SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2005.
OR
|_| TRANSITION REPORT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the transition period from __________ to __________
Commission file number 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2 HUNTINGTON QUADRANGLE, SUITE 2S01 11747
MELVILLE, NEW YORK (Zip code)
(Address of principal executive offices)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 631-777-5188
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
Common Stock, $.001 par value
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes |_| No |X|
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X|
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act.
Large Accelerated Filer |_| Accelerated Filer |X|
Non-Accelerated Filer |_|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|
Aggregate market value of Common Stock held by non-affiliates of the
Registrant as of June 30, 2005 was $158,217,433 which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers and
directors. Such exclusion should not be deemed a determination by Registrant
that all such individuals are, in fact, affiliates of the Registrant. The number
of shares of Common Stock issued and outstanding as of February 21, 2006 was
48,565,923 and 48,016,323, respectively.
DOCUMENTS INCORPORATED BY REFERENCE:
The information required by Part III of Form 10-K will be incorporated by
reference to certain portions of a definitive proxy statement which is expected
to be filed by the Company pursuant to Regulation 14A within 120 days after the
close of its fiscal year.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
2005 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
PART I.
Item 1. Business........................................................ 3
Item 1A. Risk Factors.................................................... 9
Item 1B. Unresolved Staff Comments....................................... 17
Item 2. Properties...................................................... 17
Item 3. Legal Proceedings............................................... 17
Item 4. Submission of Matters to a Vote of Security Holders............. 17
PART II.
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters............................................. 18
Item 6. Selected Consolidated Financial Data............................ 19
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 22
Item 7A. Qualitative and Quantitative Disclosures About Market Risk...... 33
Item 8. Financial Statements and Supplementary Data..................... 34
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure............................. 56
Item 9A. Controls and Procedures......................................... 56
Item 9B. Other Information............................................... 56
PART III.
Item 10. Directors and Executive Officers of the Registrant.............. 56
Item 11. Executive Compensation.......................................... 57
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 57
Item 13. Certain Relationships and Related Transactions.................. 57
Item 14. Principal Accountant Fees and Services.......................... 57
PART IV.
Item 15. Exhibits and Financial Statement Schedules ..................... 58
SIGNATURES................................................................ 60
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PART I
ITEM 1. BUSINESS
OVERVIEW
FalconStor Software, Inc. ("FalconStor") is a premier developer of adaptive data
protection solutions that maximize business continuity and data center
efficiency within all IT infrastructures, integrating seamlessly to ensure rapid
data recovery while simplifying storage management. FalconStor's comprehensive
offerings include award-winning, easy-to-deploy storage virtualization,
continuous data protection (CDP), virtual tape library (VTL), and disaster
recovery (DR) software solutions and related implementation, maintenance, and
engineering services. In addition, FalconStor recently launched its PrimeVaultSM
offsite data protection center, which provides customers with a safe secondary
location to which they can replicate their data securely and cost-effectively
for rapid recovery and archiving. From the Fortune 1000 to small and medium-size
businesses, customers across a vast range of industries worldwide have
implemented FalconStor solutions in their production IT environments in order to
meet their most stringent recovery time objectives (RTO) and recovery point
objectives (RPO), as well as to manage their storage infrastructures with
minimal total cost of ownership (TCO) and optimal return on investment (ROI).
FalconStor technology empowers IT administrators and end users to recover data
easily to any point in time in the event of hardware failure, data corruption,
deletion, or catastrophic site-level disaster, allowing rollback or failover to
a known-good, immediately useable state. To ensure that businesses maintain
reliable access to their vital applications, and to facilitate accurate data
restoration while concurrently minimizing downtime, the uniquely
application-aware FalconStor solutions are engineered to work seamlessly with
database, email, and file systems so that redundant sets of active data are
generated with transactional and point-in-time integrity. Because this
eliminates the need for the time-consuming consistency checks that traditionally
create long periods of downtime during a recovery process, business productivity
is measurably enhanced.
Designed to contain escalating costs, FalconStor solutions enable companies to
aggregate heterogeneous, distributed storage capacity and centralize
administration of both storage resources and business-critical data services
such as backup, snapshot, replication, and migration. Companies benefit from
lower administrative overhead, elimination of storage over-provisioning,
boundless scalability, and the ability to make cost-effective storage allocation
and purchasing decisions. Moreover, FalconStor's commitment to an open
software-based approach to storage networking entails any-to-any connectivity
via native support for industry standards (including Fibre Channel, iSCSI, SCSI,
CIFS, NFS, and emerging standards such as Infiniband) and delivers unified
support for multiple storage architectures (SAN, NAS, and DAS). As a result,
FalconStor solutions provide companies of any size and complexity with the
freedom to leverage the high performance of IP/iSCSI- and Fibre Channel-based
networks and to implement their choice of state-of-the-art equipment, based on
any standard protocol from any storage manufacturer, without rendering their
existing and future environments obsolete.
Recognizing the strong value proposition of FalconStor's proven, cutting-edge
technology, multiple Tier-1 partners utilize FalconStor's innovative software
products - including IPStor(R), VirtualTape Library, and DiskSafe(TM) - to power
their special-purpose storage appliances and bundled solutions.
FalconStor's products have been certified by such industry leaders as Adaptec,
Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Engenio
Information Technologies, EMC, Emulex, Fujitsu, Gadzoox, Hewlett Packard,
Hitachi Data Systems, Hitachi Engineering Co., Ltd., Huawei-3COM, IBM, Intel,
LSI Logic, McData Corporation, Microsoft, NEC, Network Appliance, Novell, NS
Solutions Corporation (subsidiary of The Nippon Steel Corporation, Japan),
Oracle, QLogic, Quantum, Sony, SUN Microsystems, and VMware.
Further validation of the best-in-class status of Falconstor's solutions, comes
from the agreements Falconstor has with many Tier-1 original equipment
manufacturers (OEMs) and others to integrate FalconStor's technology with those
companies' products.
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FalconStor was incorporated in Delaware as Network Peripherals, Inc., in 1994.
Pursuant to a merger with FalconStor, Inc., in 2001, the former business of
Network Peripherals, Inc., was discontinued, and the newly re-named FalconStor
Software, Inc., continued the storage software business started in 2000 by
FalconStor, Inc. FalconStor's headquarters are located at 2 Huntington
Quadrangle, Suite 2S01, Melville, NY 11747. The Company also maintains offices
throughout Europe and Asia.
PRODUCTS AND TECHNOLOGY
FalconStor's flexible product portfolio facilitates the simple, cost-effective
creation of customized data protection solutions that adapt to changing
requirements during the entire data lifecycle. FalconStor's innovative approach
goes beyond mere backup to address additional elements of the data protection
workflow: nearline storage; offsite storage; archiving; and, most importantly,
recovery. Because FalconStor's products are engineered from the ground up, they
are extraordinarily integrated and scalable; businesses benefit from peace of
mind that FalconStor solutions work together in an easily managed and highly
efficient fashion, with high data availability and rapid recovery always
paramount.
SOFTWARE PRODUCTS
IPSTOR(R)
FalconStor's flagship product, IPStor software - available in an Enterprise
Edition, a Standard Edition, and an Express Edition - provides advanced storage
networking and best-in-class business continuity/disaster recovery (BCDR)
functionality to all segments of the enterprise, small and medium-size business
(SMB), and small office/home office (SOHO) markets. IPStor software is comprised
of an extensive set of state-of-the-art network storage services designed to
deliver rapid data recovery and an open, unified SAN and NAS infrastructure
across heterogeneous environments. IPStor software aggregates storage capacity,
provisioning, and services to application servers via all industry-standard
protocols with speed, security, reliability, interoperability, and scalability.
o IPStor continuous data protection (CDP) solutions maintain 24x7x365
availability and usability of data in the event of an unplanned
hardware failure, deletion, or software error, or planned downtime.
o IPStor disaster recovery (DR) solutions provide rapid, reliable
recovery in the event of catastrophic site failure, such as a fire,
power outage, or flood in the main data center.
o IPStor virtualization solutions enable enterprise data centers to
consolidate heterogeneous storage environments and servers, and to
centralize storage management under one simple interface.
VIRTUALTAPE LIBRARY (VTL)
FalconStor VirtualTape Library is the industry-leading, revolutionary
backup/recovery solution that saves money and time by using disk to emulate an
extensive range of physical tape libraries. Integrating seamlessly with existing
backup software and policies, and with FalconStor CDP solutions, VTL enhances
backup reliability, speed, availability, and recoverability while consolidating
management of backup resources. VTL backup to disk-based virtual tape ensures
backup/restore success by eliminating the media/mechanical errors and manual
intervention traditionally associated with tape backup. Remote offsite
replication of virtual tapes provides disaster protection, while automated data
export to physical tape is supported for archiving purposes. Software-based
encryption technology prevents unauthorized access to data exported to physical
tapes and in transit during replication, without imposing any overhead on the
backup process. VTL is fast and easy to deploy--comparable to adding a new tape
drive or library to an existing backup environment.
DISKSAFE(TM) AND FILESAFE(TM)
FalconStor DiskSafe and FalconStor FileSafe are host-resident software tools
that protect DAS-based application servers and end user desktops or laptops, as
well as servers using third-party storage networks, by enabling them to
replicate their entire local disks (DiskSafe) or individual files and
directories (FileSafe) to IPStor-managed storage for automated backup and
off-site data storage and rapid, user-initiated data recovery. Moreover,
DiskSafe technology captures the information necessary to easily boot the
designated machine in the event of a virus or spyware attack, application
malfunction, or hard disk crash. DiskSafe and FileSafe are integral components
of FalconStor's CDP solutions,
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facilitating the transfer of replicated data over an IP or Fibre Channel network
to a centralized FalconStor data management appliance for both redundant
nearline storage and remote disaster recovery purposes.
APPLICATION-AWARE SNAPSHOT AGENTS
FalconStor Snapshot Agents automate and minimize quiesce time during data
replication, backup, and other snapshot-based operations to ensure transactional
integrity and point-in-time consistency of databases and messaging stores for
fast time-to-recovery (TTR). Snapshot Agents are available for IBM(R) DB2(R)
UDB, Informix(R), Microsoft(R) SQL Server, Oracle(R), Pervasive.SQL(R),
Sybase(R), IBM Lotus Notes(R)/Domino, Microsoft(R) Exchange, Microsoft(R) VSS,
Novell(R) GroupWise(R), VMWare(R), and many file systems.
SOFTWARE APPLIANCE KITS (SAKS)
Addressing one of the fastest growing segments of the storage industry, SMBs and
the SOHO market, FalconStor has entered into agreements with resellers and with
OEMs to develop software kits for storage appliances that combine specific
IPStor, VirtualTape Library, and DiskSafe functionality with third party
hardware to create cost-effective, turnkey storage solutions that are easy to
deploy and maintain. Currently, FalconStor's resellers and/or OEM partners offer
the following storage appliances:
o VIRTUALTAPE LIBRARY BACKUP|RECOVERY APPLIANCES use disk to enhance
the reliability, speed, and availability of backups while
consolidating the management and provisioning of backup resources -
without changing existing tape backup software and procedures. With
backup windows shrinking and rapid data restoration more critical
than ever, VirtualTape Library appliances allow users to utilize
disk storage to emulate multiple tape libraries concurrently and to
accelerate backup/restore speed across IP/iSCSI and Fibre Channel
networks.
o ISCSI STORAGE/CDP APPLIANCES leverage the industry-standard iSCSI
protocol and an existing IP network to create a reliable networked
storage solution for small or remote offices, as well as small data
centers, at an affordable price. These appliances work in
conjunction with DiskSafe and FileSafe to aggregate and provision
storage capacity and provide services that deliver rapid recovery,
continuous data protection, and disaster recovery capabilities
across networked and direct-attached storage environments.
o REALTIME DATA MIGRATION APPLIANCES deliver zero-downtime data
migration by leveraging an existing storage network to transport
data between different vendors' storage subsystems without requiring
reconfiguration or shutting down of production servers.
OFFSITE, ONLINE DATA PROTECTION FACILITY
PRIMEVAULTSM BY FALCONSTOR is an offsite, online data protection service for
organizations, that either do not have their own disaster recovery sites or wish
to replicate their data to an additional site for a supplementary layer of
redundancy. PrimeVault grants small, medium, and large businesses the power to
protect and to archive their data at a secure facility at an affordable and
predetermined price based on individualized needs. By cutting the costs of
deploying and maintaining an alternate site by half to three-quarters,
PrimeVault makes alternate sites practical for most, if not all businesses.
PrimeVault offerings include:
o Rapid 24x7x365 data recovery with maximum business continuity/disaster
recovery (BCDR) capability
o Immediate BCDR solution deployment
- Cost-effective, flexible pricing
- Minimal up-front IT investment and operating overhead
- No need to build and staff a dedicated DR center
- No need to buy software and hardware for a DR center
o Rapid compliance solution deployment while minimizing implementation costs
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o Seamless scalability of offsite data storage as business expands
o Offsite replication of virtual tapes
o Data export from virtual to physical tapes with offsite archiving for
compliance or other purposes
o End-to-end security
- Encryption for data replication, virtual tapes, and data storage
- Closed-circuit video surveillance 24x7x365
- Encrypted, multi-point verified access to facility
PrimeVault also offers:
o Managed storage with the benefit of advanced IPStor storage services,
including mirroring, continuous data replication and snapshots.
o Co-location
BUSINESS STRATEGY
FalconStor intends to maintain its position as a leading network storage
software provider to enterprises worldwide and intends to continue its expansion
into the non-enterprise storage market by offering a diverse range of products
for use in the small/medium business (SMB) and small office/home office (SOHO)
markets. FalconStor intends to achieve these objectives through the following
strategies:
o MAINTAIN A LEADERSHIP POSITION IN ENTERPRISE NETWORK STORAGE SOFTWARE.
FalconStor intends to continue to leverage the protocol-agnostic, unified
architecture, and robust data protection technology of its solutions to
maintain a leadership position in the enterprise network storage software
market. The network storage software market is defined by rapid change,
and FalconStor plans to continue to focus its research and development
efforts on continuing to invent innovative solutions and bringing them to
market quickly.
o EXPAND PRODUCT OFFERINGS. In 2005, FalconStor offered additional data
protection options and enhancements for its software, including continuous
data protection for nonstop data protection and immediate granular data
recovery; Adaptive Replication with intelligent, automated throttling
capabilities to maximize efficient usage of bandwidth during remote
replication of data; VTL Encryption to safeguard data on physical tapes
and in transit during replication of virtual tapes; and Automated Tape
Caching for simple, seamless integration with existing tape libraries.
FalconStor intends to continue to expand its data protection solution
offerings across all market segments.
o INCREASE MARKET PENETRATION AND BRAND RECOGNITION. FalconStor believes
that establishing a strong brand identity as a premier provider of data
protection solutions is important to its future success. FalconStor plans
to continue to promote corporate and product awareness by investing in
activities which have been shown to deliver positive results, such as:
o Engaging an experienced, storage-focused PR agency;
o Advertising in strategic storage publications and online
media;
o Hosting solution-focused end user and partner seminars in
partnership with industry trade groups and leading analysts;
o Forming strategic partnerships with leading industry players;
o Participating in industry-specific events, conferences and
trade shows; and
o Continuing targeted promotions and PR campaigns.
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o ESTABLISH A GLOBAL PRESENCE. Because FalconStor believes that significant
market share can be achieved in Europe and Asia, FalconStor plans to
continue expansion of its operational capabilities and promotional
activities in these regions to build on current successes. In addition,
FalconStor believes that it is developing a strong business presence and
positive reputation in Europe and the Asia/Pacific Rim.
o EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND
ALLIANCES. FalconStor believes that opportunities may exist to expand its
technological capabilities, product offerings and services through
acquisitions of businesses or software technology and through strategic
alliances. When evaluating potential acquisitions and strategic alliances,
FalconStor will focus on transactions that enable it to acquire:
o Important enabling technology;
o Complementary applications;
o Marketing, sales, customer and technological synergies; and/or
o Key personnel.
o SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to
continue to enter into OEM agreements with strategic switch, storage,
appliance and operating system vendors. Besides accelerating overall
market growth, the OEM relationships should continue to bolster
FalconStor's product recognition, corporate credibility, and revenue
stream.
o OFFER PRODUCTS AND SERVICES TO THE SMB AND SOHO MARKETS. FalconStor is
working with industry partners to offer storage solutions or services to
the SMB and SOHO markets. These solutions and services include
special-purpose appliances and applications, as well as hosted storage and
DR services via FalconStor's PrimeVault services.
SALES, MARKETING AND CUSTOMER SERVICE
FalconStor plans to continue to sell its products primarily through original
equipment manufacturers (OEMs), value-added resellers (VARs, also sometimes
called "solution providers"), and distributors.
o OEM RELATIONSHIPS. OEMs collaborate with FalconStor to integrate
FalconStor's products into their own product offerings or to resell
FalconStor's products under their own label.
o VAR AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered into VAR
and distributor agreements to help sell its product in various
geographic areas. FalconStor's VARs and distributors market various
FalconStor products and receive a discount off of the list price on
products sold.
o STORAGE APPLIANCES. FalconStor has agreements with strategic
partners to adapt FalconStor products for use in the strategic
partners' special-purpose storage appliances.
o DIRECT SALES TO END USERS. In a limited number of circumstances,
FalconStor has entered into software license agreements directly
with end users.
FalconStor's marketing efforts focus on building brand recognition amongst
customers, partners, analysts, and the media, and developing qualified leads for
the sales force.
FalconStor Professional Services personnel are also available to assist
customers and partners throughout the product life cycle of FalconStor solution
deployments. The Professional Services team includes experienced Storage
Architects
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(expert field engineers) who can assist in the assessment, planning/design,
deployment, and testing phases of a deployment project, and a Technical Support
group for post-deployment assistance and ongoing support.
COMPETITION
As the demand for network-based storage products and services increases, more
competitors will enter this high-growth market segment. Although there are
several companies attempting to offer unified storage services to application
hosts attached to iSCSI, Fibre Channel, CIFS, and NFS networks, FalconStor
believes it is the only software-based solution provider capable of
accommodating storage devices with industry-standard interfaces and provisioning
the virtualized resource over IP/iSCSI, Fibre Channel, NFS, and CIFS with
comprehensive storage services and simple end-to-end manageability.
Although some of FalconStor's products provide capabilities that put them in
competition with products from a number of companies with substantially greater
financial resources, FalconStor is not aware of any other software company
providing unified storage services running on a standard Linux-, Windows- or
Solaris-based appliance. FalconStor believes that the principal competitive
factors affecting its market include product features such as scalability, data
availability, ease of use, price, reliability, hardware/platform neutrality,
customer service, and support.
Additionally, as more partners offer appliances that integrate FalconStor
products, the Company has experienced competitive pressures from smaller, niche
players in the industry. However, FalconStor believes these competitors
currently do not offer the depth or breadth of storage services delivered by
FalconStor, nor do they possess the experience and technological innovation
needed to develop and deliver reliable, fully integrated, and proven storage
services.
As FalconStor continues its move into the non-enterprise storage market, the
products and services offered by its partners may compete with existing or new
products and services offered by current and new entrants to the market.
FalconStor's success will depend largely on its ability to generate market
demand and awareness of its products and to develop additional or enhanced
products in a timely manner. FalconStor's success will also depend on its
ability to convince potential partners of the benefits of licensing its software
rather than competing technologies. FalconStor's future and existing competitors
could introduce products with superior features, scalability and functionality
at lower prices than FalconStor's products and could also bundle existing or new
products with other more established products to compete with FalconStor.
Increased competition could result in price reductions and reduced gross
margins, which could harm FalconStor's business.
INTELLECTUAL PROPERTY
FalconStor's success is dependent in part upon its proprietary technology.
Currently, the IPStor software suite forms the core of this proprietary
technology. FalconStor currently has one patent and numerous pending patent
applications; and multiple registered trademarks - including "FalconStor,"
"FalconStor Software" and "IPStor" - and many pending trademark applications
related to FalconStor and its products.
FalconStor seeks to protect its proprietary rights and other intellectual
property through a combination of copyright, trademark and trade secret
protection, as well as through contractual protections such as proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position.
FalconStor generally enters into confidentiality or license agreements with its
employees, consultants, and corporate partners, and generally controls access to
and distribution of its software, documentation, and other proprietary
information. Despite FalconStor's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use its
products or technology. Monitoring unauthorized use of its products is
difficult, and there can be no assurance that the steps FalconStor has taken
will prevent misappropriation of its technology, particularly in foreign
countries where laws may not protect its proprietary rights as fully as do the
laws of the United States.
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MAJOR CUSTOMERS
For the year ended December 31, 2005, FalconStor had two customers that together
accounted for 31% of revenues. For the year ended December 31, 2004, FalconStor
had one customer that accounted for 16% of revenues. For the year ended December
31, 2003, FalconStor did not have any customers that accounted for over 10% of
revenues. As of December 31, 2005, the Company had two customers with accounts
receivable balances greater than 5% of gross accounts receivable, which in the
aggregate were 28% of the accounts receivable balance. As of December 31, 2004,
the Company had three customers with accounts receivable balances greater than
5% of gross accounts receivable, which in the aggregate were 33% of the accounts
receivable balance.
EMPLOYEES
As of December 31, 2005, FalconStor had 279 full-time employees, consisting of
139 in research and development, 74 in sales and marketing, 49 in service, and
17 in general administration. FalconStor is not subject to any collective
bargaining agreements and believes its employee relations are good.
INTERNET ADDRESS AND AVAILABILITY OF FILINGS
FalconStor's internet address is WWW.FALCONSTOR.COM. FalconStor makes available
free of charge, on or through its Internet website, FalconStor's Annual Report
on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Sections 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after FalconStor electronically files such material with, or furnishes it to,
the SEC. FalconStor complied with this policy for every Securities Exchange Act
of 1934 report filed during the year ended December 31, 2005.
ITEM 1A. RISK FACTORS
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET AND OUR RELIANCE ON OUR PARTNERS, WE MAY HAVE DIFFICULTY ACCURATELY
PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage software market in
which we sell our products, the degrees of effort and success of our partners'
sales and marketing efforts, and other factors that are beyond our control,
reduce our ability to accurately forecast our quarterly and annual revenue.
However, we must use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
THE MARKET FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL
MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.
The continued 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 maturing, making it difficult to predict their
potential sizes or future growth rates. If these markets develop 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 STILL MATURING, AND OUR BUSINESS
WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT.
The continued adoption of disk-based backup solutions, such as our
VirtualTape Library software, is critical to our future success. The market for
disk-based backup solutions is still maturing, making it difficult to predict
its potential size or future growth rate. If this market develops more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.
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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 important 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. We are uncertain
whether a viable market for our products will develop or be sustainable. If this
market fails to develop, or develops more slowly than we expect, our business,
financial condition and results of operations would be adversely affected.
WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS AND SMALL OFFICE/HOME
OFFICE MARKETS.
We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.
The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a storage system. All components
of these systems must comply with the same industry standards in order to
operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.
OUR 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 infrastructures. 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 could result in damage to our customers. These problems
could cause us to incur significant service and engineering costs, divert
engineering personnel from product development efforts and significantly impair
our ability to maintain existing customer relationships and attract new
customers. In addition, a product liability claim, whether successful or not,
would likely be time consuming and expensive to resolve and would divert
management time and attention. Further, if we are unable to fix the errors or
other problems that may be identified in full deployment, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.
Our other products may also contain errors or defects. If we are unable to
fix the errors or other problems that may be discovered, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.
10
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with resellers and OEM partners to develop
storage appliances that combine certain aspects of IPStor or VTL functionality
with third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would suffer.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers typically
require that each of our products undergo an extensive qualification process,
which involves interoperability testing of our product in the OEM's system as
well as rigorous reliability testing. This qualification of a product by an OEM
does not assure any sales of the product to the OEM. Despite this uncertainty,
we devote substantial resources, including engineering, sales, marketing and
management efforts, toward qualifying our products with OEMs in anticipation of
sales to them. If we are unsuccessful or delayed in qualifying any products with
an OEM, such failure or delay would preclude or delay sales of that product to
the OEM, which may impede our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage software market and in other markets. The OEM customers and
resellers may choose to focus their sales efforts on other products in the
network storage software market or other markets. The OEM customers might also
choose not to continue to develop or to market products which include our
products. This would likely result in lower revenues to us and would impede our
ability to grow our business.
WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR RECEIVABLES ARE
CONCENTRATED WITH TWO CUSTOMERS.
We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the year ended December 31, 2005, we
had two customers who together accounted for 31% of our revenues. While we
believe that we will continue to receive revenue from these clients, our
agreements with these clients do not have any minimum sales requirements and we
cannot guarantee continued revenue. If our contracts with these partners are
terminated, or if the volume of sales from these clients significantly declines,
it would have a material adverse effect on our operating results.
In addition, as of December 31, 2005, two customers accounted for a total
of 28% of our outstanding receivables. While we currently have no reason to
question the collectibility of these receivables, a business failure or
reorganization by these customers could harm our ability to collect these
receivables and could damage our cash flow.
THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN
ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR
RESPONDING TO TRENDS.
Certain of our OEM customers do not report license revenue to us until
sixty days or more after the end of the quarter in which the software was
licensed. There will thus be a delay before we learn whether licensing revenue
from these OEMs has met, exceeded, or fallen short of our expectations. The
reporting schedule from these OEMs also means that our ability to respond to
trends in the market could be harmed as well. For example, if, in a particular
quarter, we see a significant increase or decrease in revenue from our channel
sales or one of our other OEM partners, there will be a delay in our ability to
determine whether this is an anomaly or a part of a trend. However, we must use
our forecasted revenue to establish our expense budget. Most of our expenses are
fixed in the short term or incurred in advance of anticipated revenue. As a
result, we may not be able to decrease our expenses in a timely manner to offset
any shortfall in revenue or to increase our sales, marketing or support
headcounts to take advantage of positive developments.
11
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.
As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.
WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.
Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
This could result in lost sales opportunities for us with other customers or
could cause other potential OEM partners to consider or select software from our
competitors for their storage solutions. In addition, the desire for product
differentiation could cause potential OEM partners to select software from our
competitors. We cannot guarantee that our current strategic partners, or those
companies with whom we may partner in the future, will continue to be our
partners for any period of time. If our software were to be replaced in an OEM
solution by competing software, or if our software is not selected by OEMs for
future solutions, it would likely result in lower revenues to us and would
impede our ability to grow our business.
CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGIC
RELATIONSHIPS.
In the past, companies with whom we have OEM relationships have been
acquired by other companies. These acquisitions caused disruptions in the sales
and marketing of our products and in 2005, acquisitions of two of our OEM
partners had an impact on our revenues. If additional OEM customers are
acquired, the new parents might choose to stop offering solutions containing our
software. Even if the solutions continued to be offered, there might be a loss
of focus and sales momentum as the companies are integrated.
THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage software market is intensely competitive even during
periods when demand is stable. Some of our current and potential competitors
have longer operating histories, significantly greater resources, broader name
recognition and a larger installed base of customers than we have. Those
competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us;
or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business,
may enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
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:
12
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.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall demand
for network storage software. Because our sales are primarily to major corporate
customers, any softness in demand for network storage software may result in
decreased revenues.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.
Our previous results are not necessarily indicative of our future
performance and our future quarterly results may fluctuate significantly.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the seasonality of information technology, including network storage
products, spending;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive
prices before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
o new products or enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the past twelve months ended
December 31, 2005, the closing market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $5.23 and $9.67. 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;
13
o changes in market valuations of other technology companies,
particularly those in the network storage software market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.
The Financial Accounting Standards Board ("FASB") has required companies
to recognize the fair value of stock options and other equity-based compensation
to employees as compensation expense in the statement of operations. We must
implement this FASB standard effective in the first quarter of 2006. While we
are still evaluating the impact of this requirement, there will be a negative
impact on our results of operations.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Further, we have entered into change of
control agreements with certain executives, which may also have the effect of
delaying, deterring or preventing a change in control.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.
As of December 31, 2005, we had outstanding options and warrants to
purchase an aggregate of 10,950,908 shares of our common stock at a weighted
average exercise price of $5.29 per share. We also have 1,006,314 shares of our
common stock 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 and warrants and/or the
grant and exercise of additional options would dilute the then-existing
stockholders' percentage ownership of common stock, and any sales in the public
market of the common stock issuable upon such exercise could adversely affect
prevailing market prices for the common stock. Moreover, the terms upon which we
would be able to obtain additional equity capital could be adversely affected
because the holders of such securities can be expected to exercise or convert
them at a time when we would, in all likelihood, be able to obtain any needed
capital on terms more favorable than those provided by such securities.
OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS
In August, 2003, our business was interrupted due to a large scale
blackout in the northeastern United States. While our headquarters facilities
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.
14
Any interruption in power supply or telecommunications would be
particularly disruptive to our PrimeVault backup and disaster recovery
operations. If PrimeVault customers are unable to access their data, confidence
in our ability to provide disaster recovery and backup services will be damaged
which will impair our ability to retain existing customers, to gain new
customers and to expand our operations.
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.
UNITED STATES GOVERNMENT EXPORT RESTRICTIONS COULD IMPEDE OUR ABILITY TO SELL
OUR SOFTWARE TO CERTAIN END USERS.
Certain of our products include the ability for the end user to encrypt
data. The United States, through the Bureau of Industry Security, places
restrictions on the export of certain encryption technology. These restrictions
may include: the requirement to have a license to export the technology; the
requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. If we are subject to
restrictions on our ability to license products to certain end users, this could
negatively impact our business.
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, and multiple pending patent applications, numerous trademarks
registered and multiple pending trademark applications related to our products.
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.
15
We were already subject to one action, which alleged that our technology
infringed on patents held by a third party. While we settled this litigation,
the fees and expenses of the litigation as well as the litigation settlement
were expensive and the litigation diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. Any potential intellectual property litigation
against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual
property;
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which
license may not be available on reasonable terms, or at all; or
o redesign those products that use infringing intellectual property or
cease to use an infringing product or trademark.
DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.
Many of our products are designed to include software or other
intellectual property licensed from third parties, including "Open Source"
software. At least one intellectual property rights holder has alleged that it
holds the rights to software traditionally viewed as Open Source. It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
limit our ability to protect our proprietary rights in our products.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key employees,
many of whom would be extremely difficult to replace. We do not have key person
life insurance on any of our personnel. Worldwide competition for skilled
employees in the network storage software industry is extremely intense. If we
are unable to retain existing employees or to hire and integrate new employees,
our business, financial condition and operating results could suffer. In
addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
and could incur substantial costs defending ourselves against those claims.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies or
their assets. Integration of the acquired products, technologies and businesses,
could divert management's time and resources. Further, we may not be able to
properly integrate the acquired products, technologies or businesses, with our
existing products and operations, train, retain and motivate personnel from the
acquired businesses, or combine potentially different corporate cultures. If we
are unable to fully integrate the acquired products, technologies or businesses,
or train, retain and motivate personnel from the acquired businesses, we may not
receive the intended benefits of the acquisitions, which could harm our
business, operating results and financial condition.
IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.
The preparation of consolidated financial statements and related
disclosure in accordance with generally accepted account principles requires
management to establish policies that contain estimates and assumptions that
16
affect the amounts reported in the consolidated financial statements and the
accompanying notes. Note 1 to the Consolidated Financial Statements in this
Report on Form 10-K describes the significant accounting policies essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures.
We base our estimates on historical experience and assumptions that we believe
to be reasonable under the circumstances. Actual future results may differ
materially from these estimates. We evaluate, on an ongoing basis, our estimates
and assumptions.
LONG TERM CHARACTER OF INVESTMENTS
Our present and future equity investments may never appreciate in value,
and are subject to normal risks associated with equity investments in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2. PROPERTIES
FalconStor's headquarters are located in an approximately 45,000 square foot
facility located in Melville, New York. Offices are also leased for development,
sales and marketing personnel, which total an aggregate of approximately 33,000
square feet in Le Chesnay, France; Taichung, Taiwan; Tokyo, Japan; Beijing and
Shanghai, China; Munich, Germany; Seoul, Korea; and North Sydney, Australia.
Initial lease terms range from one to eight years, with multiple renewal
options.
ITEM 3. LEGAL PROCEEDINGS
We are subject to various legal proceedings and claims, asserted or unasserted,
which arise in the ordinary course of business. While the outcome of any such
matters cannot be predicted with certainty, we believe that such matters will
not have a material adverse effect on our financial condition, results of
operations, cash flows or liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
17
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our Common Stock is listed on The Nasdaq National Market ("Nasdaq") under
the symbol "FALC". The following table sets forth the range of high and
low closing sales prices of our Common Stock for the periods indicated as
reported by Nasdaq:
2005 2004
------------------- -------------------
High Low High Low
---- --- ---- ---
Fourth Quarter $ 8.02 $ 5.81 $ 9.57 $ 6.21
Third Quarter $ 6.87 $ 5.66 $ 7.85 $ 5.13
Second Quarter $ 7.43 $ 5.23 $ 8.35 $ 6.15
First Quarter $ 9.67 $ 5.78 $ 10.15 $ 6.57
HOLDERS OF COMMON STOCK
We had approximately 182 holders of record of Common Stock as of February
21, 2006. This does not reflect persons or entities whom hold Common Stock
in nominee or "street" name through various brokerage firms.
DIVIDENDS
We have not paid any cash dividends on our common stock since inception.
We expect to reinvest any future earnings to finance growth, and therefore
do not intend to pay cash dividends in the foreseeable future. Our board
of directors may determine to pay future cash dividends if it determines
that dividends are an appropriate use of Company capital.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Shares of common stock repurchased during the quarter ended December 31,
2005:
Total Number of Maximum Number
Shares Purchased of Shares that May
Total Number of Average Price as Part of Publicly Yet Be Purchased
Shares Purchased Paid per Share Announced Plan Under the Plan
November, 2005 8,000 $7.50 8,000 1,492,400
December, 2005 42,000 $7.49 42,000 1,450,400
Total 50,000 $7.49 50,000 1,450,400
18
The Company's Board of Directors approved a program, effective October 24,
2001, to repurchase up to two million shares of the Company's common
stock. The program has no expiration date.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data appearing below have been derived from our audited
consolidated financial statements, and should be read in conjunction with these
consolidated financial statements and the notes thereto and the information
contained in Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
19
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December 31, December 31, December 31,
2005 2004 2003 2002 2001
-----------------------------------------------------------------------
(In thousands, except per share data)
Revenues:
Software license revenue ............. $ 29,544 $ 21,488 $ 12,251 $ 8,667 $ 4,714
Maintenance revenue .................. 7,594 4,443 2,473 1,297 17
Software services and other revenue .. 3,826 2,778 2,220 665 861
-------- -------- -------- -------- --------
40,964 28,709 16,944 10,629 5,592
-------- -------- -------- -------- --------
Operating expenses:
Amortization of purchased
and capitalized
software ........................... 782 1,394 1,394 899 273
Cost of maintenance,
software services and
other revenue ...................... 6,114 4,150 2,580 1,309 897
Software development
costs .............................. 12,039 9,050 7,068 6,281 5,004
Selling and marketing .............. 16,109 14,277 10,967 9,856 8,085
General and administrative ......... 4,213 5,109 2,878 2,592 2,732
Litigation settlement .............. -- 1,300 -- -- --
Lease abandonment charge ........... -- -- 550 -- --
Impairment of prepaid royalty ...... -- -- -- 483 --
-------- -------- -------- -------- --------
39,257 35,280 25,437 21,420 16,991
-------- -------- -------- -------- --------
Operating income (loss) .......... 1,707 (6,571) (8,493) (10,791) (11,399)
-------- -------- -------- -------- --------
Interest and other income ............ 705 714 1,122 1,585 1,365
Impairment of long-lived assets ...... -- -- 35 (2,300) --
-------- -------- -------- -------- --------
Income (loss) before income ...... 2,412 (5,857) (7,336) (11,506) (10,034)
Provision for income taxes ........... 119 32 33 37 22
-------- -------- -------- -------- --------
Net income (loss) ................ $ 2,293 $ (5,889) $ (7,369) $(11,543) $(10,056)
-------- -------- -------- -------- --------
Beneficial conversion feature
attributable to convertible
preferred stock .................... -- -- -- -- 3,896
-------- -------- -------- -------- --------
Net income (loss) attributable to
common shareholders ................ $ 2,293 $ (5,889) $ (7,369) $(11,543) $(13,952)
======== ======== ======== ======== ========
Basic net income (loss) per share
attributable to common shareholders $ 0.05 $ (0.13) $ (0.16) $ (0.26) $ (0.40)
======== ======== ======== ======== ========
Diluted net income (loss) per share
attributable to common shareholders $ 0.05 $ (0.13) $ (0.16) $ (0.26) $ (0.40)
======== ======== ======== ======== ========
Basic weighted average common
shares outstanding ................. 47,662 46,967 45,968 45,233 35,264
======== ======== ======== ======== ========
Diluted weighted average common
shares outstanding ................. 50,776 46,967 45,968 45,233 35,264
======== ======== ======== ======== ========
20
CONSOLIDATED BALANCE SHEET DATA:
December 31, December 31, December 31, December 31, December 31,
2005 2004 2003 2002 2001
------------------------------------------------------------------------
(In thousands)
Cash and cash equivalents
and marketable securities $36,631 $33,973 $36,685 $51,102 $64,527
Working capital 39,654 36,452 39,527 47,746 57,518
Total assets 63,974 56,074 56,493 64,710 74,471
Long-term obligations 2,240 1,290 396 -- 283
Stockholders' equity 48,658 46,364 50,556 55,901 63,562
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
Fiscal 2005 was a year of continued growth and profitability. Our revenues
for the full year increased to $41.0 million from $28.7 million in 2004. We are
pleased that we were profitable for a full year for the first time.
As it has been in the past, our focus will continue to be on managing our
business with a view towards long-term success and growth. In 2005 we continued
to invest in research and development and other areas to build on our momentum,
to design new products, and to enhance our existing products to position the
Company for future growth. We will continue to invest in these areas in 2006 and
we anticipate that our research and development and sales and marketing expenses
will increase in 2006.
To continue to create industry-leading, cutting-edge network storage
solutions, we hired additional software development engineers and quality
assurance engineers. These software engineers design and test the software
products that are or will be sold by our OEM partners and resellers. Continuing
to deliver new and enhanced products to meet the demands of the storage market
is necessary for us to remain competitive and to continue our growth.
It is important to our success that our products meet the needs of end
users and that our products are - and are viewed by the market to be -
innovative. In 2005 our products continued to receive recognition for their
features, quality and innovation from several respected, independent, industry
publications and organizations. This recognition helps us gain access to
additional customers and assists us in closing sales.
We also increased our sales force and our technical support team. An
increased sales force should expand the market exposure for our products. The
expanded technical support team responds to questions and technical issues from
end users of our products and from our resellers and OEM partners. Providing top
notch technical support to these groups enhances our ability to continue to make
sales. End users who are satisfied with our technical support are more likely to
order additional products from us. Resellers and OEM partners who are happy with
our technical support, and whose end users are satisfied, will be more likely to
recommend our current products and less likely to consider other providers for
future products.
In the fourth quarter of 2005, we announced the launch of our PrimeVault
disaster recovery, archiving and hosting services. These services are based on
our IPStor and VirtualTape Library (VTL) software and provide a means for us to
leverage our successes with those products to increase our customer base to
include end users who do not have the resources - either technical or financial
- to undertake a full implementation of our products.
The key factors we look to for our future business prospects continue to
be our sales pipeline, our ability to establish and expand relationships with
key industry OEMs and resellers, sales by our OEM partners, additional orders
from resellers, growth in deferred revenue, re-orders from existing customers,
and the growth of the overall market for storage solutions. Gross margins are
also a key factor in evidencing the growth of our business.
Our sales "pipeline" consists of inquiries from end users and resellers
for possible purchases of our products. Our overall sales pipeline steadily
increased for each quarter of 2005 compared with the same quarter in 2004.
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OEM relationships are important to us for two main reasons. First, sales
by our OEM partners contribute to our revenues. Second, having our products
selected by respected, established industry leaders signals to customers,
resellers and other potential OEM partners that our products are quality
products that add value to their enterprise. Before licensing software, OEM
partners typically undertake broad reviews of many of the competing software
solutions available. The choice of our products by major industry participants
validates both the design and the capabilities of the products and our product
roadmaps.
Overall, product licenses to OEMs accounted for approximately forty
percent of our revenues in 2005. Two OEM customers each accounted for over ten
percent of our revenues. We anticipate that OEMs will account for over forty
percent of our revenues in 2006. We expect that at least one OEM will account
for at least ten percent of our revenues in 2006. Accordingly, the loss of this
customer would have a material adverse effect on our business.
In 2005, we signed a new agreement for our VTL product with a Tier-1 OEM.
This OEM released a solution using our VTL in the fourth quarter of 2005. Due to
the timing of the royalty reports from this OEM, the revenue will be recorded on
a one quarter lag. As a result of this lag, we did not have any revenue from
this OEM in 2005, but we expect to start generating revenue in 2006. In 2005, we
signed a number of agreements with international OEMs for our IPStor, VTL and
iSCSI Storage Server products. One of these agreements is with a major IP
Networking solution provider based in Hangzhou, China to offer turn-key iSCSI
solutions. We also renewed agreements with existing OEM partners. We will
continue to seek additional OEM opportunities in the future.
We do everything we can to assure that our products meet the needs of our
OEM partners and their customers. However, we cannot control decisions by our
OEM partners to change their product or marketing mix in ways that impact sales
of products licensed by the OEMs from us.
Many enterprises look to value added resellers or solution providers to
assist them in making their information technology purchases. These resellers
typically review an enterprise's needs and suggest a hardware, software, or
combined hardware and software solution to fulfill the enterprise's
requirements.
As service providers to companies, resellers' reputations are dependent on
satisfying their customers' needs efficiently and effectively. Resellers have
wide choices in fulfilling their customers' needs. If resellers determine that a
product they have been providing to their customers is not functioning as
promised, or is not providing adequate return on investment, or if the customers
are complaining about the level of support they are receiving from the
suppliers, the resellers will move quickly to offer different solutions to their
customers. Additional sales by resellers are therefore an important indicator of
our business prospects. We saw growth in the sales by most of our significant
resellers in 2005 and expect that this growth will continue in 2006. We have
established strong relationships with many premier resellers. In 2005, we signed
agreements with new resellers worldwide. We also terminated relationships with
resellers who we believed were not properly selling our products. We will
continue to enter into relationships with resellers and to discontinue
relationships with resellers with whom we are not satisfied.
Our deferred revenues consist primarily of amounts received attributable
to future support and maintenance of our products. The level of deferred revenue
is an important indicator of our success. Maintenance and support for our
products is sold for fixed periods of time. Maintenance and support agreements
are typically for one year, although some agreements are for terms in excess of
one year. If we do not deliver the support needed by end users of our products
or by our OEM partners and resellers, then they will not renew their maintenance
and support agreements. If end users stop using our products, they also will not
renew their maintenance and support agreements. An increase in deferred revenues
thus indicates growth in our installed base and end user and OEM satisfaction
with our maintenance and support services. Our deferred revenue increased to
$9.6 million as of December 31, 2005, compared with $5.4 million as of December
31, 2004. We expect deferred revenue to continue to grow in 2006.
The level of re-orders from existing end users of our products is another
measure of customer satisfaction. Information technology professionals will only
order additional products and services for their companies if they determine
that the products have reduced total cost of ownership and have provided a good
return on investment. Re-orders are thus an indication that our products are
delivering as promised and that our support is meeting the end user's needs. In
2005, many end users ordered additional copies of our products, or additional
products or ordered additional options. If re-orders decline, it would indicate
23
that future sales might also decline. As the percentage of our revenues from
OEMs increases, our ability to gauge re-orders decreases because our OEM
partners typically do not provide us with information identifying the end user
for each order.
Consolidation in the network storage market had an adverse impact on our
revenues in 2005. During 2005, two of our OEM partners were purchased by other
companies. In one case, the uncertainty caused by the impending purchase and the
subsequent consolidation of the businesses caused a loss of focus on sales by
the two companies. In the other case, after the acquisition, the acquirer
undertook a lengthy review of which solutions would be offered by the combined
entity. This review caused a near halt in sales of solutions incorporating our
product. We are pleased that both acquirers have decided to continue to offer
solutions incorporating our products.
The storage solutions market continues to grow. In addition to growth
based on demand for storage server consolidation and replication, there was
growth in backup acceleration. We expect each of these areas to continue growing
in 2006.
We have new initiatives in the small/medium business (SMB) and small
office/home office (SOHO) markets. We did not receive significant revenue from
these markets in 2005, but we believe that these non-enterprise markets are
another growth area for storage software. In early 2006, we signed an OEM
agreement with a leading computer, networking and communications products
manufacturer to offer an entry-level data storage and protection appliance,
powered by a version of IPStor optimized to run on a System-on-Chip ("SOC")
platform ("IPStor Express"), targeting the SMB/SOHO market. The launch is
scheduled for the first quarter of 2006. It is too early to estimate whether
revenues from these markets will be significant contributors to our revenues in
2006.
As we had anticipated, we saw the greatest increase in revenues from our
VirtualTape Library software. We expect this growth to continue, if not
accelerate, in 2006, as our new OEM continues it sales and as we introduce
additional features and functionality for the product. The continued decline in
prices for disk storage, and the continuing need for rapid back up, disaster
recovery and regulatory compliance, should contribute to this growth.
Market acceptance of IP-based Storage Area Networks, primarily using
iSCSI, continued in 2005. Previously, most SANs had been based on fibre-channel.
However, this portion of the storage software market has not been a significant
contributor to our revenues. Our expectations regarding the size of the revenue
contribution from this market in 2005 were impacted negatively, in part, by
sales from our Tier 1 OEM partner that were lower than we had anticipated. In
2006, we plan to work with this partner to enhance the product line to help to
grow sales. In addition, we have signed agreements with international OEMs to
market these products. We plan to continue to tap into the growth in this market
through sales of our products by other strategic partners.
Another important measure of our business is gross margin. Among other
things, gross margin measures our ability to scale our business. Unlike
manufacturers of hardware, our incremental cost for each additional unit of
software licensed is a small percentage of the software license revenue. Thus,
our gross margins tend to increase as our software license revenue increases. We
incur research and development expenses before the product is offered for
licensing. These expenses consist primarily of personnel costs for engineering
and testing, but also include other items such as the cost of hardware and
software used in development. We also have expenses for software support, sales
and marketing, and general and administrative functions.
Our gross margin increased on a full year basis to 83% compared with 81%
in 2004. We believe this demonstrates that we were successful in our ability to
scale our business.
We are pleased with our ability to contain the increase of expenses in
2005. We will continue to invest in infrastructure and personnel to maintain and
enhance our leading edge designs and to support our customers, but we will
continue to do so in a controlled, cost-effective manner.
One additional factor that we expect to continue to affect our revenues on
a quarterly, but not annual, basis, is the seasonality of the information
technology business. Historically, information technology spending has been
higher in the fourth and second quarters of each calendar year, and somewhat
slower in the other quarters, particularly the first quarter. Our quarterly
results reflected this seasonality in 2005, and we anticipate that our quarterly
results for 2006 will show the effects of seasonality as well.
24
As described in note 1 to our consolidated financial statements, beginning
with the first quarter of 2006, we will be required by Statement of Financial
Accounting Standards No. 123(R), Share Based Payment, to expense the grant date
fair value of stock options and other equity based compensation to employees and
non-employees in our financial statements. We are currently evaluating the
impact that the adoption of this statement will have on our consolidated
financial statements, but there will be a negative impact on our reported
results of operations. Notwithstanding this change to our financial statements,
we will continue to apply the criteria and the methodology we have used in the
past to determine grants of stock options or other equity-based compensation to
our employees. We believe that the opportunity to participate in the growth of
our Company is an important motivating factor for our current employees and a
valuable recruiting tool for new employees. For the management of our business
and the review of our progress, we will continue to look to our results before
stock option expense. We will use these non-GAAP financial measures in making
operating decisions because they measure the results of our day to day
operations and because they provide a more consistent basis for evaluating and
comparing our results across different periods.
Our critical accounting policies are those related to revenue recognition,
accounts receivable allowances and deferred income taxes. As described in note 1
to our consolidated financial statements, we recognize revenue in accordance
with the provisions of Statement of Position 97-2, Software Revenue Recognition,
as amended. Software license revenue is recognized only when pervasive evidence
of an arrangement exists and the fee is fixed and determinable, among other
criteria. An arrangement is evidenced by a signed customer contract for
nonrefundable royalty advances received from OEMs or a customer purchase order
or a royalty report summarizing software licenses resold by an OEM, distributor
or solution provider to an end user. The software license fees are fixed and
determinable as our standard payment terms generally range from 30 to 90 days,
depending on regional billing practices, and we have not provided any of our
customers extended payment terms. When a customer licenses software together
with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value.
We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.
Consistent with the provisions of Statement of Financial Accounting
Standards No. 109, we regularly estimate our ability to recover deferred income
taxes, and report such assets at the amount that is determined to be
more-likely-than-not recoverable. This evaluation considers several factors,
including an estimate of the likelihood of generating sufficient taxable income
in future periods over which temporary differences reverse, the expected
reversal of deferred tax liabilities, past and projected taxable income, and
available tax planning strategies. As of December 31, 2005, based primarily upon
our cumulative losses, a valuation allowance has been recorded against our
deferred tax assets. In the event that evidence becomes available in the future
to indicate that our deferred taxes will likely be recoverable (e.g., taxable
income generated in and projected for future periods), our estimate of the
recoverability of deferred taxes may change, resulting in a reversal of all or a
portion of such valuation allowance.
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2005 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2004
Revenues for the year ended December 31, 2005 increased 43% to $41.0
million compared to $28.7 million for the year ended December 31, 2004. Our
operating expenses increased 11% from $35.3 million in 2004 to $39.3 million in
2005. Net income for the year ended December 31, 2005 was $2.3 million compared
with a net loss of $5.9 million for the year ended December 31, 2004. The
25
increase in revenues was mainly due to an increase in (i) demand for our network
storage solution software and (ii) sales from our OEM partners. Revenue
contribution from our OEM partners increased in absolute dollars and as a
percentage of our total revenue for the year ended December 31, 2005. Revenue
from resellers and distributors also increased in absolute dollars. Expenses
increased in cost of maintenance, software services and other revenue, software
development, and selling and marketing to support our growth. For the year ended
December 31, 2005, 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 217 employees as of December 31, 2004 to 279
employees as of December 31, 2005. Included in our results for the year ended
December 31, 2004 are 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.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold through
our OEMs, value-added resellers and distributors to end users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer. We sometimes 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 37% to $29.5 million in 2005 from $21.5
million in 2004. Increased market acceptance and demand for our product and
increased sales from our OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from our OEM partners increased as
a percentage of total revenue. We expect our software license revenue to
continue to grow and the percentage of future software license revenue derived
from our OEM partners to increase.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenues are comprised of
software maintenance and technical support, professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Revenue derived from maintenance and technical support
contracts is deferred and recognized ratably over the contractual maintenance
term. Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In 2005 and 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 fee is recognized
as revenue when the hardware or software is delivered to the customer based on
the relative fair value of the delivered element(s). Maintenance, software
services and other revenue increased 58% to $11.4 million in 2005 from $7.2
million in 2004.
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 $4.4 million for the year ended December 31, 2004 to $7.6
million for the year ended December 31, 2005. Software services and other
revenue increased from $2.8 million in 2004 to $3.8 million in 2005. The
increase in software services and other revenue was partially attributable to
our hardware sales which increased from $1.5 million in 2004 to $2.3 million in
2005. This increase was the result of an increase in demand from our customers
for bundled solutions. Growth in our professional services sales, which
increased from $1.3 million in 2004 to $1.5 million in 2005, 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 who elected to purchase professional services. We expect
maintenance, software services and other revenues to continue to increase.
26
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations, we have purchased or licensed various software for resale since
2001. As of December 31, 2005 and 2004, we had $5.0 million and $4.9 million,
respectively, of purchased software licenses that are being amortized over three
years. For the year ended December 31, 2005, we recorded $0.8 million of
amortization related to these purchased software licenses. For the year ended
December 31, 2004, we recorded $1.4 million of amortization related to these
purchased software licenses. We will continue to evaluate third party software
licenses and may make additional purchases, which would result in an increase in
amortization expense.
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 that was resold. Cost of maintenance, software services
and other revenues for the year ended December 31, 2005 increased by 47% to $6.1
million compared to $4.2 million for the year ended December 31, 2004. 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 hired
additional employees to provide technical support and to implement our software.
Additionally, due to an increase in hardware sales, our associated hardware
costs increased from $1.0 million for the year ended December 31, 2004 to $1.5
million for the year ended December 31, 2005. Our cost of maintenance, software
services and other revenue will continue to grow in absolute dollars as our
revenue increases.
Gross profit for the year ended December 31, 2005 was $34.1 million or 83%
of revenues compared to $23.2 million or 81% of revenues for the year ended
December 31, 2004. The increase in gross profit and gross margin was directly
related to the increase in revenues. Additionally, the increased percentage of
revenue from our OEM partners in 2005 contributed to the increase in gross
margins since revenues from our OEM partners typically 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 33% to $12.0 million
in 2005 from $9.1 million in 2004. 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, we required additional employees to test and
integrate our software with our OEM partners' products. 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 13% to $16.1 million in 2005 from $14.3 million in 2004. As a result
of the increase in revenue and interest in our software, our commission expense
and travel expenses increased. In addition, we continued to hire new sales and
sales support personnel and to expand our worldwide presence to accommodate our
revenue growth. We believe that to continue to grow sales, our sales and
marketing expenses will continue to increase.
27
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 decreased 18% to $4.2
million in 2005 from $5.1 million in 2004. The overall decrease in general and
administrative expenses was primarily due to a decrease in legal expenses. For
the year ended December 31, 2004 we had $1.0 million in legal expenses
attributable to litigation related to alleged patent infringement.
LITIGATION SETTLEMENT CHARGE
During the third quarter of 2004, we resolved claims relating to alleged
patent infringement brought by Dot Hill and by Crossroads against us in the
United States District Court for the Western District of Texas. Pursuant to the
terms of the Settlement Agreement between Crossroads and us, we, without
admission of infringement, made a one-time payment of $1.3 million and granted
to Crossroads licenses to certain of our technology in exchange for a worldwide,
perpetual license to the technology underlying the Crossroads' patents at issue
in the litigation. All claims against us by both Dot Hill and Crossroads have
now been dismissed.
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
remained consistent at $0.7 million. Interest income increased from $0.7 million
to $1.0 million due to a higher average cash balance and slightly higher
interest rates. Additionally, interest and other income for the year ended
December 31, 2005, includes an out-of-period charge of approximately $0.2
million to recognize investment losses realized in prior years.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax results
incurred from the period from inception (February 10, 2000) through December 31,
2005, as we deemed that it was uncertain that the related deferred tax assets
would be realized based on our cumulative losses incurred since inception and
our limited period of profitability. Accordingly, we provided a full valuation
allowance against our net deferred tax assets. Our income tax provision consists
of tax expenses related to alternative minimum taxes and taxes from our foreign
subsidiaries.
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2004 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2003
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue increased 75% to $21.5 million in 2004 from $12.3
million in 2003. Increased market acceptance and demand for our product, the
introduction of our new products and the successful launch by one of our OEMs of
a solution powered by our product were the primary drivers of the increase in
software license revenue. Software license revenue increased from both our OEM
partners and from our resellers. Revenue from our OEM partners increased as a
percentage of total revenue.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 54% to $7.2
million in 2004 from $4.7 million in 2003. The major factor contributing to the
increase in maintenance, software services and other revenue was the increase in
the number of maintenance and technical support contracts we sold. As we are in
business longer, and as we license more software, we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and
28
support and most customers renew their maintenance and support after their
initial contracts expire. Maintenance revenue increased from $2.5 million for
the year ended December 31, 2003 to $4.4 million for the year ended December 31,
2004. Software services and other revenue increased to $2.8 million from $2.2
million in 2003. Growth in our professional services revenue, which increased
from $0.9 million in 2003 to $1.3 million in 2004, partially contributed to the
increase in software services and other revenues. This increase in professional
services revenue was related to the increase in our software license customers
that elected to purchase professional services. Additionally, our hardware sales
increased from $1.3 million in 2003 to $1.5 million in 2004. This increase was
the result of an increase in demand from our customers for bundled solutions.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
As of December 31, 2004 and 2003, we had $4.9 million of purchased
software licenses that are being amortized over three years. For the years ended
December 31, 2004 and 2003, we recorded $1.4 million of amortization related to
these purchased software licenses. Amortization of capitalized software was
$7,881 and $31,523 for the years ended December 31, 2004 and 2003, respectively.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues for the year
ended December 31, 2004 increased by 61% to $4.2 million compared to $2.6
million for the year ended December 31, 2003. The increase in cost of
maintenance, software services and other revenue was principally due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts and professional services, we required a higher number of
employees to provide technical support and to implement our software.
Gross profit for the year ended December 31, 2004 was $23.2 million or 81%
of revenues compared to $13.0 million or 77% of revenues for the year ended
December 31, 2003. The increase in gross profit and gross margin was directly
related to the increase in revenues relative to the increase in expenses. As our
software license revenues increase, the associated costs as a percentage of
those revenues tend to decrease. Additionally, the increased percentage of
revenue from our OEM partners in 2004 contributed to the increase in gross
margin since revenues from our OEM partners have higher gross margins.
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 28% to $9.1 million in 2004 from $7.1
million in 2003. The increase in software development costs was primarily due to
an increase in employees required to enhance and test our network storage
software products, as well as to develop new innovative features and options. In
addition, as we entered into agreements with new OEM partners, we required
additional employees to test and integrate our software with our OEM partners'
products. At the end of 2003, we also opened a development office in China to
assist in our development work.
SELLING AND MARKETING
Selling and marketing expenses increased 30% to $14.3 million in 2004 from
$11.0 million in 2003. As a result of the increase in revenue and interest in
our software, our commission expense and travel expenses increased. In addition,
we continued to hire new sales and sales support personnel and to expand our
worldwide presence to accommodate our revenue growth.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 77% to $5.1 million in 2004
from $2.9 million in 2003. The increase in general and administrative expenses
was partially due to a $1.0 million increase in legal expense attributable to
litigation relating to alleged patent infringement with Dot Hill Systems
Corporation ("Dot Hill") and Crossroads Systems (Texas), Inc. ("Crossroads").
29
Expenses of $0.8 million for the year ended December 31, 2004, related to
compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and an increase in
the number of employees also contributed to the increase in general and
administrative expenses.
INTEREST AND OTHER INCOME
Interest and other income decreased 36% to $0.7 million in 2004 from $1.1
million in 2003. This decrease in interest income was due to lower interest
rates and lower average cash, cash equivalent and marketable securities
balances.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss incurred
from the period from inception (February 10, 2000) through December 31, 2004, as
we deemed that it was more likely than not that the deferred tax assets will not
be realized based on our early stage of operations. Accordingly, we provided a
full valuation allowance against our net deferred tax assets. Our income tax
provision consists of tax liabilities related to our foreign subsidiaries.
LEASE ABANDONMENT CHARGE
In November 2003, we relocated our headquarters to a larger facility to
accommodate our future growth. As a result of this relocation, we vacated our
previous office space and recorded a charge for the estimated loss we expected
to incur on the remaining lease obligation. The charge of $0.6 million included
the remaining lease rental obligation reduced by cash flows we expected to
generate from an agreement to sub-lease the facility as well as the write off of
leasehold improvements at our previous facility.
LIQUIDITY AND CAPITAL RESOURCES
Our total cash and cash equivalents and marketable securities balance as
of December 31, 2005 increased by $2.7 million compared to December 31, 2004.
Our cash and cash equivalents totaled $18.8 million and marketable securities
totaled $17.8 million at December 31, 2005. As of December 31, 2004, we had
$15.5 million in cash and cash equivalents and $18.5 million in marketable
securities.
In 2005, we made investments in our infrastructure to support our
long-term growth. We increased the total number of employees in 2005 and made
investments in property and equipment to support our growth. As we continue to
grow, we will continue to make investments in property and equipment and will
need to continue to increase our headcount. In the past, we have also used cash
to purchase software licenses and to make acquisitions. We will continue to
evaluate potential software license purchases and acquisitions and if the right
opportunity presents itself we may continue to use our cash for these purposes.
However, as of the date of this filing, we have no agreements, commitments or
understandings with respect to any such acquisitions.
We currently do not have any debt and our only significant commitments are
related to our office leases.
In connection with our acquisition of IP Metrics in July 2002, we were
required to make cash payments to the former shareholders of IP Metrics, which
were contingent on the level of revenues from IP Metrics products for a period
of twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. We believe we have no
further payment obligations.
In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 549,600
shares have been repurchased at an aggregate purchase price of $3.6 million
including 272,500 shares repurchased in 2005 at an aggregate purchase price of
$1.9 million.
Net cash provided by operating activities totaled $6.5 million for the
year ended December 31, 2005, compared with net cash used in operating
activities of $1.1 million for the year ended December 31, 2004 and $5.9 million
for the year ended December 31, 2003. The positive trend in our cash provided by
operating activities is mainly due to the improvement in our net results which
resulted in net income of $2.3 million for the year ended December 31, 2005,
30
compared with a net loss of $5.9 million for the year ended December 31, 2004
and $7.4 million for the year ended December 31, 2003. In addition to our net
income for 2005 and our decrease in net loss for 2004 and 2003, our deferred
revenues increased by $4.2 million in 2005 compared to $2.8 million in 2004 and
$0.4 million in 2003. The increase in our deferred revenue is the result of an
increase in our maintenance contracts, which are deferred and recognized as
revenue ratably over the term of the contract. This amount was partially offset
by increases in our net accounts receivable balances of $4.9 million in 2005,
$3.2 million in 2004 and $2.8 million in 2003. The increases in our accounts
receivable balances are due to our revenue growth. We expect cash provided by
operating activities to continue to increase as we anticipate our net income
will increase.
Net cash used in investing activities was $2.8 million in 2005 compared to
net cash provided by investing activities of $6.3 million in 2004 and $2.5
million in 2003. Included in investing activities for each year are the sales
and purchases of our marketable securities. These represent the sales,
maturities and reinvesting of our marketable securities. The net cash provided
by investing activities from the net sale of securities was $0.6 million, $9.5
million and $8.5 million in 2005, 2004 and 2003, respectively. These amounts
will fluctuate from year to year depending on the maturity dates of our
marketable securities. The cash used to purchase property and equipment was $3.2
million, $2.8 million and $3.0 million in 2005, 2004 and 2003, respectively. The
cash used to purchase software licenses was $0.1 million in 2005 and 2004 and
$1.8 million in 2003. We continually evaluate potential software licenses and we
may continue to make similar investments if we find opportunities that would
benefit our business.
Net cash provided by financing activities was $24,385 in 2005, $1.8
million in 2004 and $0.9 million in 2003. We received proceeds from the exercise
of stock options of $1.9 million in 2005, $2.0 million in 2004 and $0.9 million
in 2003. We made payments of $1.9 million in 2005 and $0.3 million in 2004 to
acquire treasury stock.
The Company's only significant commitments relate to its operating leases.
The Company has an operating lease covering its primary office facility that
expires in February, 2012. The Company also has several operating leases related
to offices in foreign countries. The expiration dates for these leases range
from 2006 through 2012. The following is a schedule of future minimum lease
payments for all operating leases as of December 31, 2005:
Year ending December 31
-----------------------
2006...................................................... $ 1,915,879
2007...................................................... 1,433,153
2008...................................................... 1,220,435
2009...................................................... 1,254,067
2010...................................................... 1,288,708
Thereafter................................................ 1,699,218
-----------
$ 8,811,460
===========
We believe that our current balance of cash, cash equivalents and
marketable securities, and expected cash flows from operations will be
sufficient to meet our cash requirements for at least the next twelve months.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based
Payment ("SFAS 123R"), which revises SFAS 123. SFAS 123R also supersedes APB 25
and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R eliminates the
alternative to account for employee stock options under APB 25 and requires the
fair value of all share-based payments to employees (including stock options) be
recognized in the income statement, generally over the vesting period. In March
2005, the Securities and Exchange Commission issued Staff Accounting Bulletin
("SAB") No. 107, which provides additional implementation guidance for SFAS
123R. Among other things, SAB 107 provides guidance on share-based payment
valuations, income statement classification and presentation, capitalization of
costs and related income tax accounting.
31
SFAS 123R provides for adoption using either the modified prospective or
modified retrospective transition method. We will adopt SFAS 123R on January 1,
2006, using the modified prospective transition method in which compensation
cost is recognized beginning January 1, 2006 for all share-based payments
granted on or after that date and for all awards granted to employees prior to
January 1, 2006 that remain unvested on that date. We expect to continue to use
the Black-Scholes-Merton option pricing model to determine the fair value of
stock option awards.
Adoption of SFAS 123R's fair value method will have an effect on our
results of operations. The future impact of SFAS 123R cannot be predicted at
this time because it will depend on levels of share-based payments granted.
However, had SFAS 123R been adopted in prior periods, the effect would have
approximated the SFAS 123 pro forma amounts disclosed in footnote 1(j) to our
accompanying consolidated financial statements.
SFAS 123R also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as currently required. We have historically not
realized significant tax benefits associated with tax deductions for stock-based
compensation. Further, those amounts cannot be estimated for future periods
(because they depend on, among other things, when employees will exercise the
stock options and the market price of the Corporation's common stock at the time
of exercise).
In June 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR
CORRECTIONS - a replacement of APB Opinion No. 20 and FASB Statement No. 3
("SFAS 154"). SFAS 154 replaces APB Opinion No. 20, ACCOUNTING CHANGES ("APB
20"), and SFAS No. 3, REPORTING ACCOUNTING CHANGES IN INTERIM FINANCIAL
STATEMENTS. SFAS 154 requires retrospective application to prior periods'
financial statements of a voluntary change in accounting principle unless it is
impracticable to determine either the period-specific effects or the cumulative
effects of the change. APB 20 previously required that most voluntary changes in
accounting principle be recognized by including in net income in the period of
the change the cumulative effect of changing to the new accounting principle.
This standard generally will not apply with respect to the adoption of new
accounting standards, as new accounting standards usually include specific
transition provisions, and will not override transition provisions contained in
new or existing accounting literature. SFAS 154 is effective for fiscal years
beginning after December 15, 2005, and early adoption is permitted for
accounting changes and error corrections made in years beginning after the date
that SFAS 154 was issued. The Company does not expect that the adoption of SFAS
154 on January 1, 2006 will have a significant effect on its financials
condition or results of operations.
On December 21, 2004, the Financial Accounting Standards Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING FOR INCOME TAXES, TO THE TAX DEDUCTION ON QUALIFIED PRODUCTION
ACTIVITIES PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2, ACCOUNTING AND DISCLOSURE GUIDANCE FOR
THE FOREIGN EARNINGS REPATRIATION PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how companies should account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states
that the tax deduction for domestic manufacturing activities from this
legislation should be accounted for as a "special deduction" and reduce tax
expense in the period(s) the amounts are deductible on the tax return, not as an
adjustment of recorded deferred tax assets and liabilities. FSP No. 109-2 gives
a company additional time to evaluate the effects of the legislation on any plan
for reinvestment or repatriation of foreign earnings for purposes of applying
FASB Statement No. 109. The Company has determined that it will not repatriate
any undistributed foreign earnings under the new tax legislation and, therefore,
the legislation as it relates to undistributed foreign earnings will not have an
affect on the Company's consolidated financial statements.
32
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities which aggregated to $36.6 million as of December 31, 2005,
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.
We do not believe that our results would be materially affected by a 10% change
in interest or foreign exchange rates.
33
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements Page
Reports of Independent Registered Public Accounting Firm ........... 35
Consolidated Balance Sheets as of December 31, 2005 and 2004 ....... 37
Consolidated Statements of Operations for the years ended
December 31, 2005, 2004 and 2003 ................................. 38
Consolidated Statements of Stockholders' Equity and Comprehensive
Loss for the years ended December 31, 2005, 2004 and 2003 ........ 39
Consolidated Statements of Cash Flows for the years ended
December 31, 2005, 2004 and 2003 ................................. 40
Notes to Consolidated Financial Statements ......................... 41
34
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
FalconStor Software, Inc.:
We have audited the accompanying consolidated balance sheets of FalconStor
Software, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
related consolidated statements of operations, stockholders' equity and
comprehensive income (loss), and cash flows for each of the years in the
three-year period ended December 31, 2005. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of FalconStor
Software, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2005, in conformity with U.S. generally
accepted accounting principles.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of
FalconStor Software, Inc.'s internal control over financial reporting as of
December 31, 2005, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report, dated March 15, 2006, expressed an
unqualified opinion on management's assessment of, and the effective operation
of, internal control over financial reporting.
/s/ KPMG LLP
Melville, New York
March 15, 2006
35
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
FalconStor Software, Inc.:
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that
FalconStor Software, Inc. and subsidiaries (the Company) maintained effective
internal control over financial reporting as of December 31, 2005, based on
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that the Company maintained
effective internal control over financial reporting as of December 31, 2005, is
fairly stated, in all material respects, based on criteria established in
Internal Control--Integrated Framework issued by COSO. Also, in our opinion, the
Company maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2005, based on criteria established in
Internal Control--Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of the Company as of December 31, 2005 and 2004, and the related
consolidated statements of operations, stockholders' equity and comprehensive
income (loss), and cash flows for each of the years in the three-year period
ended December 31, 2005, and our report dated, March 15, 2006, expressed an
unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Melville, New York
March 15, 2006
36
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
------------
2005 2004
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents ................................................ $ 18,796,973 $ 15,484,573
Marketable securities .................................................... 17,833,683 18,488,616
Accounts receivable, net of allowances of $3,846,882 and
$2,551,616, respectively ............................................... 15,187,408 10,269,822
Prepaid expenses and other current assets ................................ 911,715 629,036
------------ ------------
Total current assets ............................................... 52,729,779 44,872,047
Property and equipment, net of accumulated depreciation of
$7,150,762 and $4,698,025, respectively ................................... 5,277,609 4,662,269
Goodwill .................................................................... 3,512,796 3,512,796
Other intangible assets, net ................................................ 216,864 307,620
Other assets, net ........................................................... 2,236,725 2,719,460
------------ ------------
Total assets ....................................................... $ 63,973,773 $ 56,074,192
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .......................................................... $ 1,152,228 $ 821,433
Accrued expenses .......................................................... 4,522,212 3,501,034
Deferred revenue .......................................................... 7,401,018 4,097,279
------------ ------------
Total current liabilities .......................................... 13,075,458 8,419,746
Deferred revenue ............................................................ 2,240,208 1,290,496
------------ ------------
Total liabilities .................................................. 15,315,666 9,710,242
------------ ------------
Commitments and Contingencies
Stockholders' equity:
Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
48,441,614 and 47,768,755 shares issued, respectively and 47,892,014
and 47,491,655 shares outstanding, respectively ....................... 48,442 47,769
Additional paid-in capital ................................................ 87,342,747 85,400,740
Accumulated deficit ....................................................... (34,659,329) (36,952,436)
Common stock held in treasury, at cost (549,600 and 277,100 shares,
respectively) .......................................................... (3,632,930) (1,714,775)
Accumulated other comprehensive loss, net ................................. (440,823) (417,348)
------------ ------------
Total stockholders' equity ......................................... 48,658,107 46,363,950
------------ ------------
Total liabilities and stockholders' equity ......................... $ 63,973,773 $ 56,074,192
============ ============
See accompanying notes to consolidated financial statements.
37
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
2005 2004 2003
------------ ------------ ------------
Revenues:
Software license revenue ................ $ 29,544,467 $ 21,487,866 $ 12,250,616
Maintenance revenue ..................... 7,593,804 4,442,724 2,473,504
Software services and other revenue ..... 3,825,832 2,778,088 2,220,015
------------ ------------ ------------
40,964,103 28,708,678 16,944,135
------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized
software ............................. 781,500 1,393,908 1,394,301
Cost of maintenance, software services
and other revenue .................... 6,114,112 4,150,309 2,580,141
Software development costs .............. 12,039,488 9,050,092 7,067,605
Selling and marketing ................... 16,109,440 14,277,167 10,966,548
General and administrative .............. 4,212,769 5,108,516 2,878,192
Litigation settlement ................... -- 1,300,000 --
Lease abandonment charge ................ -- -- 550,162
------------ ------------ ------------
39,257,309 35,279,992 25,436,949
------------ ------------ ------------
Operating income (loss) ............ 1,706,794 (6,571,314) (8,492,814)
------------ ------------ ------------
Interest and other income, net ............ 705,063 714,412 1,121,391
Other ..................................... -- -- 35,000
------------ ------------ ------------
Income (loss) before income taxes .. 2,411,857 (5,856,902) (7,336,423)
Provision for income taxes ............... 118,750 31,945 32,532
------------ ------------ ------------
Net income (loss) .................. $ 2,293,107 $ (5,888,847) $ (7,368,955)
------------ ------------ ------------
Basic net income (loss) per share ........ $ 0.05 $ (0.13) $ (0.16)
============ ============ ============
Diluted net income (loss) per share ...... $ 0.05 $ (0.13) $ (0.16)
============ ============ ============
Basic weighted average common shares
outstanding ............................. 47,662,446 46,967,422 45,967,830
============ ============ ============
Diluted weighted average common shares
outstanding ............................. 50,776,396 46,967,422 45,967,830
============ ============ ============
See accompanying notes to consolidated financial statements.
38
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
Additional
Common paid-in Deferred Accumulated
stock capital compensation deficit
------------ ------------ ------------ ------------
Balance, December 31, 2002 .. $ 45,528 $ 81,423,661 $ (471,445) $(23,694,634)
Issuance of stock options to
non-employees ............. -- 86,875 -- --
Exercise of stock options ... 1,217 850,600 -- --
Amortization of deferred
compensation .............. -- -- 463,476 --
Net loss .................... -- -- -- (7,368,955)
Adjustment to the fair value
of the net tangible assets
acquired in the NPI merger -- 916,845 -- --
Change in unrealized loss on
marketable securities, net -- -- -- --
Foreign currency translation
adjustment ................ -- -- -- --
------------ ------------ ------------ ------------
Balance, December 31, 2003 .. $ 46,745 $ 83,277,981 $ (7,969) $(31,063,589)
Issuance of stock options to
non-employees ............. -- 87,023 -- --
Exercise of stock options ... 1,024 2,035,736 -- --
Amortization of deferred
compensation .............. -- -- 7,969 --
Net loss .................... -- -- -- (5,888,847)
Acquisition of treasury stock -- -- -- --
Change in unrealized loss on
marketable securities, net -- -- -- --
Foreign currency translation
adjustment ................ -- -- -- --
------------ ------------ ------------ ------------
Balance, December 31, 2004 .. $ 47,769 $ 85,400,740 $ -- $(36,952,436)
Issuance of stock options to
non-employees ............. -- (32,860) -- --
Exercise of stock options,
including tax benefit ..... 673 1,974,867 -- --
Amortization of deferred
compensation .............. -- -- -- --
Net income .................. -- -- -- 2,293,107
Acquisition of treasury stock -- -- -- --
Change in unrealized loss on
marketable securities, net -- -- -- --
Foreign currency translation
adjustment ................ -- -- -- --
------------ ------------ ------------ ------------
Balance, December 31, 2005 .. $ 48,442 $ 87,342,747 $ -- $(34,659,329)
------------ ------------ ------------ ------------
Accumulated
other
comprehensive Total Comprehensive
Treasury income stockholders' income
stock (loss) equity (loss)
------------ ------------- ------------- -------------
Balance, December 31, 2002 .. $ (1,435,130) $ 33,073 $ 55,901,053
Issuance of stock options to
non-employees ............. -- -- 86,875 --
Exercise of stock options ... -- -- 851,817 --
Amortization of deferred
compensation .............. -- -- 463,476 --
Net loss .................... -- -- (7,368,955) (7,368,955)
Adjustment to the fair value
of the net tangible assets
acquired in the NPI merger -- -- 916,845 --
Change in unrealized loss on
marketable securities, net -- (214,394) (214,394) (214,394)
Foreign currency translation
adjustment ................ -- (81,168) (81,168) (81,168)
------------ ------------ ------------ ------------
Balance, December 31, 2003 .. $ (1,435,130) $ (262,489) $ 50,555,549 $ (7,664,517)
============
Issuance of stock options to
non-employees ............. -- -- 87,023 --
Exercise of stock options ... -- -- 2,036,760 --
Amortization of deferred
compensation .............. -- -- 7,969 --
Net loss .................... -- -- (5,888,847) (5,888,847)
Acquisition of treasury stock (279,645) -- (279,645) --
Change in unrealized loss on
marketable securities, net -- (148,849) (148,849) (148,849)
Foreign currency translation
adjustment ................ -- (6,010) (6,010) (6,010)
------------ ------------ ------------ ------------
Balance, December 31, 2004 .. $ (1,714,775) $ (417,348) $ 46,363,950 $ (6,043,706)
============
Issuance of stock options to
non-employees ............. -- -- (32,860) --
Exercise of stock options,
including tax benefit ..... -- -- 1,975,540 --
Amortization of deferred
compensation .............. -- -- -- --
Net income .................. -- -- 2,293,107 2,293,107
Acquisition of treasury stock (1,918,155) -- (1,918,155) --
Change in unrealized loss on
marketable securities, net -- 218,523 218,523 218,523
Foreign currency translation
adjustment ................ -- (241,998) (241,998) (241,998)
------------ ------------ ------------ ------------
Balance, December 31, 2005 .. $ (3,632,930) $ (440,823) $ 48,658,107 $ 2,269,632
------------ ------------ ------------ ------------
See accompanying notes to consolidated financial statements.
39
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2005 2004 2003
----------------------------------------------
Cash flows from operating activities:
Net income (loss) ................................ $ 2,293,107 $ (5,888,847) $ (7,368,955)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ................ 3,505,562 3,656,212 2,759,030
Non-cash professional services expenses ...... (32,860) 87,023 86,875
Realized loss on marketable securities ....... 270,026 17,795 --
Tax benefit from stock option exercise ....... 33,000 -- --
Equity-based compensation expense ............ -- 7,969 463,476
Provision for returns and doubtful accounts .. 4,340,102 3,296,275 1,700,100
Changes in operating assets and liabilities:
Accounts receivable .......................... (9,274,971) (6,456,175) (4,524,130)
Prepaid expenses and other current assets .... (291,693) 636,208 (137,115)
Other assets ................................. (50,401) (251,038) (227,711)
Accounts payable ............................. 354,471 259,128 125,217
Accrued expenses ............................. 1,104,416 791,498 761,827
Deferred revenue ............................. 4,234,918 2,789,987 415,059
------------ ------------ ------------
Net cash provided by (used in) operating
activities ............................... 6,485,677 (1,053,965) (5,946,327)
------------ ------------ ------------
Cash flows from investing activities:
Purchase of marketable securities ................ (61,264,424) (33,897,295) (8,537,284)
Sale of marketable securities .................... 61,867,854 43,441,277 17,034,096
Purchase of investments .......................... -- -- (137,710)
Purchase of property and equipment ............... (3,161,383) (2,842,792) (2,998,908)
Purchase of software licenses .................... (108,000) (50,000) (1,821,000)
Purchase of intangible assets .................... (126,241) (131,392) (246,697)
Net cash paid for acquisition of IP Metrics ...... -- (214,009) (287,130)
Security deposits ................................ -- (4,500) (500,000)
------------ ------------ ------------
Net cash provided by (used in) investing
activities ................................... (2,792,194) 6,301,289 2,505,367
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options .......... 1,942,540 2,036,760 851,817
Payments to acquire treasury stock ............... (1,918,155) (279,645) --
------------ ------------ ------------
Net cash provided by financing activities ...... 24,385 1,757,115 851,817
------------ ------------ ------------
Cash flows from discontinued operations (all
operating activities in 2003):
Payments of liabilities of discontinued
operations ................................... -- -- (3,034,620)
------------ ------------ ------------
Effect of exchange rate changes ..................... (405,468) (6,010) (81,168)
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents 3,312,400 6,998,429 (5,704,931)
Cash and cash equivalents, beginning of year ........ 15,484,573 8,486,144 14,191,075
------------ ------------ ------------
Cash and cash equivalents, end of year .............. $ 18,796,973 $ 15,484,573 $ 8,486,144
============ ============ ============
Increase in additional paid-in capital resulting
from an adjustment to reduce the fair value of the
liabilities of discontinued operations assumed in
the merger with NPI (Note 2) ...................... $ -- $ -- $ 916,845
============ ============ ============
Cash paid for income taxes .......................... $ 21,583 $ 24,554 $ 48,351
============ ============ ============
The Company did not pay any interest expense for the three years ended
December 31, 2005.
See accompanying notes to consolidated financial statements.
40
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) THE COMPANY AND NATURE OF OPERATIONS
FalconStor Software, Inc., a Delaware Corporation (the "Company"),
develops, manufactures and sells network storage software solutions and provides
the related maintenance, implementation and engineering services.
(B) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(C) CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$12.4 million and $10.9 million at December 31, 2005 and 2004, respectively.
Marketable securities at December 31, 2005 and 2004 amounted to $17.8 million
and $18.5 million, respectively, and consisted of corporate bonds and government
securities, which are classified as available for sale, and accordingly,
unrealized gains and losses on marketable securities are reflected as a
component of accumulated other comprehensive loss in stockholders' equity.
(D) REVENUE RECOGNITION
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, the software is delivered
and collection of the resulting receivable is deemed probable. Software
delivered to a customer on a trial basis is not recognized as revenue until a
permanent key is delivered to the customer. Reseller customers typically send
the Company a purchase order only when they have an end user identified. When a
customer licenses software together with the purchase of maintenance, the
Company allocates a portion of the fee to maintenance for its fair value.
Software maintenance fees are deferred and recognized as revenue ratably over
the term of the arrangement. The long-term portion of deferred revenue relates
to maintenance contracts with terms in excess of one year. The cost of providing
technical support is included in cost of revenues. The Company provides an
allowance for software product returns as a reduction of revenue, based upon
historical experience and known or expected trends.
Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Costs of providing these
services are included in cost of revenues.
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.
41
For the years ended December 31, 2005 and 2004, 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).
(E) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets
(generally between 3 to 7 years). Leasehold improvements are amortized on a
straight-line basis over the term of the respective leases or over their
estimated useful lives, whichever is shorter.
(F) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Consistent with Statement of Financial Accounting
Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has
not amortized goodwill related to its acquisitions, but has instead tested the
balance for impairment. The Company's annual impairment assessment is performed
on December 31st of each year, and additionally if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $216,997, $220,712 and
$159,248 for 2005, 2004 and 2003, respectively. The gross carrying amount and
accumulated amortization of other intangible assets as of December 31, 2005 and
December 31, 2004 are as follows:
December 31, December 31,
2005 2004
------------ ------------
Customer relationships and purchased technology:
Gross carrying amount .......................... $ 216,850 $ 216,850
Accumulated amortization ....................... (216,850) (180,708)
--------- ---------
Net carrying amount .......................... $ -- $ 36,142
========= =========
Patents:
Gross carrying amount .......................... $ 649,864 $ 523,623
Accumulated amortization ....................... (433,000) (252,145)
--------- ---------
Net carrying amount .......................... $ 216,864 $ 271,478
========= =========
(G) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $7,881 and $31,523 was amortized
for the years ended December 31, 2004 and 2003, respectively. Software
development costs were fully amortized as of the first quarter of 2004.
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.
42
Purchased software technology of $372,306 and $1,045,806, net of
accumulated amortization of $4,646,694 and $3,865,194, is included in other
assets in the balance sheets as of December 31, 2005 and December 31, 2004,
respectively. Amortization expense was $781,500, $1,386,027 and 1,362,778 for
the years ended December 31, 2005, 2004 and 2003, respectively. Amortization of
purchased software technology is recorded at the greater of the straight line
basis over the products estimated remaining life or the ratio of current period
revenue of the related products to total current and anticipated future revenue
of these products.
As of December 31, 2005, amortization expense on existing identifiable
intangible assets and purchased software technology will be $443,457, $104,451,
and $41,262 for the years ended December 31, 2006, 2007 and 2008, respectively.
Such assets will be fully amortized at December 31, 2008.
(H) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(I) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of the asset may
not be recoverable. If the sum of the expected future cash flows, undiscounted
and without interest, is less than the carrying amount of the asset, an
impairment loss is recognized as the amount by which the carrying amount of the
asset exceeds its fair value.
(J) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations including FASB
Interpretation No. 44, ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK
COMPENSATION, AN INTERPRETATION OF APB OPINION NO. 25 to account for its
fixed-plan stock options. Under this method, compensation expense is recorded
only if on the date of grant the current market price of the underlying stock
exceeded the exercise price. SFAS No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation
plans. As allowed by SFAS No. 123, the Company has elected to continue to apply
the intrinsic-value-based method of accounting described above, and has adopted
the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:
2005 2004 2003
------------ ------------ ------------
Net income (loss) as reported ........................ $ 2,293,107 $ (5,888,847) $ (7,368,955)
Add stock-based employee compensation expense included
in reported net loss, net of tax ............... -- 7,969 463,476
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax ............................. (8,565,701) (8,268,471) (4,930,656)
------------ ------------ ------------
Net loss - pro forma ................................. $ (6,272,594) $(14,149,349) $(11,836,135)
============ ============ ============
Diluted net income (loss) per common share-as reported $ 0.05 $ (0.13) $ (0.16)
Diluted net loss per common share-pro forma .......... $ (0.13) $ (0.30) $ (0.26)
43
The per share weighted average fair value of stock options granted during 2005,
2004 and 2003 was $4.52, $6.55 and $5.60, respectively, on the date of grant
using the Black-Scholes option-pricing method with the following weighted
average assumptions: 2005 - expected dividend yield of 0%, risk free interest
rate ranging from 3.7% to 4.6%, expected stock volatility ranging from 61% to
65% and an expected option life of six years for options granted to employees of
the Company, and an option life of ten years for options granted to
non-employees;
2004 - expected dividend yield of 0%, risk free interest rate of 3.5%, expected
stock volatility ranging from 166% to 176% and an expected option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees;
2003 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility ranging from 68% to 153% and an expected option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees;
(K) FINANCIAL INSTRUMENTS
As of December 31, 2005 and 2004, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.
(L) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations
within interest and other income, net. Such amounts have historically not been
material.
(M) EARNINGS PER SHARE (EPS)
Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the years ended December 31, 2004 and 2003,
all common stock equivalents for these periods were excluded from diluted net
loss per share. As of December 31, 2005, 2004 and 2003, potentially dilutive
common stock equivalents included 10,200,908, 8,973,358 and 9,860,425 stock
options outstanding, respectively. As of December 31, 2005, 2004 and 2003,
potentially dilutive common stock equivalents also included 750,000 warrants
outstanding.
The following represents a reconciliation of the numerators and
denominators of the basic and diluted earnings per share ("EPS") computation:
44
Twelve Months Ended December 31, 2005 Twelve Months Ended December 31, 2004
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ----------- ----------- ------------- ------------
Basic EPS ......... $ 2,293,107 47,662,446 $ 0.05 $(5,888,847) 46,967,422 $ (0.13)
----------- ----------- ----------- ----------- ----------- ------------
Effect of dilutive
securities:
Stock Options 3,113,950 --
Diluted EPS $ 2,293,107 50,776,396 $ 0.05 $(5,888,847) 46,967,422 $ (0.13)
=========== =========== =========== =========== =========== ============
Twelve Months Ended December 31, 2003
Net Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- -----------
Basic EPS ......... $(7,368,955) 45,967,830 $ (0.16)
----------- ----------- -----------
Effect of dilutive
securities:
Stock Options --
Diluted EPS $(7,368,955) 45,967,830 $ (0.16)
=========== =========== ===========
(N) COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) includes the Company's net income (loss),
foreign currency translation adjustments and unrealized losses on marketable
securities. Components of comprehensive income (loss) were comprised of foreign
currency translation adjustment losses of $391,540 and $149,542 as of December
31, 2005 and 2004, respectively and unrealized losses on marketable securities
of $49,283 and $267,806 as of December 31, 2005 and 2004, respectively.
(O) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's significant estimates include those related to
revenue recognition, accounts receivable allowances and deferred income taxes.
Actual results could differ from those estimates.
(P) NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), SHARE-BASED
PAYMENT ("SFAS 123R"), which revises SFAS 123. SFAS 123R also supersedes APB 25
and amends SFAS No. 95, STATEMENT OF CASH FLOWS. SFAS 123R eliminates the
alternative to account for employee stock options under APB 25 and requires the
fair value of all share-based payments to employees (including stock options) be
recognized in the income statement, generally over the vesting period. In March
2005, the Securities and Exchange Commission issued Staff Accounting Bulletin
("SAB") No. 107, which provides additional implementation guidance for SFAS
123R. Among other things, SAB 107 provides guidance on share-based payment
valuations, income statement classification and presentation, capitalization of
costs and related income tax accounting.
SFAS 123R provides for adoption using either the modified prospective or
modified retrospective transition method. The Company will adopt SFAS 123R on
January 1, 2006, using the modified prospective transition method in which
compensation cost is recognized beginning January 1, 2006 for all share-based
payments granted on or after that date and for all awards granted to employees
prior to January 1, 2006 that remain unvested on that date.
Adoption of SFAS 123R's fair value method will have an effect on the
Company's results of operations. The future impact of SFAS 123R cannot be
predicted at this time because it will depend on levels of share-based payments
granted. However, had SFAS 123R been adopted in prior periods, the effect would
have approximated the SFAS 123 pro forma amounts disclosed in footnote 1(j).
SFAS 123R also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as currently required. The Company has
historically not realized significant benefits associated with tax deductions
for stock-based compensation. Further, those amounts cannot be estimated for
future periods (because they depend on, among other things, when employees will
exercise the stock options and the market price of the Company's common stock at
the time of exercise).
In June 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR
CORRECTIONS - a replacement of APB Opinion No. 20 and FASB Statement No. 3
("SFAS 154"). SFAS 154 replaces APB Opinion No. 20, ACCOUNTING CHANGES ("APB
20"), and SFAS No. 3, REPORTING ACCOUNTING CHANGES IN INTERIM FINANCIAL
45
STATEMENTS. SFAS 154 requires retrospective application to prior periods'
financial statements of a voluntary change in accounting principle unless it is
impracticable to determine either the period-specific effects or the cumulative
effects of the change. APB 20 previously required that most voluntary changes in
accounting principle be recognized by including in net income in the period of
the change the cumulative effect of changing to the new accounting principle.
This standard generally will not apply with respect to the adoption of new
accounting standards, as new accounting standards usually include specific
transition provisions, and will not override transition provisions contained in
new or existing accounting literature. SFAS 154 is effective for fiscal years
beginning after December 15, 2005, and early adoption is permitted for
accounting changes and error corrections made in years beginning after the date
that SFAS 154 was issued. The Company does not expect that the adoption of SFAS
154 on January 1, 2006 will have a significant effect on its financial condition
or results of operations.
On December 21, 2004, the Financial Accounting Standards Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING FOR INCOME TAXES, TO THE TAX DEDUCTION ON QUALIFIED PRODUCTION
ACTIVITIES PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2, ACCOUNTING AND DISCLOSURE GUIDANCE FOR
THE FOREIGN EARNINGS REPATRIATION PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how companies should account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states
that the tax deduction for domestic manufacturing activities from this
legislation should be accounted for as a "special deduction" and reduce tax
expense in the period(s) the amounts are deductible on the tax return, not as an
adjustment of recorded deferred tax assets and liabilities. FSP No. 109-2 gives
a company additional time to evaluate the effects of the legislation on any plan
for reinvestment or repatriation of foreign earnings for purposes of applying
FASB Statement No. 109. The Company has determined that it will not repatriate
any undistributed foreign earnings under the new tax legislation and, therefore,
the legislation as it relates to undistributed foreign earnings will not have an
affect on the Company's consolidated financial statements.
(Q) RECLASSIFICATIONS
Certain reclassifications have been made to prior years' consolidated
financial statement presentations to conform to the current year's presentation.
(2) ACQUISITIONS
On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned
subsidiary of the Company, acquired all of the common stock of IP Metrics
Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for
mission-critical networks, for $2,432,419 in cash plus payments contingent on
the level of revenues from IP Metrics' products and services for a period of
twenty-four months. The acquisition was accounted for under the purchase method
and the results of IP Metrics are included with those of the Company from the
date of acquisition. As of December 31, 2004, the Company made final aggregate
contingent acquisition payments totaling $501,139 related to the sale of IP
Metrics' products and services. Contingent consideration incurred through
December 31, 2004 in excess of the amount accrued at the time of acquisition was
$211,197, of which $146,154 and $65,043 was added to goodwill in 2004 and 2003,
respectively.
The fair value of the net tangible liabilities of IP Metrics assumed was
$898,305, including $289,942 of accrued contingent consideration recorded at the
time of acquisition. The Company purchased certain intangible assets, including
customer relationships and purchased technology with a fair value of $216,850.
These intangible assets are being amortized under the straight-line method over
an estimated useful life of 3 years, the expected period of benefit. The
purchase price in excess of the fair value of the net tangible and intangible
assets acquired and liabilities assumed by the Company amounted to $3,325,071
and has been recorded as goodwill.
On August 22, 2001, pursuant to an Agreement and Plan of Merger and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged
with Network Peripherals, Inc. ("NPI"), with NPI as the surviving corporation.
Although NPI acquired FalconStor, as a result of the transaction, FalconStor
stockholders held a majority of the voting interests in the combined enterprise
46
after the merger. Accordingly, for accounting purposes, the acquisition was a
"reverse acquisition" and FalconStor was the "accounting acquirer." The
transaction was accounted for as a recapitalization of FalconStor and recorded
based on the fair value of NPI's net tangible assets acquired by FalconStor,
with no goodwill or other intangible assets being recognized. At the time of the
merger, NPI had no continuing operations and, thus, any post-merger transactions
related to NPI have been classified as discontinued operations. In connection
with the merger, the name of NPI was changed to FalconStor Software, Inc.
(3) PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
December 31, December 31,
2005 2004
------------ ------------
Computer hardware and software $ 11,410,607 $ 8,542,374
Furniture and equipment 501,861 503,819
Leasehold improvements 502,895 314,101
Automobile 13,008 --
------------ ------------
12,428,371 9,360,294
Less accumulated depreciation (7,150,762) (4,698,025)
------------ ------------
$ 5,277,609 $ 4,662,269
============ ============
Depreciation expense was $2,452,737, $2,041,592, and $1,205,839 in 2005,
2004, and 2003, respectively.
(4) MARKETABLE SECURITIES
The Company's investments consist of available-for-sale securities, which
are carried at fair value, with unrealized gains and losses reported as a
separate component of stockholders' equity. Unrealized gains and losses are
computed on the specific identification method. Realized gains, realized losses
and declines in value judged to be other-than-temporary, are included in other
income. The cost of available-for-sale securities sold are based on the specific
identification method and interest earned is included in interest and other
income.
The cost and fair values of the Company's available-for-sale marketable
securities as of December 31, 2005, are as follows:
Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
----------- ----------- ----------- -----------
Auction rate securities $10,098,031 $10,098,031 $ -- $ --
Government securities 6,394,262 6,431,432 -- 37,170
Corporate bonds 1,341,390 1,353,503 -- 12,113
----------- ----------- ----------- -----------
$17,833,683 $17,882,966 $ -- $ 49,283
=========== =========== =========== ===========
As of December 31, 2005 there are 3 corporate bonds and 2 government
securities which are in an unrealized loss position. Based on the credit ratings
of these securities and the timing of their respective maturities, there is no
reason to believe the Company will be unable to collect all amounts due
according to the contractual terms of these securities. Unrealized losses on the
Company's available-for-sales securities have not been determined to be
other-than-temporary due principally to the Company's intent and ability to hold
these securities for a period of time sufficient to recover the value of the
investments.
47
The cost and fair values of the Company's available-for-sale marketable
securities as of December 31, 2004, are as follows:
Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
----------- ----------- ----------- -----------
Auction rate securities $ 8,960,511 $ 8,960,511 $ -- $ --
Government securities 6,901,663 6,920,615 -- 18,952
Corporate bonds 2,626,442 2,875,296 -- 248,854
----------- ----------- ----------- -----------
$18,488,616 $18,756,422 $ -- $ 267,806
=========== =========== =========== ===========
The cost basis and fair value of available-for-sale securities by
contractual maturity as of December 31, 2005, were as follows:
Fair
Cost Value
----------- -----------
Due within one year $15,866,571 $15,838,499
Due between one and two years 2,016,395 1,995,184
----------- -----------
$17,882,966 $17,833,683
=========== ===========
(5) ACCRUED EXPENSES
Accrued expenses are comprised of the following:
December 31, December 31,
2005 2004
------------ ------------
Accrued compensation $1,517,115 $1,088,656
Accrued consulting and professional fees 598,674 899,678
Accrued marketing and promotion 229,675 193,592
Other accrued expenses 1,640,645 770,821
Accrued hardware purchases 38,946 73,252
Accrued and deferred rent 497,157 475,035
---------- ----------
$4,522,212 $3,501,034
========== ==========
6) INCOME TAXES
The provision for income taxes for the year ended December 31, 2005 is
comprised of Federal Alternative Minimum Tax, state income taxes and foreign
income taxes. The provision for income taxes for the year ended December 31,
2004 is comprised solely of foreign income taxes. The tax effects of temporary
differences that give rise to the Company's deferred tax assets (liabilities) as
of December 31, 2005 and 2004 are as follows:
48
2005 2004
------------ ------------
U.S. Federal net operating loss carryforwards (FalconStor) $ 11,123,022 $ 11,664,300
U.S. Federal net operating loss carryforwards (NPI) 31,711,302 31,711,100
Foreign net operating loss carryforwards 941,369 335,100
State net operating loss carryforwards 1,065,636 1,715,300
Start-up costs not currently deductible for taxes 90,100 271,300
Depreciation (358,207) (584,300)
Compensation 348,562 361,300
Tax credit carryforwards 1,889,255 1,433,200
Deferred revenue 650,555 1,977,400
Capital loss carryforward 847,901 883,400
Lease abandonment charge 77,327 111,800
Allowance for receivables 1,440,036 995,100
Patent 99,194 113,500
Other 11,636 8,100
------------ ------------
49,937,688 50,996,600
Valuation allowance (49,937,688) (50,996,600)
------------ ------------
$ -- $ --
============ ============
The difference between the provision for income taxes computed at the
Federal statutory rate and the reported amount of tax expense attributable to
loss before income taxes for the years ended December 31, 2005, 2004 and 2003,
are as follows:
2005 2004 2003
----------- ----------- -----------
Tax recovery at Federal statutory rate $ 820,031 $(1,991,300) $(2,494,400)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit 885,733 809,300 (318,000)
Non-deductible expenses 302,207 47,600 41,900
Compensation -- 2,700 157,600
Foreign tax credit -- (6,100) (90,000)
Net effect of foreign operations 128,150 164,800 (900)
Research and development credit (433,013) (360,100) (272,200)
Increase (decrease) in valuation allowance (1,584,358) 1,365,000 3,008,600
----------- ----------- -----------
$ 118,750 $ 31,900 $ 32,600
=========== =========== ===========
The components of the Company's current income tax provision for the years
ended December 31, 2005, 2004 and 2003 are as follows:
2005 2004 2003
-------- -------- --------
Federal $ 55,887 $ -- $ --
State and local 1,113 -- --
Foreign 61,750 31,900 32,600
-------- -------- --------
$118,750 $ 31,900 $ 32,600
======== ======== ========
Income (loss) before provision for income taxes for the years ended
December 31, 2005, 2004 and 2003 are as follows:
2005 2004 2003
----------- ----------- -----------
Domestic income (loss) $ 4,390,212 $(5,466,000) $(7,434,000)
Foreign income (loss) (1,978,355) (391,000) 98,000
----------- ----------- -----------
$ 2,411,857 $(5,857,000) $(7,336,000)
=========== =========== ===========
49
As of December 31, 2005, the Company had U.S. Federal net operating loss
carryforwards of approximately $32,714,800 which expire from 2020 through 2025.
In addition, as of the date of the merger described in Note 2, NPI had U.S.
Federal net operating loss carryforwards of $93,268,500 that starts to expire in
December, 2012. As of December 31, 2005, the Company had state net operating
loss carryforwards of approximately $20,682,000 which expire starting in 2007
through 2025. As of December 31, 2005, the Company had foreign net operating
loss carryforwards of approximately $3,083,600. At December 31, 2005 and 2004,
the Company established a valuation allowance against its deferred tax assets to
an amount that is more-likely-than-not realizable due to the Company's prior
history of pre-tax losses and uncertainty about the timing of and ability to
generate taxable income in the future. Due to the Company's various equity
transactions, which resulted in a change of control, the utilization of certain
tax loss carryforwards is subject to annual limitations imposed by Internal
Revenue Code Section 382. NPI experienced such an ownership change as a result
of the merger. As such, the Company's ability to use its NOL carryforwards to
offset taxable income in the future may be significantly limited. If the entire
deferred tax asset were realized, $4,628,100 would be allocated to
paid-in-capital with the remainder reducing income tax expense. Of the amount
allocable to paid-in-capital, $2,336,800 related to the tax effect of the
deductions for payments of the liabilities of discontinued operations and the
balance of $2,291,300 related to the tax effect of compensation deductions from
exercises of employee and consultant stock options.
(7) STOCKHOLDERS' EQUITY
In September, 2003, the Company entered into a worldwide OEM agreement
with a major technology company (the "OEM"), and granted to the OEM warrants to
purchase 750,000 shares of the Company's common stock with an exercise price of
$6.18 per share. A portion of the warrants may vest annually subject to the
OEM's achievement of pre-defined and mutually agreed upon sales objectives over
a three-year period beginning June 1, 2004. If the OEM generates cumulative
revenues to the Company in the mid-eight figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the three-year period will expire. If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants earned will be recorded as a reduction of revenue. Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. As of December 31, 2005,
the Company had not generated any revenues from this OEM and accordingly no
warrants had vested.
(8) STOCK OPTION PLANS
As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000
Stock Option Plan (the "Plan"). The Plan is administered by the Board of
Directors and, as amended, currently provides for the issuance of up to
14,162,296 options to employees, consultants and non-employee directors. Options
may be incentive ("ISO") or non-qualified. Exercise prices of ISOs granted must
be at least equal to the fair value of the common stock on the date of grant,
and have terms not greater than ten years, except those to an employee who owns
stock with greater than 10% of the voting power of all classes of stock of the
Company, in which case they must have an option price at least 110% of the fair
value of the stock, and expire no later than five years from the date of grant.
Certain of the options granted to employees had exercise prices less than
the fair value of the common stock on the date of grant, which resulted in
deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively.
The amortization of deferred compensation amounted to $7,969 and $463,476 in
2004 and 2003, respectively. Deferred compensation was fully amortized as of the
first quarter of 2004.
The Company granted options to purchase an aggregate of 50,000 shares of
common stock to certain non-employee consultants in exchange for professional
services during 2002. The aggregate fair value of these options as determined
using the fair value method under SFAS No. 123, is being expensed over the
periods the services are provided. The related expense amounted to $32,860,
$87,023 and $86,875 in 2005, 2004 and 2003, respectively. These services have
been completed as of December 31, 2005.
On May 14, 2004 the Company adopted a 2004 Outside Directors Stock Option
Plan (the "2004 Plan"). The 2004 Plan is administered by the Board of Directors
and provides for the granting of options to non-employee directors of the
50
Company to purchase up to 300,000 shares of Company common stock. Exercise
prices of the options must be equal to the fair market value of the common stock
on the date of grant. Options granted have terms of ten years. All options
granted under the 2004 Plan must be granted within three years of the adoption
of the 2004 Plan.
Stock option activity for the periods indicated is as follows:
Weighted
average
Number of exercise
Options Price
----------- --------
Outstanding at December 31, 2002 ................... 9,387,579 $ 3.55
Granted ............................................ 2,678,300 $ 7.01
Exercised .......................................... (1,224,833) $ .70
Canceled ........................................... (980,621) $ 9.19
----------
Outstanding at December 31, 2003 ................... 9,860,425 $ 4.29
----------
Granted ............................................ 1,227,000 $ 6.91
Exercised .......................................... (1,023,425) $ 1.99
Canceled ........................................... (1,090,642) $ 6.01
----------
Outstanding at December 31, 2004 ................... 8,973,358 $ 4.71
----------
Granted ............................................ 2,226,500 $ 7.31
Exercised .......................................... (465,110) $ 4.02
Canceled ........................................... (533,840) $ 6.38
----------
Outstanding at December 31, 2005 ................... 10,200,908 $ 5.22
==========
Vested at December 31, 2003 ........................ 4,950,046 $ 2.47
==========
Vested at December 31, 2004 ........................ 5,521,469 $ 3.60
==========
Vested at December 31, 2005 ........................ 6,735,403 $ 4.19
==========
Options available for grant at December 31, 2005 ... 1,006,314
==========
During 2003, one employee paid for the exercise price of certain options
with 7,094 shares of common stock that were held greater than six months. Such
shares which had a market value of $28,744 were retired.
The following table summarizes information about stock options outstanding
at December 31, 2005:
Options Outstanding Options Exercisable
------------------------------------------------------- -----------------------------------
Weighted - Average Weighted
Range of Number Remaining Contractual Average Exercise Number Weighted - Average
Exercise Prices Outstanding Life (Years) Price Exercisable Exercise Price
--------------- ----------- --------------------- ---------------- ----------- ------------------
$0.35 - $1.01 2,208,913 4.53 $ 0.35 2,208,913 $ 0.35
$3.95 - $4.04 1,124,610 6.85 $ 4.03 1,097,750 $ 4.04
$5.07 - $5.86 1,775,341 6.87 $ 5.27 1,432,252 $ 5.20
$6.01 - $6.90 1,956,570 8.08 $ 6.35 763,307 $ 6.25
$7.35 - $8.43 2,673,200 8.51 $ 8.11 839,587 $ 8.24
$8.74 - $9.72 318,624 6.99 $ 9.09 249,944 $ 9.18
$10.95 143,650 4.31 $ 10.95 143,650 $ 10.95
----------- -----------
10,200,908 6.99 $ 5.22 6,735,403 $ 4.19
----------- -----------
51
(9) LEASE ABANDONMENT CHARGE
In November 2003, the Company relocated its headquarters to a larger
facility. As a result of this relocation, the Company vacated its previous
office space and recorded a lease abandonment charge of $550,162 for the
estimated loss expected to be incurred on the remaining lease obligation through
July 2007. The charge included the remaining lease rental obligation reduced by
cash flows the Company expects to generate from an agreement to sub-lease the
facility, as well as the write-off of leasehold improvements at the Company's
previous facility. As of December 31, 2005, the remaining amounts due of
$137,429 associated with this charge were included in accrued expenses.
(10) LITIGATION SETTLEMENT CHARGE
During the third quarter of 2004, the Company resolved claims relating to
alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill")
and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company.
Pursuant to the terms of the Settlement Agreement between the Company and
Crossroads, the Company, without admission of infringement, made a one-time
payment of $1.3 million and granted to Crossroads licenses to certain Company
technology in exchange for a worldwide, perpetual license to the technology
underlying the Crossroads patents at issue in the litigation. All claims against
the Company by both Dot Hill and Crossroads were dismissed.
(11) LIABILITIES OF DISCONTINUED OPERATIONS
Liabilities of NPI's discontinued operations at December 31, 2002 totaled
$4.2 million and consisted of warranty related liabilities, foreign income
taxes, severance related payments, professional fees and other related
liabilities, including estimated settlement costs for disputes. As of December
31, 2002, the Company had reduced liabilities of discontinued operations and
increased additional paid-in-capital by $2,150,000 for its then estimate of the
excess of the remaining liabilities for discontinued operations over the amounts
estimated to be paid.
On February 14, 2003, the Company settled a claim associated with the
liabilities of discontinued operations for $2,850,000. As of December 31, 2003
all significant contingent liabilities related to the discontinued operations of
NPI were resolved and paid. As a result, on December 31, 2003 the excess of the
remaining liabilities for discontinued operations over the amounts paid of
$916,845 was reflected as an increase to additional paid-in-capital since this
liability was related to the merger with NPI, which was accounted for as a
recapitalization.
(12) COMMITMENTS AND CONTINGENCIES
The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to offices in foreign countries. The expiration dates for these leases
range from 2005 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of December 31, 2005:
Year ending December 31,
------------------------
2006...................................................... $ 1,915,879
2007...................................................... 1,433,153
2008...................................................... 1,220,435
2009...................................................... 1,254,067
2010...................................................... 1,288,708
Thereafter................................................ 1,699,218
-----------
$ 8,811,460
===========
52
These leases require the Company to pay its proportionate share of real
estate taxes and other common charges. Total rent expense for operating leases
was $1,461,051, $1,103,008, and $673,949 for the years ended December 31, 2005,
2004 and 2003, respectively.
The Company typically provides its customers a warranty on its software
products for a period of no more than 90 days. Such warranties are accounted for
in accordance with SFAS No. 5, ACCOUNTING FOR CONTINGENCIES. To date, the
Company has not incurred any costs related to warranty obligations.
Under the terms of substantially all of its software license agreements,
the Company has agreed to indemnify its customers for all costs and damages
arising from claims against such customers based on, among other things,
allegations that the Company's software infringes the intellectual property
rights of a third party. In most cases, in the event of an infringement claim,
the Company retains the right to (i) procure for the customer the right to
continue using the software; (ii) replace or modify the software to eliminate
the infringement while providing substantially equivalent functionality; or
(iii) if neither (i) nor (ii) can be reasonably achieved, the Company may
terminate the license agreement and refund to the customer a pro-rata portion of
the license fee paid to the Company. Such indemnification provisions are
accounted for in accordance with SFAS No. 5. Except for the alleged patent
infringement claim discussed in note 10, through December 31, 2005, there have
not been any claims under such indemnification provisions.
The Company is subject to various legal proceedings and claims, asserted
or unasserted, which arise in the ordinary course of business. While the outcome
of any such matters cannot be predicted with certainty, the Company believes
that such matters will not have a material adverse effect on its financial
condition or liquidity.
In November, 2005, the Company entered into a second Amended and Restated
Employment Agreement ("Employment Agreement") with ReiJane Huai. Pursuant to the
Employment Agreement, the Company agreed to employ Mr. Huai as President and
Chief Executive Officer of the Company until December 31, 2007, at an annual
salary of $275,000. The Employment Agreement also provides for the payment of
annual bonuses to Mr. Huai based on the Company's operating income (as defined)
and for certain other contingent benefits set forth in the Employment Agreement.
On December 1, 2005, the Company adopted the 2005 FalconStor Software,
Inc., Key Executive Severance Protection Plan ("Severance Plan"). Pursuant to
the Severance Plan, the Company's Chief Executive Officer, Chief Financial
Officer and certain other key executives are entitled to receive certain
contingent benefits, as set forth in the Severance Plan, including lump sum
payments and acceleration of stock option vesting, each in certain
circumstances.
(13) EMPLOYEE BENEFIT DEFINED CONTRIBUTION PLAN
Effective July 2002, the Company established a voluntary savings and
defined contribution plan (the "Plan") under Section 401(k) of the Internal
Revenue Code. This Plan covers all U.S. employees meeting certain eligibility
requirements and allows participants to contribute a portion of their annual
compensation. Employees are 100% vested in their own contributions. For the
years ended December 31, 2005, 2004 and 2003, the Company did not make any
contributions to the Plan.
(14) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the year ended December 31, 2005,
the Company purchased 272,500 shares of its common stock in open market
purchases for a total cost of $1,918,155. As of December 31, 2005, the Company
had repurchased a total of 549,600 shares for $3,632,930.
53
(15) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the years ended
December 31, 2005, 2004 and 2003 and the location of long-lived assets as of
December 31, 2005, 2004 and 2003 are summarized as follows:
2005 2004 2003
----------- ----------- -----------
Revenues:
United States $28,300,822 $18,140,465 $ 9,834,526
Asia 6,535,128 5,821,902 3,580,741
Other international 6,128,153 4,746,311 3,528,868
----------- ----------- -----------
Total Revenues $40,964,103 $28,708,678 $16,944,135
=========== =========== ===========
Long-lived assets (includes all non-current assets):
United States $ 9,716,031 $ 9,929,214 $10,329,876
Asia 1,320,865 950,387 760,148
Other international 207,098 322,544 334,576
----------- ----------- -----------
Total long-lived assets $11,243,994 $11,202,145 $11,424,600
=========== =========== ===========
For the year ended December 31, 2005, the Company had two customers that
together accounted for a total of 31% of revenues. For the year ended December
31, 2004, the Company had one customer that accounted for 16% of revenues. For
the year ended December 31, 2003, the Company did not have any customers that
accounted for over 10% of revenues. As of December 31, 2005, the Company had two
customers with accounts receivable balances greater than 5% of gross accounts
receivable, which in the aggregate were 28% of the accounts receivable balance.
As of December 31, 2004, the Company had three customers with accounts
receivable balances greater than 5% of gross accounts receivable, which in the
aggregate were 33% of the accounts receivable balance.
(16) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL
ACCOUNTS
Balance at Additions Balance at
Beginning of Charged End of
Period Ended, Period to Expense Deductions Period
----------------- ------------- ------------- ------------- -------------
December 31, 2005 $ 2,551,616 $ 4,340,102 $ 3,044,836 $ 3,846,882
December 31, 2004 $ 1,837,934 $ 3,296,275 $ 2,582,593 $ 2,551,616
December 31, 2003 $ 813,645 $ 1,700,100 $ 675,811 $ 1,837,934
(17) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of selected quarterly financial data for the
years ended December 31, 2005 and 2004:
54
Fiscal Quarter
First Second Third Fourth
------------ ------------ ------------ ------------
2005
Revenue $ 8,392,036 $ 9,495,587 $ 10,056,665 $ 13,019,815
============ ============ ============ ============
Net income (loss) (a) $ (133,829) $ 288,105 $ 482,879 $ 1,655,952
============ ============ ============ ============
Basic net income
(loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03
============ ============ ============ ============
Diluted net income
(loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03
============ ============ ============ ============
Basic weighted average
common shares
outstanding 47,528,874 47,594,072 47,720,496 47,802,694
============ ============ ============ ============
Diluted weighted average
common shares
outstanding 47,528,874 50,623,983 50,531,012 50,958,553
============ ============ ============ ============
(a) Net income for the year ended December 31, 2005, includes an out-of-period
charge of approximately $0.2 million to recognize investment losses realized in
prior years. Such charge was not considered material to any period.
2004
Revenue $ 5,258,798 $ 6,483,137 $ 7,469,999 $ 9,496,744
============ ============ ============ ============
Net income (loss) $ (2,221,507) $ (1,713,091) $ (2,293,083) $ 338,834
============ ============ ============ ============
Basic net income
(loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01
============ ============ ============ ============
Diluted net income
(loss) per share $ (0.05) $ (0.04) $ (0.05) $ 0.01
============ ============ ============ ============
Basic weighted average
common shares
outstanding 46,638,740 46,859,326 47,054,294 47,307,612
============ ============ ============ ============
Diluted weighted average
common shares
outstanding 46,638,740 46,859,326 47,054,294 51,249,985
============ ============ ============ ============
The sum of the quarterly net loss per share amounts do not always equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each such period.
55
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES.
DISCLOSURE CONTROLS AND PROCEDURES
The Company maintains "disclosure controls and procedures," as such term
is defined in Rules 13a-15e and 15d-15e of the Securities and Exchange Act
of 1934, as amended (the "Exchange Act"), that are designed to ensure that
information required to be disclosed in its reports, pursuant to the
Exchange Act, is recorded, processed, summarized and reported within the
time periods specified in the SEC's rules and forms, and that such
information is accumulated and communicated to its management, including
its Chief Executive Officer and Chief Financial Officer, as appropriate,
to allow timely decisions regarding the required disclosures. In designing
and evaluating the disclosure controls and procedures, management has
recognized that any controls and procedures, no matter how well designed
and operated, can provide only reasonable assurances of achieving the
desired control objectives, and management necessarily is required to
apply its judgment in evaluating the cost benefit relationship of possible
controls and procedures.
The Company's Chief Executive Officer (its principal executive officer)
and Chief Financial Officer (its principal finance officer and principal
accounting officer) have evaluated the effectiveness of its "disclosure
controls and procedures" as of the end of the period covered by this
Annual Report on Form 10-K. Based on their evaluation, the principal
executive officer and principal financial officer concluded that its
disclosure controls and procedures are effective.
INTERNAL CONTROL OVER FINANCIAL REPORTING
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company's management is responsible for establishing and maintaining
adequate internal control over financial reporting for the Company. To
evaluate the effectiveness of the Company's internal control over
financial reporting, the Company's management uses the Integrated
Framework adopted by the Committee of Sponsoring Organizations of the
Treadway Commission ("COSO").
The Company's management has assessed the effectiveness of the Company's
internal control over financial reporting as of December 31, 2005, using
the COSO framework. The Company's management has determined that the
Company's internal control over financial reporting is effective as of
that date.
KPMG LLP, the registered public accounting firm that has audited the
Company's consolidated financial statements included in this report has
issued their attestation report on management's assessment of the
Company's internal control over financial reporting, which is included
herein.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information called for by Part III, Item 10, regarding the Registrant's
directors will be included in our Proxy Statement relating to our annual
meeting of stockholders scheduled to be held in May 2006, and is
incorporated herein by reference. The information appears in the Proxy
Statement under the captions
56
"Election of Directors", "Management" and "Committees of the Board of
Directors." The Proxy Statement will be filed within 120 days of December
31, 2005, our year-end.
ITEM 11. EXECUTIVE COMPENSATION
Information called for by Part III, Item 11, will be included in our Proxy
Statement relating to our annual meeting of stockholders scheduled to be
held in May 2006, and is incorporated herein by reference. The information
appears in the Proxy Statement under the caption "Executive Compensation."
The Proxy Statement will be filed within 120 days of December 31, 2005,
our year-end.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information called for by Part III, Item 12, will be included in our Proxy
Statement relating to our annual meeting of stockholders scheduled to be
held in May 2006, and is incorporated herein by reference. The information
appears in the Proxy Statement under the captions "Beneficial Ownership of
Shares" and "Equity Compensation Plan Information." The Proxy Statement
will be filed within 120 days of December 31, 2005, our year-end.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding our relationships and related transactions will be
included in our Proxy Statement relating to our annual meeting of
stockholders scheduled to be held in May 2006, and is incorporated by
reference. The information appears in the Proxy Statement under the
caption "Certain Relationships and Related Transactions." The Proxy
Statement will be filed within 120 days of December 31, 2005, our
year-end.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information called for by Part III, Item 14, will be included in our Proxy
Statement relating to our annual meeting of stockholders scheduled to be
held in May 2006, and is incorporated herein by reference. The information
appears in the Proxy Statement under the caption "Principal Accountant
Fees and Services." The Proxy Statement will be filed within 120 days of
December 31, 2005, our year-end.
57
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The information required by subsections (a)(1) and (a)(2) of this item are
included in the response to Item 8 of Part II of this annual report on
Form 10-K.
(b) Exhibits
2.1 Agreement and Plan of Merger and Reorganization, dated as of
May 4, 2001, among FalconStor, Inc., Network Peripherals Inc.,
and Empire Acquisition Corp, incorporated herein by reference
to Annex A to the Registrant's joint proxy/prospectus on Form
S-4, filed May 11, 2001.
3.1 Restated Certificate of Incorporation, incorporated herein by
reference to Exhibit 3.1 to the Registrant's registration
statement on Form S-1 (File no. 33-79350), filed on April 28,
1994.
3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the
Registrant's quarterly report on form 10-Q for the period
ended March 31, 2000, filed on May 10, 2000.
3.3 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.3 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 1998, filed on March 22, 1999.
3.4 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.4 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 2001, filed on March 27, 2002.
4.1 2000 Stock Option Plan, incorporated herein by reference to
Exhibit 4.1 of the Registrant's registration statement on Form
S-8, filed on September 21, 2001.
4.2 2000 Stock Option Plan, as amended May 15, 2003, incorporated
herein by reference to Exhibit 99 to the Registrant's
quarterly report on Form 10-Q for the period ended June 30,
2003, filed on August 14, 2003.
4.3 2000 Stock Option Plan, as amended May 14, 2004, incorporated
herein by reference to Exhibit 4.3 to the Registrant's Annual
Report on Form 10-K for the year ended December 31, 2004,
filed on March 16, 2005.
4.4 1994 Outside Directors Stock Plan, as amended May 17, 2002
incorporated herein by reference to Exhibit 4.2 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 2002, filed on March 17, 2003.
4.5 2004 Outside Directors Stock Option Plan, incorporated herein
by reference to Exhibit 4.5 to the Registrant's Annual Report
on Form 10-K for the year ended December 31, 2004, filed on
March 16, 2005.
10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and
FalconStor Software, Inc., dated August, 2003, incorporated
herein by reference to Exhibit 99.1 to the Registrant's
quarterly report on Form 10-Q for the period ended September
30, 2003, filed on November 14, 2003.
10.2 Second Amended and Restated Employment Agreement, dated
November 7, 2005 between Registrant and ReiJane Huai,
incorporated herein by reference to Exhibit 10.1 to the
58
Registrant's quarterly report on Form 10-Q for the period
ended September 30, 2005, filed on November 8, 2005.
10.3 *Amended and Restated FalconStor Software, Inc., 2005 Key
Executive Severance Protection Plan.
21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC,
Inc., FalconStor Software (Korea), Inc.
23.1 *Consent of KPMG LLP.
31.1 *Certification of the Chief Executive Officer
31.2 *Certification of the Chief Financial Officer
32.1 *Certification of Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
32.2 *Certification of Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
*- filed herewith.
59
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has signed this report by the undersigned,
thereunto duly authorized in Melville, State of New York on March 15, 2006.
FALCONSTOR SOFTWARE, INC.
By: /s/ Reijane Huai Date: March 15, 2006
---------------------------------------------
ReiJane Huai, President, Chief Executive
Officer of FalconStor Software, Inc.
POWER OF ATTORNEY
FalconStor Software, Inc. and each of the undersigned do hereby appoint
ReiJane Huai and James Weber, and each of them severally, its or his true and
lawful attorney to execute on behalf of FalconStor Software, Inc. and the
undersigned any and all amendments to this Annual Report on Form 10-K and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission; each of such attorneys
shall have the power to act hereunder with or without the other.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
By: /s/ ReiJane Huai March 15, 2006
---------------------------------------------------- --------------
Reijane Huai, President, Chief Executive Officer and Date
Chairman of the Board
(Principal Executive Officer)
By: /s/ James Weber March 15, 2006
---------------------------------------------------- --------------
James Weber, Chief Financial Officer, Date
Vice President and Treasurer
(Principal Financial Officer and Principal
Accounting Officer)
By: /s/ Steven L. Bock March 15, 2006
---------------------------------------------------- --------------
Steven L. Bock, Director Date
By: /s/ Patrick B. Carney March 15, 2006
---------------------------------------------------- --------------
Patrick B. Carney, Director Date
By: /s/ Lawrence S. Dolin March 15, 2006
---------------------------------------------------- --------------
Lawrence S. Dolin, Director Date
By: /s/ Steven R. Fischer March 15, 2006
---------------------------------------------------- --------------
Steven R. Fischer, Director Date
By: /s/ Alan W. Kaufman March 15, 2006
---------------------------------------------------- --------------
Alan W. Kaufman, Director Date
60
