amortization expense.

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 were 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 and
$31,523 for the years ended December 31, 2004 and 2003, respectively.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenue consists
primarily of personnel costs and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased that was resold. Cost of maintenance, software services
and other revenues for the year ended December 31, 2004 increased by 61% to $4.2
million compared to $2.6 million for the year ended December 31, 2003. The
increase in cost of maintenance, software services and other revenue was
principally due to an increase in personnel. As a result of our increased sales
of maintenance and support contracts and professional services, we required a
higher number of employees to provide technical support and to implement our
software. Our cost of maintenance, software services and other revenue will
continue to grow in absolute dollars as our revenue increases.

Gross profit for the year ended December 31, 2004 was $23.2 million or
81% of revenues compared to $13.0 million or 77% of revenues for the year ended
December 31, 2003. The increase in gross profit and gross margin was directly
related to the increase in revenues relative to the increase in expenses. As our
software license revenues increase, the associated costs as a percentage of

those revenues tend to decrease. Additionally, the increased percentage of
revenue from our OEM partners in 2004 contributed to the increase in gross
margin since revenues from our OEM partners have higher gross margins.

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 28% to $9.1 million
in 2004 from $7.1 million in 2003. The increase in software development costs
was primarily due to an increase in employees required to enhance and test our
network storage software products, as well as to develop new innovative features
and options. In addition, as we entered into agreements with new OEM partners,
we required additional employees to test and integrate our software with our OEM
partners' products. In 2003, we also opened a development office in China to
assist in our development work. We intend to continue recruiting and hiring
product development personnel to support our development process.

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 30% to $14.3 million in 2004 from $11.0 million in 2003. As a result
of the increase in revenue and interest in our software, our commission expense
and travel expenses increased. In addition, we continued to hire new sales and
sales support personnel and to expand our worldwide presence to accommodate our
revenue growth. We believe that to continue to grow sales, our sales and
marketing expenses will continue to increase.

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 77% to
$5.1 million in 2004 from $2.9 million in 2003. The increase in general and
administrative expenses was partially due to a $1.0 million increase in legal
expense attributable to litigation relating to alleged patent infringement with
Dot Hill Systems Corporation ("Dot Hill") and Crossroads Systems (Texas), Inc.
("Crossroads"). Expenses of $0.8 million for the year ended December 31, 2004,
related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and an
increase in the number employees also contributed to the increase in general and
administrative expenses.

LITIGATION SETTLEMENT CHARGE

During the third quarter of 2004, we resolved claims relating to
alleged patent infringement brought by Dot Hill and by Crossroads against us in
the United States District Court for the Western District of Texas. Pursuant to
the terms of the Settlement Agreement between Crossroads and us, we, without
admission of infringement, made a one-time payment of $1.3 million and granted
to Crossroads licenses to certain of our technology in exchange for a worldwide,
perpetual license to the technology underlying the Crossroads' patents at issue
in the litigation. All claims against us by both Dot Hill and Crossroads have
now been dismissed.

INTEREST AND OTHER INCOME

We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
decreased 36% to $0.7 million in 2004 from $1.1 million in 2003. This decrease
in interest income was due to lower interest rates and lower average cash, cash
equivalent and marketable securities balances.

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,
2004, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our early stage of 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.

LEASE ABANDONMENT CHARGE

In November 2003, we relocated our headquarters to a larger facility to
accommodate our future growth. As a result of this relocation, we vacated our
previous office space and recorded a charge for the estimated loss we expect to
incur on the remaining lease obligation. The charge of $0.6 million included the
remaining lease rental obligation reduced by cash flows we expect to generate
from an agreement to sub-lease the facility as well as the write off of
leasehold improvements at our previous facility. This expense is not expected to
recur.

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 in the market value of NSSI's
common stock underlying the convertible preferred stock significantly below the
Company's cost, we concluded in 2002 that the decline in the fair value of our
investment in NSSI's preferred stock was 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, we concluded that the unrecouped prepaid royalty was 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. In 2003, we received a payment
from NSSI of $35,000 in exchange for all of our preferred stock of NSSI, which
was reflected as a reduction to the impairment charge in the statement of
operations. We do not expect to incur any additional expenses from this
investment.

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2003 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2002

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue increased 41% to $12.3 million in 2003 from
$8.7 million in 2002. Increased market acceptance and demand for our product
were the primary drivers of the increase in software license revenue. A
continued increase in the number of our channel partners and OEMs also helped
increase our revenues.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenue increased 139% to $4.7
million in 2003 from $2.0 million in 2002. The major factor behind the increase
in maintenance, software services and other revenue was an increase in the
number of maintenance and technical support contracts we sold. As we are in
business longer, and as we license more software, we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and
support and most customers renew their maintenance and support after their
initial contracts expire. Maintenance revenue increased from $1.3 million for
the year ended December 31, 2002 to $2.5 million for the year ended December 31,
2003. Growth in our professional services sales, which increased from $0.4
million in 2002 to $0.9 million in 2003, also contributed to the increase in
software services and other revenues. This increase in professional services
revenue was related to the increase in our software license customers that
elected to purchase professional services. Additionally, our hardware sales
increased from $0.2 million in 2002 to $1.3 million in 2003. This increase was
the result of an increase in demand from our customers for bundled solutions.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

Amortization of purchased and capitalized software increased from $0.9
million for the year ended December 31, 2002 to $1.4 million for the year ended
December 31, 2003. The increase in amortization expense was due to our purchase
of an additional $1.8 million of software licenses in 2003. As of December 31,
2003, we had $4.9 million of purchased software licenses that are being
amortized over three years. For the year ended December 31, 2003, we recorded
$1.4 million of amortization related to these purchased software licenses. As of
December 31, 2002, we had $3.0 million of purchased software licenses and
recorded approximately $0.9 million of amortization for the year ended December
31, 2002 related to these purchased software licenses. Amortization of
capitalized software was $31,523 and $31,524 for the years ended December 31,
2003 and 2002, respectively.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues for the year
ended December 31, 2003 increased by 97% to $2.6 million compared to $1.3
million for the year ended December 31, 2002. The increase in cost of
maintenance, software services and other revenue was primarily driven by an
increase in hardware sales. As we sold more hardware, our hardware costs for
resale rose from $0.2 million in 2002 to $1.0 million in 2003. The increase in
cost of maintenance, software services and other revenue was also due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts and professional services, we required a higher number of
employees to provide technical support and to implement our software.

Gross profit for the year ended December 31, 2003 was $13.0 million or
77% of revenues compared to $8.4 million or 79% of revenues for the year ended
December 31, 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 was also partially related to
margins on hardware sales, which are typically lower than the margins on
software and services.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 13% to $7.1 million in 2003 from
$6.3 million in 2002. The increase in software development costs was primarily
due to an increase in employees required to enhance and test our core network
storage software product, as well as to develop new innovative features and
options. In addition, as we negotiated and signed new OEM partners, we required
additional employees to test and customize our software with our OEM partners'
products. In 2003, we also opened a development office in China to assist in our
development work.

SELLING AND MARKETING

Selling and marketing expenses increased 11% to $11.0 million in 2003
from $9.9 million in 2002. As a result of the increase in revenue and interest
in our software, our commission expense and travel expenses increased. In
addition, we continued to hire new sales and sales support personnel and to
expand our worldwide presence to accommodate our revenue growth.

GENERAL AND ADMINISTRATIVE

General and administrative expenses increased 11% to $2.9 million in
2003 from $2.6 million in 2002. One reason for the increase in general and
administrative expenses is due to an increase in salaries. As our business grew,
we required additional general and administrative personnel to support the
growth. Another reason for the increase was due to higher premiums for our
directors and officers insurance.

INTEREST AND OTHER INCOME

Interest and other income decreased 29% to $1.1 million in 2003 from
$1.6 million in 2002. This decrease in interest income was due to lower interest
rates and lower average cash, cash equivalent and marketable securities
balances.

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,
2003, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our early stage of 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.

LEASE ABANDONMENT CHARGE

IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

LIQUIDITY AND CAPITAL RESOURCES

Our cash and cash equivalents totaled $15.5 million and marketable
securities totaled $18.5 million at December 31, 2004. As of December 31, 2003,
we had $8.5 million in cash and cash equivalents and $28.2 million in marketable
securities. The reasons for this decrease in cash and cash equivalents and
marketable securities are discussed below. Because we have not yet been
profitable on a full year basis, the major use of our cash has been to fund
operations. Until we reach profitability on a full year basis, we will continue
to use our cash and marketable securities to fund operations.

In 2004, we made investments in our infrastructure to support our
long-term growth. We increased the total number of employees in 2004 and made
investments in property and equipment to support our growth. As we continue to
grow, we will continue to make investments in property and equipment and will
need to continue to increase our headcount. In the past, we have also used cash
to purchase software licenses and to make acquisitions. We will continue to
evaluate potential software license purchases and acquisitions and if the right
opportunity presents itself we may continue to use our cash for these purposes.
However, as of the date of this filing, we have no agreements, commitments or
understandings with respect to any such acquisitions. In 2004, we also used cash
to defend and settle a patent infringement litigation. The patent litigation
settlement charge was $1.3 million and we also incurred approximately $1.0
million in legal fees associated with this litigation. If any future patent

infringement litigation is brought against us, we may have to incur similar
types of expenses. Additionally, in 2004 we incurred approximately $0.8 million
in professional fees associated with the Sarbanes-Oxley Act of 2002 compliance.
Although the fees may be lower in 2005, we will continue to incur professional
fees to ensure that we are in compliance with that Act.

We currently do not have any debt and our only significant commitments
are related to our office leases.

In connection with our acquisition of IP Metrics in July 2002, we were
required to make cash payments to the former shareholders of IP Metrics, which
were contingent on the level of revenues from IP Metrics products for a period
of twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. We have no further payment
obligations.

In October 2001, our Board of Directors authorized the repurchase of up
to two million shares of our outstanding common stock. Since October 2001,
277,100 shares have been repurchased at an aggregate purchase price of $1.7
million. During 2004, 42,100 shares were repurchased at an aggregate purchase
price of $0.3 million.

Net cash used in operating activities totaled $1.1 million for the year
ended December 31, 2004 compared to $5.9 million for the year ended December 31,
2003 and $7.5 million for the year ended December 31, 2002. The trend of
decreasing cash used in operations is partially due to our decreasing net loss.
The decrease in net loss is mainly attributable to our increases in revenues. In
addition to the decrease in net loss, our non-cash charges, including
depreciation and amortization and equity based compensation increased from $2.5
million in 2002 to $3.3 million in 2003 and $3.8 million in 2004. These
increases are mainly due to increases in property and equipment. Another factor
contributing to our decrease in cash used in operations is our increase in
deferred revenues of $2.8 million in 2004 compared to $0.4 million in 2003 and
$1.2 million in 2002. The increase in our deferred revenue is the result of an
increase in our maintenance contracts, which are deferred and recognized as
revenue ratably over the term of the contract. These amounts were partially
offset by increases in our net accounts receivable balances of $1.7 million in
2002, $2.8 million in 2003 and $3.2 million in 2004. The increases in our
accounts receivable balances are due to our revenue growth. In 2002, we incurred
a non-cash expense of $2.8 million related to an impairment of long-lived and
other assets. We expect cash used in operating activities to continue to
decrease as we anticipate our net loss will decrease.

Net cash provided by investing activities was $6.3 million in 2004 and
$2.5 million in 2003 and net cash used in investing activities was $15.5 million
in 2002. Included in investing activities for each year are the sales and
purchases of our marketable securities. These represent the sales, maturities
and reinvesting of our marketable securities. In 2004 and 2003 the net cash
provided from the net sale of securities was $9.6 million and $8.5 million,
respectively, and in 2002 the cash used from the net purchase of marketable
securities was $10.7 million. These amounts will fluctuate from year to year
depending on the maturity dates of our marketable securities. The cash used to
purchase property and equipment was $2.8 million, $3.0 million and $1.3 million
in 2004, 2003 and 2002, respectively. The cash used to purchase software
licenses was $0.1 million in 2004, $1.8 million in 2003 and $0.8 million in
2002. In 2002, we used $2.6 million in cash related to two acquisitions. We did
not make any similar acquisitions in 2003 or 2004. We continually evaluate
potential software licenses and acquisitions and we may continue to make these
investments if we find opportunities that would benefit our business.

Net cash provided by financing activities was $1.8 million in 2004 and
$0.9 million in 2003 and 2002. We received proceeds from the exercise of stock
options of $2.0 million in 2004, $0.9 million in 2003 and $1.1 million in 2002.
We made payments of $0.3 million in 2004 and $0.2 million in 2002 to acquire
treasury stock.

The Company's only contractual obligations relate to its operating
leases. The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to a domestic office and offices in foreign countries. The expiration
dates for these leases ranges from 2005 through 2012. The following is a
schedule of future minimum lease payments for all operating leases as of
December 31, 2004:

YEAR ENDING DECEMBER 31

2005.............................................. $ 1,451,844
2006.............................................. 1,520,105
2007.............................................. 1,348,593
2008.............................................. 1,230,817
2009.............................................. 1,264,449
Thereafter........................................ 3,025,992
------------
$ 9,841,800
============

For the years ended December 31, 2003 and 2002, we paid $3.0 million
and $2.1 million, respectively, related to discontinued operations. As of
December 31, 2004, all significant obligations related to our discontinued
operations have been settled.

Based on our increasing revenues, decreasing net loss and a decrease in
cash used for operations, 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 December, 2004, the Financial Accounting Standards Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING FOR INCOME TAXES, TO THE TAX DEDUCTION ON QUALIFIED PRODUCTION
ACTIVITIES PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2, ACCOUNTING AND DISCLOSURE GUIDANCE FOR
THE FOREIGN EARNINGS REPATRIATION PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how companies should account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states
that the tax relief (special tax deduction for domestic manufacturing) from this
legislation should be accounted for as a "special deduction" and reduce tax
expense in the period(s) the amounts are deductible on the tax return, instead
of a tax rate reduction. FSP No. 109-2 gives a company additional time to
evaluate the effects of the legislation on any plan for reinvestment or
repatriation of foreign earnings for purposes of applying FASB Statement No.
109. The Company does not plan to repatriate any of its undistributed foreign
earnings as of December 31, 2004.

In December 2004, the FASB issued SFAS No. 123 (R), SHARE-BASED PAYMENT
("SFAS No. 123 (R)"). This statement replaces SFAS No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION and supercedes APB No. 25, ACCOUNTING FOR STOCK ISSUED
TO EMPLOYEES. SFAS 123 (R) requires all stock-based compensation to be
recognized as an expense in the financial statements and that such cost be
measured according to the grant-date fair value of the stock options or other
equity instruments. SFAS 123 (R) will be effective for quarterly periods
beginning after June 15, 2005. While the Company currently provides the pro
forma disclosures required by SFAS No. 148, ACCOUNTING FOR STOCK-BASED
COMPENSATION - TRANSITION AND DISCLOSURE, on a quarterly basis (see "Note 1 -
Accounting for Stock-Based Compensation"), it is currently evaluating the impact
this statement will have on its consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151, INVENTORY COSTS - AN
AMENDMENT OF ARB NO. 43, Chapter 4 ("SFAS No. 151"). SFAS No. 151 requires all
companies to recognize a current-period charge for abnormal amounts of idle
facility expense, freight, handling costs and wasted materials. This statement
also requires that the allocation of fixed production overhead to the costs of
conversion be based on the normal capacity of the production facilities. SFAS
No. 151 will be effective for fiscal years beginning after June 15, 2005. The
Company believes that this statement will not have a material effect on its
consolidated financial statements.

RISK FACTORS

WE HAVE HAD A HISTORY OF NET LOSSES AND MAY NOT BE ABLE TO MAINTAIN THE
PROFITABILITY WE ACHIEVED IN THE FOURTH QUARTER OF 2004.

We were profitable for the first time in the fourth quarter of 2004. Prior
to that we had a history of losses, including the full year ended December 31,
2004, in which we had a net loss of $5.9 million. For the period from inception
(February 2000), through December 31, 2004, we had a cumulative net loss of
$37.0 million. 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;

o our ability to increase our customer base and to increase the sales of our
products; and

o competitive conditions in the network storage 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 commenced on November 1, 2003 and continues through February, 2012. This
commitment along with several operating leases related to our foreign offices
could impact our ability to achieve or to maintain profitability.

DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS
AND APPROPRIATELY BUDGETING FOR EXPENSES.

The rapidly evolving nature of the network storage 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
must 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.

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

The operating results of our business depend in part on the overall demand
for network storage software. Because our sales are primarily to major corporate
customers, any softness in demand for network storage software may result in
decreased revenues.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS.

During the fiscal year ended December 31, 2004, one OEM customer accounted
for 16% of our revenues. While we believe that we will continue to receive
revenue from this client during the fiscal year ended December 31, 2005, our
agreement with this customer is terminable upon 90 days notice. If our contract
with this OEM terminates it would have a material adverse effect on our
operating results.

THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK 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) and Network Attached
Storage (NAS) solutions is critical to our future success. The markets for SAN
and NAS 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.

THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of IP-based Storage Area Networks (SAN) is critical to
our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. 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 this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.

THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of disk-based backup solutions is critical to our future
success. The market for disk-based backup solutions is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current tape backup
infrastructure, and they may elect to remain with current infrastructure or to
adopt new solutions 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 this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.

WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS, SMALL OFFICE AND HOME
OFFICE MARKETS.

We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.

IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.

The network storage 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 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 software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking 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 or NAS 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 engineering 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.

FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.

We have entered into agreements with resellers and OEM partners to develop
storage appliances that combine certain aspects of IPStor functionality with
third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales 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 engineering, 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 software market or other markets. The OEM
customers might also choose not to continue to develop or to market products
which include our products. 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.

WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.

Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
This could result in lost sales opportunities for us with other customers or
could cause other potential OEM partners to consider or select software from our
competitors for their storage solutions. In addition, the desire for product
differentiation could cause potential OEM partners to select software from our
competitors. We cannot guarantee that our current strategic partners, or those
companies with whom we may partner in the future, will continue to be our
partners for any period of time. If our software were to be replaced in an OEM
solution by competing software, or if our software is not selected by OEMs for
future solutions, it would likely result in lower revenues to us and would
impede our ability to grow our business.

THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.

The network storage 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 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.

While we were profitable in the fourth quarter of 2004, such profitability
is not an indicator of future profitability and our future quarterly results may
fluctuate significantly.

Our future performance will depend on many factors, including:

o the timing of securing software license contracts and the delivery of
software and related revenue recognition;

o the seasonality of information technology spending;

o the average unit selling price of our products;

o existing or new competitors introducing better products at competitive
prices before we do;

o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;

o new products or enhancements from us or our competitors;

o import or export restrictions on our proprietary technology; and

o personnel changes.

Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.

OUR STOCK PRICE MAY BE VOLATILE

The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the past twelve months ended
December 31, 2004, the closing market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $5.13 and $10.15. 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 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.

OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.

The Financial Accounting Standards Board ("FASB") has required companies
to recognize the fair value of stock options and other stock-based compensation
to employees as compensation expense in the statement of operations, effective
July 1, 2005 for FalconStor. While it is too early to tell the exact impact of
this requirement, there will be a negative impact on our results of operations.

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 December 31, 2004, we had outstanding options and warrants to
purchase an aggregate of 9,723,358 shares of our common stock at a weighted
average exercise price of $4.82 per share. We also have 2,698,974 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.

OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS

In August, 2003, our business was interrupted due to a large scale
blackout in the northeastern United States. While the headquarters facilities we
moved in to in November, 2003 contain redundant power supplies and generators,
our domestic and foreign operations, and the operations of our industry
partners, remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.

Terrorist actions domestically or abroad could lead to business
disruptions or to cancellations of customer orders or a general decrease in
corporate spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.

THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.

We sell our products worldwide. Accordingly, our operating results could
be materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.

Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.

Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.

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 one
patent issued, multiple pending patent applications, numerous trademarks
registered 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 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.

We have already been subject to one action alleging that our technology
infringes patents held by a third party. While we settled this litigation, the
litigation was expensive and diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. 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.

DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.

Many of our products are designed to include software or other
intellectual property licensed from third parties, including "Open Source"
software. At least one intellectual property rights holder has alleged that it
holds the rights to software traditionally viewed as Open Source. It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
limit our ability to protect our proprietary rights in our products.

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 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 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.

IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.

The preparation of consolidated financial statements and related
disclosure in accordance with generally accepted account principles requires
management to establish policies that contain estimates and assumptions that
affect the amounts reported in the consolidated financial statements and the
accompanying notes. Note 1 to the Consolidated Financial Statements in this
Report on Form 10-K describes the significant accounting policies essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures.
We base our estimates on historical experience and assumptions that we believe
to be reasonable under the circumstances. Actual future results may differ
materially from these estimates. We evaluate, on an ongoing basis, our estimates
and assumptions.

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 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.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

Page

Reports of Independent Registered Public Accounting Firm ..............34

Consolidated Balance Sheets as of December 31, 2004 and 2003...........36

Consolidated Statements of Operations for the years ended
December 31, 2004, 2003 and 2002...................................37

Consolidated Statements of Stockholders' Equity and Comprehensive
Loss for the years ended December 31, 2004, 2003 and 2002..........38

Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002...................................40

Notes to Consolidated Financial Statements.............................42

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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, 2004 and 2003, and
the related consolidated statements of operations, stockholders' equity and
comprehensive loss, and cash flows for each of the years in the three-year
period ended December 31, 2004. 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 the standards of the Public
Company Accounting Oversight Board (United States). 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, 2004 and 2003, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2004, in conformity with U.S. generally
accepted accounting principles.

We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of
FalconStor Software, Inc.'s internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated March 10, 2005 expressed an
unqualified opinion on management's assessment of, and the effective operation
of, internal control over financial reporting.

/s/ KPMG LLP

Melville, New York
March 10, 2005

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
FalconStor Software, Inc.:

We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that
FalconStor Software, Inc. and subsidiaries (the "Company") maintained effective
internal control over financial reporting as of December 31, 2004, based on
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.

A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.

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

In our opinion, management's assessment that the Company maintained
effective internal control over financial reporting as of December 31, 2004, is
fairly stated, in all material respects, based on criteria established in
Internal Control--Integrated Framework issued by COSO. Also, in our opinion, the
Company maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control--Integrated Framework issued by COSO.

We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of the Company as of December 31, 2004 and 2003, and the related
consolidated statements of operations, stockholders' equity and comprehensive
loss, and cash flows for each of the years in the three-year period ended
December 31, 2004, and our report dated March 10, 2005, expressed an unqualified
opinion on those consolidated financial statements.

/s/ KPMG LLP

Melville, New York
March 10, 2005

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

DECEMBER 31,
2004 2003
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents ................................................. $ 15,484,573 $ 8,486,144
Marketable securities ..................................................... 18,488,616 28,199,242
Accounts receivable, net of allowances of $2,551,616 and
$1,837,934, respectively ................................................ 10,269,822 7,109,922
Prepaid expenses and other current assets ................................. 629,036 1,273,125
------------ ------------

Total current assets ............................................. 44,872,047 45,068,433

Property and equipment, net .................................................. 4,662,269 3,861,069
Goodwill ..................................................................... 3,512,796 3,366,642
Other intangible assets, net ................................................. 307,620 396,940
Other assets ................................................................. 2,719,460 3,799,949
------------ ------------

Total assets ..................................................... $ 56,074,192 $ 56,493,033
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .......................................................... $ 821,433 $ 562,305
Accrued expenses .......................................................... 3,501,034 2,777,391
Deferred revenue .......................................................... 4,097,279 2,202,179
------------ ------------

Total current liabilities ........................................ 8,419,746 5,541,875

Deferred revenue ............................................................. 1,290,496 395,609
------------ ------------

Total liabilities ................................................ 9,710,242 5,937,484
------------ ------------

Commitments

Stockholders' equity:
Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
47,768,755 and 46,745,330 shares issued, respectively and 47,491,655
and 46,510,330 shares outstanding, respectively ........................ 47,769 46,745
Additional paid-in capital ................................................ 85,400,740 83,277,981
Deferred compensation ..................................................... -- (7,969)
Accumulated deficit ....................................................... (36,952,436) (31,063,589)
Common stock held in treasury, at cost (277,100 and 235,000 shares,
respectively) .......................................................... (1,714,775) (1,435,130)
Accumulated other comprehensive loss ...................................... (417,348) (262,489)
------------ ------------

Total stockholders' equity ....................................... 46,363,950 50,555,549
------------ ------------
Total liabilities and stockholders' equity ....................... $ 56,074,192 $ 56,493,033
============ ============

See accompanying notes to consolidated financial statements

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31,

2004 2003 2002
-----------------------------------------------------

Revenues:
Software license revenue ................................ $ 21,487,866 $ 12,250,616 $ 8,666,583
Maintenance revenue ..................................... 4,442,724 2,473,504 1,297,146
Software services and other revenue ..................... 2,778,088 2,220,015 665,163
------------ ------------ ------------
28,708,678 16,944,135 10,628,892
------------ ------------ ------------

Operating expenses:
Amortization of purchased and capitalized software....... 1,393,908 1,394,301 899,024
Cost of maintenance, software services and other revenue 4,150,309 2,580,141 1,309,139
Software development costs .............................. 9,050,092 7,067,605 6,280,936
Selling and marketing ................................... 14,277,167 10,966,548 9,856,496
General and administrative .............................. 5,108,516 2,878,192 2,591,430
Litigation settlement ................................... 1,300,000 -- --
Lease abandonment charge ................................ -- 550,162 --
Impairment of prepaid royalty ........................... -- -- 482,715
------------ ------------ ------------
35,279,992 25,436,949 21,419,740
------------ ------------ ------------
Operating loss .................................. (6,571,314) (8,492,814) (10,790,848)
------------ ------------ ------------

Interest and other income .................................. 714,412 1,121,391 1,585,351
Impairment of long-lived assets ............................ -- 35,000 (2,300,062)
------------ ------------ ------------

Loss before income taxes .......................... (5,856,902) (7,336,423) (11,505,559)

Provision for income taxes ................................ 31,945 32,532 37,606
------------ ------------ ------------

Net loss .......................................... $ (5,888,847) $ (7,368,955) $(11,543,165)
------------ ------------ ------------

Basic and diluted net loss per share ...................... $ (0.13) $ (0.16) $ (0.26)
============ ============ ============

Basic and diluted weighted average common shares
outstanding ............................................. 46,967,422 45,967,830 45,232,595
============ ============ ============

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS

Accumulated
other
compre-
Additional Deferred hensive
Common paid-in compen- Accumulated Treasury income
stock capital sation deficit stock (loss)
--------------- --------------- --------------- ----------------- --------------- -------------

Balance, December 31, 2001 $ 45,049 $ 77,991,996 $ (1,026,674) $ (12,151,469) $ (1,220,730) $ (76,600)

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 forfeitures - (95,610) 555,229 - - -

Net loss - - - (11,543,165) - -

Acquisition of treasury stock - - - - (214,400) -

Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger - 2,150,000 - - - -

Net unrealized gain on
marketable securities - - - - - 90,904

Foreign currency translation
adjustment - - - - - 18,769
--------------- --------------- --------------- ----------------- --------------- -------------

Balance, December 31, 2002 $ 45,528 $ 81,423,661 $ (471,445) $ (23,694,634) $ (1,435,130) $33,073

Issuance of stock options to
non-employees - 86,875 - - - -

Exercise of stock options 1,217 850,600 - - - -

Amortization of deferred
compensation - - 463,476 - - -

Net loss - - - (7,368,955) - -

Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger - 916,845 - - - -

Net unrealized loss on
marketable securities - - - - - (214,394)

Foreign currency translation
adjustment - - - - - (81,168)
--------------- --------------- --------------- ----------------- --------------- -------------

Balance, December 31, 2003 $ 46,745 $ 83,277,981 $ (7,969) $ (31,063,589) $ (1,435,130) $ (262,489)

Issuance of stock options to
non-employees - 87,023 - - - -

Exercise of stock options 1,024 2,035,736 - - - -

Amortization of deferred
compensation - - 7,969 - - -

Net loss - - - (5,888,847) - -

Acquisition of treasury stock - - - - (279,645) -

Net unrealized loss on
marketable securities - - - - - (148,849)

Foreign currency translation
adjustment - - - - - (6,010)
--------------- --------------- --------------- ----------------- --------------- -------------

Balance, December 31, 2004 $ 47,769 $ 85,400,740 $ - $ (36,952,436) $ (1,714,775) $ (417,348)
=============== =============== =============== ================= =============== =============

Total
stockholders' Comprehensive
equity loss
---------------- ----------------

Balance, December 31, 2001 $ 63,561,572 -

Issuance of stock options to
non-employees 32,890 -

Compensation expense for accelerated
vesting of stock options 231,415 -

Exercise of stock options 1,113,449 -

Amortization of deferred
compensation and option forfeitures 459,619 -

Net loss (11,543,165) (11,543,165)

Acquisition of treasury stock (214,400) -

Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger 2,150,000 -

Net unrealized gain on
marketable securities 90,904 90,904

Foreign currency translation
adjustment 18,769 18,769
--------------- ----------------

Balance, December 31, 2002 $ 55,901,053 $ (11,433,492)
================

Issuance of stock options to
non-employees 86,875 -

Exercise of stock options 851,817 -

Amortization of deferred
compensation 463,476 -

Net loss (7,368,955) (7,368,955)

Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger 916,845 -

Net unrealized loss on
marketable securities (214,394) (214,394)

Foreign currency translation
adjustment (81,168) (81,168)
--------------- ----------------

Balance, December 31, 2003 $ 50,555,549 $ (7,664,517)
================

Issuance of stock options to
non-employees 87,023 -

Exercise of stock options 2,036,760 -

Amortization of deferred
compensation 7,969 -

Net loss (5,888,847) (5,888,847)

Acquisition of treasury stock (279,645) -

Net unrealized loss on
marketable securities (148,849) (148,849)

Foreign currency translation
adjustment (6,010) (6,010)
--------------- ----------------

Balance, December 31, 2004 $ 46,363,950 $ (6,043,706)
=============== ================

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31,

2004 2003 2002
-------------------------------------------------

Cash flows from operating activities:
Net loss ......................................................... $ (5,888,847) $ (7,368,955) $(11,543,165)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization .............................. 3,656,212 2,759,030 1,747,380
Non-cash professional services expenses .................... 87,023 86,875 32,890
Equity-based compensation expense .......................... 7,969 463,476 691,034
Provision for returns and doubtful accounts ................ 3,296,275 1,700,100 930,150
Impairment of long-lived and other assets .................. -- -- 2,782,777
Changes in operating assets and liabilities, net
of effects of acquisitions:
Accounts receivable ........................................ (6,456,175) (4,524,130) (2,658,455)
Prepaid expenses and other current assets .................. 636,208 (137,115) (571,635)
Other assets ............................................... (251,038) (227,711) (9,119)
Accounts payable ........................................... 259,128 125,217 (121,685)
Accrued expenses ........................................... 791,498 761,827 55,868
Deferred revenue ........................................... 2,789,987 415,059 1,175,735
------------ ------------ ------------

Net cash used in operating activities ................... (1,071,760) (5,946,327) (7,488,225)
------------ ------------ ------------

Cash flows from investing activities:
Purchase of marketable securities ................................ (33,897,295) (8,537,284) (39,507,257)
Sale of marketable securities .................................... 43,459,072 17,034,096 28,843,893
Purchase of investments .......................................... -- (137,710) (75,000)
Purchase of property and equipment ............................... (2,842,792) (2,998,908) (1,272,104)
Purchase of software licenses .................................... (50,000) (1,821,000) (800,000)
Purchase of intangible assets .................................... (131,392) (246,697) (145,534)
Net cash paid for acquisition of IP Metrics ...................... (214,009) (287,130) (2,381,726)
Net cash paid for acquisition of FarmStor ........................ -- -- (169,640)
Security deposits ................................................ (4,500) (500,000) (35,802)
------------ ------------ ------------

Net cash provided by (used in) investing
activities.................................................... 6,319,084 2,505,367 (15,543,170)
------------ ------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options .......................... 2,036,760 851,817 1,113,449
Payments to acquire treasury stock ............................... (279,645) -- (214,400)
------------ ------------ ------------

Net cash provided by financing activities ..................... 1,757,115 851,817 899,049
------------ ------------ ------------

Cash flows from discontinued operations:
Payments of liabilities of discontinued operations............. -- (3,034,620) (2,066,285)
------------ ------------ ------------

Effect of exchange rate changes ..................................... (6,010) (81,168) 18,769
------------ ------------ ------------

Net increase (decrease) in cash and cash equivalents................. 6,998,429 (5,704,931) (24,179,862)

Cash and cash equivalents, beginning of year ........................ 8,486,144 14,191,075 38,370,937
------------ ------------ ------------

Cash and cash equivalents, end of year .............................. $ 15,484,573 $ 8,486,144 $ 14,191,075
============ ============ ============

Increase in additional paid-in capital resulting
from an adjustment to reduce the fair value of the
liabilities of discontinued operations assumed in
the merger with NPI (Notes 2 and 12) ............................. $ -- $ 916,845 $ 2,150,000
============ ============ ============

Cash paid for income taxes .......................................... $ 24,554 $ 48,351 $ 34,082
============ ============ ============

The Company did not pay any interest expense for the three years ended December 31, 2004.

See accompanying notes to consolidated financial statements

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2004

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) THE COMPANY AND NATURE OF OPERATIONS

FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops,
manufactures and sells network storage software solutions and provides the
related maintenance, implementation and engineering services.

(b) PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

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
$10.9 million and $8.2 million at December 31, 2004 and 2003, respectively.
Marketable securities at December 31, 2004 and 2003 amounted to $18.5 million
and $28.2 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, 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. Reseller customers typically send
the Company a purchase order only when they have an end user identified. When a
customer licenses software together with the purchase of maintenance, the
Company allocates a portion of the fee to maintenance for its fair value based
on the contractual maintenance renewal rate. Software maintenance fees are
deferred and recognized as revenue ratably over the term of the contract. The
long-term portion of deferred revenue relates to maintenance contracts with
terms in excess of one year. The cost of providing technical support is included
in cost of revenues. The Company provides an allowance for software product
returns as a reduction of revenue.

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
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 years ended December 31, 2004 and 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 fee is recognized as
revenue when the software or hardware is delivered based on the relative fair
value of the delivered element(s).

(e) PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost and are depreciated using the
straight-line method over the estimated useful lives of the assets (generally
between 3 to 7 years). Leasehold improvements are amortized on a straight-line
basis over the term of the respective leases or over their estimated useful
lives, whichever is shorter.

(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. 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. The Company's annual impairment assessment is performed
on December 31st of each year, and additionally if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $220,712, $159,248 and
$52,893 for 2004, 2003 and 2002, respectively. The gross carrying amount and
accumulated amortization of other intangible assets as of December 31, 2004 and
December 31, 2003 are as follows:

December 31, December 31,
2004 2003
------------ ------------

Customer relationships and purchased technology:

Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (180,708) (108,425)
--------- ---------

Net carrying amount $ 36,142 $ 108,425
========= =========

Patents:

Gross carrying amount $ 523,623 $ 392,231
Accumulated amortization (252,145) (103,716)
--------- ---------

Net carrying amount $ 271,478 $ 288,515
========= =========

As of December 31, 2004, amortization expense on existing identifiable
intangible assets and purchased software technology will be $965,629, $361,427,
and $26,370 for the years ended December 31, 2005, 2006 and 2007, respectively.
Such assets will be fully amortized at December 31, 2007.

(g) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE 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, $31,523 and $31,524 was
amortized for the years ended December 31, 2004, 2003 and 2002, 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.

Purchased software technology of $1,045,806 and $2,381,833, net of
accumulated amortization of $3,865,194 and $2,479,167, is included in other
assets in the balance sheets as of December 31, 2004 and December 31, 2003,
respectively. Amortization expense was $1,386,027, $1,362,778 and 867,499 for
the years ended December 31, 2004, 2003 and 2002, 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 to account for its
fixed-plan stock options. Under this method, compensation expense is recorded
only if on the date of grant 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
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:

2004 2003 2002
------------- ------------- -------------

Net loss as reported $ (5,888,847) $ (7,368,955) $(11,543,165)

Add stock-based employee compensation expense included
in reported net loss, net of tax 7,969 463,476 691,034

Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax (8,268,471) (4,930,656) (3,689,789)
------------ ------------ ------------

Net loss -pro forma $(14,149,349) $(11,836,135) $ (14,541,920)
============ ============ ============

Diluted net loss per common share-as reported $ (0.13) $ (0.16) $ (0.26)

Diluted net loss per common share-pro forma $ (0.30) $ (0.26) $ (0.32)

The per share weighted average fair value of stock options granted during 2004,
2003 and 2002 was $6.55, $5.60 and $2.29, respectively, on the date of grant
using the Black-Scholes option-pricing method with the following weighted
average assumptions: 2004 - expected dividend yield of 0%, risk free interest
rate of 3.5%, expected stock volatility ranging from 166% to 176% 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;

2003 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility ranging from 68% to 153% 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;

(k) FINANCIAL INSTRUMENTS

As of December 31, 2004 and 2003, 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) 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.

(m) 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,
2004, 2003 and 2002, potentially dilutive common stock equivalents included
8,973,358, 9,860,425 and 9,387,579 stock options outstanding, respectively. As
of December 31, 2004 and 2003, potentially dilutive common stock equivalents
also included 750,000 warrants outstanding.

(n) COMPREHENSIVE INCOME (LOSS)

Comprehensive loss includes the Company's net loss, foreign currency
translation adjustments and unrealized (losses) gains on marketable securities.

(o) 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.

(p) NEW ACCOUNTING PRONOUNCEMENTS

In November 2004, the FASB issued SFAS No. 151, INVENTORY COSTS - AN
AMENDMENT OF ARB NO. 43, CHAPTER 4 ("SFAS No. 151"). SFAS No. 151 requires all
companies to recognize a current-period charge for abnormal amounts of idle
facility expense, freight, handling costs and wasted materials. This statement
also requires that the allocation of fixed production overhead to the costs of
conversion be based on the normal capacity of the production facilities. SFAS
No. 151 will be effective for fiscal years beginning after June 15, 2005. The
Company believes that this statement will not have a material effect on its
consolidated financial statements.

(q) RECLASSIFICATIONS

Certain reclassifications have been made to prior years' 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 December 31, 2004, the Company made final aggregate
contingent acquisition payments totaling $501,139 related to the sale of IP
Metrics' products and services. Contingent consideration incurred through
December 31, 2004 in excess of the amount accrued at the time of acquisition was
$211,197, of which $146,154 and $65,043 was added to goodwill in 2004 and 2003,
respectively.

The fair value of the net tangible liabilities of IP Metrics assumed was
$898,305, including $289,942 of accrued contingent consideration recorded at the
time of acquisition. 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 $3,325,071
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.

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.
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." 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. At the time of the
merger, NPI had no continuing operations and, thus, any post-merger transactions
related to NPI have been classified as discontinued operations. In connection
with the merger, the name of NPI was changed to FalconStor Software, Inc.

(3) PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

DECEMBER 31, DECEMBER 31,
2004 2003
------------------------------

Computer hardware and software $ 8,542,374 $ 5,746,303

Furniture and equipment 503,819 473,774

Leasehold improvements 314,101 297,425
----------- -----------

9,360,294 6,517,502

Less accumulated depreciation (4,698,025) (2,656,433)
----------- -----------

$ 4,662,269 $ 3,861,069
=========== ===========

Depreciation expense was $2,041,592, $1,205,839, and $826,989 in 2004,
2003, and 2002, respectively.

(4) MARKETABLE SECURITIES

The Company accounts for its short-term investments in accordance with
SFAS 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 cost and fair values of the Company's marketable securities as of
December 31, 2004 and 2003 are as follows:

Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
------------ ----------- --------- --------------

Available-for-sales securities:

December 31, 2004 $18,488,616 $18,756,422 $-- $ (267,806)

December 31, 2003 $28,199,242 $28,318,199 $-- $ (118,957)

Marketable securities at December 31, 2004 and 2003 consist of corporate
bonds and government securities.

(5) ACCRUED EXPENSES

Accrued expenses are comprised of the following:

DECEMBER 31, DECEMBER 31,
2004 2003
----------- ----------

Accrued compensation $1,088,656 $ 697,839

Accrued consulting and professional fees 899,678 302,425

Accrued marketing and promotion 193,592 50,000

Other accrued expenses 770,821 965,774

Accrued IP Metrics contingent purchase price -- 67,855

Accrued hardware purchases 73,252 253,682

Accrued and deferred rent 475,035 439,816
---------- ----------

$3,501,034 $2,777,391
========== ==========

(6) INCOME TAXES

The provision for income taxes for the years ended December 31, 2004, 2003
and 2002 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, 2004 and 2003 are as follows:

2004 2003
------------ ------------

U.S. net operating loss carryforwards (FalconStor) $ 13,379,600 $ 12,525,600
U.S. net operating loss carryforwards (NPI) 31,711,100 31,756,000
Start-up costs not currently deductible for taxes 384,800 714,300
Depreciation (584,300) (584,500)
Compensation 361,300 367,900
Tax credit carryforwards 1,433,200 1,067,100
Deferred revenue 1,977,400 957,700
Capital loss carryforward 883,400 951,300
Lease abandonment charge 111,800 231,100
Allowance for receivables 995,100 771,900
Other 8,100 103,600
------------ ------------
50,661,500 48,862,000
Valuation allowance (50,661,500) (48,862,000)
------------ ------------

$ -- $ --
============ ============

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, 2004, 2003 and 2002,
are as follows:

2004 2003 2002
------------- ------------ -------------

Tax recovery at Federal statutory rate $(1,991,300) $(2,494,400) $(3,911,900)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit 809,300 (318,000) (788,400)
Non-deductible expenses 47,600 41,900 41,400
Compensation 2,700 157,600 389,800
Foreign tax credit (6,100) (90,000) (125,800)
Net effect of foreign operations 164,800 (900) 75,700
Research and development credit (360,100) (272,200) (233,500)
Increase in valuation allowance 1,365,000 3,008,600 4,590,300
----------- ----------- -----------

$ 31,900 $ 32,600 $ 37,600
=========== =========== ===========

Income (loss) before provision for income taxes for the years ended
December 31, 2004, 2003 and 2002 are as follows:

2004 2003 2002
------------- -------------- ------------

Domestic loss $ (5,466,000) $ (7,434,000) $(11,393,000)
Foreign income (loss) (391,000) 98,000 (113,000)
------------ ------------ ------------

$ (5,857,000) $ (7,336,000) $(11,506,000)
============ ============ ============

As of December 31, 2004, the Company had U.S. net operating loss
carryforwards of approximately $34,307,000 which expire from 2020 through 2024.
In addition, as of the date of the merger described in Note 2, NPI had U.S. net
operating loss carryforwards of $93,268,000 that start to expire in December,
2012. At December 31, 2004 and 2003, the Company 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 Internal Revenue Code Section 382. NPI

experienced such an 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, $4,618,000 would be allocated to paid-in-capital with the remainder
reducing income tax expense. Of the amount allocable to paid-in-capital,
$2,327,000 related to the tax effect of the deductions for payments of the
liabilities of discontinued operations and the balance of $2,291,000 related to
the tax effect of compensation deductions from exercises of employee and
consultant stock options.

(7) STOCKHOLDERS' 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 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 beginning June 1, 2004. 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 that all or a portion of 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. As of December 31, 2004,
the Company had not generated any revenues from this OEM.

(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 14,162,296 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 $7,969, $463,476 and
$459,619 in 2004, 2003 and 2002, respectively.

The Company granted options to purchase an aggregate of 50,000 shares of
common stock to certain non-employee consultants in exchange for professional
services during 2002. The aggregate fair value of these options as determined
using the fair value method under SFAS No. 123, is being expensed over the
periods the services are provided. The related expense amounted to $87,023,
$86,875 and $32,890 in 2004, 2003 and 2002, 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.

On May 14, 2004 the Company adopted a 2004 Outside Directors Stock Option
Plan (the "2004 Plan"). The 2004 Plan is administered by the Board of Directors
and provides for the granting of options to non-employee directors of the
Company to purchase up to 300,000 shares of Company common stock. Exercise
prices of the options must be equal to the fair market value of the common stock
on the date of grant. Options granted have terms of ten years. The 2004 Plan has
a term of three years.

Stock option activity for the periods indicated is as follows:

Weighted
average
Number of exercise
Options price
------------ ------------

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
----------
Granted ........................................ 2,678,300 $ 7.01
Exercised ...................................... (1,224,833) $ .70
Canceled ....................................... (980,621) $ 9.19
----------
Outstanding at December 31, 2003 ............... 9,860,425 $ 4.29
----------
Granted ........................................ 1,227,000 $ 6.91
Exercised ...................................... (1,023,425) $ 1.99
Canceled ....................................... (1,090,642) $ 6.01
----------
Outstanding at December 31, 2004 ............... 8,973,358 $ 4.71
==========

Vested at December 31, 2002 .................... 3,829,793 $ 3.21
==========

Vested at December 31, 2003 .................... 4,950,046 $ 2.47
==========

Vested at December 31, 2004 .................... 5,521,469 $ 3.60
==========

Options available for grant at December 31, 2004 2,698,974
==========

During 2003, one employee paid for the exercise price of certain options
with 7,094 shares of common stock that were held greater than six months. Such
shares which had a market value of $28,744 were retired.

The following table summarizes information about stock options outstanding
at December 31, 2004:

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------------------------- -----------------------------------------

Weighted-Average Weighted
Range of Number Remaining Contractual Average Exercise Number Weighted - Average
Exercise Prices Outstanding Life (Years) Price Exercisable Exercise Price
----------------- --------------- --------------------- -------------------- ----------------- ---------------------

$0.35 - $1.01 2,391,130 5.52 $0.35 2,391,130 $0.35
$3.95 - $4.04 1,222,381 7.88 $4.03 746,861 $4.04
$5.07 - $5.86 1,899,646 7.68 $5.24 961,459 $5.18
$6.20 - $6.90 1,276,190 7.88 $6.30 675,790 $6.20
$7.44 - $8.43 1,663,150 9.14 $8.09 372,075 $8.41
$8.74 - $9.72 375,045 7.10 $9.16 228,338 $9.41
$10.95 145,816 6.37 $10.95 145,816 $10.95
----------- ----------
8,973,358 7.39 $4.71 5,521,469 $3.60
=========== ==========

(9) LEASE ABANDONMENT CHARGE

In November 2003, the Company relocated its headquarters to a larger
facility. As a result of this relocation, the Company vacated its previous
office space and recorded a lease abandonment charge of $550,162 for the
estimated loss expected to be incurred on the remaining lease obligation through

July 2007. The charge included the remaining lease rental obligation reduced by
cash flows the Company expects to generate from an agreement to sub-lease the
facility, as well as the write-off of leasehold improvements at the Company's
previous facility. As of December 31, 2004, the remaining amounts due of
$217,429 associated with this charge were included in accrued expenses.

(10) 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 that commenced in May, 2002 in the market
value of NSSI's common stock underlying the convertible preferred stock to a
value which was significantly below the Company's cost, the Company concluded in
2002 the decline in the fair value of its investment in NSSI's preferred stock
was other than temporary. Accordingly, in 2002 the Company recorded an
impairment charge of $2,300,062 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. In 2003, the Company sold all its NSSI convertible preferred
stock for $35,000, which was reflected as a reduction to the impairment charge
in the statement of operations.

(11) LITIGATION SETTLEMENT CHARGE

During the third quarter of 2004, the Company resolved claims relating to
alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill")
and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company.
Pursuant to the terms of the Settlement Agreement between the Company and
Crossroads, the Company, without admission of infringement, made a one-time
payment of $1.3 million and granted to Crossroads licenses to certain Company
technology in exchange for a worldwide, perpetual license to the technology
underlying the Crossroads patents at issue in the litigation. All claims against
the Company by both Dot Hill and Crossroads were dismissed.

(12) LIABILITIES OF DISCONTINUED OPERATIONS

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. As of December
31, 2002, the Company had reduced liabilities of discontinued operations and
increased additional paid-in-capital by $2,150,000 for its then estimate of the
excess of the remaining liabilities for discontinued operations over the amounts
estimated to be paid.

On February 14, 2003, the Company settled a claim associated with the
liabilities of discontinued operations for $2,850,000. As of December 31, 2003
all significant contingent liabilities related to the discontinued operations of
NPI were resolved and paid. As a result, on December 31, 2003 the excess of the
remaining liabilities for discontinued operations over the amounts paid of
$916,845 was reflected as an increase to additional paid-in-capital since this
liability was related to the merger with NPI, which was accounted for as a
recapitalization.

(13) COMMITMENTS AND CONTINGENCIES

The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to a domestic office and offices in foreign countries. The expiration
dates for these leases ranges from 2005 through 2012. The following is a
schedule of future minimum lease payments for all operating leases as of
December 31, 2004:

YEAR ENDING DECEMBER 31,

2005................................................ $ 1,451,844
2006................................................ 1,520,105
2007................................................ 1,348,593
2008................................................ 1,230,817
2009................................................ 1,264,449
Thereafter.......................................... 3,025,992
------------
$ 9,841,800
============

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 $1,103,008, $673,949, and $596,578 for the years ended December 31, 2004,
2003 and 2002, respectively.

The Company typically provides its customers a warranty on its software
products for a period of no 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. Except for the alleged patent
infringement claim discussed in note 11, through December 31, 2004, there have
not been any claims under such indemnification provisions.

The Company is subject to various legal proceedings and claims, asserted
or unasserted, which arise in the ordinary course of business. While the outcome
of any such matters cannot be predicted with certainty, the Company believes
that such matters will not have a material adverse effect on its financial
condition or liquidity.

(14) STOCK REPURCHASE PROGRAM

On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the year ended December 31, 2004,
the Company purchased 42,100 shares of its common stock in open market purchases
for a total cost of $279,645. As of December 31, 2004, the Company repurchased a
total of 277,100 shares for $1,714,775.

(15) 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, 2004, 2003 and 2002 and the location of long-lived assets as of
December 31, 2004, 2003 and 2002 are summarized as follows:

2004 2003 2002
-------------------------------------------

Revenues:

United States $18,140,465 $ 9,834,526 $ 6,629,147

Asia 5,821,902 3,580,741 2,878,108

Other international 4,746,311 3,528,868 1,121,637
----------- ----------- -----------

Total Revenues $28,708,678 $16,944,135 $10,628,892
=========== =========== ===========

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

United States $ 9,929,214 $10,329,876 $ 7,655,900

Asia 950,387 760,148 425,791

Other international 322,544 334,576 73,706
----------- ----------- -----------

Total long-lived assets $11,202,145 $11,424,600 $ 8,155,397
=========== =========== ===========

For the year ended December 31, 2004, the Company had one customer that
accounted for 16% of revenues. For the year ended December 31, 2003, the Company
did not have any customers that accounted for over 10% of revenues. For the year
ended December 31, 2002, the Company had one customer that accounted for 16% of
revenues. As of December 31, 2004, the Company had three customers with accounts
receivable balances greater than 5% of gross accounts receivable, which in the
aggregate were 30% of the accounts receivable balance. As of December 31, 2003,
the Company had two customers with accounts receivable balances greater than 5%
of gross accounts receivable, which in the aggregate were 11% of the accounts
receivable balance.

(16) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL
ACCOUNTS

Balance at Additions Balance at
Beginning of charged End of
Period Ended, Period to Expense Deductions Period
------------------ ----------- ----------- ---------- ------------

December 31, 2004 $1,837,934 $3,296,275 $2,582,593 $2,551,616
December 31, 2003 $ 813,645 $1,700,100 $ 675,811 $1,837,934
December 31, 2002 $ 375,541 $ 930,150 $ 492,046 $ 813,645

(17) QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of selected quarterly financial data for the
years ended December 31, 2004 and 2003:

Fiscal Quarter
First Second Third Fourth
--------------- -------------- --------------- ----------------- ----------------

2004

Revenue $ 5,258,798 $ 6,483,137 $ 7,469,999 $ 9,496,744
=============== ============== ================ ==============
Net income (loss) $ (2,221,507) $ (1,713,091) $ (2,293,083) $ 338,834
=============== ============== ================= ==============
Basic net income
(loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01
=============== ============== ================ =============

Diluted net income
(loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01
=============== ============== ================ =============
Basic weighted average
common shares
outstanding 46,638,740 46,859,326 47,054,294 47,307,612
=============== ============== ================ =============
Diluted weighted average
common shares
outstanding 46,638,740 46,859,326 47,054,294 51,249,985
=============== ============== ================ =============

2003

Revenue $ 3,678,907 $ 4,090,877 $ 4,082,617 $ 5,091,734
=============== ============== ================ =============
Net loss $ (1,738,853) $ (1,578,925) $ (1,894,198) $ (2,156,979)
=============== ============== ================ ==============
Basic and diluted net
loss per share $ (0.04) $ (0.03) $ (0.04) $ (0.05)
=============== =============== ================= ==============
Basic and diluted
weighted average common
shares outstanding 45,499,862 45,848,994 46,134,816 46,376,183
=============== ============== ================= ==============

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.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES.

Disclosure Controls and Procedures
----------------------------------

The Company maintains "disclosure controls and procedures," as such
term is defined in Rules 13a-15e and 15d-15e of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), that are
designed to ensure that information required to be disclosed in its
reports, pursuant to the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the
SEC's rules and forms, and that such information is accumulated and
communicated to its management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow
timely decisions regarding the required disclosures. In designing
and evaluating the disclosure controls and procedures, management
has recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurances of
achieving the desired control objectives, and management
necessarily is required to apply its judgment in evaluating the
cost benefit relationship of possible controls and procedures.

The Company's Chief Executive Officer and Chief Financial Officer
(its principal executive officer and principal accounting officer,
respectively) have evaluated the effectiveness of its "disclosure
controls and procedures" as of the end of the period covered by
this Annual Report on Form 10-K. Based on their evaluation, the
principal executive officer and principal financial officer
concluded that its disclosure controls and procedures are
effective.

Internal Control Over Financial Reporting
-----------------------------------------

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Company's management is responsible for establishing and
maintaining adequate internal control over financial reporting for
the Company. To evaluate the effectiveness of the Company's
internal control over financial reporting, the Company's management
uses the Integrated Framework adopted by the Committee of
Sponsoring Organizations of the Treadway Commission ("COSO").

The Company's management has assessed the effectiveness of the
Company's internal control over financial reporting as of December
31, 2004, using the COSO framework. The Company's management has
determined that the Company's internal control over financial
reporting is effective as of that date.

KPMG LLP, the registered public accounting firm that has audited
the Company's financial statements included in this report has
issued their attestation report on management's assessment of the
Company's internal control over financial reporting, which is
included herein.

ITEM 9B. OTHER INFORMATION

Not applicable.

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 2005, and is incorporated herein by reference. The
information appears in the Proxy Statement under the captions
"Election of Directors", "Management" and "Committees of the Board
of Directors". The Proxy Statement will be filed within 120 days of
December 31, 2004, 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 2005, 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, 2004, 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 2005, 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, 2004, 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 2005, 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, 2004, our year-end.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information called for by Part III, Item 14, will be included in
our Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2005, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
caption "Principal Accountant Fees and Services." The Proxy
Statement will be filed within 120 days of December 31, 2004, our
year-end.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

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) Exhibits

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, incorporated herein by
reference to Exhibit 4.1 of the Registrant's
registration statement on Form S-8, filed on
September 21, 2001.

4.2 2000 Stock Option Plan, as amended May 15, 2003,
incorporated herein by reference to Exhibit 99 to
the Registrant's quarterly report on Form 10-Q
for the period ended June 30, 2003, filed on
August 14, 2003.

4.3 *2000 Stock Option Plan, as amended May 14, 2004.

4.4 1994 Outside Directors Stock Plan, as amended May
17, 2002 incorporated herein by reference to
Exhibit 4.2 to the Registrant's annual report on
Form 10-K for the year ended December 31, 2002,
filed on March 17, 2003.

4.5 *2004 Outside Directors Stock Option Plan.

10.1 Agreement of lease between Huntington Quadrangle
2, LLC, and FalconStor Software, Inc., dated
August, 2003, incorporated herein by reference to
Exhibit 99.1 to the Registrant's quarterly report
on Form 10-Q for the period ended September 30,
2003, filed on November 14, 2003.

10.2 Amended and Restated Employment Agreement, dated
September 1, 2004 between Registrant and ReiJane
Huai, incorporated herein by reference to Exhibit
10.1 to the Registrant's quarterly report on Form
10-Q for the period ended September 30, 2004,
filed on November 9, 2004.

10.3 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.

10.4 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.

10.5 Change of Control Agreement dated February 2,
2004 between the Registrant and Jim Weber,
incorporated herein by reference to Exhibit 99 to
the Registrant's quarterly report on Form 10-Q
for the period ended March 31, 2004, filed on May
10, 2004.

21.1 Subsidiaries of Registrant - FalconStor, Inc.,
FalconStor AC, Inc., FalconStor Software (Korea),
Inc.

23.1 *Consent of KPMG LLP.

31.1 *Certification of the Chief Executive Officer

31.2 *Certification of the Chief Financial Officer

32.1 *Certification of Chief Executive Officer
pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. ss. 1350)

32.2 *Certification of Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. ss. 1350)

*- filed herewith.

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
10, 2005.

FALCONSTOR SOFTWARE, INC.

By: /s/ ReiJane Huai March 16, 2005
----------------------------------------- --------------
ReiJane Huai, President, Chief Executive Date
Officer of FalconStor Software, Inc.

POWER OF ATTORNEY

FalconStor Software, Inc. and each of the undersigned do hereby
appoint ReiJane Huai and James Weber, 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 16, 2005
---------------------------------------------------- -----------------
ReiJane Huai, President, Chief Executive Officer and Date
Chairman of the Board
(Principal Executive Officer)

By: /s/ James Weber March 16, 2005
----------------------------------------------------- -----------------
James Weber, Chief Financial Officer, Vice President Date
and Treasurer
(Principal Accounting Officer)

By: /s/ Steven L. Bock March 16, 2005
----------------------------------------------------- ----------------
Steven L. Bock, Director Date

By: /s/ Patrick B. Carney March 16, 2005
----------------------------------------------------- ----------------
Patrick B. Carney, Director Date

By: /s/ Lawrence S. Dolin March 16, 2005
----------------------------------------------------- ----------------
Lawrence S. Dolin, Director Date

By: /s/ Steven R. Fischer March 16, 2005
----------------------------------------------------- ----------------
Steven R. Fischer, Director Date