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.

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

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.

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.

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.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) The Company and Nature of Operations

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

(b) Principles of Consolidation

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

The unaudited interim consolidated financial statements of the Company as of
and for the three and nine months ended September 30, 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.

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
=========== ============

(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

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

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:

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.

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.

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

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

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.

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.

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

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

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

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

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

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.

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.

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.

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.

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

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.

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.

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.

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.

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