**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                              AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**For the fiscal yearended December 31, 2006**

**OR**

**o**                                 TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe transition period from                to                **

**Commission File Number 000-28317**

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**DIGIMARCCORPORATION**

(Exact name of registrantas specified in its charter)

| **Delaware**                     |   | **94-3342784**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

| **9405 SW Gemini Drive, Beaverton, Oregon 97008**    |
|------------------------------------------------------|
| (Address of  principal executive offices) (Zip Code) |

 

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant to Section 12(b) of the Act:

| **Title of Each Class**                   |   | **Name of  Each Exchange on Which Registered** |
|-------------------------------------------|--------|------------------------------------------------|
| Common Stock,  $0.001 Par Value Per Share |   | The Nasdaq Global  Market                      |

 

Securities registered pursuant to Section 12(g) ofthe Act: **NONE**

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Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act.  Yes o   No x

Indicate by check mark if theregistrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o   No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.

Large accelerated filer o          Acceleratedfiler x          Non-acceleratedfiler o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act).  Yes o   No x

The aggregate market value ofcommon stock, par value $0.001 per share, held by non-affiliates of theregistrant, based on the closing price for the common stock on The NasdaqNational Market on the last business day of the registrant’s most recentlycompleted fiscal second quarter (June 30, 2006), was approximately$127 million. Shares of common stock beneficially held by each officer anddirector have been excluded from this computation in that such persons may bedeemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for any other purposes.

As of January 31, 2007,there were 21,342,330 shares of the registrant’s common stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the registrant’s proxy statement pursuant to Regulation 14A (the “ProxyStatement”) for its 2006 annual meeting of stockholders are incorporated byreference into Items 10, 11, 12, 13 and 14 of Part III of this AnnualReport on Form 10-K. The registrant intends to file the ProxyStatement not later than 120 days after the end of the fiscal year coveredby this Annual Report on Form 10-K.

 

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**Tableof Contents**

| **PART I**   |       |                                                                                                                    |       |       |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|------------|
| Item 1.           |       | Business                                                                                                                |       | 1          |
| Item 1A.          |       | Risk  Factors                                                                                                           |       | 8          |
| Item 1B.          |       | Unresolved Staff Comments                                                                                               |       | 8          |
| Item 2.           |       | Properties                                                                                                              |       | 9          |
| Item  3.          |       | Legal  Proceedings                                                                                                      |       | 9          |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                     |       | 10         |
| **PART II**  | ** ** | ** **                                                                                                              | ** ** | ** ** |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 11         |
| Item  6.          |       | Selected  Financial Data                                                                                                |       | 14         |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                   |       | 14         |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                             |       | 53         |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                             |       | 53         |
| Item 9.           |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |       | 53         |
| Item  9A.         |       | Controls  and Procedures                                                                                                |       | 53         |
| Item  9B.         |       | Other  Information                                                                                                      |       | 57         |
| **PART III** | ** ** | ** **                                                                                                              | ** ** | ** ** |
| Item 10.          |       | Directors, Executive Officers and Corporate Governance                                                                  |       | 58         |
| Item  11.         |       | Executive  Compensation                                                                                                 |       | 58         |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       | 58         |
| Item 13.          |       | Certain Relationships and Related Transactions, and  Director Independence                                              |       | 58         |
| Item 14.          |       | Principal Accounting Fees and Services                                                                                  |       | 58         |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                              |       | 59         |
| SIGNATURES        |       | 60                                                                                                                      |
| EXHIBIT INDEX     |       |                                                                                                                    |

 

** **

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**PART I**

*The followingdiscussion of Digimarc’s business contains forward-looking statements relatingto future events or the future financial performance of Digimarc. Digimarc’sactual results could differ materially from those anticipated in these forward-lookingstatements. Please see the discussion regarding forward-looking statementsincluded in this Annual Report on Form 10-K in Item 7,Management’s Discussion and Analysis of Financial Condition and Results ofOperations, under the caption “Safe Harbor Statement under the PrivateSecurities Litigation Reform Act of 1995.”*

*Although Digimarcbelieves that the expectations reflected in such forward-looking statements arereasonable, it cannot give any assurances that these expectations will prove tobe correct. Such statements by their nature involve substantial risks anduncertainties that could significantly affect expected results. Actual futureresults could differ materially from those described in such forward-lookingstatements, and Digimarc does not intend to update or revise anyforward-looking statements as a result of new information, future events orotherwise. Readers are urged to carefully review and consider the variousdisclosures made by us which attempt to advise interested parties of the factorswhich affect our business, including without limitation the disclosures made inItem 7, Management’s Discussion and Analysis of Financial Condition andResults of Operations, under the caption “Factors Affecting Forward LookingStatements” in this Annual Report on Form 10-K, the auditedconsolidated financial statements and related notes included in this AnnualReport on Form 10-K, and other reports and filings made with theSEC.*

*The followingdiscussion should be read in conjunction with our consolidated financialstatements and the related notes and other financial information appearingelsewhere in this Annual Report on Form 10-K.*

This Annual Report on Form 10-Kincludes trademarks and registered trademarks of Digimarc Corporation. Productsor service names of other companies mentioned in this Annual Report on Form 10-Kmay be trademarks or registered trademarks of their respective owners.

**ITEM 1:**               BUSINESS

**Overview**

DigimarcCorporation (“Digimarc,” “the Company,” “our” or “we”) is a leading supplier ofsecure identity solutions and digital watermarking technology for use in mediamanagement. Our solutions enable governments and businesses around the world toenhance traffic safety and national security, combat identity theft and fraud,facilitate the effectiveness of voter identification programs, improve themanagement of media content, deter counterfeiting and piracy and support newdigital media distribution models that provide consumers with more choice andaccess to media content. Our mission is two-fold:

·       Foster large-scale adoption of digital watermarking solutions licensedunder the Company’s intellectual property; and

·       Be the most desired profitable supplier ofdriver license issuance systems.

We issue more than 60 million identification documents(“IDs”) annually and are the leading supplier of government-issued citizen IDsin North America, including supplying systems that produce more than two-thirdsof all driver licenses issued in the United States (the “U.S.”). We are also apioneer and leading owner of intellectual property in a signal processingtechnology innovation known as “digital watermarking” which allows imperceptible digital information to be embeddedin all forms of digitally designed, produced or distributed media content, includingpersonal identification documents, financial instruments, photographs, movies,music, television, and product packages. The embedded data within various typesof media content can be detected and read by software or hardware detectors inpersonal computers and other digital devices.

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Digital watermarking is a strategic component ofnearly all of our product offerings. We provide solutions based on thistechnology directly and through our licensees. Digital watermarking has alreadyproven to be a powerful differentiator in banknote security, giving rise to ourlong-term relationship with a consortium of leading Central Banks andmany leading companies in the information technology industry. We are workingto achieve a similar success in secure identity management systems. Weanticipate that by the end of 2007 more than one out of  two driver licenses then in production in theU.S. will carry digital watermarks as a means to provide cross-jurisdictionalmachine authentication. In addition, Digimarc and its licensees havesuccessfully propagated digital watermarking in music, movies, television andradio broadcasts, images and printed materials. Digital watermarks have beenused in these applications to provide improved media rights and assetmanagement, reduce piracy and counterfeiting losses, improve marketingprograms, permit more efficient and effective distribution of valuable mediacontent, and enhance consumer experiences.

Our principal administrative, marketing, research, andintellectual property development facility is located in Beaverton, Oregon. Oursecure ID systems business is headquartered in Burlington, Massachusetts, andour logistics center is in Fort Wayne, Indiana.

The substantial majority of our revenue is generatedpursuant to long-term contracts with government agencies—primarily U.S. stategovernment agencies responsible for driver license issuance, a consortium ofleading Central Banks, and national governments of a number of countries. Thesecustomers rely on our systems design, integration and materials scienceexpertise, and proprietary technologies such as digital watermarking, toimplement issuance systems and processes that improve the security of identitydocuments and banknotes.

The remainder of our revenue is generated throughcommercial applications of our digital watermarking and related technologies,primarily from patent and technology license fees paid by business partners.Our licensing business is built upon our extensive patent portfolio, whichcontains 300 issued U.S. patents as of December 31, 2006. Private sectormedia and entertainment industry customers use secure media managementsolutions from the Company and its business partners to identify, track, manageand protect content as it is distributed and consumed—either digitally orphysically—and to enable new consumer applications to improve access tonetworks and information from personal computers and mobile devices. We expectthat patent licensing will continue to contribute most of our revenues fromnon-government customers for the foreseeable future.

Financial informationabout geographic areas is incorporated by reference to Note 7 of ourconsolidated financial statements.

**History**

Digimarc was incorporated in 1995. The Company wasfounded to commercialize a signal processing innovation known as “digitalwatermarking.” Digital watermarking is a technology that allows our customersto infuse digital data into any media content that is digitally processed atsome point during its lifecycle. The technology can be applied to printedmaterials, video, audio, and images. The inclusion of this digital data enablesa wide range of improvements in security and media management, and enables newbusiness models for distribution and consumption of media content. We use digitalwatermarking as a differentiator in nearly all of our product offerings and toincrease value to our customers.

Banknote counterfeit deterrence was the firstcommercially successful use of digital watermarking. Digimarc, in cooperationwith an international consortium of leading Central Banks, developed a systemto deter the use of digital technologies in the unauthorized reproduction ofbanknotes. More recently, innovations based on the Company’s digitalwatermarking technology and experience have been leveraged to create newproducts to deter counterfeiting and tampering of driver licenses and othergovernment-issued secure credentials. In parallel, Digimarc’s businesspartners, under patent license from Digimarc, 

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are delivering digitalwatermarking solutions to track and monitor the distribution of music,television, movies and radio to consumers.

On the heels of 9/11, we realized that our expertisein security printing and digital imaging technologies and systems placed us ina position to understand both the digital threats to identity managementcredentials and the environment and concerns of the issuers of thesecredentials. In late 2001, we acquired the Large Government Programs businessunit of Polaroid Corporation (“Polaroid”). The primary focus of this businessis the production of driver licenses and other IDs issued by governmentagencies. The acquired assets included all relevant software, hardware,services, materials science and distribution assets of Polaroid’sgovernment-issued photo identification business.

In this strategicacquisition, we saw a unique opportunity to assist in efforts to deter identitytheft and fraud and thereby enhance transportation safety and Homeland Securitythrough the combination of a new layer of security using our digitalwatermarking technology and Polaroid’s expertise in secure ID solutions. Theresulting business has over 50 years of experience in the delivery andoperation of secure ID issuance systems, has produced more than 2 billionissued IDs, and has guided customers through numerous major upgrades andtechnology migrations in ID security. We are the leader in deployingnew solutions to meet driver license security and related servicechallenges. This includes being first to:

·       producedriver licenses with digital portraits,

·       deployfacial recognition and State-wide fingerprint matching in 1995 and 1996,

·       introducemarket leading security features, including digital watermarking, Kinegrams,and secure card materials,

·       producedriver licenses in secure, networked central issuance factories,

·       offerdriver license renewal by Internet, and

·       offera comprehensive and modular ID validation and archiving suite toaddress recently enacted Federal legislation, such as the federal legislationpassed in May 2005 known as the REAL ID Act (the “REAL ID Act”). The RealID Act imposes certain federal requirements for State-issued driver licenses. Theserequirements will increase the security of driver licenses, require validationof applicants prior to issuance, and mandate certain changes in businessprocesses relating to security and the sharing and storage of data.

With increasing interestin issues surrounding Homeland Security, prevention of identity theft andfraud, traffic safety, copyright and intellectual property protection andestablishment of new business models for digital distribution and use of mediacontent, Digimarc has evolved from a technology-driven early stage company toan important supplier of critical infrastructure to government agencies and a strategicbusiness partner to solution providers supporting the media and entertainmentindustry.

**Customers andBusiness Partners**

The substantial majority of our revenue is derivedfrom long-term contracts with government agencies, primarily State driver licenseissuers, a consortium of leading Central Banks, and governments of variousforeign countries and provinces. The retention rate for our driver licensecustomers is high. The Company’s contract with the Central Bank consortium isin its eighth year. The contract is in the second year of a 5-yearextension and provides for two additional 3-year extensions that theCompany expects will be exercised.

The remainder of theCompany’s revenue is generated through commercial applications of its digitalwatermarking and related technologies, primarily from patent and technologylicense fees paid by business partners providing media and rights managementsolutions to movie studios and music labels, television 

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andradio broadcasters, creative professionals and other customers around theworld. Patent licensing is expected to continue to contribute most of therevenues from non-government customers for the foreseeable future.

**Products andServices**

The Company providesfinancial document security and secure ID solutions to government agencies:

***Financial DocumentSecurity***

**We have a multi-year contract with an internationalconsortium of Central Banks in which we have developed, deployed, and aresupporting and continuing to enhance a system to deter digital counterfeitingof currency using personal computers and digital reprographics. Work on thesystem began in 1997. Details of the system are confidential for securityreasons.**

***Secure ID Solutions***

As the leading provider of government-issued secureIDs in North America, our systems produce more than 60 million driver licensesand other secure personal IDs per year. Approximately two-thirds of theU.S. States and many foreign governments, including Russia, Latvia, Mexico,Ghana and four Canadian provinces, use Digimarc secure ID solutions to issuecredentials to citizens.**In NorthAmerica, we are generally a prime contractor, providing full issuance systemsto Federal, State, and Provincial departments of motor vehicles or othergovernment issuing authorities. Our North American driver license issuancesystems vary from jurisdiction to jurisdiction. These systems are typicallyprovided under long-term (normally five or more years) contracts. The systemsprovided include hardware, software, consumable supplies (such as ribbons, blankor preprinted card materials, and laminates), and on-going support necessaryfor a “turnkey” solution. They typically involve custom software and/orhardware development, integration services, and implementation services. Whenwe provide a full issuance system to a customer, we generally retain title toall equipment, software and consumables associated with the system and areresponsible for maintaining the system over the contractual period.

Digimarc offerssolutions that span the entire secure ID lifecycle, including enrollment,production, secure credential designs, and post issuance inspection. The goalsof the process are to:

·       Verifythe true identity of applicants for licenses and ID cards;

·       Verifythe authenticity of information and documents submitted as proof of identity;

·       Verifythe authenticity of information presented as proof of residency;

·       Issuesecure IDs that deter counterfeiting;

·       Detectand facilitate investigation and prosecution of identity theft and fraud;

·       Securethe issuance process from internal and supply chain fraud; and

·       Providemultiple perspectives—see, feel, machine validate—to the end-users of issuedIDs, including the police, merchants, border crossing staff, employers,government agencies, and financial institutions.

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Digimarc’sstrategy regarding the anticipated opportunities relating to the REAL ID Act isto provide solutions that embody the key elements of the REAL ID Act: identityverification; document scanning and archiving; individual background checking;data and image sharing; and migration to and production of REAL ID Actcompliant driver license documents. These solutions are available to customersas upgrades or complete issuance systems. Digimarc will also offer the Statesprogram management assistance to safely migrate to REAL ID Act compliance.

***Media and Entertainment***

We license ourtechnology and patents and otherwise foster development of the market fordigital watermarking-based solutions for commercial as well as governmentaluses. These licenses primarily involve use of our technology and patents in themedia and entertainment area. Commercial customers use secure media solutionsfrom our business partners and us to identify, track, manage and protectcontent as it is distributed and consumed—either digitally or physically—and toenable new consumer applications to access networks and information frompersonal computers and mobile devices. Many movie studios, record labels,broadcasters, creative professionals and other customers rely on digital watermarkingas a cost-effective means to:

·       deterpiracy and illegal use of movies, music and images;

·       protectentertainment content from copyright infringement;

·       trackand monitor entertainment content for rights usage and licensing compliance;

·       monitoradvertisements to verify ad placement and measure return on investment; and

·       enablefair and legitimate use of content by consumers.

Our business partnersinclude Activated Content Corporation, AquaMobile, Cinea, Inc., asubsidiary of Dolby Laboratories, Inc., GCS Research LLC, MediaGrid,Mobile Data Systems, Inc., Nielsen, Royal Philips, Signum TechnologiesLimited, Thomson Multimedia, S.A., USA Video, Verance Corporation, Verimatrix, Inc.and VCP (an affiliate of VEIL Interactive Technologies). Although each partneraddresses particular customer needs, as a whole these partners are propagatingdigital watermarking in music, movies, images, and television and radio as ameans to improve media rights and asset management, reduce piracy losses,improve marketing programs, and provide more efficient and effectivedistribution of valuable media content.

**Technology andIntellectual Property**

The Company uses intellectualproperty (“IP”) to differentiate its products and technologies, mitigateinfringement risk, and develop opportunities for licensing. Licensing ofour digital watermarking and related technologies is supported by a broadpatent portfolio covering a wide range of methods, applications, and systemarchitectures.

Most of our patents relate to various methods forembedding digital information in video, audio, and images, whether the contentis rendered in analog or digital formats. The digital information is generallyembedded by making subtle modifications to the fundamental elements of thecontent itself, generally at a signal processing level. The changes necessaryto embed this information are so subtle that they are generally not noticeableby people during normal use. Because the message is carried by the contentitself, it is file-format independent. The message generally survivesmost normal compression, edits, rotation, scaling, re-sampling, file-formattransformations, copying, scanning and printing.

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To protect our significant efforts in creating thesetechnologies, we have implemented an extensive intellectual property protectionprogram that relies on a combination of patent, copyright, trademark and tradesecret laws, and nondisclosure agreements and other contracts. As a result, webelieve we have one of the world’s most extensive patent portfolios in thefield of digital watermarking, with 300 U.S. and 70 foreign issued patents andmore than 500 U.S. and foreign patent applications on file as of December 31,2006 in the areas of digital watermarking, personal identification, and relatedtechnologies. Separately, we own registered trademarks in both the U.S. andother countries and have applied for other trademarks. We continue to developand broaden our portfolio of patented technologies, including digitalwatermarking and related applications and systems, and other technologiesrelated to secure ID systems. For IDsystems-related technologies, the focus of patent development has been in theareas of imaging and printing systems, card architecture and materials, andsecurity features. Some patents relate to future product offerings or relatedtechnologies like smart cards, laser engraving and alternative card systems.

Although we devote significant resources to developingand protecting our technologies, and periodically evaluate potentialcompetitors of our technologies for infringement of our intellectual propertyrights, these infringements may nonetheless go undetected or may arise in thefuture. We expect that infringement claims may increase as companies becomemore concerned with protecting their content from electronic copying.

**Markets**

***Government***

We believe that the U.S. driver license market willcontinue to grow as a result of broadening use of the driver license as asecure credential beyond its traditional role as evidence of competence todrive a motor vehicle; technological innovation; desire among issuers toimprove security and efficiency; and new governmental regulations such as theREAL ID Act. Weanticipate that these regulations may result in substantial system upgrades byour customers.

Final rules under the REAL ID Act have not yetbeen promulgated. As result, no significant funding has occurred under the RealID Act, and the Federal grant process under the REAL ID Act has not yet begun. TheDepartment of Homeland Security published draft regulations in the form of aNotice of Proposed Rulemaking on March 1, 2007. Final rules arenot expected until the late spring of 2007, at the earliest.

We believe thatmany aspects of our driver license issuance solutions have value in other formsof credentials and secure personal identification systems. As the global marketfor secure personal identification solutions develops, we believe that ourposition as the leading supplier of government-issued citizen IDs in NorthAmerica and our extensive investments in research and development provide agood foundation for participation in the global market for government programsestablishing the identities of citizens and issuing associated credentials.

An example of such a potential opportunity is in themarket for smart cards. We anticipate that the Western Hemisphere TravelInitiative will require that all U.S. citizens returning from outside the U.S.present either a passport or a new border PASS Card. The Federal government iscurrently expected to require a Radio-frequency identification (RFID) chip ineach Pass Card.  In other applications, the Federal government has beenadvancing worker identification using smart cards. In response to these moves, werecently announced a smart card option for our driver license solution, whichwould allow the driver license to contain an optional smart card chip to act asa border PASS Card substitute. We stand ready to provide either our traditionalrange of secure ID offerings, or smart cards, as driven by customer demand andadoption. We believe that these activities will position us to serve any emergingsmart card 

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needsamong driver license issuers. In addition, we will continue to look foropportunities to participate in smart card ID programs in Europe and otherparts of the world where smart cards are more widely used.

***Commercial***

**Ourdigital watermarking technology is used in various products and solutionsaffecting a variety of media objects, from movies and music, to banknotes andsecure credentials. Each media object enabled by our technology creates thepotential for several applications, such as:**

·       counterfeiting and piracy deterrence,

·       media identification and management,

·       authentication and monitoring,

·       linking to networks,

·       and enhanced services in support of mobile commerce.

**Webelieve the market for digital watermarking applications is in the early stagesof development and that existing solutions represent only a small portion ofthe potential market for our products, services, and technologies.**

**Competition**

**Digimarc competes for government business with systemintegrators, biometrics suppliers, security printers, card manufacturers, andsmart card and other security technology suppliers, including companies like L-1Identity Solutions, Inc. (formerly Viisage Technology, Inc.)(biometrics), Unisys (system integration) and De La Rue (security printer). Eachof these companies is a supplier to U.S. driver license issuers. As U.S. driverlicenses gain utility as general credentials and the Federal government isdemanding higher security and a certain amount of standardization, competitionmay increase. For instance, certain aspects of the REAL ID Act may expedite anexisting trend toward central issuance of driver licenses. Although the Companyis proficient at central issuance, the possible acceleration of this trendcould draw new competition from classic security printers such as CanadianBanknote (CBN) and Giesieke & Devrient (G&D).**

Thepossibility of including smart card technologies in driver licenses isgenerating a great deal of public debate. The smart card industry is generallydriven by European chip manufacturers such as Infineon and Gemalto. Whilesuccessful in bank cards, mobile phone SIMs and phone cards, smart cards haveonly recently begun to gain distribution as government-issued credentials. TheU.S. government is a strong advocate. Federal identity standards are embracingsmart cards for the military, transportation workers, and government employeesand contractors, and new “ePassports” will carry a portrait in an on-book chip.Despite considerable investment by the federal government, we believe no Stateshave attempted or even piloted smart card driver licenses. We understand thatin recent years, at least two States have expressly considered and rejectedsmart card driver licenses. Emerging border control and Federal travelerprograms are considering smart card concepts, but have not gained traction andface privacy issues. The Company anticipates that it will be prepared tosupport requirements from customers for smart card technology if, and when,such requirements arise.

TheCompany is seeing increased interest in the U.S. ID market from large systemsintegrators such as EDS, IBM Global Services, Accenture, and Bearing Point. Smallerapplication providers are also emerging as point-product competition, includingSaber and Archon.

Internationally,Digimarc supplies credentialing systems, components or supplies to numerousforeign governments, including four Canadian provinces, Latvia, Mexico, Ghanaand Russia. Competition in 

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internationalmarkets, like in the U.S., comes from security printers, card producers,biometric companies and systems integrators, such as Sagem, De La Rue, Gemplus,Siemens Nixdorf, Unisys, and Hewlett Packard.

In media and entertainment, Digimarc and its businesspartners generally compete with application-specific alternative technologiesfor the security budget of the producers and distributors of the media objects.These alternatives include technologies and solutions based on encryption or onpattern recognition. The Company anticipates that its competitive positionwithin certain markets may be affected by factors such as reluctance to adoptnew technologies and, positively or negatively, by changes in governmentregulations.

***Backlog***

Backlog as of December 31,2006 was approximately $250 million. We expect more than $85 million of thisamount to be recognized as revenue during 2007. This amount includes productionvolumes reasonably expected to be achieved under currently effective contracts,government orders that are firm but not yet funded, and government contractsawarded but not yet signed. Backlog as of December 31, 2005 was approximately$230 million.

There can be no assurance that our backlog will resultin actual revenue in any particular period, because the orders, awards and contractsincluded in our backlog may be subject to modification, cancellation orsuspension. We may not realize revenue on certain contracts, orders or awardsincluded in our backlog or the timing of such recognition may change.

**Employees**

At December 31, 2006, we had 422 full-timeemployees, including 59 in sales, marketing, technical support and customersupport; 84 in research, development and engineering; 88****infinance, administration, information technology and legal; and 191 in fieldoperations, manufacturing and supply chain. We also had 32 contract workers at December 31,2006. Our future success will depend, in part, on our ability to continue toattract, retain and motivate highly qualified technical and managementpersonnel, for whom competition is intense. Our employees are not covered byany collective bargaining agreement, and we have never experienced a workstoppage. We believe that our relations with our employees are good.

**AvailableInformation**

We make available through our website at www.digimarc.comour Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K, and amendments to these and otherreports filed or furnished by us pursuant to Section 13(a) or 15(d) ofthe Securities Exchange Act of 1934 as soon as reasonably practicable after wefile such materials with the Securities and Exchange Commission.

**ITEM 1A:**       RISKFACTORS

Certain risk factors that may affect our business,financial condition, results of operation and cash flows, or that may cause ouractual results to vary from the forward-looking statements contained in thisAnnual Report on Form 10-K are set forth in Item 7, Management’sDiscussion and Analysis of Financial Condition and Results of Operations, underthe caption “Factors Affecting Forward Looking Statements,” in this AnnualReport on Form 10-K.

**ITEM 1B:**      UNRESOLVEDSTAFF COMMENTS

None.

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**ITEM 2:**               PROPERTIES

Our principaladministrative, marketing, research, and intellectual property developmentfacility is located in Beaverton, Oregon. Our secure ID systems business isheadquartered in Burlington, Massachusetts, and our logistics center is in FortWayne, Indiana. Information about our office leases is set forth below.

| ** **                | ** ** | ** ** | **Square Feet** | ** **        | ** ** | **Expires** |
|---------------------------|------------|------------|----------------------|-------------------|------------|-------------|
| Beaverton, Oregon         |       | 46,000     |                 | August 2011  |
| Burlington, Massachusetts |       | 60,000     |                 | October 2010 |
| Fort Wayne, Indiana       |       | 48,000     |                 | January 2010 |

 

We also lease sales andsupport offices in multiple locations throughout the United States andinternationally.

**ITEM 3:**               LEGALPROCEEDINGS

Beginning in September 2004, three purportedclass action lawsuits were filed in the U.S. District Court for the District ofOregon against the Company and certain of its current and former directors andofficers on behalf of purchasers of the Company’s securities during the period April 17,2002 to July 28, 2004. These lawsuits were later consolidated into oneaction for all purposes. The amended complaint, which sought unspecifieddamages, asserted claims under the federal securities laws relating to theCompany’s restatement of its financial statements for 2003 and the first twoquarters of 2004 and alleged that the Company issued false and misleadingfinancial statements and issued misleading public statements about the Company’soperations and prospects. On August 4, 2006, the court granted our motionto dismiss the lawsuit with prejudice and entered judgment in our favor.Plaintiffs have filed a notice of appeal in the Ninth Circuit Court of Appeals.The appeal has been stayed pending the U.S. Supreme Court’s determination inanother case of issues relating to the Private Securities Litigation Reform Act.Due to the inherent uncertainties of litigation, the Company cannot accuratelypredict the ultimate outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company.The Board of Directors appointed an independent committee to investigate theclaims asserted in this derivative lawsuit. On July 19, 2005, the courtgranted the Company’s motion to stay these consolidated actions in favor of ashareholder derivative action to be filed by plaintiffs in the Circuit Court ofthe State of Oregon for the County of Washington. On August 25, 2005, theCalifornia plaintiffs filed two new derivative lawsuits in the United StatesDistrict Court for the District of Oregon. On October 17, 2005, defendantsfiled a motion to dismiss these complaints for lack of subject matterjurisdiction and failure to state a claim. In May of 2006, the Boardcommittee, after completing its investigation, concluded that pursuit of theallegations would not be in the best interests of Digimarc or its shareholders.On August 24, 2006, the court granted defendants’ motion and dismissed thelawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22,2006. The schedule for submission of appellate briefs has not been set. Due tothe inherent uncertainties of litigation, the Company cannot accurately predictthe ultimate outcome of the matter.

9

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Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including Digimarc, certain ofits officers and directors, and certain underwriters of the Company’s initialpublic offering as defendants. The complaints have since been consolidated intoa single action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-marketsubsequent to the Company’s initial public offering. The Company and certain ofits officers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions, includingthe Company. The claims against the Company under Section 10(b), however,were dismissed. In June 2003, a committee of the Company’s board ofdirectors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval. The settlement would provide,among other things, a release of the Company and of the individual defendantsfor the conduct alleged in the amended complaint to be wrongful. The Companywould agree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. On August 31, 2005, the courtissued a preliminary order further approving the modifications to thesettlement and certifying the settlement classes. The court also appointed theNotice Administrator for the settlement and ordered that notice of thesettlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearingwas held on April 26, 2006, but the court has not yet rendered itsdecision. If the court determines that the settlement is fair to the classmembers, the settlement will be approved. On December 5, 2006, the UnitedStates Court of Appeals for the Second Circuit issued a decision vacating theorder of the United States District Court for the Southern District of New Yorkthat had granted class certification for the plaintiffs and remanded the matterfor further proceedings. There can be no assurance that the proposed settlementwill be approved and implemented in its current form, or at all. Due to theinherent uncertainties of litigation and the recent decision of the Court ofAppeals vacating the order granting class certification, the Company cannotaccurately predict the ultimate outcome of the matter.

**ITEM 4:**               SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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**PART II**

**ITEM 5:**               MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURTIES

Our common stock is traded on The Nasdaq Global Marketunder the symbol “DMRC.” The closing price of our common stock on TheNasdaq Global Market was $9.52 as of January 31, 2007. The following tablelists the high and low sales prices of our common stock for the periodsindicated, as reported by The Nasdaq National Market.

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **     | ** ** | **High**                                   | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                          | 8.00       |   | $ | 5.85 |   | $ | 9.79 |   | $ | 5.81 |   |
| Second quarter |       | $                                          | 7.76       |   | $ | 5.85 |   | $ | 6.40 |   | $ | 4.44 |   |
| Third quarter  |       | $                                          | 8.45       |   | $ | 5.56 |   | $ | 7.34 |   | $ | 5.20 |   |
| Fourth quarter |       | $                                          | 9.75       |   | $ | 7.51 |   | $ | 6.95 |   | $ | 5.82 |   |

 

At February 28, 2007, there were 119 stockholdersof record of our common stock, as shown in the records of our transfer agent.

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

Thefollowing table sets forth information regarding the Company’s purchases of itsequity securities during the quarter ended December 31, 2006, all of whichwere shares subject to restricted stock awards that we purchased from five ofour executive officers to cover applicable tax withholding obligations whenthese awards vested.

| ** Period**          | ** ** | ** ** | ** ** | **(a)  Total number  of shares (or units)  purchased** | ** ** | **(b)  Average price paid  per share (or unit)** | ** ** | **(c)  Total number of  shares (or units)  purchased as part of  publicly announced  plans or programs** | ** ** | **(d)  Maximum number (or  approximate dollar value)  of shares (or units) that  may yet be purchased  under the plans or  programs** | ** ** |
|---------------------------|------------|------------|------------|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Month 1                   |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| October 1,  2006 to  |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| October 31, 2006     |       |       | —     |                                                                       |       |                                                                      | —     |                                                                                                                                                       |       |                                                                                                                                                                                                        | —     |   |   |   | — |   |   |
| Month 2                   |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| November 1,  2006 to |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| November 30, 2006    |       |       | —     |                                                                       |       |                                                                      | —     |                                                                                                                                                       |       |                                                                                                                                                                                                        | —     |   |   |   | — |   |   |
| Month 3                   |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| December 1,  2006 to |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| December 31, 2006    |       |       | 23,649     |                                                                       |       |                                                                      | $          | 8.79                                                                                                                                                       |       |                                                                                                                                                                                                        |       | — |   |   |   | — |   |   |
| Total.                    |       |       | 23,649     |                                                                       |       |                                                                      | $          | 8.79                                                                                                                                                       |       |                                                                                                                                                                                                        |       | — |   |   |   | — |   |   |

 

11

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**STOCK PERFORMANCEGRAPH**

*Not withstandinganything to the contrary set forth in any of the Company’s previous filingsunder the Securities Act of 1933, as amended (the “Securities Act”), or theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), that might incorporatefuture filings, in whole or in part, the following graph shall not be deemed tobe “soliciting material” or to be “filed” with the Securities and ExchangeCommission, nor shall such graph be incorporated by reference into any suchfilings, nor shall the following graph be deemed to be incorporated byreference into any future filings under the Securities Act or the Exchange Act.*

The following graphcompares the performance of our common stock with the performance of (i) theNasdaq U.S. Index, (ii) a peer group selected by the Company and (iii) thecompanies included in Standard Industrial Classification (“SIC”) Code 7373—computerIntegrated Systems Design (the peer group used for purposes of the stockperformance graph included in the proxy statement relating to our 2006 annualmeeting of stockholders). The comparison assumes $100 was invested on December 31,2001 in our common stock at the closing price on such date and in each of theother three indices at the closing price on such date and assumes reinvestmentof any dividends. We have changed our peer group from the companies included inSIC Code 7373 to a peer group consisting of companies within the securitysoftware and government information technology industries. We believe that thecompanies in the latter group are more comparable to the Company in terms ofline-of-business, market capitalization, revenues, and number of employees and,therefore, comprise a more appropriate peer group for purposes of comparingstock performance. The comparisons in the graph are based on historical dataand are not indicative of, nor intended to forecast, future performance of theCompany’s common stock.

****

| ** **                              | ** ** | **Indexed Data** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **Base**              | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Period**            | ** ** | **Year Ending December 31,** | ** ** |
| **Company Name / Index** | ** ** | ** **            | ** ** | **Dec01** | ** ** | **Dec02** | ** ** | **Dec03** | ** ** | **Dec04** | ** ** | **Dec05** | ** ** | **Dec06** | ** ** |
| **DIGIMARC CORP**                       | ** ** |                  | **100**    |   |   | 61.03 |   | 71.58 |   | 50.16 |   | 31.75 |   | 47.31 |   |
| **NASDAQ U.S INDEX**                    | ** ** |                  | **100**    |   |   | 69.13 |   | 103.36 |   | 112.49 |   | 114.88 |   | 126.69 |   |
| **PEER GROUP**                          | ** ** |                  | **100**    |   |   | 50.00 |   | 78.61 |   | 91.69 |   | 72.10 |   | 66.79 |   |
| **SIC  GROUP**                          | ** ** |                  | **100**    |   |   | 59.19 |   | 92.24 |   | 104.28 |   | 102.26 |   | 119.76 |   |
|                                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

12

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| Companies included in the  peer group index of the stock performance graph are as follows:    |
|-----------------------------------------------------------------------------------------------|
| ACTIVIDENTITY CORP                                                                            |   | ENTRUST INC |   | NIC INC |
| ALADDIN KNOWLEDGE SYS LTD                                                                     |   | L-1 IDENTITY SOLUTIONS INC |   | RAE SYSTEMS INC |
| AMERICAN BK NT HOLOGRAPHICS                                                                   |   | LASERCARD CORP |   | SAFENET INC |
| COGENT INC                                                                                    |   | MACROVISION CORP |   | SCM MICROSYSTEMS INC |
| COMPUDYNE CORP                                                                                |   | MEDIALINK WORLDWIDE INC |   | TYLER TECHNOLOGIES INC |
| DTS INC                                                                                       |   | NCI INC |   | VERINT SYSTEMS INC |
| DYNAMICS RESEARCH CORP                                                                        |   |   |   |   |
| **Companies included in the SIC  group index of the stock performance graph are as follows:** |
| 1MAGE SOFTWARE INC                                                                            |   | F5 NETWORKS INC |   | NYFIX INC |
| 3SI HOLDINGS INC                                                                              |   | FAIR ISAAC CORP |   | PACKETEER INC |
| ACE COMM CORP                                                                                 |   | FIRST CONSULTING GROUP INC |   | PDF SOLUTIONS INC |
| ACS MOTION CONTROL LTD                                                                        |   | FUJITSU LTD—ADR |   | PEROT SYSTEMS CORP |
| ALADDIN KNOWLEDGE SYS LTD                                                                     |   | FUNDTECH LTD |   | PLANGRAPHICS INC |
| ALLIN CORP                                                                                    |   | FUTURELINK CORP |   | PRACTICEXPERT INC |
| ALTERNATE ENERGY CORP                                                                         |   | GUARDIAN TECHNOLOGIES INTL |   | PRESCIENT APPLIED INTELLIGEN |
| AMERIRESOURCE TECHNLGIES  INC                                                                 |   | HALIFAX CORP |   | PSI CORP |
| APPLIED DIGITAL SOLUTIONS                                                                     |   | HALO TECHNOLOGY HLDGS INC |   | QUALITY SYSTEMS INC |
| ARADYME CORP                                                                                  |   | HENRY (JACK) & ASSOCIATES |   | RADIANT SYSTEMS INC |
| AREL  COMMUNICATIONS & SFTWR                                                         |   | IBSG INTERNATIONAL INC |   | REDBACK NETWORKS INC |
| ASA INTERNATIONAL LTD                                                                         |   | IMAGEWARE SYSTEMS INC |   | S1 CORP |
| ASPYRA INC                                                                                    |   | IMERGENT INC |   | SABRE HOLDINGS CORP—CL A |
| AT ROAD INC                                                                                   |   | INFOTECH USA INC |   | SAFEGUARD SCIENTIFICS INC |
| AUTHENTIDATE HOLDING CORP                                                                     |   | INTEGRAL SYSTEMS INC |   | SAFLINK CORP |
| AWARE INC                                                                                     |   | INTELLIGROUP INC |   | SEACHANGE INTERNATIONAL INC |
| BELL INDUSTRIES INC                                                                           |   | INTERACTIVE GAMES INC |   | SECURE TECHNOLOGIES GROUP |
| BRAINTECH INC                                                                                 |   | INTERMOST CORP |   | SECURED SERVICES INC |
| BREAKAWAY SOLUTIONS INC                                                                       |   | IPIX CORP |   | SECURELOGIC CORP |
| BROADVISION INC                                                                               |   | ITA HOLDINGS INC |   | SENTO CORP |
| BVR SYSTEMS LTD                                                                               |   | KANBAY INTERNATIONAL INC |   | SI INTERNATIONAL INC |
| CACI INTL INC—CL A                                                                       |   | L-1 IDENTITY SOLUTIONS INC |   | SONUS NETWORKS INC |
| CAM COMM SOLUTIONS INC                                                                        |   | LEVEL 3 COMMUNICATIONS INC |   | SPESCOM SOFTWARE INC |
| CERNER CORP                                                                                   |   | MANATRON INC |   | STREAMLINE HEALTH SOLUTIONS |
| CERTICOM CORP                                                                                 |   | MANHATTAN ASSOCIATES INC |   | SYNIVERSE HOLDINGS INC |
| CEYONIQ AG—ADR                                                                           |   | MANTECH INTL CORP |   | SYS |
| COGENT INC                                                                                    |   | MEDCOM USA INC |   | TECHNOLOGY SOLUTIONS CO |
| COMPUTER PROGRAMS &  SYSTEMS                                                         |   | MEDIWARE INFORMATION SYSTEMS |   | TELTRONICS INC |
| CSP INC                                                                                       |   | MENTOR GRAPHICS CORP |   | TRIMOL GROUP INC |
| DATALINK CORP                                                                                 |   | MERCURY COMPUTER SYSTEMS INC |   | TRIPLE P NV |
| DEALERADVANCE INC                                                                             |   | MERGE TECHNOLOGIES INC |   | TROY GROUP INC |
| DIGITAL DESCRIPTOR SYS INC                                                                    |   | MICROS SYSTEMS INC |   | TTI TEAM TELECOM INTL LTD |
| DIGITAL LIGHTHOUSE CORP                                                                       |   | NAVTECH INC |   | TYLER TECHNOLOGIES INC |
| DYNAMICS RESEARCH CORP                                                                        |   | NCI INC |   | UNISYS CORP |
| DYNTEK INC                                                                                    |   | NESS TECHNOLOGIES INC |   | USA VIDEO INTERACTIVE CORP |
| ECLIPSYS CORP                                                                                 |   | NESTOR INC |   | VERINT SYSTEMS INC |
| ELBIT SYSTEMS LTD                                                                             |   | NETSCOUT SYSTEMS INC |   | VERSO TECHNOLOGIES INC |
| ELBIT VISION SYSTEMS LTD                                                                      |   | NETSMART TECHNOLOGIES INC |   | VIRTUALSCOPICS INC |
| EMBARCADERO TECHNOLOGIES  INC                                                                 |   | NETWORK ENGINES INC |   | WIPRO LTD—ADR |
| EMERGE INTERACTIVE INC                                                                        |   | NQL INC |   | WORLDGATE COMMUNICATIONS INC |
| EMTEC INC                                                                                     |   |   |   |   |

 

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**ITEM 6:**               SELECTEDFINANCIAL DATA

Theselected financial data set forth below should be read in conjunction with theconsolidated financial statements and the notes to the consolidated financialstatements and “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” which are included elsewhere in this report. Theconsolidated statement of operations and balance sheet data as of and for eachof the five years in the period ended December 31, 2006, are derived fromour audited consolidated financial statements.

| ** **                                      | ** ** | **Year Ended December 31,**                          | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                      | ** ** | **(in 000’S, except per share data)** | ** ** |
| **Consolidated Statement of  Operations Data:** |       |                                                                |       |   |   |   |   |   |   |   |   |
| Revenue                                         |       | $                                                                   | 104,247    |   | $ | 101,053 |   | $ | 92,947 |   | $ | 85,591 |   | $ | 86,617 |   |
| Net income (loss)                               |       | $                                                                   | (11,740    | ) | $ | (23,097 | ) | $ | (9,022 | ) | $ | 175 |   | $ | (8,689 | ) |
| Net income (loss) per share—basic          |       | $                                                                   | (0.57      | ) | $ | (1.13 | ) | $ | (0.44 | ) | $ | 0.01 |   | $ | (0.50 | ) |
| Net income (loss) per share—diluted        |       | $                                                                   | (0.57      | ) | $ | (1.13 | ) | $ | (0.44 | ) | $ | 0.01 |   | $ | (0.50 | ) |
| Weighted average shares—basic              |       | 20,649                                                              |       | 20,485 |   | 20,326 |   | 18,572 |   | 17,361 |   |
| Weighted average  shares—diluted           |       | 20,649                                                              |       | 20,485 |   | 20,326 |   | 19,351 |   | 17,361 |   |

 

| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                     | ** ** | **(in 000’S)**                   | ** ** |
| **Consolidated Balance Sheet  Data:**          |       |                                       |       |   |   |   |   |   |   |   |   |
| Total assets                                   |       | 134,631                                    |       | 140,239 |   | 163,287 |   | 161,153 |   | 132,467 |   |
| Long-term  obligations, net of current portion |       | 6,230                                      |       | 3,009 |   | 3,104 |   | 2,006 |   | 488 |   |

 

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                             | ** ** | **(in 000’S)**                   | ** ** |
| Long-term  obligations, net of current portion, before |       | $                                          | 969        |   | $ | 1,112 |   | $ | 1,286 |   | $ | 7 |   |
| Deferred revenue,  long-term                           |       | 2,040                                      |       | 1,992 |   | 720 |   | 481 |   |
| Long-term obligations,  net of current portion, after  |       | $                                          | 3,009      |   | $ | 3,104 |   | $ | 2,006 |   | $ | 488 |   |

 

See Note 1 to theconsolidated financial statements for information regarding thereclassification of long-term deferred revenue.

**ITEM 7:**               MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements relating to future events or thefuture financial performance of Digimarc, which involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements. Please see the discussionregarding forward-looking statements included in this Item 7, under thecaption “Safe Harbor Statement under the Private Securities Litigation ReformAct of 1995.”*

*Although Digimarcbelieves that the expectations reflected in such forward-looking statements arereasonable, it cannot give any assurances that these expectations will prove tobe correct. Such statements by their nature involve substantial risks anduncertainties that could significantly affect expected results. Actual futureresults could differ materially from those described in such forward-lookingstatements, and Digimarc does not intend to update or revise anyforward-looking statements as a result of new information, future events orotherwise. Readers are urged to carefully review and consider the variousdisclosures made by us which attempt to advise interested parties of thefactors which affect our business, including without limitation the disclosuresmade under the caption “Factors Affecting Forward Looking Statements” in thisItem 7, the audited*

14

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*consolidated financial statements and related notesincluded in this Annual Report on Form 10-K, and other reports andfilings made with the SEC.*

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-K.*

**Overview**

Digimarc is a leading supplier of secure identitysolutions and digital watermarking technology for use in media management. Oursolutions enable governments and businesses around the world to enhance trafficsafety and national security, combat identity theft and fraud, facilitate theeffectiveness of voter identification programs, improve the management of mediacontent, deter counterfeiting and piracy and support new digital mediadistribution models that provide consumers with more choice and access to mediacontent.

The substantial majorityof our revenue is generated pursuant to long-term contracts with governmentagencies—primarily U.S. state government agencies responsible for driverlicense issuance, a consortium of leading Central Banks, and nationalgovernments of a number of foreign countries. These customers rely on oursystems design, integration and materials science expertise, and proprietarytechnologies such as digital watermarking, to implement issuance systems andprocesses that improve the security of identity documents and banknotes. Theremainder of our revenue is generated through commercial applications of ourdigital watermarking and related technologies, primarily from patent andtechnology license fees paid by business partners.

*Secure ID Solutions*

We issue more than 60 million IDs annually and are theleading supplier of government-issued citizen IDs in North America and producesmore than two-thirds of all driver licenses issued in the U.S. Most of our U.S.revenue is generated through the issuance of State driver licenses and is paidin the form of a fixed price per credential issued. Our secure ID solutionstypically include hardware (including specialized cameras, printers, personalcomputers and servers), software, consumable supplies (such as ribbons, blankor preprinted card materials and laminated and related consumables) and ongoingsupport services.

*Seasonality.**  *We have observed seasonality in our U.S. driverlicense issuance revenues, with larger revenues in the second and third quarterof the year, and generally lower revenues in the first and fourth quarters. Thefourth quarter is usually the seasonally lowest quarter each year. We use thestraight line method of depreciation and amortization for program-relatedassets. The combination of the seasonality of our revenues and straight linedepreciation and amortization can cause significant variations in quarterlygross margin trends, generally increasing margins in the second and thirdquarters when our issuance revenues are higher and decreasing margins in thefirst and fourth quarters when our issuance revenues are typically lower, whilehaving a neutral effect on a yearly basis.

*International.**  *In international markets, where we provide driverlicense, national identification, and voter identification systems, services,and components in partnership with local card producers, security printers,system integrators, and others, we may serve as prime contractor orsub-contractor, depending on the circumstances. As a sub-contractor, wegenerally are responsible for delivering hardware, software, or consumables,and some degree of integration services to the prime contractor; whereas as aprime contractor, we are responsible for integrating all components of thesystem to the customer’s specifications.

International revenues are typically generated fromsales of equipment and/or consumables to government agencies or their primecontractors. These sales may occur at irregular intervals, carry relatively lowmargins and cause variations in quarterly revenue and gross profit trends. Weenter into low margin contracts and transactions from time to time to maintainmarket presence and build relationships 

15

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with customers andbusiness partners, as often transition to more profitable digital technologiesover time. Due to the nature of such international programs and customers, thetiming of these sales is less predictable than our service revenues provided bydomestic customers and, consequently, international sales can occur unevenlyduring the course of a year.

*Backlog.**  *Based on projected government-issued credentialproduction volumes and other commitments we have for the periods under contractwith our respective customers, we anticipate our current contracts as of December 31,2006 will generate approximately $250 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectmore than $85 million of this amount to be recognized as revenue during 2007.This amount includes production volumes reasonably expected to be achievedunder currently effective contracts, government orders that are firm but notyet funded, and government contracts awarded but not yet signed. Backlog as of December 31,2005 was approximately $230 million.

Some factors thatlead to increased backlog are:

·       Competitivebid wins,

·       Renewalswith current customers,

·       Add-onsales to current customers, and

·       Contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Some factors thatlead to decreased backlog are:

·       Recognitionof revenue associated with backlog currently in place,

·       Lowbid activity,

·       Contractswith shorter contractual periods replacing contracts with longer contractualperiods, and

·       Therevenue model utilized for a particular customer (e.g., a “price-per-card”model with a large associated backlog vs. a “hardware and consumables” modelwith a small associated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period. For example,during the year ended December 31, 2006, we had a high level of awards andextensions, and as a result we have increased our backlog during the year. Overthe next year or so, we anticipate several States to request bids or negotiateextensions on their driver license issuance system programs. This period ofexpected high bid and potential extension activity could lead to additionalbacklog if we are successful with our bids. Another example is our variablerevenue model. From time to time we have sales to our customers that are notcharacteristic of our price-per-card model, but instead included hardware andconsumable sales. Although these types of revenue models are positive growthindicators for our business, they can lead to lower reported backlog.

There can be no assurance that our backlog will resultin actual revenue in any particular period, because the orders, awards andcontracts included in our backlog may be subject to modification, cancellationor suspension. We may not realize revenue on certain contracts, orders orawards included in our backlog or the timing of such recognition may change.

*Depreciation.**  *Starting January 1, 2006, we changed our policyfor depreciating fixed assets that were specifically used to provide servicesunder long-term contracts to the shorter of the original contract term plus2.75 years or estimated useful life. Through December 31, 2005, wedepreciated these assets over the shorter of the original contract term orestimated useful life. This change in estimate was supported by an analysis wecompleted during the first quarter of 2006 which showed that historically 95%of contracts were extended beyond the original contract term, that the averagecontract had at least two contract 

16

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extensions during its lifeand that these extensions added on average 2.75 years to the length of thecontracts’ original terms.

Since contract-specificprogram assets are tracked on a contract basis, the finding that contracts areroutinely extended beyond the original term and that these extensions are notgenerally accompanied by significant incremental capital investment indicatesthat the useful life of contract-related assets is generally longer than theoriginal term of the contract. Given these findings, we concluded that it wasappropriate to change the estimated useful lives of these assets for purposesof depreciation. In addition, the change in useful lives achieves a bettermatching of the utility of these assets with the resulting revenues. For theyear ended December 31, 2006, we performed an updated analysis on contractspecific assets which resulted in no change to our previous conclusions. Wewill continue to analyze the useful lives of contract specific assets in futureperiods. The financial impact of this change is discussed below in the Cost ofRevenue.

*Restructuring*

During the last half of2005 and continuing during 2006, the Company restructured it operations toimprove productivity and reduce fixed costs. During the second quarter of 2006we accelerated those activities significantly, resulting in a reduction of ourworkforce by nearly 20%. Overall, our workforce was reduced by over 30% sincemid 2005. Our actions included the redeployment and reallocation of resourcesto better align with our operating strategies. The discussion and analysis ofour operations presented below reflects the improvement in the operatingresults for the year ended December 31, 2006 as compared to the year endedDecember 31, 2005.

**Critical AccountingPolicies and Estimates**

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the U.S. (“U.S.GAAP”) requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to bad debts, inventories, intangibleassets, income taxes, restructuring, long-term service contracts, warranties,investments, and contingencies and litigation. We base our estimates onhistorical experience and on various other assumptions we believe to bereasonable under the circumstances. Actual results may differ from theseestimates under different assumptions or conditions.

Certain of our accounting policies require higherdegrees of judgment than others in their application. These include revenuerecognition on long-term service contracts, impairments and estimation ofuseful lives of long-lived assets, inventory valuation, reserves foruncollectible accounts receivable, and contingencies and litigation. We believethe following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements:

**Revenue recognition on long-term service contracts:****  **We recognize revenue on long-term identificationand driver license production contracts using primarily a price-per-cardmethod. We use actual monthly volume amounts, if available, or we estimate thecard production volume on a monthly basis for certain of these contracts inorder to recognize revenue earned during the period. In the case of estimates,when the actual production information becomes available, which is typicallywithin four weeks, we bill the customer accordingly and any differences from theestimates are recognized in the month the billing occurs. These amountsrepresent our best estimates of cards produced and are based on historicaltrends, known events during the period, and discussions with contractrepresentatives. Prior to publicly reporting results, our practice is tocompare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Any estimated amounts are included inunbilled receivables on the balance sheet until the actual production 

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information is available and the billing occurs. Anyestimation process involves inherent risk. We reduce the inherent risk relatingto production estimation through our approval and monitoring processes relatedto accounting estimates. We also evaluate contracts for multiple elements andaccount for these items under the appropriate accounting literature.

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. Losses on contracts, if any, are provided for in the period in whichthe loss becomes determinable. Billing for services rendered generally occurswithin one month following when the services are provided. Revenue earned whichhas not been invoiced is classified as unbilled trade receivables, which isincluded in the balance of trade accounts receivable, net in the consolidatedbalance sheets.

**Impairments and estimation of useful lives of long-livedassets:****  **Weperiodically assess long-lived assets for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable, in accordance with the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal of Long-Lived Assets.* Thisstatement requires that long-lived assets and certain identifiable intangiblesbe reviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future net undiscounted cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Fair value is determined based ondiscounted cash flows or appraised values, depending on the nature of theasset. Also, we periodically review the useful lives of long-lived assetswhenever events or changes in circumstances indicate that the useful life mayhave changed. If the estimated useful lives of such assets do change, we adjustthe depreciation or amortization period to a shorter or longer period, based onthe circumstances identified.

**Inventory valuation:****  **Inventory consists primarily of consumablesupplies that are used in the production of driver licenses and products heldfor resale to customers. We value inventory at the lower of cost or marketvalue (which lower amount is the net realizable value). We reduce the value ofour inventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required.

**Reserves for uncollectible accounts receivable:****  **We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. We determine the allowance based on historical write-off experienceand current information. We review, and adjust when appropriate, our allowancefor doubtful accounts on at least a quarterly basis. If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required.

**Contingencies and Litigation:**   We periodically evaluate all pending orthreatened contingencies or commitments, if any, that are reasonably likely tohave a material adverse effect on our operations or financial position. Weassess the probability of an adverse outcome and determine if it is remote,reasonably possible or probable as defined in accordance with the provisions ofSFAS No. 5, *Accounting for Contingencies*. Ifinformation available prior to the issuance of our financial statementsindicates that it is probable that an asset has been impaired or a liabilityhas been incurred at the date of our financial statements, and the amount ofthe loss, or the range of probable loss can be reasonably estimated, then suchloss is accrued and charged to operations. If no accrual is made for a 

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loss contingency because one or both of the conditions pursuant to SFASNo. 5 are not met, but the probability of an adverse outcome is at leastreasonably possible, we will disclose the nature of the contingency and providean estimate of the possible loss or range of loss, or state that such anestimate cannot be made.

**Stock-based compensation:****  **OnJanuary 1, 2006, we adopted *SFAS No. 123(R),*Share-Based Payment(Revised 2004), whichrequires the measurement and recognition of compensation for all stock-basedawards made to employees and directors including stock options and employeestock purchases under a stock purchase plan based on estimated fair values.Under SFAS 123(R), we use the Black-Scholes option pricing model as ourmethod of valuation for stock-based awards. Our determination of the fairvalue of stock-based awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofhighly complex and subjective variables. These variables include, but are notlimited, to the expected life of the award, our expected stock price,volatility over the term of the award and actual and projected exercisebehaviors. Although the fair value of stock-based awards is determined inaccordance with SFAS 123(R), the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results.

**Results ofOperations**

Thefollowing table presents our consolidated statement of operations data for theperiods indicated as a percentage of total revenue.

| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                       | 82         | % |   |   | 84 | % |   |   | 80 | % |   |
| Product and subscription                         |       |                                       | 18         |   |   |   | 16 |   |   |   | 20 |   |   |
| Total revenue                                    |       |                                       | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                       | 58         |   |   |   | 61 |   |   |   | 51 |   |   |
| Product and subscription                         |       |                                       | 8          |   |   |   | 7 |   |   |   | 13 |   |   |
| Total cost of revenue                            |       |                                       | 66         |   |   |   | 68 |   |   |   | 64 |   |   |
| Gross profit                                     |       |                                       | 34         |   |   |   | 32 |   |   |   | 36 |   |   |
| Operating expenses:                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                                       | 15         |   |   |   | 16 |   |   |   | 14 |   |   |
| Research, development and engineering            |       |                                       | 10         |   |   |   | 13 |   |   |   | 9 |   |   |
| General and administrative                       |       |                                       | 16         |   |   |   | 21 |   |   |   | 19 |   |   |
| Amortization of intangibles                      |       |                                       | 2          |   |   |   | 4 |   |   |   | 3 |   |   |
| Intellectual property                            |       |                                       | 2          |   |   |   | 2 |   |   |   | 2 |   |   |
| Restructuring charges, net                       |       |                                       | 1          |   |   |   | — |   |   |   | — |   |   |
| Total operating expenses                         |       |                                       | 46         |   |   |   | 56 |   |   |   | 47 |   |   |
| Operating income (loss)                          |       |                                       | (12        | ) |   |   | (24 | ) |   |   | (11 | ) |   |
| Other income (expense):                          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                  |       |                                       | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                 |       |                                       | —     |   |   |   | — |   |   |   | — |   |   |
| Other                                            |       |                                       | —     |   |   |   | — |   |   |   | — |   |   |
| Total other income, net                          |       |                                       | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                                       | (11        | ) |   |   | (23 | ) |   |   | (10 | ) |   |
| Provision for  income taxes                      |       |                                       | —     |   |   |   | — |   |   |   | — |   |   |
| Net income (loss)                                |       |                                       | (11        | )% |   |   | (23 | )% |   |   | (10 | )% |   |

 

 

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**Years Ended December 31,2006 and 2005**

*Revenue*

| ** **                       | ** ** | **Twelve Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|----------------------------------|------------|-----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                       | ** ** | **December 31,**             | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                       | ** ** | **2006**                          | ** ** | **2005**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                       | ** ** | ** **                        | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Revenue:                         |       |                              |       |                     |       |           |       |   |   |   |   |   |   |
| Service                          |       | $                                 | 85,681     |                     | $          | 84,691         |       |   | $ | 990 |   |   |   | 1 | % |   |
| Product and subscription         |       | 18,566                            |       | 16,362                   |       |           | 2,204      |   |   |   | 13 | % |   |
| Total                            |       | $                                 | 104,247    |                     | $          | 101,053        |       |   | $ | 3,194 |   |   |   | 3 | % |   |
| Revenue (as % of total revenue): |       |                              |       |                     |       |           |       |   |   |   |   |   |   |
| Service                          |       | 82%                               |       | 84%                      |       |           |       |   |   |   |   |   |   |
| Product and subscription         |       | 18%                               |       | 16%                      |       |           |       |   |   |   |   |   |   |
| Total                            |       | 100%                              |       | 100%                     |       |           |       |   |   |   |   |   |   |

 

*Service.**  *Servicerevenue consists primarily of:

·        cardproduction on a price-per-card basis,

·        softwaredevelopment services, and

·        hardwareand software maintenance.

The majority of service revenue arrangements aretypically structured as price-per-card product agreements, time and materialsconsulting agreements, or fixed price consulting agreements.

Service revenue increased primarily due to increasedprogram work from the consortium of central banks, increased production forcertain programs that reached full production in 2006 including programs forstate driver license issuers in Florida and Alabama. These increases in servicerevenue were offset by decreased revenue from the Mexico program due to ahiatus before national elections, changes in driver license renewal terms inCalifornia and Massachusetts, and the completion of our contract with WestVirginia.

*Productand subscription.**  *Product revenueconsists primarily of the sale of equipment and consumables related toidentification card production systems and software licenses that are variablein nature and occur from time to time. Subscription revenue consists primarilyof royalty revenue from our intellectual property licenses and the sale of ourweb-based subscriptions related to various software products, both of which aremore recurring in nature.

Product and subscriptionrevenue increased primarily from the addition of three large internationalprograms with Yemen, Ghana and Russia, related to either new ID programs orincreased volume of consumable sales. The product and subscription revenue wasoffset by decreased revenue from certain domestic customers due to lowerhardware sales in 2006.

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*Revenue by Geography*

| ** **                        | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2006**                          | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                        | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Revenue by geography:             |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                          |       | $                                 | 83,161     |         | $          | 80,119         |       |   | $ | 3,042 |   |   |   | 4 | % |   |
| International                     |       | 21,086                            |       | 20,934       |       |           | 152        |   |   |   | 1 | % |   |
| Total                             |       | $                                 | 104,247    |         | $          | 101,053        |       |   | $ | 3,194 |   |   |   | 3 | % |   |
| Revenue (as % of  total revenue): |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                          |       | 80%                               |       | 79%          |       |           |       |   |   |   |   |   |   |
| International                     |       | 20%                               |       | 21%          |       |           |       |   |   |   |   |   |   |
| Total                             |       | 100%                              |       | 100%         |       |           |       |   |   |   |   |   |   |

 

The increase in domestic revenue was primarily due toincreased revenue from the state driver license issuers in Florida and Alabamaas these programs reached full production levels, offset by lower productionrevenues in West Virginia, lower hardware sales in Ohio and certain otherStates that occurred as a result of normal fluctuations in issuance volumesthat we may experience from time to time.

The slight increase ininternational revenue was primarily due to increased revenue from Yemen, Ghanaand Russia related to either new ID programs or an increase in consumablesales. These increases are not expected to continue in a linear manner or recurat regular intervals. The increase in international revenue was offset byreduced revenue from our Mexico program due to a hiatus before nationalelections and decreased product sales to Honduras.

*Cost of Revenue*

| ** **                                             | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                             | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                             | ** ** | **2006**                          | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                             | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Cost of Revenue:                                       |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | $                                 | 60,817     |         | $          | 61,465         |       |   | $ | (648 | ) |   |   | (1 | )% |   |
| Product and subscription                               |       | 7,952                             |       | 6,707        |       |           | 1,245      |   |   |   | 19 | % |   |
| Total                                                  |       | $                                 | 68,769     |         | $          | 68,172         |       |   | $ | 597 |   |   |   | 1 | % |   |
| Cost of Revenue (as % of  related revenue components): |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | 71%                               |       | 73%          |       |           |       |   |   |   |   |   |   |
| Product and  subscription                              |       | 43%                               |       | 41%          |       |           |       |   |   |   |   |   |   |

 

*Service.*   Cost of service revenue primarilyincludes:

·        costsof consumables used in delivering a service,

·        compensationfor software developers, quality assurance personnel, product managers, fieldoperations personnel, business development personnel and outside contractors,

·        depreciationcharges for machinery, equipment and capitalized software,

·        deploymentcosts used specifically for service delivery,

·        provisionsfor obsolete and excess inventories,

·        travelcosts directly attributable to service and development contracts,

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·        stockbased compensation expense, and

·        chargesfor infrastructure and centralized costs.

Cost of servicerevenue decreased primarily due to:

·        decreaseddepreciation expense, net of $3.4 million, as a result of the estimateddecrease of $8.0 million attributable to the change in estimated useful livesof program assets as of December 31, 2005, as discussed below, offset byan increase of $4.6 million related to programs that were deployed in 2005 andfor which we realized a full year of depreciation in 2006 and an increase indepreciation attributable to upgrades made to certain other programs,

·        decreasedcontract and temporary labor of $2.6 million as part of the cost cuttinginitiative where a number of contractors were converted to employees at loweraverage costs,

·        decreasedother operating expenses such as small tools and repairs and maintenance of$0.7 million related to cost cutting initiatives, offset by

·        increasedemployee compensation-related expenses of $5.7 million resulting from:

·       convertingcontract labor to permanent labor at a lower average cost per person,

·       redeployingresources to program activities as part our restructuring initiative undertakenthroughout the year,

·       allocatingresources to fixing or improving existing programs, rather than to capitalprojects relating to the development of new programs, which occurred primarilyduring the first half of the year,

·       increasein stock option expense related to the adoption of SFAS 123(R) regardingstock-based compensation as discussed below, and

·        increasedallocated infrastructure and centralized costs of $0.9 million primarily due tosystem upgrades and enhancements in our information technology operations.

*Productand subscription.*   Cost of product and subscription revenue primarilyincludes costs of equipment and consumables related to our ID productionsystems, as well as Internet service provider connectivity charges and imagesearch data fees to support the services offered to our subscription customers.

Cost of product andsubscription revenue increased primarily due to:

·        increaseddirect consumable costs related to three international customers of $2.5million, offset by

·        lowerdirect hardware costs related to a domestic customer of $1.8 million.

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Thecosts components included in our cost of revenue are comprised of threecategories as described below:

| ** **                                 | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                 | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                 | ** ** | **2006**                          | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                 | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Cost of revenue:                           |       |                              |       |         |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                   |       |                              | $          | 29,145       |       |           | $          | 28,083 |   |   | $ | 1,062 |   |   |   | 4 | % |   |
| Fixed field support and manufacturing |       |                              | 28,972     |         |       | 25,997         |       |   | 2,975 |   |   |   | 11 | % |   |
| Program depreciation                       |       |                              | 10,652     |         |       | 14,092         |       |   | (3,440 | ) |   |   | (24 | )% |   |
| Total                                      |       |                              | $          | 68,769       |       |           | $          | 68,172 |   |   | $ | 597 |   |   |   | 1 | % |   |
| Cost of revenue (as % of  total revenue):  |       |                              |       |         |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                   |       |                              | 28%        |         |       | 28%            |       |   |   |   |   |   |   |   |   |
| Fixed field support and manufacturing |       |                              | 28%        |         |       | 26%            |       |   |   |   |   |   |   |   |   |
| Program depreciation                       |       |                              | 10%        |         |       | 14%            |       |   |   |   |   |   |   |   |   |
| Total                                      |       |                              | 66%        |         |       | 68%            |       |   |   |   |   |   |   |   |   |

 

Variable costs include:

·        priceof materials and labor to produce an identification card,

·        directcosts of hardware and software delivered, and

·        othercosts that are variable in nature.

While the variable cost as a percentage of revenueremained the same, the increase in variable costs is primarily due to theincrease in sales of consumables and product sales to our internationalcustomers.

Fixed field supportand manufacturing includes:

·        fieldoperations and support,

·        manufacturing,

·        supplychain costs, and

·        chargesfor infrastructure and centralized costs.

These costs are considered fixed with respect tosupporting current contracts. As new contracts are entered into and delivered,the overall level of fixed costs increases. The increase in fixed costs areprimarily due to newer contracts requiring additional headcount, as well astravel costs to support them. During the first two quarters of the fiscal year,we focused on improving certain existing programs and as a result fewerexpenditures were capitalized to the balance sheet. As a result of theseactions, fixed support costs increased. After improving the efficiencies inthese programs, our fixed costs returned to more normal levels during thesecond half of the year.

Program depreciation primarily consists of amortizationand depreciation of costs incurred during the delivery process, where suchcosts are capitalized and then amortized or depreciated over the useful livesof the assets to which the costs relate. Program depreciation decreased inrelation to the other components of cost of revenue primarily due to the changein the estimated useful lives of program-related fixed assets.

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Thefollowing table shows the effect of this policy of reducing depreciationexpense in 2006 for assets in place at December 31, 2005, as well as theexpected effect in the future periods specified:

| ** **                         | ** ** | **Q1 2006**         | ** ** | **Q2 2006** | ** ** | **Q3 2006** | ** ** | **Q4 2006** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** |
|------------------------------------|------------|--------------------------|------------|------------------|------------|------------------|------------|------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                         | ** ** | **(in 000’S)** | ** ** |
| Previous  estimated depreciation   |       |                     | $          | 4,540            |       |             |       | $                | 4,464      |     |       |     | $          | 4,177    |       |   |   | $ | 4,199 |   |   | $ | 17,380 |   | $ | 16,067 |   | $ | 14,911 |   |
| Updated estimated  depreciation    |       |                     | 2,394      |             |       |             | 2,369      |             |       |     | 2,315      |     |       |     | 2,298      |   |   | 9,376 |   | 9,787 |   | 10,788 |   |
| Reduction in  depreciation expense |       |                     | $          | 2,146            |       |             |       | $                | 2,095      |     |       |     | $          | 1,862    |       |   |   | $ | 1,901 |   |   | $ | 8,004 |   | $ | 6,280 |   | $ | 4,123 |   |

 

For the year ended December 31, 2006, the changein estimating the useful lives of program-related fixed assets had the effectof reducing depreciation expense by $8.0 million and increasing basic anddiluted earnings per share by $0.39. Given that the depreciation expenseattributed to contract-specific assets is included in cost of revenue, thedecrease in depreciation expense also caused gross margins to increase by theamount of the reduction in depreciation expense.

The primary factoroffsetting the reduction in program depreciation was higher than average coststo deploy certain new programs where we provided a complete system replacementusing advanced technologies. These programs were completed in late 2005 and2006 and are now in production. These installations were particularlychallenging for us, representing a more expanded scope than that of ourhistorical system deliveries. We were successful in delivering these programs,but at higher costs than have been customary. In another case, we bid a programaggressively as part of a broader market development strategy that we believewill yield good long-term performance. The fixed costs for these systems, whichinclude amortization and depreciation of costs capitalized during the deliveryprocess, as well as field service and operational costs to manage and maintainthem, are higher than average and, thus, reduce reported margins. We anticipatethat we will be able to improve profit margins in these accounts over time andearn a better return on investment over the life of the account relationship.

*Gross Profit*

| ** **                                          | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|-----------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                          | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                          | ** ** | **2006**                          | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Gross Profit:                                       |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                                             |       | $                                 | 24,864     |         | $          | 23,226         |       |   | $ | 1,638 |   |   |   | 7 | % |   |
| Product and subscription                            |       | 10,614                            |       | 9,655        |       |           | 959        |   |   |   | 10 | % |   |
| Total                                               |       | $                                 | 35,478     |         | $          | 32,881         |       |   | $ | 2,597 |   |   |   | 8 | % |   |
| Gross Profit (as % of  related revenue components): |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                                             |       | 29%                               |       | 27%          |       |           |       |   |   |   |   |   |   |
| Product and subscription                            |       | 57%                               |       | 59%          |       |           |       |   |   |   |   |   |   |
| Total                                               |       | 34%                               |       | 32%          |       |           |       |   |   |   |   |   |   |

 

The changes in gross profit as a percentage ofrevenue, for both the revenue components and overall gross profit, for the yearended December 31, 2006 and as compared to the year ended December 31,2005 was primarily due to the reasons described above under the “Cost ofRevenue” section.

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*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                   | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Sales and  marketing                         |       | $                                                    | 16,355     |                     |       | $                     | 15,777     |   |   |   | $ | 578 |   |   |   | 4 | % |   |
| Sales and marketing (as %  of total revenue) |       | 15%                                                  |       |                     | 16%        |                  |       |   |   |   |   |   |   |   |   |
|                                              |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

Sales and marketingexpenses consist primarily of:

·        compensation,benefits and related costs of sales and marketing employees, product managersand sales engineers,

·        recruiting,

·        travel,

·        marketresearch,

·        costsassociated with marketing programs, such as trade shows, public relations andnew product launches,

·        stock-basedcompensation expense, and

·        chargesfor infrastructure and centralized costs.

The increase insales and marketing expense resulted primarily from:

·        increasedprofessional fees of $0.5 million related to supporting the sales effort in anumber of state bids and proposals,

·        increasedstock option expense of $0.5 million, related to the adoption of SFAS 123(R) regardingstock-based compensation as discussed below, offset by

·        decreasedtemporary labor of $0.5 million as part of the cost cutting initiative.

We anticipate that we willcontinue to invest in sales and marketing at slightly above 2006 levelsreflecting an enhanced focus on domestic and international markets.

*Research, development and engineering*

| ** **                                                     | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                                     | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Research,  development and engineering                         |       | $                                                    | 10,269     |                     |       | $                     | 13,131     |   |   |   | $ | (2,862 | ) |   |   | (22 | )% |   |
| Research, development  and engineering (as % of total revenue) |       | 10%                                                  |       |                     | 13%        |                  |       |   |   |   |   |   |   |   |   |
|                                                                |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

Research,development and engineering expenses consist primarily of:

·        compensation,benefits and related costs of software developers and quality assurancepersonnel,

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·        paymentsto outside contractors,

·        thepurchase of materials and services for product development, primarily in thecard systems area,

·        stock-basedcompensation expense, and

·        chargesfor infrastructure and centralized costs.

The decrease in research,development and engineering expenses resulted primarily from:

·        decreasedemployee compensation-related expenses of $2.4 million resulting from thecompletion of key products and subsequent redeployment of resources to programactivities as part our restructuring initiative undertaken throughout thecurrent year, offset by

·        increasedstock option expense of $0.3 million.

We anticipate that we willreduce research, development and engineering expenses in the near termreflecting completion of some of our more significant product initiatives,while working to moderate spending in the longer term.

*General and administrative*

| ** **                                          | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| General and  administrative                         |       | $                                                    | 17,484     |                     |       | $                     | 21,524     |   |   |   | $ | (4,040 | ) |   |   | (19 | )% |   |   |
| General and  administrative (as % of total revenue) |       | 16%                                                  |       |                     | 21%        |                  |       |   |   |   |   |   |   |   |   |   |
|                                                     |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

General andadministrative expenses consist primarily of:

·        compensation,benefits and related costs of executive, finance and administrative personnel,

·        legal,human resources and other professional fees,

·        stock-basedcompensation expense, and

·        chargesfor infrastructure and centralized costs.

The decrease ingeneral and administrative expenses resulted primarily from:

·        decreasedaudit, consulting and legal fees of $2.7 million related to our audit andreview, Sarbanes-Oxley audit, compliance and remediation efforts in 2005,

·        decreasedother administration costs such as travel related expenses, telephone andinsurance of $0.8 million related to cost cutting initiatives,

·        decreasedtemporary labor of $0.7 million as part of the cost cutting initiative,

·        decreasein depreciation expense of $0.5 million as part of the cost cutting initiativeand assets being fully depreciated,

·        decreasedreserves for bad debts of $0.2 million, offset by

·        increasedstock option expense of $1.4 million.

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We anticipate that we willreduce our general and administrative expenses in the near term reflecting the benefitsof our cost cutting initiatives. We are continuing to examine means to gainefficiencies to reduce general and administrative spending as a percentage ofrevenue in the longer term.

*Amortization of intangible assets*

| ** **                                           | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                           | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Amortization of  intangibles                         |       | $                                                    | 2,171      |                     |       | $                     | 4,035      |   |   |   | $ | (1,864 | ) |   |   | (46 | )% |   |
| Amortization of  intangibles (as % of total revenue) |       | 2%                                                   |       |                     | 4%         |                  |       |   |   |   |   |   |   |   |   |
|                                                      |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

We account for intangible assets resulting fromacquisitions in accordance with Financial Accounting Standards Board (“FASB”)Statement Nos. 141, *BusinessCombinations*and 142, *Goodwilland Other Intangible Assets*. These statements require the recordingof intangible assets under purchase accounting rules, and require theamortization of such intangible assets over their expected useful life. As aresult, in December 2001, we recorded $29.5 million of intangible assetsrelated to the acquisition of certain assets and certain liabilities fromPolaroid and affiliates. These intangible assets were set up to amortize over a12-year period, representing the expected useful life. Changes incontract status and customer relationships may lengthen or shorten the expecteduseful life of such intangible assets, or cause an impairment charge related tothe intangible asset, so some variability is expected to exist related tointangibles depending on internal and external factors.

The decrease in amortization of intangible assetsresulted primarily from extended amortization periods from contract extensionson several domestic customers and the increased amortization in 2005 related toa domestic customer who awarded their contract to a competitor. The intangibleasset related to this customer was fully amortized by the fourth quarter of2005.

Theestimated amortization of intangibles over the next five years is as follows:

| ** **                   | ** ** | **2007**            | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
|------------------------------|------------|---------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                   | ** ** | **(in 000’S)** | ** ** |
| Amortization of  intangibles |       | $1,669              |       | $1,669   |       | $1,669   |       | $1,669   |       | $1,669   |       |

 

*Intellectual property*

| ** **                                     | ** ** | **Twelve Months Ended  December 31** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**                                            | ** ** | **2005**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                     | ** ** | ** **                                          | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Intellectual  property                         |       |                                                | $          | 1,774                    |       |                  |       | $ | 2,014 |   |   |   | $ | (240 | ) |   |   | (12 | )% |   |
| Intellectual property (as  % of total revenue) |       |                                                | 2%         |                     |       |                  | 2%         |   |   |   |   |   |   |   |   |   |   |

 

Intellectualproperty costs primarily consist of:

·       employee-relatedexpenses, such as salaries, benefits, recruiting costs, and incentive plans,

·       costsassociated with documenting, applying for, maintaining patents,

·       stock-basedcompensation expense, and

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·       chargesfor infrastructure and centralized costs.

The slight decreasein intellectual property expenses resulted primarily from:

·        decreaseof $0.2 million related as part of the restructuring initiative, and

·        decreaseof $0.1 million in consulting fees paid to third-party agents and governmentfees related to patent and other intellectual property work.

We anticipate that we willcontinue to invest at approximately the current run rate of dollars in intellectualproperty in the near term while working to moderate spending in the longerterm.

*Restructuring charges, net*

| ** **                             | ** ** | **Twelve Months Ended  December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                             | ** ** |
| ** **                             | ** ** | **(in 000’S)**                             | ** ** |
| Cost of revenue                        |       |                                                 | $          | 159 |   |   |
| Sales and  marketing                   |       |                                                 | 93         |   |   |
| Research,  development and engineering |       |                                                 | 248        |   |   |
| General and  administrative            |       |                                                 | 47         |   |   |
| Total                                  |       |                                                 | $          | 547 |   |   |

 

*In thesecond quarter, we accelerated productivity improvement initiatives andsignificantly reduced fixed costs in order to facilitate our effort to achieveprofitability. The reduction in fixed costs included reduction of our workforceby nearly 20% since the beginning of 2006. The restructuring charge for theyear ended December 31, 2006 totaled $547,000, primarily due to employeeseverance and related costs. These restructuring charges were allocated out ofthe departments as noted above.*

*Stock-basedcompensation.**  **Stock-based compensation includesexpense charges for all stock-based awards to employees and directors. Suchawards include option grants, restricted stock awards, and shares expected tobe purchased under an employee stock purchase plan.**On January 1, 2006, the Companyadopted SFAS 123(R), which requires the measurement and recognition ofcompensation for all stock-based awards made to employees and directorsincluding stock options and employee stock purchases under a stock purchaseplan based on estimated fair values. SFAS 123(R) supersedes previousaccounting under Accounting Principles Board Opinion (“APB”) No. 25,*Accountingfor Stock Issued to Employees,*for periods beginning in fiscal 2006. In March 2005,the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”)No. 107 relating to application of SFAS 123(R). The Company has appliedthe provisions of SAB 107 in our adoption of SFAS 123(R).*

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the year ended December 31, 2006 is based on the value ofthe portion of the stock-based award that will vest during the period, adjustedfor expected forfeitures. Stock-based compensation recognized in the Company’sconsolidated financial statements in the year ended December 31, 2006includes compensation cost for stock-based awards granted prior to, but notfully vested as of, December 31, 2005 and stock-based awards grantedsubsequent to December 31, 2005. The compensation cost for awards grantedprior to January 1, 2006 is based on the grant date fair value estimatedin accordance with the pro forma provisions of SFAS 123 while awards granted onor after January 1, 2006 follow the provisions of SFAS 123(R) todetermine the grant date fair value and 

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compensation cost.Compensation cost for all stock-based awards is recognized using thestraight-line method.

Upon adoption of SFAS 123(R), the Companycontinued to use the Black-Scholes option pricing model as its method ofvaluation for stock-based awards. The Company’s determination of the fairvalue of stock-based awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofhighly complex and subjective variables. These variables include, but are notlimited to the expected life of the award, our expected stock price volatilityover the term of the award and actual and projected exercise behaviors.Although the fair value of stock-based awards is determined in accordance withSFAS 123(R) and SAB 107, the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results.

Prior to January 1, 2006, the Company applied therecognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including FASB Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation, an Interpretation of APB Opinion No. 25*, asallowed by FASB Statement No. 123, *Accountingfor Stock-Based Compensation*. FASB Statement No. 123 and FASBStatement No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure, an amendment of FASBStatement No. 123*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans. Under APB Opinion No. 25, stock-basedcompensation expense is recognized for stock awards granted with an exerciseprice below fair market value on the date of grant.

Theexpense was recorded in the respective statement of operations expensecategories for the employees to which it applies, as set forth in the tablebelow.

| ** **                             | ** ** | **Twelve Months Ended** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|
| ** **                             | ** ** | **December 31,**             | ** ** |
| ** **                             | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **(in 000’S)**          | ** ** |
| Cost of revenue                        |       |                              | $          | 281 |   |   |   | $ | — |   |   |
| Sales and  marketing                   |       |                              | 509        |   |   |   | — |   |   |
| Research,  development and engineering |       |                              | 325        |   |   |   | — |   |   |
| General and  administrative            |       |                              | 1,863      |   |   |   | 506 |   |   |
| Intellectual  Property                 |       |                              | 35         |   |   |   | — |   |   |
|                                   |       |                              | $          | 3,013 |   |   |   | $ | 506 |   |   |

 

We anticipate an additional $6.6 million instock-based compensation expense through fiscal 2010 for awards outstanding asof December 31, 2006. Our tax accounting may also be impacted by actual exercisebehavior and the relative market prices at exercise.

On December 15, 2005, the Board of Directors ofthe Company approved the acceleration of vesting of the Company’s outstandingstock options with option exercise prices equal to or greater than $9.00. Theacceleration applied to all options outstanding as of December 31,2005 under the Company’s Restated 1999 Stock Incentive Plan and 2000Non-Officer Employee Stock Incentive Plan, except for options held by membersof the Company’s Board of Directors. Options to purchase 422,248 shares of theCompany’s common stock, or 6% of the Company’s total outstanding options, witha weighted average exercise price of $11.51 and varying remaining vestingschedules, were subject to this acceleration and became immediately vested andexercisable as of December 31, 2005. Of these 422,248 options, 120,972options are held by the Company’s executive officers.

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On December 21, 2004,the Audit, Compensation and Corporate Governance Committees of the Board ofDirectors of the Company approved the acceleration of vesting of the Company’soutstanding stock options with option exercise prices greater than $15.00. The accelerationapplied to all options outstanding under the Company’s Restated 1999 StockIncentive Plan and 2000 Non-Officer Employee Stock Incentive Plan that wouldnot have otherwise vested in full by June 30, 2005 in accordance withtheir terms. The effective date of the vesting acceleration wasDecember 31, 2004. Options to purchase 310,057 shares of theCompany’s common stock, or 5% of the total number of options of the Companyoutstanding as of December 31, 2004 with remaining vesting schedules, wereaccelerated. Of these 310,057 options, approximately 50,000 options wereheld by the Company’s executive officers.

As a result of theseaccelerations, the Company reduced its exposure to the effects of SFAS123(R) by approximately $2.5 million for fiscal years 2006 through 2009. Noadditional compensation expense was recorded in the statement of operations asthe options that were accelerated had an exercise price greater than the fairmarket value of the shares underlying the options on the date of themodification.

*Total other income(expense), net.**  *Otherincome (expense), net consists primarily of interest received and paid. Theincrease in other income (expense) resulted primarily from higher interestearned on cash and investment balances, which was partially offset by higherinterest expense related to capitalized leases. In addition, we experienced aforeign currency translation gain of approximately $0.3 million in connectionwith the consolidation of our international subsidiaries.

*Provision for incometaxes.**  *Dueto the Company’s domestic losses for the years ended December 31, 2006,2005 and 2004 there was no provision for U.S. federal or state income taxes. Asthe Company was profitable in some foreign jurisdictions during 2006, 2005 and2004 we provided for income taxes expected to be paid on our internationaloperations. At December 31, 2006, the Company had net operating losscarryforwards for federal, state and foreign income tax reporting purposes ofapproximately $116.5 million and research and experimentation credits ofapproximately $2.0 million which expire through 2026 and 2024, respectively, ifnot utilized. Approximately $26.4 million of the net operating losses isrelated to the tax benefit from the exercise of stock options and thus any taxbenefit realized in relation to those carryforwards will be allocated tocontributed capital if subsequently recognized. Under the Tax Reform Act of1986, the amounts of and benefits from net operating loss carryforwards may beimpaired or limited in certain circumstances, including a change of more than50% in ownership.

***Years Ended December 31,2005 and 2004***

*Revenue*

| ** **                       | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|----------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                       | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                       | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                       | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Revenue:                         |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                          |       | $                                 | 84,691     |         | $          | 73,919         |       |   | $ | 10,772 |   |   |   | 15 | % |   |
| Product and subscription         |       | 16,362                            |       | 19,028       |       |           | (2,666     | ) |   |   | (14 | )% |   |
| Total                            |       | $                                 | 101,053    |         | $          | 92,947         |       |   | $ | 8,106 |   |   |   | 9 | % |   |
| Revenue (as % of total revenue): |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Service                          |       | 84%                               |       | 80%          |       |           |       |   |   |   |   |   |   |
| Product and subscription         |       | 16%                               |       | 20%          |       |           |       |   |   |   |   |   |   |
| Total                            |       | 100%                              |       | 100%         |       |           |       |   |   |   |   |   |   |

 

Total revenue increased$8.1 million from 2004 to 2005. The increase resulted primarily from additionalgovernment programs added in late 2004 and early 2005, such as Florida,Alabama, Mexico, Latvia and Ohio, that were either at or near full productionby the end of 2005.

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*Service.**  *The $10.8 million increase in Servicerevenue was primarily due to issuance revenue from new programs for Mexico andLatvia, which started generating revenue in the second quarter of 2004;Florida, which started in the third quarter of 2004; Ohio, which started in thefirst quarter of 2005; and Alabama, which started in the second quarter of2005, offset partially by contracts that ended and contracts that converted toconsumable sales.

*Product and subscription.**  *The $2.7 million decrease in productand subscription revenue was primarily related to the timing of largenon-recurring sales to domestic and foreign customers that occurred in 2004,partially offset by smaller non-recurring sales to domestic and foreigncustomers that occurred in 2005.

*Revenue by Geography*

| ** **                       | ** ** | **Twelve Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|----------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                       | ** ** | **December 31,**             | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                       | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                       | ** ** | **(in 000’S)**          | ** ** | ** **   | ** ** |
| Revenue by geography:            |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                         |       | $                                 | 80,119     |         | $          | 72,173         |       |   | $ | 7,946 |   |   |   | 11 | % |   |
| International                    |       | 20,934                            |       | 20,774       |       |           | 160        |   |   |   | 1 | % |   |
| Total                            |       | $                                 | 101,053    |         | $          | 92,947         |       |   | $ | 8,106 |   |   |   | 9 | % |   |
| Revenue (as % of total revenue): |       |                              |       |         |       |           |       |   |   |   |   |   |   |
| Domestic                         |       | 79%                               |       | 78%          |       |           |       |   |   |   |   |   |   |
| International                    |       | 21%                               |       | 22%          |       |           |       |   |   |   |   |   |   |
| Total                            |       | 100%                              |       | 100%         |       |           |       |   |   |   |   |   |   |

 

International revenue in2005 was essentially the same as in 2004 because incremental issuance revenuefrom Mexico and Latvia largely offset a one time sales of products thatoccurred in 2004.

We had no customer thataccounted for more than 10% of our revenue in 2005 or 2004.

*Cost of Revenue*

| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                             | ** ** | **December 31,**            | ** ** | **Increase** | ** ** | **Increase**   | ** ** |
| ** **                                             | ** ** | **2005**                         | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                             | ** ** | **(in 000’S)**         | ** ** | ** **   | ** ** |
| Cost of Revenue:                                       |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | $                                | 61,465     |         | $          | 47,591         |       |   | $ | 13,874 |   |   |   | 29 | % |   |
| Product and subscription                               |       | 6,707                            |       | 11,784       |       |           | (5,077     | ) |   |   | (43 | )% |   |
| Total                                                  |       | $                                | 68,172     |         | $          | 59,375         |       |   | $ | 8,797 |   |   |   | 15 | % |   |
| Cost of Revenue (as % of related revenue  components): |       |                             |       |         |       |           |       |   |   |   |   |   |   |
| Service                                                |       | 73%                              |       | 64%          |       |           |       |   |   |   |   |   |   |
| Product and subscription                               |       | 41%                              |       | 62%          |       |           |       |   |   |   |   |   |   |

 

*Service.  *The$13.9 million increase was primarily the result of higher consumables andgeneral support costs related to the higher revenue identified above, higherdepreciation on revenue-generating assets, increased costs to deliver supportand maintenance for new and existing programs, and increased freight costsrelated to higher shipping activity, partially offset by lower charges forinventory reserves.

*Productand subscription.  *The cost of product andsubscription revenue primarily includes compensation for operations personnel,costs of consumables sold to third parties, costs of machinery sold to thirdparties, and Internet service provider connectivity charges and image searchdata fees to support 

31

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the services offered toour subscription customers. The $5.1 million decrease was the result of acombination of lower revenues and lower costs on the 2005 revenue mix.

Thecosts included in our cost of revenue are comprised of three categories asdescribed below:

| ** **                                  | ** ** | **Twelve Months Ended** | ** ** | **Dollar**               | ** ** | **Percent**    | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|----------------|------------|
| ** **                                  | ** ** | **December 31,**             | ** ** | **Increase**             | ** ** | **Increase**   | ** ** |
| ** **                                  | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                  | ** ** | ** **                        | ** ** | **(in 000’S)** | ** ** | ** **     | ** ** | ** ** | ** ** |
| Cost of revenue:                            |       |                              |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                    |       | $                                 | 28,083     |                     |       | $              | 29,253     |   |   |   | $ | (1,170 | ) |   |   | (4 | )% |   |
| Fixed field  support and manufacturing |       | 25,997                            |       |                     | 21,511     |           |       |   | 4,486 |   |   |   | 21 | % |   |
| Program depreciation                        |       | 14,092                            |       |                     | 8,611      |           |       |   | 5,481 |   |   |   | 64 | % |   |
| Total                                       |       | $                                 | 68,172     |                     |       | $              | 59,375     |   |   |   | $ | 8,797 |   |   |   | 15 | % |   |
| Cost of revenue (as % of  total revenue):   |       |                              |       |                     |       |           |       |   |   |   |   |   |   |   |   |
| Variable                                    |       | 28%                               |       |                     | 32%        |           |       |   |   |   |   |   |   |   |   |
| Fixed field  support and manufacturing |       | 26%                               |       |                     | 23%        |           |       |   |   |   |   |   |   |   |   |
| Program depreciation                        |       | 14%                               |       |                     | 9%         |           |       |   |   |   |   |   |   |   |   |
| Total                                       |       | 68%                               |       |                     | 64%        |           |       |   |   |   |   |   |   |   |   |

 

As a percentage ofrevenue, we experienced a slight reduction in our variable costs to deliverincremental revenue. The improvement related to continued pricing improvementwith vendors and improved yields during the manufacturing process.

The increase in fixedcosts was primarily due to newer contracts requiring additional headcount aswell as travel costs to support them.

Program depreciationshowed the largest increase of the three components of cost of revenue. Thehigher fixed costs as a percentage of revenue was a result of several factors.The primary factor related to some new programs involving competitive wins,where we provided a complete system replacement using advanced technologies.These programs were completed and transitioned from deployment to revenueproduction, and thus affected margins. These installations were particularlychallenging for us, representing a stretch in terms of scope from ourhistorical system deliveries. We were successful in delivering these programs,but at higher costs than had been customary. In one other case, we bid aprogram aggressively as part of a broader market development strategy that webelieved would yield good long-term performance. The fixed costs for thesesystems, which included amortization and depreciation of costs capitalizedduring the delivery process as well as field service and operational costs tomanage and maintain them, were higher than average and, thus, reduced reportedmargins.

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*Gross Profit*

| ** **                                          | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2005**                                             | ** ** | **2004**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | **(in 000’S)**                             | ** ** | ** **           | ** ** |
| Gross Profit:                                       |       |                                                 |       |                 |       |                  |       |   |   |   |   |   |   |
| Service                                             |       | $                                                    | 23,226     |                 | $          | 26,328                |       |   | $ | (3,102 | ) |   |   | (12 | )% |   |
| Product and subscription                            |       | 9,655                                                |       | 7,244                |       |                  | 2,411      |   |   |   | 33 | % |   |
| Total                                               |       | $                                                    | 32,881     |                 | $          | 33,572                |       |   | $ | (691 | ) |   |   | (2 | )% |   |
| Gross Profit (as % of  related revenue components): |       |                                                 |       |                 |       |                  |       |   |   |   |   |   |   |
| Service                                             |       | 27%                                                  |       | 36%                  |       |                  |       |   |   |   |   |   |   |
| Product and subscription                            |       | 59%                                                  |       | 38%                  |       |                  |       |   |   |   |   |   |   |
| Total                                               |       | 32%                                                  |       | 36%                  |       |                  |       |   |   |   |   |   |   |

 

The $0.7 million decreasein gross profit for the year ended December 31, 2005 compared to the prioryear was largely for the reasons stated above under the “Cost of Revenue”section.

*Operating Expenses*

*Sales and marketing*

| ** **                                  | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2005**                                             | ** ** | **2004**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                  | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Sales and marketing                         |       | $                                                    | 15,777     |                     |       | $                     | 12,908     |   |   |   | $ | 2,869 |   |   |   | 22 | % |   |   |
| Sales and marketing (as % of total revenue) |       | 16%                                                  |       |                     | 14%        |                  |       |   |   |   |   |   |   |   |   |   |
|                                             |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theincrease in sales and marketing expenses of $2.9 million resultedprimarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $2.2 million due to personnel mix for higher levelfocus on marketing and governmental activities, and higher benefit programcosts;

·       anincrease in bids and proposals work of $0.9 million;

·       anincrease in presence at tradeshows, advertising, consulting fees and eventsponsorship of approximately $0.4 million;

·       partially offset by animpairment charge of $0.5 million taken in 2004, with no such charge in 2005,related to investments in companies licensed to market our digital watermarkingtechnology.

*Research, development and engineering*

| ** **                                                     | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** **   | **Percent  Increase** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|--------------|-----------------------|------------|
| ** **                                                     | ** ** | **2005**                                             | ** ** | **2004**                 | ** **   | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                                     | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** **   | ** **            | ** ** | ** ** | ** ** |
| Research, development  and engineering                         |       | $                                                    | 13,131     |                     | $ 8,327 |                  |       | $ | 4,804 |   |   |   | 58 | % |   |
| Research, development and engineering (as % of total  revenue) |       | 13%                                                  |       | 9%                       |         |                  |       |   |   |   |   |   |   |
|                                                                |            |                                                      |            |                          |              |                       |            |  |  |  |  |  |  |  |  |

 

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Theincrease in research, development and engineering expenses of $4.8 millionresulted primarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $2.5 million due to personnel mix for higher levelfocus on government program activities, and higher benefit program costs,offset by a decrease in contract labor of $2.2 million as we transitionedcontractors to full time employee status;

·       changein the application of resources from capital projects to research activitieswhich are expensed of $3.5 million to enhance existing products, develop newproducts, and focus on requirements of the recently passed REAL ID Act;

·       increasedconsulting and professional fees of $0.3 million for various projects; and

·       increased allocatedinfrastructure and centralized costs of $0.5 million.

*General and administrative*

| ** **                                         | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**                                             | ** ** | **2004**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                         | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| General and  administrative                        |       | $                                                    | 21,524     |                     |       | $                     | 17,150     |   |   |   | $ | 4,374 |   |   |   | 26 | % |   |
| General and administrative (as % of total revenue) |       | 21%                                                  |       |                     | 19%        |                  |       |   |   |   |   |   |   |   |   |
|                                                    |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

Theincrease in general and administrative expenses of $4.4 million resultedprimarily from the following:

·       increasedheadcount and change in skills mix to address enhanced governance and internalcontrols drove up employee-related expenses such as salaries, benefits,recruiting costs, and incentive plans by $2.2 million;

·       auditand consulting fees increased $1.4 million primarily related to our 2004year-end audit, restatement work, Sarbanes-Oxley audit, and finance staffexpansion;

·       increasedsoftware expense of $0.4 million related to continued licensing costs and softwareupgrades; and,

·       increasedstock-based compensation of $0.5 million related to restricted stock.

*Amortization of intangible assets*

| ** **                                          | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2005**                                             | ** ** | **2004**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | ** **                                           | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Amortization of  intangibles                        |       | $                                                    | 4,035      |                     |       | $                     | 2,536      |   |   |   | $ | 1,499 |   |   |   | 59 | % |   |
| Amortization of intangibles (as % of total revenue) |       | 4%                                                   |       |                     | 3%         |                  |       |   |   |   |   |   |   |   |   |
|                                                     |            |                                                      |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

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Amortization expenseincreased in 2005 due to the loss of certain contracts with relatively highintangible balances, and the reassessment of useful lives for certaininternational customers.

*Intellectual property*

| ** **                                     | ** ** | **Twelve Months Ended  December 31** | ** ** | **Dollar  Increase**     | ** ** | **Percent  Increase** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2005**                                            | ** ** | **2004**                 | ** ** | **(Decrease)**        | ** ** | **(Decrease)** | ** ** |
| ** **                                     | ** ** | ** **                                          | ** ** | **(in 000’S)** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Intellectual  property                         |       | $                                                   | 2,014      |                     |       | $                     | 2,162      |   |   |   | $ | (148 | ) |   |   | (7 | )% |   |
| Intellectual property  (as % of total revenue) |       | 2%                                                  |       |                     | 2%         |                  |       |   |   |   |   |   |   |   |   |
|                                                |            |                                                     |            |                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in intellectual property expense of $0.1million was primarily due to consulting fees paid to third-party attorneysrelated to patent work in 2004.

*Stock-based compensation.**  *Stock-based compensation expense relates torestricted stock granted in 2005, as described below, is based on the fairmarket value of the Company’s common stock on the date the restricted stock wasgranted (measurement date), and is recognized over the four-year vesting periodof the related restricted stock using the straight-line method. The expense wasrecorded in the respective statement of operations expense categories for theemployees to which it applies, as set forth in the table below.

| ** **                             | ** ** | **Twelve Months Ended** | ** **          |
|----------------------------------------|------------|-----------------------------------|---------------------|
| ** **                             | ** ** | **December 31,**             | ** **          |
| ** **                             | ** ** | **2005**                          | ** **          | **2004** | ** ** |
| ** **                             | ** ** | ** **                        | **(in 000’S)** | ** ** | ** ** |
| Sales and  marketing                   |       |                              | $                   | — |   |   |   | $ | — |   |   |
| Research,  development and engineering |       |                              | —              |   |   |   | — |   |   |
| General and  administrative            |       |                              | 506                 |   |   |   | — |   |   |
|                                   |       |                              | $                   | 506 |   |   |   | $ | — |   |   |

 

*Totalother income (expense), net.**  *Otherincome (expense), net consists primarily of interest received and paid. Therelatively flat difference resulted from lower average cash balances and higheraverage interest rates during the majority of fiscal 2005.

*Provision for incometaxes.**  *Forthe years ended December 31, 2005 and 2004, the Company was profitable insome foreign jurisdictions. Therefore, during 2005 and 2004 we provided forincome taxes expected to be paid on our international operations.

**Liquidity andCapital Resources**

As of December 31, 2006, we had cash and cashequivalents, restricted cash, and short-term investments of $33.1** **million, representing an increase of $1.1****million from****$32.0** **million at December 31, 2005. As of December 31,2006, $9.9** **million of cash and cashequivalents is restricted as a result of the requirements of performance bondsthat we are obligated to maintain in connection with some of our long-termcontracts in our secure ID systems business. We support the performance bondswith letters of credit, which may or may not require restricted cash. Workingcapital at December 31, 2006 was****$29.9 million,compared to working capital of $33.4** **million****at December 31, 2005. The decrease in working capitalprimarily relates to investments made in various programs that we anticipatewill contribute to revenue growth beyond 2007.

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*Operating Cash Flow.*   Thecomponents of operating cash flows were:

| ** **                                           | ** ** | **Twelve Months Ended** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                           | ** ** | **December 31,**             | ** ** |
| ** **                                           | ** ** | **2006**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in 000’S)**               | ** ** |
| Net loss                                             |       | $                                 | (11,740    | ) | $ | (23,097 | ) | $ | (9,022 | ) |
| Non-cash items                                       |       | 17,946                            |       | 20,167 |   | 15,269 |   |
| Changes in  operating assets and liabilities         |       | 3,112                             |       | (267 | ) | (1,568 | ) |
| Net cash provided  by (used in) operating activities |       | $                                 | 9,318      |   | $ | (3,197 | ) | $ | 4,679 |   |

 

The major changesfor the year ended December 31, 2006 in the non-cash charges related to:

·       decreasesin depreciation and amortization from $19.7 million to $15.5 millionprimarily related to the change in estimated useful lives of our program assetsand offset by the increase in newer program assets, and

·       increasein stock-based compensation expense from $0.5 million to $3.0 million primarilyrelated to the implementation of SFAS 123(R).

The major changesin the operating assets and liabilities for the year ended December 31,2006 primarily related to:

·       increasein deferred revenue of $3.6 million related to cash collections that contributedto an increased backlog of future revenues, and

·       decreasesof $1.4 million in accounts receivable and $0.9 million in inventory, netreflecting improved asset management while increasing revenues, offset by

·       increasein restricted cash of $2.7 million associated with renewals of our performancebonds for our major state programs, and

·       decreasein accounts payable of $1.0 million reflecting lower level of operatingexpenses and inventory during 2006.

The $3.2 million of cash used in operations forthe year ended December 31, 2005 resulted from net loss of $23.1 millionwhich includes non cash items related to depreciation, amortization, andstock-based compensation aggregating to $20.2 million. Items positivelyimpacting operating cash flow were decreases in restricted cash of $1.0 millionand in inventory of $1.4 million, and increases in deferred revenue of$2.0 million and in accrued payroll and related costs of $1.6 million.Negatively impacting operating cash flow was an increase in trade and unbilledaccounts receivable, net of $1.0 million and in other current assets of $1.0million, along with a decrease in accounts payable of $4.7 million.

The $4.7 million of cash provided by operationsfor the year ended December 31, 2004 resulted from net loss of $9.0million which includes non cash items related to depreciation and amortizationof $13.5 million. Items positively impacting operating cash flow wereincreases in accounts payable of $4.8 million, in deferred revenue of$1.7 million, and in accrued payroll and related costs of $1.1 million.Negatively impacting operating cash flow was an increase in restricted cash of$6.3 million, an increase in inventory of $2.6 million and an increase intrade and unbilled accounts receivable, net of $1.4 million.

*InvestingCash Flow.*   The $9.8 million of cash used ininvesting activities for the year ended December 31, 2006 primarilyrelated to $10.5 million for the purchase of property and equipment,including capitalized labor costs of $3.9 million, partially offset by $0.7million in net sales of short-term investments. We also acquired approximately$0.6 million of fixed assets during 2006 through capital leasearrangements.

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The $8.8 million of cash provided by investingactivities for the year ended December 31, 2005 primarily related to $24.3million in net sales of short-term investments, partially offset by$15.5 million for the purchase of property and equipment, includingcapitalized labor costs of $7.9 million. We also acquired approximately$0.3 million of fixed assets during 2005 through capital leasearrangements.

The $21.7 million of cash used in investingactivities for the year ended December 31, 2004 primarily related to$39.7 million for the purchase of property and equipment, includingcapitalized labor costs of $12.4 million, partially offset by $18.0 in netsales of short-term investments. We also acquired approximately$0.1 million of fixed assets during 2004 through capital leasearrangements.

*FinancingCash Flow.*   The $0.4 million of cash used infinancing activities for the year ended December 31, 2006 primarilyrelated to $0.6 million of principal payments under capital leases, offsetby proceeds from the issuance of stock for $0.2 million related to the employeestock option and employee stock purchase plans.

The $0.2 million of cash used in financing activitiesfor the year ended December 31, 2005 primarily related to$0.5 million of principal payments under capital leases, offset byproceeds from the issuance of stock for $0.3 million related to the employeestock option and employee stock purchase plans.

The $1.9 million of cash provided by financingactivities for the year ended December 31, 2004 primarily related to theissuance of stock for $2.1 million related to the employee stock option andemployee stock purchase plans, offset by $0.2 million of principalpayments under capital leases.

*Commitments andContingencies.*   Our significant commitmentsconsist of obligations under non-cancelable operating leases, which totaled$8.1** **million as of December 31,2006, and are payable in monthly installments through October 2011. Ourobligations under non-cancelable capital leases, which totaled $1.0****million as of December 31, 2006, are payable inmonthly installments through 2011. We are contractually obligated to make thefollowing payments as of December 31, 2006:

**ContractualObligations **

| ** **                     | ** ** | **Payment Due by Period (in 000’s)** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                                         | ** ** | **Less  than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| ** **                     | ** ** | **Total**                                                          | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **5 years** | ** ** |
| Capital leases                 |       | $                                                                  | 1,027      |   | $ | 573 |   |   | $ | 316 |   |   |   | $ | 138 |   |   |   | $ | — |   |   |
| Operating leases               |       | 8,076                                                              |       | 2,144 |   |   | 3,836 |   |   |   | 2,096 |   |   |   | — |   |   |
| Total contractual  obligations |       | $                                                                  | 9,103      |   | $ | 2,717 |   |   | $ | 4,152 |   |   |   | $ | 2,234 |   |   |   | $ | — |   |   |

 

Many of our secure identity management contracts havesignificant capital requirements. The general industry model for supplyingdriver license issuance systems to State driver license issuers is for thesystem supplier to develop and install the issuance system using the supplier’scapital and to charge the customer on a per-card issued basis. As a result,during times of substantial competitive wins and/or substantial systemupgrades, the Company may experience significant working capital needs that mayexceed cash flow from operations. To date, the Company has relied upon cashreserves to fund such expenditures.

We have driver license contracts with various Statesthat are not yet fully deployed and we have pending add-on and upgrade orders.In order to complete these contracts and pending orders, we estimate we willincur approximately $17 million of expenditures. The estimates are derivedfrom information known to us as of quarter end, the time the estimates wereprepared. Actual expenditures may vary from our estimates. We anticipate thatthese expenditures will be recouped through receipts from the related long-termprice-per-card agreements and from the value of the add-on andupgrade orders we have received.

37

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Depending on our operating results, our plannedoperating expenses and capital expenditures may constitute a material use ofour cash resources. In addition, we expect that we will utilize cash in theupcoming few quarters as we complete program implementations. We may utilizecash resources to fund acquisitions or investments in complementary businesses,technologies or product lines.

The Company from time to time experiences delays inidentification system implementation, timely acceptance for identificationsystems programs, concerns regarding identification system program performance,and other contractual disputes. Customers have asserted, and may in the future assert, compensatory orliquidated damages, breach of contract, or other claims alleging that we havefailed to meet timing or other delivery requirements and milestones pursuant tothe terms of such contracts. From time to time, customers have givennotice of their intention to assert claims for liquidated damages. Managementbelieves that these assertions are part of the resolution process involvingcommercial disagreements over the delivery terms of these contracts. Suchdisputes are not uncommon and tend to be resolved over time. To date, we havenot paid any material contractual damages in connection with a customerdispute. While there is always risk that damages could be assessed in thefuture, management cannot predict, as of December 31, 2006, whether anymaterial damages will be imposed in the future or what the amount of any suchdamages would be if they were to be imposed. However, our failure to meet contractual milestones or other performance requirementsas promised, or to successfully resolve customer disputes, could result in ourhaving to incur liability for damages, as well as increased costs, lowermargins, or compensatory obligations in addition to other losses, such as harmto our reputation. Such circumstances could have a material adverse effect onour business and financial results. We anticipate that future contracts willcontinue to have such provisions unless and until industry practices change.

*FutureCash Expectations.*   We believe that our currentcash, cash equivalents, and short-term investment balances will satisfy ourprojected working capital and capital expenditure requirements for at least thenext 12 months. In addition, we expect to generate positive cash flow fromoperations in 2007 which will fund a substantial portion of our capital needs.We also intend to utilize capital and operating lease financing whereappropriate. Thereafter, we anticipate continuing to use cash, cashequivalents, short-term investment balances and equipment lease financing tosatisfy our projected working capital and capital expenditure requirements. However,in the event that we were to win contracts requiring significant capitalinvestment, we may need to seek additional financing.

In order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities. However, we do not believe atthis time that our long-term working capital and capital expenditures would requireus to take steps to remedy any such potential deficiencies. If it werenecessary to obtain additional financings or credit facilities, we may not beable to do so, or if these funds are available, they may not be available onsatisfactory terms.

**Off-Balance SheetArrangements**

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenue or expenses, results of operations, liquidity, capitalexpenditures or capital resources that is material to investors.

**Recent AccountingPronouncements**

In March 2006, the FASB issued SFAS No. 156,Accounting for Servicing of Financial Assets, an amendment of SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities. The statement changes the way entities account for servicingassets and obligations associated with financial assets acquired or disposedof. SFAS No. 156 is effective for the first fiscal year beginning after September 15,2006. The Company has concluded that this standard does not currently apply.

38

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In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,*which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair value. Thisstatement does not require any new fair value measurements, but providesguidance on how to measure fair value by providing a fair value hierarchy usedto classify the source of the information. SFAS No. 157 is effective forfirst fiscal year beginning after November 15, 2007. The Company iscurrently assessing the potential impact that adoption of this standard willhave on our financial statements.

In July 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,which defines the threshold for recognizing the benefits of tax returnpositions in the financial statements as “more-likely-than-not” to be sustainedby the taxing authority. Interpretation No. 48 applies to all taxpositions accounted for under SFAS No. 109, *Accountingfor Income Taxes*. Interpretation No. 48 is effective as of thebeginning of the first fiscal year beginning after December 15, 2006. Uponadoption, the Company will adjust the financial statements if needed to reflectonly those tax positions that are more-likely-than-not to be sustained asof the adoption date. Any adjustment will be recorded directly to our beginningretained earnings balance in the period of adoption and reported as a change inaccounting principle. The Company is currently analyzing the effects ofadopting Interpretation No. 48.

In September 2006, the SEC issued SAB 108, *Considering the Effects of Prior Year Misstatements When QuantifyingMisstatements in Current Year Financial Statements*. The bulletinprovides interpretive guidance on how to consider the effects of carryovers orreversals of prior year misstatements in quantifying a current yearmisstatement. SAB 108 is effective for the first fiscal year ending after November 15,2006. The Company has applied the provisions of this interpretive bulletin andnoted no material effect on the current financial statements.

In June 2006, theFASB ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2,*Accounting for Sabbatical Leave and Other SimilarBenefits Pursuant to FASB Statement No. 43,* which requirescompanies to accrue the cost of compensated absences under a sabbatical orsimilar benefit arrangement over the requisite service period. EITF Issue No. 06-2is effective for fiscal years beginning after December 15, 2006. Thecumulative effect of the application of this consensus on prior period resultsshould be recognized through a cumulative-effect adjustment to retainedearnings as of the beginning of the year of adoption. Elective retrospectiveapplication is also permitted. The Company has concluded that this issue doesnot currently apply.

**Safe HarborStatement under the Private Securities Litigation Reform Act of 1995**

Because this Reporton Form 10-K contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995, any of the riskfactors set forth below or elsewhere in this Report on Form 10-Q orincorporated herein by reference could cause our actual results to differmaterially from those results projected or suggested in such forward-lookingstatements. Statements that are not historical facts are hereby identified as “forward-lookingstatements” for the purposes of the safe harbor provided by Section 21E ofthe Securities Exchange Act of 1934 and Section 27A of the Securities Actof 1933. Such forward-looking statements include but are not limited tostatements relating to:

·       trendsand expectations in revenue growth, including, but not limited to, statementsregarding the temporary nature of the decrease in ID systems bid activity in2006 and the expected increase of such activity in the future, statementsregarding anticipated growth in U.S. driver license revenues due to broadeninguse of the driver license as a secure credential, and statements regardingopportunities to facilitate efforts of state government agencies to comply withthe REAL ID Act;

·       thesuccess of new products, such as products relating to compliance with the REALID Act;

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·       ourfuture level of investment in our business, including investment in developmentof products and technology, acquisition of new customers and development of newmarket opportunities;

·       ourability to improve margins;

·       anticipatedexpenses, costs, margins and investment activities in the foreseeable future;

·       anticipatedrevenue to be generated from current contracts, patent and license technologyfees and as a result of new programs;

·       theinvestments required to complete certain driver license programs and ourability to recoup those expenses under the relevant contract;

·       ourprofitability in future periods;

·       thedevelopment and growth of the market for digital watermarking technology;

·       momentumin the recognition of the benefits offered by digital watermarking and in theadoption of digital watermarking;

·       businessopportunities that could require that we seek additional financing;

·       opportunitiesfor increased participation in the global market for ID systems;

·       thesize and growth of our markets, including the U.S. driver license market;

·       theexistence of international growth opportunities and our future investment insuch opportunities;

·       thesource of our future revenue;

·       ourexpected short-term and long-term liquidity positions;

·       ourability to fund our capital needs through cash flow from operations;

·       ouruse of cash in upcoming quarters;

·       anticipatedlevels of backlog in future periods;

·       anticipatedextensions of the term of our contract with the central banks; and

·       thelikelihood or outcome of legal proceedings and claims and their effect on ourbusiness.

Such forward-looking statements also include otherstatements containing words such as “anticipate,” “estimate,” “expect,” “managementbelieves,” “we believe,” “we intend,” “should” and similar words or phrases,which are intended to identify forward-looking statements. Actual results mayvary materially due to, among other things, our failure to become profitable,the failure of the potential markets for our digital watermarking technology todevelop as anticipated, the adoption of alternative technologies within thesemarkets, as well as changes in economic, business, competitive, technologyand/or regulatory factors and trends, and the other factors described in this Form 10-Kor in our other documents filed with the SEC. All forward-looking statementsare necessarily only estimates of future results and there can be no assurancethat actual results will not differ materially from expectations, and, therefore,investors are cautioned not to place undue reliance on such statements.Investors should understand that it is not possible to predict or identify allrisk factors and that the risks discussed below should not be considered acomplete statement of all potential risks and uncertainties. We do not intendto update any forward-looking statements as a result of future events ordevelopments.

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**Factors AffectingForward Looking Statements**

Our business, financialcondition, results of operation and cash flows may be impacted by a number offactors, including the factors set forth below.

*Given our historyof losses, we cannot guarantee profitability, particularly if we were to loselarge contracts.*

Except for the year 2003,we have incurred significant net losses from inception. Our accumulated deficitas of December 31, 2006 was $99.7 million. In the second half of 2005 andcontinuing through 2006, we restructured our operations to improve productivityand reduce fixed costs. During the second quarter of 2006, we accelerated thoseactivities significantly, resulting in a reduction of our workforce by nearly20%. Overall, our workforce has been reduced by 30% since mid 2005. Theseactions resulted in an increase in earnings to a near break even level in thesecond half of 2006. However, in order to achieve sustained profitability, wewill need to generate higher revenue than we have in prior years whilecontrolling expenditures. Achieving sustained profitability will depend upon avariety of factors, including the impact of new financial accounting mandatesrequiring us to expense stock options, as well as the extent to which we may berequired to increase the size of our workforce in order to execute our businessstrategy and capitalize on new opportunities. In addition, we evaluate ourstrategy and market opportunities on an ongoing basis and will adjust ourapproach to market conditions that prevail from time to time. Finally, variousadverse developments including the loss of large contracts or cost overruns onour existing contracts could have a negative impact on our revenue or ourmargins. Accordingly, increases in our expenses may not be offset by revenueincreases and as a result we may not be able to achieve or sustainprofitability.

*The loss of anylarge contract may result in loss of revenue and potential acceleration ofamortization expense or impairment of intangible assets.*

Contracts betweengovernment agencies and Digimarc have varying duration, generally five or moreyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. We anticipate that several of oursignificant customers will award new contracts through such a competitivebidding process in 2007. If we were to lose a contract due to cancellation orin a competitive bidding situation, then, in addition to the loss of revenueand margin on a prospective basis, we could also incur accelerated amortizationexpense or impairment of intangible assets related to the customer, which couldadversely affect our financial results. We have not experienced the earlytermination of any driver license issuance contracts and are not aware of anyearly terminations of such contracts of our competitors.

*The market for our products is highly competitive, andas a result, alternative technologies or larger companies may undermine, limitor eliminate the market for our products’ technologies, which would decreaseour revenue and profits.*

The markets inwhich we compete for business are intensely competitive and rapidly evolving.We expect competition to continue from both existing competitors and new marketentrants. We face competition from other companies and from alternativetechnologies. The potential for an influx of federal funds into our core U.S.driver license market has drawn new competition and is likely to continue to doso. As we expand the applications for our technologies, we will experience morecompetition from products and services that are substitutes for ourapplications. Because our digital watermarking business is still in an earlystage of development, we also may face competition from unexpected sources.Alternative technologies that may directly or indirectly compete withparticular applications of our watermarking technologies include:

·       Encryption—securingdata during distribution using a secret code so it cannot be accessed except byauthorized users;

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·       Containers—insertinga media object in an encrypted wrapper, which prevents the media object frombeing duplicated and is used for content distribution and transactionmanagement;

·       DataGlyphs®—a slightly visiblemodification of the characteristics of an image or document that ismachine-readable;

·       ScrambledIndicia®—an opticalrefraction-based data-hiding technique that is inserted into an image and canbe read with a lens;

·       Traditionalanti-counterfeiting technologies—a number of solutions used currently by manygovernments (and that compete for budgetary outlays) designed to detercounterfeiting, including optically sensitive ink, magnetic threads and othermaterials used in the printing of currencies;

·       Radiofrequency tags—embedding a chip that emits a signal when in close proximitywith a receiver, which is being used in photo identification credentials,labels and tags;

·       Internettechnologies—numerous existing and potential Internet access and search methodsare competitive with the Digimarc MediaBridge system and the searchingcapabilities of Digimarc ImageBridge;

·       Digitalfingerprints and signatures—a metric, or metrics, computed solely from a sourceimage or audio or video track, that can be used to uniquely identify an imageor track, or authenticate the image or track;

·       Smartcards—badges and cards including a semiconductor memory and/or processor usedfor authentication and related purposes; and

·       Barcodes—a data-carrying code, typically visible in nature (but invisible ifprinted in ultraviolet- or infrared-responsive inks).

In addition, as we morebroadly apply our digital watermarking technologies to the Internet through newcommercial solutions applications, we may begin to compete with a wide range ofother types of companies beyond those companies using digital watermarkingtechnologies and alternative technologies. We cannot assure you that digitalwatermarking technologies, and our products and services using these technologies,will gain widespread market acceptance.

New developments areexpected to continue, and we cannot assure you that discoveries by others,including current and potential competitors, will not render our services andproducts noncompetitive. Moreover, because of rapid technological changes, wemay be required to expend greater amounts of time and money than currentlyanticipated to develop new products and services, which in turn may necessitateus to require greater revenue streams on such products and services to coverdevelopmental costs. Many of the companies that currently compete with us forsome of our business, as well as other companies with whom we may compete inthe future, are larger and national or international in scope and may have greatertechnical, financial, marketing, and political resources than we do. Theseresources could enable these companies to initiate severe price cuts or takeother measures in an effort to gain market share or otherwise impede ourprogress. We cannot assure you that we will be able to compete successfullyagainst current or future participants in our market or against alternativetechnologies, nor can we assure you that the competitive pressures we face willnot decrease our revenue and profits in the future.

*Our products could have unknown defects or errors,which may give rise to claims against us, divert application of our resourcesfrom other purposes or increase our project implementation and support costs.*

Products and systems ascomplex as those we offer or develop may contain undetected defects or errors.Furthermore, we often provide complex implementation, integration,customization, consulting and 

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othertechnical services in connection with the implementation and ongoingmaintenance of our products. Despite testing, defects or errors in our productsand services may occur, which could result in delays in the development andimplementation of products and systems, inability to meet customer requirementsor expectations in a timely manner, loss of revenue or market share, increasedimplementation and support costs, failure to achieve market acceptance,diversion of development resources, injury to our reputation, increasedinsurance costs, increased service and warranty costs and warranty or breach ofcontract claims. Although we attempt to reduce the risk of losses resultingfrom warranty or breach of contract claims through warranty disclaimers andliability limitation clauses in our sales agreements when we can, thesecontractual provisions are sometimes not included and may not be enforceable inevery instance. If a court refuses to enforce the liability-limiting provisionsof our contracts for any reason, or if liabilities arose that were notcontractually limited or adequately covered by insurance, the expenseassociated with defending such actions or paying the resultant claims could besignificant.

*If leading companies in our industry orstandard-setting bodies or institutions downplay, minimize, or reject the useof digital watermarking, its deployment may be slowed and we may be unable toachieve revenue growth—particularly in the media and entertainment sectors.*

Many of our businessendeavors, such as our licensing of intellectual property in support of audioand video copy-control applications, can be impeded or frustrated by larger,more influential companies or by standard-setting bodies or institutionsdownplaying, minimizing or rejecting the value or use of watermarkingtechnology or any of our other technologies. Such a negative position by thesecompanies, bodies or institutions, if taken, may result in obstacles for usthat we would be incapable of overcoming and may block or impede the adoptionof digital watermarking—particularly in the media and entertainment market. Inaddition, potential customers in the media and entertainment industry may delayor reject initiatives that relate to deployment of digital watermarking. Such adevelopment would make the achievement of our business objectives in thismarket difficult or impossible.

*If we are unable to respond to regulatory or industrystandards effectively, or if we are unable to develop and integrate newtechnologies effectively, our growth and the development of our products andservices could be delayed or limited.*

Our future success will dependin part on our ability to enhance and improve the responsiveness, functionalityand features of our products and services in accordance with regulatory orindustry standards. Our ability to remain competitive will depend in part onour ability to influence and respond to emerging industry and governmentalstandards, such as future regulations under the REAL ID Act, in a timely andcost-effective manner. If we are unable to influence these or other standardsor respond to such standards effectively, our growth and the development ofcertain products and services could be delayed or limited.

Ourmarket is characterized by new and evolving technologies. The success of ourbusiness will depend on our ability to develop and integrate new technologieseffectively and address the increasingly sophisticated technological needs ofour customers in a timely and cost-effective manner. Our ability to remaincompetitive will depend in part on our ability to:

·       enhanceand improve the responsiveness, functionality and other features of theproducts and services we offer or plan to offer;

·       continueto develop our technical expertise; and

·       developand introduce new services, applications and technologies to meet changingcustomer needs and preferences and to integrate new technologies.

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We cannot assure you thatwe will be successful in responding to these technological and industrychallenges in a timely and cost-effective manner. If we are unable to developor integrate new technologies effectively or respond to these changing needs,our margins could decrease, and our release of new products and services andthe deployment of our watermarking technology could be adversely affected.

*We may need to retain additional employees or contractlabor in the future in order to take advantage of new business opportunitiesarising from increased demand, which could impede our ability to achieve orsustain profitability.*

In the second half of 2005and in 2006, we made significant reductions in our workforce as part of ourefforts to reach profitability. These reductions did not impede our ability tomeet demand because they were accompanied by improvements in our internalbusiness processes and coincided with a period of relatively low bid activitywith respect to development and deployment of new systems. We believe that thisdecrease in bid activity is temporary and that the U.S. driver license marketwill demonstrate increased demand in future periods. Our current reducedstaffing levels could affect our ability to respond to increased demand for ourservices. In addition, to meet any increased demand and take advantage of newbusiness opportunities in the future, we may need to increase our workforcethrough additional employees or contract labor, which would increase our costs.If we experience such an increase in costs, we may not succeed in achieving orsustaining profitability.

*We depend on our senior management and key employeesfor our future success. If we are not able to retain, hire or integrate theseemployees, we may not be able to meet our commitments.*

Our success depends to asignificant extent on the performance and continued service of our seniormanagement. Except for our Chief Executive Officer, our senior management doesnot have employment agreements. The loss of the services of any of our seniormanagement could delay projects or undermine customer relationships.

Due to the high level oftechnical expertise that our industry requires, our ability to successfullydevelop, market, sell, license and support our products, services, andintellectual property depends to a significant degree upon the continuedcontributions of our key personnel in engineering, sales, marketing,operations, legal and licensing, many of whom would be difficult to replace.Similarly, without the continued contributions of our key finance personnel, webelieve that our ability to meet our reporting obligations and operatesuccessfully as a public company may be limited. We believe our future successwill depend in large part upon our ability to retain our current key employeesand our ability to attract, integrate and retain such personnel in the future.It may not be practical for us to match the compensation certain of ouremployees could garner at other employment. In addition, we may encounterdifficulties in hiring and retaining employees because of concerns related toour financial performance. In addition, these circumstances may have a negativeimpact on the market price of our common stock, and employees and prospectiveemployees may factor in the uncertainties relating to our stability and thevalue of any equity-based incentives in their decisions regardingemployment opportunities and decide to leave our employ. In addition, ourbusiness is based in part on patented technology, which is unique and notgenerally known. New employees require substantial training, involvingsignificant resources and management attention. Competition for experiencedpersonnel in our business can be intense. If we do not succeed in attractingnew, qualified personnel or in integrating, retaining and motivating ourcurrent personnel, our growth and ability to deliver products and services thatour customers require may be hampered. Although our employees generally haveexecuted agreements containing non-competition clauses, there is no assurancethat a court would enforce all of the terms of these clauses or the clausesgenerally. If these clauses were not fully enforced, our employees could beable to freely join our competitors. Although we generally attempt to controlaccess to and distribution of our proprietary information by our employees,there can be no assurances that the confidential nature of our proprietary 

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informationwill be maintained in the course of such future employment. Any of these eventscould have a material adverse effect on our financial and business prospects.

*We expect our secure ID systems business to experiencevariability in gross margins.*

We arelikely to experience variability in gross margins on our government contractsdue to numerous factors, including, among other things, the following:

·       delaysin project implementation;

·       failureto achieve add-on sales to existing customers;

·       governmentalregulation of credentials and issuance policies;

·       privatesector usage trends for driver licenses and other credentials;

·       levelof commodity vs. proprietary components applicable to customer systemspecifications;

·       whethercontracts have been extended or renewed; and the amount of capital expenditureassociated with such extension or renewal;

·       pricecompetition in competitive bids, contract renewals and contract extensions;

·       variationsin costs of materials and manufacturing;

·       varyinglevels of efficiency of our workforce in delivering, implementing, andservicing contracts;

·       seasonalityof issuance volumes;

·       salesmix related to card issuance revenues compared to product sales;

·       salesmix related to domestic sales compared to international sales;

·       salesmix related to adoption of new products compared to sales of current products;

·       strategicdecisions on new business;

·       depreciationand amortization of capitalized project costs related to new or upgradedprograms; and

·       variabilityin the extent to which we are able to allocate personnel expenses to capitalprojects and thereby amortize such costs over the life of the relevantcontract, rather than expensing such costs in the quarter in which they areincurred.

The numerous factors affecting gross margins make suchmargins complex and difficult to predict. We are continually refining ourpredictive tools and increasing our understanding of what drives these variousfactors. For reasons such as those listed above, we expect that there will befluctuations in our future operating results as a result of the variability inmargins from period to period in the secure ID systems business.

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*The majority of ourrevenue is subject to government procurement processes that may involveunpredictable delays and other unexpected changes which might limit our actualrevenue in any given quarter.*

We derive substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new revenueare tied to procurement schedules, which could shift as the needs of therelated government procurement agencies change. Many of these governmentalcustomers are facing continued budget pressures introducing added uncertainty.In addition, the Department of Homeland Security’s initiatives in passports andborder crossing cards, as well as delays in disbursement of funding for REAL IDAct projects, could create confusion within the U.S. driver license market thatmay delay purchase decisions by government customers. Any shift in thegovernment procurement process, which is outside our control and may not bepredictable, could result in delays in bookings forecasted for any particularfinancial period, could impact the predictability of our quarterly results, andmight limit our actual revenue in any given quarter, resulting in reduced andless predictable revenue and an adverse affect on profitability.

*Our future growthwill depend to some extent on our successful implementation of our intellectualproperty in solutions provided by third parties, including partners andsuppliers.*

Our business and strategyrely, in part, on deployment of our digital watermark reader technology bythird-party software developers and original equipment manufacturers. Forexample, one form of our digital watermark reader is commonly deployed in imageediting applications (offered by vendors including Adobe, Corel and Ulead) topermit users of these products to read watermarks embedded in imagery, andthereby discern the identities of image owners. Another form of our digitalwatermark reader is used in our anti-counterfeiting product offerings. Weanticipate entering into additional agreements with third-party vendors tocreate, promote and service products that incorporate, embed, integrate orbundle our technologies. If third parties who include such technologies intheir products cease to do so, or we fail to obtain other partners that willincorporate, embed, integrate or bundle such technologies, or these partnersare unsuccessful in their efforts, our efforts to expand deployment of ourtechnologies would be adversely affected and, consequently, our ability toincrease revenues would be adversely affected and we may suffer other adverseeffects to our business. In addition, if our technologies do not performaccording to market expectations, our future sales would suffer as customersseek other providers.

*Some of our revenuemodels relating to anticipated products and services are under development. Ifthese revenue models and pricing structures do not gain market acceptance, thecorresponding anticipated products and services may fail to attract or retaincustomers and we may not be able to generate new or sustain existing revenue.*

Some of our businessinvolves embedding digital watermarks in traditional and digital media,including identification documents, secure documents, audio, video and imagery,and licensing our intellectual property. Through 2001, our revenue stream wasbased primarily on a combination of development, consulting, subscription andlicense fees from copyright protection and counterfeit deterrence applications.Beginning in 2002 and for the foreseeable future, we have seen, and weanticipate, that the majority of our revenue will be from government andprivate-sector customers for providing security-related applications relatingto secure personal identification, copyright protection, and counterfeitdeterrence to such customers. We have not fully developed revenue models forcertain of our future digital watermarking applications and licensingendeavors. Because some of our products and services are not yetwell-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure for these products and services will gain marketacceptance or be sustainable over time or that the marketing for such productsand services will be effective.

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*The securitysystems used in our product and service offerings may be circumvented orsabotaged by third parties, which could result in the disclosure of sensitivegovernment information or private personal information or cause other businessinterruptions that could damage our reputation and disrupt our business.*

Our business relies on computers and other informationtechnologies, both in-house and at customer and vendor locations. In addition,many of the systems we sell manage private personal information and protectinformation involved in sensitive government functions. The protective measuresthat we use in these systems may not prevent security breaches, and failure toprevent security breaches may disrupt our business, damage our reputation, andexpose us to litigation and liability. A party who is able to circumventsecurity measures used in these systems could misappropriate sensitive orproprietary information or materials or cause interruptions or otherwise damageour products, services and reputation, and the property of our customers. Ifunintended parties obtain sensitive data and information, or create bugs orviruses or otherwise sabotage the functionality of our systems, we may receivenegative publicity, incur liability to our customers or lose the confidence ofour customers, any of which may cause the termination or modification of ourcontracts. Further, our insurance coverage may be insufficient to cover lossesand liabilities that may result from such events.

In addition, we may berequired to expend significant capital and other resources to protect ourselvesagainst the threat of security breaches or to alleviate problems caused bythese breaches. Such protection or remedial measures may not be available at areasonable price or at all, or may not be entirely effective if commenced.

*As internationalcustomers have accounted for approximately 20% of our total revenue during thefiscal year ended December 31, 2006, the loss of these customers or thefailure to find new customers may result in a decline in our internationalrevenue, which could adversely affect our profitability and slow our growth.*

We expect revenuefrom sales of products and services to governments and other customers outsidethe U.S. to represent a growing percentage of our total revenue in the future.International sales and services are subject to a number of risks, includingthe following:

·       changesin foreign government regulations and security requirements;

·       exportlicense requirements, tariffs and taxes;

·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       longerpayment cycles than those for customers in the United States;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

In addition, our experience with large internationalissuance programs is more limited than our experience with domestic programs. Wedo not have an extensive operational infrastructure for our internationalbusiness. We generally act as a subcontractor or depend on local orinternational business partners and subcontractors for performance of substantialportions of these programs. These factors may result in greater risk ofperformance problems or of reduced profitability with respect to our internationalprograms.

If we are affected by these risks, our sales ofproducts and services to customers outside the U.S. could be reducedsignificantly. In addition, if foreign customers, in particular foreigngovernment authorities, 

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terminate or delay theimplementation of our products and services, we may have limited recourseagainst them to recover any potential losses.

We generally do notinvoice our foreign sales in U.S. dollars, and, consequently, we are exposed tocurrency exchange fluctuations. We currently do not engage in foreign currencyhedging transactions. We may in the future choose to limit our exposure by thepurchase of forward foreign exchange contracts, collared options, currency swapagreements or through similar hedging strategies. However, no currency hedgingstrategy can fully protect against exchange-related losses.

*A significantportion of our business depends on contracts that are subject to a variety ofterms and conditions, including damage payment obligations, as well as avariety of other provisions that may cause our quarterly results to fluctuateand our anticipated revenue to potentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and related products typically include termsrelating to time-based performance, development and delivery schedules,customer acceptance and testing, and other performance milestones. Suchprovisions are common in large scale government contracts at the state andfederal levels. Because procedures often require compliance over extendedperiods of time, they give rise to an increased risk that we may fail to meettiming or other delivery requirements and milestones pursuant to the terms ofsuch contracts. If we failed to meet such requirements or milestones, customersmay assert against us compensatory or liquidated damages, breach of contract,or other claims. Consequently, our failure to meet contractual milestones orother performance requirements as promised could result in our having to incurincreased costs, lower margins, or compensatory obligations, in addition toother losses, such as harm to our reputation. Such unexpected increases incosts to meet our contractual obligations or any other requirements necessaryto address claims and damages with regard to our customer contracts could havea material adverse effect on our business and financial results. We anticipatethat future contracts will continue to have such provisions unless and untilindustry practices change.

A significant portion of our business depends on alimited number of large, public-sector contracts, which are generally subject totermination for convenience, as determined by the subject agency, or for lackof budgetary appropriation provided for the subject agency. Some governmentcontracts also may be one-time events, such as in the case of some personalidentification systems in non-U.S. markets involving voter registrationprograms. In such cases, we may generate substantial revenue that may not besubject to future renewal. Moreover, government contracts result frompurchasing decisions made by public sector agencies that may be subject topolitical influence, unusual procurement procedures, strict legal requirements,budget changes and cutbacks during economic downturns, variations inappropriations cycles, and protests of contract awards. Additionally, somegovernmental authorities require performance bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bondsrequire that we maintain large restricted cash reserves as a guarantee,reducing our ability to use these funds for our other business purposes. Evenwith the availability of such cash reserve guarantees, we may not be able toobtain such performance bond underwriting at a favorable rate or at all. Inaddition, these performance bonds may provide for security interests coveringour receivables or other assets, which could cause additional financing to bemore difficult or more expensive to obtain.

Our failure to be able toprovide such performance bonds may preclude our ability to bid on newgovernment contracts or maintain our existing contracts for their full terms.The size, nature and purpose of, and the risks and uncertainties associatedwith, public sector contracts can potentially cause our quarterly results tofluctuate and anticipated revenue to decrease significantly.

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*A significantportion of our business depends on contracts with fixed price terms. In theevent of cost overruns in connection with such contracts, our margins may beadversely affected.*

In addition to our normalprice-per-card issuance contracts, we occasionally enter into agreements tosell entire systems or portions of a system for an agreed upon price. Thesecontracts normally do not have clauses that allow for recovery of costoverruns. Under these contracts, we provide specific tasks for a specific priceand are typically paid on a milestone basis. We have experienced low margins orlosses on some of these contracts in the recent past. Such contracts involvegreater financial risks because we bear the risk if actual project costs exceedthe amounts we are paid under the contracts.

*We may decline topursue new, or renew existing, business opportunities in secure ID systemsmarkets due to objectionable terms required by the contracting agencies, or wemay agree to objectionable contract terms for competitive reasons.*

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure ID issuance systems. For example, it is customary for state agencies torequire that a vendor fund the capital-intensive initial deployment of a driverlicense issuance system (the costs of which the vendor normally recoups overthe life of the contract in per-card fees), while reserving the right toterminate the contract for convenience. Similarly, in connection withintellectual property rights, a contract may require that our pre-existingissuance system software be written in a different language and a state maythen argue that it falls within the class of works for which it owns thecopyright, enabling the state to turn the Digimarc-authored software over toone of our competitors, dedicate it to the public domain, or otherwise use thesoftware in a manner detrimental to our business. Objectionable contract termsmay lead us to decline to bid on identification issuance systems to new customers,or to decline to retain business with customers we have historically served,which could reduce our market share and lower our revenues or profits. Inaddition, if we decline to retain business with customers we have historicallyserved, it could result in the accelerated depreciation of intangible assets.Alternatively, we may decide to accept at least some level of objectionableterms rather than cede an important contract to a competitor, which could alsolower our revenues or profits.

*A loss of a materialsupplier could have a material adverse effect on our ability to performeffectively under some of our contracts.*

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. While we strive to havealternative suppliers provide us with many of our products, a loss of one ormore of such suppliers could have a material adverse effect on our ability toperform effectively, if at all, under some of our contracts.

*We are subject torisks encountered by companies developing and relying upon new technologies,products and services for substantial amounts of their growth or revenue.*

Our business and prospects must be considered in lightof the risks and uncertainties to which companies with new and rapidly evolvingtechnologies, products and services, such as digital watermarking, are exposed.These risks include the following:

·     We maybe unable to develop sources of new revenue or sustainable growth in revenuebecause our current and anticipated technologies, products and services may beinadequate or may be unable to attract or retain customers;

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·       Theintense competition and rapid technological change in our industry couldadversely affect the market’s acceptance of our existing and new products andservices; and

·       Wemay be unable to develop and maintain new technologies upon which our existingand new products and services are dependent in order for our products andservices to be sustainable and competitive and in order for us to expand ourrevenue and business.

Some of our keytechnologies are in the development stage. Consequently, products incorporatingthese key technologies are undergoing technological change and are in the earlystage of introduction in the marketplace. Delays in the adoption of theseproducts or adverse competitive developments may result in delays in thedevelopment of new revenue sources or the growth in our revenue. In addition,we may be required to incur unanticipated capital expenditures in the eventproduct changes or improvements are required. Additionally, new industrystandards might redefine the products that we are able to sell, especially ifthese products are only in the prototype stage of development. If productchanges or improvements are required, success in marketing these products andachieving profitability from these products could be delayed or halted. We alsomay be required to fund such changes or improvements out of operating income,which could adversely affect our profitability.

*We may not be ableto protect adequately our intellectual property, and we may be subject toinfringement claims and other litigation, which could adversely affect ourbusiness.*

Our success depends in part on licensing ourproprietary technologies. To protect our growing intellectual propertyinvestments, we rely on a combination of patent, copyright, trademark and tradesecret rights, confidentiality procedures and licensing arrangements.Unlicensed copying and use of our intellectual property or illegalinfringements of our intellectual property rights represent losses of revenueto us.

We face risks associated with our patent position,including the potential and sometimes actual need from time to time to engagein significant legal proceedings to enforce our patents, the possibility thatthe validity or enforceability of our patents may be denied, and thepossibility that third parties will be able to compete against us withoutinfringing our patents. Budgetary concerns may cause us not to file, orcontinue, litigation against known infringers of our patent rights, or maycause us not to file for, or pursue, patent protection for all of our inventivetechnologies in jurisdictions where they may have value. Some governmentalentities that might infringe our intellectual property rights may enjoysovereign immunity from such claims. Failure to reliably enforce our patentrights against infringers may make licensing more difficult. If we fail toprotect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to ourinterests, or if we become involved in litigation relating to our intellectualproperty rights and proprietary technologies or relating to the intellectualproperty rights of others, our business could be seriously harmed because thevalue ascribed to our intellectual property could diminish and result in alower stock price or we may incur significant costs in bringing legalproceedings against third parties who are infringing our patents.

Effective protection of intellectual property rightsmay be unavailable or limited, both in the United States and in othercountries. Patent protection throughout the world is generally established on acountry-by-country basis. We have applied for patent protection both inthe United States and in various other countries. However, we cannot assure youthat pending patents will be issued or that issued patents will be valid orenforceable. Failure to obtain such patents or failure to enforce those patentsthat are obtained may result in a loss of revenue to us. We cannot assure youthat the protection of our proprietary rights will be adequate or that ourcompetitors will not independently develop similar technologies, duplicate ourservices or design around any of our patents or other intellectual propertyrights we hold.

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We are the exclusive licensee under some third-partypatents, and may need the assistance of these parties if we choose to enforceany of these patent rights. The cooperation of these third parties cannot beassured even though we rely on some of these technologies for our products.

As more companies engage in business activitiesrelating to personal identification technologies and digital watermarking, anddevelop corresponding intellectual property rights, it is increasingly likelythat claims may arise which assert that some of our products or servicesinfringe upon other parties’ intellectual property rights. These claims couldsubject us to costly litigation, divert management resources and result in theinvalidation of our intellectual property rights. These claims may require usto pay significant damages, cease production of infringing products, terminateour use of infringing technologies or develop non-infringing technologies. Inthese circumstances, continued use of our technologies may require that weacquire licenses to the intellectual property that is the subject of thealleged infringement, and we might not be able to obtain these licenses oncommercially reasonable terms or at all. Our use of protected technologies mayresult in liability that threatens our continuing operation.

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. Asdeployment of our technology increases, and more companies enter our markets,the likelihood of a third party lawsuit resulting from such indemnificationincreases. If an infringement arose in a context governed by such a contract,we may have to refund to our customer amounts already paid to us or paysignificant damages, or we may be sued by the party allegedly infringed upon.Similarly, as we seek to broaden the number of companies licensed under ourpatent portfolio, some may seek contractual assurances that we will pursue—bylitigation if necessary—their competitors who use our patented technology butare not licensed to do so. Compliance with any such contract provisions mayrequire that we pursue litigation where our costs exceed our likely recovery.

As part of ourconfidentiality procedures, we generally enter into non-disclosure agreementswith our employees, directors, consultants and corporate partners, and attemptto control access to and distribution of our technologies, solutions,documentation and other proprietary information. Despite these procedures,third parties could copy or otherwise obtain and make unauthorized use of ourtechnologies, solutions or other proprietary information or independentlydevelop similar technologies, solutions or information. The steps that we havetaken to prevent misappropriation of our solutions, technologies or otherproprietary information may not prevent their misappropriation, particularlyoutside the United States where laws or law enforcement practices may notprotect our proprietary rights as fully as in the United States.

*Products that weare developing for new secure identification markets and components andsubsystems markets may not be accepted as quickly as we have projected or atall, which may negatively impact our revenues, margins, earnings and stockprice.*

We have investedsignificant time and resources in product development activities for new secureidentification markets, including designing and developing numerousenhancements to our driver license systems and improving our cards’ ability towithstand intrusions or alterations without detection. At present, our newproducts include Digimarc Camera Tower, Digimarc Capture Software, DigimarcImage Server, Digimarc ID Validation Suite (IDVS), Digimarc IDMarc,Digimarc Biometric Identification solution and Digimarc Document Inspector. Ifwe do not experience a timely, positive reaction from issuing authorities toour new offerings, our projected revenues, margins and earnings may benegatively impacted.

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*We are engaged inseveral lawsuits alleging violations of securities law and cannot predict theoutcome or ultimate cost of these actions with certainty.*

We currently are engagedin litigation relating to the initial public offering of our securities, inaddition to the class actions filed against us in connection with ourpreviously announced accounting errors. These matters are discussed in greaterdetail in Part II, Item 1 (Legal Proceedings) of this Quarterly Report on Form 10-Qand in Note 5 (Commitments and Contingencies) of the Notes to ConsolidatedFinancial Statements included in this Quarterly Report on Form 10-Q.We have incurred significant costs relating to these matters. Due to theinherent uncertainties of such litigation, the ultimate cost and outcome cannotbe predicted.

*If a judgment wereto be entered against the Company and our director and officer liabilityinsurance was inadequate or unavailable, the obligation to pay the judgment maymaterially harm our business and financial condition.*

Our director and officerliability insurance policies provide protection against certain liabilitiesrelating to the securities class action and derivative lawsuits against us andcertain of our officers and directors up to prescribed policy limits. If thesepolicies do not adequately cover expenses and certain liabilities relating tothese lawsuits, our financial condition could be materially harmed. Inaddition, if this insurance coverage becomes unavailable to us or premiumsincrease significantly in the future, it could make it more difficult for us toretain and attract officers and directors and could expose us to potentially self-fundingcertain future liabilities ordinarily mitigated by director and officerliability insurance.

*We may be requiredto invest significant additional time and resources to comply with therequirements of Section 404 of the Sarbanes-Oxley Act of 2002, which couldharm our operating results or cause us to fail to meet our reportingobligations.*

In 2004, we discoveredcertain material weaknesses in our internal controls and procedures, which weremediated. Since then, we have deployed significant resources to design andimplement new and enhanced controls and procedures. We cannot be certain,however, that other deficiencies will not arise or be identified in the future,particularly if we experience rapid growth or change in our business, includinggrowth or change resulting from any future acquisition. Any failure tomaintain adequate controls or to adequately implement required new or improvedcontrols could harm our operating results or cause us to fail to meet ourreporting obligations in a timely and accurate manner.

*There can be no assurance that our disclosure controlsand procedures will succeed in achieving their stated goals under all potentialfuture conditions, regardless of how remote.*

The SEC defines the term “disclosurecontrols and procedures” to mean a company’s controls and other procedures thatare designed to ensure that information required to be disclosed in the reportsthat it files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported, within the time periods specified in the Commission’srules and forms. While our disclosure controls and procedures are designed toprovide reasonable assurance of achieving their objectives, the design of anysystem of controls is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.  If ourdisclosure controls and procedures do not succeed in achieving their statedgoals, our operating results could be harmed or we could fail to meet ourreporting obligations in a timely and accurate manner.

52

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**ITEM 7A:**       QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to marketrisk for changes in interest rates relates primarily to the increase ordecrease in the amount of interest income we can earn on our investmentportfolio and on the increase or decrease in the amount of any interest expensewe must pay with respect to outstanding debt instruments. The risk associatedwith fluctuating interest expense is limited, however, to the exposure relatedto those debt instruments and credit facilities that are tied to market rates.We do not plan to use derivative financial instruments in our investmentportfolio. We plan to ensure the safety and preservation of our investedprincipal funds by limiting default risk, market risk and investment risk. Weplan to mitigate default risk by investing in low-risk securities. At December 31,2006, we had an investment portfolio of money market funds, commercialsecurities and U.S. Government securities, including those classified as cashand cash equivalents, restricted cash, and short-term investments, of$28.4 million. The original maturities of our investment portfolio rangefrom 4 to 62 days with an average interest rate of 5.4%. We had capitallease obligations of approximately $1.0****million at December 31,2006. If market interest rates were to increase immediately and uniformly by10% from levels as of December 31, 2006, the decline of the fair marketvalue of the fixed income portfolio and loans outstanding would not bematerial. To a lesser extent, the Company is also subject to foreign currencyexchange risk in the form of exposures to fluctuations in currency exchangerates.

**ITEM 8:**               FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

The consolidated financialstatements and notes thereto of Digimarc Corporation and its subsidiaries as ofDecember 31, 2006 and 2005 and for the three year period ended December 31,2006 and the independent registered public accounting firm reports thereon areset forth on the F pages of this Annual Report on Form 10-K andare incorporated herein by reference.

**ITEM 9:**               CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**ITEM 9A:**       CONTROLSAND PROCEDURES

The certifications of ourprincipal executive officer and the principal financial officer required inaccordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attachedas exhibits to this Form 10-K. The disclosures set forth in thisItem 9A contain information concerning the evaluation of our internal controlsand procedures, and changes in internal control over financial reporting,referred to in paragraph 4 of the certifications. This Item 9A should be readin conjunction with the officer certifications for a more completeunderstanding of the topics presented.

**Evaluation ofDisclosure Controls and Procedures**

The SEC defines the term “disclosurecontrols and procedures” to mean a company’s controls and other procedures thatare designed to ensure that information required to be disclosed in the reportsthat it files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported, within the time periods specified in the Commission’srules and forms. While our disclosure controls and procedures are designedto provide reasonable assurance of achieving their objectives, the design ofany system of controls is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote. Our management, with the participation of ourprincipal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) ofthe 

53

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SecuritiesExchange Act of 1934) as of December 31, 2006, which included anevaluation of disclosure controls and procedures applicable to the periodcovered by the filing of this periodic report. Based on the evaluation of theeffectiveness of our disclosure controls and procedures by our management as ofDecember 31, 2006, our principal executive officer and principal financialofficer have concluded that our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in the reportsthat we file or submit under the Securities Exchange Act of 1934 is accumulatedand communicated to our management, including our principal executive andprincipal financial officers, or persons performing similar functions, asappropriate to allow timely decisions regarding required disclosure.

**Management’s Reporton Internal Control Over Financial Reporting**

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting as defined in Rules 13a-15(f) and 15d-15(f) underthe Securities Exchange Act of 1934. Our internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with U.S. GAAP. Our internal control overfinancial reporting included those policies and procedures that:

·       Pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets;

·       Providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with U.S. GAAP, and thatreceipts and expenditures are being made only in accordance with authorizationsfrom our management and directors; and

·       Providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of our assets that could have a materialeffect on the financial statements.

With the participation of our principal executiveofficer and our principal financial officer, our management conducted anevaluation of the effectiveness of our internal control over financialreporting based on the framework established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission,(COSO). Based on this evaluation, our management has concluded that ourinternal control over financial reporting was effective as of December 31,2006.

Any control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are knowledge and resource constraintsin any such system, and a large number of complex permutations of facts,circumstances, accounting policies, procedural implications, and businesspractices that must be considered. Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and breakdowns can occur because of a simple error or mistake. Additionally,controls can be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the controls. Thedesign of any system of controls also is based in part upon certain assumptionsabout the likelihood of future events, and there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions. Over time, the control systems we develop may become inadequatebecause of changes in conditions, or the degree of compliance with the policiesor procedures may deteriorate.

54

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Management is committed to continue monitoring ourinternal controls over financial reporting and will modify or implementadditional controls and procedures that may be required to ensure the ongoingintegrity of our financial statements.

Management’s assessment ofthe effectiveness of our internal control over financial reporting as of December 31,2006 has been audited by Grant Thornton LLP, an independent registered publicaccounting firm. Their attestation report is included herein.

**Changes to theInternal Control Environment**

There have not been anychanges in our internal control environment during the Company’s fiscal quarterended December 31, 2006 that have materially affected or are reasonablylikely to materially affect our internal control over financial reporting.

55

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**Report of Independent Registered Public AccountingFirm**

**To theBoard of Directors and StockholdersDigimarc Corporation:**

We have audited management’sassessment, included in the accompanying Management’s Report on InternalControls Over Financial Reporting set forth in item 9(A), that DigimarcCorporation (a Delaware Corporation) maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.Digimarc Corporation’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinions.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (3) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, ordisposition of the company’s assets that could have a material effect on thefinancial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that Digimarc Corporation maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in allmaterial respects, based on criteria established in *Internal Control—Integrated Framework*issued by theCommittee of Sponsoring Organizations of the Treadway Commission. Also in ouropinion, Digimarc Corporation has maintained in all material respects,effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.

56

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We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheet of Digimarc Corporation andsubsidiaries as of December 31, 2006 and 2005, and the relatedconsolidated statement of operations, stockholders’ equity, and cash flows foreach of the two years in the period ended December 31, 2006 and our reportdated March 8, 2007 expressed an unqualified opinion on those financialstatements.

| /s/ Grant Thornton LLP |
|------------------------|
| Portland, Oregon       |
| March 8,  2007    |

 

**ITEM 9B: OTHERINFORMATION**

None.

57

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**PART III**

Certain informationrequired by Part III of this Annual Report on Form 10-K is  incorporated herein by reference to the ProxyStatement for our 2007 annual meeting of stockholders, which we intend to fileno later than 120 days after the end of the fiscal year covered by thisAnnual Report on Form 10-K.

**ITEM 10:**        DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

**Code of Ethics**

We have adopted a Code of Business Conduct thatapplies to our principal executive officer, principal financial officer andcontroller, as well as a Code of Ethics for Financial Professionals thatapplies to our principal financial officer and controller. We have made thesecodes available in the Corporate Governance section of our website at www.digimarc.com/corp/governance.If we waive, or implicitly waive, any material provision of the codes, orsubstantively amend the codes, we will disclose that fact on our website withinfour business days.

The other informationrequired by this item is incorporated herein by reference to the information inthe Proxy Statement, which we intend to file with the SEC no later than120 days after the end of the fiscal year covered by this Annual Report onForm 10-K under the captions “Election of Directors,” “Meetings andCommittees of the Board of Directors,” “Management,” “Report of the Governanceand Nominating Committee of the Board of Directors” and “Section 16(a) BeneficialOwnership Reporting Compliance.”

**ITEM 11:**        EXECUTIVECOMPENSATION

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the captions “Director Compensation,” “CompensationCommittee Interlocks and Insider Participation,” “Compensation Discussion andAnalysis” and “Executive Compensation.”

**ITEM 12:**        SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement, which we intend to file with the SEC no later than120 days after the end of the fiscal year covered by this Annual Report onForm 10-K under the captions “Security Ownership of CertainBeneficial Owners and Management” and “Equity Compensation Plan Information.”

**ITEM 13:**        CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement, which we intend to file with the SEC no later than120 days after the end of the fiscal year covered by this Annual Report onForm 10-K under the caption “Related Party Transactions” and “Determinationof Independence.”

**ITEM 14:**        PRINCIPALACCOUNTING FEES AND SERVICES

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement, which we intend to file with the SEC no later than120 days after the end of the fiscal year covered by this Annual Report onForm 10-K under the caption “Audit and Non-Audit Fees.”

58

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**ITEM 15:**        EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**(a)(1) FinancialStatements**

The followingfinancial statements are set forth on pages F-1 to F-35attached to the Annual Report on Form 10-K filed with Securities andExchange Commission on March 8, 2007:

(i)            Report of Independent Registered PublicAccounting Firm—Grant Thornton LLP

(ii)        Report of IndependentRegistered Public Accounting Firm—KPMG LLP

(iii)    Consolidated Balance Sheets asof December 31, 2006 and 2005

(iv)      Consolidated Statements ofOperations for the years ended December 31, 2006, 2005 and 2004

(v)          Consolidated Statementsof Stockholders’ Equity for the years ended December 31, 2006, 2005 and2004

(vi)      Consolidated Statements ofCash Flows for the years ended December 31, 2006, 2005 and 2004

(vii)  Notesto Consolidated Financial Statements

**(a)(2) FinancialStatement Schedules**

Allschedules have been omitted since they are not required or are not applicableor the required information is shown in the financial statements or relatednotes.

**(a)(3) Exhibits**

See Exhibit Index.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
|                          |   | DIGIMARC CORPORATION                                                                                        |
|--------------------------|--------|-------------------------------------------------------------------------------------------------------------|
|                     |   | /s/  Michael McConnell                                                                                      |
| Date: March 8, 2007 |   | Michael McConnell                                                                                           |
|                     |   | *Title:  Chief Financial Officer (Duly Authorized Officer and Principal Financial and  Accounting Officer)* |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this Form 10-Khas been signed below by the following persons on behalf of the registrant andin the capacities and on the dates indicated:

|                                | **Signature** | ** **                                    | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------------|---------------|-----------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ Bruce Davis                |          | Chief Executive  Officer and Chairman         |       | March 8, 2007 |
| Bruce  Davis                   |          | of the Board of  Directors                    |       |               |
|                           |          | (Principal Executive  Officer)                |       |               |
| /s/ Michael McConnell          |          | Chief Financial  Officer and Treasurer        |       | March 8, 2007 |
| Michael  McConnell             |          | (Principal Financial and  Accounting Officer) |       |               |
| /s/ Robert Chamness            |          | Chief Legal  Officer and Secretary            |       | March 8, 2007 |
| Robert  Chamness               |          |                                          |       |               |
| /s/ Philip J. Monego, Sr. |          | Director                                      |       | March 8, 2007 |
| Philip  J. Monego, Sr.    |          |                                          |       |               |
| /s/ Brian J. Grossi            |          | Director                                      |       | March 8, 2007 |
| Brian  J. Grossi               |          |                                          |       |               |
| /s/ Peter W. Smith             |          | Director                                      |       | March 8, 2007 |
| Peter  W. Smith                |          |                                          |       |               |
| /s/ Jim Roth                   |          | Director                                      |       | March 8, 2007 |
| Jim  Roth                      |          |                                          |       |               |
| /s/ James T. Richardson        |          | Director                                      |       | March 8, 2007 |
| James  T. Richardson           |          |                                          |       |               |
| /s/ William J. Miller          |          | Director                                      |       | March 8, 2007 |
| William  J. Miller             |          |                                          |       |               |
| /s/ Bernard Whitney            |          | Director                                      |       | March 8, 2007 |
| Bernard  Whitney               |          |                                          |       |               |
| /s/ Lloyd G. Waterhouse        |          | Director                                      |       | March 8, 2007 |
| Lloyd G.  Waterhouse           |          |                                          |       |               |

 

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**DIGIMARCCORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                  | ** ** | **Page** |
|----------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm—Grant Thornton LLP |       | F-2      |
| Report of Independent Registered Public Accounting  Firm—KPMG LLP           |       | F-3      |
| Consolidated Balance Sheets                                                      |       | F-4      |
| Consolidated Statements of Operations                                            |       | F-5      |
| Consolidated Statements of Stockholders’ Equity  (Deficit)                  |       | F-6      |
| Consolidated Statements of Cash Flows                                            |       | F-7      |
| Notes to Consolidated Financial Statements                                       |       | F-8      |

 

F-1

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directorsand Stockholders ofDigimarc Corporation:

We have audited the accompanying consolidated balancesheets of Digimarc Corporation (a Delaware Corporation) and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the two years in the periodended December 31, 2006. These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 statementsreferred to above present fairly, in all material respects, the financialposition of Digimarc Corporation and subsidiaries as of December 31, 2006and 2005, and the results of their operations and their cash flows for each ofthe two years in the period ended December 31, 2006 in conformity withaccounting principles generally accepted in the United States of America.

As discussed in Note 1 to consolidated financialstatements, the Company has adopted Statement of Financial Accounting StandardsNo. 123(R), *Share-Based Payments* (Revised2004) during 2006.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Digimarc Corporation and its subsidiaries’internal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission and our report dated March 8, 2007 expressed anunqualified opinion on management’s assessment, and an unqualified opinion onthe effective operation of internal control over financial reporting.
| /s/ Grant Thornton LLP |
|------------------------|
| Portland, Oregon       |
| March 8, 2007     |

 

F-2

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of DirectorsandStockholders of Digimarc Corporation:

Wehave audited the accompanying consolidated statements of operations,stockholders’ equity, and cash flows of Digimarc Corporation and subsidiariesfor the year ended December 31, 2004. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, theoperations and cash flows of Digimarc Corporation and subsidiaries for the yearended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles.
| /s/ KPMG LLP      |
|-------------------|
| Portland, Oregon  |
| May 27, 2005 |

 

F-3

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**DIGIMARC CORPORATIONCONSOLIDATED BALANCE SHEETS(In thousands, except share and per share data)**

| ** **                                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                                                    |       |                  |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                                                               |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                     |       |                  | $          | 23,135                |       |   |   | $ | 23,964 |   |   |
| Restricted cash                                                                                                                                                                                               |       |                  | 378        |                  |       |   | — |   |   |
| Short-term investments                                                                                                                                                                                        |       |                  | —     |                  |       |   | 739 |   |   |
| Trade accounts receivable, net                                                                                                                                                                                |       |                  | 14,403     |                  |       |   | 15,697 |   |   |
| Inventory, net                                                                                                                                                                                                |       |                  | 6,600      |                  |       |   | 7,451 |   |   |
| Other current assets                                                                                                                                                                                          |       |                  | 2,273      |                  |       |   | 2,828 |   |   |
| Total current assets                                                                                                                                                                                          |       |                  | 46,789     |                  |       |   | 50,679 |   |   |
| Restricted cash                                                                                                                                                                                               |       |                  | 9,560      |                  |       |   | 7,279 |   |   |
| Property and  equipment, net                                                                                                                                                                                  |       |                  | 61,898     |                  |       |   | 64,108 |   |   |
| Intangible  assets, net                                                                                                                                                                                       |       |                  | 15,374     |                  |       |   | 17,164 |   |   |
| Other assets, net                                                                                                                                                                                             |       |                  | 1,010      |                  |       |   | 1,009 |   |   |
| Total assets                                                                                                                                                                                                  |       |                  | $          | 134,631               |       |   |   | $ | 140,239 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                |       |                  |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                          |       |                  |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                              |       |                  | $          | 5,708                 |       |   |   | $ | 6,722 |   |   |
| Accrued payroll and related costs                                                                                                                                                                             |       |                  | 3,894      |                  |       |   | 3,731 |   |   |
| Deferred revenue                                                                                                                                                                                              |       |                  | 5,050      |                  |       |   | 4,769 |   |   |
| Other current liabilities                                                                                                                                                                                     |       |                  | 2,258      |                  |       |   | 2,032 |   |   |
| Total current liabilities                                                                                                                                                                                     |       |                  | 16,910     |                  |       |   | 17,254 |   |   |
| Long-term deferred  revenue, net of current portion                                                                                                                                                           |       |                  | 5,345      |                  |       |   | 2,040 |   |   |
| Other long-term  liabilities                                                                                                                                                                                  |       |                  | 885        |                  |       |   | 969 |   |   |
| Total liabilities                                                                                                                                                                                             |       |                  | 23,140     |                  |       |   | 20,263 |   |   |
| Commitments and  contingencies (Note 8)                                                                                                                                                                       |       |                  |       |                  |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                                                                                   |       |                  |       |                  |       |   |   |   |   |
| Common stock,  $0.001 par value; 100,000,000 shares authorized at December 31, 2006 and  2005; issued and outstanding 21,191,918 and 20,808,994 shares at  December 31, 2006 and 2005, respectively |       |                  | 22         |                  |       |   | 21 |   |   |
| Additional  paid-in capital                                                                                                                                                                                   |       |                  | 211,072    |                  |       |   | 209,337 |   |   |
| Deferred stock  compensation                                                                                                                                                                                  |       |                  | —     |                  |       |   | (1,519 | ) |   |
| Accumulated other  comprehensive income                                                                                                                                                                       |       |                  | 137        |                  |       |   | 137 |   |   |
| Accumulated  deficit                                                                                                                                                                                          |       |                  | (99,740    | )                     |       |   | (88,000 | ) |   |
| Total stockholders’ equity                                                                                                                                                                               |       |                  | 111,491    |                  |       |   | 119,976 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                              |       |                  | $          | 134,631               |       |   |   | $ | 140,239 |   |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)**

| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                          |       |                                       |       |   |   |   |   |
| Service                                           |       | $                                          | 85,681     |   | $ | 84,691 |   | $ | 73,919 |   |
| Product and subscription                          |       | 18,566                                     |       | 16,362 |   | 19,028 |   |
| Total revenue                                     |       | 104,247                                    |       | 101,053 |   | 92,947 |   |
| Cost of revenue:                                  |       |                                       |       |   |   |   |   |
| Service                                           |       | 60,817                                     |       | 61,465 |   | 47,591 |   |
| Product and subscription                          |       | 7,952                                      |       | 6,707 |   | 11,784 |   |
| Total cost of revenue                             |       | 68,769                                     |       | 68,172 |   | 59,375 |   |
| Gross profit                                      |       | 35,478                                     |       | 32,881 |   | 33,572 |   |
| Operating expenses:                               |       |                                       |       |   |   |   |   |
| Sales and marketing                               |       | 16,355                                     |       | 15,777 |   | 12,908 |   |
| Research, development and engineering             |       | 10,269                                     |       | 13,131 |   | 8,327 |   |
| General and administrative                        |       | 17,484                                     |       | 21,524 |   | 17,150 |   |
| Amortization of intangibles                       |       | 2,171                                      |       | 4,035 |   | 2,536 |   |
| Intellectual property                             |       | 1,774                                      |       | 2,014 |   | 2,162 |   |
| Restructuring charges, net                        |       | 547                                        |       | — |   | — |   |
| Total operating expenses                          |       | 48,600                                     |       | 56,481 |   | 43,083 |   |
| Operating loss                                    |       | (13,122                                    | )          | (23,600 | ) | (9,511 | ) |
| Other income  (expense):                          |       |                                       |       |   |   |   |   |
| Interest income                                   |       | 1,391                                      |       | 1,095 |   | 905 |   |
| Interest expense                                  |       | (93                                        | )          | (203 | ) | (104 | ) |
| Other                                             |       | 289                                        |       | (41 | ) | 53 |   |
| Total other income, net                           |       | 1,587                                      |       | 851 |   | 854 |   |
| Income (loss)  before provision for income taxes  |       | (11,535                                    | )          | (22,749 | ) | (8,657 | ) |
| Provision for  income taxes                       |       | (205                                       | )          | (348 | ) | (365 | ) |
| Net income (loss)                                 |       | $                                          | (11,740    | ) | $ | (23,097 | ) | $ | (9,022 | ) |
| Net income (loss)  per share—basic           |       | $                                          | (0.57      | ) | $ | (1.13 | ) | $ | (0.44 | ) |
| Net income (loss)  per share—diluted         |       | $                                          | (0.57      | ) | $ | (1.13 | ) | $ | (0.44 | ) |
| Weighted average shares outstanding—basic    |       | 20,649                                     |       | 20,485 |   | 20,326 |   |
| Weighted average  shares outstanding—diluted |       | 20,649                                     |       | 20,485 |   | 20,326 |   |

 

See accompanying notes to consolidated financial statements.

F-5

----

**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**

| ** **                                                                      | ** ** | **Common stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred  stock** | ** ** | ** **       | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Accumulated** | ** ** | **Total  stockholders’** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|-----------------------------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**         | ** ** | **compensation** | ** ** | **Warrant**                                   | ** ** | **(loss)**      | ** ** | **Deficit**                   | ** ** | **equity** | ** ** |
| **BALANCE AT DECEMBER 31,  2003**                                          |       | 20,129,846            |       |                    | $          | 20                  |       |             |       | $                                             | 203,634    |            |       |                          | $          | — |   |   |   | $ | 881 |   |   |   | $ | 96 |   |   |   | $ | (55,881 | ) |   |   | $ | 148,750 |   |   |
| Exercise of stock  options                                                      |       | 160,622               |       |                    | 1          |                |       |             | 679        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 680 |   |   |
| Issuance of  employee stock purchase plan shares                                |       | 48,455                |       |                    | —     |                |       |             | 468        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 468 |   |   |
| Issuance of common  stock and warrants through private placement, net |       | 74,506                |       |                    | —     |                |       |             | 969        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 969 |   |   |
| Issuance of common  stock for litigation settlement                        |       | 40,000                |       |                    | —     |                |       |             | 348        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 348 |   |   |
| Conversion and  expiration of warrants                                          |       | —                |       |                    | —     |                |       |             | 881        |                                          |       |            | —     |                          |       |   | (881 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Foreign currency  translation gain                                              |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | 51 |   |   |   | — |   |   |   | 51 |   |   |
| Net loss                                                                        |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | (9,022 | ) |   |   | (9,022 | ) |   |
| **BALANCE  AT DECEMBER 31, 2004**                                          |       | 20,453,429            |       |                    | 21         |                |       |             | 206,979    |                                          |       |            | —     |                          |       |   | — |   |   |   | 147 |   |   |   | (64,903 | ) |   |   | 142,244 |   |   |
| Exercise of stock  options                                                      |       | 22,795                |       |                    | —     |                |       |             | 70         |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 70 |   |   |
| Issuance of  employee stock purchase plan shares                                |       | 82,254                |       |                    | —     |                |       |             | 378        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 378 |   |   |
| Issuance of  restricted common stock                                            |       | 270,000               |       |                    | —     |                |       |             | 2,025      |                                          |       |            | (2,025     | )                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and  retirement of common stock                                   |       | (19,484               | )          |                    | —     |                |       |             | (115       | )                                             |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (115 | ) |   |
| Stock-based  compensation expense                                               |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | 506        |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 506 |   |   |
| Foreign currency  translation loss                                              |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | (10 | ) |   |   | — |   |   |   | (10 | ) |   |
| Net loss                                                                        |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | (23,097 | ) |   |   | (23,097 | ) |   |
| **BALANCE  AT DECEMBER 31, 2005**                                          |       | 20,808,994            |       |                    | 21         |                |       |             | 209,337    |                                          |       |            | (1,519     | )                             |       |   | — |   |   |   | 137 |   |   |   | (88,000 | ) |   |   | 119,976 |   |   |
| Reclass of  deferred stock compensation                                         |       | —                |       |                    | —     |                |       |             | (1,519     | )                                             |       |            | 1,519      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Exercise of stock  options                                                      |       | 44,584                |       |                    | 1          |                |       |             | 201        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 202 |   |   |
| Issuance of  employee stock purchase plan shares                                |       | 52,957                |       |                    | —     |                |       |             | 248        |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 248 |   |   |
| Issuance of  restricted common stock                                            |       | 312,365               |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and  retirement of common stock                                   |       | (26,982               | )          |                    | —     |                |       |             | (208       | )                                             |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (208 | ) |   |
| Stock-based  compensation expense                                               |       | —                |       |                    | —     |                |       |             | 3,013      |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,013 |   |   |
| Net loss                                                                        |       | —                |       |                    | —     |                |       |             | —     |                                          |       |            | —     |                          |       |   | — |   |   |   | — |   |   |   | (11,740 | ) |   |   | (11,740 | ) |   |
| **BALANCE AT DECEMBER 31, 2006**                                           |       | 21,191,918            |       |                    | $          | 22                  |       |             |       | $                                             | 211,072    |            |       |                          | $          | — |   |   |   | $ | — |   |   |   | $ | 137 |   |   |   | $ | (99,740 | ) |   |   | $ | 111,491 |   |   |

 

** **

See accompanying notes to consolidated financial statements.

F-6

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands, except share and per share data)**

| ** **                                                                                          | ** ** | **Twelve Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                          | ** ** | **December 31,  2006**       | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| Cash flows from operating  activities:                                                              |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Net  income (loss)                                                                                  |       |                              | $          | (11,740 | ) |   |   | $ | (23,097 | ) |   |   | $ | (9,022 | ) |   |
| Adjustments to reconcile  net income (loss) to net cash provided by (used in) operating activities: |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  and amortization of property and equipment                                            |       |                              | 13,320     |   |   |   | 15,665 |   |   |   | 10,954 |   |   |
| Amortization  of intangibles                                                                        |       |                              | 2,171      |   |   |   | 4,035 |   |   |   | 2,536 |   |   |
| Stock-based  compensation expense                                                                   |       |                              | 3,013      |   |   |   | 506 |   |   |   | — |   |   |
| Impairment  of investments                                                                          |       |                              | —     |   |   |   | — |   |   |   | 465 |   |   |
| Issuance  of common stock for litigation settlement                                                 |       |                              | —     |   |   |   | — |   |   |   | 348 |   |   |
| Increase  (decrease) in allowance for doubtful accounts                                             |       |                              | (155       | ) |   |   | 25 |   |   |   | 263 |   |   |
| Other  non-cash charges                                                                             |       |                              | (403       | ) |   |   | (64 | ) |   |   | 703 |   |   |
| Changes in operating assets  and liabilities:                                                       |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Restricted  cash                                                                                    |       |                              | (2,659     | ) |   |   | 1,000 |   |   |   | (6,303 | ) |   |
| Trade  and unbilled accounts receivable, net                                                        |       |                              | 1,449      |   |   |   | (1,048 | ) |   |   | (1,448 | ) |   |
| Inventory,  net                                                                                     |       |                              | 851        |   |   |   | 1,407 |   |   |   | (2,605 | ) |   |
| Other  current assets                                                                               |       |                              | 555        |   |   |   | (1,049 | ) |   |   | 273 |   |   |
| Other  assets, net                                                                                  |       |                              | (1         | ) |   |   | (6 | ) |   |   | (253 | ) |   |
| Accounts  payable                                                                                   |       |                              | (1,014     | ) |   |   | (4,702 | ) |   |   | 4,840 |   |   |
| Accrued  payroll and related costs                                                                  |       |                              | 163        |   |   |   | 1,570 |   |   |   | 1,092 |   |   |
| Deferred  revenue                                                                                   |       |                              | 3,586      |   |   |   | 1,955 |   |   |   | 1,694 |   |   |
| Other  liabilities                                                                                  |       |                              | 182        |   |   |   | 606 |   |   |   | 1,142 |   |   |
| Net  cash provided by (used in) operating activities                                                |       |                              | 9,318      |   |   |   | (3,197 | ) |   |   | 4,679 |   |   |
| Cash flows from investing  activities:                                                              |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Purchase  of property and equipment and capitalized labor costs                                     |       |                              | (10,466    | ) |   |   | (15,487 | ) |   |   | (39,691 | ) |   |
| Purchase  of intangibles                                                                            |       |                              | (40        | ) |   |   | (20 | ) |   |   | — |   |   |
| Sale  or maturity of short-term investments                                                         |       |                              | 136,946    |   |   |   | 180,568 |   |   |   | 193,355 |   |   |
| Purchase  of short-term investments                                                                 |       |                              | (136,207   | ) |   |   | (156,239 | ) |   |   | (175,392 | ) |   |
| Net  cash provided by (used in) investing activities                                                |       |                              | (9,767     | ) |   |   | 8,822 |   |   |   | (21,728 | ) |   |
| Cash flows from financing  activities:                                                              |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Issuance  of common stock                                                                           |       |                              | 450        |   |   |   | 448 |   |   |   | 2,117 |   |   |
| Purchase of common stock                                                                            |       |                              | (208       | ) |   |   | (115 | ) |   |   | — |   |   |
| Principal  payments under capital lease obligations                                                 |       |                              | (622       | ) |   |   | (483 | ) |   |   | (205 | ) |   |
| Net  cash provided by (used in) financing activities                                                |       |                              | (380       | ) |   |   | (150 | ) |   |   | 1,912 |   |   |
| Net  increase (decrease) in cash and cash equivalents                                               |       |                              | (829       | ) |   |   | 5,475 |   |   |   | (15,137 | ) |   |
| Cash  and cash equivalents at beginning of year                                                     |       |                              | 23,964     |   |   |   | 18,489 |   |   |   | 33,626 |   |   |
| Cash  and cash equivalents at end of year                                                           |       |                              | $          | 23,135 |   |   |   | $ | 23,964 |   |   |   | $ | 18,489 |   |   |
| Supplemental disclosure of  cash flow information:                                                  |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Cash  paid for interest                                                                             |       |                              | $          | 93 |   |   |   | $ | 203 |   |   |   | $ | 104 |   |   |
| Cash  paid for income taxes                                                                         |       |                              | $          | 179 |   |   |   | $ | 139 |   |   |   | $ | 400 |   |   |
| Summary of non-cash  investing and financing activities:                                            |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Equipment  acquired or exchanged under capital lease obligations                                    |       |                              | $          | 582 |   |   |   | $ | 274 |   |   |   | $ | 77 |   |   |

 

See accompanying notes to consolidated financial statements.

F-7

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

**(1)   Descriptionof Business and Summary of Significant Accounting Policies**

*Description ofBusiness*

Digimarc Corporation (“Digimarc”or “the Company”) is a supplier of secure identity solutions and advancedtechnologies for use in media management. The Company’s solutions enablegovernments and businesses around the world to deter counterfeiting and piracy,enhance traffic safety and national security, combat identity theft and fraud,facilitate the effectiveness of voter identification programs, improve themanagement of media content, and support new digital media distribution modelsthat provide consumers with more choice and access to media content.

*Principles ofConsolidation*

*Theconsolidated financial statements include the accounts of Digimarc and itswholly-owned subsidiaries. All significant intercompany transactions andbalances have been eliminated.*

*Use of Estimates*

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the U.S.requires Digimarc to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. Certain of the Company’s accounting policiesrequire higher degrees of judgment than others in their application. Theseinclude revenue recognition on long-term service contracts, impairments andestimation of useful lives of long-lived assets, inventory valuation, reservesfor uncollectible accounts receivable, and contingencies and litigation.Digimarc bases its estimates on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions.

Starting January 1, 2006, we changed our policyfor depreciating fixed assets that were specifically used to provide servicesunder long-term contracts to the shorter of the original contract term plus2.75 years or estimated useful life. Through December 31, 2005, wedepreciated these assets over the shorter of the original contract term orestimated useful life. This change in estimate was supported by an analysis wecompleted during the first quarter of 2006 which showed that historically 95%of contracts were extended beyond the original contract term, that the averagecontract had at least two contract extensions during its life and that these extensionsadded on average 2.75 years to the length of the contracts’ original terms.

Since contract-specific program assets are tracked ona contract basis, the finding that contracts are routinely extended beyond theoriginal term and that these extensions are not generally accompanied bysignificant incremental capital investment indicates that the useful life ofcontract-related assets is generally longer than the original term of thecontract. Given these findings, we concluded that it was appropriate to changethe estimated useful lives of these assets for purposes of depreciation. Inaddition, the change in useful lives achieves a better matching of the utilityof these assets with the resulting revenues. For the year ended December 31,2006, we performed an updated analysis on contract specific assets which resultedin no change to our previous conclusions. We will continue to analyze theuseful lives of contract specific assets in future periods.

F-8

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

For the year ended December 31,2006, the change in estimating the useful lives of program-related fixed assetshad the effect of reducing depreciation expense by $8.0 million and increasingbasic and diluted earnings per share by $0.39. Given that the depreciationexpense attributed to contract-specific assets is included in cost of revenue,the decrease in depreciation expense also caused gross margins to increase bythe amount of the reduction in depreciation expense.

*Reclassifications*

Certain amounts in the 2005 and 2004 consolidatedfinancial statements and notes thereon have been reclassified to conform tocurrent year presentation. These reclassifications had no material effect onthe results of operations or financial position for any year presented.

During2006 we experienced significant growth in our deferred revenue balance. Inprior years we had classified the entire balance in current liabilities. However,due to the increased revenue to be recognized in the future from theseincreases, we classified our deferred balance between current and long-term inorder to be more informative and meaningful:

| ** **                                             | ** ** | **2005** | ** ** |
|--------------------------------------------------------|------------|----------|------------|
| Long-term  obligations, net of current portion, before |       | $969     |       |
| Deferred revenue,  long-term                           |       | 2,040    |       |
| Long-term obligations,  net of current portion, after  |       | $3,009   |       |

 

*Cash Equivalents*

The Company considers allhighly liquid investments with original maturities of 90 days or less atthe date of acquisition to be cash equivalents. Cash equivalents include moneymarket funds, certificates of deposit, commercial paper, and investments ingovernment bonds totaling $18,505 and $19,171 at December 31, 2006 and2005, respectively. Cash equivalents are carried at cost or amortized cost,which approximates market.

*Restricted Cash*

Restricted cash of $9,938and $7,279 at December 31, 2006 and 2005, respectively, consists of cash andcash equivalents that are primarily held as a guarantee for certain performancebond obligations that the Company is obligated to maintain in connection withsome of its long-term contracts relating to the secure ID systems business. TheCompany supports the performance bonds with letters of credit, which may or maynot require restricted cash as security. The letters of credit must be renewedannually if they continue to be required by the issuers of the performancebonds. The Company’s banks have informed the Company that letters of creditwill continue to require restricted cash until the Company returns toprofitability for one year. Restricted cash is classified as either a currentand/or  a non-current asset depending onthe timing of performance bond releases.

*Investments*

The Company considers all investments with originalmaturities over 90 days that mature in less than one year to be short-terminvestments. Short-term investments include federal agency notes, companynotes, and commercial paper. The Company’s marketable securities are generallyclassified as held-to-

F-9

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

maturity as of the balancesheet date and are reported at amortized cost, which approximates market. Thebook value of these investments approximates fair market value and,accordingly, no amounts have been recorded to other comprehensive income.

A decline in the market value of any security belowcost that is deemed to be other-than-temporary results in a reduction incarrying amount to fair value. The impairment is charged to earnings and a newcost basis for the security is established. To determine whether an impairmentis other-than-temporary, the Company considers whether it has the ability andintent to hold the investment until a market price recovery and considerswhether evidence indicating the cost of the investment is recoverable outweighsevidence to the contrary. There have been no other-than-temporary impairmentsidentified or recorded by the Company.

Premiums and discounts areamortized or accreted over the life of the related security as an adjustment toyield using a method that approximates the effective-interest method. Dividendand interest income are recognized when earned.

*Fair Value ofFinancial Instruments*

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

*Concentrations ofBusiness and Credit Risk*

A significant portion of the Company’s businessdepends on a limited number of large public sector contracts, typicallydepartments of motor vehicles for various states within the United States.Government contracts are generally subject to termination for convenience orlack of appropriation at the determination of the subject agency.

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of cash and cashequivalents, restricted cash, investments, and trade and unbilled accountsreceivable. The Company places its cash and cash equivalents with major banksand financial institutions and at times deposits may exceed insured limits. TheCompany’s investment policy limits its credit exposure to any one financialinstitution or type of financial instrument by limiting the maximum of 5% or $1,000,whichever is greater, to be invested in any one issuer except for the U.S.Government and U. S. federal agencies, which have no limits, at the time ofpurchase. As a result, the credit risk associated with cash and investments isminimal. At December 31, 2006, the Company had no customer which accountedfor more than 10% of trade and unbilled accounts receivable. At December 31,2005, the Company had one customer which accounted for 11% of trade andunbilled accounts receivable.

The Company is dependenton a limited number of third parties to produce systems or components necessaryfor the Company to produce some of its products. While the Company strives tohave alternative 

F-10

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

suppliersprovide it with many of its products, a loss of one or more of such supplierscould have a material adverse effect on the Company’s ability to performeffectively, if at all, for some of its long-term contracts.

*Trade AccountsReceivable*

Tradeaccounts receivable are recorded at the invoiced amount and do not bear interest.Revenue earned which has not been invoiced is classified as unbilled tradereceivables in the consolidated balance sheets.

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Billed trade  receivables, net  |       | $        | 8,804      |     | $          | 9,469 |   |
| Unbilled trade  receivables     |       | 5,599    |       | 6,228    |       |
| Trade accounts receivable,  net |       | $        | 14,403     |     | $          | 15,697 |   |

 

Theallowance for doubtful accounts is the Company’s best estimate of the amount ofprobable credit losses in the Company’s existing accounts receivable. TheCompany determines the allowance based on historical write-off experience andcurrent information. The Company reviews its allowance for doubtful accountsmonthly. Account balances are charged off against the allowance after all meansof collection have been exhausted and the potential for recovery is consideredremote. The Company does not have an off-balance sheet credit exposure relatedto its customers. The amount of the allowance and the charges were as follows:

| ** **                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**   | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|------------|------------|
| Balance—beginning  of period |       | $        | 341        |     | $          | 316        |       | $ | 53 |   |
| Provision  (recovery)             |       | (38      | )          | 184      |       | 263        |       |
| Charge offs                       |       | (117     | )          | (159     | )          | **—** | ** ** |
| Balance—end of period        |       | $        | 186        |     | $          | 341        |       | $ | 316 |   |

 

*Inventories*

Inventoryconsists primarily of the consumable materials used to manufactureidentification cards, such as inks, laminates, and adhesives (considered raw material),equipment held for sale (considered finished goods) and deferred contract costs(considered either finished goods or in-process). Inventories are valued on afirst-in, first-out basis at the lower of cost or market value (net realizablevalue).

| ** **                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Equipment and deferred contract costs |       | $        | 1,046      |     | $          | 899 |   |
| Consumable  materials, net                                |       | 5,554    |       | 6,552    |       |
| Inventory, net                                            |       | $        | 6,600      |     | $          | 7,451 |   |

 

The reserve for slow moving and obsolete consumablematerials was $100 and $240 at December 31, 2006 and December 31,2005, respectively. While the Company does not currently expect to be able tosell or otherwise use the reserved inventory it has on hand based upon itsforecast and backlog, it is possible that one or more customers will decide inthe future to purchase a portion of the reserved inventory.

F-11

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

TheCompany records a provision for excess and obsolete inventory based on changesin market conditions, sales orders, expected sales volumes, and technologyadvances. The provision was recorded in the period the circumstances occurredor were identified. The activity in the inventory reserve is as follows:

| ** **                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance—beginning  of period |       | $        | 240        |     | $          | 271      |       | $ | 70 |   |
| Provision  (recovery)             |       | (62      | )          | 288      |       | 726      |       |
| Charge offs                       |       | (78      | )          | (319     | )          | (525     | )          |
| Balance—end of period        |       | $        | 100        |     | $          | 240      |       | $ | 271 |   |

 

*Property andEquipment*

Property and equipment are stated at cost. Propertyand equipment under capital lease obligations are stated at the lower of thepresent value of minimum lease payments at the beginning of the lease term orfair value of the leased assets at the inception of the lease. Repairs andmaintenance are charged to expense when incurred.

Depreciation on propertyand equipment is calculated by the straight-line method over the estimateduseful lives of the assets, generally two to seven years. Property andequipment held under capital leases are amortized by the straight-line methodover the shorter of the lease term or the estimated useful life. Amortizationof property and equipment under capital lease is included in depreciationexpense. Assets specifically used to provide services under long-term contractsare depreciated over the shorter of the original contract term plus 2.75 yearsor estimated useful life.

*Pre-contract Costs*

Costs related to pre-contractactivity are expensed as incurred in accordance with the American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) No. 98-5,*Reporting on the Costs of Start-UpActivities*. The Company begins capitalizing costs when it receivesnotification that a contract will be awarded.

*SoftwareDevelopment Costs*

Under Statement of Financial Accounting Standards (“SFAS”)No. 86, *Accounting for the Cost ofComputer Software to Be Sold, Leased, or Otherwise Marketed,*softwaredevelopment costs are to be capitalized beginning when a product’stechnological feasibility has been established and ending when a product ismade available for general release to customers. To date, the establishment oftechnological feasibility of the Company’s products has occurred shortly beforegeneral release and, therefore, software development costs qualifying forcapitalization have been immaterial. Accordingly, the Company has notcapitalized any software development costs and has charged all such costs toresearch and development expense.

Internal use softwaredevelopment costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred inthe preliminary project stage are expensed as incurred and costs incurred inthe application development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. Costs incurred in thepost-implementation 

F-12

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

stageare expensed as incurred. Internal use software development projects that havebeen capitalized to date relate to card manufacturing and control systemssoftware.

*Intangible Assets*

Intangibleassets relate to the value of customer relationships acquired when the Companypurchased certain assets of Polaroid and other technology and intellectualproperty rights. Customer relationships are generally being amortized on astraight-line basis over an estimated useful life of 12 years and theother technology and intellectual property rights are being amortized over anestimated useful life of three to five years. The useful life of the individualasset is evaluated and adjusted when warranted by changes in the contractualarrangement or other evidence indicates a change in useful life. The grossassets and accumulated amortization for intangibles are as follows:

| ** **                | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Gross intangible  assets  |       | $        | 29,946     |     | $          | 29,906 |   |
| Accumulated  amortization |       | (14,572  | )          | (12,742  | )          |
| Intangible assets, net    |       | $        | 15,374     |     | $          | 17,164 |   |

 

Intangibleassets are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Theestimated amortization of intangibles over the next five years is as follows:

| ** **                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Amortization of  intangibles |       | $        | 1,669      |     | $          | 1,669    |       | $        | 1,669      |     | $          | 1,669 |   | $ | 1,669 |   |
|                              |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

*Impairment ofLong-Lived Assets*

The Company accounts forlong-lived assets in accordance with the provisions of SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values, dependingon the nature of the asset. Assets to be disposed of are reported at the lowerof the carrying amount or fair value less costs to sell. During 2004, theCompany recorded impairment charges of $465 related to investments inearly-stage technology companies. These charges are reflected as sales andmarketing expenses in the consolidated statement of operations.

F-13

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

*Revenue Recognition*

The Company’s revenue is comprised of service revenuefrom its government-issued credentials systems and related maintenance,installation and system integration services as well as product andsubscription revenue which includes hardware and software sales, royalties andrevenues from the licensing of digital watermarking products and relatedauthentication services. The Company’s revenue recognition policy follows SECStaff Accounting Bulletin (“SAB”) No. 104 *“RevenueRecognition”,*Statement of Position (“SOP”) No. 97-2, *“Software Revenue Recognition,”*as amended by SOPNo. 98-9, *“Modification of SOPNo. 97-2, Software Recognition, With Respect to CertainTransactions,”*SOP 81-1*“Accounting for thePerformance of Construction Type and Certain Production-Type Contracts,” and*EmergingIssues Task Force (“EITF”) Issue No. 00-21, *RevenueArrangements with Multiple Deliverables.*

Certain customer arrangements encompass multiple deliverables, such as software, hardware sales, consumables sales,maintenance fees, and software development fees. The Company accounts for thesearrangements in accordance with EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If thedeliverables meet the criteria in EITF Issue No. 00-21, the deliverablesare divided into separate units of accounting and revenue is allocated to thedeliverables based on their relative fair values. The criteria specified inEITF Issue No. 00-21 are as follows (i) the delivered item hasvalue to the customer on a stand-alone basis, (ii) there is objective andreliable evidence of the fair value of the undelivered item, and (iii) ifthe arrangement includes a general right of return relative to the delivereditem, delivery or performance of the undelivered item is considered probableand substantially in the control of the vendor. For our purposes, fair value isgenerally defined as the price at which a customer could purchase each of theelements independently from other vendors or as the price that the Company hassold the element separately to another customer. Management applies judgment toensure appropriate application of EITF Issue No. 00-21, includingvalue allocation among multiple deliverables, determination of whetherundelivered elements are essential to the functionality of delivered elementsand timing of revenue recognition, among others.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence (“VSOE”) exists only for undelivered elements. Under theresidual method, revenue is recognized as follows: (1) the total fairvalue of undelivered elements, as indicated by vendor specific objectiveevidence, is deferred and subsequently recognized in accordance with therelevant sections of AICPA SOP No. 97-2, and (2) the differencebetween the total arrangement fee and the amount deferred for the undeliveredelements is recognized as revenue related to the delivered elements.

Applicable revenuerecognition criteria is considered separately for each separate unit ofaccounting as follows:

·       Revenuefrom the Company’s government-issued credential systems is generally billed andrecognized on a per card produced basis. The Company recognizes revenue onthese contracts based on the actual monthly production, if available, and inlimited situations on estimated volume information. When actual productioninformation becomes available, typically within one month, the Company billsthe customer accordingly and any differences from the estimates are recognizedin the month the billing occurs. Differences to date have not been significant.

F-14

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

·       Revenuerelated to an enhancement of, or upgrade to, an existing system is deferred andrecognized over the remaining life of the contract, unless VSOE can be establishedfor the delivered items, title passes to those items and all obligations arecompleted in which case we recognize revenue at acceptance.

·       Revenuefor sales of consumables and equipment not related to a driver licenseproduction contract is recognized when the products have been shipped,ownership has been transferred, evidence of an arrangement exists, the salesprice is fixed and determinable, and collectibility is reasonably assured. Whensignificant obligations remain after products are delivered, such as for systemintegration or customer acceptance, revenue and related costs are deferreduntil such obligations are fulfilled.

·       Revenuefrom professional services arrangements is generally determined based on timeand material or a cost plus a profit margin measure. Revenue for professionalservices is recognized as the services are performed. Progress towardscompletion is measured using costs incurred compared to the budgeted amountscontained in the contract. Losses on contracts, if any, are provided for in theperiod in which the loss becomes determinable. Billing for services renderedgenerally occurs within one month following when the services are provided.

·       Maintenancerevenue is recognized when the maintenance amounts owed to the Company havebeen earned, are determinable, and collection is probable. Maintenancecontracts are, at times, paid in advance and revenue is recognized ratably on astraight-line basis over the term of the service period.

·       Royaltyrevenue is recognized when the royalty amounts owed to the Company have beenearned, are determinable, and collection is probable. Subscriptions are paid inadvance and revenue is recognized ratably over the term of the subscription.These revenues include the licensing of digital watermarking products andservices for use in authenticating documents, detecting fraudulent documentsand deterring unauthorized duplication or alteration of high-value documents,for use in communicating copyright, asset management and business-to-business imagecommerce solutions, and for use in connecting analog media to a digitalenvironment.

·       Softwarerevenue is recognized in accordance with AICPA SOP No. 97-2, asamended by AICPA SOP No. 98-9, *Modificationof SOP 97-2*, *With Respectto Certain Transactions*. Revenue for licenses of the Company’ssoftware products is recognized upon the Company meeting the followingcriteria: persuasive evidence of an arrangement exists; delivery has occurred;the vendor’s fee is fixed or determinable; and collectibility is probable.Software revenue is recognized over the term of the license or upon deliveryand acceptance if the Company grants a perpetual license with no furtherobligations.

·       TheCompany records revenue from certain customers upon cash receipt as a result ofcollectibility not being reasonably assured.

·       Revenueearned which has not been invoiced is classified as unbilled trade receivables,which is included in the balance of trade accounts receivable, net in theconsolidated balance sheets.

·       Deferred revenue consistsof payments received in advance for professional services, subscriptions andhardware for which revenue has not been earned.

F-15

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

*Research andDevelopment*

Research and developmentcosts are expensed as incurred as defined in SFAS No. 2, *Accounting for Research and Development Costs*. The Companyaccounts for amounts received under its funded research and developmentarrangements 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 anyof the amounts provided by the funding parties. As a result, the Companyrecognizes revenue as the services are performed.

*Stock-BasedCompensation*

Stock-based compensation includes expense charges forall stock-based awards to employees and directors. Such awards include optiongrants, restricted stock awards, and shares expected to be purchased under anemployee stock purchase plan. On January 1, 2006, the Company adopted SFASNo. 123(R), *Share-Based Payment (Revised 2004)*,which requires the measurement and recognition of compensation for allstock-based awards made to employees and directors including stock options andemployee stock purchases under a stock purchase plan based on estimated fairvalues. SFAS 123(R) supersedes previous accounting under AccountingPrinciples Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, for periods beginning in fiscal 2006.In March 2005, the Securities and Exchange Commission issued SAB No. 107relating to application of SFAS 123(R). The Company has applied the provisionsof SAB 107 in the adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of its 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the year ended December 31, 2006 is based on the value ofthe portion of the stock-based award that vested during the period, adjustedfor expected forfeitures. Stock-based compensation recognized in the Company’sconsolidated financial statements in the year ended December 31, 2006includes compensation cost for stock-based awards granted prior to, but notfully vested as of, December 31, 2005 and stock-based awards grantedsubsequent to December 31, 2005. The compensation cost for awards grantedprior to January 1, 2006 is based on the grant date fair value estimatedin accordance with the pro forma provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*, while awardsgranted on or after January 1, 2006 follow the provisions of SFAS 123(R)to determine the grant date fair value and compensation cost. Compensation costfor all stock-based awards is recognized using the straight-line method.

Upon adoption of SFAS 123(R), the Companycontinued to use the Black-Scholes option pricing model as its method ofvaluation for stock-based awards. The Company’s determination of the fairvalue of stock-based awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofhighly complex and subjective variables. These variables include, but are notlimited, to the expected life of the award, our expected stock price volatilityover the term of the award and actual and projected exercise behaviors.Although the fair value of stock-based awards is determined in accordance withSFAS 123(R) and SAB 107, the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results.

F-16

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

Prior to January 1,2006, the Company applied the recognition and measurement principles of APB 25**and related interpretations includingFinancial Accounting Standards Board (“FASB”) Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation, an Interpretation of APB Opinion No. 25*, asallowed by SFAS 123 and FASB Statement No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, an amendment of FASB Statement No. 123*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. Under APB 25,stock-based compensation expense is recognized for stock awards granted with anexercise price below fair market value on the date of grant.

***Determining Fair Value Under SFAS 123(R)***

*Valuationand Amortization Method.**  **The Company estimates the fair value ofstock-based awards granted using the Black-Scholes option valuation model. TheCompany amortizes the fair value of all awards on a straight-line basis overthe requisite service periods, which are generally the vesting periods.*The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model.

*ExpectedLife.*   The expected life of awards grantedrepresents the period of time that they are expected to be outstanding. The Companydetermines the expected life based on historical experience with similarawards, giving consideration to the contractual terms, vesting schedules andpre-vesting and post-vesting forfeitures. Stock options granted duringthe year ended December 31, 2006 and 2005 generally vest over four yearsand have contractual terms of ten years.

*ExpectedVolatility.*   The Company estimates the volatilityof its common stock at the date of grant based on the historical volatility ofits common stock using the Black-Scholes option valuation model based onhistorical stock prices over the most recent period commensurate with theestimated expected life of the award. This historical period excludes portionsof time when unusual transactions occurred, such as a significant acquisition.

*Risk-FreeInterest Rate.**  *TheCompany bases the risk-free interest rate used in the Black-Scholes optionvaluation model on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent remaining term approximately equal to theexpected life of the award.

*ExpectedDividend Yield.**  *TheCompany has never paid any cash dividends on its common stock and does notanticipate paying any cash dividends in the foreseeable future. Consequently,the Company uses an expected dividend yield of zero in the Black-Scholes optionvaluation model.

*ExpectedForfeitures.**  *TheCompany uses relevant historical data to estimate pre-vesting optionforfeitures. The Company records stock-based compensation only for those awardsthat are expected to vest.

F-17

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

A summary of theweighted average assumptions and results for options granted during the periodspresented is as follows:

| ** **               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected life (in years) |       | 6.0                                        |       | 4.0 |   | 4.0 |   |
| Expected volatility      |       | 53%                                        |       | 50% |   | 50% |   |
| Risk-free interest rate  |       | 4.7%                                       |       | 4.5% |   | 4.0% |   |
| Expected dividend yield  |       | 0%                                         |       | 0% |   | 0% |   |
| Expected forfeiture rate |       | 14%                                        |       | 20% |   | 17% |   |
| Fair value               |       | $                                          | 3.62       |   | $ | 2.85 |   | $ | 4.75 |   |
|                          |            |                                            |            |  |  |  |  |  |  |  |

 

The Company also recognizes stock-based compensation in connection withits 1999 Employee Stock Purchase Plan. The plan allowed employees to purchaseshares of Digimarc common stock through payroll deductions of up to 15% oftheir base compensation during each six-month plan period, up to a maximumdeduction of $10.6 for each plan period, not to exceed $21 per year. Planperiods were generally from December 1 to May 31 and from June 1to November 30. The price an employee paid for the shares was 85% of thelower of (i) the fair market value of Digimarc common stock at thebeginning of the plan period or (ii) the fair market value at the end ofthe plan period. Employees purchased 52,957 shares under the plan during theyear ended December 31, 2006 and purchased 82,254 shares under the planduring the year ended December 31, 2005. The plan was suspended effective June 1,2006.

An amended plan was reinstated effective November 2,2006 which slightly modified the earlier plan. The changes included changing theplan periods from six to three months and the maximum deduction to $5.3 foreach plan period. The plan periods are generally from December 1 to February 28,March 1 to May 31, June 1 to August 31 and from September 1to November 30.

***Stock-based Compensation Under SFAS 123(R)***

The following tablesummarizes stock-based compensation expense related to stock-based awards underSFAS 123(R) for the year ended December 31, 2006, which was incurredas follows (in thousands):

| ** **                             | ** ** | **Year Ended  December 31, 2006** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|
| Stock-based compensation:              |       |                                             |       |   |   |
| Cost of revenue                        |       |                                             | $          | 281 |   |   |
| Sales and marketing                    |       |                                             | 509        |   |   |
| Research, development and  engineering |       |                                             | 325        |   |   |
| General and  administrative            |       |                                             | 1,863      |   |   |
| Intellectual property                  |       |                                             | 35         |   |   |
| Total stock-based compensation         |       |                                             | $          | 3,013 |   |   |

 

At December 31, 2006, the Company had 1.5 million non-vestedstock options that had a weighted average grant date price of $6.39. As of December 31,2006, the Company had $6.6 million of total unrecognized compensation costrelated to non-vested stock-based awards granted under all equity compensationplans, including options, restricted stock, and employee stock purchase plan.Total 

F-18

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

unrecognized compensation cost will beadjusted for any future changes in estimated forfeitures. The Company expectsto recognize this cost over a weighted average period of 1.73 years.

The following tablepresents the impact of the Company’s adoption of SFAS 123(R) on selectedline items from its consolidated financial statements for the year December 31,2006 (in thousands, except per share amounts):

| ** **                                       | ** ** | **Year Ended  December 31, 2006** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                       | ** ** | **As  Reported**Following  SFAS 123(R)      | ** ** | **If  Reported**Following  APB 25 | ** ** |
| Consolidated statement of operations:            |       |                                             |       |   |   |   |   |
| Operating income (loss)                          |       |                                             | $          | (13,122 | ) |   | $ | (10,976 | ) |
| Income (loss) before  provision for income taxes |       |                                             | (11,535    | ) |   | (9,389 | ) |
| Net income (loss)                                |       |                                             | (11,740    | ) |   | (9,594 | ) |
| Net income (loss) per  share                     |       |                                             |       |   |   |   |   |
| Basic                                            |       |                                             | (0.57      | ) |   | (0.46 | ) |
| Diluted                                          |       |                                             | (0.57      | ) |   | (0.46 | ) |
|                                                  |            |                                                  |            |  |  |  |  |  |  |

 

***Pro Forma Information Under SFAS 123 and APB 25***

Prior to the fiscalyear ending December 31, 2006, the Company accounted for stock-basedcompensation plans using the intrinsic value method prescribed in APB 25 andrelated interpretations. No stock-based compensation related to option grantsor the employee stock purchase plan was reflected in net loss in the yearsended December 31, 2005 and 2004, as all stock options granted under thoseplans had an exercise price equal to or greater than the market value of theunderlying common stock on the date of grant. Had compensation cost for theplans been determined based on the fair value at the grant dates for awardsunder those plans consistent with the method of SFAS 123, the Company’s netloss and basic and diluted net loss per share for the years ended December 31,2005 and 2004 would have been changed to the pro forma amounts indicated below(in thousands, except for per share data):

| ** **                                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net income  (loss), as reported                                                                                   |       |                                       | $          | (23,097 | ) |   |   | $ | (9,022 | ) |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       |                                       | 506        |   |   |   | — |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards |       |                                       | (7,170     | ) |   |   | (12,834 | ) |   |
| Pro forma net  loss                                                                                               |       |                                       | $          | (29,761 | ) |   |   | $ | (21,856 | ) |   |
| *Earnings per share:*                                                                                             |       |                                       |       |   |   |   |   |   |   |
| Basic—as reported                                                                                            |       |                                       | $          | (1.13 | ) |   |   | $ | (0.44 | ) |   |
| Diluted—as  reported                                                                                         |       |                                       | $          | (1.13 | ) |   |   | $ | (0.44 | ) |   |
| Basic—pro forma                                                                                              |       |                                       | $          | (1.45 | ) |   |   | $ | (1.08 | ) |   |
| Diluted—pro forma                                                                                            |       |                                       | $          | (1.45 | ) |   |   | $ | (1.08 | ) |   |

 

F-19

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

On December 15, 2005, the Board of Directors ofthe Company approved the acceleration of vesting of the Company’s outstandingstock options with option exercise prices equal to or greater than $9.00. Theacceleration applied to all options outstanding as of December 31, 2005under the Company’s Restated 1999 Stock Incentive Plan and 2000 Non-OfficerEmployee Stock Incentive Plan, except for options held by members of theCompany’s Board of Directors. Options to purchase 422,248 shares of the Company’scommon stock, or 6% of the Company’s total outstanding options, with a weightedaverage exercise price of $11.51 and varying remaining vesting schedules, weresubject to this acceleration and became immediately vested and exercisable asof December 31, 2005. Of these 422,248 options, 120,972 options are heldby the Company’s executive officers.

On December 21, 2004, the Audit, Compensation andCorporate Governance Committees of the Board of Directors of the Companyapproved the acceleration of vesting of the Company’s outstanding stock optionswith option exercise prices greater than $15.00. The acceleration applied toall options outstanding under the Company’s Restated 1999 Stock Incentive Planand 2000 Non-Officer Employee Stock Incentive Plan that would not have otherwisevested in full by June 30, 2005 in accordance with their terms. Theeffective date of the vesting acceleration was December 31, 2004. Optionsto purchase 310,057 shares of the Company’s common stock, or 5% of thetotal number of options of the Company outstanding as of December 31, 2004with remaining vesting schedules, were accelerated. Of these310,057 options, approximately 50,000 options were held by the Company’sexecutive officers.

As a result of these accelerations, the Companyreduced its exposure to the effects of SFAS 123(R) by approximately $2.5million for fiscal years 2006 through 2009. No additional compensation expensewas recorded in the statement of operations as the options that wereaccelerated had an exercise price greater than the fair market value of theshares underlying the options on the date of the modification.

Information regardingdeferred stock compensation expense and information related to the assumptionsused in the above calculations is further described in Note 5.

*Income Taxes*

The Company accounts forincome taxes under the asset and liability method. Under the asset andliability method, deferred income taxes reflect the future tax consequences ofdifferences between the tax bases of assets and liabilities and their financialreporting amounts at each year-end. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactment date.Valuation allowances are established when necessary to reduce tax assets to theamount expected to be realized.

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

*Net Income (Loss) PerShare*

Netincome (loss) per share is calculated in accordance with SFAS No. 128, *Earnings per Share,*which provides thatbasic and diluted net income (loss) per share for all periods presented are tobe computed using the weighted average number of common shares outstandingduring each period, with diluted net income per share including the effect ofpotentially dilutive common shares.

| ** **    | ** ** | **Year Ended December 31, 2006** | ** ** | **Year  Ended December 31, 2005** | ** ** | **Year  Ended December 31, 2004** | ** ** |
|---------------|------------|------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **    | ** ** | **Income  (000’s)  (Numerator)**                | ** ** | **Shares  (000’s)  (Denominator)**                    | ** ** | **Per  Share    Amount**                         | ** ** | **Income  (000’s)  (Numerator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** | **Income  (000’s)  (Numerator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic EPS** |       |                                                 |       |                                                       |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|               |            |                                                      |            |                                                            |            |                                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Income  available to common stockholders |   |   | $      | (11,740 | )      |   |   | 20,649 |   |   |   | $      | (0.57  | )      |   |   | $      | (23,097 | )      |   |   | 20,485 |   |   |   | $      | (1.13  | )      |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $ | (0.44 | ) |   |
|------------------------------------------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|-------|---|--------|
| **Effect of Dilutive Securities**        |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options                                  |   |   |   |    |   |   | — |   |   |   |   |   |   |   |   |   |   |    | — |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Warrants                                 |   |   |   |    |   |   | — |   |   |   |   |   |   |   |   |   |   |    | — |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| **Diluted EPS**                          |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income available to common stockholders  |   |   | $      | (11,740 | )      |   |   | 20,649 |   |   |   | $      | (0.57  | )      |   |   | $      | (23,097 | )      |   |   | 20,485 |   |   |   | $      | (1.13  | )      |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $ | (0.44 | ) |   |

 

Common stock equivalentsrelated to stock options and warrants of 4,924,625, 6,203,114 and 5,893,251were excluded from diluted net income per share calculations for 2006, 2005 and2004, respectively, as their exercise price was higher than the average marketprice of the underlying common stock for the period. Common stock equivalentsrelated to stock options and warrants of 875,579, 425,249 and 308,944 areantidilutive in a net loss year and, therefore, are not included in 2006, 2005and 2004 diluted net loss per share, respectively.

*Recent AccountingPronouncements*

In March 2006, the FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets, anamendment of SFAS No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities*. The statementchanges the way entities account for servicing assets and obligationsassociated with financial assets acquired or disposed of. SFAS No. 156 iseffective for the first fiscal year beginning after September 15, 2006.The Company has concluded that this standard does not currently apply.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,*which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair value. Thisstatement does not require any new fair value measurements, but providesguidance on how to measure fair value by providing a fair value hierarchy usedto classify the source of the information. SFAS No. 157 is effective forfirst fiscal year beginning after November 15, 2007. The Company iscurrently assessing the potential impact that adoption of this standard willhave on our financial statements.

In July 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,which defines the threshold for recognizing the benefits of tax returnpositions in the financial statements as “more-likely-than-not” to be sustainedby the taxing authority. Interpretation No. 48 applies to all taxpositions accounted for under SFAS No. 109, *Accountingfor Income Taxes*. Interpretation No. 48 is effective as of thebeginning of the first fiscal year beginning after December 15, 2006. Uponadoption, the 

F-21

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

Company will adjust thefinancial statements if needed to reflect only those tax positions that aremore-likely-than-not to be sustained as of the adoption date. Anyadjustment will be recorded directly to our beginning retained earnings balancein the period of adoption and reported as a change in accounting principle. TheCompany is currently analyzing the effects of adopting Interpretation No. 48.

In September 2006, the SEC issued SAB 108, *Considering the Effects of Prior Year Misstatements When QuantifyingMisstatements in Current Year Financial Statements*. The bulletinprovides interpretive guidance on how to consider the effects of carryovers orreversals of prior year misstatements in quantifying a current yearmisstatement. SAB 108 is effective for the first fiscal year ending after November 15,2006. The Company has applied the provisions of this interpretive bulletin andnoted no material effect on the current financial statements.

In June 2006,the FASB ratified the EITF consensus on EITF Issue No. 06-2, *Accounting for Sabbatical Leave and Other Similar Benefits Pursuant toFASB Statement No. 43,* which requires companies to accrue thecost of compensated absences under a sabbatical or similar benefit arrangementover the requisite service period. EITF Issue No. 06-2 is effectivefor fiscal years beginning after December 15, 2006. The cumulative effectof the application of this consensus on prior period results should berecognized through a cumulative-effect adjustment to retained earnings as ofthe beginning of the year of adoption. Elective retrospective application isalso permitted. The Company has concluded that this issue does not currentlyapply.

**(2)**   Property andEquipment

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Office furniture  and equipment                 |       | $                     | 8,686      |   | $ | 4,999 |   |
| Production  equipment                           |       | 104,053               |       | 96,770 |   |
| Leasehold  improvements                         |       | 1,816                 |       | 1,738 |   |
|                                            |       | 114,555               |       | 103,507 |   |
| Less accumulated  depreciation and amortization |       | (52,657               | )          | (39,399 | ) |
|                                            |       | $                     | 61,898     |   | $ | 64,108 |   |

 

Property and equipment additions for the years ended December 31,2006, 2005 and 2004 totaled $10,466, $15,487 and $39,691, respectively,including capitalized labor of $3,882, $7,932 and $12,444, respectively.

F-22

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

**(3)   Leases**

The Company leases certain computers and officeequipment under long-term capital leases, which expire over the next48 months. The cost of these assets was $2,398 and $1,815 at December 31,2006 and 2005, respectively, and accumulated amortization was $1,303 and $954at December 31, 2006 and 2005, respectively.

Futureminimum lease payments under non-cancelable operating leases and the presentvalue of future minimum capital lease payments are as follows:

| **Year ending December 31:** | ** ** | ** ** | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| 2007                                        |       | $          | 624        |                |       | $                     | 2,144      |   |   |
| 2008                                        |       | 230        |       |                | 1,895      |                  |       |
| 2009                                        |       | 143        |       |                | 1,941      |                  |       |
| 2010                                        |       | 123        |       |                | 1,509      |                  |       |
| 2011                                        |       | 24         |       |                | 587        |                  |       |
| Thereafter                                  |       | —     |       |                | —     |                  |       |
| Total minimum  lease payments               |       | 1,144      |       |                | $          | 8,076                 |       |   |
| Less amount  representing interest          |       | (117       | )          |                |       |                  |       |
| Net obligation  under capital leases        |       | 1,027      |       |                |       |                  |       |
| Less current  portion                       |       | (573       | )          |                |       |                  |       |
| Non-current portion                         |       | $          | 454        |                |       |                  |       |   |

 

Rentexpense on the operating leases for the years ended December 31, 2006,2005 and 2004 totaled $2,516, $2,546 and $2,998, respectively.

**(4)   DefinedContribution Pension Plan**

TheCompany sponsors an employee savings plan (the “Plan”) which qualifies as adeferred salary arrangement under Section 401(k) of the InternalRevenue Code. Employees become eligible to participate in the Plan at the beginningof the following quarter after the employees’ hire date. Employees maycontribute up to 20% of their pay to the Plan, subject to the limitations ofthe Internal Revenue Code. Company matching contributions are discretionary.For the years ended December 31, 2006, 2005 and 2004, the Company madediscretionary matching contributions in the aggregate amount of $491, $479 and$70, respectively.

**(5)   Stockholders’Equity**

*Common Stock*

In November 2004, the Board of Directors authorized and declared adividend of one right for each outstanding share of common stock tostockholders of record at the close of business on November 29, 2004, andauthorized the issuance of one right for each share of common stock issued byDigimarc under certain circumstances in the future. Each right entitles theregistered holder, subject to the terms of the Rights Agreement between us andthe rights agent, to purchase from us one one-hundredth of a share (a unit) of Series APreferred Stock, par value $0.001 per share, at a purchase price of $100.00 perunit, under 

F-23

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

circumstances described in the RightsAgreement. The purchase price, the number of units of preferred stock and thetype of securities issuable upon exercise of the rights are subject toadjustment. The rights will expire at the close of business November 16,2014 unless earlier redeemed or exchanged. Until a right is exercised, theholder thereof, as such, will have no rights as one of our stockholders,including the right to vote or to receive dividends. The rights are notimmediately exercisable. Subject to the terms and conditions of the RightsAgreement, they will become exercisable ten business days after a person orgroup acquires, or commences a tender or exchange offer which would lead to theacquisition of beneficial ownership of 15% or more of Digimarc’s outstandingcommon stock, subject to prior redemption or exchange and subject to exceptionsspecified in the Rights Agreement, including an exception for certain existinglarge shareholders that have historically held ownership positions in excess of15 percent. Subject to these exceptions, once a person or group acquiresbeneficial ownership of 15% or more of Digimarc’s outstanding common stock,each right not owned by that person or group or certain related parties willentitle its holder to purchase, at the right’s then-current purchase price,units of Series A preferred stock or, at Digimarc’s option, shares ofcommon stock or cash, property or other securities of our company having amarket value equal to twice the then-current purchase price, subject to termsand conditions of the Rights Agreement.

*Restricted Stock*

During 2005 and 2006 the Compensation Committee of theBoard of Directors awarded restricted stock shares under the Company’s 1999Stock Incentive Plan, as amended, to certain officers, employees and directors.The shares subject to the restricted stock awards will vest over a certainperiod, usually one to four years, following the date of the grant. Inaddition, in 2006 the Compensation Committee awarded performance vesting sharesunder the 1999 Stock Incentive Plan, as amended, to certain executive officers.The performance vesting shares will vest in full (or terminate) based on theachievement of specified performance goals. Specific terms of the restrictedstock awards and performance vesting share awards are governed by RestrictedStock Agreements and Performance Vesting Share Agreements between the Companyand the award recipients. Copies of the forms of these agreements have beenfiled with the SEC and are listed in the Exhibit Index of this report asExhibits 10.15 and 10.21, respectively.

The Deferred Stock Compensation balance of $1,519 at December 31,2005 has been reclassed to Additional Paid-in Capital in accordance with SFAS123(R) along with the restricted stock and performance vesting shareawards during the year ended December 31, 2006.

The following table details the number of sharesgranted each year as restricted stock and performance vesting share awards:

| **Date** | ** ** | ** ** | ** ** | **# of  Restricted  Shares** | ** ** | **# of  Performance  Vesting  Shares** | ** ** |
|----------|------------|------------|------------|-----------------------------------|------------|---------------------------------------------|------------|
| 2005     |       |       | 270,000    |                              |       |                                        | —     |   |   |
| 2006     |       |       | 177,365    |                              |       |                                        | 135,000    |   |   |

 

F-24

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

Thefollowing table reconciles the unvested balance of restricted and performanceshares:

| ** **                                | ** ** | **Number of  Shares** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|
| Unvested balance,  December 31, 2004 |       |                       | —     |   |   |
| Granted                                   |       |                       | 270,000    |   |   |
| Vested                                    |       |                       | (67,500    | ) |   |
| Canceled                                  |       |                       | —     |   |   |
| Unvested balance,  December 31, 2005 |       |                       | 202,500    |   |   |
| Granted                                   |       |                       | 312,365    |   |   |
| Vested                                    |       |                       | (67,500    | ) |   |
| Canceled                                  |       |                       | (3,333     | ) |   |
| Unvested Balance,  December 31, 2006 |       |                       | 444,032    |   |   |

 

*Deferred StockCompensation*

In 2006 and 2005,stock-based compensation expense includes restricted stock granted during theyear, is based on the fair market value of the Company’s common stock on thedate the restricted stock was granted (measurement date), and is beingrecognized over the vesting period of the related restricted stock using thestraight-line method. For the year ended December 31, 2006 and 2005, $865and $506, respectively, of stock-based compensation expense related torestricted stock was recorded. No stock-based compensation was recorded asexpense in 2004.

*Stock IncentivePlan*

In October 1995, the 1995 Stock Incentive Plan,subsequently amended (the “1995 Plan”), was approved by the Company’s Board ofDirectors. Under the terms of the 1995 Plan, the Board of Directors isauthorized to grant incentive stock options, non-qualified stock options andrestricted stock to officers, directors, employees or consultants. Prices forall options or stock granted under the 1995 Plan are determined by the Board ofDirectors. Option prices for incentive stock options are set at not less thanthe fair market value of the common stock at the date of grant. Options vestover periods determined by the Board of Directors, generally four years.Options are contingent upon continued employment with the Company and, unlessotherwise specified, expire ten years from the date of grant. The Company hasreserved 2,800,000 shares of its common stock for issuance under the 1995 Plan.

In October 1999, the 1999 Stock Incentive Plan,subsequently amended and restated (the “1999 Plan”) was approved by the Company’sBoard of Directors. The Company initially reserved 1,500,000 shares of itscommon stock for issuance under the 1999 Plan. Upon completion of the Company’sinitial public offering, shares available for grant from the 1995 Plan weretransferred to the 1999 Plan. Since adoption, the Company has reserved anadditional 12,023,687 shares of its common stock for issuance under the 1999Plan bringing the total reserved under the 1999 plan to 13,523,687 shares, andthe total reserved under the 1995 Plan and the 1999 Plan combined to 16,323,687shares. The exercise price and term of options granted under the 1999 Plan aredetermined by the Company’s Board of Directors or by a committee theydesignate.

As part of the 1999 Plan, the Company adopted the 1999Non-Employee Director Option Program (the “Director Plan”), which isadministered under the 1999 Plan. Under the Director Plan, an automatic 

F-25

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

option grant to acquire10,000 shares will be given to each non-employee director then-existing orfirst elected to the Company’s Board of Directors which vest in three annualincrements on the anniversary date of the grant date. Additionally, an annualoption grant of 10,000 shares is given to each non-employee director on thedate of the Company’s annual stockholders’ meeting if certain conditions aremet. These options vest on the first anniversary of the grant date. Theexercise price of the options under the Director Plan is the fair market valueon the date of grant. In 2002, the Director Plan was further amended to allowfor 20,000 shares to be granted to non-employee directors elected or appointedto the Board of Directors for the first time on or after March 29, 2002.These options vest and become exercisable in 36 equal installments on eachmonthly anniversary of the grant date, such that the stock options will befully exercisable three years after the grant date. Upon the date of eachannual stockholders meeting, each non-employee director who has been a memberof the Company’s Board of Directors for at least six months prior to the dateof the stockholders meeting will receive an automatic grant of options toacquire 12,000 shares of the Company’s common stock at an exercise price pershare equal to fair market value of the common stock at the date of grant.These options vest and become exercisable in twelve equal installments on eachmonthly anniversary of the grant date, such that the stock options will befully exercisable one year after the grant date. The Director Plan was alsoamended to allow for the grant of options exercisable for 3,000 shares ofcommon stock at an exercise price equal to the fair market value of the commonstock at the date of grant to each non-employee director who serves as a memberof a committee of the Board of Directors immediately following each annualmeeting of the Company’s stockholders, provided such non-employee director hasbeen a member of the Company’s Board of Directors for at least six months priorto the date of the stockholders meeting.

These stock options vest and become exercisable intwelve equal installments on each monthly anniversary of the grant date, suchthat the stock options will be fully exercisable one year after the date ofgrant. The Director Plan was amended on April 17, 2003 to clarify thatcommittee-related option grants were to be made to non-employee directorsserving only on “standing committees” of the Board of Directors. The DirectorPlan was also amended on May 2, 2003 to eliminate the requirement that anon-employee director must have been a member of the Company’s Board ofDirectors for at least six months prior to the date of the stockholders meetingin order to receive a committee-related option grant. The Director Plan wasfurther amended on March 10, 2004 to provide that the Board of Directorsmay waive the issuance of option grants under the Director Plan, in whole or inpart, for any particular year. The Board of Directors determined not to grantan option to purchase 3,000 shares of common stock to directors in 2004, 2005and 2006 under the Director Plan for service on each standing committee of theBoard of Directors.

The Director Plan was amended on May 3, 2006 toprovide for changes to the types of equity compensation awards for non-employeedirectors effective at the Company’s 2006 Annual Meeting of Shareholders. Underthese amendments, the annual option grant was reduced to 6,000 shares and a newannual grant of 2,400 shares of restricted stock was added. Annual restrictedstock awards are subject to a forfeiture restriction that lapses as to 100% ofthe shares subject to the stock award one year after the grant date. The Board continuesto have discretion to elect not to make the automatic annual option andrestricted stock grants to continuing Board members and standing committeemembers.

In June 2000,the 2000 Non-Officer Employee Stock Incentive Plan (the “2000 Plan”) was approvedby the Company’s Board of Directors. The Company initially reserved 275,000shares of its common stock for issuance under the 2000 Plan. Options from the2000 Plan cannot be granted to officers or directors of 

F-26

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

the Company. The exercise price and term of optionsgranted under the 2000 Plan are determined by the Company’s Board of Directorsor by a committee they designate. The exercise price is generally set at thefair market value of the stock on the date of grant. Options under the 2000Plan generally vest over four years.

Transactions involving the stock incentive plans aresummarized as follows:

| ** **                                   | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| Options  outstanding, December 31, 2003 |       | 6,308,538                  |       |                                           | $          | 16.98 |   |   |
| Granted                                      |       | 1,429,952                  |       |                                           | 11.95      |   |   |
| Exercised                                    |       | (160,622                   | )          |                                           | 4.23       |   |   |
| Canceled                                     |       | (741,688                   | )          |                                           | 16.00      |   |   |
| Options  outstanding, December 31, 2004 |       | 6,836,180                  |       |                                           | 16.33      |   |   |
| Granted                                      |       | 1,257,850                  |       |                                           | 6.35       |   |   |
| Exercised                                    |       | (22,795                    | )          |                                           | 2.23       |   |   |
| Canceled                                     |       | (702,599                   | )          |                                           | 15.62      |   |   |
| Options  outstanding, December 31, 2005 |       | 7,368,636                  |       |                                           | 14.74      |   |   |
| Granted                                      |       | 1,246,160                  |       |                                           | 6.52       |   |   |
| Exercised                                    |       | (44,584                    | )          |                                           | 4.51       |   |   |
| Canceled                                     |       | (1,524,461                 | )          |                                           | 13.26      |   |   |
| Options outstanding,  December 31, 2006 |       | 7,045,751                  |       |                                           | $          | 13.67 |   |   |

 

 

| ** **                                  | ** ** | **Outstanding** | ** ** | **Exercisable**                | ** ** |
|---------------------------------------------|------------|-----------------|------------|--------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **      | ** ** | **Number of Shares** | ** ** | **Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Price** | ** ** | **Number of Shares** | ** ** | **Weighted  Average  Price** | ** ** |
| $  0.50  – $  5.96 |       |            | 851,979    |                           |       |   | 7.71 |   |   |   | $ | 5.03 |   |   |   | 392,312 |   |   |   | $ | 4.06 |   |   |
| $  6.00  – $  6.15 |       |            | 516,559    |                           |       |   | 8.51 |   |   |   | $ | 6.07 |   |   |   | 187,422 |   |   |   | $ | 6.06 |   |   |
| $  6.16  – $  6.99 |       |            | 616,566    |                           |       |   | 9.07 |   |   |   | $ | 6.47 |   |   |   | 136,102 |   |   |   | $ | 6.49 |   |   |
| $  7.02  – $  9.85 |       |            | 629,246    |                           |       |   | 8.02 |   |   |   | $ | 8.43 |   |   |   | 411,825 |   |   |   | $ | 8.74 |   |   |
| $10.29 – $12.23                        |       |            | 632,937    |                           |       |   | 6.96 |   |   |   | $ | 11.53 |   |   |   | 632,937 |   |   |   | $ | 11.53 |   |   |
| $12.40 – $13.25                        |       |            | 595,883    |                           |       |   | 6.06 |   |   |   | $ | 12.82 |   |   |   | 595,883 |   |   |   | $ | 12.82 |   |   |
| $13.38 – $14.13                        |       |            | 792,000    |                           |       |   | 4.17 |   |   |   | $ | 14.07 |   |   |   | 792,000 |   |   |   | $ | 14.07 |   |   |
| $14.40 – $15.24                        |       |            | 583,290    |                           |       |   | 5.96 |   |   |   | $ | 15.10 |   |   |   | 583,290 |   |   |   | $ | 15.10 |   |   |
| $15.25 – $17.00                        |       |            | 695,297    |                           |       |   | 5.92 |   |   |   | $ | 16.24 |   |   |   | 695,297 |   |   |   | $ | 16.24 |   |   |
| $17.88 – $26.25                        |       |            | 757,744    |                           |       |   | 4.40 |   |   |   | $ | 21.03 |   |   |   | 757,744 |   |   |   | $ | 21.03 |   |   |
| $27.50 – $53.94                        |       |            | 374,250    |                           |       |   | 3.17 |   |   |   | $ | 46.74 |   |   |   | 374,250 |   |   |   | $ | 46.74 |   |   |
| $  0.50 – $53.94             |       |            | 7,045,751  |                           |       |   | 6.39 |   |   |   | $ | 13.67 |   |   |   | 5,559,062 |   |   |   | $ | 15.62 |   |   |
|                                             |            |                 |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

AtDecember 31, 2006, the aggregate intrinsic value of outstanding andexercisable stock options was $6,365 and $2,792, respectively. The aggregateintrinsic value is based on our closing price of $8.79 on December 29, 2006,which would have been received by the optionees had all of the options withexercise prices less than $8.79 been exercised on that date.

At December 31, 2006,5,775,055 shares were available for grant.

At December 31, 2005,6,315,656 options were exercisable at a weighted average price of $16.16.

F-27

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

*Employee StockPurchase Plan*

Under the 1999 Employee Stock Purchase Plan,subsequently amended and restated (the “Purchase Plan”), the Company hasauthorized the issuance of 1,806,665 shares of common stock, 1,581,592 of whichare available for purchase at December 31, 2006. The Purchase Plan allowseligible employees to purchase the Company’s common stock through payrolldeductions, which may not exceed 15% of an employee’s base compensation, up toa maximum deduction of $10.6 per each plan period, not to exceed $21 per year,including commissions, bonuses and overtime, at a price equal to 85% of thelower of the fair value at the beginning or end of each enrollment period. Theplan was suspended effective June 1, 2006.

An amended plan was reinstated effective November 2,2006 which slightly modified the earlier plan. The changes included changingthe plan periods from six to three months and the maximum deduction to $5.3 foreach plan period. The plan periods are generally from December 1 to February 28,March 1 to May 31, June 1 to August 31 and from September 1to November 30.

*Warrants*

The Company has in the past issued warrants andoptions for the purchase of common stock to certain non-employee partners,consultants and investors. As of the date of these financial statements, allsuch warrants have expired. Because these warrants are reflected in the Company’sConsolidated Statements of Stockholders’ Equity for the 2004 fiscal year,accounting rules require that we include in these notes certaininformation concerning these warrants.

In 2001, the Company issued 5,000 options tonon-employees who provided consulting services and recorded expense related tothose options of $42 using the Black-Scholes option pricing model with thefollowing weighted average assumptions: no expected dividends; expectedvolatility of 100%; risk-free interest rate of 4.40%; and contractual liferanging from 0.5 to 3.0 years. In January 2002, 3,000 of theseoptions expired. The remainder of these options expired in July of 2006.

In August 2003,the Company issued an aggregate of 267,899 warrants with an exercise price of$14.00 per share as a part of a private placement of 1,785,996 units, with eachunit consisting of one share of common stock and warrants exercisable for0.15 shares of common stock. The warrants were exercisable for15 days beyond the effective date of the common stock registration for theprivate placement. The effective date of the common stock registration was December 23,2003. In January 2004, 74,506 warrants were exercised. The remainder ofthese warrants have expired unexercised.

**(6)**   IncomeTaxes

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

| ** ** | ** ** | **Year ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic   |       | $                                          | (10,892    | ) | $ | (21,491 | ) | $ | (7,226 | ) |
| Foreign    |       | (643                                       | )          | (1,258 | ) | (1,431 | ) |
| Total      |       | $                                          | (11,535    | ) | $ | (22,749 | ) | $ | (8,657 | ) |

 

F-28

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

Forthe years ended December 31, 2006, 2005 and 2004, the Company wasprofitable in some foreign jurisdictions. Therefore, a provision for currentforeign tax of $205, $348 and $365, respectively, was recorded. No provisionwas recorded for federal or state taxes. The reconciliation of the statutoryfederal income tax rate to the Company’s effective income tax rate is asfollows:

| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income taxes  computed at statutory rates      |       | $                                          | (3,922     | ) | $ | (7,734 | ) | $ | (2,943 | ) |
| Increases  (decreases) resulting from:         |       |                                       |       |   |   |   |   |
| State income taxes, net of federal tax benefit |       | (466                                       | )          | (930 | ) | (270 | ) |
| Change in valuation allowance                  |       | 3,671                                      |       | 8,220 |   | 3,524 |   |
| Statutory stock option expense                 |       | 493                                        |       | — |   | — |   |
| Recharge expenses                              |       | —                                     |       | — |   | 381 |   |
| Amortization expenses                          |       | 138                                        |       | 323 |   | — |   |
| Other non-deductible                           |       | 28                                         |       | 81 |   | — |   |
| Generated research credits                     |       | —                                     |       | — |   | (273 | ) |
| Foreign rate differential, net of credits      |       | 250                                        |       | 169 |   | 89 |   |
| Meals and entertainment                        |       | 93                                         |       | 116 |   | 78 |   |
| Other                                          |       | (80                                        | )          | 103 |   | (221 | ) |
| Total                                          |       | $                                          | 205        |   | $ | 348 |   | $ | 365 |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. The tax effects of significant itemscomprising the Company’s deferred tax assets and deferred tax liabilities as ofDecember 31 are as follows:

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets:                 |       |                  |       |   |   |
| Net operating loss carry forwards    |       | $                     | 44,577     |   | $ | 37,708 |   |
| Research and experimentation credits |       | 1,987                 |       | 2,183 |   |
| Accrued expenses and allowances      |       | 1,327                 |       | 1,672 |   |
| Deferred revenue                     |       | 2,694                 |       | 1,475 |   |
| Deferred compensation                |       | 586                   |       | 272 |   |
| Foreign tax credit                   |       | 331                   |       | 331 |   |
| Impairment of investments            |       | 192                   |       | 192 |   |
| Other                                |       | —                |       | 1 |   |
| Total gross deferred tax assets      |       | 51,694                |       | 43,834 |   |
| Less valuation allowance             |       | (46,201               | )          | (41,825 | ) |
| Net deferred tax assets              |       | 5,493                 |       | 2,009 |   |
| Deferred tax  liabilities:           |       |                  |       |   |   |
| Tax depreciation and amortization    |       | 5,493                 |       | 2,009 |   |
| Total deferred tax liabilities       |       | 5,493                 |       | 2,009 |   |
| Net deferred tax  asset (liability)  |       | $                     | —     |   | $ | — |   |

 

F-29

----

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

The Company has recorded a full valuation allowanceagainst deferred tax assets as it is not more likely than not that deferred taxassets will be recoverable. The net change in the total valuation allowance forthe year ended December 31, 2006, 2005 and 2004 was an increase of $4,376,$7,254, and $3,617, respectively. Included in the valuation allowance at December 31,2006 is $10,124 for deferred tax assets for which subsequently recognized taxbenefits, if any, will be allocated to contributed capital.

At December 31, 2006, the Company had netoperating loss carryforwards of approximately $116,500 to offset against futureincome for foreign, federal and state tax purposes, and research andexperimentation credits of approximately $2,000. These carryforwards expirethrough 2026 and 2024 respectively. Approximately $26,394 of the net operatingloss carryforward will be allocated to contributed capital if subsequentlyrecognized.

A provision of the Internal Revenue Code imposes alimitation on the utilization of net operating losses and research andexperimentation credits when there is a change of more than 50% in ownership ofthe Company. The Company has had several such changes since 1996.

UnitedStates taxes have not been provided on undistributed earnings of internationalsubsidiaries. The Company’s intention is to reinvest these earnings andrepatriate only when it is tax efficient to do so. Accordingly, the Companybelieves no federal or state tax will be incurred upon repatriation.

**(7)**   SegmentInformation

*GeographicInformation*

The Company derives its revenue from a singlereporting segment: secure identification and media management solutions.Revenue is generated in this segment through licensing and subscription of itsvarious products and the delivery of contracted and consulting services relatedto these products. The Company markets its products in the United States and innon-U.S. countries through its sales personnel and its subsidiaries. TheCompany’s management evaluates resource allocation decisions and theperformance of the Company based upon revenue by the geographic regions of thesegment and does not receive discrete financial information about assetallocation and expense allocation on a disaggregated basis.

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

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| **Revenue:**  | ** ** | ** **                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                           | 83,161     |   | $ | 80,119 |   | $ | 72,173 |   |
| International |       | 21,086                                      |       | 20,934 |   | 20,774 |   |
|          |       | $                                           | 104,247    |   | $ | 101,053 |   | $ | 92,947 |   |
|               |            |                                             |            |  |  |  |  |  |  |  |  |  |

 

Revenueis attributed to countries based on the location of the identifiable customers.

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| **Long-lived tangible assets:** | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States                             |       | $                     | 55,690     |   | $ | 60,123 |   |
| International                             |       | 6,208                 |       | 3,985 |   |
|                                      |       | $                     | 61,898     |   | $ | 64,108 |   |
|                                           |            |                       |            |  |  |  |  |  |  |

 

F-30

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

 

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| **Intangible assets, net:** | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States                         |       | $                     | 14,285     |   | $ | 15,826 |   |
| International                         |       | 1,089                 |       | 1,338 |   |
|                                  |       | $                     | 15,374     |   | $ | 17,164 |   |
|                                       |            |                       |            |  |  |  |  |  |  |

 

*Major Customers*

There was onecustomer that accounted for slightly over 10% of the Company’s revenues for theyear ended December 31, 2006. No single customer accounted for 10% or moreof the Company’s revenues for the year ended December 31, 2005 or 2004. Nocustomer accounted for more than 10% of trade and unbilled accounts receivableat December 31, 2006. There was one customer that accounted for 11% of theCompany’s trade and unbilled accounts receivable for the year ended December 31,2005.

**(8)**   Commitments andContingencies

Beginning in September 2004,three purported class action lawsuits were filed in the U.S. District Court forthe District of Oregon against the Company and certain of its current andformer directors and officers on behalf of purchasers of the Company’ssecurities during the period April 17, 2002 to July 28, 2004. Theselawsuits were later consolidated into one action for all purposes. The amendedcomplaint, which sought unspecified damages, asserted claims under the federalsecurities laws relating to the Company’s restatement of its financialstatements for 2003 and the first two quarters of 2004 and alleged that theCompany issued false and misleading financial statements and issued misleadingpublic statements about the Company’s operations and prospects. On August 4,2006, the court granted our motion to dismiss the lawsuit with prejudice andentered judgment in our favor. Plaintiffs have filed a notice of appeal in theNinth Circuit Court of Appeals. The appeal has been stayed pending the U.S.Supreme Court’s determination in another case of issues relating to the PrivateSecurities Litigation Reform Act. Due to the inherent uncertainties oflitigation, the Company cannot accurately predict the ultimate outcome of thematter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company.The Board of Directors appointed an independent committee to investigate theclaims asserted in this derivative lawsuit. On July 19, 2005, the courtgranted the Company’s motion to stay these consolidated actions in favor of ashareholder derivative action to be filed by plaintiffs in the Circuit Court ofthe State of Oregon for the County of Washington. On August 25, 2005, theCalifornia plaintiffs filed two new derivative lawsuits in the United StatesDistrict Court for the District of Oregon. On October 17, 2005, defendantsfiled a motion to dismiss these complaints for lack of subject matterjurisdiction and failure to state a claim. In May of 2006, the Boardcommittee, after completing its investigation, concluded that pursuit of theallegations would not be in the best interests of Digimarc or its shareholders.On August 24, 2006, the court granted defendants’ motion and dismissed thelawsuit with prejudice. Plaintiffs filed a notice of 

F-31

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

appeal on September 22,2006. The schedule for submission of appellate briefs has not been set. Due tothe inherent uncertainties of litigation, the Company cannot accurately predictthe ultimate outcome of the matter.

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including Digimarc, certain ofits officers and directors, and certain underwriters of the Company’s initialpublic offering as defendants. The complaints have since been consolidated intoa single action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-marketsubsequent to the Company’s initial public offering. The Company and certain ofits officers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),however, were dismissed. In June 2003, a committee of the Company’s boardof directors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval. The settlement would provide,among other things, a release of the Company and of the individual defendantsfor the conduct alleged in the amended complaint to be wrongful. The Companywould agree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. On August 31, 2005, the courtissued a preliminary order further approving the modifications to thesettlement and certifying the settlement classes. The court also appointed theNotice Administrator for the settlement and ordered that notice of thesettlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearingwas held on April 26, 2006, but the court has not yet rendered itsdecision. If the court determines that the settlement is fair to the classmembers, the settlement will be approved. On December 5, 2006, the UnitedStates Court of Appeals for the Second Circuit issued a decision vacating theorder of the United States District Court for the Southern District of New Yorkthat had granted class certification for the plaintiffs and remanded the matterfor further proceedings. There can be no assurance that the proposed settlementwill be approved and implemented in its current form, or at all. Due to theinherent uncertainties of litigation and the recent decision of the Court ofAppeals vacating the order granting class certification, the Company cannotaccurately predict the ultimate outcome of the matter.

F-32

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

Our contracts fordriver license and other identification issuance systems and their relatedproducts typically include provisions imposing (i) development, deliveryand installation schedules and milestones, (ii) customer acceptance andtesting requirements and (iii) other performance requirements,  Such provisions are common in large scalegovernment contracts at the state and federal levels. To the extent theseprovisions involve performance over extended periods of time, there may beincreased risk of noncompliance. The Company from time to timeexperiences delays in identification system implementation, timely acceptancefor identification systems programs, concerns regarding identification systemprogram performance, and other contractual disputes. Customers have asserted from time totime, and may in the future assert, claims for compensatory or liquidated damagesor breach of contract, or other claims alleging that the Company has failed tomeet timing or other delivery requirements and milestones pursuant to the termsof such contracts. Management believes that these assertions are oftenpart of the resolution process involving commercial disagreements over theterms of these contracts. Such disputes are not uncommon and tend to beresolved over time. However, theCompany’s failure to meet contractual milestones or other performancerequirements as promised, or to successfully resolve customer disputes, couldresult in the Company incurring liability for damages, as well as increasedcosts, lower margins, or compensatory obligations in addition to other losses,such as harm to the Company’s reputation. Such circumstances could have amaterial adverse effect on the Company’s business and financial results. TheCompany anticipates that future contracts will continue to have such provisionsunless and until industry practices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on such contracts inthe recent past. Such contracts involve greater financial risks because we bearthe risk if actual project costs exceed the amounts we are paid under thecontracts. A material percentage of our revenues are derived from fixed pricecontracts and our reliance on fixed price contracts may grow.

A significant portionof our business depends on a limited number of large, public-sector contracts,which are generally subject to termination for convenience, as determined bythe subject agency, or for lack of budgetary appropriation provided for thesubject agency. Some government contracts also may be one-time events, such asin the case of some personal identification systems in non-U.S. marketsinvolving voter registration programs. In such cases, we may generatesubstantial revenue that may not be subject to future renewal. Further, we mayface competitive bids for a number of our major accounts in 2007. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards.

Certain of the Company’s product license and servicesagreements include an indemnification provision for claims from third partiesrelating to the Company’s intellectual property. Such indemnificationprovisions are accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*. To date,there have been no claims made under such indemnification provisions.

F-33

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

The Company is subject from time to time to otherlegal proceedings and claims arising in the ordinary course of business. Although the ultimateoutcome of these matters cannot be determined, management believes that, as of September 30,2006, the final disposition of these proceedings will not have a materialadverse effect on the consolidated financial position, results of operations,or liquidity of the Company. No accrual has been recorded because the amountsare not probable or reasonably estimatable in accordance with SFAS No. 5,*Accounting for Contingencies*.

A portion of the Company’srevenue each year is generated from licensing of technology. In the competitiveenvironment in which the Company operates, product generation, development andmarketing processes relating to technology are uncertain and complex, requiringaccurate prediction of demand as well as successful management of variousdevelopment risks inherent in technology development. In light of these dependencies,it is possible that failure to successfully manage future changes in technologywith respect to the Company’s technology could have a long-term impact on theCompany’s growth and results of operations.

*Performance Bonds*

Somegovernmental authorities require performance bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bondsrequire that we obtain letters of credit to secure our obligations under thebonds. The letters of credit may in turn require us to maintain largerestricted cash reserves as security, reducing our ability to use these fundsfor our other business purposes. Even with the availability of such cashreserve guarantees, we may not be able to obtain such performance bondunderwriting at a favorable rate or at all. Our failure to be able to providesuch performance bonds may preclude us frombidding on new government contracts or maintaining our existing contracts fortheir full terms. In addition, these performance bonds may provide forsecurity interests covering our receivables or other assets, which could causeadditional financing to be more difficult or more expensive to obtain. Thesize, nature and purpose of, and the risks and uncertainties associated with,public sector contracts can potentially cause our quarterly results tofluctuate and anticipated revenue to decrease significantly.

**(9)**   RelatedParty Transactions

In 2006, 2005 and 2004, the Company entered intoservices and licensing arrangements with a holder of common stock. The Companyrecognized $659, $486 and $638 in revenue for the years ended December 31,2006, 2005 and 2004, respectively, in connection with these arrangements. At December 31,2006 and 2005, net accounts receivable from this customer were $329 and $231, respectively.At December 31, 2006 and 2005, deferred revenue from this customer was$288 and $320, respectively.

During the quarter ended September 30,2005, the Company entered into a relocation agreement with an executiveofficer. As part of the relocation package, the Company purchased the personalresidence of that officer. The purchase price was based on independentappraisals and totaled $825. The Company has assumed all rights and obligationsrelated to the residence. During the quarter ended March 31, 2006, theCompany sold the personal residence to an unrelated third party for $710,resulting in a net loss of $115.

F-34

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

** (10)**   QuarterlyFinancial Information—Unaudited

| **Quarter ended:**                   | ** ** | ** ** | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-------------------------------------------|------------|------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| **2006**                                  |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 27,193            |       |             | $          | 24,907                |       |                 | $          | 26,733 |   |   |   | $25,414 |   |   |
| Total cost of  revenue                    |       |       | 19,648     |              |       | 16,677           |       |                  | 16,719     |                 |       |   | 15,725 |   |   |
| Gross profit                              |       |       | 7,545      |              |       | 8,230            |       |                  | 10,014     |                 |       |   | 9,689 |   |   |
| Sales and  marketing                      |       |       | 4,539      |              |       | 4,685            |       |                  | 3,440      |                 |       |   | 3,691 |   |   |
| Research,  development and engineering    |       |       | 3,236      |              |       | 2,994            |       |                  | 2,158      |                 |       |   | 1,881 |   |   |
| General and  administrative               |       |       | 5,210      |              |       | 4,172            |       |                  | 3,684      |                 |       |   | 4,418 |   |   |
| Amortization of  intangibles              |       |       | 573        |              |       | 550              |       |                  | 537        |                 |       |   | 511 |   |   |
| Intellectual  property                    |       |       | 431        |              |       | 481              |       |                  | 460        |                 |       |   | 402 |   |   |
| Restructuring  charges, net               |       |       | —     |              |       | 547              |       |                  | —     |                 |       |   | — |   |   |
| Operating income  (loss)                  |       |       | (6,444     | )                 |       | (5,199           | )          |                  | (265       | )                    |       |   | (1,214 | ) |   |
| Net income (loss)                         |       |       | (6,172     | )                 |       | (4,869           | )          |                  | 213        |                 |       |   | (912 | ) |   |
| Net income (loss)  per share—basic   |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   | (0.04 | ) |   |
| Net income (loss)  per share—diluted |       |       | (0.30      | )                 |       | (0.24            | )          |                  | 0.01       |                 |       |   | (0.04 | ) |   |
| **2005**                                  |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 24,379            |       |             | $          | 24,753                |       |                 | $          | 26,781 |   |   |   | $ | 25,140 |   |   |
| Total cost of  revenue                    |       |       | 16,077     |              |       | 16,560           |       |                  | 17,043     |                 |       |   | 18,492 |   |   |
| Gross profit                              |       |       | 8,302      |              |       | 8,193            |       |                  | 9,738      |                 |       |   | 6,648 |   |   |
| Sales and  marketing                      |       |       | 3,777      |              |       | 3,889            |       |                  | 4,295      |                 |       |   | 3,816 |   |   |
| Research,  development and engineering    |       |       | 2,908      |              |       | 3,428            |       |                  | 3,199      |                 |       |   | 3,596 |   |   |
| General and  administrative               |       |       | 5,497      |              |       | 5,521            |       |                  | 4,852      |                 |       |   | 5,654 |   |   |
| Amortization of  intangibles              |       |       | 811        |              |       | 1,339            |       |                  | 1,147      |                 |       |   | 738 |   |   |
| Intellectual  property                    |       |       | 536        |              |       | 467              |       |                  | 528        |                 |       |   | 483 |   |   |
| Operating income  (loss)                  |       |       | (5,227     | )                 |       | (6,451           | )          |                  | (4,283     | )                    |       |   | (7,639 | ) |   |
| Net income (loss)                         |       |       | (5,120     | )                 |       | (6,217           | )          |                  | (4,228     | )                    |       |   | (7,532 | ) |   |
| Net income (loss)  per share—basic   |       |       | (0.25      | )                 |       | (0.30            | )          |                  | (0.21      | )                    |       |   | (0.37 | ) |   |
| Net income (loss)  per share—diluted |       |       | (0.25      | )                 |       | (0.30            | )          |                  | (0.21      | )                    |       |   | (0.37 | ) |   |
| **2004**                                  |       |       |       |              |       |             |       |                  |       |                 |       |   |   |   |   |
| Total revenue                             |       |       | $          | 23,658            |       |             | $          | 23,474                |       |                 | $          | 23,520 |   |   |   | $ | 22,295 |   |   |
| Total cost of  revenue                    |       |       | 15,275     |              |       | 15,222           |       |                  | 14,199     |                 |       |   | 14,679 |   |   |
| Gross profit                              |       |       | 8,383      |              |       | 8,252            |       |                  | 9,321      |                 |       |   | 7,616 |   |   |
| Sales and  marketing                      |       |       | 2,781      |              |       | 3,062            |       |                  | 3,376      |                 |       |   | 3,689 |   |   |
| Research,  development and engineering    |       |       | 1,935      |              |       | 1,771            |       |                  | 2,259      |                 |       |   | 2,362 |   |   |
| General and  administrative               |       |       | 3,506      |              |       | 3,558            |       |                  | 5,160      |                 |       |   | 4,926 |   |   |
| Amortization of  intangibles              |       |       | 642        |              |       | 547              |       |                  | 688        |                 |       |   | 659 |   |   |
| Intellectual  property                    |       |       | 455        |              |       | 573              |       |                  | 505        |                 |       |   | 629 |   |   |
| Operating income  (loss)                  |       |       | (936       | )                 |       | (1,259           | )          |                  | (2,667     | )                    |       |   | (4,649 | ) |   |
| Net income (loss)                         |       |       | (786       | )                 |       | (1,271           | )          |                  | (2,467     | )                    |       |   | (4,498 | ) |   |
| Net income (loss)  per share—basic   |       |       | (0.04      | )                 |       | (0.06            | )          |                  | (0.12      | )                    |       |   | (0.22 | ) |   |
| Net income (loss) per  share—diluted |       |       | (0.04      | )                 |       | (0.06            | )          |                  | (0.12      | )                    |       |   | (0.22 | ) |   |

 

F-35

----

**EXHIBITINDEX**

| Exhibit   Number | ** ** | **Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 3.1              |       | Second Amended and Restated Certificate of  Incorporation of the Registrant, as amended (incorporated by reference to  Exhibit 10.19 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                                                                                      |
| 3.2              |       | Amended and Restated  Bylaws of the Registrant, as amended (incorporated by reference to  Exhibit 3.3 to the Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on August 9, 2005)                                                                                                                                                                                                                                                                                                                                  |
| 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 10.19 to the Registrant’s Annual Report on  Form 10-K, as filed with the Securities and Exchange Commission on  March 13, 2006)                                                                                                                                                                                                                 |
| 4.3              |       | Rights Agreement, dated  as of November 16, 2004, between Digimarc Corporation and EquiServe  Trust Company, N.A. together with: Exhibit A Form of Rights  Certificate; Exhibit B Form of Summary of Rights to Purchase  Preferred Stock; and Exhibit C Form of Certificate of Designation  of the Series A Preferred Stock of Digimarc Corporation (incorporated by reference to Exhibit 4.1  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on November 17, 2004) |
| 10.1             |       | Form of  Indemnification Agreement between the Registrant and each of its executive  officers and directors (incorporated by reference to Exhibit 10.19 to  the Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                                                             |
| 10.2             |       | Registrant’s 1995 Stock  Incentive Plan, as amended (incorporated by reference to Exhibit 10.19  to the Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                                                                                                                     |
| 10.3             |       | Registrant’s Restated  1999 Stock Incentive Plan, as amended and restated on April 17, 2003  (incorporated by reference to Exhibit 10.3 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 15, 2004)                                                                                                                                                                                                                                                                                        |
| 10.4             |       | Form of Notice of  Stock Option Award and Stock Option Award Agreement for employees under the  Digimarc Corporation 1999 Stock Incentive Plan (incorporated by reference to  Exhibit 10.19 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                          |
| 10.5             |       | Registrant’s 1999  Employee Stock Purchase Plan, as amended and restated on November 2, 2006,  including forms of agreements thereunder                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.6             |       | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Macrovision Corporation (incorporated by reference to Exhibit 10.19 to  the Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                                                    |
| 10.7             |       | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Koninklijke Philips Electronics N.V. (incorporated by reference to  Exhibit 10.19 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 13, 2006)                                                                                                                                                                                                                                                       |

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| 10.8  |   | Registrant’s 2000 Non-Officer  Employee Stock Incentive Plan, as amended and restated on February 19,  2004 (incorporated by reference to Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q, as filed with the Securities and  Exchange Commission on May 10, 2004)                                        |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9  |   | Registrant’s 1999 Non-Employee  Director Option Program, as amended and restated May 3, 2006                                                                                                                                                                                                                                                 |
| 10.10 |   | First Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.16 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                            |
| 10.11 |   | Second Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.17 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                           |
| 10.12 |   | Employment Agreement,  dated as of July 16, 2001, between the Registrant and Bruce Davis  (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on May 15, 2003)                                                               |
| 10.13 |   | Form of Warrant  (incorporated by reference to Exhibit 4.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on August 27, 2003)                                                                                                                                         |
| 10.14 |   | Purchase Agreement by  and between the Registrant and each of the purchasers whose names are set  forth on the signature pages thereof (incorporated by reference to  Exhibit 10.1 to the Registrant’s Current Report on Form 8-K,  as filed with the Securities and Exchange Commission on August 27, 2003)                  |
| 10.15 |   | Form of Restricted  Stock Agreement for the Digimarc Corporation 1999 Stock Incentive Plan  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on March 1, 2005)                                                               |
| 10.16 |   | Form of Stock  Option Award Agreement for the 1999 Non-Employee Director Option Program  adopted under the Digimarc Corporation 1999 Stock Incentive Plan (incorporated by reference to Exhibit 10.2  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on March 1, 2005) |
| 10.17 |   | Forms of Notice of Stock  Option Award and Stock Option Award Agreement for officers under the Digimarc  Corporation 1999 Stock Incentive Plan (incorporated by reference to  Exhibit 10.21 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on April 7, 2005)                |
| 10.18 |   | Full Service Lease,  dated March 22, 2004, by and between PS Business Parks, L.P., and the  Registrant (incorporated by reference to Exhibit 10.21 to the Registrant’s  Annual Report on Form 10-K, as filed with the Securities and  Exchange Commission on April 7, 2005)                                                   |
| 10.19 |   | Summary of Key Terms of  Named Executive Officer Compensation Arrangements                                                                                                                                                                                                                                                                             |
| 10.20 |   | Summary of Key Terms of  Nonemployee Director Compensation Arrangements                                                                                                                                                                                                                                                                                |
| 10.21 |   | Form of Performance  Vesting Share Agreement (incorporated by reference to Exhibit 10.21 to  the Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006)                                                                                                            |

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| 10.22 |   | Form of Change of  Control Retention Agreement (incorporated by reference to Exhibit 10.1  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on January 4, 2007) |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21.1  |   | List of Subsidiaries                                                                                                                                                                                                                          |
| 23.1  |   | Consent of Grant  Thornton LLP, Independent Registered Public Accounting Firm                                                                                                                                                                 |
| 23.2  |   | Consent of KPMG LLP,  Independent Registered Public Accounting Firm                                                                                                                                                                           |
| 31.1  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                  |
| 31.2  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                  |
| 32.1  |   | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                   |
| 32.2  |   | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                   |

 

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