sec document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the quarterly period ended September 30, 2006
------------------
| | 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.
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(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 a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act.
Large Accelerated Filer Accelerated Filer X Non-Accelerated Filer
--- --- ---
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
The number of shares of Common Stock issued and outstanding as of
October 24, 2006 was 48,919,480 and 48,054,280, which includes redeemable common
shares.
1
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Condensed Consolidated Financial Statements 3
Condensed Consolidated Balance Sheets at September 30, 2006
(unaudited) and December 31, 2005 3
Unaudited Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2006 and 2005 4
Unaudited Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2006 and 2005 5
Notes to the Unaudited Condensed Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 16
Item 3. Qualitative and Quantitative Disclosures about Market Risk 24
Item 4. Controls and Procedures 25
PART II. Other Information 25
Item 1. Legal Proceedings 25
Item 1A. Risk Factors 25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 34
Item 6. Exhibits 34
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, 2006 December 31, 2005
------------------ -----------------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents.................................................. $ 12,564,588 $ 18,796,973
Marketable securities...................................................... 26,478,649 17,833,683
Accounts receivable, net of allowances of $5,309,900 and
$3,846,882, respectively................................................. 15,439,649 15,187,408
Prepaid expenses and other current assets.................................. 1,045,940 911,715
------------ ------------
Total current assets................................................. 55,528,826 52,729,779
Property and equipment, net of accumulated depreciation of
$9,421,097 and $7,150,762, respectively..................................... 5,604,105 5,277,609
Goodwill...................................................................... 3,512,796 3,512,796
Other intangible assets, net.................................................. 297,883 216,864
Other assets.................................................................. 1,852,170 2,236,725
------------ ------------
Total assets......................................................... $ 66,795,780 $ 63,973,773
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................ $ 1,132,011 $ 1,152,228
Accrued expenses............................................................ 4,469,176 4,522,212
Deferred revenue............................................................ 9,154,879 7,401,018
------------ ------------
Total current liabilities........................................ 14,756,066 13,075,458
Deferred revenue.............................................................. 2,825,887 2,240,208
------------ ------------
Total liabilities................................................ 17,581,953 15,315,666
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,
48,894,191 and 48,441,614 shares issued, respectively and 48,028,991
and 47,892,014 shares outstanding, respectively.......................... 48,894 48,442
Additional paid-in capital.................................................. 96,197,585 87,342,747
Accumulated deficit......................................................... (40,859,381) (34,659,329)
Common stock held in treasury, at cost (865,200 and 549,600 shares,
respectively)............................................................ (5,780,164) (3,632,930)
Accumulated other comprehensive loss........................................ (393,107) (440,823)
------------ ------------
Total stockholders' equity........................................... 49,213,827 48,658,107
------------ ------------
Total liabilities and stockholders' equity........................... $ 66,795,780 $ 63,973,773
============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
3
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended September 30, Nine Months Ended September 30,
--------------------------------- --------------------------------
2006 2005 2006 2005
------------- ------------- ------------- ------------
Revenues:
Software license revenue................................... $ 8,685,667 $ 7,007,075 $ 23,088,377 $ 19,940,026
Maintenance revenue........................................ 3,315,771 1,972,037 8,815,288 5,293,478
Software services and other revenue........................ 964,673 1,077,553 2,938,993 2,710,784
------------ ------------ ------------ ------------
12,966,111 10,056,665 34,842,658 27,944,288
------------ ------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized
software.............................................. 81,334 189,472 334,389 605,472
Cost of maintenance, software services and
other revenue......................................... 2,246,085 1,666,459 6,550,747 4,462,542
Software development costs............................... 5,067,882 3,007,337 14,580,122 8,438,473
Selling and marketing.................................... 5,809,706 3,814,540 16,400,453 11,298,883
General and administrative............................... 1,489,537 1,103,778 4,200,971 3,121,089
------------ ------------ ------------ ------------
14,694,544 9,781,586 42,066,682 27,926,459
------------ ------------ ------------ ------------
Operating income (loss)......................... (1,728,433) 275,079 (7,224,024) 17,829
------------ ------------ ------------ ------------
Interest and other income, net............................. 514,415 245,218 1,185,075 668,713
------------ ------------ ------------ ------------
Income (loss) before income taxes................... (1,214,018) 520,297 (6,038,949) 686,542
Provision for income taxes................................. 44,353 37,418 161,103 49,387
------------ ------------ ------------ ------------
Net income (loss)................................... $ (1,258,371) $ 482,879 $ (6,200,052) $ 637,155
------------ ------------ ------------ ------------
Basic net income (loss) per share.......................... $ (0.03) $ 0.01 $ (0.13) $ 0.01
============ ============ ============ ============
Diluted net income (loss) per share........................ $ (0.03) $ 0.01 $ (0.13) $ 0.01
============ ============ ============ ============
Weighted average basic shares outstanding.................. 47,990,558 47,720,496 48,014,662 47,615,182
============ ============ ============ ============
Weighted average diluted shares outstanding................ 47,990,558 50,531,012 48,014,662 50,715,162
============ ============ ============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
4
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended September 30,
-----------------------------------------
2006 2005
------------- -------------
Cash flows from operating activities:
Net income (loss)............................................................. $ (6,200,052) $ 637,155
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation and amortization............................................. 2,723,834 2,560,186
Share-based payment compensation.......................................... 7,079,960 --
Non-cash professional services............................................ 3,935 (89,765)
Loss on marketable securities............................................. 28,855 22,701
Loss on foreign currency exchange......................................... 41,670 --
Gain on sale of cost method investment.................................... (3,112) --
Gain on sale of warrants.................................................. (38,378) --
Tax benefit from stock option exercise.................................... (40,958) --
Provision for returns and doubtful accounts............................... 3,000,241 2,825,430
Changes in operating assets and liabilities:
Accounts receivable....................................................... (3,247,212) (3,991,715)
Prepaid expenses and other current assets................................. (138,270) (59,774)
Other assets.............................................................. 341,424 128,575
Accounts payable.......................................................... (29,396) 496,276
Accrued expenses.......................................................... (64,303) (282,381)
Deferred revenue.......................................................... 2,357,503 2,198,245
------------ ------------
Net cash provided by operating activities............................... 5,815,741 4,444,933
------------ ------------
Cash flows from investing activities:
Sale of marketable securities................................................. 51,109,599 44,853,759
Purchase of marketable securities............................................. (59,758,208) (45,187,523)
Sale of cost method investment................................................ 96,755 --
Purchase of cost method investment............................................ (198,764) --
Sale of warrants.............................................................. 673,378 --
Purchase of warrants.......................................................... (635,000) --
Purchase of property and equipment............................................ (2,562,621) (2,326,747)
Purchase of software licenses................................................. (173,431) (108,000)
Purchase of intangible assets................................................. (216,333) (99,156)
Security deposits............................................................. (2,062) --
------------ ------------
Net cash used in investing activities....................................... (11,666,687) (2,867,667)
------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options....................................... 1,730,437 1,038,976
Payments to acquire treasury stock............................................ (2,147,234) (1,543,631)
Tax benefit from stock option exercise........................................ 40,958 --
------------ ------------
Net cash used in financing activities....................................... (375,839) (504,655)
------------ ------------
Effect of exchange rate changes on cash and cash equivalents..................... (5,600) (168,666)
------------ ------------
Net increase (decrease) in cash and cash equivalents............................. (6,232,385) 903,945
Cash and cash equivalents, beginning of period................................... 18,796,973 15,484,573
------------ ------------
Cash and cash equivalents, end of period......................................... $ 12,564,588 $ 16,388,518
============ ============
Cash paid for income taxes....................................................... $ 37,946 $ 6,320
============ ============
The Company did not pay any interest expense for the nine months ended September 30, 2006 and 2005.
See accompanying notes to unaudited condensed 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) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's significant estimates include those related to
revenue recognition, accounts receivable allowances, deferred income taxes and
accounting for share-based payment compensation. Actual results could differ
from those estimates.
(D) UNAUDITED INTERIM FINANCIAL INFORMATION
The unaudited interim consolidated financial statements of the Company as
of September 30, 2006, and for the three and nine months ended September 30,
2006 and 2005, 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 September 30, 2006, and the results of its operations
for the three and nine months ended September 30, 2006 and 2005. The results of
operations of any interim period are not necessarily indicative of the results
of operations to be expected for the fiscal year.
(E) 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
$9.5 million and $12.4 million at September 30, 2006 and December 31, 2005,
respectively. Marketable securities at September 30, 2006 and December 31, 2005
amounted to $26.5 million and $17.8 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.
(F) 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 code is delivered to the customer. Reseller customers
typically send the Company a purchase order only when they have an end user
6
identified. When a customer licenses software together with the purchase of
maintenance, the Company allocates a portion of the fee to maintenance for its
fair value. Software maintenance fees are deferred and recognized as revenue
ratably over the term of the 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,
based upon historical experience and known or expected trends.
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.
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, if any, are complete and the software
product master is delivered and accepted.
For the quarters ended September 30, 2006 and 2005, 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 and nine months ended September 30, 2006, the Company had
one customer that accounted for 27% and 25% of revenues, respectively, and one
customer that accounted for 18% of the accounts receivable balance at September
30, 2006.
(G) 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 $766,078 and $615,861 for the three months
ended September 30, 2006 and 2005, respectively, and $2,270,335 and $1,780,441
for the nine months ended September 30, 2006 and 2005, 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.
(H) 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 Financial Accounting Standards Board
("FASB") Statement of Financial Accounting Standards ("SFAS") 142, GOODWILL AND
OTHER INTANGIBLE ASSETS, the Company has not amortized goodwill related to its
acquisitions, but instead tests the balance for impairment. The Company's annual
impairment assessment is performed as of December 31st of each year, and an
assessment is made 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 $44,666 and $46,162 for the three months ended
September 30, 2006 and 2005, respectively, and $135,314 and $174,273 for the
nine months ended September 30, 2006 and 2005, respectively. The gross carrying
amount and accumulated amortization of other intangible assets as of September
30, 2006 and December 31, 2005 are as follows:
September 30, December 31,
2006 2005
------------ ------------
Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (216,850) (216,850)
--------- ---------
Net carrying amount $ -- $ --
========= =========
Patents:
Gross carrying amount $ 866,197 $ 649,864
Accumulated amortization (568,314) (433,000)
--------- ---------
Net carrying amount $ 297,883 $ 216,864
========= =========
7
(I) 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. 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 $211,348 and $372,306, net of
accumulated amortization of $4,981,083 and $4,646,694 is included in other
assets in the balance sheets as of September 30, 2006 and December 31, 2005,
respectively. Amortization expense was $81,334 and $189,472 for the three months
ended September 30, 2006 and 2005, respectively and $334,389 and $605,472 for
the nine months ended September 30, 2006 and 2005, respectively. Amortization of
purchased software technology is recorded at the greater of the straight line
basis over the products' estimated remaining life or the ratio of current period
revenue of the related products to total current and anticipated future revenue
of these products.
(J) 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. The Company provides a full valuation
allowance against its deferred tax assets.
(K) 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.
(L) SHARE-BASED PAYMENTS
Effective January 1, 2006, the Company adopted the provisions of SFAS No.
123(R), SHARE-BASED PAYMENT, which establishes the accounting for transactions
in which an entity exchanges its equity instruments for goods or services. Under
the provisions of SFAS No. 123(R), share-based payment compensation is measured
at the grant date, based on the fair value of the award, and is recognized as an
expense over the requisite employee service period (generally the vesting
period). The Company adopted SFAS No. 123(R) using the modified prospective
method and, as a result, periods prior to January 1, 2006 have not been
restated.
(M) FINANCIAL INSTRUMENTS
As of September 30, 2006 and December 31, 2005, 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.
8
(N) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations
within interest and other income, net. Such amounts have historically not been
material.
(O) 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 the net loss for the three and nine months ended September
30, 2006, all common stock equivalents were excluded from diluted net loss per
share for the periods. As of September 30, 2006, potentially dilutive common
stock equivalents included 11,059,460 stock options and shares of restricted
stock 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 September 30, 2006 Three Months Ended September 30, 2005
---------------------------------------- ---------------------------------------
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------ -------------- --------- ------------ ------------- ---------
Basic EPS $(1,258,371) 47,990,558 $ (0.03) $ 482,879 47,720,496 0.01
======== ========
Effect of dilutive securities:
Stock Options -- 2,810,516
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $(1,258,371) 47,990,558 $ (0.03) $ 482,879 50,531,012 $ 0.01
=========== ========== ======== =========== ========== ========
Nine Months Ended September 30, 2006 Nine Months Ended September 30, 2005
---------------------------------------- ---------------------------------------
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------ -------------- --------- ------------ ------------- ---------
Basic EPS $(6,200,052) 48,014,662 $ (0.13) $ 637,155 47,615,182 $ 0.01
======== ========
Effect of dilutive securities:
Stock Options -- 3,099,980
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $(6,200,052) 48,014,662 $ (0.13) $ 637,155 50,715,162 $ 0.01
=========== ========== ======== =========== ========== ========
(P) COMPREHENSIVE INCOME (LOSS)
The Company's comprehensive income (loss) is as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
----------- ----------- ----------- -----------
Net Income (loss) $(1,258,371) $ 482,879 $(6,200,052) $ 637,155
----------- ----------- ----------- -----------
Other comprehensive income (loss):
Foreign currency translation
adjustments (81,997) (136,697) 22,504 (168,666)
Unrealized gains (loss) on investments 44,092 (25,929) 25,212 (12,806)
----------- ----------- ----------- -----------
Other comprehensive income (loss) (37,905) (162,626) 47,716 (181,472)
----------- ----------- ----------- -----------
Comprehensive income (loss) $(1,296,276) $ 320,253 $(6,152,336) $ 455,683
=========== =========== =========== ===========
9
(Q) NEW ACCOUNTING PRONOUNCEMENTS
In June 2006, the FASB issued FASB Interpretation No. 48, ACCOUNTING FOR
UNCERTAINTY IN INCOME TAXES ("FIN No. 48"). FIN No. 48 establishes a recognition
threshold and measurement for income tax positions recognized in an enterprise's
financial statement in accordance with SFAS No. 109, ACCOUNTING FOR INCOME
TAXES. FIN No. 48 also prescribes a two-step evaluation process for tax
positions. The first step is recognition and the second is measurement. For
recognition, an enterprise judgmentally determines whether it is
more-likely-than-not that a tax position will be sustained upon examination,
including resolution of related appeals or litigation processes, based on the
technical merits of the position. If the tax position meets the
more-likely-than-not recognition threshold, it is measured and recognized in the
financial statements as the largest amount of tax benefit that is greater than
50% likely of being realized. If a tax position does not meet the
more-likely-than-not recognition threshold, the benefit of that position is not
recognized in the financial statements.
Tax positions that meet the more-likely-than-not recognition threshold at
the effective date of FIN No. 48 may be recognized, or continue to be
recognized, upon adoption of FIN No. 48. The cumulative effect of applying the
provisions of FIN No. 48 shall be reported as an adjustment to the opening
balance of retained earnings for that fiscal year. FIN No. 48 is effective for
the Company beginning in fiscal year 2007, with earlier adoption permitted. The
Company is in the process of assessing the effect FIN No. 48 may have on its
consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting
Standard ("SFAS") No. 157, "Fair Value Measurements" ("SFAS No. 157") to clarify
the definition of fair value, establish a framework for measuring fair value and
expand the disclosures on fair value measurements. SFAS No. 157 defines fair
value as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date (an exit price). SFAS No. 157 also stipulates that, as a
market-based measurement, fair value should be determined based on the
assumptions that market participants would use in pricing the asset or
liability, and establishes a fair value hierarchy that distinguishes between (a)
market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. The Company is currently evaluating the
impact of the provisions of SFAS No. 157 on its consolidated financial
statements.
In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No.
108, "Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" ("SAB No. 108") to provide
guidance on the consideration of the effects of prior year misstatements in
quantifying current year misstatements for the purpose of a materiality
assessment. Under SAB No. 108, companies should evaluate a misstatement based on
its impact on the current year income statement, as well as the cumulative
effect of correcting such misstatements that existed in prior years existing in
the current year's ending balance sheet. The Company will adopt SAB No. 108 for
the year ended December 31, 2006, and is currently evaluating the impact of
adoption.
(R) RECLASSIFICATIONS
Certain reclassifications have been made to prior years' consolidated
financial statement presentations to conform to the current year's presentation.
(2) SHARE-BASED PAYMENT ARRANGEMENTS
As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000
Stock Option Plan (the "2000 Plan"). The 2000 Plan is administered by the Board
of Directors and, as amended, provides for the grant of options to purchase up
to 14,162,296 shares of Company common stock to employees, consultants and
non-employee directors. Options may be incentive ("ISO") or non-qualified. ISOs
granted must have exercise prices at least equal to the fair value of the common
stock on the date of grant, and have terms not greater than ten years, except
those to an employee who owns stock with greater than 10% of the voting power of
all classes of stock of the Company, in which case they must have an option
price at least 110% of the fair value of the stock, and expire no later than
five years from the date of grant. Non-qualified options granted must have
10
exercise prices not less than eighty percent of the fair value of the common
stock on the date of grant, and have terms not greater than ten years. All
options granted under the 2000 Plan must be granted before May 1, 2010.
The Company granted options to purchase an aggregate of 50,000 shares of
common stock to certain non-employee consultants in exchange for professional
services during 2002. The aggregate fair value of these options as determined
using the fair value method is expensed over the periods the services are
provided. The related expense amounted to $(14,036) and $(89,765) for the three
and nine months ended September 30, 2005, respectively. These services were
completed as of December 31, 2005.
On May 14, 2004, the Company adopted the FalconStor Software, Inc. 2004
Outside Directors Stock Option Plan (the "2004 Plan"). The 2004 Plan is
administered by the Board of Directors and provides for the granting of options
to non-employee directors of the Company to purchase up to 300,000 shares of
Company common stock. Exercise prices of the options must be equal to the fair
market value of the common stock on the date of grant. Options granted have
terms of ten years. All options granted under the 2004 Plan must be granted
within three years of the adoption of the 2004 Plan.
On May 17, 2006, the Company adopted the FalconStor Software, Inc. 2006
Incentive Stock Plan (the "2006 Plan"). The 2006 Plan is administered by the
Board of Directors and provides for the grant of incentive and nonqualified
stock options, and restricted stock, to employees, officers, consultants and
advisors of the Company. A maximum of 1,500,000 of the authorized but unissued
or treasury shares of the common stock of the Company may be issued upon the
grant of restricted stock or upon the exercise of options granted under the 2006
Plan. Exercise prices of the options must be equal to the fair market value of
the common stock on the date of grant. Options granted have terms of not greater
than ten years. All options and shares of restricted stock granted under the
2006 Plan must be granted within ten years of the adoption of the 2006 Plan.
The following table summarizes stock option activity during the nine months
ended September 30, 2006:
Weighted
Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic
Options Price Life (Years) Value
---------- --------- ------------ ------------
Options Outstanding at December 31, 2005 10,200,908 $ 5.22
Granted 284,000 $ 8.93
Exercised (247,888) $ 3.21
Canceled (61,434) $ 8.97
---------- --------
Options Outstanding at March 31, 2006 10,175,586 $ 5.35 6.89 $ 41,918,935
========== ========= ============ ============
Granted 897,400 $ 6.63
Exercised (67,628) $ 4.50
Canceled (69,694) $ 7.43
---------- --------
Options Outstanding at June 30, 2006 10,935,664 $ 5.45 6.88 $ 21,541,580
========== ========= ============ ============
Granted 228,250 $ 6.71
Exercised (137,061) $ 4.60
Canceled (167,393) $ 7.14
---------- --------
Options Outstanding at September 30, 2006 10,859,460 $ 5.46 6.70 $ 26,703,904
========== ========= ============ ============
Options Exercisable at September 30, 2006 7,231,638 $ 4.52 5.68 $ 24,304,721
---------- -------- ------------ ------------
11
Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended
September 30, 2006 and 2005 was $630,165 and $255,772, respectively. The total
cash received from stock option exercises for the nine months ended September
30, 2006 and 2005 was $1,730,437 and $1,038,976. The total intrinsic value of
stock options exercised during the three months ended September 30, 2006 and
2005 was $347,090 and $719,396 respectively. The total intrinsic value of stock
options exercised during the nine months ended September 30, 2006 and 2005 was
$1,970,327 and $2,082,148 respectively.
The Company recognized share-based payment compensation for awards issued
under the Company's stock option plans in the following line items in the
consolidated statement of operations:
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2006
------------------ -----------------
Cost of maintenance software services and other revenue $ 361,263 $1,060,812
Software development costs 1,100,510 3,233,609
Selling and marketing 758,718 2,104,256
General and administrative 202,782 685,218
---------- ----------
$2,423,273 $7,083,895
========== ==========
The Company recognized $30,492 and $40,958 of tax benefits related to
share-based payment compensation during the three and nine months ended
September 30, 2006.
During the third quarter of 2006, the Company granted options to purchase
an aggregate of 25,000 shares of common stock to certain non-employee
consultants in exchange for professional services. The aggregate fair value of
these options as determined using the fair value method under SFAS No. 123(R),
$141,644, is being expensed over the periods the services are provided. The
related expense amounted to $3,935 during the three and nine months ended
September 30, 2006.
During the third quarter of 2006, the Company granted 200,000 shares of
restricted stock at a price of $6.88 per share. As of September 30, 2006, the
weighted average fair value per share was $7.69. There were no restricted shares
issued or outstanding as of December 31, 2005.
For periods prior to January 1, 2006, the Company recorded compensation
expense for employee stock options based upon their intrinsic value on the date
of grant pursuant to Accounting Principles Board ("APB") Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Since the exercise price for such
options was equal to the fair market value of the Company's stock at the date of
grant, the stock options had no intrinsic value upon grant and, therefore, no
expense was recorded in the consolidated statements of operations.
Had the compensation cost of the Company's share-based payments been
determined in accordance with SFAS No. 123, the Company's pro forma net income
and net income per share for the three and nine months ended September 30, 2005
would have been:
Three Months Ended Nine Months Ended
September 30, September 30,
2005 2005
------------------ -----------------
Net Income as reported $ 482,879 $ 637,155
Add share-based payment compensation expense
included in reported net income, net of tax $ -- $ --
Deduct total share-based payment compensation
expense determined under fair-value-based method,
net of tax $(2,508,463) $(7,321,788)
----------- -----------
Net loss - pro forma $(2,025,584) $(6,684,633)
=========== ===========
Basic and diluted net income per common share- $ .01 $ .01
as reported
Basic and diluted net loss per common share- $ (.04) $ (.14)
pro forma
12
Under the modified prospective method, SFAS No. 123(R) applies to new
awards and to awards outstanding on the effective date that are subsequently
modified or cancelled. Compensation expense for outstanding awards for which the
requisite service had not been rendered as of December 31, 2005 is recognized
over the remaining service period using the compensation cost calculated for pro
forma disclosure purposes under SFAS No. 123. Prior to the adoption of SFAS No.
123(R), the Company valued graded vesting awards based on the entire award for
purposes of pro forma disclosure. The Company has elected to continue valuing
awards with graded vesting, based on the value of the entire award. The Company
amortizes the fair value of all awards on a straight-line basis over the total
vesting period. Cumulative compensation expense recognized at any date will at
least equal the grant date fair value of the vested portion of the award at that
time.
The Company estimates the fair value of share-based payments using the
Black-Scholes option pricing model. The Company believes that this valuation
technique and the approach utilized to develop the underlying assumptions are
appropriate in estimating the fair value of the Company's share-based payments
granted during the three and nine months ended September 30, 2006. Estimates of
fair value are not intended to predict actual future events or the value
ultimately realized by the employees who receive equity awards.
The per share weighted average fair value of share-based payments granted
during the three months ended September 30, 2006 and 2005 was $5.42 and $5.95,
respectively. The per share weighted average fair value of share-based payments
granted during the nine months ended September 30, 2006 and 2005 was $4.58 and
$6.94, respectively. In addition to the exercise and grant date prices of the
awards, certain weighted average assumptions that were used to estimate the fair
value of share-based payment grants in the respective periods are listed in the
table below:
Three months ended September 30, Nine months ended September 30,
-------------------------------- -------------------------------
2006 2005 2006 2005
---- ---- ---- ----
Expected dividend yield 0% 0% 0% 0%
Expected volatility 59% 151% 59-60% 151-166%
Risk-free interest rate 4.7-5.1% 3.5% 4.4-5.1% 3.5%
Expected term (years) 6 5 6 5
Discount for post-vesting N/A N/A N/A N/A
restrictions
Options granted during fiscal 2006 have exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
a vesting period of three years and an estimated forfeiture rate of 23%. All
options granted through December 31, 2005 had exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
generally a vesting period of three years and an estimated forfeiture rate of
23%.
The Company estimates expected volatility based primarily on historical
daily price changes of the Company's stock and other factors. The risk-free
interest rate is based on the United States treasury yield curve in effect at
the time of grant. The expected option term is the number of years that the
Company estimates that options will be outstanding prior to exercise. The
13
expected term of the awards issued after December 31, 2005 was determined using
the "simplified method" prescribed in SEC Staff Accounting Bulletin ("SAB") No.
107.
As of September 30, 2006, there was approximately $11,411,767 of total
unrecognized compensation cost related to the Company's unvested options and
restricted shares granted under the Company's stock plans. The unrecognized
compensation cost is expected to be recognized over a weighted-average period of
2.1 years.
In September 2003, the Company entered into a worldwide OEM agreement
with a major technology company (the "OEM"), and granted to the OEM warrants to
purchase 750,000 shares of the Company's common stock with an exercise price of
$6.18 per share. A portion of the warrants may vest annually subject to the
OEM's achievement of pre-defined and mutually agreed upon sales objectives over
a three-year period beginning June 1, 2004. If the OEM generates cumulative
revenues to the Company in the mid-eight figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the three-year period will expire. If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants earned will be recorded as a reduction of revenue. Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. As of September 30,
2006, the Company had not generated any revenues from this OEM and accordingly
no warrants had vested.
(3) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the three and nine
months ended September 30, 2006 and 2005 and the location of long-lived assets
as of September 30, 2006 and December 31, 2005 are summarized as follows:
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2006 2005 2006 2005
---- ---- ---- ----
United States $ 8,263,470 $ 6,963,134 $23,162,241 $19,055,023
Asia 2,157,413 1,357,702 5,657,281 4,700,680
Other international 2,545,228 1,735,829 6,023,136 4,188,585
----------- ----------- ----------- -----------
Total revenues $12,966,111 $10,056,665 $34,842,658 $27,944,288
=========== =========== =========== ===========
September 30, December 31,
2006 2005
------------ ------------
Long-lived assets:
United States $ 9,648,673 $ 9,716,031
Asia 1,311,870 1,320,865
Other international 306,411 207,098
----------- -----------
Total long-lived assets $11,266,954 $11,243,994
=========== ===========
(4) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the three and nine months ended
14
September 30, 2006, the Company purchased 65,600 and 315,600 shares of its
common stock in open market purchases for a total cost of $475,661 and
$2,147,234, respectively. As of September 30, 2006, the Company had repurchased
a total of 865,200 shares for $5,780,164.
(5) COMMITMENTS AND CONTINGENCIES
The Company has an operating lease covering its corporate office facility
that expires in February, 2012. The Company also has several operating leases
related to offices in foreign countries. The expiration dates for these leases
range from 2006 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of September 30, 2006:
2006........................... $ 519,894
2007........................... 1,771,733
2008........................... 1,355,003
2009........................... 1,350,761
2010........................... 1,326,398
Thereafter..................... 2,051,003
----------
$8,374,792
==========
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, such matters are not
expected to have a material adverse effect on our financial condition or
operating results.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
We were pleased with the sequential year over year growth in our revenues
for the third quarter of 2006.
Revenues for the third quarter of 2006 increased 29% to $13 million
compared with revenues in the third quarter of 2005. Revenues from both our OEM
partners and our resellers increased from the same period last year. Revenues
for the nine months ended September 30, 2006 increased 25% to $34.8 million
compared with $27.9 million for the same period in the prior year.
Revenues increased 2% compared with the second quarter of 2006. The
increase was mainly attributable to an increase in maintenance revenues. The
change in software license revenues from the second quarter of 2006 was small.
We believe that the modest increase in software license revenues was due to
seasonality of demand.
We had one customer who accounted for 27% of our revenues in the third
quarter of 2006. Sun Microsystems, which accounted for 10% of our revenues in
the second quarter, did not reach this level in the third quarter. We believe
the decline in revenues from Sun was due to the pending announcement and
clarification of Sun's VTL strategy. During the second week of the fourth
quarter, Sun announced its VTL roadmap and its strategic partnership with
FalconStor. Although there can be no assurance, we expect that revenue from Sun
will increase in the fourth quarter.
During the third quarter, we hired a Chief Marketing Officer and an
additional Vice President of Information Lifecycle Management to bolster our
management team. We believe these additions, when added to our existing team,
provide us with more organizational breadth and depth to take advantage of both
current and future opportunities.
We are also continuing to monitor our channel sales operations to
determine whether structural changes or additional resources will help to
continue or to accelerate the positive momentum. We anticipate that we will need
to add resources to our sales and marketing team to realize the full potential
of our existing opportunities, to establish our visibility in the marketplace,
and to generate additional business prospects.
In addition to increased revenues, the other indicators we use to assess
our performance and growth continued to be positive.
While we had an operating loss for the three months ended September 30,
2006, including $2.4 million of share-based payment compensation expense related
to the implementation of SFAS No. 123(R), cash flows from operations in the
third quarter of 2006 were again positive. This is the eighth consecutive
quarter we have realized positive cash flows from operations. We believe that
our ability to fund our own growth internally bodes well for our long-term
success.
Deferred revenue at September 30, 2006 increased 8%, compared with the
balance at June 30, 2006, and by 58% 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.
16
Operating expenses increased by $0.3 million, or 2%, over the previous
quarter. Operating expenses include $2.4 million in share-based payment
compensation expense for the third quarter of 2006, and $2.4 million in
share-based payment compensation expense for the second quarter of 2006, as
required by accounting standards that went into effect on January 1, 2006. The
sum of other operating expenses increased by $0.3 million, or 2%, from the
second quarter of 2006. Operating expenses for the quarter ended September 30,
2006 increased by $4.9 million from the third quarter of 2005. Of such increase,
$2.4 million was attributable to share-based payment compensation expense.
Our gross margins increased to 82% for the third quarter from 81% for the
second quarter of 2006. Share-based payment compensation expense within cost of
maintenance, software services and other revenue was 3% of revenue in each of
the second and third quarters of 2006.
We plan to continue adding research and development, sales and support
personnel, both in the United States and worldwide, as necessary. We also plan
to continue investing in infrastructure, including both equipment and property.
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.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED
WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2005.
Revenues for the three months ended September 30, 2006 increased 29% to
$13.0 million compared with $10.1 million for the three months ended September
30, 2005. Our operating expenses increased 50% from $9.8 million for the three
months ended September 30, 2005 to $14.7 million for the three months ended
September 30, 2006. Included in our operating expenses for the three months
ended September 30, 2006 was $2.4 million of share-based payment compensation
expense related to the implementation of SFAS No. 123(R) beginning January 1,
2006. For the three months ended September 30, 2005, there was no share-based
payment compensation expense. Net loss for the three months ended September 30,
2006 was $1.3 million compared with net income of $0.5 million for the three
months ended September 30, 2005. The increase in revenues was due to an increase
in software license revenue and maintenance revenue partially offset by a
decrease in software services and other revenue. Revenue contribution from our
OEM partners increased in absolute dollars and as a percentage of our total
revenue for the quarter ended September 30, 2006. Revenue from resellers and
distributors also increased in absolute dollars. Expenses increased in all
aspects of our business to support our growth. For the three months ended
September 30, 2006, 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 267 employees as of September 30, 2005 to
344 employees as of September 30, 2006.
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 24% from $7.0 million for the three
months ended September 30, 2005 to $8.7 million for the three months ended
September 30, 2006. Increased market acceptance and demand for our product and
increased sales from our OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from our OEM partners increased as
17
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 third quarters of 2006 and 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 40% to
$4.3 million for the three months ended September 30, 2006 from $3.0 million for
the three months ended September 30, 2005.
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 $2.0 million for the three months ended September 30,
2005 to $3.3 million for the three months ended September 30, 2006. The increase
in maintenance revenue was partially offset by a slight decrease in software
services and other revenue. 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 September 30, 2006, we had $0.2 million of purchased software
licenses, net of accumulated amortization of $5.0 million, that are being
amortized over three years. For the three months ended September 30, 2006, we
recorded $0.1 million of amortization related to these purchased software
licenses. As of September 30, 2005, we had $0.5 million of purchased software
licenses, net of accumulated amortization of $4.5 million, and recorded
approximately $0.2 million of amortization for the three months ended September
30, 2005 related to these purchased software licenses. We will continue to
evaluate third party software licenses and may make additional purchases, which
would result in an increase in amortization expense.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues consists
primarily of personnel and other costs associated with providing software
implementations, technical support under maintenance contracts, training and
share-based payment compensation expense associated with the implementation of
SFAS No. 123(R). 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 September 30,
2006 increased by 35% to $2.2 million compared with $1.7 million for the three
months ended September 30, 2005. The increase in cost of maintenance, software
services and other revenue was principally due to $0.4 million of share-based
payment compensation expense. There was no share-based payment compensation
expense included in cost of maintenance, software services and other revenue for
the three months ended September 30, 2005. Additionally, cost of maintenance,
software services and other revenue increased due to an increase in personnel.
As a result of our increased sales of maintenance and support contracts, we
hired additional employees to provide technical support. Our cost of
18
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenue increases.
Gross profit for the three months ended September 30, 2006 was $10.6
million or 82% of revenue compared to $8.2 million or 82% of revenue for the
three months ended September 30, 2005. Gross margin remained consistent due to
the share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the three months ended September 30,
2006. Share-based payment compensation expense was equal to 3% of revenue for
the three months ended September 30, 2006.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for
product development personnel, share-based payment compensation expense
associated with the implementation of SFAS No. 123(R), and other related costs
associated with the development of new products, enhancements to existing
products, quality assurance and testing. Software development costs increased
69% to $5.1 million for the three months ended September 30, 2006 from $3.0
million for the three months ended September 30, 2005. The major contributing
factor to the increase in software development costs was $1.1 million of
share-based payment compensation expense. There was no share-based payment
compensation expense included in cost of maintenance, software services and
other revenue for the three months ended September 30, 2005. The increase is
also 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 software development
process.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, share-based payment compensation expense associated
with the implementation of SFAS No. 123(R), 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 52% to $5.8 million for the three months ended September 30, 2006 from
$3.8 million for the three months ended September 30, 2005. The increase in
selling and marketing expenses was partially due to $0.8 million of share-based
payment compensation expense. There was no share-based payment compensation
expense included in selling and marketing expenses for the three months ended
September 30, 2005. In addition, we continued to hire new sales and sales
support personnel and to expand our worldwide presence to accommodate our
anticipated revenue growth. We believe that to continue to grow sales, our sales
and marketing expenses will continue to increase.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel costs
of general and administrative functions, share-based payment compensation
expense associated with the implementation of SFAS No. 123(R), public company
related costs, directors and officers insurance, legal and professional fees,
and other general corporate overhead costs. General and administrative expenses
increased 35% to $1.5 million for the three months ended September 30, 2006 from
$1.1 million for the three months ended September 30, 2005. The major
contributing factor to the increase in general and administrative expenses was
$0.2 million of share-based payment compensation expense. There was no
share-based payment compensation expense included in general and administrative
expenses for the three months ended September 30, 2005. Additionally, as our
revenue and number of employees increase, our legal and professional fees and
other general corporate overhead costs have increased and are likely to continue
to increase.
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
increased to $0.5 million for the three months ended September 30, 2006 compared
to $0.2 million for the three months ended September 30, 2005. This increase is
primarily due to a higher average cash balance and higher interest rates.
19
INCOME TAXES
For the three months ended September 30, 2006, our provision for income
taxes consisted 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. Our provision for income taxes for the three months ended
September 30, 2006 consist primarily of foreign taxes and U.S. federal
alternative minimum taxes and state minimum taxes that are expected to be
incurred (despite our pre-tax book loss) primarily as a result of the
limitations of our ability to utilize net operating losses and the
non-deductibility of certain share-based payment compensation expenses for
income tax purposes that has been recognized for financial statement purposes.
RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED
WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2005.
Revenues for the nine months ended September 30, 2006 increased 25% to
$34.8 million compared with $27.9 million for the nine months ended September
30, 2005. Our operating expenses increased 51% from $27.9 million for the nine
months ended September 30, 2005 to $42.1 million for the nine months ended
September 30, 2006. Included in our operating expenses for the nine months ended
September 30, 2006 was $7.1 million of share-based payment compensation expense
related to the implementation of SFAS No. 123(R) beginning January 1, 2006. For
the nine months ended September 30, 2005, there was no share-based payment
compensation expense. Net loss for the nine months ended September 30, 2006 was
$6.2 million compared with net income of $0.6 million for the nine months ended
September 30, 2005. We experienced an increase in revenue from all lines of
business. Revenue contribution from our OEM partners increased in absolute
dollars and as a percentage of our total revenue for the nine months ended
September 30, 2006. Revenue from resellers and distributors also increased in
absolute dollars. Expenses increased in all aspects of our business to support
our growth. For the nine months ended September 30, 2006, 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
267 employees as of September 30, 2005 to 344 employees as of September 30,
2006.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue increased 16% from $19.9 million for the nine
months ended September 30, 2005 to $23.1 million for the nine months ended
September 30, 2006. Increased market acceptance and demand for our product and
increased sales from our OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from our OEM partners increased as
a percentage of total revenue.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 47% to $11.8
million for the nine months ended September 30, 2006 from $8.0 million for the
nine months ended September 30, 2005. 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 $5.3 million for the nine
months ended September 30, 2005 to $8.8 million for the nine months ended
September 30, 2006. Growth in our professional services sales, which increased
by $0.1 million for the nine months ended September 30, 2006 compared with the
nine months ended September 30, 2005, also contributed to the increase in
software services and other revenues. This increase in professional services
revenue was related to the increase in our software license customers who
elected to purchase professional services. Additionally, our hardware sales
increased from $1.6 million for the nine months ended September 30, 2005 to $1.7
million for the nine months ended September 30, 2006. This increase was the
result of an increase in demand from our customers for bundled solutions.
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COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
Amortization of purchased and capitalized software decreased from $0.6
million for the nine months ended September 30, 2005, to $0.3 million for the
nine months ended September 30, 2006. The decrease in amortization expense was
due to some of the purchased software licenses being fully amortized as of
September 30, 2006. We will continue to evaluate third party software licenses
and may make additional purchases, which would result in an increase in
amortization expense.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues for the nine
months ended September 30, 2006 increased by 47% to $6.6 million compared with
$4.5 million for the nine months ended September 30, 2005. The increase in cost
of maintenance, software services and other revenue was partially due to $1.1
million of share-based payment compensation expense. There was no share-based
payment compensation expense included in cost of maintenance, software services
and other revenue for the nine months ended September 30, 2005. Additionally,
cost of maintenance, software services and other revenue increased due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts, we hired additional 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 nine months ended September 30, 2006 was $28.0
million or 80% of revenue compared with $22.9 million or 82% of revenue for the
nine months ended September 30, 2005. The decrease in gross margin was mainly
related to the share-based payment compensation expense included in cost of
maintenance, software services and other revenue for the nine months ended
September 30, 2006. Share-based payment compensation expense was equal to 3% of
revenue for the nine months ended September 30, 2006.
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 73% to $14.6 million for the nine
months ended September 30, 2006 from $8.4 million for the nine months ended
September 30, 2005. The increase in software development costs was partially due
to $3.2 million of share-based payment compensation expense. There was no
share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the nine months ended September 30,
2005. The increase is also 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
software development process.
SELLING AND MARKETING
Selling and marketing expenses increased 45% to $16.4 million for the
nine months ended September 30, 2006 from $11.3 million for the nine months
ended September 30, 2005. The increase in selling and marketing expenses was
partially due to $2.1 million of share-based payment compensation expense. There
was no share-based payment compensation expense included in selling and
marketing expenses for the nine months ended September 30, 2005. In addition, we
continued to hire new sales and sales support personnel and to expand our
worldwide presence to accommodate our anticipated revenue growth.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 35% to $4.2 million for the
nine months ended September 30, 2006 from $3.1 million for the nine months ended
September 30, 2005. The overall increase in general and administrative expenses
was primarily due to $0.7 million of share-based payment compensation expense.
There was no share-based payment compensation expense included in general and
administrative expenses for the nine months ended September 30, 2005. As a
result of the overall growth of our business, we experienced an increase in
general and administrative expenses related to headcount, insurance, and other
general corporate overhead costs.
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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
increased to $1.2 million for the nine months ended September 30, 2006 compared
to $0.7 million for the nine months ended September 30, 2005. This increase is
primarily due to a higher average cash balance and higher interest rates.
INCOME TAXES
For the nine months ended September 30, 2006, our provision for income
taxes consisted 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. Our provision for income taxes for the nine months ended
September 30, 2006 consist primarily of foreign taxes and U.S. federal
alternative minimum taxes and state minimum taxes that are expected to be
incurred (despite our pre-tax book loss) primarily as a result of the
limitations of our ability to utilize net operating losses and the
non-deductibility of certain share-based payment compensation expense for income
tax purposes that has been recognized for financial statement purposes.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are those related to revenue
recognition, accounts receivable allowances, deferred income taxes and
accounting for share-based payment compensation.
REVENUE RECOGNITION. 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.
ACCOUNTS RECEIVABLE. 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.
DEFERRED INCOME TAXES. Consistent with the provisions of Statement of
Financial Accounting Standards No. 109, we regularly estimate our ability to
recover deferred income taxes, and report such assets at the amount that is
determined to be more-likely-than-not recoverable. This evaluation considers
several factors, including an estimate of the likelihood of generating
sufficient taxable income in future periods over which temporary differences
reverse, the expected reversal of deferred tax liabilities, past and projected
taxable income, and available tax planning strategies. As of September 30, 2006,
based primarily upon our cumulative losses, a valuation allowance has been
recorded against our deferred tax assets. In the event that evidence becomes
available in the future to indicate that our deferred taxes will likely be
recoverable (e.g., taxable income generated in and projected for future
periods), our estimate of the recoverability of deferred taxes may change,
resulting in a reversal of all or a portion of such valuation allowance.
ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to
Unaudited Condensed Consolidated Financial Statements - Note (1L) SHARE-BASED
PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified
prospective method. Through December 31, 2005, we accounted for our stock option
plans under the intrinsic value method of Accounting Principles Board ("APB")
Opinion No. 25, and as a result no compensation costs had been recognized in our
historical consolidated statements of operations.
22
We have used and expect to continue to use the Black-Scholes
option-pricing model to compute the estimated fair value of stock-based awards.
The Black-Scholes option pricing model includes assumptions regarding dividend
yields, expected volatility, expected option term and risk-free interest rates.
The assumptions used in computing the fair value of stock-based awards reflect
our best estimates, but involve uncertainties relating to market and other
conditions, many of which are outside of our control. We estimate expected
volatility based primarily on historical daily price changes of our stock and
other factors. Additionally, we estimate forfeiture rates based primarily upon
historical experiences, adjusted when appropriate for known events or expected
trends. If other assumptions or estimates had been used, the share-based payment
compensation expense that was recorded for the three and nine months ended
September 30, 2006 could have been materially different. Furthermore, if
different assumptions or estimates are used in future periods, share-based
payment compensation expense could be materially impacted in the future. Total
compensation cost related to unvested share-based payment awards not yet
recognized as of September 30, 2006 is $11,411,767. That cost is expected to be
recognized over a weighted average period of 2.1 years.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2006, the FASB issued FASB Interpretation No. 48, ACCOUNTING FOR
UNCERTAINTY IN INCOME TAXES ("FIN No. 48"). FIN No. 48 establishes a recognition
threshold and measurement for income tax positions recognized in an enterprise's
financial statement in accordance with SFAS No. 109, ACCOUNTING FOR INCOME
TAXES. FIN No. 48 also prescribes a two-step evaluation process for tax
positions. The first step is recognition and the second is measurement. For
recognition, an enterprise judgmentally determines whether it is
more-likely-than-not that a tax position will be sustained upon examination,
including resolution of related appeals or litigation processes, based on the
technical merits of the position. If the tax position meets the
more-likely-than-not recognition threshold, it is measured and recognized in the
financial statements as the largest amount of tax benefit that is greater than
50% likely of being realized. If a tax position does not meet the
more-likely-than-not recognition threshold, the benefit of that position is not
recognized in the financial statements.
Tax positions that meet the more-likely-than-not recognition threshold at
the effective date of FIN No. 48 may be recognized, or continue to be
recognized, upon adoption of FIN No. 48. The cumulative effect of applying the
provisions of FIN No. 48 shall be reported as an adjustment to the opening
balance of retained earnings for that fiscal year. FIN No. 48 is effective for
the Company beginning in fiscal year 2007, with earlier adoption permitted. The
Company is in the process of assessing the effect FIN No. 48 may have on its
consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting
Standard ("SFAS") No. 157, "Fair Value Measurements" ("SFAS No. 157") to clarify
the definition of fair value, establish a framework for measuring fair value and
expand the disclosures on fair value measurements. SFAS No. 157 defines fair
value as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date (an exit price). SFAS No. 157 also stipulates that, as a
market-based measurement, fair value should be determined based on the
assumptions that market participants would use in pricing the asset or
liability, and establishes a fair value hierarchy that distinguishes between (a)
market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. The Company is currently evaluating the
impact of the provisions of SFAS No. 157 on its consolidated financial
statements.
In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No.
108, "Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" ("SAB No. 108") to provide
guidance on the consideration of the effects of prior year misstatements in
quantifying current year misstatements for the purpose of a materiality
assessment. Under SAB No. 108, companies should evaluate a misstatement based on
its impact on the current year income statement, as well as the cumulative
effect of correcting such misstatements that existed in prior years existing in
the current year's ending balance sheet. The Company will adopt SAB No. 108 for
the year ended December 31, 2006, and is currently evaluating the impact of
adoption.
23
LIQUIDITY AND CAPITAL RESOURCES
Our total cash and cash equivalents and marketable securities balance as
of September 30, 2006 increased by $2.4 million compared to December 31, 2005.
Our cash and cash equivalents totaled $12.6 million and marketable securities
totaled $26.5 million at September 30, 2006. As of September 30, 2005, we had
approximately $16.4 million in cash and cash equivalents and $18.8 million in
marketable securities.
We continued to invest in our infrastructure to support our long-term
growth during the nine months ended September 30, 2006. We made investments in
property and equipment and we increased the number of employees during the third
quarter of 2006. 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 October 2001, our Board of Directors authorized the repurchase of up
to two million shares of our outstanding common stock. Since October 2001,
865,200 shares have been repurchased at an aggregate purchase price of $5.8
million. During the third quarter and for the nine months ended September 30,
2006, we repurchased 65,600 and 315,600 shares at an aggregate purchase price of
$0.5 and $2.1 million, respectively.
Net cash provided by operating activities totaled $5.8 million for the
nine months ended September 30, 2006, compared with $4.4 million for the nine
months ended September 30, 2005. Net cash provided by operating activities of
$5.8 million was primarily derived from an increase in deferred revenue of $2.4
million and non-cash charges of $2.7 million for depreciation and amortization
and $7.1 million related to share-based payment compensation expense. These
amounts were partially offset by our net loss of $6.2 million for the nine
months ended September 30, 2006. The cash provided by operating activities for
the nine months ended September 30, 2005 was mainly comprised of our net income
of $0.6 million, an increase in deferred revenue of $2.2 million and non-cash
charges of $2.5 million. These amounts were partially offset by net increases in
accounts receivable, prepaid expenses and other current assets and accrued
expenses.
Net cash used in investing activities was $11.7 million for the nine
months ended September 30, 2006, due primarily to net purchases of marketable
securities of $8.6 million, purchases of property and equipment of $2.6 million
and purchases of software licenses and intangible assets of $0.4 million. Net
cash used in investing activities was $2.9 million for the nine months ended
September 30, 2005, due primarily to net purchases of marketable securities of
$0.3 million, purchase of property and equipment of $2.3 million and purchases
of software licenses and intangible assets of $0.2 million.
Net cash used in financing activities was $0.4 million for the nine
months ended September 30, 2006. We received proceeds from the exercise of stock
options of $1.7 million and we made payments of $2.1 million for the nine months
ended September 30, 2006 to acquire treasury stock. Net cash used in financing
activities was $0.5 million for the nine months ended September 30, 2005. This
amount was primarily related to payments to acquire treasury stock of $1.5
million partially offset by proceeds from the exercise of stock options of $1.0
million.
We currently do not have any debt and our only material cash commitments
are related to our office leases. We have an operating lease covering our
corporate 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 2006 through 2012. Refer to Note 5 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.
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 September 30, 2006, the effect on our financial results
would be insignificant.
24
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 September 30, 2006, 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 September 30, 2006, 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.
ITEM 1A. RISK FACTORS
We are affected by risks specific to us as well as factors that affect
all businesses operating in a global market. The significant factors known to us
that could materially adversely affect our business, financial condition, or
operating results are set forth below, whether or not there has been a material
change in any Risk Factor.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET AND OUR RELIANCE ON OUR PARTNERS, WE MAY HAVE DIFFICULTY ACCURATELY
PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage software market in
which we sell our products, the degrees of effort and success of our partners'
sales and marketing efforts, and other factors that are beyond our control,
reduce our ability to accurately forecast our quarterly and annual revenue.
However, we must use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
THE MARKET FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL
MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.
The continued adoption of Storage Area Networks (SAN) and Network
Attached Storage (NAS) solutions is critical to our future success. The markets
for SAN and NAS solutions are still maturing, making it difficult to predict
their potential sizes or future growth rates. If these markets develop more
slowly than we expect, our business, financial condition and results of
operations would be adversely affected.
25
THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS STILL MATURING, AND OUR BUSINESS
WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT.
The continued adoption of disk-based backup solutions, such as our
VirtualTape Library software, is critical to our future success. The market for
disk-based backup solutions is still maturing, making it difficult to predict
its potential size or future growth rate. If this market develops more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.
THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.
The rapid adoption of IP-based Storage Area Networks (SAN) is important
to our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. We are uncertain
whether a viable market for our products will develop or be sustainable. If this
market fails to develop, or develops more slowly than we expect, our business,
financial condition and results of operations would be adversely affected.
WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS AND SMALL OFFICE/HOME
OFFICE MARKETS.
We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.
THE MARKET FOR OUR PRIMEVAULT SM SERVICES IS COMPETITIVE AND IT IS UNCERTAIN
WHETHER WE WILL ATTRACT ENOUGH CUSTOMERS TO PROVIDE AN ADEQUATE RETURN ON
INVESTMENT.
We have continued to make investments in infrastructure and in operating,
sales and marketing personnel for our PrimeVault disaster recovery, data backup,
managed storage, and VTL replication services. The market for these services is
competitive with a number of vendors offering similar services. Despite what we
believe are competitive advantages offered by our PrimeVault services based on
our proprietary IPStor and VTL families of software, there can be no assurance
that we will be able to attract enough customers, or earn enough revenues, to
cover our investment in PrimeVault services or to provide an adequate return on
that investment.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.
The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a storage system. All
components of these systems must comply with the same industry standards in
order to operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.
26
OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FOR
OUR PRODUCTS OR COSTLY LITIGATION.
Our IPStor platform is complex and is designed to be deployed in large
and complex networks. Many of our customers have unique infrastructures, which
may require additional professional services in order for our software to work
within their infrastructures. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
defects in our product could result in damage to our customers. These problems
could cause us to incur significant service and engineering costs, divert
engineering personnel from product development efforts and significantly impair
our ability to maintain existing customer relationships and attract new
customers. In addition, a product liability claim, whether successful or not,
would likely be time consuming and expensive to resolve and would divert
management time and attention. Further, if we are unable to fix the errors or
other problems that may be identified in full deployment, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.
Our other products may also contain errors or defects. If we are unable
to fix the errors or other problems that may be discovered, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with resellers and OEM partners to
develop storage appliances that combine certain aspects of IPStor or VTL
functionality with third party hardware to create single purpose turnkey
solutions that are designed to be easy to deploy. If the storage appliances are
not easy to deploy or do not integrate smoothly with end user systems, the basic
premise behind the appliances will not be met and sales would suffer.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers typically
require that each of our products undergo an extensive qualification process,
which involves interoperability testing of our product in the OEM's system as
well as rigorous reliability testing. This qualification of a product by an OEM
does not assure any sales of the product to the OEM. Despite this uncertainty,
we devote substantial resources, including engineering, sales, marketing and
management efforts, toward qualifying our products with OEMs in anticipation of
sales to them. If we are unsuccessful or delayed in qualifying any products with
an OEM, such failure or delay would preclude or delay sales of that product to
the OEM, which may impede our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage software market and in other markets. The OEM customers and
resellers may choose to focus their sales efforts on other products in the
network storage software market or other markets. The OEM customers might also
choose not to continue to develop or to market products which include our
products. This would likely result in lower revenues to us and would impede our
ability to grow our business.
OUR OEM CUSTOMERS ARE NOT OBLIGATED TO CONTINUE TO SELL OUR PRODUCTS.
We have no control over the shipping dates or volumes of systems
incorporation our product that our OEM customers ship and they have no
obligation to ship systems incorporating our software applications. They also
have no obligation to recommend or offer our software applications exclusively
or at all, and they have no minimum sales requirements. These OEMs also could
choose to develop their own data protection and network storage software
internally and incorporate those products into their systems instead of our
software applications. The OEMs that we do business with also compete with one
another. If one of our OEMs views our arrangement with another OEM as competing
with its products, it may decide to stop doing business with us. Any material
decrease in the volume of sales generated by OEMs with whom we do business, as a
result of these factors or otherwise, would have a material adverse effect on
our revenues and results of operations in future periods.
27
THE FAILURE OF OUR RESELLERS TO EFFECTIVELY SELL OUR SOFTWARE APPLICATIONS COULD
HAVE A MATERIAL ADVERSE EFFECT ON OUR REVENUES AND RESULTS OF OPERATIONS.
We rely significantly on our value-added resellers, systems integrators
and corporate resellers, which we collectively refer to as resellers, for the
marketing and distribution of our software applications and services. Resellers
are our most significant distribution channel. However, our agreements with
resellers are generally not exclusive, are generally renewable annually and in
many cases may be terminated by either party without cause. Many of our
resellers carry software applications that are competitive with ours. These
resellers may give a higher priority to other software applications, including
those of our competitors, or may not continue to carry our software applications
at all. If a number of resellers were to discontinue or reduce the sales of our
products, or were to promote our competitors' products in lieu of our
applications, it would have a material adverse effect on our future revenues.
Events or occurrences of this nature could seriously harm our sales and results
of operations. In addition, we expect that a significant portion of our sales
growth will depend upon our ability to identify and attract new reseller
partners. The use of resellers is an integral part of our distribution network.
We believe that our competitors also use reseller arrangements. Our competitors
may be more successful in attracting reseller partners and could enter into
exclusive relationships with resellers that make it difficult to expand our
reseller network. Any failure on our part to expand our network of resellers
could impair our ability to grow revenues in the future.
WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR RECEIVABLES HAS
HISTORICALLY BEEN CONCENTRATED WITH TWO CUSTOMERS.
We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the quarter ended September 30, 2006,
we had one customer who accounted for 27% of our revenues. While we believe that
we will continue to receive revenue from this client, and from another customer
which has provided 10% or more of our revenues in recent quarters, our
agreements do not have any minimum sales requirements and we cannot guarantee
continued revenue. If our contracts with either of these customers are
terminated, or if the volume of sales from these customer significantly
declines, it would have a material adverse effect on our operating results.
In addition, as of September 30, 2006, one customer accounted for a total
of 18% of our outstanding receivables. While we currently have no reason to
question the collectibility of this receivable, a business failure or
reorganization by this customer could harm our ability to collect this
receivable and could damage our cash flow.
THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN
ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR
RESPONDING TO TRENDS.
Certain of our OEM customers do not report license revenue to us until
sixty days or more after the end of the quarter in which the software was
licensed. There will thus be a delay before we learn whether licensing revenue
from these OEMs has met, exceeded, or fallen short of our expectations. The
reporting schedule from these OEMs also means that our ability to respond to
trends in the market could be harmed as well. For example, if, in a particular
quarter, we see a significant increase or decrease in revenue from our channel
sales or one of our other OEM partners, there will be a delay in our ability to
determine whether this is an anomaly or a part of a trend. However, we must use
our forecasted revenue to establish our expense budget. Most of our expenses are
fixed in the short term or incurred in advance of anticipated revenue. As a
result, we may not be able to decrease our expenses in a timely manner to offset
any shortfall in revenue or to increase our sales, marketing or support
headcounts to take advantage of positive developments.
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.
28
WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.
Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
This could result in lost sales opportunities for us with other customers or
could cause other potential OEM partners to consider or select software from our
competitors for their storage solutions. In addition, the desire for product
differentiation could cause potential OEM partners to select software from our
competitors. We cannot guarantee that our current strategic partners, or those
companies with whom we may partner in the future, will continue to be our
partners for any period of time. If our software were to be replaced in an OEM
solution by competing software, or if our software is not selected by OEMs for
future solutions, it would likely result in lower revenues to us and would
impede our ability to grow our business.
CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGIC
RELATIONSHIPS.
In the past, companies with whom we have OEM relationships have been
acquired by other companies. These acquisitions caused disruptions in the sales
and marketing of our products and in 2005, acquisitions of two of our OEM
partners had an impact on our revenues. If additional OEM customers are
acquired, the new parents might choose to stop offering solutions containing our
software. Even if the solutions continued to be offered, there might be a loss
of focus and sales momentum as the companies are integrated.
THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage software market is intensely competitive even during
periods when demand is stable. Some of our current and potential competitors
have longer operating histories, significantly greater resources, broader name
recognition and a larger installed base of customers than we have. Those
competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us; or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business,
may enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
OUR ABILITY TO SELL OUR SOFTWARE APPLICATIONS IS HIGHLY DEPENDENT ON THE QUALITY
OF OUR SERVICES OFFERINGS, AND OUR FAILURE TO OFFER HIGH QUALITY SUPPORT AND
PROFESSIONAL SERVICES WOULD HAVE A MATERIAL ADVERSE AFFECT ON OUR SALES OF
SOFTWARE APPLICATIONS AND RESULTS OF OPERATIONS.
Our services include the assessment and design of solutions to meet our
customers' storage management requirements and the efficient installation and
deployment of our software applications based on specified business objectives.
Further, once our software applications are deployed, our customers depend on us
to resolve issues relating to our software applications. A high level of service
is critical for the successful marketing and sale of our software. If we or our
partners do not effectively install or deploy our applications, or succeed in
helping our customers quickly resolve post-deployment issues, it would adversely
affect our ability to sell software products to existing customers and could
harm our reputation with potential customers. As a result, our failure to
maintain high quality support and professional services would have a material
adverse effect on our sales of software applications and results of operations
29
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.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall
demand for network storage software. Because our sales are primarily to major
corporate customers, any softness in demand for network storage software may
result in decreased revenues.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.
Our previous results are not necessarily indicative of our future
performance and our future quarterly results may fluctuate significantly.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the seasonality of information technology, including network storage
products, spending;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive
prices before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
o new products or enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and
may be volatile in the future. For example, during the past twelve months ended
September 30, 2006, the closing market price of our common stock as quoted on
the NASDAQ Global Market fluctuated between $5.81 and $9.78. The market price of
our common stock may be significantly affected by the following factors:
o actual or anticipated fluctuations in our operating results;
30
o failure to meet financial estimates;
o changes in market valuations of other technology companies, particularly
those in the network storage software market;
o announcements by us or our competitors of significant technical innovations,
acquisitions, strategic partnerships, joint ventures or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
OUR ABILITY TO FORECAST EARNINGS IS LIMITED BY THE IMPACT OF ACCOUNTING
REQUIREMENTS.
The Financial Accounting Standards Board requires companies to recognize
the fair value of stock options and other share-based payment compensation to
employees as compensation expense in the statement of operations. However, this
expense, which, in accordance with accounting standards, we calculate based on
the "Black-Scholes" model, is subject to factors beyond our control. These
factors include the market price of our stock on a particular day and stock
price "volatility." In addition, we do not know how many options our employees
will exercise in any future period. These unknowns make it difficult for us to
forecast accurately what the stock option and equity-based compensation expense
will be in the future. Because we are unable to make accurate expense forecasts,
our ability to make accurate forecasts of future earnings is compromised.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Further, we have entered into change of
control agreements with certain executives, which may also have the effect of
delaying, deterring or preventing a change in control.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS, RESTRICTED SHARES AND
WARRANTS, THE EXERCISE OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS'
PERCENTAGE OWNERSHIP OF OUR COMMON STOCK.
As of September 30, 2006, we had an aggregate of 11,809,460 outstanding
restricted shares and outstanding options and warrants to purchase our common
stock. The weighted average exercise price of the outstanding options and
warrants is $5.51 per share. We also have 1,195,185 shares of our common stock
reserved for issuance under our stock plans with respect to options (or
restricted stock) that have not been granted.
The exercise of all of the outstanding options and warrants and/or the
grant and exercise of additional options or restricted stock 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.
31
OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS
In August, 2003, our business was interrupted due to a large scale
blackout in the northeastern United States. While our headquarters facilities
contain redundant power supplies and generators, our domestic and foreign
operations, and the operations of our industry partners, remain susceptible to
fire, floods, power loss, power shortages, telecommunications failures,
break-ins and similar events.
Any interruption in power supply or telecommunications would be
particularly disruptive to our PrimeVault backup and disaster recovery
operations. If PrimeVault customers are unable to access their data, confidence
in our ability to provide disaster recovery and backup services will be damaged
which will impair our ability to retain existing customers, to gain new
customers and to expand our operations.
Terrorist actions domestically or abroad could lead to business
disruptions or to cancellations of customer orders or a general decrease in
corporate spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.
UNITED STATES GOVERNMENT EXPORT RESTRICTIONS COULD IMPEDE OUR ABILITY TO SELL
OUR SOFTWARE TO CERTAIN END USERS.
Certain of our products include the ability for the end user to encrypt
data. The United States, through the Bureau of Industry Security, places
restrictions on the export of certain encryption technology. These restrictions
may include: the requirement to have a license to export the technology; the
requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. Certain of our products
are subject to various levels of export restrictions. These export restrictions
could negatively impact our business.
THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.
We sell our products worldwide. Accordingly, our operating results could
be materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.
Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.
Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.
Our success is dependent upon our proprietary technology. Currently, the
IPStor software suite is the core of our proprietary technology. We have three
patents issued, and multiple pending patent applications, numerous trademarks
registered and multiple pending trademark applications related to our products.
We cannot predict whether we will receive patents for our pending or future
patent applications, and any patents that we own or that are issued to us may be
invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.
We also rely on trade secret, copyright and trademark laws, as well as
the confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
32
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 fees and expenses of the litigation as well as the litigation settlement
were expensive and the litigation diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. Any potential intellectual property litigation
against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual property;
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which license
may not be available on reasonable terms, or at all; or
o redesign those products that use infringing intellectual property or cease
to use an infringing product or trademark.
DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.
Many of our products are designed to include software or other
intellectual property licensed from third parties, including "Open Source"
software. At least one intellectual property rights holder has alleged that it
holds the rights to software traditionally viewed as Open Source. It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
limit our ability to protect our proprietary rights in our products.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key
employees, many of whom would be extremely difficult to replace. We do not have
key person life insurance on any of our personnel. Worldwide competition for
skilled employees in the network storage software industry is extremely intense.
If we are unable to retain existing employees or to hire and integrate new
employees, our business, financial condition and operating results could suffer.
In addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
and could incur substantial costs defending ourselves against those claims.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies
or their assets. Integration of the acquired products, technologies and
businesses, could divert management's time and resources. Further, we may not be
able to properly integrate the acquired products, technologies or businesses,
with our existing products and operations, train, retain and motivate personnel
from the acquired businesses, or combine potentially different corporate
cultures. If we are unable to fully integrate the acquired products,
technologies or businesses, or train, retain and motivate personnel from the
acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
33
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.
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 2. UNREGISTERED SALES OF EQUITY PROCEEDS AND USE OF PROCEEDS
Shares of common stock repurchased during the quarter ended September 30, 2006:
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
---------------- -------------- ------------------- ------------------
September, 2006 65,600 $ 7.25 65,600 1,134,800
Total 65,600 $ 7.25 65,600 1,134,800
The Company's Board of Directors approved a program, effective October 24, 2001,
to repurchase up to two million shares of the Company's common stock. The
program has no expiration date.
ITEM 6. EXHIBITS
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
32.2 Certification of Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
34
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)
November 9, 2006