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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

(Mark One)

|ý | Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
|- | ------------------------------------------------------------------------------------

For the fiscal year ended December 31, 2001

OR

|o | 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 0-28317

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DIGIMARC CORPORATION(Exact name of registrant as specified in its charter)

Delaware(State or other jurisdiction of
incorporation or organization)

94-3342784(I.R.S. Employer Identification No.)19801 SW 72nd Ave, Ste 100, Tualatin, Oregon 97062(Address of principal executive offices, Zip Code)(503) 885-9699(Registrant's telephone number, including area code)


Securities
registered pursuant to Section 12(b) of the Act: NONE

Securities
registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value

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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 ý    No o

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of
registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o

The
aggregate market value of Common Stock held by non-affiliates of the Registrant (based on the closing price for the Common Stock on the Nasdaq National Market on
February 28, 2002) was approximately $93.3 million. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have
been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As
of February 28, 2002, there were 17,136,639 shares of the Registrant's Common Stock outstanding.

Documents Incorporated by Reference

The information required by Part III is omitted from this Annual Report in that the Registrant will file a definitive proxy statement pursuant to
Regulation 14A (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information
included therein is incorporated into Part III of this Annual Report by reference.

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Table of Contents

|PART I   |  |                                                                                       |  |   
|-------- |  | ------------------------------------------------------------------------------------- |  | --
|Item 1.  |  | Business                                                                              |  | 2 
|Item 2.  |  | Properties                                                                            |  | 18
|Item 3.  |  | Legal Proceedings                                                                     |  | 18
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                   |  | 19
|PART II  |  |                                                                                       |  |   
|Item 5.  |  | Market for Registrant's Common Equity and Related Stockholder Matters                 |  | 19
|Item 6.  |  | Selected Financial Data                                                               |  | 20
|Item 7.  |  | Management's Discussion and Analysis of Financial Condition and Results of Operations |  | 21
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 29
|Item 8.  |  | Financial Statements and Supplementary Data                                           |  | 30
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  |  | 30
|PART III |  |                                                                                       |  |   
|Item 10. |  | Directors and Executive Officers of the Registrant                                    |  | 30
|Item 11. |  | Executive Compensation                                                                |  | 30
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management                        |  | 30
|Item 13. |  | Certain Relationships and Related Transactions                                        |  | 30
|PART IV  |  |                                                                                       |  |   
|Item 14. |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                      |  | 31

PART I

This Annual Report on Form 10-K contains certain forward-looking statements that are based on the beliefs of, and
estimates made by and information currently available to, our management. The words "expect," "anticipate," "intend," "plan" and similar expressions identify forward-looking statements. These
statements are subject to risks and uncertainties. Actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not
limited to, those discussed below in "Risks Related to Our Business," "Risks Related to Our Industry" and elsewhere in this Annual Report on Form 10-K. We assume no obligation to
update this information.

ITEM 1: BUSINESS

Overview

Digimarc is a leading provider of patented digital watermarking technologies that allow imperceptible digital code to be embedded in the printed or digital
versions of media content, such as commercial and consumer photographs, movies, music, magazine advertisements, catalogs, product packages and valuable documents like identification documents,
financial instruments, and event tickets. In addition to a code that can be embedded within various types of media content, our technologies include reader
software that, as a resident application on personal computers and other devices, enables the recognition of these embedded codes. We believe our technologies have many potential applications.

Since
the introduction of our first watermarking product in 1996, we have built a broad technology platform that we believe has a range of applications. Our initial products allowed
copyright owners to deter the unintentional use of professional digital imaging tools in producing unauthorized high-quality copies of their images. We later developed image commerce
applications that allowed customers to persistently identify their protected properties and locate these properties across the Internet, which further discourages their unauthorized distribution and
use. Subsequent to that, we developed the

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Digimarc MediaBridge system, which is intended to enable imperceptible digital code to be embedded within print media, such as magazine advertisements and articles, direct mail, coupons, product
packaging, stationery and envelopes, trading cards, catalogs, credit cards, bank cards and business cards. When recognized by personal computer cameras enabled by our patented reader technology, that
code will automatically launch the user directly to the specific Internet destination chosen by the producer of the print media.

On
December 21, 2001, we acquired the assets and assumed certain liabilities of the United States government identification systems business and foreign government digital
identification systems business of Polariod Corporation, Polariod ID Systems, Inc. and certain other affiliated entities of Polaroid Corporation (collectively known as Large Government Program
Identification Business (a division of Polaroid Corporation) or "LGP"). LGP provides secure identification card systems to the majority of U.S. State Motor Vehicles divisions, as well as to various
international government agencies. Our wholly owned subsidiary, Digimarc ID Systems, LLC ("DIDS") and its wholly owned subsidiaries operate LGP. With this acquisition, we became a leading provider of
identification card systems to government agencies, which include drivers' licenses, voter identification cards and other similar programs. We acquired this business to gain access to an additional
platform in which we can further deploy and demonstrate the capabilities of our watermarking technology, among other reasons.

We
continue to develop and refine the patented watermarking technologies and believe there are many potential applications not yet addressed by us. A summary of our product offering is
listed below.

Products

PRODUCTS IN 2001

Our products available through the majority of 2001 were grouped along three lines of business: Secure Documents, Media Commerce, and Digimarc MediaBridge. Each
product line offered systems generally including embedder software to place our digital watermarks into content, and reader technology that is incorporated into digital devices to detect, read and
respond to the embedded code.

Secure Documents

We have relationships with a number of financial institutions that are involved in the creation or protection of high-value documents. These
relationships include a development and license agreement with a consortium of leading central banks related to deterring the use of personal computers in the counterfeiting of currencies. This
agreement accounted for the majority of our revenues in 2001 and 2000, and the agreement is expected to continue for the next several years. We intend to pursue further development of our relationship
with the consortium of central banks to develop other sources of revenue by proposing that we develop additional products and services for this customer over time. Further, our planned document
security products will use digital watermarking to authenticate original documents, detect fraudulent documents and deter unauthorized duplication or alteration of high-value documents
such as passports, tax stamps, tickets and financial instruments like securities, traveler's checks and currencies.

Media Commerce

Our Media Commerce products provide a range of solutions, including copyright communication, enabling online licensing, and other digital asset control and
management solutions. Media Commerce products and services include those listed below:



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Digimarc MediaBridge

Digimarc MediaBridge provides the means to link directly from printed documents to specific Web destinations by showing the enabled document to a Web camera or by
scanning the document using a Twain-compliant scanner, in each case, enabled with our reader software. We believe that these enhanced documents and associated reader technology will enable a variety
of potential applications.

The
Digimarc MediaBridge system is based on our patented core technology. We believe that the system creates new communications capabilities for media content that can promote and
enhance e-commerce. The Digimarc MediaBridge system is a fundamentally new way to access and use the Internet by embedding imperceptible digital code in printed materials, including, among
other things, product packaging, stationery and envelopes, trading cards, magazine advertisements, articles, covers and subscription cards, direct mailers, debit and credit cards, greeting cards,
coupons, catalogs, tickets and business cards that can be read by digital devices enabled by our patented reader technology. We believe that the same technology can be used to permit audio, video,
images and other creative properties in digital form to interact with the digital world.

CURRENT AND PLANNED PRODUCTS

In October 2001 we reorganized the way in which we manage our business. In addition, in December 2001 we acquired the assets and assumed certain
liabilities of LGP. As a result, our current and planned products are grouped along four areas: personal identification systems, government programs, commercial solutions, and licensing. Each area
offers, or will offer, systems generally including embedder software to place our digital watermarks into content, and reader technology that is incorporated into digital devices to detect, read and
respond to the embedded code.

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Personal Identification Systems

As of December 31, 2001 we have contracts with 37 U.S. State drivers' license issuing authorities to produce drivers' licenses. We also have relationships
with various foreign government agencies relating to the production of identification cards related to drivers' licenses, voter identification cards, and national identification cards among others. We
acquired this business to gain access to an additional platform in which we can further deploy and demonstrate the capabilities of our watermarking technology, among other reasons.

Government Programs

We have relationships with a number of financial institutions that are involved in the creation or protection of high-value documents. These
relationships include a development and license agreement with a consortium of leading central banks related to deterring the use of personal computers in the counterfeiting of currencies. This
agreement accounted for the majority of our revenues in 2001 and 2000. We intend to pursue further development of our relationship with the consortium of central banks to develop other sources of
revenue by proposing that we develop additional products and services for this customer over time.

In
addition, we have been working with various government agencies to develop and deploy applications to secure and enhance defense imaging systems, and enhance the security of badging
applications for airports, marine ports and government installations. Our efforts include investigation of applications to authenticate original documents, detect fraudulent documents and deter
unauthorized duplication or alteration of high-value documents such as passports, tax stamps, tickets and financial instruments like securities, traveler's checks and currencies.

Commercial Solutions

Our commercial products provide a range of solutions, including copyright communication, enabling online licensing, and other digital asset control and management
solutions.

Customers
can use our ImageBridge watermarking solutions to protect their copyrights and enhance licensing opportunities for their images, using a number of applications. Image creators
can use Digimarc plug-ins that are bundled with image editing applications from leading companies such as Adobe Systems, Corel, and Micrografx. The Digimarc digital watermarking software
development kit (SDK) provides a programmatic interface to digital watermark embedding, detection and reading, designed for integration into client and server products. Our SDK application enables "on
the fly" server-based watermarking, where digital watermarks carrying transactional data are added to images as they are delivered to customers and can be found in products from companies such as JASC
Software.

Digimarc
ImageBridge Pro watermarking enables image specific licensing and commerce opportunities by enabling each image to direct customers to image specific information on
their Web site. This extends the capabilities of our previous Digimarc ImageBridge watermarking beyond copyright communication to provide robust image commerce capabilities that aid in licensing
images, finding similar images and support asset and rights management activities.

Digimarc
ImageBridge reader for Windows provides easier identification and reading of Digimarc ImageBridge and ImageBridge Pro watermarks by allowing watermarks to be read
from the Windows Explorer desktop without opening the image file or requiring an ImageBridge enabled image editing application. ImageBridge reader for Windows is a downloadable
plug-in that allows image viewers to link to copyright information and owner contact information, review usage restrictions and learn about commerce opportunities.

Our
MarcSpider service searches the public Web for images containing our digital watermarks and produces reports on where and when such images are found. This service allows Web content
developers, photographers, stock photography agencies and publishers of entertainment, sports and news images to track their works on the Web.

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Digimarc
MediaBridge provides the means to link directly from printed documents to specific Web destinations by showing the enabled document to a Web camera or by scanning the document
using a Twain-compliant scanner, in each case, enabled with our reader software. We believe that these enhanced documents and associated reader technology will enable a variety of potential
applications. The Digimarc MediaBridge system is based on our patented core technology. We believe that the
system creates new communications capabilities for media content that can promote and enhance e-commerce. The Digimarc MediaBridge system is a fundamentally new way to access and use the
Internet by embedding imperceptible digital code in printed materials, including, among other things, product packaging, stationery and envelopes, trading cards, magazine advertisements, articles,
covers and subscription cards, direct mailers, debit and credit cards, greeting cards, coupons, catalogs, tickets and business cards that can be read by digital devices enabled by our patented reader
technology. We believe that the same technology can be used to permit audio, video, images and other creative properties in digital form to interact with the digital world.

Licensing



Technology and Intellectual Property

Digimarc's watermarking technologies allow users to embed in audio, images, video, and printed documents a digital code that is imperceptible during normal use
but readable by computers and software. The science of creating these imperceptible codes is known as digital watermarking. We are a
leading owner of intellectual property relating to digital watermarks and a pioneer in the commercial application of this technology. Our technologies are supported by a broad patent portfolio
covering a wide range of methods and applications.

Our
core technology incorporates a method for embedding code within visual images in digital formats, such as computer files; in physical representations, such as print or film; and in
audio content. Our most widely deployed systems embed messages in images by making subtle changes to the brightness of the pixels, creating messages that can be detected and decoded by hardware or
software that has been enabled with our patented reader technology. Whether in images, video or audio, our

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embedding process generally adjusts to the unique characteristics of the content, placing a stronger watermark signal in areas with rich detail and a weaker watermark signal in areas with little
detail. Because the message is carried by the content itself, it is file-format independent. The message can survive most normal compression, edits, rotation, scaling,
re-sampling, file-format transformations, copying, scanning and printing.

To
protect our significant efforts in creating these technologies, we have implemented an extensive intellectual property protection program that relies upon a combination of patent,
copyright, trademark and trade secret laws, nondisclosure agreements and other contractual provisions. We have adopted an aggressive patent strategy. We believe that we have established one of the
world's most extensive patent portfolios in the field of digital watermarking, personal identification, and related technologies, holding rights to approximately 50 U.S. issued patents with over 300
U.S. patent applications on file as of December 31, 2001. We also believe, based on published patents, that we hold some of the earliest invention dates on issued patents in the field of
digital watermarking and that some of these early patents may be of significant value to our competitive position. DIDS has its own growing portfolio of issued and pending patents. We also own
registered trademarks in both the U.S. and other countries and have applied for other trademarks and have licensed rights to other technologies. We seek to protect new product applications through
both existing patents and filings for new patents.

Although
we devote significant resources to developing and protecting our technologies, and periodically evaluate potential competitors of our technologies for infringement of our
intellectual property rights, these infringements may nonetheless go undetected or may arise in the future. We expect that infringement claims may increase as companies become more concerned with
protecting their content from electronic copying. We cannot assure you that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar
technologies, duplicate our services or design around any patents or other intellectual property rights we hold.

Competition

The markets in which we compete are emerging, highly competitive, fragmented and characterized by rapidly changing technology and evolving standards. We face
competition in the overall digital watermarking market as well as in each of the market segments where our products and services
compete. We believe that the principal competitive factors in the markets for our products are functionality, interoperability with major hardware and software platforms, and the costs, time to
implementation and support services associated with the installation of new products and services. We have experienced and expect to continue to experience competition from enterprises in
high-technology industries that are developing watermarking capabilities of their own, many of whom have significantly greater financial, technical and marketing resources than we have.

Digimarc's
major competition comes from the internal development efforts at high-technology companies. Internal technology departments have staffed projects to build their
own watermarking systems utilizing a variety of tools. The competitive factors in this area require that we generate a product that conforms to the customer's technology standards, scales to meet the
needs of large enterprises, operates globally and costs less than the results of an internal development effort.

Most
competition in the secure documents market comes from traditional security features, such as holograms, security threads, special inks, and laminates which compete for the portion
of the production budget reserved for security features, and machine-readable features, such as Scrambled Indicia, radio frequency identification (RFID) tags, two dimensional barcodes, Glyphs from
Xerox, and data-carrying magnetic stripes. Competition in the personal identification systems business comes from both large and small systems integrators, such as Unisys and Viisage. As
the digital identification market receives more attention due to general security concerns in the United States and abroad, additional competitors may seek to enter the market.

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Our
Internet-based technology faces competition from companies that provide Internet portals, and search and directory services. For example, we compete with search engines, including
Google, Excite@Home, Inktomi and AltaVista, for the traffic generated by Internet users seeking links to third-party content to address their online information needs. We also compete with directory
services, such as Yahoo! and LookSmart, because they provide alternative ways for users to obtain the desired information.

Our
current and potential competitors, irrespective of the technology they use or intend to use, may have well-established relationships with current and potential customers
of ours, extensive knowledge of the markets targeted by us, better name recognition, and more extensive financial, development, sales and marketing resources than we have. Therefore, our competitors'
products may achieve greater market acceptance than those offered by us. The development and marketing of competing software may reduce the marketability of our products and therefore may harm our
business, operating results and financial condition.

Our
business is characterized by extensive research efforts and rapid technological change. To remain competitive, we will be required to expand and enhance the functionality of our
watermarking software and reader technologies. Company-sponsored research and development expenditures for 2001, 2000,
and 1999 were $6.8 million, $4.3 million, and $1.1 million, respectively. New developments are expected to continue, and we cannot assure you that discoveries by others, including
current and potential competitors and internal development efforts, will not render our services and products noncompetitive. Because of rapid technological change, we may be required to expend
greater amounts in the development of each new product than currently anticipated, which in turn will require greater revenue to recoup such expenditures.

Employees

As of December 31, 2001, we had 338 full-time employees, including 101 in sales, marketing, technical support and customer support; 123 in
research, development and engineering; 42 in finance, administration, information technology and legal; and 72 in field operations. On December 21, 2001, we added 186 employees who formerly
worked for LGP. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel, for whom competition is
intense. Our employees are not covered by any collective bargaining agreement, and we have never experienced a work stoppage. We believe that our relations with our employees are good.

Risks Related to Our Business

Uncertainties associated with the integration of Large Government Program Identification Business (a division of Polaroid Corporation)

The
acquisition of LGP involves a number of risks, including:



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The
process of integrating DIDS' operations, including its personnel, could cause interruption of, or loss in momentum in our current business and operating activities, and the business
and operating activities of the business acquired. In the course of the integration and transition effort, it is possible that we may discover facts or circumstances that were not known or apparent
prior to the date we executed the asset purchase agreement relating to the acquisition of LGP or during our due diligence review of LGP.

We may incur additional charges related to the integration

In connection with the acquisition, we may incur charges or capital expenditures associated with integrating the acquired business with our own. Such charges may
include:



The
aggregate amount of these expenses, if any, is not yet determinable, but could be significant. In addition, we cannot assure you that we will not incur additional charges in
subsequent quarters to reflect costs associated with this acquisition or the integration of DIDS' operations. Adverse developments associated with our integration efforts that could increase such
costs include unexpected employee turnover, unforeseen delays in addressing duplicate facilities and the associated costs of hiring temporary employees, delays in implementing new financial and
information systems, and delays in transitioning DIDS' away from depending on Polaroid for business support processes. Costs associated with this acquisition, or liabilities and expenses associated
with the operation of DIDS, that exceed our expectations, could materially affect our business, financial condition and results of operations.

We may not realize the synergistic, strategic, and financial benefits expected from the acquisition

We cannot assure you that we will realize the synergistic, strategic and financial benefits sought through this acquisition. Although we view this acquisition as
an opportunity to significantly enhance the security and usefulness of drivers' licenses and other LGP products, we cannot assure you that we will be successful in combining our current technological
applications and product offerings with that of DIDS or that such combined product offerings will be acceptable in the marketplace. Factors that could affect acceptance of such combined product
offerings are changes in government regulations and industry standards, and increased competition from DIDS' primary competitors who may develop superior or alternative technology that is more widely
acceptable in the marketplace.

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We have a history of losses and expect future losses; we cannot assure you that we will achieve profitability

We have incurred significant net losses since inception and we expect to incur a loss for the 2002 fiscal year in light of our planned operating expenditures. We
incurred net losses of $19.2 million in 2001. We have not been profitable and cannot assure you that we will realize sufficient revenue to achieve profitability. Our accumulated deficit as of
December 31, 2001 was approximately $47.4 million. In order to achieve profitability, we will need to generate significantly higher revenue than we have in prior years. Even if we
ultimately achieve profitability, we may not be able to sustain or increase our profitability. We anticipate that we will increase our research and development, sales and marketing, product
development and general and administrative expenses for the foreseeable future. If our revenue grows more slowly than we anticipate, or if our operating expenses exceed our expectations, our operating
results will be harmed and we may not be profitable.

Some of our revenue models are under development, and the corresponding anticipated products and services may fail to attract or retain customers

Our business involves embedding digital watermarks in traditional and digital media, including secure documents, images on the Internet and video merchandise. To
date, our revenue stream has been based primarily on a combination of development, consulting, subscription and license fees from copyright communication, from Secure Document applications and from
Media Commerce applications. In the future, we anticipate that an increasing share of our revenue will be from security related applications in the government and commercial market areas (including
identification systems), and sales of other applications of our digital watermarking technologies. We have not fully developed a revenue model for our future applications. In addition, because these
products are not yet fully established in the marketplace and because these products will be sold in new and undeveloped markets, we cannot be certain that the pricing structure and product marketing
that are developed and are currently developing for these products will be accepted. We cannot assure you that our anticipated products and services will be able to compete effectively against other
alternative technologies in our target markets or that we will be able to compete effectively against current or future digital watermark companies in terms of price, performance, applications or
other features of their technologies. In addition, as we develop models for generating revenue, they may not be sustainable over time, and as a result, our business, operating results and financial
condition may seriously be harmed.

Because we currently receive 56% of our revenue from a single customer, the loss of this customer or any large DIDS contract may seriously harm our business, operating results
and financial condition

We have derived a substantial portion of our revenue from a consortium of leading central banks with which we have a development and license agreement related to
banknote counterfeit deterrence. Revenue from products and services provided to this significant customer accounted for 56% of our total revenue in 2001 and 76% of our total revenue in 2000. With the
acquisition of LGP, revenue
generated from the consortium is expected to significantly decrease as a percentage of our total revenue; however, the loss of this consortium as a customer would harm our business, operating results
and financial condition. The consortium has a discretionary right of early termination with respect to the agreement. Unless the consortium exercises this right, we expect to earn revenue under the
agreement for at least the next two years, which concludes the current agreement with the consortium of banks. While we are optimistic that the agreement will be renewed for future periods, we cannot
guarantee that this will happen.

Under
the terms of our agreement with the consortium, we are obliged to keep the identity of the participating banks, design of the system and timetable for deployment confidential. Any
change in our relationship with the consortium, including any actual or alleged breach of the contract by either party or the early termination of, or any other material change in the agreement would
seriously harm our business, operating results and financial condition.

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The
contracts that were entered into with state government agencies by LGP generally have a three to five year term, after which such agency can open the contract for bidding. The loss
of any such large government contract may seriously harm our business, operating results and financial condition.

Our future growth will depend on the successful implementation of our product solutions by third-party partners

The Digimarc MediaBridge system, personal identification systems products and other applications and services that we intend to provide in the future will rely on
the successful implementation of our product solutions, including our reader technology, by third-party software developers and original equipment manufacturers. We anticipate maintaining and entering
into agreements with third-party vendors to create and promote products that incorporate, embed, integrate or bundle our technologies. If we fail to obtain partners that will incorporate, embed,
integrate or bundle our technologies, or these partners are unsuccessful in their efforts, our business, operating results and financial condition could be seriously harmed. In addition, if our
technologies do not perform according to market expectations, our business will be seriously harmed.

We have a limited operating history and are subject to the risks encountered by early-stage companies

We incorporated in January 1995. Accordingly, we have a limited operating history, and our business and prospects must be considered in light of the risks
and uncertainties to which early-stage companies
in new and rapidly evolving markets, such as digital watermarking, are exposed. These risks include the following:



We
cannot assure you that our business strategy will be successful or that we will successfully address these risks and the risks described below.

Our new revenue sources are tied largely to government procurements

Both our government programs business and personal identification systems business derive their revenue from government contract awards. Many of these contracts
are awarded based on a bid or request for proposal (RFP) process. As such, large components of new revenue are tied to procurement schedules, which could shift as the needs of the related government
procurement changes. Such a shift could result in bookings sliding out of the forecasted quarter, outside the company's control. In addition, these government contracts result from purchasing
decisions made by public sector agencies that are often subject to political influence, onerous procurement procedures, budget changes and award protests. Any change in purchasing decisions would have
an impact on the predictability of our quarterly results.

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Our future quarterly operating results may not meet analysts' expectations and may fluctuate significantly in the future, which could adversely affect our stock price

Our quarterly operating results have fluctuated significantly in the past, and we expect that our quarterly operating results will fluctuate significantly in the
future. Our operating results are difficult to forecast because of our limited operating history. Accordingly, you should not rely on quarter-to-quarter comparisons of our
historical results as an indication of future performance or any trend in our performance. If our quarterly operating results do not meet the expectations of analysts or investors, the market price of
our common stock will likely decline.

Our
quarterly results may fluctuate in the future as a result of many factors, some of which are outside our control, including:



In
addition, because the markets for our products and services are new and rapidly evolving, it is difficult for us to predict our future financial results. Our research and development,
sales and marketing efforts and business expenditures are based in part on our expectations regarding developments in counterfeiting and piracy, and our estimates as to the use of digital watermarking
as a solution to those problems. To the extent that these predictions prove inaccurate, our revenue and operating results will fluctuate from our anticipated results.

The markets for digital watermark applications are new and developing

Digital watermarking is a new and developing technology. Our success depends on the acceptance of this technology and the adoption of applications in areas such
as digital media commerce, counterfeiting and piracy deterrence and self-authentication of documents. The markets for products and services using digital watermarks are rapidly evolving
and are characterized by an increasing number of market entrants who have introduced or developed products and services using digital watermarking or alternative technologies. As is typical in a new
and rapidly evolving industry, demand and market acceptance of recently introduced products and services are subject to a high level of uncertainty. Our products and services are currently used by
only a limited number of customers. It is

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difficult to predict the future growth rate, if any, and ultimate size of these markets or our anticipated future markets. We cannot assure you that new markets for our products and services will
develop or that our existing markets will grow.

We may not be able to adequately protect our intellectual property, and we may be subject to infringement claims

Our success depends on our proprietary technologies. We rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures
and licensing arrangements to establish and protect our proprietary rights. We face risks associated with our patent position, including the potential need to engage in significant legal proceedings
to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our
patents and the possibility that our products may infringe patent rights of third parties. If we fail to protect our intellectual property rights and proprietary technologies adequately, if there are
changes in applicable laws that are adverse to our interests, or if we become involved in litigation relating to our intellectual property rights and proprietary technologies or relating to the
intellectual property rights of others, our business could be seriously harmed.

As
part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, consultants and corporate partners, and attempt to control
access to and distribution of our technologies, documentation and other proprietary information. Despite these procedures, third parties could copy or otherwise obtain and make unauthorized use of our
technologies or independently develop similar technologies. The steps that we have taken to prevent misappropriation of our solutions or technologies may not prevent their misappropriation,
particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States.

Effective
protection of intellectual property rights may be unavailable or limited, both in the United States and in foreign countries. Patent protection throughout the world is
generally established on a country-by-country basis. We have applied for patent protection both inside the United States and in various countries outside the United States.
However, we cannot assure you that pending patents will issue or that issued patents will be valid or enforceable. We cannot assure you that the protection of our proprietary rights will be adequate
or that our competitors will not independently develop similar technologies, duplicate our services or design around any patents or other intellectual property rights we hold.

We
are the exclusive licensee under some third party patents, and may need the assistance of these parties if we choose to enforce any of these patent rights. The cooperation of these
third parties cannot be assured. Although we do not currently rely on these technologies for our core products, we may in the future.

We
have registered "DIGIMARC" "MARCSPIDER" "MARCCENTRE" "PICTUREMARC" and the "D" logo as trademarks in the United States and other countries, and are pursuing registration of the
"DIGIMARC" trademark in additional countries. We also have trademark rights with respect to "MediaBridge" and are pursuing registration of this mark in the United States and other countries. However,
our tradenames or trademarks may be registered by third parties in other countries, impairing our ability to enter and compete in these markets. In the United States, the trademarks
"Digimark" and "Mediabridge" and the domain names "Digimark.com" and "Mediabridge.com" have been registered by unrelated companies. While we have successfully co-existed with these other
companies, we cannot assure you that this state of affairs will continue. If we were forced to change our name or were prevented from using our other brand names, including MediaBridge, we would lose
a significant amount of our brand equity, and our business would suffer.

13

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As
more companies enter the digital watermarking marketplace and develop intellectual property rights, it is increasingly likely that claims may arise which assert that some of our
products or services infringe upon other parties' intellectual property rights. These claims could subject us to costly litigation, divert management resources and result in the invalidation of our
intellectual property rights. These claims may require us to pay significant damages, cease production of infringing products, terminate our use of infringing technologies or develop
non-infringing technologies. In these circumstances, continued use of our technologies may require that we acquire licenses to the intellectual property that is the subject of the alleged
infringement, and we might not be able to obtain these licenses on commercially reasonable terms or at all. Our use of protected technologies may result in liability that threatens our continuing
operation.

The security systems that we use in our proprietary technologies may be circumvented by third parties, which could damage our reputation and disrupt our business

Our products and services involve the embedding of digital code in media content that is imperceptible in normal use but that can be read by digitally-enabled
devices. The success of our products and services depends on the security of our media commerce, anti-counterfeiting and piracy systems, self-authentication solutions, and
supporting infrastructure. Security breaches of these systems and solutions could damage our reputation and expose us to a risk of loss or litigation and possible liability. The security measures that
we use in our products and services may not prevent security breaches, and failure to prevent these security breaches may disrupt our business. A party who is able to circumvent our security measures
could misappropriate proprietary information or cause interruptions or otherwise damage our products, services and reputation and the properties of our customers. If unintended parties obtain
sensitive data and information, or create bugs or viruses in an attempt to sabotage the functionality of our products and services, we may receive negative publicity, incur liability to our customers
or lose the confidence of our customers, any of which may cause the termination or modification of our contracts.

We
may be required to expend significant capital and other resources to protect ourselves against the threat of security breaches or to alleviate problems caused by these breaches.
However, protection may not be available at a reasonable price or at all.

Our products could have unknown defects

Products as complex as those we offer or develop frequently contain undetected defects or errors. Despite testing, defects or errors may occur in existing or new
products, which could result in loss of revenue or market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance costs and
increased service and warranty costs, any of which could materially harm our business. Furthermore, we often provide implementation, customization, consulting and other technical services in
connection with the implementation and ongoing maintenance of our products. The performance of these products typically involves working with sophisticated software, computing and communications
systems. Our inability to meet customer expectations or project milestones in a timely manner could also result in a loss of, or delay in, revenue, loss of market share, failure to achieve market
acceptance, injury to our reputation and increased costs.

Because
customers rely on our products for critical security applications, defects or errors in our products might discourage customers from purchasing our products. These defects or
errors could also result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty disclaimers and liability limitation
clauses in our sales agreements, these contractual provisions are sometimes not included and may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance,
this insurance coverage may not adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our

14

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contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by insurance, our business could be materially harmed.

In
addition, when we acquired LGP, there were certain issues with several of the customer contracts relating to transitioning from film to digital based identification systems, late or
delayed implementation and continued customer testing of systems. To the extent that DIDS is unable to work through these issues and correct such defects in the systems within the contracted
timeframes, this could result in the loss of a customer and injury to our reputation in the marketplace.

We may encounter difficulties managing our planned growth and expansion that may harm our business

As of December 31, 2001 we had 338 employees. In October 2001 we implemented a reduction in workforce decreasing our then-current
headcount by approximately 20% due to redundant functions within certain departments. In December 2001 we added 186 employees who formerly worked for LGP. To manage our operations, management
must continue to improve our operational and financial systems and expand, train, retain and manage our employee base. Additional growth of our product lines or business could significantly strain our
managerial and financial resources. If we cannot manage our growth effectively, we may not be able to coordinate the activities of our technical, accounting and marketing staffs, and our business
could be harmed.

We may acquire other businesses or technologies; if we do, we may be unable to integrate them with our own business, or we may impair our financial performance

From time to time we have discussions with third parties about potential acquisitions. If appropriate opportunities present themselves, we may attempt to acquire
other businesses or technologies. We may not be able to identify, negotiate or finance any future acquisition successfully. The acquisition of LGP is our largest acquisition to date and as such, we
have limited experience in integrating an acquired business into our business. The process of integration may produce operating difficulties and expenditures and may require significant attention of
our management that otherwise would be available for the ongoing development of our business. Moreover, if we make acquisitions, we may issue shares of our stock that would dilute the equity holdings
of our existing stockholders, incur debt, assume contingent liabilities or create additional expenses related to amortizing goodwill and other intangible assets, any of which might negatively affect
our financial results and cause our stock price to decline. Any financing that we might need for future acquisitions may also place restrictions on our business. Furthermore, we may never achieve any
of the benefits that we might anticipate from a future acquisition.

We depend on our key employees for our future success

Our success depends to a significant extent on the performance and continued service of our senior management. Most of our senior management do not have an
employment agreement. Although our employees have executed agreements containing non-competition clauses, there is no assurance that a court would enforce all of the terms of these clauses
or the clauses generally. If these clauses were not fully enforced, our employees would be freely able to join our competitors. In addition, we currently have key person life insurance only on Bruce
Davis, our chief executive officer, and Geoffrey Rhoads, our chief technology officer. The loss of the services of any of our senior management or any of our other key employees could harm our
business.

If we are not able to hire, integrate or retain qualified personnel, our business may be harmed

Our ability to successfully develop, market and sell our applications and products depends to a significant degree upon the continued contributions of our key
personnel in engineering, sales, marketing and operations, many of whom would be difficult to replace. We believe our future success

15

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will also depend in large part upon our ability to retain our current key employees or our ability to attract, integrate and retain other highly skilled managerial, engineering, sales, marketing and
operations personnel in the future. In addition, because our business is based on our patented technology, which is unique and not generally known, new employees will require substantial training,
which will require substantial resources and management attention. Competition for experienced personnel in our market segments is intense. If we do not succeed in attracting new personnel or in
integrating, retaining and motivating our current personnel, our business could be harmed. In October 2001, we implemented a reduction of force decreasing our then-current headcount
by approximately 20% due to redundant functions within certain departments. We do not believe these reductions in workforce have had a material adverse affect on our operations. However, these
reductions in workforce may make it difficult for us to recruit necessary personnel in the future. In December 2001 we hired 186 people formerly employed by LGP. If we are unable to attract or
retain qualified personnel in the future, successfully integrate and retain the 186 former LGP employees, or if we experience delays in hiring required personnel, particularly qualified engineers and
sales personnel, our ability to develop, introduce and sell our products could be harmed.

Our promotion of the Digimarc brand must be successful in order for us to attract users as well as advertisers and other strategic partners

We believe that establishing and maintaining our brand is critical to our success and that the importance of brand recognition will increase due to the growing
number of technologies that compete with our watermarking technologies and the increasing number of competitors offering technologies similar to ours. We intend to increase our marketing and branding
expenditures in our effort to increase awareness of our brand. If our brand-building strategy is unsuccessful, these expenses may never be recovered, we may be unable to increase our future revenue
and our business could be seriously harmed.

Anti-takeover provisions in our charter documents could prevent or delay transactions that could be profitable for our stockholders from occurring

The anti-takeover provisions of Delaware law and our certificate of incorporation and bylaws may make a change of control of us more difficult, even
if a change of control would be beneficial to our stockholders. These provisions may allow our board of directors to prevent changes in management and control of us. Under Delaware law, our board may
adopt additional anti-takeover measures in the future.

We
have the following anti-takeover provisions in our charter documents:



These
provisions could have the effect of discouraging a third party from making a tender offer or otherwise attempting to gain control of us. In addition, these provisions could limit
the price that investors might be willing to pay in the future for shares of our common stock.

16

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Risks Related to Our Industry

If we are unable to respond to regulatory or industry standards effectively, our business could be harmed

Our future success will depend in part on our ability to enhance and improve the responsiveness, functionality and features of our products and services in
accordance with newly-imposed regulatory or industry standards. Our ability to remain competitive will depend in part on our ability to influence and respond to emerging industry standards, including
any standards that may be adopted for the protection of audio, video, and image content, and for other uses of metadata with such content, in a timely and cost-effective manner. If we are
unable to influence or respond to these standards effectively, our business could be harmed.

If we are unable to integrate new technologies effectively, our business could be harmed

Our target markets are characterized by new and evolving technologies. The success of our business will depend on our ability to address the increasingly
sophisticated technological needs of our customers in a timely and cost-effective manner. Our ability to remain competitive will depend in part on our ability to:



We
cannot assure you that we will be successful in responding to these technological and industry challenges in a timely and cost-effective manner. If we are unable to
integrate new technologies effectively or respond to these changing needs, our business could be harmed.

Our markets are highly competitive

The markets for digital watermarking applications are new, intensely competitive and rapidly evolving. We expect competition to continue from both existing
competitors and new market entrants. We face competition from other companies using digital watermarking technologies and from alternative technologies. As we expand the applications for our digital
watermarking technologies, we will experience more competition from products and services that are substitutes for our digital watermarking applications. Because our business models are new and
emerging, we may face competition from unexpected sources. Alternative technologies that may directly or indirectly compete with certain applications of our watermarking technologies include:



17

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In
addition, as we more broadly apply our technologies to the Internet through the Digimarc MediaBridge system and other new image commerce applications, we may begin to compete with a
wide range of other companies. Many of the companies that currently compete with us, as well as other companies with whom we may compete in the future, are national or international in scope and may
have greater resources than we do. These resources could enable these companies to initiate severe price cuts or take other measures in an effort to gain market share in our target markets. We cannot
assure you that digital watermarking technologies, and our products and services using these technologies, will gain widespread market acceptance.

We
cannot assure you that we will be able to compete successfully against current or future participants in our markets or against alternative technologies, nor can we assure you that
the competitive pressures we face will not harm our business, operating results and financial condition.

ITEM 2: PROPERTIES

Our principal administrative, sales, marketing, support, research, development and engineering facility is currently located in Tualatin, Oregon, with additional
space in Tulsa, Oklahoma for sales, marketing, and technical support operations. Our personal identification systems business is headquartered in Bedford, Massachusetts, with additional space in Fort
Wayne, Indiana for certain administrative and customer support functions. These leases contain the following approximate information:

Square Feet

ExpiresTualatin, Oregon

38,000

December 2004 and February 2005Tulsa, Oklahoma

12,000

January 2005Bedford, Massachusetts

71,000

September 2003Fort Wayne, Indiana

33,000

January 2005


We
also lease sales and support offices in multiple locations throughout the United States and internationally. We will likely require additional space before the end of 2002, but
believe that securing additional suitable space to accommodate our growth will not be difficult.

ITEM 3: LEGAL PROCEEDINGS

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the
United States District Court for the Southern District of New York naming Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's initial public offering as defendants.
The complaints have since been consolidated into a single action. The complaints allege, among other things, that the underwriters of our initial public offering violated the securities laws by
failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in our initial public offering registration statement. Similar
complaints have been filed against over 180 other issuers that have had initial public offerings since 1998. We intend to defend these actions vigorously. Although no assurance

18

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can be given that this matter will be resolved in our favor, we believe that the resolution of these lawsuits will not have a material adverse effect on our financial position, results of operations
or cash flows.

In
November 2001, Verance Corporation filed counterclaims against Digimarc alleging patent infringement, fraud, and monopolistic activities. We intend to vigorously defend
ourselves against these allegations. Although no assurance can be given that this matter will be resolved in our favor, we believe that the resolution of these allegations will not have a material
adverse effect on our financial position, results of operations or cash flows.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the Nasdaq National Market under the symbol "DMRC." Our initial public offering of stock was December 2, 1999 at $20.00 per
share. The following table lists the high and low sales prices of our Common Stock for the periods indicated, as reported by the Nasdaq National Market.

Year Ended December 31,2001

2000High

Low

High

LowFirst quarter

$
16.28

$
9.00

$
75.75

$
40.50Second quarter

$
26.03

$
11.50

$
48.63

$
21.00Third quarter

$
28.20

$
10.02

$
38.50

$
11.00Fourth quarter

$
21.10

$
10.51

$
19.44

$
11.75


At
December 31, 2001, there were approximately 150 stockholders of record of our common stock, as shown in the records of our transfer agent.

We
have never declared or paid cash dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future
earnings, if any, to finance the future growth of our business.

19

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ITEM 6: SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial
statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," which are included elsewhere in this report. The consolidated statement of operations data for
each of the five years in the period ended December 31, 2001, and the consolidated balance sheet data as of the years then ended are derived from our audited consolidated financial statements.

|                                           |                                           | Year Ended December 31,               |                         
|------------------------------------------ | ----------------------------------------- | ------------------------------------- | ------------------------
|
|
|Consolidated Statement of Operations Data: |                                           |                                       |                         
|                                           | Revenue                                   |                                       | $                       
|                                           | Cost of revenue                           |                                       |                         
|                                           |                                           |                                       |                         
|                                           |                                           | Gross margin                          |                         
|                                           | Operating expenses:                       |                                       |                         
|                                           |                                           | Sales and marketing                   |                         
|                                           |                                           | Research, development and engineering |                         
|                                           |                                           | General and administrative            |                         
|                                           |                                           | Restructure/Impairment charge         |                         
|                                           |                                           |                                       |                         
|                                           |                                           |                                       | Total operating expenses
|                                           |                                           |                                       |                         
|                                           |                                           |                                       | Operating loss          
|                                           | Other income (expense), net               |                                       |                         
|                                           |                                           |                                       |                         
|                                           |                                           |                                       | Net loss                
|                                           |                                           |                                       |                         
|                                           | Net loss per sharebasic and diluted      |                                       | $                       
|                                           |                                           |                                       |                         
|                                           | Weighted average sharesbasic and diluted |                                       |                         

|                                 |                                                    | December 31, |  
|-------------------------------- | -------------------------------------------------- | ------------ | -
|
|
|Consolidated Balance Sheet Data: |                                                    |              |  
|                                 | Cash, cash equivalents, and short-term investments |              | $
|                                 | Working capital                                    |              |  
|                                 | Total assets                                       |              |  
|                                 | Long-term obligations, net of current portion      |              |  
|                                 | Convertible redeemable preferred stock             |              |  
|                                 | Total stockholders' equity (deficit)               |              | $

20

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ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements
relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including those set forth under "Risks Related to Our Business" and "Risks Related to Our Industry" and elsewhere in this Annual Report on
Form 10-K. We assume no obligation to update this information. This discussion and analysis should be read in conjunction with our consolidated financial statements and related
notes included elsewhere herein.

Overview

Digimarc is a leading provider of digital watermarking technologies that allow imperceptible digital code to be embedded in the printed or digital versions of
media content, such as commercial and consumer photographs, movies, music, magazine advertisements, catalogs, product packages and valuable documents like identification cards, financial instruments,
passports and event tickets. In addition to a code that can be embedded within various types of media content, our technologies include reader software that, as a resident application on PCs and other
devices, enables the recognition of these embedded codes. We believe our technologies have many potential applications. We are developing products and services to address what we currently believe are
our three largest near-term market opportunities: the deterrence of digital counterfeiting and piracy; the enhancement of Internet access and navigation; and the enhancement and protection
of audio and video digital files.

On
December 21, 2001, we consummated, through our wholly-owned subsidiary, Digimarc ID Systems, LLC and certain of its wholly-owned subsidiaries, the purchase of certain assets
used primarily in the United States government identification systems business and foreign government digital identification systems business of Polaroid Corporation, Polaroid ID Systems, Inc.
and certain other affiliated entities of Polaroid Corporation (collectively known as Large Government Program Identification Business (a division of Polaroid Corporation), or "LGP"). As part of the
transaction, we also assumed certain liabilities of LGP. The acquisition was accounted for using the purchase method of accounting. Digimarc's consolidated financial statements include the results of
operations of LGP from the date of acquisition on December 21, 2001 through December 31, 2001. With this acquisition, we became a leading provider of identification card systems to
government agencies, which include drivers' licenses, voter identification cards and other similar programs.

We
intend to increase our revenue through increasing adoption of our products and services, marketing new digital watermarking applications, and licensing our intellectual property. We
expect to target, among other sources of revenue, government agencies, commercial printers, packaging companies, publishers, advertisers, proprietors of large image collections, and other producers of
printed materials. Our aim is to license our technologies to those content producers so that they may embed our digital watermarks in their print media, such as identification documents, magazine
advertisements and articles, direct mail coupons, catalogs, stationery and envelopes, product packaging, labels and tags, trading cards, credit cards, and business cards. Our current and anticipated
products are intended to enable content producers to control reproduction and alteration of their content, as well as to enable their print materials to provide a link to relevant Web destinations.
Revenue from our new applications may include one-time license fees, time-based or volume-based fees, subscription fees, royalties and revenue-sharing arrangements. We
anticipate that the calculation of fees and royalties will be based at least in part on the size of the installed base of personal computers, cameras, scanners, digital image capture and output
devices, and software carrying our patented reader technology as well as the nature of the use, and the nature and amount of licensed content carrying our digital watermarks.

21

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Since
inception, we have invested a significant portion of our resources and capital in attracting top senior management, in developing our products and technology and in building our
sales and marketing organizations. We have a limited operating history upon which investors may evaluate our business and prospects. We have incurred significant losses to date, and as of
December 31, 2001, we had an accumulated deficit of approximately $47.4 million. We intend to continue to expend significant financial and management resources on developing additional
products and services, improving sales and marketing activities, advancing our technologies and expanding our operations. As a result, we expect to continue to incur additional losses and negative
cash flow through most of, if not all of 2002 and possibly beyond. Our revenue may not increase or even continue at its current levels and we may not achieve or maintain profitability or generate cash
from operations in future periods. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stages of development,
particularly companies deploying new technologies and applications, such as our efforts to include digital watermarking in the personal identification systems business and develop our Digimarc
MediaBridge system as a new means of using the Internet.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements requires Digimarc to make estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories,
intangible assets, income taxes, restructuring, long-term service contracts, warranties, investments, and contingencies and litigation. We base our estimates on historical experience and
on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Certain
of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term service contracts,
impairments and estimation of useful lives of long-term assets, inventory valuation, and accruals for loss contracts and contingencies. We believe the following critical accounting
policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:



22

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In
addition, Note 1 to the Consolidated Financial Statements includes further discussion of our significant accounting policies.

Results of Operations

The following table presents our consolidated statement of operations data for the periods indicated as a percentage of total revenue.

|                            |                                        | Years Ended
December 31, |     
|--------------------------- | -------------------------------------- | ------------------------ | ----
|
|Revenue:                    |                                        |                          |     
|                            | Product and subscription               |                          | 12  
|                            | Service                                |                          | 88  
|                            |                                        |                          |     
|                            |                                        | Total revenue            |     
|Cost of revenue:            |                                        |                          |     
|                            | Product and subscription               |                          | 1   
|                            | Service                                |                          | 47  
|                            |                                        |                          |     
|                            |                                        | Total cost of revenue    |     
|                            | Gross margin                           |                          | 52  
|Operating expenses:         |                                        |                          |     
|                            | Sales and marketing                    |                          | 76  
|                            | Research, development, and engineering |                          | 46  
|                            | General and administrative             |                          | 92  
|                            | Restructuring charges                  |                          | 4   
|                            |                                        |                          |     
|                            |                                        | Total operating expenses |     
|                            |                                        |                          |     
|                            |                                        | Operating loss           |     
|Other income (expense), net |                                        | 37                       |     
|                            |                                        |                          |     
|                            | Net loss                               |                          | (129
|                            |                                        |                          |     

Years Ended December 31, 2001 and 2000

Revenue

Total revenue was $14.9 million and $11.9 million for the years ended December 31, 2001 and 2000, respectively. The $3.0 million or
26% increase was related to the addition of the personal identification systems business from the date of acquisition on December 21, 2001 through December 31, 2001, which increased
revenue by $1.7 million, along with increased service revenue of $0.8 million and licensing revenue of approximately $0.5 million. Revenue from identified international customers
was $2.5 million and $1.3 million for 2001 and 2000, respectively. The consortium of banks accounted for approximately 56% and 76% of our total revenue for the years ended
December 31, 2001 and 2000, respectively. Revenue from the consortium of banks is expected to decrease as percent of total revenue in the future due to the acquisition of LGP. This customer has
a discretionary right of early termination with respect to the agreement. Unless this customer exercises this right, we expect to earn revenue under the agreement for at least the next two years. We
intend to pursue further business

23

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with this customer and may be able to achieve other sources of revenue in future periods by providing additional products and services to them and other related institutions. We also expect to
develop new products and services, which we anticipate selling to customers through a variety of pricing plans, including license fees and license fees per document from issuers of valuable documents
other than banknotes and from magazine advertisers and publishers, commercial printers, and other producers of print and digital media. Successful introduction and implementation of these new products
and services, if achieved, would significantly change the mix and concentration of our future revenue.

Product and subscription.Product and subscription revenue was $1.8 million and $1.3 million for the years
ended December 31, 2001 and 2000, respectively. The $0.5 million or 38% increase was primarily related to an increase in licensing fees of $0.3 million and in recognized
subscription revenue of $0.2 million.

Service.Service revenue was $13.0 million and $10.5 million for the years ended December 31, 2001 and
2000, respectively. The $2.5 million or 24% increase was primarily the result of the addition of the personal identification systems business, which resulted in an increase of
$1.7 million in service revenue, and an increase in contract-based service revenues of $0.8 million.

Cost of Revenue

Product and subscription.Cost of product and subscription revenue primarily includes compensation for operations personnel,
costs of consumables sold to third parties, costs of machinery sold to third parties, Internet service provider connectivity charges and image search data fees to support the services offered to our
subscription customers. Cost of product and subscription revenue was $0.2 million and $0.1 million for the years ended December 31, 2001 and 2000, respectively.

Service.Cost of service revenue primarily includes compensation for software developers, quality assurance personnel,
product managers, field operations personnel, and business development personnel, outside contractors, costs of consumables used in delivering a service, depreciation charges for machinery used
specifically for service delivery, and travel costs directly attributable to service and development contracts. Cost of service revenue was $7.0 million and $6.5 million for the years
ended December 31, 2001 and 2000, respectively. The $0.5 million or 7% increase was primarily the result of adding the personal identification systems business in December 2001.
Field operations employees totaled 72 and zero at December 31, 2001 and 2000, respectively. All of the field operations employees at December 31, 2001 were the result of hiring personnel
formerly employed by LGP.

Operating Expenses

Sales and marketing.Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and
marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research and costs associated with marketing programs, such as trade shows, public relations and new
product launches. Sales and marketing expenses were $11.3 million and $10.9 million for the years ended December 31, 2001 and 2000, respectively. The $0.4 million or 4%
increase resulted from increased salaries and other employee related costs of approximately $0.7 million, increased administrative costs of approximately $0.4 million related to sales
and marketing activities, and an increase of approximately $0.2 million in sales and marketing costs due to the decreased use of sales and marketing personnel to provide services for our
revenue generating contracts that would have been included in cost of service revenue. These increases were offset by a decrease of approximately $0.6 million related to decreased promotional
costs and approximately $0.2 million related to decreased use of outside consulting services. Sales and marketing employees totaled 101 and 69 as of December 31, 2001 and 2000,
respectively. Of the total employees in sales and marketing at December 31, 2001, 42 were the result of hiring personnel formerly employed by LGP. We anticipate that we will continue to invest
significantly in sales and marketing for the foreseeable future.

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Research, development and engineering.Research, development and engineering expenses consist primarily of compensation,
benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $6.8 million and
$4.3 million for the years ended December 31, 2001 and 2000, respectively. The
$2.5 million or 58% increase resulted from increased salaries and other employee related costs of $0.8 million, increased costs related to outside consultants of approximately
$0.3 million, increased administrative costs of $0.8 million associated with research, development and engineering activities, and $0.5 million related to decreased use of
research, development and engineering personnel to provide services for our revenue generating contracts. Research, development and engineering personnel totaled 123 and 77 as of December 31,
2001 and 2000, respectively. Of the total employees in research, development and engineering at December 31, 2001, 58 were the result of hiring personnel formerly employed by LGP. We anticipate
that we will continue to invest significantly in product research, development and engineering for the foreseeable future.

General and administrative.General and administrative expenses consist primarily of compensation, benefits and related costs
of executive, finance and administrative personnel, facilities costs, legal and other professional fees and depreciation and amortization expense. General and administrative expenses were
$13.8 million and $11.8 million for the years ended December 31, 2001 and 2000, respectively. The $2.0 million or 17% increase resulted from increased costs of
$0.7 million related to salaries and other employee related costs, including travel expenses, increased professional fees of approximately $0.4 million, and increased administrative
costs of $0.8 million, including bad debt expense. General and administrative employees totaled 42 and 26 as of December 31, 2001 and 2000, respectively. Of the total employees in
general and administrative at December 31, 2001, 14 were the result of hiring personnel formerly employed by LGP. We anticipate that we will continue to invest significantly in general and
administrative costs for the foreseeable future.

Restructuring charges.Restructuring charges include employee severance costs associated with the October 2001
reduction of 34 personnel and abandoned space. Restructuring charges were $0.6 million and zero for the years ended December 31, 2001 and 2000, respectively. Excess leased facility cost
related to non-cancelable leases included in restructuring charges extend over the next 18 months. As of December 31, 2001, approximately $0.4 million of cash had been
paid related to restructuring charges.

Stock-based compensation.Stock-based compensation expense includes costs relating to stock-based employee compensation
arrangements. Stock-based compensation expense is based on the difference between the fair market value of our common stock and the exercise price of options to purchase that stock on the date of the
grant, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $2.0 million and $2.2 million was recorded for the
years ended December 31, 2001 and 2000, respectively, and is included in the respective statements of operations expense categories for the employees to which it applies. At December 31,
2001, $3.3 million of stock-based compensation remains deferred and we expect approximately $1.9 million for 2002 and $1.4 million for 2003 to be recognized as expense.

Other income (expense), net.Other income (expense), net consists primarily of interest received and paid. Other income
(expense) was $5.6 million and $5.9 million for the years ended December 31, 2001 and 2000, respectively. The $0.3 million or 5% decrease came as a result of lower interest
rates during the majority of fiscal 2001.

Provision for income taxes.We have recognized operating losses since inception and as such have not incurred income tax
expense. As of December 31, 2001, we had net operating loss carryforwards for federal and state income tax reporting purposes of approximately $55.1 million and research and
experimentation credits of approximately $1.3 million, which expire through 2021 if not utilized. Under the Tax Reform Act of 1986, the amounts of and benefits from net operating loss
carryforwards may be

25

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impaired or limited in certain circumstances, including a change of more than 50% in ownership. Such a change in ownership occurred with the sale of preferred stock in June 1996,
July 1996, and July 1999 and in connection with the initial public offering of our common stock in December 1999. Accordingly, we estimate that approximately $10.0 million
of net operating loss carryforwards are subject to the utilization limitation.

Years Ended December 31, 2000 and 1999

Revenue

Total revenue was $11.9 million and $6.9 million for the years ended December 31, 2000 and 1999, respectively. The $5.0 million or 71%
increase was primarily the result of increased service revenue that we earned through our relationship with a consortium of leading central banks and increased product and subscription revenue from
our Media Commerce business. One customer (the consortium of banks) accounted for approximately 76% and 89% of our total revenue for the years ended December 31, 2000 and 1999, respectively.

Product and subscription.Product and subscription revenue was $1.3 million and $0.2 million for the years
ended December 31, 2000 and 1999, respectively. The $1.1 million or 554% increase was the direct result of increased licensing and royalty fees from our Media Commerce business.

Service.Service revenue was $10.5 million and $6.7 million for the years ended December 31, 2000 and
1999, respectively. The increase of $3.8 million or 57% was primarily the result of an increase in the level of service provided to our anti-counterfeiting system customer (the
consortium of banks) along with increased consulting revenues from our Media Commerce business.

Cost of Revenue

Product and subscription.Cost of product and subscription revenue primarily includes compensation for operations personnel,
cost of outsourced customer support, Internet service provider connectivity charges and image search data fees to support our services. Cost of product and subscription revenue was $0.1 million
for the years ended December 31, 2000 and 1999.

Service.Cost of service revenue includes compensation for software developers, quality assurance personnel, product managers
and business development personnel, outside contractors and travel costs directly attributable to certain service and development contracts. Cost of service revenue was $6.5 million and
$3.5 million for the years ended December 31, 2000 and 1999, respectively. The $3.0 million or 85% increase was the result of increased services provided to our
anti-counterfeiting customer under the development contract.

Operating Expenses

Sales and marketing.Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and
marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research and costs associated with marketing programs, such as trade shows, public relations and new
product launches. Sales and marketing expenses were $10.9 million and $2.0 million for the years ended December 31, 2000 and 1999, respectively, representing an increase of
$8.9 million or 431%. This increase resulted from increased costs of $5.6 million related to salaries and other employee costs, including travel expenses; increased costs of
$3.6 million related to promotional activities, including advertising; and increased costs of $0.5 million related to stock-based compensation. These increases were offset in part by an
increased allocation of $1.2 million to cost of service revenue associated with sales and marketing personnel, who provided education, outreach and product definition services to our
anti-counterfeiting system customer. Sales and marketing employees totaled 69 and 27 as of December 31, 2000 and 1999, respectively.

26

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Research, development and engineering.Research, development and engineering expenses consist primarily of compensation,
benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $4.3 million and
$1.1 million for the years ended December 31, 2000 and 1999, respectively, representing an increase of $3.2 million or 305%. This increase resulted from increased costs of
$4.7 million related to salaries and other employee related costs, including travel expenses, and increased costs of $0.4 million related to stock-based compensation. These increases
were offset by increased use of research, development and engineering personnel to provide services to our anti-counterfeiting system customer, which resulted in an additional
$1.7 million of these expenses being allocated to cost of service revenue. Research, development and engineering personnel totaled 77 and 34 as of December 31, 2000 and 1999,
respectively.

General and administrative.General and administrative expenses consist primarily of compensation, benefits and related costs
of executive, finance and administrative personnel, facilities costs, legal and other professional fees and depreciation expense. General and administrative expenses were $11.8 million and
$3.0 million for the years ended December 31, 2000 and 1999, respectively, representing an increase of $8.8 million or 295%. This increase resulted from increased costs of
$1.7 million related to salaries and other employee related costs, including travel expenses; increased costs of $2.6 million related to administrative costs, including facilities,
office expenses, and depreciation; increased costs of $3.3 million related to professional fees, including litigation costs; and increased costs of $0.7 million related to stock-based
compensation. General and administrative employees totaled 26 and 15 as of December 31, 2000 and 1999, respectively.

Stock-based compensation.Stock-based compensation expense includes costs relating to stock-based employee compensation
arrangements. Stock-based compensation expense is based on the difference between the fair market value of our common stock and the exercise price of options to purchase that stock on the date of the
grant, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $2.2 million and $0.5 million was recorded for the
years ended December 31, 2000 and 1999, respectively, and is included in the respective statements of operations expense categories for the employees to which it applies.

Other income (expense), net.Other income (expense), net consists primarily of interest income, interest expense, and other
non-operating expenses. Other income (expense), net increased to income of $5.9 million in 2000 from income of $0.4 million in 1999, an increase of $5.5 million or
1,393%. The Company had increased interest income of $5.6 million from significantly higher cash, cash equivalents, and short-term investments balances, partially offset by a
$0.1 million increase in other non-operating expenses incurred by the Company.

Liquidity and Capital Resources

As of December 31, 2001, we had cash, cash equivalents and short-term investments of $61.6 million, representing a decrease of
$74.3 million from $135.9 million at December 31, 2000. Working capital at December 31, 2001 was $79.2 million, compared to working capital of $135.2 million
at December 31, 2000. The decrease in working capital is attributable primarily to cash used to purchase the assets of, and the assumption of certain liabilities of LGP and related expenses in
connection with the acquisition of LGP in the aggregate amount of $61.4 million and cash used in our operations.

Net
cash used in operating activities was $13.5 million in the year ended December 31, 2001. Net cash used in operating activities in the year ended December 31,
2001 was primarily attributed to the net loss for the year (less non-cash expenses) partially offset by increases in accounts payable. Net cash used in operating activities was
$12.1 million for the year ended December 31, 2000 and was primarily attributed to the net loss for the year (less non-cash expenses), an increase in prepaid assets, and a

27

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decrease in deferred revenue partially offset by increases in accounts payable and other accruals. Net cash used in operating activities was $1.1 million for the year ended December 31,
1999 and was primarily attributed to the net loss for the year (less non-cash expenses), an increase in accounts receivable, and an increase in prepaids and other assets, partially offset
by increases in accounts payable and deferred revenue.

Net
cash used in investing activities was $36.0 million in the year ended December 31, 2001. Net cash used in investing activities in the year ended December 31,
2001 was primarily attributed to payments made in the acquisition of LGP, purchases of short-term investments, and purchase of capital equipment offset by sales and maturities of
short-term investments. Net cash used in investing activities was $67.4 million for the year ended December 31, 2000 and was primarily attributed to purchases of
short-term investments and property and equipment. Net cash used in investing activities was $0.8 million for the year ended December 31, 1999 and was primarily attributed to
purchases of property, plant and equipment.

Net
cash provided by financing activities was $1.8 million in the year ended December 31, 2001. Net cash provided by financing activities in the year ended
December 31, 2001 was primarily attributed to net proceeds from the issuance of common stock related to employee stock purchases. Net cash provided by financing activities was
$61.2 million for the year ended December 31, 2000 and was primarily attributed to net proceeds from the issuance of common stock partially offset by the repayment of
short-term borrowings and principal payments under capital leases. Net cash provided by financing activities was $90.5 million for the year ended December 31, 1999 and was
primarily attributed to net proceeds from the issuance of common and preferred stock, partially offset by the repayment of short-term borrowings and principal payments under capital
leases.

On
October 20, 2000, we completed the sale of 1,089,983 shares of our common stock to Macrovision Corporation for proceeds of approximately $21.8 million. Additionally on
October 20, 2000, we completed the sale of 1,933,879 shares of our common stock to Koninklijke Philips Electronics N.V. for proceeds of approximately $38.7 million.

We
have computers and office equipment financed under long-term capital leases that expire over the next 32 months. As of December 31, 2001, we had an
outstanding balance of $0.6 million of capital lease obligations. Other significant commitments consist of obligations under non-cancelable operating leases, which totaled
$5.7 million as of December 31, 2001, and are payable in monthly installments through 2006.

On
June 22, 1999, we entered into a five-year operating lease agreement for office space. The lease required a letter of credit in lieu of a cash security deposit in
the amount of $0.4 million. The letter of credit dated August 1999 was secured by a certificate of deposit in the amount of $0.4 million. The letter of credit is to be released
over two years in increments if we meet certain milestones. At December 31, 2001, the remaining letter of credit balance and certificate of deposit balance was $0.2 million.

Our
planned operating expenses and capital expenditures may constitute a material use of our cash resources. In addition, we may utilize our cash resources to fund acquisitions or
investments in complementary businesses, technologies or product lines.

We
believe that our current cash, cash equivalent, and short-term investment balances will satisfy our projected working capital and capital expenditure requirements for at
least the next 12 months. Thereafter, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities. We may not be able to obtain additional financings or
credit facilities, or if these funds are available, they may not be available on satisfactory terms.

28

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Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141,Business
Combinations, and SFAS No. 142,Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase
method of accounting be used and establishes new standards on the recognition of certain identifiable intangible assets separate from goodwill for all business combinations initiated after
June 30, 2001. SFAS No. 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized but instead tested for impairment at least annually. SFAS
No. 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values.

We
adopted the provisions of SFAS No. 141 effective July 1, 2001 and will fully adopt SFAS No. 142 effective January 1, 2002. In accordance with the
transitional provisions of SFAS No. 142, goodwill that was acquired in purchase business combinations completed after June 30, 2001 is not amortized, but is evaluated for impairment in
accordance with the accounting literature in effect prior to the issuance of SFAS No. 142. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001
continue to be amortized through December 31, 2001.

Under
SFAS No. 142, we are required to perform transitional impairment tests for our goodwill and certain intangible assets as of the date of adoption. The transitional impairment
test for these intangible assets will be completed by March 31, 2002. Step one of the transitional goodwill impairment test, which compares the fair values of our reporting units to their
respective carrying values, will be completed by June 30, 2002. Transitional impairment losses for goodwill and these certain intangibles, if any, will be recognized as the cumulative effect of
a change in accounting principle in our consolidated statement of operations.

In
June 2001, the FASB issued SFAS No. 143,Accounting for Asset Retirement Obligations. SFAS No. 143 requires that
the fair value of the liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset
retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We are
currently evaluating the requirements and impact of this Standard, but its adoption is not expected to have a material impact on our results of operations and financial position.

In
August 2001, the FASB issued SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.
SFAS No. 144 establishes one accounting model to be used for long-lived assets to be disposed of by sale and broadens the presentation requirements of discontinued operations to
include more disposal transactions. SFAS No. 144 supersedes SFAS No. 121,Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of OperationsReporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, relative to discontinued operations. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. We are currently evaluating the
requirements of this Standard, but the impact of its adoption, if any, is not expected to have a material impact on our results of operations and financial position.

ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our
investment portfolio and on the increase or decrease in the amount of any interest expense we must pay with respect to outstanding debt instruments. The risk associated with fluctuating interest
expense is limited, however, to the exposure related to those debt instruments and credit facilities that are tied to market rates. We do not plan to use derivative financial instruments in our
investment portfolio. We plan to ensure the safety and

29

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preservation of its invested principal funds by limiting default risk, market risk and investment risk. We plan to mitigate default risk by investing in low-risk securities. At
December 31, 2001, we had an investment portfolio of money market funds, commercial securities and U.S. Government securities, including those classified as cash and cash equivalents and
short-term investments, of $61.0 million. The original maturities of our investment portfolio range from 7 to 350 days with an average interest rate of 2.65%. We had capital
lease obligations totaling $0.6 million at December 31, 2001. If market interest rates were to increase immediately and uniformly by 10% from levels as of December 31, 2001, the
decline of the fair market value of the fixed income portfolio and loans outstanding would not be material.

ITEM 8: CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The Consolidated Financial Statements and Related Notes of Digimarc Corporation and its subsidiaries as of December 31, 2001 and 2000 and for the three
year period ended December 31, 2001 and the independent accountants report thereon are set forth on pages F-1 to F-22 of this Annual Report on
Form 10-K.

ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

PART III

The information required by Part III is omitted from this Annual Report in that the Registrant will file a definitive proxy statement pursuant to
Regulation 14A (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information
included therein is incorporated by reference into Part III of this Annual Report.

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS COMPENSATION OF THE REGISTRANT

The information concerning Digimarc's directors required by this item is incorporated herein by reference to the information under the caption "Director
Compensation" to be contained in the Proxy Statement.

The
information concerning Digimarc's executive officers required by this item is incorporated herein by reference to the information under the caption "Executive Compensation" to be
contained in the Proxy Statement.

ITEM 11: EXECUTIVE COMPENSATION

The information required by this item is incorporated herein by reference to the information under the caption "Executive Compensation" to be contained in the
Proxy Statement.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item is incorporated herein by reference to the information under the caption "Security Ownership of Certain Beneficial Owners
and Management" to be contained in the Proxy Statement.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is incorporated herein by reference to the information under the caption "Certain Relationships and Related Transactions" to
be contained in the Proxy Statement.

30

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PART IV

ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)(1)    CONSOLIDATED
FINANCIAL STATEMENTS

The
Consolidated Financial Statements, together with the report thereon of KPMG LLP are set forth on pages F-1 to F-22 attached hereto and are incorporated herein
by reference.

| |                       |                                                                                                               
| | --------------------- | --------------------------------------------------------------------------------------------------------------
| | Digimarc Corporation: |                                                                                                               
| |                       | Independent Auditors' Report                                                                                  
| |                       | Consolidated Balance Sheets as of December 31, 2001 and 2000                                                  
| |                       | Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999                    
| |                       | Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2001, 2000 and 1999
| |                       | Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999                    
| |                       | Notes to Consolidated Financial Statements                                                                    

(a)(2)    Financial Statement Schedules

All
schedules have been omitted since they are not required or are not applicable or the required information is shown in the financial statements or related notes.

(a)(3)Exhibits

|Exhibit
Number |  | Document                                                                                                                                                                                                                                                                                                                                    
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1            |  | Asset Purchase Agreement among Polaroid Corporation, Polaroid ID Systems, Inc. and Digimarc Corporation (incorporated by reference to Exhibit 2.1 to Registrant's Report on Form 8-K, as filed with the Commission on January
3, 2002)                                                                                                      
|3.1            |  | Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Commission on November 14,
2001)                                                                                                          
|3.2            |  | Certificate of Amendment of Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the
Commission on November 14, 2001)                                                                              
|3.3            |  | Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Commission on November 14, 2001)                                                                                                                                                
|4.1            |  | Reference is made to Exhibits 3.1 and 3.2                                                                                                                                                                                                                                                                                                   
|4.2            |  | Second Amended and Restated Investor Rights Agreement, dated as of November 2, 1999, between the Registrant and the holders of the Registrant's preferred stock (incorporated by reference to Exhibit 4.2 to the
Registrant's Registration Statement on Form S-1 (Commission File No. 333-87501) which became effective on December 2, 1999)

31

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|10.1  |  | Form of Indemnification Agreement between the Registrant and each of its executive officers and directors (incorporated by reference to Exhibit 10.1 to the Registrant's Registration Statement on Form S-1
(Commission File No. 333-87501) which became effective on December 2, 1999)                                                                 
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.2  |  | Registrant's 1995 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 99.1 to the Registrant's Registration Statement on Form S-8 (Commission File No. 333-31114) which became effective on
February 25, 2000)                                                                                                                       
|10.3  |  | Registrant's Restated 1999 Stock Incentive Plan (incorporated by reference to Exhibit 99.2 to the Registrant's Registration Statement on Form S-8 (Commission File No. 333-42042) which became effective on
July 24, 2000)                                                                                                                              
|10.4  |  | Registrant's 1999 Employee Stock Purchase Plan, as amended, including forms of agreements thereunder (incorporated by reference to Exhibit 99.3 to the Registrant's Registration Statement on Form S-8 (Commission
File No. 333-31114) which became effective on February 25, 2000)                                                                     
|10.5  |  | Office Lease Agreement, dated as of April 16, 1998, between the Registrant and Property Reserve, Inc. (incorporated by reference to Exhibit 10.5 of Exhibits to Registrant's Registration Statement on Form S-1 (Commission
File No. 333-87501) which became effective on December 2, 1999)                                                             
|10.6  |  | Sublease, dated as of April 23, 1998, between the Registrant and Southern Pacific Funding Corporation (incorporated by reference to Exhibit 10.6 of Exhibits to Registrant's Registration Statement on Form S-1 (Commission
File No. 333-87501) which became effective on December 2, 1999)                                                             
|10.7  |  | Sublease, dated as of April 27, 1998, between the Registrant and Southern Pacific Funding Corporation (incorporated by reference to Exhibit 10.7 of Exhibits to Registrant's Registration Statement on Form S-1 (Commission
File No. 333-87501) which became effective on December 2, 1999)                                                             
|10.8  |  | Lease Agreement, dated as of June 25, 1999, between the Registrant and Southplace Associates LLC (incorporated by reference to Exhibit 10.8 of Exhibits to Registrant's Registration Statement on Form S-1 (Commission File
No. 333-87501) which became effective on December 2, 1999)                                                                  
|10.9 |  | Counterfeit Deterrence System Development and License Agreement, dated as of January 1, 1999 (incorporated by reference to Exhibit 10.9 of Exhibits to Registrant's Registration Statement on Form S-1 (Commission File No.
333-87501) which became effective on December 2, 1999)                                                                      
|10.10 |  | First Amendment to Lease Agreement, dated as of February 17, 2000, between the Registrant and Southplace Associates LLC (incorporated by reference to Exhibit 10.10 of Exhibits to Registrant's Registration Statement on
Form S-1 (Commission File No. 333-32778) which was filed with the Commission on March 17, 2000 and withdrawn on July 31, 2000)
|10.11 |  | CityPlex Towers Lease Agreement, dated as of January 4, 2000, between the Registrant and Oral Roberts University (incorporated by reference to Exhibit 10.11 of Exhibits to Registrant's Registration Statement on Form
S-1 (Commission File No. 333-32778) which was filed with the Commission on March 17, 2000 and withdrawn on July 31, 2000)       
|10.12 |  | Strategic Investment Agreement, dated as of September 17, 2000, between the Registrant and Macrovision Corporation (incorporated by reference to Exhibit 10.12 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as
filed with the Commission on November 14, 2001)                                                                            

32

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|10.13 |  | Strategic Investment Agreement, dated as of September 17, 2000, between the Registrant and Koninklijke Philips Electronics N.V. (incorporated by reference to Exhibit 10.13 of Exhibits to Registrant's Quarterly Report on
Form 10-Q, as filed with the Commission on November 14, 2001)
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.14 |  | Registrant's 2000 Non-Officer Employee Stock Incentive Plan (incorporated by reference to Exhibit 99.1 of Exhibits to the Registrant's Registration Statement on Form S-8 (Commission File No. 333-42042) which became
effective on July 24, 2000)                                       
|21.1  |  | List of Subsidiaries                                                                                                                                                                                                                                                                     
|23.1  |  | Consent of KPMG LLP, Independent Certified Public Accountants                                                                                                                                                                                                                            
|24.1  |  | Powers of Attorney (see signature page to this form)                                                                                                                                                                                                                                     

---



33

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this
Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on this 1st day of April, 2002.

Digimarc CorporationBy:

/s/E.K. RANJITE.K. Ranjit Chief Financial Officer (Duly Authorized Officer and
Principal Financial Officer)


POWER OF ATTORNEY

KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Bruce Davis and EK Ranjit and each of them,
jointly and severally, his attorneys-in-fact, each with full power of substitution, for him in any and all capacities, to sign any and all amendments to this
Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all
that each said attorneys-in-fact or his substitute or substitutes, may do or cause to be done by virtue hereof.

Pursuant
to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the Registrant and in
the capacities and on the dates indicated:

|Signature                                 |  | Title                                                                |  | Date         
|----------------------------------------- |  | -------------------------------------------------------------------- |  | -------------
|                                          |  |                                                                      |  |              
|/s/BRUCE DAVIS(Bruce Davis)               |  | Chief Executive Officer and Director (Principal Executive Officer)   |  | April 1, 2002
|/s/PAUL GIFFORD(Paul Gifford)             |  | President and Chief Operating Officer                                |  | April 1, 2002
|/s/ROBERT CHAMNESS(Robert Chamness)       |  | General Counsel and Secretary                                        |  | April 1, 2002
|/s/E.K. RANJIT(E.K. Ranjit)               |  | Chief Financial Officer (Principal Financial and Accounting Officer) |  | April 1, 2002
|/s/GEOFFREY RHOADS(Geoffrey Rhoads)       |  | Chief Technology Officer, and Director                               |  | April 1, 2002
|/s/PHILIP MONEGO, SR.(Philip Monego, Sr.) |  | Chairman of the Board of Directors                                   |  | April 1, 2002
|                                          |  |                                                                      |  |              

34

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|/s/BRIAN J. GROSSI(Brian J. Grossi)       |  | Director |  | April 1, 2002
|----------------------------------------- |  | -------- |  | -------------
|/s/JOHN TAYSOM(John Taysom)               |  | Director |  | April 1, 2002
|/s/PETER SMITH(Peter Smith)               |  | Director |  | April 1, 2002
|/s/WILLIAM A. KREPICK(William A. Krepick) |  | Director |  | April 1, 2002
|/s/ALTY VAN LUIJT(Alty van Luijt)         |  | Director |  | April 1, 2002

35

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DIGIMARC CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                          |  | Page
|--------------------------------------------------------- |  | ----
|Independent Auditor's Report                              |  | F-2 
|Consolidated Balance Sheets                               |  | F-3 
|Consolidated Statements of Operations                     |  | F-4 
|Consolidated Statements of Stockholders' Equity (Deficit) |  | F-5 
|Consolidated Statements of Cash Flows                     |  | F-6 
|Notes to Consolidated Financial Statements                |  | F-7 

F-1

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INDEPENDENT AUDITORS' REPORT

To
the Board of Directors and
Stockholders of Digimarc Corporation:

We
have audited the accompanying consolidated balance sheets of Digimarc Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of
operations, stockholders' equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We
conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Digimarc Corporation and subsidiaries as of
December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001 in conformity with
accounting principles generally accepted in the United States of America.

| |  | LOGO
| |  | ----

Portland, Oregon
February 11, 2002

F-2

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DIGIMARC CORPORATION  CONSOLIDATED BALANCE SHEETS  (In thousands, except share and per share data)

|                                                                                                                                                                                                 |                                           | 2001                                       |         | 2000   |        
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------------- | ------------------------------------------ | ------- | ------ | -------
|ASSETS                                                                                                                                                                                           |                                           |                                            |         |        |        
|Current assets:                                                                                                                                                                                  |                                           |                                            |         |        |        
|                                                                                                                                                                                                 | Cash and cash equivalents                 |                                            | $       | 24,724 |        
|                                                                                                                                                                                                 | Short-term investments                    |                                            |         | 36,881 |        
|                                                                                                                                                                                                 | Trade accounts receivable, net            |                                            |         | 9,838  |        
|                                                                                                                                                                                                 | Unbilled trade receivables                |                                            |         | 5,662  |        
|                                                                                                                                                                                                 | Inventory, net                            |                                            |         | 5,678  |        
|                                                                                                                                                                                                 | Prepaid expenses and other current assets |                                            |         | 2,280  |        
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total current assets                       |         |        | 85,063 
|Property and equipment, net                                                                                                                                                                      |                                           |                                            | 14,707  |        |        
|Intangibles, net                                                                                                                                                                                 |                                           |                                            | 29,438  |        |        
|Other assets, net                                                                                                                                                                                |                                           |                                            | 159     |        |        
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total assets                               |         | $      | 129,367
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                                             |                                           |                                            |         |        |        
|Current liabilities:                                                                                                                                                                             |                                           |                                            |         |        |        
|                                                                                                                                                                                                 | Accounts payable                          |                                            | $       | 3,404  |        
|                                                                                                                                                                                                 | Accrued payroll and related costs         |                                            |         | 1,165  |        
|                                                                                                                                                                                                 | Other short term liabilities              |                                            |         | 800    |        
|                                                                                                                                                                                                 | Deferred revenue                          |                                            |         | 491    |        
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total current liabilities                  |         |        | 5,860  
|Capital lease obligations, less current portion                                                                                                                                                  |                                           |                                            | 33      |        |        
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total liabilities                          |         |        | 5,893  
|Commitments and contingencies (Note 9)                                                                                                                                                           |                                           |                                            |         |        |        
|Stockholders' equity:                                                                                                                                                                            |                                           |                                            |         |        |        
|Preferred stock, 5,000,000 shares authorized at December 31, 2001 and 2000; no shares issued and outstanding at December 31, 2001 and 2000                                                       |                                           |                                            |        |        |        
|Common stock, $0.001 par value; 100,000,000 shares authorized at December 31, 2001 and 2000; issued and outstanding 17,020,818 and 16,295,435 shares at December 31, 2001 and 2000, respectively |                                           |                                            | 17      |        |        
|Additional paid-in capital                                                                                                                                                                       |                                           |                                            | 173,443 |        |        
|Deferred stock compensation                                                                                                                                                                      |                                           |                                            | (3,294  | )      |        
|Warrant                                                                                                                                                                                          |                                           |                                            | 675     |        |        
|Accumulated deficit                                                                                                                                                                              |                                           |                                            | (47,367 | )      |        
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total stockholders' equity                 |         |        | 123,474
|                                                                                                                                                                                                 |                                           |                                            |         |        |        
|                                                                                                                                                                                                 |                                           | Total liabilities and stockholders' equity |         | $      | 129,367
|                                                                                                                                                                                                 |                                           |                                            |         |        |        

See
accompanying notes to consolidated financial statements.

F-3

---



DIGIMARC CORPORATION  CONSOLIDATED STATEMENTS OF OPERATIONS  (in thousands, except share and per share data)

|                                          |                                       | Years Ended December 31,               |           
|----------------------------------------- | ------------------------------------- | -------------------------------------- | ----------
|
|Revenue:                                  |                                       |                                        |           
|                                          | Product and subscription              |                                        | $         
|                                          | Service                               |                                        |           
|                                          |                                       |                                        |           
|                                          |                                       | Total revenue                          |           
|Cost of revenue:                          |                                       |                                        |           
|                                          | Product and subscription              |                                        |           
|                                          | Service                               |                                        |           
|                                          |                                       |                                        |           
|                                          |                                       | Total cost of revenue                  |           
|                                          |                                       |                                        |           
|                                          |                                       | Gross margin                           |           
|Operating expenses:                       |                                       |                                        |           
|                                          | Sales and marketing                   |                                        |           
|                                          | Research, development and engineering |                                        |           
|                                          | General and administrative            |                                        |           
|                                          | Restructuring charges                 |                                        |           
|                                          |                                       |                                        |           
|                                          |                                       | Total operating expenses               |           
|                                          |                                       |                                        |           
|                                          |                                       | Operating loss                         |           
|Other income (expense):                   |                                       |                                        |           
|                                          | Interest income                       |                                        |           
|                                          | Interest expense                      |                                        |           
|                                          | Other                                 |                                        |           
|                                          |                                       |                                        |           
|                                          |                                       | Loss before provision for income taxes |           
|Provision for income taxes                |                                       |                                        |          
|                                          |                                       |                                        |           
|                                          |                                       | Net loss                               |           
|                                          |                                       |                                        |           
|Net loss per sharebasic and diluted      |                                       | $                                      | (1.15     
|                                          |                                       |                                        |           
|Weighted average sharesbasic and diluted |                                       |                                        | 16,704,149

See
accompanying notes to consolidated financial statements.

F-4

---



DIGIMARC CORPORATION  CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)  (In thousands, except share and per share data)

|                                                                           |  | Convertible
preferred stock |   | Preferred
stock |   |  |   |  |   |   |  |            |  |   |    |  |   |         |  
|-------------------------------------------------------------------------- |  | --------------------------- | - | --------------- | - |  | - |  | - | - |  | ---------- |  | - | -- |  | - | ------- | -
|
|
|
|BALANCE AT DECEMBER 31, 1998                                               |  | 162,500                     |   | $               |  |  |  |  | $ |  |  | 2,313,623  |  | $ | 2  |  | $ | 878     |  
|Issuance of common stock through conversion of redeemable preferred stock  |  |                            |   |                 |  |  |  |  |   |  |  | 5,259,775  |  |   | 6  |  |   | 17,261  |  
|Issuance of common stock through initial public offering, net              |  |                            |   |                 |  |  |  |  |   |  |  | 4,600,000  |  |   | 5  |  |   | 83,796  |  
|Issuance of common stock through conversion of convertible preferred stock |  | (162,500                    | ) |                 |  |  |  |  |   |  |  | 325,000    |  |   |   |  |   |        |  
|Warrant issued                                                             |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|Exercise of stock options                                                  |  |                            |   |                 |  |  |  |  |   |  |  | 116,747    |  |   |   |  |   | 51      |  
|Deferred compensation related to stock options                             |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   | 8,689   |  
|Stock-based compensation expense                                           |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|Net loss                                                                   |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|                                                                           |  |                             |   |                 |   |  |   |  |   |   |  |            |  |   |    |  |   |         |  
|BALANCE AT DECEMBER 31, 1999                                               |  |                            |   |                 |  |  |  |  |   |  |  | 12,615,145 |  |   | 13 |  |   | 110,675 |  
|Issuance of common stock through private placement, net                    |  |                            |   |                 |  |  |  |  |   |  |  | 3,023,862  |  |   | 3  |  |   | 60,233  |  
|Exercise of stock options                                                  |  |                            |   |                 |  |  |  |  |   |  |  | 595,721    |  |   |   |  |   | 429     |  
|Purchase of employee stock purchase plan shares                            |  |                            |   |                 |  |  |  |  |   |  |  | 60,707     |  |   |   |  |   | 939     |  
|Stock-based compensation expense                                           |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|Net loss                                                                   |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|                                                                           |  |                             |   |                 |   |  |   |  |   |   |  |            |  |   |    |  |   |         |  
|BALANCE AT DECEMBER 31, 2000                                               |  |                            |   |                 |  |  |  |  |   |  |  | 16,295,435 |  |   | 16 |  |   | 172,276 |  
|Purchase of employee stock purchase plan shares                            |  |                            |   |                 |  |  |  |  |   |  |  | 65,302     |  |   |   |  |   | 918     |  
|Exercise of stock options                                                  |  |                            |   |                 |  |  |  |  |   |  |  | 660,081    |  |   | 1  |  |   | 969     |  
|Options issued to non-employees                                            |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   |        |  
|Stock-based compensation expense                                           |  |                            |   |                 |  |  |  |  |   |  |  |           |  |   |   |  |   | (720    | )
|Net loss                                                                   |  |                            |   |                 |  |  |  |  |   |  |  |            |  |   |   |  |   |        |  
|                                                                           |  |                             |   |                 |   |  |   |  |   |   |  |            |  |   |    |  |   |         |  
|BALANCE AT DECEMBER 31, 2001                                               |  |                            |   | $               |  |  |  |  | $ |  |  | 17,020,818 |  | $ | 17 |  | $ | 173,443 |  
|                                                                           |  |                             |   |                 |   |  |   |  |   |   |  |            |  |   |    |  |   |         |  

See accompanying notes to consolidated financial statements.

F-5

---



DIGIMARC CORPORATION  CONSOLIDATED STATEMENTS OF CASH FLOWS  (in thousands, except share and per share data)

|                                          |                                                                             | Years Ended December 31,                                        |                                          
|----------------------------------------- | --------------------------------------------------------------------------- | --------------------------------------------------------------- | -----------------------------------------
|
|Cash flows from operating activities:     |                                                                             |                                                                 |                                          
|                                          | Net loss                                                                    |                                                                 | $                                        
|                                          | Adjustments to reconcile net loss to net cash used in operating activities: |                                                                 |                                          
|                                          |                                                                             | Depreciation and amortization                                   |                                          
|                                          |                                                                             | Amortization of discount on note payable                        |                                          
|                                          |                                                                             | Stock-based compensation expense                                |                                          
|                                          |                                                                             | Other non-cash expenses                                         |                                          
|                                          |                                                                             | Changes in assets and liabilities, net of acquisition:          |                                          
|                                          |                                                                             |                                                                 | Trade accounts receivable                
|                                          |                                                                             |                                                                 | Inventory                                
|                                          |                                                                             |                                                                 | Prepaid expenses and other current assets
|                                          |                                                                             |                                                                 | Accounts payable                         
|                                          |                                                                             |                                                                 | Accrued payroll and related costs        
|                                          |                                                                             |                                                                 | Other short term liabilities             
|                                          |                                                                             |                                                                 | Deferred revenue                         
|                                          |                                                                             |                                                                 |                                          
|Net cash used in operating activities     |                                                                             |                                                                 | (13,546                                  
|                                          | Cash flows from investing activities:                                       |                                                                 |                                          
|                                          |                                                                             | Purchase of property and equipment                              |                                          
|                                          |                                                                             | Purchases of technology                                         |                                          
|                                          |                                                                             | Purchase of tradename                                           |                                          
|                                          |                                                                             | Sale of tradename                                               |                                          
|                                          |                                                                             | Sales and maturities of short-term investments                  |                                          
|                                          |                                                                             | Purchase of short-term investments                              |                                          
|                                          |                                                                             | Payments related to business acquisition                        |                                          
|                                          |                                                                             |                                                                 |                                          
|Net cash used in investing activities     |                                                                             |                                                                 | (35,953                                  
|                                          | Cash flows from financing activities:                                       |                                                                 |                                          
|                                          |                                                                             | Repayment of short-term borrowings                              |                                          
|                                          |                                                                             | Net proceeds from issuance of preferred stock                   |                                          
|                                          |                                                                             | Net proceeds from issuance of common stock                      |                                          
|                                          |                                                                             | Principal payments under capital lease obligations              |                                          
|                                          |                                                                             |                                                                 |                                          
|Net cash provided by financing activities |                                                                             |                                                                 | 1,769                                    
|                                          |                                                                             |                                                                 |                                          
|                                          | Net increase (decrease) in cash and cash equivalents                        |                                                                 |                                          
|                                          | Cash and cash equivalents at beginning of period                            |                                                                 |                                          
|                                          |                                                                             |                                                                 |                                          
|                                          | Cash and cash equivalents at end of period                                  |                                                                 | $                                        
|                                          |                                                                             |                                                                 |                                          
|                                          | Supplemental disclosure of cash flow information:                           |                                                                 |                                          
|                                          |                                                                             | Cash paid for interest                                          |                                          
|                                          | Summary of non-cash investing and financing activities:                     |                                                                 |                                          
|                                          |                                                                             | Equipment acquired or exchanged under capital lease obligations |                                          

See accompanying notes to consolidated financial statements.

F-6

---



DIGIMARC CORPORATION  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (In thousands, except share and per share data)

(1)  Description of Business and Summary of Significant Accounting Policies

Description of Business

Digimarc Corporation ("Digimarc" or the "Company") is a leading provider of patented digital watermarking technologies that allow imperceptible digital code to be
embedded in the printed or digital versions of media content, such as commercial and consumer photographs, movies, music, magazine advertisements, catalogs, product packages and valuable documents
like identification cards, financial instruments, passports and event tickets. In addition to a code that can be embedded within various types of media content, our technologies include reader
software that, as a resident application on personal computers and other devices, enables the recognition of embedded codes. Digimarc is also a leading provider of identification card systems to
government agencies, which include driver's licenses, voter identification cards and other similar programs.

On
December 21, 2001, the Company consummated, through its wholly-owned subsidiary, Digimarc ID Systems, LLC and certain of its wholly-owned subsidiaries, the purchase of certain
assets used primarily in the United States government identification systems business and foreign government digital identification systems business of Polaroid Corporation, Polaroid ID
Systems, Inc. and certain other affiliated entities of Polaroid Corporation (collectively known as Large Government Program Identification Business (a division of Polaroid Corporation), or
"LGP"). As part of the transaction, we also assumed certain liabilities of LGP. The acquisition was accounted for using the purchase method of accounting. Digimarc's consolidated financial statements
include the results of operations from the date of acquisition on December 21, 2001 through December 31, 2001.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements requires Digimarc to make estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Digimarc evaluates its estimates, including those related to bad debts,
inventories, intangible assets, income taxes, restructuring, long-term service contracts, warranties, investments, and contingencies and litigation. Digimarc bases its estimates on
historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Certain
of the Company's accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term service
contracts, impairments and estimation of useful lives of long-term assets, inventory valuation, and accruals for loss contracts and contingencies. Digimarc believes the following critical
accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:



F-7

---



Reclassifications

Certain prior year amounts in the accompanying consolidated financial statements and notes thereon have been reclassified to conform to current year presentation.
These reclassifications had no effect on the results of operations or financial position for any year presented.

Principles of Consolidation

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

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of 90 days or less at the date of acquisition to be cash equivalents. Cash
equivalents include money market funds, certificates of deposit, commercial paper, and investments in government bonds totaling $24,088 and $72,084 at December 31, 2001 and 2000, respectively.
Cash equivalents are carried at amortized cost, which approximates market.

Investments

The Company considers all investments with original maturities over 90 days but less than one year to be short-term investments.
Short-term investments include federal agency notes, company notes, and commercial paper totaling $36,881 and $63,418 at December 31, 2001 and 2000, respectively. The Company's
marketable securities are classified as held-to-maturity as of the balance sheet date and are reported at amortized cost, which approximates market.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, short-term investments, trade accounts receivable, accounts payable and accrued payroll approximate
fair value due to the short-term nature of these instruments. The carrying amounts of capital leases approximate fair value as the stated interest rates reflect current market rates. Fair
value estimates are made at a specific point in time, based on relevant market information about the financial instrument when available. These estimates are subjective in
nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

F-8

---

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and investments and trade receivables. The
Company places its cash and cash equivalents with major banks and financial institutions. The Company's investment policy limits its credit exposure to any one financial institution or type of
financial instrument. As a result, the credit risk associated with cash and investments is minimal. At December 31, 2001, the Company had no customers with greater than 10% of trade accounts
receivable. The Company had accounts receivable from one customer representing approximately 63% of trade accounts receivable at December 31, 2000.

Accounts Receivable

Trade accounts receivable are shown net of allowance for doubtful accounts. The amount of the allowance and the charges were as follows:

December 31,2001

2000

1999Balancebeginning of period

$


$
3

$
2Provision (recovery)


892


2


5Charge offs


(14
)

(5
)

(4
)Balanceend of period

$
878

$


$
3


Inventories

Inventories are valued on a first-in, first-out (FIFO) basis at the lower of cost or market value (net realizable value).

Property and Equipment

Property and equipment are stated at cost. Property and equipment under capital lease obligations are stated at the lower of the present value of minimum lease
payments at the beginning of the lease term or fair value of the leased assets at the inception of the lease. Repairs and maintenance are charged to expense when incurred.

Depreciation
on property and equipment is calculated by the straight-line method over the estimated useful lives of the assets, generally two to five years. Property and
equipment held under capital leases are amortized by the straight-line method over the shorter of the lease term or the estimated useful life. Amortization of property and equipment under
capital lease is included in depreciation expense. Assets specifically used to provide services under long-term contracts are depreciated over the shorter of the contract term or estimated
useful life.

Pre-contract Costs

Costs related to pre-contract activity are expensed as incurred in accordance with the American Institute of Certified Public Accountants Statement of
Position No. 98-5 (SOP 98-5),Reporting on the Costs of Start-Up Activities.

Software Development Costs

Under Statement of Financial Accounting Standards (SFAS) No. 86,Accounting for the Cost of Computer Software to Be Sold, Leased,
or Otherwise Marketed,software development costs are to be capitalized beginning when a product's technological feasibility has been established and ending when a product is
made available for general release to customers. To date, the establishment of technological

F-9

---

feasibility of the Company's products has occurred shortly before general release and, therefore, software development costs qualifying for capitalization have been immaterial. Accordingly, the
Company has not capitalized any software development costs and has charged all such costs to research and development expense.

Internal
use software development costs are accounted for in accordance with AICPA Statement of Position (SOP) 98-1,Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use. Costs incurred in the preliminary project stage are expensed as incurred and costs incurred in the application
development stage, which meet the capitalization criteria, are capitalized and amortized on a straight-line basis over the estimated useful life of the asset.

Intangible Assets

Intangible assets relate to the value of customer relationships acquired when the Company purchased the assets of LGP and other technology and intellectual
property rights purchased during the year for $145. Customer relationships are being amortized over an estimated useful life of 12 years and the other technology and intellectual property
rights are being amortized over an estimated useful life of 5 years. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount
of an asset may not be recoverable.

Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of

The Company accounts for long-lived assets in accordance with the provisions of SFAS No. 121,Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.This statement requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be
held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired,
the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the
carrying amount or fair value less costs to sell.

Contingencies and Factors that Could Affect Future Results

A portion of the Company's revenue each year is generated from licensing of technology. In the competitive environment in which the Company operates, such product
generation, development and marketing processes are uncertain and complex, requiring accurate prediction of demand as well as
successful management of various development risks inherent in technology development. In light of these dependencies, it is possible that failure to successfully manage future changes in technology
with respect to the Company's technology could have a long-term impact on the Company's growth and results of operations.

Revenue Recognition

The Company generates revenue from the licensing of digital watermarking products and services for use in authenticating documents, detecting fraudulent documents
and deterring unauthorized duplication or alteration of high-value documents, for use in communicating copyright, asset management and business-to-business image
commerce solutions, and for use in connecting analog media to a digital environment.

Software
revenue is recognized when earned in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, as amended by SOP
98-9,Modification of SOP 97-2,With Respect to Certain Transactions.

F-10

---

Revenue
for licenses of the Company's software products is recognized upon the Company meeting the following criteria, in accordance with SOP 97-2: persuasive evidence of an
arrangement exists; delivery has occurred; the vendor's fee is fixed or determinable; and, collectibility is probable.

SOP
98-9 requires that revenue is recognized under certain circumstances using the "residual method." Under the residual method, revenue is recognized as follows:
(1) the total fair value of undelivered elements, as indicated by vendor specific objective evidence (VSOE), is deferred and subsequently recognized in accordance with the relevant sections of
SOP 97-2, and (2) the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements.

The
Company recognizes revenue on identification card production contracts on a per-card fee basis. Revenue earned in excess of billings is classified as unbilled trade
receivables in the balance sheets. Billing for long-term contracts generally occurs within one to three months following card production. Revenue for consumables and equipment sales is
recognized when the products have been shipped and ownership has been transferred. At the time of revenue recognition, the sales price to the customer has been fixed or is determinable, and
collectibility of the sales price is reasonably assured.

Revenue
for subscriptions is paid in advance and is recognized ratably over the term of the subscription. Revenue for contracted professional services is recognized as the services are
performed. The Company recognizes revenue on service contracts on a method that approximates the percentage of completion basis using budgeted amounts established with the customer at the inception of
the contract. Progress towards completion is measured using allowable costs incurred as compared to the budgeted amounts contained in the basic contract. Losses on contracts, if any, are provided for
in the period in which the loss becomes determinable. The contract is considered complete upon completion of the deliverables specified in the contract. Deferred revenue consists of payments received
in advance for consulting services and subscriptions to the Company's Internet service for service and support not yet performed.

Research and Development

Research and development costs are expensed as incurred. The Company accounts for amounts received under its funded research and development arrangements in
accordance with the provisions of SFAS No. 68,Research and Development Arrangements. Under the terms of the arrangements, the Company is not
obligated to repay any of the amounts provided by the funding parties. As a result, the Company recognizes revenue as the services are performed.

Revenues
recognized under vendor and end-user funding arrangements totaled $250, $50, and $6 for the years ended December 31, 2001, 2000, and 1999, respectively.
Direct costs allocated to the arrangement were $250, $43, and $3 for the years ended December 31, 2001, 2000 and 1999, respectively.

Advertising Costs

Advertising costs are expensed as incurred. Total advertising expenses were $82, $1,464 and $86 for the years ended December 31, 2001, 2000 and 1999,
respectively.

Stock-Based Compensation

The Company adopted SFAS No. 123,Accounting for Stock-Based Compensation, which permits entities to
recognize stock-based compensation expense over the vesting period based on the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees,under which no
compensation expense for stock options is recognized for

F-11

---

stock awards granted at or above fair market value and to provide pro forma net income and pro forma earnings per share disclosures as if the fair-value-based method defined in SFAS
No. 123 had been
applied. The Company has elected to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.

The
Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or Services.

Income Taxes

The Company accounts for income taxes under the asset and liability method. Under the asset and liability method, deferred income taxes reflect the future tax
consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. 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 recovered 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. Valuation allowances are established when necessary to reduce tax assets to the amount expected to be
realized.

Net Loss Per Share

Net loss per share is calculated in accordance with SFAS No. 128,Earnings per Share,which provides that
basic and diluted net loss per share for all periods presented are to be computed using the weighted average number of common shares outstanding during each period, with diluted net income per share
including the effect of potentially dilutive common shares.

Common
stock equivalents related to stock options and warrants of 1,283,342, 2,604,382, and 1,615,944 are antidilutive in a net loss year and, therefore, are not included in 2001, 2000
and 1999 diluted net loss per share, respectively.

(2)  Acquisitions

Large Government Program Identification Business (a division of Polaroid Corporation)

On December 21, 2001, the Company consummated, through its wholly-owned subsidiary, Digimarc ID Systems, LLC and certain of its wholly-owned subsidiaries,
the purchase of certain assets used primarily in the United States government identification systems business and foreign government digital identification systems business of Polaroid Corporation,
Polaroid ID Systems, Inc. and certain other affiliated entities of Polaroid Corporation (collectively known as Large Government Program Identification Business (a division of Polaroid
Corporation), or "LGP"). As part of the transaction, certain liabilities of LGP were assumed.

The
acquisition of LGP assets was accounted for using the purchase method of accounting with the purchase price allocated to assets acquired and liabilities assumed based on their fair
values. The purchase price consisted of $56,500 in cash paid to Polaroid Corporation at the auction, $1,650 provided to Polaroid Corporation for interim business funding, $198 in assumed cure amounts,
$581 in assumed capital leases, and $2,437 in professional fees. Cure amounts represent prepetition claims on LGP by third parties. Professional fees include banking fees, legal fees, accounting fees,
and fees for other related professional services.

F-12

---

The
purchase price was allocated to the following assets and liabilities:

Assets acquired:Trade accounts receivable, net

$
13,521Inventory, net


6,040Other current assets


439Long-lived assets


42,145Liabilities assumed:Cure costs


(198
)Capital lease obligations


(581
)$
61,366


Among
the assets acquired were all personal property, equipment, trade fixtures, supplies and other tangible property, customer contracts and intellectual property owned by or licensed
to Polaroid Corporation, Polaroid ID Systems, Inc. and certain affiliates of Polaroid Corporation and used primarily in the businesses that was acquired. The Company also acquired all of the
inventories used in connection with the businesses, including all raw materials, components, work in process and unfinished and finished goods inventories. The excess of fair value of the net assets
acquired over the purchase price has been allocated as a pro rata reduction of the amounts that otherwise would have been assigned to long-lived assets. These assets were used in
connection with LGP and the Company intends to continue to use these assets for such purposes.

Pro Forma Financial Information

The following unaudited pro forma financial information combines the results of operations of the Company and LGP assuming the acquisition was consummated at the
beginning of the periods presented. The unaudited pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented. In
addition, they are not intended to be a projection and do not reflect any synergies that might be achieved from combined operations.

(unaudited)
Years Ended
December 31,2001

2000Revenue

$
85,566

$
82,405Net loss


(15,309
)

(11,137
)Net loss per sharebasic and diluted

$
(0.92
)
$
(0.82
)


(3)  Property and Equipment

December 31,2001

2000Office furniture and equipment

$
8,165

$
4,853Production equipment


10,234


Leasehold improvements


687


59119,086


5,444Less accumulated depreciation and amortization


(4,379
)

(1,922
)$
14,707

$
3,522


F-13

---

(4)  Leases

The Company leases certain computers and office equipment under long-term capital leases, which expire over the next 32 months. The cost of
these assets was $910 and $584 at December 31, 2001 and 2000, respectively, and accumulated amortization was $560 and $463, at December 31, 2001 and 2000, respectively.

Future
minimum lease payments under non-cancelable operating leases and the present value of future minimum capital lease payments are as follows:

Year ending December 31:

Capital
Leases

Operating
Leases2002


606


2,0482003


32


1,9412004


11


1,5842005





1612006





4Total minimum lease payments


649

$
5,738Less amount representing interest


40609Less current portion of capital lease


576$
33


On
June 22, 1999, the Company entered into a five-year operating lease agreement for office space. The lease required a letter of credit in lieu of a cash security
deposit in the amount of $350. The letter of credit dated August 1999 was secured by a certificate of deposit in the amount of $350. The letter of credit is to be released over two years in
increments upon the Company's meeting certain milestones. At December 31, 2001, the remaining letter of credit balance and certificate of deposit balance is $175.

Rent
expense on the operating leases for the years ended December 31, 2001, 2000 and 1999 totaled $1,169, $804, and $141, respectively.

(5)  Defined Contribution Pension Plan

The Company sponsors an employee savings plan (the Plan) which qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue
Code. Employees become eligible to
participate in the Plan at the beginning of the following quarter after the employees' hire date. Employees may contribute up to 20% of their pay to the Plan, subject to the limitations of the
Internal Revenue Code. Company matching contributions are discretionary. For the years ending December 31, 2001, 2000 and 1999 the Company made no discretionary matching contributions.

(6)  Stockholders' Equity

Preferred Stock

In December 1999, all outstanding preferred stock of the Company was converted to common stock upon the closing of the Company's initial public offering.
The authorized preferred stock of the Company following its re-incorporation and the initial public offering consists of 5,000,000 shares of undesignated preferred stock.

F-14

---

Common Stock

In December 1999, the Company completed its initial public offering of common stock of 4,600,000 shares of its common stock which included the exercise of
the underwriters over-allotment option resulting in net proceeds of $83,801, after deducting underwriting discounts, commissions and offering expenses.

Deferred Stock Compensation

Deferred stock compensation expense is based on the difference between the deemed fair market value of the Company's common stock and the exercise price of
options to purchase that stock on the date of grant, and is being recognized over the vesting period of the related options, usually four years. Stock-based compensation expense of $1,975, $2,173, and
$527 was recorded for the years ended December 31, 2001, 2000, and 1999, respectively. At December 31, 2001, $3,294 of stock-based compensation remains deferred and we expect
approximately $1,884 and $1,410 to be amortized to expense in 2002 and 2003, respectively.

Stock Incentive Plan

In October 1995, the 1995 Stock Incentive Plan (the 1995 Plan) was approved by our Board of Directors. Under the terms of the 1995 Plan, the Board of
Directors is authorized to grant incentive stock options, non-qualified stock options and restricted stock to officers, directors, employees or consultants. Prices for all options or stock
granted under the 1995 Plan are determined by the Board of Directors. Option prices for incentive stock options are set at not less than the fair market value of the common stock at the date of grant.
Options vest over periods determined by the Board of Directors, generally four years. Options are contingent upon continued employment with the Company and, unless otherwise specified, expire ten
years from the date of grant. The Company has reserved 2,800,000 shares of its common stock for issuance under the 1995 Plan.

In
October 1999, the 1999 Stock Incentive Plan (the 1999 Plan) was approved by our Board of Directors. The Company initially reserved 1,500,000 shares of its common stock for
issuance under the 1999 Plan. Upon completion of the Company's initial public offering, shares available for grant from the 1995 Plan were transferred to the 1999 Plan. During 2001 and 2000, the
Company reserved an additional 1,476,400 and 1,500,000 shares, respectively of its common stock for issuance under the 1999 Plan bringing the total to 7,276,400 shares. The exercise price and term of
options granted under the 1999 Plan are determined by our Board of Directors or by a committee they designate.

As
part of the 1999 Plan, the Company adopted the Non-Employee Director Option Plan (the Director Plan). Under the Director Plan, an automatic option grant to acquire 10,000
shares will be given to each non-employee director then-existing or first elected to the Company's Board of Directors. In 2001, the Director Plan was amended to allow these
options to vest in three annual increments on the anniversary date of the grant date and an annual option grant of 10,000 shares to be given to each non-employee director on the date of
the Company's annual stockholders' meeting if certain conditions are met. These options will vest on the first anniversary of the grant date. The exercise price of the options under this plan is fair
market value on the date of grant.

In
June 2000, the 2000 Non-Officer Employee Stock Incentive Plan (the 2000 Plan) was approved by our Board of Directors. The Company initially reserved 275,000 shares
of its common stock for issuance under the 2000 Plan. Options from the 2000 Plan cannot be granted to Officers or Directors of the Company. The exercise price and term of options granted under the
2000 Plan are determined by our Board of Directors or by a committee they designate. The exercise price is generally set at the fair market value of the stock on the date of grant. Options under the
2000 Plan generally vest over four years.

F-15

---

SFAS
No. 123 defines a fair value based method of accounting for an employee stock option and similar equity instrument. As is permitted under SFAS No. 123, the Company has
elected to continue to account for its stock-based compensation plans under APB Opinion No. 25. The Company has
computed, for pro forma disclosure purposes, the value of all options granted during 2001, 2000 and 1999 using the Black-Scholes option pricing model as prescribed by SFAS No. 123 with the
following weighted average assumption for grants:

2001

2000

1999Risk-free interest rate

5.00
%
6.00
%
6.25
%Expected dividend yield





Expected life (in years)

4

4

4Expected volatility

100
%
100
%
100
%


Using
the Black-Scholes methodology, the total value of options granted during 2001, 2000, and 1999 was $34,496, $49,201, and $9,015, respectively, which would be amortized on a pro
forma basis over the vesting period of the options. The weighted average fair value of options granted during 2001, 2000, and 1999 was $12.37, $22.28, and $7.91 per share, respectively. If the Company
had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Company's loss per share would approximate the pro forma disclosures below:

Years Ended December 31,2001

2000

1999Pro forma net loss

$
(36,259
)
$
(38,398
)
$
(5,700
)Pro forma net loss per share

$
(2.17
)
$
(2.83
)
$
(1.87
)


The
estimated fair value of purchase rights granted under the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted
average assumptions for the year ended December 31, 2001: no expected dividends; expected volatility of 100%; risk-free interest rate of 6.00%; and expected life of approximately
six months. The weighted-average fair value of the purchase rights granted under the Purchase Plan during fiscal 2001 was $4.63.

The
effects of applying SFAS No. 123 in this pro forma disclosure are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to January 1,
1995, and additional awards are anticipated in future years.

F-16

---

Transactions
involving the stock incentive plans are summarized as follows:

Number of shares

Weighted average
exercise priceOptions outstanding, December 31, 1998

1,304,800

$
0.42Granted

1,516,750


3.67Exercised

(116,747
)

0.44Canceled

(47,992
)

0.50Options outstanding, December 31, 1999

2,656,811


2.28Granted

2,954,750


30.96Exercised

(595,721
)

0.72Canceled

(217,941
)

43.34Options outstanding, December 31, 2000

4,797,899


18.37Granted

2,789,662


15.13Exercised

(660,081
)

1.47Canceled

(1,130,406
)

32.26Options outstanding, December 31, 2001

5,797,074

$
16.02


|  |             | Outstanding |           | Exercisable
|- | ----------- | ----------- | --------- | -----------
|
|$ | 0.15-$2.50  |             | 1,222,063 |            
|  | 11.05-14.02 |             | 1,333,282 |            
|  | 14.13-15.92 |             | 964,208   |            
|  | 16.00-24.34 |             | 1,483,718 |            
|  | 25.63-31.00 |             | 340,411   |            
|  | 35.13-53.94 |             | 453,392   |            
|  |             |             |           |            
|$ | 0.15-$53.94 |             | 5,797,074 |            
|  |             |             |           |            

At
December 31, 2001, 69,689 shares were available for grant.

Employee Stock Purchase Plan

Under the 1999 Employee Stock Purchase Plan (the Purchase Plan), the Company has authorized the issuance of 835,930 shares of common stock, 709,921 of which are
available for purchase at December 31, 2001. The Purchase Plan allows eligible employees to purchase the Company's common stock through payroll deductions, which may not exceed 15% of an
employee's base compensation, not to exceed $21 per year, including commissions, bonuses and overtime, at a price equal to 85% of the lower of the fair value at the beginning or end of each enrollment
period.

Warrant

In October 1999, the Company entered into a two-year agreement with Hearst Communications, Inc. (Hearst) in which the Company and Hearst
would jointly promote Internet-enabled advertising. In connection with the Hearst agreement, the Company issued a warrant to purchase 150,000 shares of common stock to Hearst at $20 per share. Of the
150,000 shares, 62,500 vested upon the Company's initial public offering, another 62,500 shares were to vest based on the achievement of certain milestones within the first year of the agreement, and
the final 25,000 were to vest upon reaching the one-year anniversary of the commercial availability date for Digimarc MediaBridge. The warrant is exercisable for three years after each
vesting date.

F-17

---

The
Company recorded $633 of sales and marketing expense during 1999 that related to the vested portion of the warrant. During 2000 and 2001, the specified milestones for vesting were
not met and the agreement with Hearst was terminated prior to the one-year anniversary of the commercial availability date for Digimarc MediaBridge. Therefore, no additional warrant
expense was recorded as no additional vesting occurred. As of December 31, 2001, no portion of the warrant had been exercised.

In
2001, the Company issued 5,000 options to non-employees and recorded expense related to those options of $42 using the Black-Scholes option pricing model with the
following weighted average
assumptions: no expected dividends; expected volatility of 100%; risk-free interest rate of 4.40%; and contractual life ranging from 0.5 to 3.0 years.

(7)  Income Taxes

Domestic and foreign pre-tax income (loss) is as follows:

2001

2000

1999Domestic

$
(19,302
)
$
(15,845
)
$
(2,389
)Foreign


144





Total

$
(19,158
)
$
(15,845
)
$
(2,389
)


Due
to the Company's losses before the provision for income taxes for the years ended December 31, 2001, 2000 and 1999, there has been no provision for federal, foreign, and state
taxes. The reconciliation of the statutory federal income tax rate to the Company's effective income tax rate is as follows:

|                                    |                                                | Years Ended
December 31, |   
|----------------------------------- | ---------------------------------------------- | ------------------------ | --
|
|Federal statutory rate              |                                                | (34                      | )%
|Increase (decrease) resulting from: |                                                |                          |   
|                                    | State income taxes, net of federal tax benefit |                          | (6
|                                    | Change in valuation allowance                  |                          | 43
|                                    | Research and experimentation credits           |                          | (3
|                                    | Other, net                                     |                          |  
|                                    |                                                |                          |   
|                                    |                                                | Effective tax rate       |   
|                                    |                                                |                          |   

Deferred
income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used
for income tax

F-18

---

purposes. The tax effects of significant items comprising the Company's deferred tax assets and deferred tax liabilities as of December 31 are as follows:

|                     |                                      | 2001                                  |                                    | 2000    |       
|-------------------- | ------------------------------------ | ------------------------------------- | ---------------------------------- | ------- | ------
|Deferred tax assets: |                                      |                                       |                                    |         |       
|                     | Net operating loss carryforwards     |                                       | $                                  | 21,142  |       
|                     | Tax depreciation and amortization    |                                       |                                    | 380     |       
|                     | Research and experimentation credits |                                       |                                    | 1,167   |       
|                     | Accrued expenses                     |                                       |                                    | 678     |       
|                     | Deferred revenue                     |                                       |                                    | 19      |       
|                     | Deferred compensation                |                                       |                                    | 1,579   |       
|                     |                                      |                                       |                                    |         |       
|                     |                                      | Total gross deferred tax assets       |                                    |         | 24,965
|                     | Less valuation allowance             |                                       |                                    | (24,965 | )     
|                     |                                      |                                       |                                    |         |       
|                     |                                      | Net deferred tax assets               |                                    |         |      
|                     | Deferred tax liabilities:            |                                       |                                    |         |       
|                     |                                      | Unamortized discount on notes payable |                                    |         |      
|                     |                                      |                                       |                                    |         |       
|                     |                                      |                                       | Total deferred tax liabilities     |         |       
|                     |                                      |                                       |                                    |         |       
|                     |                                      |                                       | Net deferred tax liability (asset) |         | $     
|                     |                                      |                                       |                                    |         |       

The
net change in the total valuation allowance for the year ended December 31, 2001, 2000 and 1999 was an increase of $10,656, $9,586, and $1,024, respectively. Included in the
valuation allowance at December 31, 2001 is $6,518 for deferred tax assets for which subsequently recognized tax benefits, if any, will be allocated to contributed capital.

At
December 31, 2001, the Company had net operating loss carryforwards of approximately $55.1 million to offset against future income for federal and state tax purposes,
and research and experimentation credits of $1.3 million. These carryforwards expire through 2021.

A
provision of the Internal Revenue Code requires that the utilization of net operating losses and research and experimentation credits be limited when there is a change of more than 50%
in ownership of the Company. Such a change occurred with the sale of Series A preferred stock in June 1996 and the sale of Series B preferred stock in July 1996.
Accordingly, the utilization of the net operating loss carryforwards generated from periods prior to July of 1996 is limited; the amount subject to limitation is approximately $915.

A
change of more than 50% in ownership occurred twice during 1999. The change occurred with the sale of Series D preferred stock in June 1999 and again with the Company's
initial public offering in December 1999. As such, the utilization of the net operating loss carryforwards generated from periods prior to June and December of 1999 is limited. The amount of
the net operating loss carryforward subject to the utilization limitation is approximately $9,037.

(8)  Segment Information

Geographic Information

The Company derives its revenue from a single operating segment, digital watermarking applications. Revenue is generated in this segment through licensing and
subscription of its various products and the delivery of contracted and consulting services related to these products. The Company markets its products in the United States and in foreign countries
through its sales personnel and its subsidiaries. The Company's management evaluates resource allocation decisions and the performance of the Company based upon revenue by the geographic regions of
the segment and does not receive discrete financial information about asset allocation and expense allocation on a disaggregated basis.

F-19

---

Information
regarding geographic areas for the years ended December 31 is as follows:

|Revenue: |               | 2001 |        | 2000   |   | 1999  
|-------- | ------------- | ---- | ------ | ------ | - | ------
|         | United States |      | $      | 12,406 |   | $     
|         | International |      |        | 2,472  |   |       
|         |               |      |        |        |   |       
|         |               | $    | 14,878 |        | $ | 11,850
|         |               |      |        |        |   |       

Revenue
is attributed to countries based on the location of the identifiable customers.

|Long-lived tangible assets: |  | 2001 |        | 2000 |   | 1999 
|--------------------------- |  | ---- | ------ | ---- | - | -----
|United States               |  | $    | 14,534 |      | $ | 3,522
|International               |  |      | 173    |      |   |     
|                            |  |      |        |      |   |      
|                            |  | $    | 14,707 |      | $ | 3,522
|                            |  |      |        |      |   |      

Major Customers

Revenue from the Company's major customers was as follows:

|           |  | Years Ended
December 31,
|---------- |  | ------------------------
|
|Customer A |  | 8,326                   
|Customer B |  | 1,877                   

---

Accounts
receivable from one customer represented approximately 63% of trade accounts receivable at December 31, 2000. No customer accounted for more than 10% of trade accounts
receivable at December 31, 2001.

(9)  Commitments and Contingencies

At December 31, 2001, the Company had an unused line of credit of $5,000. This line is secured by $5,000 in investments at the bank providing the line.

Beginning
in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District
Court for the Southern District of New York naming Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's
initial public offering as defendants. The complaints have since been consolidated into a single action. The complaints allege, among other things, that the underwriters of the Company's initial
public offering violated the securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company's
initial public offering registration statement. Similar complaints have been filed against over 180 other issuers that have had initial public offerings since 1998. The Company intends to defend these
actions vigorously. Although no assurance can be given that this matter will be resolved favorably, the Company believes that the resolution of these lawsuits will not have a material adverse effect
on its consolidated financial position, results of operations or cash flows.

In
November 2001, Verance Corporation filed counterclaims against Digimarc alleging patent infringement, fraud, and monopolistic activities. The Company intends to vigorously
defend against these allegations. Although no assurance can be given that this matter will be resolved favorably, the

F-20

---

Company believes that the resolution of these allegations will not have a material adverse effect on its consolidated financial position, results of operations or cash flows.

DIDS
in its normal course of business from time to time experiences delays in identification system implementation, timely acceptance for identification systems programs, concerns
regarding identification system program performance, and other contractual disputes. Management does not believe that there will be any material effect to the results of operations for costs related
to these contingencies.

Digimarc
is subject to other legal proceedings and claims arising in the ordinary course of business. Although the ultimate outcome of these matters cannot be determined, management
believes that the final disposition of these proceedings will not have a material adverse effect on the consolidated financial position, results of operations, or liquidity of the Company.

(10) Restructuring

The Company recorded restructuring charges that include employee severance costs associated with the October 2001 reduction of 34 personnel and abandoned
space. Restructuring charges were $574 for the year ended December 31, 2001. Excess leased facility cost related to non-cancelable leases included in restructuring charges extend
over the next 18 months. As of December 31, 2001, approximately $440 of cash had been paid related to restructuring charges.

(11) Related Party Transactions

In 2000, the Company entered into a royalty arrangement with a holder of common stock. The Company recognized $1,000 in revenue in each of the years ended
December 31, 2001 and 2000 in connection with this arrangement. At December 31, 2001 and 2000, there were no net accounts receivable or deferred revenue related to this customer. The
arrangement was negotiated at arms-length in a manner consistent with arrangements with other customers of the Company.

In
2001 and 2000, the Company entered into services and licensing arrangements with a holder of common stock. The Company recognized $1,877 and $667 in revenue for the years ended
December 31, 2001 and 2000, respectively, in connection with these arrangements. At December 31, 2001 and 2000, net accounts receivable from this customer was $150 and $101,
respectively. At December 31, 2001 and 2000, deferred revenue from this customer was $150 and zero, respectively. The arrangement was negotiated at arms-length in a manner
consistent with arrangements with other customers of the Company.

F-21

---

(12) Quarterly Financial InformationUnaudited

A summary of quarterly financial information follows:

|Quarter ended                         |  | March 31 |        | June 30 |   | September 30 |   | December 31 |       
|------------------------------------- |  | -------- | ------ | ------- | - | ------------ | - | ----------- | ------
|2001                                  |  |          |        |         |   |              |   |             |       
|Total revenue                         |  | $        | 3,735  |         | $ | 4,207        |   | $           | 3,067 
|Cost of revenue                       |  |          | 1,594  |         |   | 2,097        |   |             | 1,573 
|Operating loss                        |  |          | (5,898 | )       |   | (5,261       | ) |             | (5,838
|Net loss                              |  |          | (3,875 | )       |   | (3,726       | ) |             | (4,611
|Net loss per share, diluted and basic |  | $        | (0.24  | )       | $ | (0.22        | ) | $           | (0.27 
|2000                                  |  |          |        |         |   |              |   |             |       
|Total revenue                         |  | $        | 2,570  |         | $ | 2,704        |   | $           | 3,140 
|Cost of revenue                       |  |          | 1,511  |         |   | 1,821        |   |             | 1,748 
|Operating loss                        |  |          | (3,675 | )       |   | (7,495       | ) |             | (5,530
|Net loss                              |  |          | (2,464 | )       |   | (6,185       | ) |             | (4,256
|Net loss per share, diluted and basic |  | $        | (0.19  | )       | $ | (0.48        | ) | $           | (0.33 

The
four quarters for net loss per share may not add for the year because of the effect of weighting the shares during the year.



F-22

---



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