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FALCONSTOR SOFTWARE INC - Quarter Report: 2004 September (Form 10-Q)


                                    FORM 10-Q

                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549


/X/   QUARTERLY  REPORT  PURSUANT  TO  SECTION  13 OR  15(d)  OF THE  SECURITIES
      EXCHANGE ACT OF 1934 For the quarterly period ended  SEPTEMBER 30, 2004
                                                           ------------------

/_/   TRANSITION  REPORT  PURSUANT  TO  SECTION  13 OR 15(d)  OF THE  SECURITIES
      EXCHANGE ACT OF 1934
      For the transition period from                   to
                                     ------------------  -----------------------

                         COMMISSION FILE NUMBER 0-23970

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

                   DELAWARE                         77-0216135

          (State of Incorporation)       (I.R.S. Employer Identification No.)



           2 HUNTINGTON QUADRANGLE

           MELVILLE, NEW YORK                          11747

     (Address of principal executive offices)        (Zip code)

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

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

            Yes X     No

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

The number of shares of Common  Stock issued and  outstanding  as of October 26,
2004 was 47,177,845, which includes redeemable common shares.




                                       1


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                                    FORM 10-Q

                                      INDEX

                                                                           Page

PART I.   Financial Information                                               3



Item 1.   Consolidated Financial Statements                                   3



          Consolidated Balance Sheets at September 30, 2004
                   (unaudited) and December 31, 2003                          3

          Unaudited Consolidated Statements of Operations for the
                   three and nine months ended September 30, 2004 and 2003    4

          Unaudited Consolidated Statements of Cash Flows for the nine
                   months ended September 30, 2004 and 2003                   5

          Notes to the Unaudited Condensed Consolidated
                   Financial Statements                                       6

Item 2.   Management's Discussion and Analysis of Financial Condition
                   and Results of Operations                                 12

Item 3.   Qualitative and Quantitative Disclosures about Market Risk         27

Item 4.   Controls and Procedures                                            27


PART II.  Other Information                                                  28

Item 1.   Legal Proceedings                                                  28

Item 5.   Other Information                                                  28

Item 6.   Exhibits and Reports on Form 8-K                                   28




                                       2





PART I.  FINANCIAL INFORMATION
ITEM 1.     CONSOLIDATED FINANCIAL STATEMENTS

                                            FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
                                                   CONSOLIDATED BALANCE SHEETS
                                                                                   SEPTEMBER 30, 2004    DECEMBER 31, 2003
                                                                                   ------------------    -----------------
                                                    ASSETS                             (UNAUDITED)
Current assets:
   Cash and cash equivalents ......................................................   $ 13,909,687          $  8,486,144
   Marketable securities ..........................................................     18,994,701            28,199,242
   Accounts receivable, net of allowances of $2,323,899 and
      $1,837,934, respectively ....................................................      8,716,928             7,109,922
   Prepaid expenses and other current assets ......................................      1,010,832             1,273,125
                                                                                      ------------          ------------

            Total current assets ..................................................     42,632,148            45,068,433

Property and equipment, net .......................................................      4,209,593             3,861,069
Goodwill ..........................................................................      3,512,796             3,366,642
Other intangible assets, net ......................................................        335,595               396,940
Other assets ......................................................................      2,709,550             3,799,949
                                                                                      ------------          ------------

            Total assets ..........................................................   $ 53,399,682          $ 56,493,033
                                                                                      ============          ============


                                     LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable ...............................................................   $  1,077,692          $    562,305
   Accrued expenses ...............................................................      3,268,372             2,777,391
   Deferred revenue ...............................................................      2,850,656             2,202,179
                                                                                      ------------          ------------

              Total current liabilities ...........................................      7,196,720             5,541,875

Deferred revenue ..................................................................      1,364,003               395,609
                                                                                      ------------          ------------

              Total liabilities ...................................................      8,560,723             5,937,484
                                                                                      ------------          ------------

Commitments

Stockholders' equity:
   Convertible preferred stock - $.001 par value, 2,000,000 shares authorized .....           --                    --
   Common stock - $.001 par value, 100,000,000 shares authorized,
      47,412,996 and 46,745,330 shares issued, respectively and                             47,413                46,745
      47,135,896 and 46,510,330 shares outstanding, respectively ..................
   Additional paid-in capital .....................................................     84,243,821            83,277,981
   Deferred compensation ..........................................................           --                  (7,969)
   Accumulated deficit ............................................................    (37,291,270)          (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 ...........................................       (446,230)             (262,489)
                                                                                      ------------          ------------

            Total stockholders' equity ............................................     44,838,959            50,555,549
                                                                                      ------------          ------------
            Total liabilities and stockholders' equity ............................   $ 53,399,682          $ 56,493,033
                                                                                      ============          ============


                                           See accompanying notes to unaudited consolidated financial statements.


                                       3


                                                         FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                                                           CONSOLIDATED STATEMENTS OF OPERATIONS
                                                                        (UNAUDITED)


                                                THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
                                                -------------------------------  -------------------------------
                                                    2004             2003          2004             2003
                                                -----------    ------------    ------------    -------------

Revenues:
Software license revenue ...................    $ 5,430,010    $  2,878,448    $ 13,893,339    $  8,589,186
Maintenance revenue ........................      1,332,179         663,951       3,197,234       1,710,999
Software services and other revenue ........        707,810         540,218       2,121,361       1,552,216
                                               ------------    ------------    ------------      -----------
                                                  7,469,999       4,082,617      19,211,934       11,852,401
                                               ------------    ------------    ------------      -----------

Operating expenses:
   Amortization of purchased and
    capitalized  software ..................        347,027         358,798       1,171,325         981,337
   Cost of maintenance, software
     services and other revenue ............      1,112,662         620,359       3,080,622       1,804,015
   Software development costs ..............      2,271,437       1,821,442       6,612,280       5,105,196
   Selling and marketing ...................      3,532,531       2,706,326      10,247,147       7,893,247
   General and administrative ..............      1,358,833         736,774       3,566,885       2,127,593
   Litigation settlement ...................      1,300,000            --         1,300,000            --
                                               ------------    ------------    ------------      -----------
                                                  9,922,490       6,243,699      25,978,259      17,911,388
                                               ------------    ------------    ------------      -----------
           Operating loss ..................     (2,452,491)     (2,161,082)     (6,766,325)     (6,058,987)
                                               ------------    ------------    ------------      -----------

Interest and other income ..................        162,146         270,075         553,923         867,914
                                               ------------    ------------    ------------      -----------

         Loss before income taxes ..........     (2,290,345)     (1,891,007)     (6,212,402)     (5,191,073)

Provision for income taxes .................          2,738           3,191          15,279          20,903
                                               ------------    ------------    ------------      -----------

         Net loss...........................   $ (2,293,083)   $ (1,894,198)   $ (6,227,681)   $ (5,211,976)


Basic and diluted net loss per share........   $      (0.05)   $      (0.04)   $      (0.13)   $      (0.11)
                                               ============    ============    ============      ===========
Weighted average basic and diluted
    shares outstanding .....................     47,054,294      46,134,816      46,852,779      45,830,216
                                               ============    ============    ============      ===========

                     See accompanying notes to unaudited consolidated financial statements.


                                       4


                                                         FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                                                           CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                                        (UNAUDITED)

                                                                                                       NINE MONTHS ENDED
                                                                                                          SEPTEMBER 30,
                                                                                                 2004                     2003
                                                                                        ---------------------       --------------------
Cash flows from operating activities:
   Net loss ..................................................................              $ (6,227,681)              $ (5,211,976)
      Adjustments to reconcile net loss to net cash
         used in operating activities:
         Depreciation and amortization .......................................                 2,813,772                  2,059,840
         Non-cash professional services expenses .............................                    23,738                     47,315
         Equity-based compensation expense ...................................                     7,969                    347,607
         Provision for returns and doubtful accounts .........................                 2,268,067                    635,100

      Changes in operating assets and liabilities:
         Accounts receivable, net ............................................                (3,875,073)                (1,728,484)
         Prepaid expenses and other current assets ...........................                   254,412                   (207,569)
         Other assets ........................................................                   (18,543)                  (145,412)
         Accounts payable ....................................................                   515,387                    200,271
         Accrued expenses ....................................................                   490,981                    341,468
         Deferred revenue ....................................................                 1,616,871                   (146,854)
                                                                                            ------------               ------------

            Net cash used in operating activities ............................                (2,130,100)               (3,808,694)
                                                                                            ------------               ------------

Cash flows from investing activities:
   Sale of marketable securities .............................................                30,053,292                 14,850,965
   Purchase of marketable securities .........................................               (20,963,131)                (8,113,555)
   Purchase of investment ....................................................                      --                     (137,710)
   Purchase of property and equipment ........................................                (1,827,752)                (2,128,364)
   Purchase of software licenses .............................................                   (50,000)                (1,171,000)
   Purchase of intangible assets .............................................                  (101,875)                  (165,499)
   Security deposits .........................................................                    (4,501)                  (500,000)
   Net cash paid for acquisition of IP Metrics ...............................                  (146,155)                  (287,130)
                                                                                            ------------               ------------

      Net cash provided by investing activities ..............................                 6,959,878                  2,347,707
                                                                                            ------------               ------------

Cash flows from financing activities:
   Proceeds from exercise of stock options ...................................                   942,771                    433,010
   Payments to acquire treasury stock ........................................                  (279,645)                      --
                                                                                            ------------               ------------

      Net cash provided by financing activities ..............................                   663,126                    433,010
                                                                                            ------------               ------------

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

Effect of exchange rate changes on cash ......................................                   (69,361)                     1,167
                                                                                            ------------               ------------

Net increase (decrease) in cash and cash equivalents .........................                 5,423,543                 (4,061,430)

Cash and cash equivalents, beginning of period ...............................                 8,486,144                 14,191,075
                                                                                            ------------               ------------

Cash and cash equivalents, end of period .....................................              $ 13,909,687               $ 10,129,645
                                                                                            ============               ============

The Company did not pay any interest expense or income taxes for the nine months
ended September 30, 2004 and 2003. See accompanying notes to unaudited
consolidated financial statements.

                                       5


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

         NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) The Company and Nature of Operations

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

(b) Principles of Consolidation

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

(c) Unaudited Interim Financial Information

    The unaudited interim consolidated financial statements of the Company as of
and for the three and nine months ended  September  30, 2004 and 2003,  included
herein  have  been  prepared  pursuant  to  the  rules  and  regulations  of the
Securities  and  Exchange  Commission  ("SEC").  Certain  information  and  note
disclosures  normally  included in financial  statements  prepared in accordance
with accounting  principles  generally  accepted in the United States of America
have been condensed or omitted  pursuant to such rules and regulations  relating
to interim financial statements.

    In the opinion of management,  the accompanying  unaudited interim condensed
consolidated  financial  statements reflect all adjustments,  consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at September 30, 2004 and the results of its  operations  for the
three months and nine months ended September 30, 2004 and 2003.

(d) Cash Equivalents and Marketable Securities

    The Company considers all highly liquid investments with a maturity of three
months  or  less  when  purchased  to be  cash  equivalents.  Cash  equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$12.0 million at September 30, 2004. Marketable securities at September 30, 2004
amounted to $19.0  million  and  consisted  of  corporate  bonds and  government
securities,  which  are  classified  as  available  for sale,  and  accordingly,
unrealized  gains  and  losses  on  marketable  securities  are  reflected  as a
component of accumulated other comprehensive loss in stockholders' equity.

(e)  Revenue Recognition

    The Company  recognizes  revenue from software  licenses in accordance  with
Statement of Position ("SOP") 97-2, Software Revenue  Recognition.  Accordingly,
revenue for  software  licenses is  recognized  when  persuasive  evidence of an
arrangement  exists,  the fee is fixed  and  determinable  and the  software  is
delivered  and  collection  of the  resulting  receivable  is  deemed  probable.
Software  delivered to a customer on a trial basis is not  recognized as revenue
until a permanent  key is delivered to the  customer.  When a customer  licenses
software  together  with the purchase of  maintenance,  the Company  allocates a
portion of the fee to  maintenance  for its fair value based on the  contractual
maintenance renewal rate. Software  maintenance fees are deferred and recognized
as  revenue  ratably  over  the  term of the  contract.  The  cost of  providing
technical support is included in cost of revenues.

    Revenues  associated with software  implementation and software  engineering
services are recognized as the services are performed.  Costs of providing these
services are included in cost of revenues.

                                       6


    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 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 quarters  ended  September  30, 2004 and  September  30,  2003,  the
Company had a limited number of transactions in which it purchased  hardware and
bundled this hardware with the Company's  software and sold the bundled solution
to its customer.  Since the software is not essential for the  functionality  of
the equipment included in the Company's bundled solutions, and both the hardware
and  software  have  stand-alone  value  to  the  customer,  a  portion  of  the
contractual  fees is  recognized  as revenue  when the  software  or hardware is
delivered based on the relative fair value of the delivered element(s).

(f) Property and Equipment

    Property and  equipment  are recorded at cost.  Depreciation  is  recognized
using the straight-line  method over the estimated useful lives of the assets (3
to 7 years). Depreciation expense was $511,192 and $361,911 for the three months
ended September 30, 2004 and 2003, respectively, and $1,479,227 and $992,888 for
the nine months ended September 30, 2004 and 2003, respectively.

(g) Goodwill and Other Intangible Assets

    Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and  identifiable  intangible  assets acquired in business
combinations.  Consistent  with  Statement  of  Financial  Accounting  Standards
("SFAS")  142,  Goodwill  and  Other  Intangible  Assets,  the  Company  has not
amortized  goodwill related to its acquisitions,  but instead tested the balance
for impairment.  The Company's annual  impairment  assessment is performed as of
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 $57,308 and $42,643 for
the three months ended September 30, 2004 and 2003,  respectively,  and $163,220
and  $109,258  for  the  nine  months  ended   September   30,  2004  and  2003,
respectively.  The gross carrying amount and  accumulated  amortization of other
intangible assets as of September 30, 2004 and December 31, 2003 are as follows:


                                                                September 30,         December 31,

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

    Customer relationships and purchased technology:

    Gross carrying amount                                      $   216,850          $   216,850
    Accumulated amortization                                      (162,637)            (108,425)
                                                                -----------         ------------

    Net carrying amount                                        $    54,213          $   108,425
                                                                ===========         ============


    Patents:

    Gross carrying amount                                      $   494,106          $   392,231
    Accumulated amortization                                      (212,724)            (103,716)
                                                                -----------         ------------

    Net carrying amount                                        $   281,382          $   288,515
                                                                ===========         ============



                                       7


(h) Software Development Costs and Purchased Technology

    Costs  associated  with  the  development  of  new  software   products  and
enhancements  to existing  software  products  are  expensed  as incurred  until
technological  feasibility  of the  product has been  established.  Based on the
Company's product development process,  technological feasibility is established
upon completion of a working model.  The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released,  the Company capitalized
$94,570 of software  development  costs.  Software  development costs were fully
amortized as of September 30, 2004. For the nine months ended September 30, 2004
and 2003,  $7,881 and  $23,643 of  software  development  costs were  amortized,
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  $1,268,389  and  $2,381,833,   net  of
accumulated  amortization  of $3,642,611  and  $2,479,167,  is included in other
assets in the balance  sheets as of  September  30, 2004 and  December 31, 2003,
respectively.  Amortization  expense was  $347,027  and  $350,917  for the three
months ended  September  30, 2004 and 2003,  respectively,  and  $1,163,444  and
$957,694 for the nine months ended September 30, 2004 and 2003, respectively.

(i) Income Taxes

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

(j) Long-Lived Assets

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

(k) Accounting for Stock-Based Compensation

    The  Company  applies  the   intrinsic-value   based  method  of  accounting
prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for
Stock  Issued  to  Employees,   and  related   interpretations   including  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
only the disclosure requirements of SFAS No. 123.

    Had the Company determined stock-based compensation cost based upon the fair
value method under SFAS No. 123,  the  Company's  pro forma net loss and diluted
net loss per share would have been adjusted to the pro forma  amounts  indicated
below:

                                                                      THREE MONTHS ENDED SEPT 30,       NINE MONTHS ENDED SEPT 30,
                                                                      ---------------------------       --------------------------

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

Net loss as reported                                                $ (2,293,083)    $ (1,894,198)    $ (6,227,681)    $ (5,211,976)
Add stock-based employee compensation expense
included  in reported netincome, net of tax                                 --            115,861            7,969          347,607


                                       8


Deduct total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of tax                                            (2,451,647)      (1,736,751)      (7,538,144)      (4,742,578)
                                                                    ------------     ------------     ------------     ------------



Net loss - pro forma                                                $ (4,744,730)    $ (3,515,088)    $(13,757,856)    $ (9,606,947)
                                                                    ============     ============     ============     ============
Basic and diluted net loss per common share-as reported             $       (.05)    $       (.04)    $       (.13)    $       (.11)
Basic and diluted net loss per common share-pro forma               $       (.10)    $       (.08)    $       (.29)    $       (.21)

The per share weighted average fair value of stock options granted was $4.59 for
the three months ended  September 30, 2003.  There were no stock options granted
during the three months ended September 30, 2004. The per share weighted average
fair  value of stock  options  granted  was $5.38 and $3.11 for the nine  months
ended September 30, 2004 and 2003, 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%,  expected
stock  volatility  ranging from 116% to 160% 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.

(l) Financial Instruments

    As of  September  30,  2004 and  December  31,  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.

(m) Foreign Currency

    Assets and  liabilities  of foreign  operations  are  translated at rates of
exchange at the end of the period, while results of operations are translated at
average  exchange  rates in effect for the period.  Unrealized  gains and losses
from the  translation  of foreign  assets and  liabilities  are  classified as a
separate  component  of  stockholders'  equity.  Realized  gains and losses from
foreign currency transactions are included in the statements of operations.

(n)  Earnings Per Share (EPS)

    Basic EPS is  computed  based on the  weighted  average  number of shares of
common stock outstanding.  Diluted EPS is computed based on the weighted average
number  of  common  shares  outstanding   increased  by  dilutive  common  stock
equivalents.  Due to net  losses for the  periods  presented,  all common  stock
equivalents  were excluded from diluted net loss per share.  As of September 30,
2004,  potentially  dilutive common stock equivalents  included  9,039,602 stock
options outstanding and 750,000 warrants outstanding.

(o)  Comprehensive Loss

    Comprehensive  loss  amounted to  $2,333,468  and  $2,026,200  for the three
months ended  September  30, 2004 and 2003,  respectively,  and  $6,411,422  and
$5,410,396 for the nine months ended September 30, 2004 and 2003,  respectively.
Comprehensive  loss  includes  the  Company's  net  loss  and  foreign  currency
translation  adjustments  of  $(69,739)  and $55,969 for the three  months ended
September 30, 2004 and 2003, respectively, and $(69,361) and $1,167 for the nine
months  ended   September  30,  2004  and  2003,   respectively.   Additionally,
comprehensive   loss  includes  the  Company's   unrealized   gains/(losses)  on
marketable  securities  of $29,354 and  $(183,571)  for the three  months  ended


                                       9


September 30, 2004 and 2003, respectively, and $(114,380) and $(199,587) for the
nine months ended September 30, 2004 and 2003, respectively.

(p) Indemnification

    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 a finding of  infringement,  the
Company  retains the right to (i) procure for the customer the right to continue
using the  software;  (ii)  replace  or modify the  software  to  eliminate  the
infringement while providing substantially equivalent functionality; or (iii) if
neither (i) nor (ii) can be reasonably  achieved,  the Company may terminate the
license  agreement and refund to the customer a pro-rata  portion of the license
fee paid to the Company.  Such  indemnification  provisions are accounted for in
accordance with SFAS No.5.  Through  September 30, 2004, there have not been any
claims under such  indemnification  provisions,  expect for the one discussed in
Note 3.

(q) 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.

(r) New Accounting Pronouncements

    In March 2004 the Financial  Accounting  Standard Board  ("FASB")  issued an
exposure draft entitled Share-Based Payment, an amendment of FASB Statements No.
123 and 95.  This  exposure  draft would  require  stock-based  compensation  to
employees to be recognized as a cost in the financial  statements  and that such
cost be  measured  according  to the fair  value of the  stock  options.  In the
absence of an observable  market price for the stock  awards,  the fair value of
the stock  options would be based upon a valuation  methodology  that takes into
consideration  various factors,  including the exercise price of the option, the
expected term of the option,  the current price of the  underlying  shares,  the
expected volatility of the underlying share price, the expected dividends on the
underlying shares and the risk-free interest rate. The proposed  requirements in
the exposure  draft would be effective for interim or annual  periods  beginning
after July 1, 2005. The Company will continue to monitor communications on  this
subject  from the  FASB in  order  to  determine  the  impact  on the  Company's
consolidated financial statements.

(s) Reclassifications

    Certain  reclassifications  have  been  made to  prior  year's  consolidated
financial statements to conform to the current year's presentation.



(2) SEGMENT REPORTING

    The Company is  organized  in a single  operating  segment  for  purposes of
making operating decisions and assessing  performance.  Revenues from the United
States to customers in the following  geographical  areas for the three and nine
months  ended  September  30, 2004 and  September  30, 2003 and the  location of
long-lived  assets as of September 30, 2004 and December 31, 2003 are summarized
as follows:

                                       10




                                   THREE MONTHS ENDED SEPTEMBER 30,    NINE MONTHS ENDED SEPTEMBER 30,

                                         2004            2003                2004             2003
                                         ----            ----                ----             ----
United States                       $ 4,797,735       $ 2,397,445       $11,300,465       $ 6,878,237
Asia                                  1,854,925           924,815         4,387,127         2,492,048
Other international                     817,339           760,357         3,524,342         2,482,116
                                    -----------       -----------       -----------       -----------

      Total revenues                $ 7,469,999       $ 4,082,617       $19,211,934       $11,852,401
                                    ===========       ===========       ===========       ===========


                                                               September 30,    December 31,

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

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

     United States                                             $  9,728,231    $ 10,329,876
     Asia                                                           750,147         760,148
     Other international                                            289,156         334,576
                                                               ------------    ------------

                      Total long-lived assets                  $ 10,767,534    $ 11,424,600
                                                               ============    ============



(3) 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 in the
United States District Court for the Western District of Texas.  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 have now been dismissed.



(4) STOCK REPURCHASE PROGRAM

    On October 25,  2001,  the  Company  announced  that its Board of  Directors
authorized  the  repurchase  of  up to  two  million  shares  of  the  Company's
outstanding  common stock. The repurchases 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 nine months ended September
30, 2004, the Company purchased 42,100 shares of its common stock in open market
purchases for a total cost of $279,645.  The Company did not purchase any shares
during  the third  quarter  of 2004.  As of  September  30,  2004,  the  Company
repurchased a total of 277,100 shares for $1,714,775.



(5) STOCK OPTION PLAN

    On May 14, 2004,  the  Company's  stockholders  approved an amendment to the
Company's  2000 Stock  Option  Plan to  increase  the number of shares of common
stock  reserved  for  issuance   thereunder  by  1,500,000  from  12,662,296  to
14,162,296.  In addition,  the Company's  stockholders approved the 2004 Outside
Director  Stock Option Plan (the "2004 Plan").  A maximum of 300,000  authorized
but unissued or treasury shares of the common stock of the Company may be issued
upon the exercise of the options granted under the 2004 Plan.


                                       11


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

The following  Management's  Discussion and Analysis of Financial  Condition and
Results of Operations contains  "forward-looking  statements" within the meaning
of Section 27A of the  Securities  Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These forward-looking  statements can be identified by the
use  of  predictive,   future-tense  or  forward-looking  terminology,  such  as
"believes,"  "anticipates,"  "expects,"  "estimates," "plans," "may," "intends,"
"will," or similar  terms.  Investors  are  cautioned  that any  forward-looking
statements  are not  guarantees of future  performance  and involve  significant
risks and  uncertainties,  and that actual  results may differ  materially  from
those  projected in the  forward-looking  statements.  The following  discussion
should be read together with the consolidated  financial statements and notes to
those financial statements included elsewhere in this report.


OVERVIEW

    We continued our sales  momentum in the third quarter of 2004.  Our revenues
increased 83% compared with the third quarter of 2003, and 15% compared with the
second quarter of 2004. This ongoing growth  reflects the continued  success and
acceptance of our products in the marketplace.

    Despite the year over year and sequential  growth,  revenues were lower than
we anticipated for the quarter. Revenues from our Europe, Middle East and Africa
(EMEA)  region  declined  from the  second  quarter of 2004 and did not meet our
expectations.  We  believe  that  the  shortfall  from  EMEA  was  a  result  of
seasonality and was not due to lack of market acceptance of our products.

    In  addition,  we had  expected  a  contribution  to  revenue  from  the OEM
relationship  announced  in the third  quarter  of 2003,  in which we had issued
warrants  to this OEM  partner.  Unfortunately,  the OEM partner has delayed its
launch of the product  incorporating  our technology.  This delay results solely
from internal issues at the OEM; we are unaware of any issue with the technology
they were to have licensed from us for inclusion in the product. As a result, we
did not  recognize  any revenue from this  relationship  in the third quarter of
2004.

    During the third quarter of 2004,  we signed an OEM  agreement  with a major
U.S.-based technology company for our iSCSI Storage Server product.

    In the third quarter of 2004,  software  license and other sales by both our
resellers and our  strategic OEM partners  increased.  As we  anticipated  would
happen,  and as we expect will  continue for several  additional  quarters,  the
percentage of revenues  attributable to sales by our OEM partners as compared to
our resellers  increased.  This increase in sales attributable to OEMs is one of
the key factors we look to for the future growth of our  business.  In addition,
increasing revenues from OEMs help improve our gross margins.

    Our deferred  revenues  also  increased on both a third  quarter  2004/third
quarter 2003 and a third quarter 2004/second quarter 2004 comparison. We believe
this is an indicator of the health of our business because it reflects, in part,
maintenance renewals from satisfied customers.

    During  the third  quarter  of 2004,  we  settled  the  patent  infringement
litigation pending against us for $1.3 million, plus the exchange of licenses to
certain  technology.  As a result,  the  indemnification  claim  against  us was
dismissed. See Note 3 to our financial statements.

    Our  operating  expenses in the third  quarter of 2004,  excluding  the $1.3
million patent infringement  litigation settlement,  increased 38% compared with
the third  quarter of 2003.  This  increase  in  expenses  was  expected  and is
attributable  primarily to: increases in our research and  development,  quality
assurance,  support and sales  staffs;  the higher cost of our new  headquarters
compared with our old office space; and the purchase of additional  hardware and
software to support and to develop our  products.  All of these  increases  were
necessary to support the growth of our business.  In addition,  we incurred $0.4
million in  litigation  expenses  related to the  alleged  patent  infringement,
discussed in Note 3 to our financial statements.


                                       12


     We try  to  contain  the  growth  of our  expenses  by  exercising  prudent
oversight of spending.  To that end,  expenses related to the growth and support
of our business, and other recurring expenses,  increased only $0.4 million from
the second quarter of 2004. A major contributor to that increase was the cost of
compliance  with  Section  404 of the  Sarbanes-Oxley  Act  of  2002.  Operating
expenses, including attorney's fees related to the litigation concerning alleged
patent infringement in both quarters,  but excluding the $1.3 million litigation
settlement,  increased  only $0.2  million from the second  quarter of 2004.  We
anticipate  that our  expenses for the fourth  quarter of 2004 will  continue to
increase.

RESULTS OF  OPERATIONS - FOR THE THREE MONTHS ENDED  SEPTEMBER 30, 2004 COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 2003.

     Revenues for the three months ended  September  30, 2004  increased  83% to
$7.5 million compared with $4.1 million for the three months ended September 30,
2003. Our operating  expenses,  excluding the $1.3 million  patent  infringement
litigation  settlement,  increased  38% from $6.2  million for the three  months
ended  September  30, 2003 to $8.6  million for the three months  September  30,
2004.  Net loss  increased  21% from $1.9  million  for the three  months  ended
September  30, 2003 to $2.3  million for the three months  ended  September  30,
2004.  The  increase in revenues was mainly due to an increase in demand for our
network storage solution  software.  Revenue  contribution from our OEM partners
increased to  approximately  30% of our total revenue for the three months ended
September  30, 2004,  and the remaining  revenue was derived from  resellers and
distributors.  Expenses  increased in all aspects of our business to support our
growth. Included in our results for the three months ended September 30, 2004 is
a litigation  settlement  charge of $1.3 million and legal fees of $0.4 million,
each associated with litigation relating to alleged patent infringement that was
resolved  in the  third  quarter  of  2004.  In  November,  2003  we  moved  our
headquarters  to a larger  facility and for the three months ended September 30,
2004,  we  increased  the  number  of  employees  and  continued  to  invest  in
infrastructure  by  purchasing  additional  computers  and  equipment.  We  also
increased the number of employees from 158 as of September 30, 2003 to 207 as of
September 30, 2004.

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  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  89% from $2.9  million for the three
months  ended  September  30, 2003 to $5.4  million for the three  months  ended
September 30, 2004.  Increased market acceptance and demand for 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  software  license  revenue to  continue  to grow and the  percentage  of
software license revenue derived from 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.  For the three months  ended  September  30,  2004,  we had a limited
number of transactions in which we purchased  hardware and bundled this hardware
with our software and sold the bundled  solution to our  customer.  A portion of
the  contractual  fees 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).  For the nine months  ended  September  30,  2004,  the software and


                                       13


hardware in bundled  solutions  have been  delivered to the customer in the same
quarter. Maintenance,  software services and other revenue increased 69% to $2.0
million for the three months ended  September 30, 2004 from $1.2 million for the
three months ended September 30, 2003.

     The major factor behind 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 $0.7 million for the three months ended  September  30,
2003 to $1.3 million for the three months ended  September 30, 2004. An increase
in our hardware sales also contributed to the increase in software  services and
other revenues. Hardware sales increased from approximately $0.3 million for the
three  months ended  September  30, 2003 to  approximately  $0.5 million for the
three  months  ended  September  30,  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.  Amortization  of purchased and capitalized  software  decreased from $0.4
million for the three  months ended  September  30, 2003 to $0.3 million for the
three months ended September 30, 2004. The decrease in amortization  expense was
due to some software  licenses becoming fully amortized during the third quarter
of 2004.  As of September  30, 2004,  we had $4.9 million of purchased  software
licenses that are being  amortized over three years.  For the three months ended
September 30, 2004, we recorded  $0.3 million of  amortization  related to these
purchased  software  licenses.  As of September 30, 2003, we had $4.2 million of
purchased   software  licenses  and  recorded   approximately  $0.4  million  of
amortization  for the three  months  ended  September  30, 2003 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 costs was $7,881
for the three months ended September 30, 2003.  Capitalized  software costs were
fully amortized as of the end of the first quarter of 2004.

Cost of maintenance, software services and other revenue

     Cost  of  maintenance,   software  services  and  other  revenues  consists
primarily  of  personnel  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 for resale.  Cost of maintenance,  software  services and
other revenues for the three months ended September 30, 2004 increased by 79% to
$1.1 million  compared to $0.6 million for the three months ended  September 30,
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.  Additionally, due to the increase in hardware sales our
associated hardware costs increased from $0.2 million for the three months ended
September  30, 2003 to $0.3  million for the three months  ended  September  30,
2004. Our cost of maintenance, software services and other revenue will continue
to grow in absolute dollars as our revenues increase.

     Gross profit for the three months ended September 30, 2004 was $6.0 million
or 80% of revenue  compared  to $3.1  million  or 76% of  revenue  for the three
months ended  September 30, 2003.  The increase in gross profit and gross margin


                                       14


was directly related to the increase in revenues.  Additionally, the increase in
revenue  from our OEM partners  contributed  to the increase in gross profit and
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 25% to $2.3 million for the three months
ended  September 30, 2004 from $1.8 million for the three months ended September
30, 2003.  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 entered  into  agreements  with new OEM  partners,  we required
additional  employees to test and  integrate our software with our OEM partners'
products. In the fourth quarter of 2003, we opened a development office in China
to assist in our development efforts,  which also contributed to the increase in
software  development costs. 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 31% to $3.5 million for the three months ended September 30, 2004 from
$2.7 million for the three months ended  September  30, 2003. As a result of the
increase in revenue, our commission expense increased. In addition, we continued
to hire new sales and sales support personnel and 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  84% to $1.4
million for the three months ended  September 30, 2004 from $0.7 million for the
three  months   ended   September   30,  2003.   The  increase  in  general  and
administrative  expenses was primarily  due to a $0.4 million  increase in legal
expenses  attributable to the litigation relating to alleged patent infringement
with Dot Hill Systems  Corporation  ("Dot Hill") and Crossroad  Systems (Texas),
Inc.  ("Crossroads").  Expenses  of $0.2  million  for the  three  months  ended
September 30, 2004, related to compliance with Section 404 of the Sarbanes-Oxley
Act of 2002,  also  contributed  to the  increase in general and  administrative
expenses.  Additionally, an increase in the number of employees also resulted in
an 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  Company  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 40% to $0.2 million for the three months ended September 30, 2004 from
$0.3 million for the three months ended  September  30, 2003.  This  decrease in
interest  income was due to lower  interest  rates and lower average cash,  cash
equivalent and marketable securities balances.


                                       15



INCOME TAXES

     We did not record a tax benefit  associated  with the pre-tax loss incurred
from the period from inception  (February 10, 2000) through  September 30, 2004,
as we deemed that it was more likely than not that the  deferred tax assets will
not be  realized  based on our net results to date.  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.

                                       16


RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO
THE NINE MONTHS ENDED SEPTEMBER 30, 2003.

REVENUES

     Revenues  for the nine months ended  September  30, 2004  increased  62% to
$19.2 million  compared  with $11.9 million for the nine months ended  September
30, 2003. Our operating expenses, excluding the $1.3 million patent infringement
litigation  settlement,  increased  38% from $17.9  million  for the nine months
ended  September 30, 2003 to $24.7  million for the nine months ended  September
30,  2004.  Net loss  increased  19% from $5.2 million for the nine months ended
September 30, 2003 to $6.2 million for the nine months ended September 30, 2004.
The increase in revenues was mainly due to an increase in demand for our network
storage solution software.  Revenue contribution from our OEM partners increased
in absolute dollars and as a percentage of our total revenue for the nine months
ended September 30, 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 nine months ended  September  30, 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
158 as of September  30, 2003 to 207 as of September  30, 2004.  Included in our
results for the nine months ended September 30, 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.

Software license revenue

     Software  license  revenue  increased  62% from $8.6  million  for the nine
months  ended  September  30, 2003 to $13.9  million  for the nine months  ended
September 30, 2004.  Increased market acceptance and demand for 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  software  license  revenue to  continue  to grow and the  percentage  of
software license revenue derived from OEM partners to increase.

Maintenance, software services and other revenue

     Maintenance,  software  services and other  revenue  increased  63% to $5.3
million for the nine months ended  September 30, 2004 compared with $3.3 million
for the nine  months  ended  September  30,  2003.  The  primary  reason for the
increase in maintenance,  software services and other revenue was an increase in
the number of our  maintenance  and technical  support  contracts.  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 $1.7 million for
the nine months  ended  September  30, 2003 to $3.2  million for the nine months
ended  September  30, 2004.  Growth in our  professional  service  sales,  which
increased from $0.6 million for the nine months ended September 30, 2003 to $1.0
million for the nine months ended  September 30, 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  approximately  $1.0 million for the nine months ended  September
30, 2003 to  approximately  $1.1 million for the nine months ended September 30,
2004.  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 $1.0
million for the nine months  ended  September  30, 2003 to $1.2  million for the
nine months ended September 30, 2004. The increase in  amortization  expense was
primarily due to our purchase of an additional $0.7 million of software licenses
subsequent  to the third  quarter of 2003. As of September 30, 2004, we had $4.9
million of  purchased  software  licenses  that are being  amortized  over three
years. For the nine months ended September 30, 2004, we recorded $1.2 million of


                                       17


amortization  related to these purchased software licenses.  As of September 30,
2003,  we  had  $4.2  million  of  purchased   software  licenses  and  recorded
approximately  $1.0 million of amortization  for the nine months ended September
30,  2003  related  to  these  purchased  software  licenses.   Amortization  of
capitalized  software was $7,881 and $23,643 for the nine months ended September
30, 2004 and September 30, 2003, respectively.

Cost of maintenance, software services and other revenue

     Cost of  maintenance,  software  services  and other  revenues for the nine
months ended  September  30, 2004  increased by 71% to $3.1 million  compared to
$1.8 million for the nine months ended  September 30, 2003. The increase in cost
of maintenance,  software  services and other revenues 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 nine months ended September 30, 2004 was $15.0 million
or 78% of revenues  compared  with $9.1  million or 76% of revenues for the nine
months ended  September 30, 2003.  The increase in gross profit and gross margin
was directly related to the increase in revenues.  Additionally, the increase in
revenue from our OEM partners also  contributed  to the increase in gross profit
and gross  margins,  since  revenue  from our OEM  partners  have  higher  gross
margins.

SOFTWARE DEVELOPMENT COSTS

     Software  development  costs  increased  30% to $6.6  million  for the nine
months ended  September  30, 2004 compared with $5.1 million for the nine months
ended September 30, 2003. The increase in software  development costs was mainly
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 entered into agreements with new OEM partners,  we
required  additional  employees to test and  integrate our software with our OEM
partners' products.

SELLING AND MARKETING

     Selling and marketing  expenses increased 30% to $10.2 million for the nine
months  ended  September  30, 2004 from $7.9  million for the nine months  ended
September  30,  2003.  This  increase  in selling  and  marketing  expenses  was
partially due to increased commission expense,  which is directly related to our
increase in  revenues.  In  addition,  we  continued to hire new sales and sales
support  personnel and expand our worldwide  presence to accommodate our revenue
growth.

GENERAL AND ADMINISTRATIVE

     General and  administrative  expenses increased 68% to $3.6 million for the
nine months ended September 30, 2004 from $2.1 million for the nine months ended
September  30,  2003.  The increase in general and  administrative  expenses was
primarily  due to a $1.0  million  increase  in legal  expense  attributable  to
litigation relating to alleged patent infringement with Dot Hill and Crossroads.
Expenses of $0.2 million for the nine months ended  September 30, 2004,  related
to  compliance  with  Section  404  of the  Sarbanes-Oxley  Act  of  2002,  also
contributed   to  the   increase   in  general  and   administrative   expenses.
Additionally,  an increase in the number of employees resulted in an 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  Company  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.


                                       18


INTEREST AND OTHER INCOME

     Interest and other income decreased 36% to $0.6 million for the nine months
ended  September 30, 2004 from $0.9 million for the nine months ended  September
30, 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  September 30, 2004,
as we deemed that it was more likely than not that the  deferred tax assets will
not be  realized  based on our net results to date.  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.



LIQUIDITY AND CAPITAL RESOURCES

     Our  cash  and  cash  equivalents  totaled  $13.9  million  and  marketable
securities  totaled  $19.0  million at September  30, 2004.  As of September 30,
2003, we had approximately  $10.1 million in cash and cash equivalents and $30.0
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, our cash has been used primarily to fund operations.  Until
we  reach  profitability,  we will  continue  to use  our  cash  and  marketable
securities to fund operations.

     In  November,  2003 we moved  our  headquarters  to a larger  facility.  We
continued to invest in our infrastructure to support our long-term growth during
the nine months ended  September 30, 2004. We made  investments  in property and
equipment and we increased  the number of employees  during the third quarter of
2004.

     We currently do not have any debt and our only  material  commitments  that
could impact liquidity are related to our office leases.

     During  the third  quarter  of 2004,  we made a  one-time  payment  of $1.3
million to settle a patent  infringement  litigation,  as discussed in Note 3 to
the financial statements.


     In October 2001, our Board of Directors  authorized the repurchase of up to
two million shares of our outstanding common stock, of which 277,100 shares were
repurchased  through September 30, 2004, at an aggregate  purchase price of $1.7
million.  During the nine months ended September 30, 2004, the Company purchased
42,100  shares of its common stock in open market  purchases for a total cost of
$279,645. We did not repurchase any shares during the third quarter of 2004.

     Net cash used in  operating  activities  totaled  $2.1 million for the nine
months ended  September 30, 2004. This was primarily a result of our net loss of
$6.2  million,  and an increase of $3.9  million in accounts  receivable.  These
amounts were partially offset by non-cash charges of $5.1 million  consisting of
depreciation  and  amortization,   non-cash   professional   services  expenses,
equity-based  compensation  and  provision  for returns and  doubtful  accounts.
Additional  offsetting  amounts include increases in accounts  payable,  accrued
expenses,  deferred revenue and a decrease in prepaid expenses and other current
assets of $2.9 million in the aggregate.  Net cash used in operating  activities
for the nine months ended September 30, 2003 was $3.8 million.  The cash used in
operating  activities  for the nine months ended  September  30, 2003 was mainly
comprised of the Company's  net loss of $5.2 million,  and increases in accounts
receivable,  prepaid and other current assets and other assets and a decrease in
deferred revenue of $2.2 million in the aggregate.  These amounts were partially
offset by non-cash  expenses of $3.1  million,  as well as increases in accounts
payable and accrued expenses totaling $0.5 million.

     Net cash  provided by  investing  activities  was $7.0 million for the nine
months ended  September  30,  2004,  due  primarily  to net sales of  marketable
securities  of $9.1 million.  This amount was  partially  offset by purchases of
property and  equipment of $1.8  million,  net cash paid for  acquisition  of IP
Metrics of $0.1  million,  and  purchases of software  licenses  and  intangible
assets of $0.2  million.  Net cash  provided by  investing  activities  was $2.3
million for the nine months  ended  September  30, 2003,  primarily  due to $6.7
million in net sales of marketable securities.  This amount was partially offset
by $2.1  million  in  purchases  of  property  and  equipment,  $1.2  million in

                                       19


purchases of software licenses, purchase of investment of $0.1 million, net cash
paid for  acquisition  of IP Metrics of $0.3  million,  purchase  of  intangible
assets of $0.2  million,  and a  security  deposit of $0.5  million  for our new
office space.

     Net cash  provided by  financing  activities  was $0.7 million for the nine
months ended September 30, 2004.  This amount was primarily  related to proceeds
from the exercise of stock options of $0.9 million  partially offset by payments
to acquire  treasury  stock of $0.3  million.  Net cash  provided  by  financing
activities  was $0.4 million for the nine months ended  September 30, 2003 which
was related to the proceeds from the exercise of stock options.

     Our only  obligations with a material effect on our liquidity relate to our
operating  leases.  We have an  operating  lease  covering  our  primary  office
facility that expires in February,  2012. We also have several  operating leases
related to a second  domestic  office and  offices  in  foreign  countries.  The
expiration dates for these leases range from 2004 through 2012.

     For the nine months ended  September 30, 2003, we paid $3.0 million related
to  liabilities  of  discontinued  operations.  As of  December  31,  2003,  all
significant liabilities related to our discontinued operations had been paid.

     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 March 2004 the Financial  Accounting  Standard Board ("FASB")  issued an
exposure draft entitled Share-Based Payment, an amendment of FASB Statements No.
123 and 95.  This  exposure  draft would  require  stock-based  compensation  to
employees to be recognized as a cost in the financial  statements  and that such
cost be  measured  according  to the fair  value of the  stock  options.  In the
absence of an observable  market price for the stock  awards,  the fair value of
the stock  options would be based upon a valuation  methodology  that takes into
consideration  various factors,  including the exercise price of the option, the
expected term of the option,  the current price of the  underlying  shares,  the
expected volatility of the underlying share price, the expected dividends on the
underlying shares and the risk-free interest rate. The proposed  requirements in
the exposure  draft would be effective for interim or annual  periods  beginning
after July 1, 2005. The Company will continue to monitor  communications on this
subject  from the  FASB in  order  to  determine  the  impact  on the  Company's
consolidated financial statements.



                                  RISK FACTORS

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

     We have had limited  revenues  and a history of losses.  For the year ended
December 31, 2003 and the nine months ended  September 30, 2004, we had revenues
of $16.9 million and $19.2 million,  respectively. For the period from inception
(February  10, 2000)  through  September  30, 2004 and for the nine months ended
September  30,  2004,  we had a net loss of  $37.3  million  and  $6.2  million,
respectively.  We have signed  contracts with  resellers and original  equipment
manufacturers,  or OEMs,  and believe that as a result of these  contracts,  our
revenues should increase in the future,  and although we expect to be profitable
in the fourth  quarter of 2004 we are unable to predict  whether or when we will
be  profitable  on a full-year  basis.  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.

                                       20


     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 could impact our ability to achieve or to maintain profitability.

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

     The rapidly evolving nature of the network storage infrastructure  software
market in which we sell our  products,  and other  factors  that are  beyond our
control,  reduces our ability to  accurately  forecast our  quarterly and annual
revenue. However, we use our forecasted revenue to establish our expense budget.
Most of our  expenses  are fixed in the short  term or  incurred  in  advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.

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 infrastructure software.  Because our sales are primarily to
major  corporate   customers,   any  softness  in  demand  for  network  storage
infrastructure software may result in decreased revenues.

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.

                                       21



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.

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

     The network storage infrastructure  software market continues to evolve and
as a result there is  continuing  demand for new products.  Accordingly,  we may
need to develop and  manufacture  new products that address  additional  network
storage  infrastructure  software market  segments and emerging  technologies to
remain  competitive  in the data storage  software  industry.  We are  uncertain
whether we will successfully qualify new network storage infrastructure software
products  with  our  customers  by  meeting  customer  performance  and  quality
specifications or quickly achieve high volume  production of storage  networking
infrastructure  software  products.  Any  failure to address  additional  market
segments could harm our business, financial condition and operating results.

OUR  PRODUCTS  MUST  CONFORM TO  INDUSTRY  STANDARDS  IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.

     Our  current  products  are  only  one  part  of a SAN 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  warranty  costs,  divert  engineering  personnel  from
product  development  efforts and  significantly  impair our ability to maintain
existing  customer  relationships  and attract new  customers.  In  addition,  a
product  liability  claim,  whether  successful  or not,  would  likely  be time
consuming  and  expensive  to  resolve  and  would  divert  management  time and
attention.  Further,  if we are unable to fix the errors or other  problems that
may be  identified in full  deployment,  we would likely  experience  loss of or
delay in revenues and loss of market share and our business and prospects  would
suffer.

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 our  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 be impacted negatively.

OUR OEM  CUSTOMERS  REQUIRE  OUR  PRODUCTS  TO UNDERGO A LENGTHY  AND  EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.

                                       22


     Prior to offering  our products for sale,  our OEM  customers  require that
each of our products undergo an extensive  qualification process, which involves
interoperability  testing of our product in the OEM's system as well as rigorous
reliability  testing.  This qualification of a product by an OEM does not assure
any  sales of the  product  to the OEM.  Despite  this  uncertainty,  we  devote
substantial resources, including sales, marketing and management efforts, toward
qualifying  our products with OEMs in  anticipation  of sales to them. If we are
unsuccessful  or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.

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

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

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

     The network storage infrastructure software market is intensely competitive
even during  periods  when demand is stable.  Some of our current and  potential
competitors have longer operating  histories,  significantly  greater resources,
broader name  recognition and a larger installed base of customers than we have.
Those competitors and other potential competitors may be able to establish or to
expand network storage infrastructure  software offerings more quickly, adapt to
new  technologies  and  customer  requirements  faster,  and take  advantage  of
acquisition and other opportunities more readily.

     Our competitors also may:

o  consolidate or establish  strategic  relationships  among themselves to lower
   their product costs or to otherwise compete more effectively against us; or

o  bundle  their  products  with other  products  to  increase  demand for their
   products.

     In addition,  some OEMs with whom we do  business,  or hope to do business,
may enter the market  directly and rapidly  capture market share.  If we fail to
compete  successfully  against  current  or future  competitors,  our  business,
financial condition and operating results may suffer.

OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY,  WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.

                                       23


     While we  expect to be  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 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
September 30, 2004, the market price of our common stock as quoted on the NASDAQ
National Market System fluctuated  between $5.03 and $10.32. The market price of
our common stock may be significantly affected by the following factors:

       o  actual or anticipated fluctuations in our operating results;

       o  failure to meet financial estimates;

       o  changes  in  market   valuations   of  other   technology   companies,
          particularly those in the storage networking  infrastructure  software
          market;

       o  announcements  by us  or  our  competitors  of  significant  technical
          innovations,  acquisitions,  strategic partnerships, joint ventures or
          capital commitments;

       o  loss of one or more key OEM customers; and

       o  departures of key personnel.

     The stock market has  experienced  extreme  volatility  that often has been
unrelated to the performance of particular companies.  These market fluctuations
may cause our stock price to fall regardless of our performance.

WE HAVE A SIGNIFICANT  AMOUNT OF AUTHORIZED BUT UNISSUED  PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

     Our Board of Directors has the  authority,  without  further  action by the
stockholders,  to issue up to 2,000,000  shares of preferred stock on such terms
and  with  such  rights,  preferences  and  designations,   including,   without
limitation  restricting  dividends on our common  stock,  dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our  common  stock,  as  the  Board  may  determine  without  any  vote  of  the
stockholders.  Issuance  of such  preferred  stock,  depending  upon the rights,
preferences and designations thereof may have the effect of delaying,  deterring


                                       24


or  preventing  a  change  in  control.  In  addition,  certain  "anti-takeover"
provisions of the Delaware  General  Corporation  Law,  among other things,  may
restrict  the  ability  of our  stockholders  to  authorize  a merger,  business
combination  or change of  control.  Finally,  we have  entered  into  change of
control agreements with certain executives.

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

     As of  September  30,  2004,  we had  outstanding  options and  warrants to
purchase an  aggregate  of  9,789,602  shares of our common  stock at a weighted
average  exercise  price of $4.67  per  share.  We also  have  3,027,761  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.

IF WE ARE REQUIRED TO RECOGNIZE  THE FAIR VALUE OF STOCK  OPTIONS  GRANTED AS AN
EXPENSE, OUR RESULTS OF OPERATIONS WILL BE IMPACTED NEGATIVELY.

     The Financial  Accounting Standards Board ("FASB") has formally proposed to
require  companies  to  recognize  the fair  value of stock  options  and  other
stock-based  compensation to employees as compensation  expense in the statement
of operations, which would be effective July 1, 2005 for FalconStor. If the FASB
proposal  is  adopted,  there  will  be a  negative  impact  on our  results  of
operations.

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.

                                       25


     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.  Legal proceedings could subject us to
significant  liability  for  damages or  invalidate  our  intellectual  property
rights.  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.  Any  potential  intellectual
property  litigation  against  us  could  force  us to  take  specific  actions,
including:

           o cease  selling our products  that use the  challenged  intellectual
             property;

           o obtain from the owner of the infringed  intellectual property right
             a license  to sell or use the  relevant  technology  or  trademark,
             which license may not be available on reasonable  terms, or at all;
             or

           o redesign those products that use infringing  intellectual  property
             or cease to use an infringing product or trademark.

THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.

     Our success depends upon the continued  contributions of our key employees,
many of whom would be extremely  difficult to replace. We do not have key person
life  insurance  on any of our  personnel.  Worldwide  competition  for  skilled
employees in the network storage  infrastructure  software industry is extremely
intense.  If we are unable to retain existing employees or to hire and integrate
new employees,  our business,  financial  condition and operating  results could
suffer. In addition, companies whose employees accept positions with competitors
often claim that the competitors have engaged in unfair hiring practices. We may
be the  subject  of such  claims  in the  future  as we  seek to hire  qualified
personnel and could incur  substantial  costs defending  ourselves against those
claims.

WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.

     We have made, and may continue to make,  acquisitions of other companies or
their assets. Integration of the acquired products, technologies and businesses,
could divert  management's  time and resources.  Further,  we may not be 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.



                                       26


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 Quarterly Report
on  Form  10-Q  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 be
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 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

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

Foreign  Currency  Risk.  We have  several  offices  outside the United  States.
Accordingly,  we are  subject to  exposure  from  adverse  movements  in foreign
currency   exchange  rates.  The  effect  of  foreign  currency   exchange  rate
fluctuations  have  not  been  material  since  our  inception.  We do  not  use
derivative financial instruments to limit our foreign currency risk exposure.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the  participation  of our management,  including
our  principal  executive  officer  and  principal  financial  officer,  we have
evaluated  the  effectiveness  of the design  and  operation  of our  disclosure
controls and procedures as of the end of the period covered by this report, and,
based on  their  evaluation,  our  principal  executive  officer  and  principal
financial  officer  have  concluded  that  these  controls  and  procedures  are
effective.  No  changes  in  the  Company's  internal  controls  over  financial
reporting  occurred  during the quarter  ended  September  30,  2004,  that have
materially  affected,  or  are  reasonably  likely  to  materially  affect,  the
Company's internal controls over financial reporting.

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

                                       27


PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

During the third quarter of 2004, we resolved claims brought by Dot Hill Systems
Corporation ("Dot Hill") and by Crossroad Systems (Texas),  Inc.  ("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 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.

In  addition to the action  discussed  above,  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 operating results.

ITEM 5. OTHER INFORMATION

On October 21,  2004,  we issued a press  release  containing  our  Consolidated
Statement of Operations for the three and nine months-ended  September 30, 2004,
and we  furnished  the  press  release  on a Form  8-K.  On  November  4,  2004,
subsequent to the filing of the Form 8-K, our independent accountants advised us
to reclassify the $1.3 million patent infringement  litigation settlement charge
as an operating expense.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

        (a)    Exhibits

               10.1     FalconStor   Software,   Inc.   Amended   and   Restated
                        Employment Agreement

               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)

        (b) Reports on Form 8-K

               On July 28, 2004, we filed a Form 8-K under Items 7 and 12.

               On August 18, 2004, we filed a Form 8-K under items 5 and 7.

               On September 1, 2004, we filed a Form 8-K under item 1.01.



                                       28



                                   SIGNATURES

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



                           FALCONSTOR SOFTWARE, INC.


                           /s/ James Weber
                          ----------------
                           James Weber
                           Chief Financial Officer, Vice President and Treasurer
                           (Principal Accounting Officer)

November 9, 2004


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