FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 2005
-----------------------------------------
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to __________________
COMMISSION FILE NUMBER 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer
Identification No.)
2 HUNTINGTON QUADRANGLE
MELVILLE, NEW YORK 11747
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: 631-777-5188
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes /X/ No / /
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes /X/ No / /
The number of shares of Common Stock issued and outstanding as of July 28, 2005
was 48,142,403 and 47,717,803, which includes redeemable common shares.
-1-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Consolidated Financial Statements 3
Consolidated Balance Sheets at June 30, 2005
(unaudited) and December 31, 2004 3
Unaudited Condensed Consolidated Statements of Operations
for the three and six months ended June 30, 2005 and 2004 4
Unaudited Condensed Consolidated Statements of Cash Flows
for the six months ended June 30, 2005 and 2004 5
Notes to the Unaudited Condensed Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13
Item 3. Qualitative and Quantitative Disclosures about Market Risk 27
Item 4. Controls and Procedures 27
PART II. Other Information 27
Item 1. Legal Proceedings 27
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 28
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information 28
Item 6. Exhibits 28
-2-
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
JUNE 30, 2005 DECEMBER 31, 2004
------------- -----------------
ASSETS (UNAUDITED)
Current assets:
Cash and cash equivalents ....................................................... $ 15,839,208 $ 15,484,573
Marketable securities ........................................................... 18,435,167 18,488,616
Accounts receivable, net of allowances of $3,305,357 and
$2,551,616, respectively....................................................... 11,145,340 10,269,822
Prepaid expenses and other current assets ....................................... 932,636 629,036
------------ ------------
Total current assets ................................................... 46,352,351 44,872,047
Property and equipment, net ........................................................ 4,854,508 4,662,269
Goodwill ........................................................................... 3,512,796 3,512,796
Other intangible assets, net ....................................................... 257,769 307,620
Other assets ....................................................................... 2,278,473 2,719,460
------------ ------------
Total assets ........................................................... $ 57,255,897 $ 56,074,192
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................................................ $ 983,953 $ 821,433
Accrued expenses ................................................................ 3,233,610 3,501,034
Deferred revenue ................................................................ 5,447,644 4,097,279
------------ ------------
Total current liabilities ............................................ 9,665,207 8,419,746
Deferred revenue ................................................................... 1,450,955 1,290,496
------------- ------------
Total liabilities .................................................... 11,116,162 9,710,242
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized ...... -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
48,066,226 and 47,768,755 shares issued, respectively and 47,641,626
and 47,491,655 shares outstanding, respectively .............................. 48,066 47,769
Additional paid-in capital ...................................................... 86,107,917 85,400,740
Accumulated deficit ............................................................. (36,798,160) (36,952,436)
Common stock held in treasury, at cost (424,600 and 277,100 shares,
respectively).................................................................. (2,781,894) (1,714,775)
Accumulated other comprehensive loss ............................................ (436,194) (417,348)
------------- ------------
Total stockholders' equity ............................................. 46,139,735 46,363,950
------------- ------------
Total liabilities and stockholders' equity ............................. $ 57,255,897 $ 56,074,192
============= ============
See accompanying notes to unaudited consolidated financial statements.
-3-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------------ ------------------------------
2005 2004 2005 2004
------------- ------------ ------------- -------------
Revenues:
Software license revenue ..................................... $ 6,650,442 $ 4,915,498 $ 12,932,951 $ 8,463,329
Maintenance revenue .......................................... 1,791,267 1,043,202 3,321,441 1,865,055
Software services and other revenue .......................... 1,053,878 524,437 1,633,231 1,413,551
------------ ------------ ------------ ------------
9,495,587 6,483,137 17,887,623 11,741,935
------------ ------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized
software ................................................ 193,417 409,250 416,000 824,298
Cost of maintenance, software services and
other revenue ........................................... 1,468,866 989,955 2,796,083 1,967,960
Software development costs ................................ 2,763,745 2,178,927 5,431,136 4,340,843
Selling and marketing ..................................... 3,979,124 3,401,078 7,484,343 6,714,616
General and administrative ................................ 1,031,285 1,397,409 2,017,311 2,208,052
------------ ------------ ------------ ------------
9,436,437 8,376,619 18,144,873 16,055,769
------------ ------------ ------------ ------------
Operating income (loss) ........................... 59,150 (1,893,482) (257,250) (4,313,834)
------------ ------------ ------------ ------------
Interest and other income .................................... 236,909 188,852 423,495 391,777
------------ ------------ ------------ ------------
Income (loss) before income taxes ................... 296,059 (1,704,630) 166,245 (3,922,057)
Provision for income taxes ................................... 7,954 8,461 11,969 12,541
------------ ------------ ------------ ------------
Net income ( loss) .................................. $ 288,105 $ (1,713,091) $ 154,276 $ (3,934,598)
------------ ------------ ------------ ------------
Basic net income (loss) per share ............................ $ 0.01 $ (0.04) $ 0.00 $ (0.08)
============ ============ ============ =============
Diluted net income (loss) per share .......................... $ 0.01 $ (0.04) $ 0.00 $ (0.08)
============ ============ ============ ==============
Weighted average basic shares
outstanding ............................................... 47,594,072 46,859,326 47,561,653 46,750,352
============ =========== ============ ==============
Weighted average diluted shares
outstanding ............................................... 50,623,983 46,859,326 50,806,365 46,750,352
============ =========== ============ ==============
See accompanying notes to unaudited consolidated financial statements.
-4-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
2005 2004
------------ ------------
Cash flows from operating activities:
Net income (loss) ................................................... $ 154,276 $ (3,934,598)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Depreciation and amortization ................................. 1,708,690 1,853,942
Non-cash professional services ................................ (75,728) 21,092
Equity-based compensation expense ............................. -- 7,969
Provision for returns and doubtful accounts ................... 965,196 1,468,067
Changes in operating assets and liabilities:
Accounts receivable, net ...................................... (1,840,715) (2,318,335)
Prepaid expenses and other current assets ..................... (303,600) (57,914)
Other assets .................................................. 24,987 (1,948)
Accounts payable .............................................. 162,520 359,709
Accrued expenses .............................................. (267,424) 596,207
Deferred revenue .............................................. 1,510,824 1,337,640
------------ ------------
Net cash provided by (used in) operating activities 2,039,026 (668,169)
------------ ------------
Cash flows from investing activities:
Sale of marketable securities ....................................... 31,448,900 22,698,597
Purchase of marketable securities ................................... (31,382,328) (16,810,099)
Purchase of property and equipment .................................. (1,356,820) (1,245,281)
Purchase of software licenses ....................................... -- (50,000)
Purchase of intangible assets ....................................... (78,258) (43,472)
Security deposits ................................................... -- (4,501)
------------ ------------
Net cash (used in) provided by investing activities ................. (1,368,506) 4,545,244
------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options ............................. 783,203 451,165
Payments to acquire treasury stock .................................. (1,067,119) (279,645)
------------ ------------
Net cash (used in) provided by financing activities .............. (283,916) 171,520
------------ ------------
Effect of exchange rate changes on cash and cash equivalents ........... (31,969) 378
------------ ------------
Net increase in cash and cash equivalents .............................. 354,635 4,048,973
Cash and cash equivalents, beginning of period ......................... 15,484,573 8,486,144
------------ ------------
Cash and cash equivalents, end of period ............................... $ 15,839,208 $ 12,535,117
============ ============
Cash paid for income taxes ............................................. $ 6,294 $ 323
============ =============
The Company did not pay any interest expense for the six months ended June 30,
2005 and 2004. See accompanying notes to unaudited consolidated financial
statements.
-5-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) THE COMPANY AND NATURE OF OPERATIONS
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops,
manufactures and sells network storage software solutions and provides the
related maintenance, implementation and engineering services.
(B) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(C) UNAUDITED INTERIM FINANCIAL INFORMATION
The unaudited interim consolidated financial statements of the Company as of
June 30, 2005 and for the three and six months ended June 30, 2005 and 2004,
included herein have been prepared, without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission ("SEC"). Certain
information and note disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted pursuant to such rules
and regulations relating to interim financial statements.
In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at June 30, 2005, and the results of its operations for the three
months and six months ended June 30, 2005 and 2004.
(D) CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$11.5 million and $10.9 million at June 30, 2005 and December 31, 2004,
respectively. Marketable securities at June 30, 2005 and December 31, 2004
amounted to $18.4 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.
(E) REVENUE RECOGNITION
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable and the software is
delivered and collection of the resulting receivable is deemed probable.
Software delivered to a customer on a trial basis is not recognized as revenue
until a permanent key is delivered to the customer. Reseller customers typically
send the Company a purchase order only when they have an end user identified.
When a customer licenses software together with the purchase of maintenance, the
Company allocates a portion of the fee to maintenance for its fair value based
on the contractual maintenance renewal rate. Software maintenance fees are
deferred and recognized as revenue ratably over the term of the contract. The
long-term portion of deferred revenue relates to maintenance contracts with
terms in excess of one year. The cost of providing technical support is included
in cost of revenues. The Company provides an allowance for software product
returns as a reduction of revenue.
Revenues associated with software implementation and software engineering
services are recognized as the services are completed. Costs of providing these
services are included in cost of revenues.
-6-
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.
For the quarters ended June 30, 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).
For the three months ended June 30, 2005, the Company had two customers that
together accounted for 27% of revenues and one customer that accounted for 11%
of the accounts receivable balance at June 30, 2005.
(F) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years). Depreciation expense was $579,451 and $498,967 for the three months
ended June 30, 2005 and 2004, respectively, and $1,164,580 and $923,731 for the
six months ended June 30, 2005 and 2004, respectively. 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.
(G) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and identifiable intangible assets acquired in business
combinations. Consistent with Statement of Financial Accounting Standards
("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not
amortized goodwill related to its acquisitions, but instead tested the balance
for impairment. The Company's annual impairment assessment is performed as of
December 31st of each year, and at other times 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 $65,851 and $54,169 for
the three months ended June 30, 2005 and 2004, respectively, and $128,110 and
$105,912 for the six months ended June 30, 2005 and 2004, respectively. The
gross carrying amount and accumulated amortization of other intangible assets as
of June 30, 2005 and December 31, 2004 are as follows:
June 30, 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 $ 601,881 $ 523,623
Accumulated amortization (344,113) (252,145)
--------- ---------
Net carrying amount $ 257,768 $ 271,478
========= =========
(H) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
-7-
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs. Software development costs were fully
amortized as of June 30, 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.
Purchased software technology of $629,806 and $1,045,806, net of accumulated
amortization of $4,281,194 and $3,865,194, is included in other assets in the
balance sheets as of June 30, 2005 and December 31, 2004, respectively.
Amortization expense was $193,417 and $409,250 for the three months ended June
30, 2005 and 2004, respectively, and $416,000 and $816,416 for the six months
ended June 30, 2005 and 2004, respectively.
(I) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(J) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. If the sum of the expected future cash flows, undiscounted and
without interest, is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.
(K) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board ("APB") Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44, ACCOUNTING FOR
CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB
OPINION NO. 25 to account for its fixed-plan stock options. Under this method,
compensation expense is recorded only if on the date of grant the current market
price of the underlying stock exceeded the exercise price. SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION, established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based
employee compensation plans. As allowed by SFAS No. 123, the Company has elected
to continue to apply the intrinsic-value-based method of accounting described
above, and has adopted only the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the fair
value method under SFAS No. 123, the Company's pro forma net loss and diluted
net loss per share would have been adjusted to the pro forma amounts indicated
below:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Net Income (loss) as reported $ 288,105 $ (1,713,091) $ 154,276 $ (3,934,598)
Add stock-based employee compensation expense
included in reported net income, net of tax -- -- -- 7,969
Deduct total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of tax (2,563,735) (2,035,104) (4,813,325) (3,718,235)
------------- ------------- ------------- -------------
Net loss - pro forma $ (2,275,630) $ (3,748,195) $ (4,659,049) $ (7,644,864)
============= ============= ============= =============
-8-
Basic and diluted net income (loss) per common
share-as reported $ .01 $ (.04) $ .00 $ (.08)
Basic and diluted net loss per common $ (.05) $ (.08) $ (.10) $ (.16)
share-pro forma
Due to the pro forma net loss in all periods, diluted net loss per common
share is equal to basic net loss per common share on a pro forma basis.
The per share weighted average fair value of stock options granted was $5.66
and $5.18 for the three months ended June 30, 2005 and 2004, respectively,
and $7.06 and $5.41 for the six months ended June 30, 2005 and 2004,
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 of 3.5%,
expected stock volatility ranging from 161% to 166% and an expected option
life of five years for options granted to employees of the Company;
2004--expected dividend yield of 0%, risk free interest rate of 3.5%,
expected stock volatility ranging from 172% to 176% and an expected option
life of five years for options granted to employees of the Company.
(L) FINANCIAL INSTRUMENTS
As of June 30, 2005 and December 31, 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.
(M) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the unaudited consolidated
statements of operations.
(N) EARNINGS PER SHARE (EPS)
Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the three and six months ended June 30, 2004,
all common stock equivalents were excluded from diluted net loss per share for
these periods. As of June 30, 2005, potentially dilutive common stock
equivalents included 10,225,391 stock options outstanding and 750,000 warrants
outstanding (such warrants become exercisable only if certain performance
targets are met by the grantee).
The following represents a reconciliation of the numerators and denominators
of the basic and diluted earnings per share ("EPS") computation:
Three Months Ended June 30, 2005 Three Months Ended June 30, 2004
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
Basic EPS $ 288,105 47,594,072 $ 0.01 $(1,713,091) 46,859,326 $ (0.04)
========= ========
Effect of dilutive securities:
Stock Options 3,029,911 --
------------ ---------- ---------- ----------- ----------- -----------
Diluted EPS $ 288,105 50,623,983 $ 0.01 $(1,713,091) 46,859,326 $ (0.04)
============ ========== ========== =========== =========== ==========
-9-
Six Months Ended June 30, 2005 Six Months Ended June 30, 2004
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
Basic EPS $ 154,276 47,561,653 $ 0.00 $(3,934,598) 46,750,352 $ (0.08)
========== ==========
Effect of dilutive securities:
Stock Options 3,244,712 -
------------ ---------- ---------- ----------- ----------- -----------
Diluted EPS $ 154,276 50,806,365 $ 0.00 $(3,934,598) 46,750,352 $ (0.08)
============ ========== ========== =========== =========== ==========
(O) COMPREHENSIVE INCOME (LOSS)
The Company's comprehensive income (loss) is as follows:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Net Income $ 288,105 $(1,713,091) $ 154,276 $(3,934,598)
----------- ----------- ----------- -----------
Other comprehensive income (loss):
Foreign currency translation
adjustments (16,446) (63,699) (31,969) 378
Unrealized gains (loss) on investments 6,968 3,942 13,123 (143,734)
----------- ----------- ----------- -----------
Other comprehensive loss (9,478) (59,757) (18,846) (143,356)
----------- ----------- ----------- -----------
Comprehensive income (loss) $ 278,627 $(1,772,848) $ 135,430 $(4,077,954)
=========== =========== =========== ===========
(P) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
(Q) NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (R), SHARE BASED PAYMENT
("SFAS 123(R)"). This statement replaces SFAS No.123, ACCOUNTING FOR STOCK BASED
COMPENSATION and supersedes APB No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES. SFAS 123 (R) requires all stock based compensation to be recognized
as an expense in the financial statements and that such cost be measured
according to the grant date fair value of stock options or other equity
instruments. SFAS 123 (R) will become effective for the Company on January 1,
2006. The Company is currently evaluating the impact that the adoption of this
statement will have on the Company's consolidated financial statements, although
the Company expects that there will be a negative impact on its results of
operations.
(R) RECLASSIFICATIONS
Certain reclassifications have been made to prior year's consolidated
financial statements to conform to the current year's presentation.
(2) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the three and six
-10-
months ended June 30, 2005 and June 30, 2004 and the location of long-lived
assets as of June 30, 2005 and December 31, 2004 are summarized as follows:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
United States $ 6,331,096 $ 3,888,657 $12,091,889 $ 6,502,730
Asia 1,959,658 1,348,748 3,342,978 2,532,202
Oher international 1,204,833 1,245,732 2,452,756 2,707,003
----------- ----------- ----------- -----------
Total revenues $ 9,495,587 $ 6,483,137 $17,887,623 $11,741,935
=========== =========== =========== ===========
June 30, December 31,
2005 2004
----------- ------------
Long-lived assets
(includes all non-current assets):
United States $ 9,405,608 $ 9,929,214
Asia 1,229,304 950,387
Other international 268,634 322,544
----------- -----------
Total long-lived assets $10,903,546 $11,202,145
=========== ===========
(3) 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 quarter and six months ended
June 30, 2005, the Company purchased 22,500 and 147,500 shares of its common
stock in open market purchases for a total cost of $154,024 and $1,067,119,
respectively. As of June 30, 2005, the Company had repurchased a total of
424,600 shares for $2,781,894.
(4) COMMITMENTS AND CONTINGENCIES
The Company's only contractual obligations relate to its operating leases.
The Company has an operating lease covering its primary office facility that
expires in February, 2012. The Company also has several operating leases related
to offices in foreign countries. The expiration dates for these leases ranges
from 2005 through 2012. The following is a schedule of future minimum lease
payments for all operating leases as of June 30, 2005:
2005.................................... $ 746,967
2006.................................... 1,525,211
2007.................................... 1,340,057
2008.................................... 1,222,281
2009.................................... 1,255,913
Thereafter.............................. 3,000,385
------------
$ 9,090,814
============
-11-
We are subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, we believe that such
matters will not have a material adverse effect on our financial condition or
operating results.
-12-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
Our revenues for the second quarter of 2005 increased 46% compared with
the same period a year ago and 13% from the previous quarter. Revenues from both
our resellers and our OEM partners increased in the quarter as compared with the
first quarter of 2005. This continued growth on both a quarterly sequential
basis and year over year indicates that we are increasing our market presence
and that our resellers, OEM customers and end users value our products.
However, while our revenues increased on a quarter-over-quarter and
year-over-year basis, they still fell below our expectations. We believe that at
least part of the shortfall from what we had projected was due to unexpected
events at two of our OEM customers. In the first quarter of 2005, CNT announced
that it was being purchased by McDATA Corporation. This transaction closed on
the last day of our second quarter. During the second quarter of 2005,
StorageTek announced that it was being purchased by Sun Microsystems. This
transaction has net yet closed. In each instance, the announcement and the
actual or planned transaction caused a near term loss of focus at the OEM
customer and our license revenues suffered.
We recorded a profit in the second quarter. Net income for the quarter
was $0.3 million, or $0.01 per share, compared with a net loss of $1.7 million,
or $0.04 per share, for the same period a year ago. Operating expenses in the
second quarter of 2004 included $0.6 million in legal fees related to a patent
litigation which has been settled. We are pleased that we returned to
profitability, but, as a direct result of the lower than expected revenues
discussed above, the level of profit fell below our expectations.
We continue to expect that revenues from our VirtualTape Library
software, both FalconStor- and OEM-branded, will grow at a higher rate in the
second half of 2005 than our other products. We also continue to expect that
revenues from our iSCSI products, which have not yet been significant, will
begin to increase this year.
Deferred revenue at quarter end increased 13%, compared with the balance
at March 31, 2005, and by 75% compared with the same period a year ago. We
consider the continued growth of our deferred revenue as an important indicator
of the success of our products. We believe that support and maintenance
renewals, which comprise the majority of our deferred revenue, are expressions
of satisfaction with our products and our support organization from our end
users.
We remain pleased with our ability to scale our business. The 46%
increase in revenues was accomplished with only a 13% increase in operating
expenses from the same period last year. Our gross margins increased from 78%
for the second quarter of 2004 to 82% in the second quarter this year.
We continue to operate the business with the goal of long term growth. We
believe that our ability to continue to refine our existing products and
features and to introduce new products and features will be the primary driver
of additional growth among existing resellers, OEMs and end users, and will
drive our strategy to attempt to engage additional OEM partners and to expand
the FalconStor product lines offered by these OEMs.
-13-
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED JUNE 30, 2005 COMPARED TO THE
THREE MONTHS ENDED JUNE 30, 2004.
Revenues for the three months ended June 30, 2005 increased 46% to
$9.5 million compared with $6.5 million for the three months ended June 30,
2004. Our operating expenses increased 13% from $8.4 million for the three
months ended June 30, 2004 to $9.4 million for the three months ended June 30,
2005. Net income for the three months ended June 30, 2005 was $0.3 million
compared with a net loss of $1.7 million for the three months ended June 30,
2004. The 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 quarter ended June 30, 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 three
months ended June 30, 2005, we increased the number of employees and continued
to invest in our infrastructure by purchasing additional computers and
equipment. We increased the number of employees from 189 employees as of June
30, 2004 to 261 employees as of June 30, 2005.
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 35% from $4.9 million for the
three months ended June 30, 2004 to $6.7 million for the three months ended June
30, 2005. 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 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 the second quarter of 2005, we had a limited number of
transactions in which we purchased hardware and bundled this hardware with our
software and sold the bundled solution to our customer. A portion of the
contractual fees is recognized as revenue when the hardware or software is
delivered to the customer based on the relative fair value of the delivered
element(s). Maintenance, software services and other revenue increased 81% to
$2.8 million for the three months ended June 30, 2005 from $1.6 million for the
three months ended June 30, 2004.
The major factor behind the increase in maintenance, software
services and other revenue was an increase in the number of maintenance and
technical support contracts we sold. As we are in business longer, and as we
license more software, we expect these revenues will continue to increase. The
majority of our new customers purchase maintenance and support and most
customers renew their maintenance and support after their initial contracts
expire. Maintenance revenue increased from $1.0 million for the three months
ended June 30, 2004 to $1.8 million for the three months ended June 30, 2005.
Growth in our professional services sales, which increased by $0.2 million for
the three months ended June 30, 2005 compared with the three months ended June
30, 2004, also contributed to the increase in software services and other
revenues. This increase in professional services revenue was related to the
increase in our software license customers who elected to purchase professional
services. Additionally, our hardware sales increased from approximately $0.2
million for the three months ended June 30, 2004 to approximately $0.5 million
-14-
for the three months ended June 30, 2005. This increase was the result of an
increase in demand from our customers for bundled solutions. We expect
maintenance, software services and other revenues to continue to increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed various software for resale since
2001. As of June 30, 2005 and 2004, we had $4.9 million of purchased software
licenses that are being amortized over three years. For the three months ended
June 30, 2005 and June 30, 2004, we recorded $0.2 million and $0.4 million of
amortization related to these purchased software licenses, respectively. We will
continue to evaluate third party software licenses and may make additional
purchases, which would result in an increase in amortization expense.
The Company did not capitalize any software development costs until our
initial product reached technological feasibility in March 2001. At that point,
we capitalized $0.1 million of software development costs, which were being
amortized at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products. Capitalized software costs were fully amortized as of
the end of the first quarter of 2004.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues consists
primarily of personnel and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased that was resold. Cost of maintenance, software services
and other revenues for the three months ended June 30, 2005 increased by 48% to
$1.5 million compared with $1.0 million for the three months ended June 30,
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
required a higher number of employees to provide technical support and to
implement our software. Additionally, due to the increase in hardware sales, our
associated hardware costs increased from $0.2 million for the three months ended
June 30, 2004 to $0.3 million for the three months ended Junes 30, 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 three months ended June 30, 2005 was $7.8 million
or 82% of revenue compared to $5.1 million or 78% of revenue for the three
months ended June 30, 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 contributed to the increase in gross
margins since revenues from our OEM partners have higher gross margins.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for
product development personnel and other related costs associated with the
development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased 27% to $2.8 million
for the three months ended June 30, 2005 from $2.2 million for the three months
ended June 30, 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.
-15-
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 17% to $4.0 million for the three months ended June 30, 2005 from $3.4
million for the three months ended June 30, 2004. As a result of the increase in
revenue and interest in our software, our commission expense and travel expenses
increased. We believe that to continue to grow sales, our sales and marketing
expenses will continue to increase.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related costs,
directors and officers insurance, legal and professional fees, and other general
corporate overhead costs. General and administrative expenses decreased 26% to
$1.0 million for the three months ended June 30, 2005 from $1.4 million for the
three months ended June 30, 2004. The decrease in general and administrative
expenses was primarily due to a decrease in legal expenses. For the three months
ended June 30, 2004, we had $0.6 million in legal expenses attributable to
litigation relating to alleged patent infringement. This decrease in legal
expenses was offset by an increase in professional services of $0.1 million
associated with our compliance with the provisions of the Sarbanes-Oxley Act of
2002.
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 $0.2 million.
INCOME TAXES
For the three months ended June 30, 2005, our provision for income
taxes consists of U.S. and foreign taxes in amounts necessary to align our
year-to-date tax provision with the effective rate that we expect to achieve for
the full year. For the three months ended June 30, 2004, we did not record a tax
benefit associated with the pre-tax loss incurred for the period due primarily
to the uncertainty of recoverability of the related deferred tax assets.
Accordingly, we provided a full valuation allowance against our net deferred tax
assets.
RESULTS OF OPERATIONS - FOR THE SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO THE
SIX MONTHS ENDED JUNE 30, 2004.
REVENUES
Revenues for the six months ended June 30, 2005 increased 52% to
$17.9 million compared with $11.7 million for the six months ended June 30,
2004. Our operating expenses increased 13% from $16.1 million for the six months
ended June 30, 2004 to $18.1 million for the six months ended June 30, 2005. Net
income for the six months ended June 30, 2005 was $0.2 million compared with a
net loss of $3.9 million for the six months ended June 30, 2004. The 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 six months ended June 30, 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 six months ended June 30,
2005, we increased the number of employees and continued to invest in our
infrastructure by purchasing additional computers and equipment. We increased
the number of employees from 189 employees as of June 30, 2004 to 261 employees
as of June 30, 2005.
SOFTWARE LICENSE REVENUE
Software license revenue increased 53% from $8.5 million for the six
months ended June 30, 2004 to $12.9 million for the six months ended June 30,
2005. Increased market acceptance and demand for our product and the ramp up in
-16-
sales from 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 software license revenue to continue to grow and the
percentage of software license revenue derived from OEM partners to increase.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 51% to
$5.0 million for the six months ended June 30, 2005 compared with $3.3 million
for the six months ended June 30, 2004. The primary reason for the increase in
maintenance, software services and other revenue was an increase in the number
of our maintenance and technical support contracts. As we are in business
longer, and as we license more software, we expect these revenues will continue
to increase. The majority of our new customers purchase maintenance and support
and most customers renew their maintenance and support after their initial
contracts expire. Maintenance revenue increased from $1.9 million for the six
months ended June 30, 2004 to $3.3 million for the six months ended June 30,
2005. Growth in our hardware sales, which increased from $0.7 million for the
six months ended June 30, 2004 to $0.9 million for the six months ended June 30,
2005, also contributed to the increase in software services and other revenues.
This increase was the result of an increase in demand from our customers for
bundled solutions.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
Amortization of purchased and capitalized software decreased from $0.8
million for the six months ended June 30, 2004 to $0.4 million for the six
months ended June 30, 2005. The decrease in amortization expense was due to some
of the purchased software licenses being fully amortized as of June 30, 2005. We
will continue to evaluate third party software licenses and may make additional
purchases, which would result in an increase in amortization expense.
Amortization of capitalized software costs was $7,881 for the six months ended
June 30, 2004. Capitalized software costs were fully amortized as of the end of
the first quarter of 2004.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues for the six
months ended June 30, 2005 increased by 42% to $2.8 million compared with $2.0
million for the six months ended June 30, 2004. The increase in cost of
maintenance, software services and other revenues was principally due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts, we required a higher number of employees to provide technical
support. Our cost of maintenance, software services and other revenue will
continue to grow in absolute dollars as our revenue increases.
Gross profit for the six months ended June 30, 2005 was $14.7
million or 82% of revenues compared with $8.9 million or 76% of revenues for the
six months ended June 30, 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 contributed to the increase in gross
margin since revenues from our OEM partners have higher gross margins.
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 25% to $5.4 million for the six
months ended June 30, 2005 compared with $4.3 million for the six months ended
June 30, 2004. The increase in software development costs was mainly due to an
increase in employees required to enhance and test our core network storage
software product, as well as to develop new innovative features and options. In
addition, 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 increased 11% to $7.5 million for the
six months ended June 30, 2005 from $6.7 million for the six months ended June
30, 2004. This increase in selling and marketing expenses was partially due to
-17-
increased commission expense, which is directly related to our increase in
revenues. Additionally, salary related expenses increased as we increased our
headcount to support our revenue growth.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased 9% to $2.0 million for
the six months ended June 30, 2005 from $2.2 million for the six months ended
June 30, 2004. The decrease in general and administrative expenses was primarily
due to a decrease in legal expenses. For the six months ended June 30, 2004 we
had $0.6 million in legal expenses attributable to litigation related to alleged
patent infringement. This decrease in legal expenses was offset by an increase
in professional services of $0.3 million associated with our compliance with the
provisions of the Sarbanes-Oxley Act of 2002.
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 $0.4 million.
INCOME TAXES
For the six months ended June 30, 2005, our provision for income taxes
consists of U.S. and foreign income taxes provided at the effective rate
expected for the full year. Our effective rate for the six months ended June 30,
2005 differs from the U.S. Federal statutory rate primarily due to the
availability of net operating losses to offset a substantial portion of our U.S.
taxable income. We did not record a tax benefit associated with the pre-tax loss
incurred for the six months ended June 30, 2004, due primarily to the
uncertainty of recoverability of the related deferred tax assets. Accordingly,
we provided a full valuation allowance against our net deferred tax assets.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are those related to revenue
recognition and accounts receivable allowances. We recognize revenue in
accordance with the provisions of Statement of Position 97-2, SOFTWARE REVENUE
RECOGNITION, as amended. Software license revenue is recognized only when
pervasive evidence of an arrangement exists and the fee is fixed and
determinable, among other criteria. An arrangement is evidenced by a signed
customer contract for nonrefundable royalty advances received from OEMs or a
customer purchase order or a royalty report summarizing software licenses sold
for each software license resold by an OEM, distributor or solution provider to
an end user. The software license fees are fixed and determinable as our
standard payment terms range from 30 to 90 days, depending on regional billing
practices, and we have not provided any of our customers extended payment terms.
When a customer licenses software together with the purchase of maintenance, we
allocate a portion of the fee to maintenance for its fair value based on the
contractual maintenance renewal rate.
We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Accounting Financial Standards ("SFAS") No. 123 (R), SHARE
BASED PAYMENT ("SFAS 123(R)"). This statement replaces SFAS No.123, ACCOUNTING
FOR STOCK BASED COMPENSATION and supersedes APB No. 25, ACCOUNTING FOR STOCK
ISSUED TO EMPLOYEES. SFAS 123 (R) requires all stock based compensation to be
recognized as an expense in the financial statements and that such cost be
measured according to the grant date fair value of the stock options or other
equity instruments. SFAS 123 (R) will become effective for the Company on
-18-
January 1, 2006. We are currently evaluating the impact that the adoption of
this statement will have on our consolidated financial statements, although we
expect that there will be a negative impact on our results of operations.
LIQUIDITY AND CAPITAL RESOURCES
Our total cash and cash equivalents and marketable securities balance
as June 30, 2005 increased by $0.3 million compared to December 31, 2004. Our
cash and cash equivalents totaled $15.8 million and marketable securities
totaled $18.4 million at June 30, 2005. As of June 30, 2004, we had
approximately $12.5 million in cash and cash equivalents and $22.2 million in
marketable securities.
For the six months ended June 30, 2005 we generated positive cash
flows. We continued to invest in our infrastructure to support our long-term
growth during the six months ended June 30, 2005. We made investments in
property and equipment and we increased the number of employees during the
second quarter of 2005. 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 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 that 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,
424,600 shares have been repurchased at an aggregate purchase price of $2.8
million. During the second quarter of 2005, 22,500 shares were purchased at an
aggregate purchase price of $0.2 million.
Net cash provided by operating activities totaled $2.0 million for the
six months ended June 30, 2005, compared with net cash used in operating
activities of $0.7 million for the six months ended June 30, 2004. This change
was primarily due to our net income of $0.2 million for the six months ended
June 30, 2005, compared with a net loss of $3.9 million for the six months ended
June 30, 2004. Net cash provided by operating activities of $2.0 million was
primarily derived from increases in deferred revenue of $1.5 million. These
amounts were partially offset by net increases in accounts receivable, prepaid
expenses and other currents assets and accrued expenses. The cash used in
operating activities for the six months ended June 30, 2004 was mainly comprised
of our net loss of $3.9 million, and increases in accounts receivable and
prepaid expenses, offset by increases in accounts payable, accrued expenses and
deferred revenue of $2.3 million in the aggregate.
Net cash used in investing activities was $1.4 million for the six
months ended June 30, 2005, due primarily to net sales of marketable securities
of $0.1 million and purchases of property and equipment of $1.4 million. Net
cash provided by investing activities was $4.5 million for the six months ended
June 30, 2004, due primarily to net sales of marketable securities of $5.9
million. This amount was partially offset by purchases of property and equipment
of $1.2 million and purchases of software licenses and intangible assets of $0.1
million.
Net cash used in financing activities was $0.3 million for the six
months ended June 30, 2005. We received proceeds from the exercise of stock
options of $0.8 million and we made payments of $1.1 million for the six months
ended June 30, 2005 to acquire treasury stock. Net cash provided by financing
activities was $0.2 million for the six months ended June 30, 2004. This amount
was primarily related to proceeds from the exercise of stock options of $0.5
million partially offset by payments to acquire treasury stock of $0.3 million.
We currently do not have any debt and our only material commitments are
related to our office leases. We have an operating lease covering our primary
office facility that expires in February, 2012. We also have several operating
leases related to offices in foreign countries. The expiration dates for these
leases range from 2004 through 2012. Refer to Note 4 of the notes to our
unaudited condensed consolidated financial statements.
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.
-19-
RISK FACTORS
WE HAVE HAD A HISTORY OF NET LOSSES AND MAY NOT BE ABLE TO RETURN TO OR TO
MAINTAIN PROFITABILITY.
For the second quarter of 2005, we had a net profit of $0.3 million.
This is only the second profitable quarter in our history. Other than the second
quarter of 2005 and the fourth quarter of 2004, we have had a history of losses,
including the full year ended December 31, 2004, in which we had a net loss of
$5.9 million. Our business model depends upon signing agreements with additional
OEM customers, further developing our reseller sales channel, and expanding our
sales force. Any difficulty in obtaining these OEM and reseller customers or in
attracting qualified sales personnel will hinder our ability to generate
additional revenues and achieve or maintain profitability.
FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.
Achieving our anticipated growth will depend on a number of factors,
some of which include:
o retention of key management, marketing and technical personnel;
o our ability to increase our customer base and to increase the sales of
our products; and
o competitive conditions in the network storage infrastructure software
market.
We cannot assure you that the anticipated growth will be achieved. The
failure to achieve anticipated growth could harm our business, financial
condition and operating results.
WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.
During the third quarter of 2003, we signed a lease for new office
space that commenced on November 1, 2003 and continues through February, 2012.
This commitment along with several operating leases related to our foreign
offices could impact our ability to achieve or to maintain profitability.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS
AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage software market in
which we sell our products, and other factors that are beyond our control,
reduces our ability to accurately forecast our quarterly and annual revenue.
However, we must use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall
demand for network storage software. Because our sales are primarily to major
corporate customers, any softness in demand for network storage software may
result in decreased revenues.
WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS.
We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the three months ended June 30, 2005,
we had two customers that together accounted for 27% of our revenues. While we
believe that we will continue to receive revenue from these clients, our
agreements typically give customers the ability to terminate the relationship
upon 90 days notice. 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.
-20-
THE MARKETS 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 IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.
The rapid adoption of IP-based Storage Area Networks (SAN) is critical
to our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current storage networking
infrastructure, and they may elect to remain with current network architectures
or to adopt new architecture in limited stages or over extended periods of time.
We are uncertain whether a viable market for our products will develop or be
sustainable. If this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.
THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.
The rapid adoption of disk-based backup solutions is critical to our
future success. The market for disk-based backup solutions is still unproven,
making it difficult to predict the potential size or future growth rate. Most
potential customers have made substantial investments in their current tape
backup infrastructure, and they may elect to remain with their current
infrastructure or to adopt new solutions in limited stages or over extended
periods of time. We are uncertain whether a viable market for our products will
develop or be sustainable. If this market fails to develop, or develops more
slowly than we expect, our business, financial condition and results of
operations would be adversely affected.
WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS, SMALL OFFICE AND HOME
OFFICE MARKETS.
We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.
The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN or NAS system. All
components of these systems must comply with the same industry standards in
order to operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.
-21-
OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.
Our IPStor platform is complex and is designed to be deployed in large
and complex networks. Many of our customers have unique infrastructures, which
may require additional professional services in order for our software to work
within their infrastructure. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
defects in our product within our customers' networks could result in lost
profits or damage to our customers. These problems could cause us to incur
significant service and engineering costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with resellers and OEM partners to
develop storage appliances that combine certain aspects of IPStor functionality
with third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would suffer.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require that
each of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification of a product by an OEM does not assure
any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including engineering, sales, marketing and management
efforts, toward qualifying our products with OEMs in anticipation of sales to
them. If we are unsuccessful or delayed in qualifying any products with an OEM,
such failure or delay would preclude or delay sales of that product to the OEM,
which may impede our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage infrastructure software market and in other markets. The OEM
customers and resellers may choose to focus their sales efforts on other
products in the network storage software market or other markets. The OEM
customers might also choose not to continue to develop or to market products
which include our products. This would likely result in lower revenues to us and
would impede our ability to grow our business.
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.
As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.
WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.
Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
-22-
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 several months, two companies with whom we have OEM
relationships have been acquired or have announced plans to be acquired by other
companies. If an OEM customer is acquired, the new parent 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.
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.
-23-
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
June 30, 2005, the closing market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $5.13 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;
o changes in market valuations of other technology companies,
particularly those in the storage networking software market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures
or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.
The Financial Accounting Standards Board ("FASB") has required
companies to recognize the fair value of stock options and other stock-based
compensation to employees as compensation expense in the statement of
operations. In accordance with SEC rules, we must implement the FASB rules
effective in the first quarter of 2006. While it is too early to tell the exact
impact of this requirement, there will be a negative impact on our results of
operations.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Finally, we have entered into change of
control agreements with certain executives.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.
As of June 30, 2005, we had outstanding options and warrants to
purchase an aggregate of 10,975,391 shares of our common stock at a weighted
average exercise price of $5.17 per share. We also have 1,357,219 shares of our
common stock reserved for issuance under our stock option plans with respect to
options that have not been granted.
-24-
The exercise of all of the outstanding options and warrants would
dilute the then-existing stockholders' percentage ownership of common stock, and
any sales in the public market of the common stock issuable upon such exercise
could adversely affect prevailing market prices for the common stock. Moreover,
the terms upon which we would be able to obtain additional equity capital could
be adversely affected because the holders of such securities can be expected to
exercise or convert them at a time when we would, in all likelihood, be able to
obtain any needed capital on terms more favorable than those provided by such
securities.
OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS
In August, 2003, our business was interrupted due to a large scale
blackout in the northeastern United States. While the headquarters facilities we
moved in to in November, 2003 contain redundant power supplies and generators,
our domestic and foreign operations, and the operations of our industry
partners, remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.
Terrorist actions domestically or abroad could lead to business
disruptions or to cancellations of customer orders or a general decrease in
corporate spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.
THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.
We sell our products worldwide. Accordingly, our operating results
could be materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.
Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.
Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.
Our success is dependent upon our proprietary technology. Currently,
the IPStor software suite is the core of our proprietary technology. We have one
patent issued, multiple pending patent applications, numerous trademarks
registered and multiple pending trademark applications related to our IPStor
product. We cannot predict whether we will receive patents for our pending or
future patent applications, and any patents that we own or that are issued to us
may be invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.
We also rely on trade secret, copyright and trademark laws, as well as
the confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United
States involving patents, trademarks and other intellectual property rights.
We 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 litigation was expensive and diverted management's time and
-25-
attention. Any additional litigation, regardless of its outcome, would likely be
time consuming and expensive to resolve and would divert management's time and
attention and might subject us to significant liability for damages or
invalidate our intellectual property rights. Any potential intellectual property
litigation against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual
property;
o obtain from the owner of the infringed intellectual property right
a license to sell or use the relevant technology or trademark,
which license may not be available on reasonable terms, or at
all; or
o redesign those products that use infringing intellectual property
or cease to use an infringing product or trademark.
DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.
Many of our products are designed to include software or other
intellectual property licensed from third parties, including "Open Source"
software. At least one intellectual property rights holder has alleged that it
holds the rights to software traditionally viewed as Open Source. It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
limit our ability to protect our proprietary rights in our products.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key
employees, many of whom would be extremely difficult to replace. We do not have
key person life insurance on any of our personnel. Worldwide competition for
skilled employees in the network storage software industry is extremely intense.
If we are unable to retain existing employees or to hire and integrate new
employees, our business, financial condition and operating results could suffer.
In addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
and could incur substantial costs defending ourselves against those claims.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies
or their assets. Integration of the acquired products, technologies and
businesses, could divert management's time and resources. Further, we may not be
able to properly integrate the acquired products, technologies or businesses,
with our existing products and operations, train, retain and motivate personnel
from the acquired businesses, or combine potentially different corporate
cultures. If we are unable to fully integrate the acquired products,
technologies or businesses, or train, retain and motivate personnel from the
acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.
The preparation of consolidated financial statements and related
disclosure in accordance with generally accepted account principles requires
management to establish policies that contain estimates and assumptions that
affect the amounts reported in the consolidated financial statements and the
accompanying notes. Note 1 to the Consolidated Financial Statements in this
Report on Form 10-Q describes the significant accounting policies essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures.
-26-
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 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities. If interest rates were to change by
10% from the levels at June 30, 2005, the effect on our financial results would
be insignificant.
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. If foreign currency
exchange rates were to change by 10% from the levels at June 30, 2005, the
effect on our other comprehensive income would be insignificant. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report, and,
based on their evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. No changes in the Company's internal controls over financial
reporting occurred during the quarter ended June 30, 2005, that have materially
affected, or are reasonably likely to materially affect, the Company's internal
controls over financial reporting.
Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to various legal proceedings and claims, asserted or unasserted,
which arise in the ordinary course of business. While the outcome of any such
matters cannot be predicted with certainty, we believe that such matters will
not have a material adverse effect on our financial condition or operating
results.
-27-
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Shares of common stock repurchased during the quarter ended June 30, 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
June, 2005 22,500 $6.85 22,500 1,575,400
Total 22,500 $6.85 22,500 1,575,400
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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its annual meeting of stockholders on May 10, 2005. 45,314,028
shares of Common Stock, 95% of the outstanding shares, were represented in
person or by proxy.
Steven R. Fischer was elected to serve as a director of the Company for a term
expiring in 2008 with 45,187,608 shares voted in favor, 126,420 shares withheld
and 0 broker non-votes.
Alan W. Kaufman was elected to serve as a director of the Company for a term
expiring in 2008 with 45,183,208 shares voted in favor, 130,820 shares withheld
and 0 broker non-votes.
The selection of KPMG LLP as independent accountants for the Company was
ratified with 45,176,918 shares voted in favor, 12,305 shares voted against,
24,805 shares abstained and 0 broker non-votes.
ITEM 5. OTHER INFORMATION
During the second quarter of 2005, the annual cash compensation for each of
Wayne Lam, James Weber and Bernard Wu, all of whom are executive officers of the
Company, was increased to $190,000. None of such individuals has an employment
agreement with the Company.
ITEM 6. EXHIBITS
Exhibits
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
-28-
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)
-29-
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ James Weber
-----------------------------------
James Weber
Chief Financial Officer, Vice President and Treasurer
(Chief Accounting Officer)
August 8, 2005
-30-
