**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

**Forthe fiscal year ended December 31, 2005**

**OR**

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

**Forthe transition period from                to                **

**CommissionFile Number 000-28317**

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**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

**9405 SW GeminiDrive, Beaverton, Oregon 97008**(Addressof principal executive offices) (Zip Code)

**(503) 469-4800**(Registrant’stelephone number, including area code)

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

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock,$0.001 par value**

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yeso No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer o                                Acceleratedfiler x                                 Non-acceleratedfiler o

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

The aggregate market value of common stock, par value$0.001 per share, held by non-affiliates of the registrant, based on theclosing price for the common stock on The Nasdaq National Market on the lastbusiness day of the registrant’s most recently completed fiscal second quarter(June 30, 2005), was approximately $112 million. Shares of commonstock beneficially held by each officer and director have been excluded fromthis computation in that such persons may be deemed to be affiliates. Thisdetermination of affiliate status is not necessarily a conclusive determinationfor any other purposes.

As of January 31, 2006, there were 21,018,994shares of the registrant’s common stock outstanding.

**DocumentsIncorporated by Reference**

Portions of the registrant’sproxy statement pursuant to Regulation 14A (the “Proxy Statement”) for its2006 annual meeting of stockholders are incorporated by reference into Items10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K.The registrant intends to file the Proxy Statement not later than 120 daysafter the end of the fiscal year covered by this Annual Report on Form 10-K.

 

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**Table of Contents**

| **PART I**   |   |                                                                                                                    |   |   |
|-------------------|--------|-------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.           |   | Business                                                                                                                |   | 1      |
| Item 1A.          |   | Risk Factors                                                                                                            |   | 13     |
| Item 1B.          |   | Unresolved Staff Comments                                                                                               |   | 13     |
| Item 2.           |   | Properties                                                                                                              |   | 14     |
| Item  3.          |   | Legal Proceedings                                                                                                       |   | 14     |
| Item 4.           |   | Submission of Matters to a Vote of Security Holders                                                                     |   | 16     |
| **PART II**  |   |                                                                                                                    |   |   |
| Item 5.           |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 17     |
| Item  6.          |   | Selected  Financial Data                                                                                                |   | 17     |
| Item 7.           |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                   |   | 18     |
| Item 7A.          |   | Quantitative and Qualitative Disclosures About Market  Risk                                                             |   | 52     |
| Item 8.           |   | Financial Statements and Supplementary Data                                                                             |   | 52     |
| Item 9.           |   | Changes in and Disagreements with Accountants on Accounting  and Financial Disclosure                              |   | 52     |
| Item  9A.         |   | Controls  and Procedures                                                                                                |   | 52     |
| Item  9B.         |   | Other Information                                                                                                       |   | 56     |
| **PART III** |   |                                                                                                                    |   |   |
| Item 10.          |   | Directors and Executive Officers of the Registrant                                                                      |   | 57     |
| Item  11.         |   | Executive  Compensation                                                                                                 |   | 57     |
| Item 12.          |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |   | 57     |
| Item 13.          |   | Certain Relationships and Related Transactions                                                                          |   | 57     |
| Item 14.          |   | Principal Accounting Fees and Services                                                                                  |   | 57     |
| **PART IV**  |   |                                                                                                                    |   |   |
| Item 15.          |   | Exhibits and Financial Statement Schedules                                                                              |   | 58     |
| SIGNATURES        |   | 59                                                                                                                      |
| 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**

Digimarc Corporation (“Digimarc,” “the Company,” “our”or “we”) is a leading supplier of secure identity solutions and advancedtechnologies for use in media management. Our solutions enable governments andbusinesses around the world to deter counterfeiting and piracy, enhance trafficsafety and national security, combat identity theft and fraud, facilitate theeffectiveness of voter identification programs, improve the management of mediacontent, and support new digital media distribution models that provideconsumers with more choice and access to media content.

The Company issues more than 60 million identificationdocuments (“IDs”) annually and is the leading supplier of government-issuedcitizen IDs in the United States (“U.S.”), producing more than two-thirds ofall driver licenses issued in the U.S. Digimarc also is a pioneer and leadingowner of intellectual property in a signal processing technology innovationknown as “digital watermarking”, whichallows imperceptible digital information to be embedded in all forms of digitally-designed,produced or distributed media content, including personal identificationdocuments, financial instruments, photographs, movies, music and productpackages. The embedded data within various types of media content can bedetected and read by software or hardware detectors in personal computers andother digital devices. We provide solutions based on this technology directlyand through our licensees. As of December 31, 2005, the Company heldrights in 222 issued U.S. patents and 59 issued foreign patents on thistechnology and related technologies, applications, systems, and processes andhad more than 500 U.S. and foreign applications pending. Digimarc’s solutionsand technologies are deployed by the Company and its business partners in mediaobjects and digital devices around the world.

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Our principal administrative, sales, marketing,support, research, development and engineering facility is located inBeaverton, Oregon. Our secure ID systems business is headquartered inBurlington, Massachusetts, and our logistics center is in Fort Wayne, Indiana.

The substantial majority of the Company’s revenue isgenerated  pursuant to long-termcontracts with government agencies—primarily U.S. state government agenciesresponsible for driver license issuance (“State DL Issuers”), a consortium ofleading Central Banks, and national governments of a number of foreigncountries. These systems rely on our systems design, integration and materialsscience expertise, and proprietary technologies such as digital watermarking,to implement issuance systems and processes that improve the security ofidentity documents and banknotes.

The remainder of our revenues is generated primarilyfrom patent and technology license fees paid by business partners providingmedia and rights management solutions to movie studios and music labels,television and radio broadcasters, creative professionals and other customersaround the world. Private sector media and entertainment industry customers usesecure media management solutions from the Company and its business partners toidentify, track, manage and protect content as it is distributed and consumed—eitherdigitally or physically—and to enable new consumer applications to improve accessto networks and information from PCs and mobile devices.

Financial information about geographic areas isincorporated by reference to Note 7 of our consolidated financialstatements.

We make available throughour website at www.digimarc.com our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K,and amendments to these and other reports filed or furnished by us pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after we file such materials with the Securities and ExchangeCommission.

**History**

Digimarc was incorporated in 1995. The Company wasfounded to commercialize a signal processing innovation known as “digitalwatermarking.” Digital watermarking is a technology breakthrough that allowsour customers to infuse digital data into any media content that is digitallyprocessed at some point during its lifecycle. The technology can be applied toprinted materials, video, audio, and images. The inclusion of such digital dataenables a wide range of improvements in security and media management, andenables new business models for distribution and consumption of media content.We use digital watermarking as a value driver and differentiator in nearly allof our product offerings.

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, 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 issuer’s environment. In late 2001, we acquired the LargeGovernment Programs (“LGP”) business unit of Polaroid Corporation (“Polaroid”).The primary focus of this business is the production of driver licenses (“DLs”)and other IDs issued by government agencies. The acquired 

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assets included allrelevant software, hardware, services, materials science and distributionassets of Polaroid’s government-issued photo identification business.

Inthis strategic acquisition, we saw a unique opportunity to assist in efforts todeter identity theft and fraud and enhance transportation safety and Homeland Securitythrough the combination of a new layer of security using our digitalwatermarking innovations and market-leading competence in secure ID solutionsfrom Polaroid. The resulting business has more than 47 years of experience inthe delivery and operation of secure ID issuance systems, has produced morethan 2 billion issued IDs, and has guided customers through numerous majorupgrades and technology migrations in ID security. We are the leader indeploying new solutions to meet driver license security and relatedservice challenges. 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  Federallegislation, such as the REAL ID Act.

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 astrategic business partner to solution providers supporting the media andentertainment industry.

**Vision and Mission**

TheCompany’s vision is to improve the value of media content through technology. Itsmission is two-fold:

·       Fosterlarge-scale adoption of digital watermarking solutions licensed under theCompany’s intellectual property

·       Be the most desired profitable supplier of driver license issuancesystems

The provision of issuancesystems for driver licenses and other government-issued credentials furthersthe adoption of digital watermarking as this technology is increasingly includedas a security feature of such documents.

**Customers**

The majority of Digimarc’srevenues is derived from supplying infrastructure to government agenciespursuant to long-term contracts, primarily State DL Issuers, a consortium ofleading Central Banks, and national governments of various foreign countries.The retention rate for our driver license customers is high. Our contract withthe Central Banks is in its eighth year. Last year we agreed upon a 5-yearextension, with two additional 3-year extensions that we expect to beimplemented.

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 the world.Patent licensing is expected to continue to contribute most of the revenues fromnon-government customers for the foreseeable future.

Digimarc views its patentlicensees and government agency customers as long-term business partners andbelieves that a focus on customer satisfaction will foster future growth andimproved financial performance.

Representativecustomers and business partners include:

·       Stateand national government agencies that issue driver licenses, national IDs andvoter credentials, including 32 U.S. states, the District of Columbia, twoCanadian provinces, Latvia, Mexico and Russia;

·       aninternational consortium of the world’s leading Central Banks; and

·       Activated Content, DolbyLaboratories/Cinea, GCS Research, MediaGrid, Nielsen Media Research, RoyalPhilips Electronics, Thomson, Signum, Verance and Verimatrix.

**GovernmentProducts and Services**

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

***Financial Document Security.*****  **The Company has a multi-year contract with an international consortiumof Central Banks in which it has developed, deployed, and is supporting andcontinuing to enhance a system to deter digital counterfeiting of currencyusing personal computers and digital reprographics. Work on the system began in1997. Details of the system are confidential for security reasons.

***Secure IDSolutions*.***  *As the leadingprovider of government-issued secure IDs in North America, Digimarc systemsproduce more than 60 million driver licenses and other secure personalidentification documents per year. Two-thirds of the U.S. states and manyforeign governments, including Russia, Latvia, Mexico, and Canada, use Digimarcsecure ID solutions to issue credentials to citizens.**InNorth America, we are generally a prime contractor, providing full issuancesystems to Federal, State, and Provincial departments of motor vehicles orother government issuing authorities. Our North American driver licenseissuance systems vary from jurisdiction to jurisdiction. These systems aretypically provided pursuant to long-term (normally five or more years)contracts. The systems provided include the hardware, software, consumablesupplies (such as ribbons, blank or preprinted card marterials, and laminates),and on-going support necessary for a “turnkey” solution. They typically involvecustom software and/or hardware development, integration services, andimplementation services. When we provide a full issuance system to a customer,we generally retain title to all assets associated with the system and areresponsible for maintaining the system over the contractual period. A digitaldriver license issuance system typically captures images (photo and signature)and demographic information, validates applicant identity, produces the actualdriver license or identification document (either at the point of service or ata central production facility operated by us), provides or delivers thefinished driver license or other identity document to the individual licensee,stores the images and associated data in a database, and communicates with the issuer’sother systems for completion of processing of the driver license applicants.

Digital driver licenseworkstations installed in government driver license offices typically consistof a personal computer, digital camera system, signature capture device, networkinterface hardware, and other associated peripherals as required, includingcard printers, receipt printers, dossier printers, scanners, fingerprintcapture devices, and bar code readers. Most of this hardware is sourced fromthird-party suppliers. We provide software application components that drivethe specific peripherals and workflow to process the applicants through thecapture and printing sequences. Graphical user interfaces, encoding of businessrules into the work flow sequences, and communication interfaces arecustom developed to the specific needs of the customer. We provide services inconjunction with State and National databases to 

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confirmthe validity of applicant provided information. Some commercial “off the shelf”software is also provided, such as operating systems (typically MicrosoftWindows XP), and virus protection. Additionally, we often provide the necessarydatabase design, hardware, and software to store portrait, signature, andbiometric images for later retrieval. We generally supply the documentconsumables, including card materials, custom laminates, printer ribbons,mailing supplies, and receipt paper.

In the case ofinstallations that issue documents from a central location, we provide a large-scalecentral production system, including high-volume personalization printers, laminationand die cutting machinery, encoding equipment, workstations, files servers, andproprietary software to control the production process and adhere to processand product quality levels. The typical central production capability isdesigned to produce tens of thousands of documents per day. We usually providethe production facility and staffing for turnkey production of the documentspursuant to a fixed price contract.

Our sales and marketingorganization for North America ID issuing systems is organized into geographicterritories with senior level sales/business development professionals andprogram management assigned to each territory. Because our contracts arelong-term in nature, and the market is relatively homogeneous and stable,long-term relationships are key to our successful positioning for newopportunities and for maximizing potential within existing accounts. Contractsare most often granted through competitive bidding based on either “best value”or “low compliant cost” to the issuing jurisdiction. A “Bids &Proposals” organization, consisting of bid managers, technical writers,production assistants and technical support, is responsible for working withour sales and program management staffs to deliver winning bids based on salespositioning and strategy. Our marketing group is responsible for translatingmarket/sales needs into product plans, supporting the sales effort withnecessary collateral and market positioning, and managing long-term companystrategy. An industry association, the American Association of Motor VehicleAdministrators, to which all North American driver license agencies belong,provides us with another vehicle for marketing and education within our NorthAmerican customer community through regional and international conferences,seminars, and trade shows.

In non-U.S. markets, wherewe provide driver licenses, national identification, and voter identificationsystems, services, and components in partnership with local card producers,security printers, system integrators, and others, we may serve as primecontractor or sub-contractor, depending on the circumstances. Internationalsales for us have typically taken the form of an outright sale of equipmentand/or consumables to international government agencies or their primecontractors. When we provide a partial credential issuance system to acustomer, we usually transfer title of the assets to the customer upon deliveryand typically have no further obligations. We are paid on standard billingterms upon delivery of the assets. When we provide services for a partialcredential issuance system, we usually are paid in accordance with customarycommercial practice upon performance of the services.

Our customers areincreasingly sensitive to the issue of identity theft and fraud, to concernsaround verifying personal identity and, in the case of U.S. customers, to therole that the U.S. driver license plays as a primary form of identityverification for personal access to secure facilities and publictransportation, the conduct of financial transactions, and at point-of-sale forage restricted products such as alcohol and tobacco. As a result, we believe therewill be increasing interest from our customers in a variety of fraud detectionand prevention systems, including biometric-based solutions based onthird-party technologies. We are a leading provider of biometricsolutions in the driver license market, operating systems that process tens ofmillions of fingerprint or facial images. As an example, our facial recognitionsolutions can help our customers determine if an applicant may have alreadybeen issued a valid license within a particular jurisdiction, and ourfingerprinting and fingerprint matching solutions can be used to verify anapplicant’s identity prior to issuance of credentials such as a commercialdriver license. Several States incorporate identity verification solutionswhich employ a background check on the applicant-supplied demographicdata during the initial enrollment process, further enhancing the integrity ofthe issuance process.

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We are working onbroadening our security offerings to provide more integrated identityverification and fraud detection capabilities within the issuance workflow ofour customers. Many aspects of our advanced technology solutions anticipateboth the mandate of Federal legislation passed in May 2005 known as theREAL ID Act (the “REAL ID Act”) and the emerging consensus on best practicesconsistent with our product and service strategy.**Someof the requirements of the REAL ID Act that may require states to upgrade to bein compliance include:

*Applicant DataCapture*

·       capturedigital images of identity source documents in a transferable format

·       retaincopies of source documents—7 years for paper or 10 years for image

·       conduct mandatory facialimage capture

*IdentityVerification*

·       verify,with the issuing agency, the issuance, validity, and completeness of eachdocument

·       verifythe legal residency of a person

·       confirmor verify a renewing applicant’s information

·       confirmwith Social Security Administration all applicant Social Security Numbers usingthe full 9-digit number

·       confirmtermination of previous license in another State before issuance

·       provide electronic accessto all other States to information contained in the motor vehicle database ofthe State

*Secure Credentialand ID Validation*

·       limitvalidity period of IDs

·       implementphysical security features designed to prevent tampering, counterfeiting, orduplication

·       deploycommon machine-readable technology, with defined minimum data elements

Serving government needs for citizen identitymanagement involves successfully delivering solutions that span the secure IDlifecycle, ranging from demographic data capture, identity validation, andapplicant data and biometric verification systems, to the design and secureproduction of credentials incorporating linked and layered security features,culminating with effective ID authentication deployed at various points ofinspection. It also requires the expertise to integrate these solutions withexisting government agency applications and IT infrastructure, and the service,support and training necessary to effectively manage the implementations overthe course of long-term customer relationships. Digimarc has worked extensively with driver license issuers across theU.S. to strengthen their issuance systems and secure credential designs. As aresult, the Company has identified and implemented numerous “best practices”throughout its processes and developed modular, flexible solutions designed toimprove security within each component of the secure ID lifecycle—from the timean applicant applies for or renews his or her driver license; to the secureproduction and issuance of the ID to the legitimate cardholder; to theauthentication of that document at a traffic stop, a bank, a border crossing, astore, or the DMV. The chart below maps Digimarc’s solutions to an overview ofthe secure ID lifecycle.

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**

*ApplicantData Capture and Identity Verification.**  *Validation of documents and verification ofapplicant identity are keys to the secure intake and enrollment process, and acritical step toward ensuring that driver licenses are only issued tolegitimate applicants. In 2005, Digimarc introduced the Digimarc IdentityValidation Suite (“IDVS”) to validate identity documents and verify thebiometric and demographic data presented to establish an applicant’s identity. Asidentity credentials become more secure and difficult to counterfeit,counterfeiters turn to producing false breeder documents to fuel attempts tofraudulently obtain valid secure credentials. Thus the process of validatingidentity is becoming central to secure ID issuance as document qualityimproves, ensuring that only valid applicants receive genuine IDs. This marketdevelopment is underscored by the focus of the REAL ID Act on identityvalidation. IDVS is the Company’s most strategic product offering in 2006,enabling migration to compliance with the REAL ID Act, and serving a growingdemand by our customers for effective multi-factor identification ofapplicants. Digimarc’s role in the secure ID lifecycle is expanding to one thatencompasses identity validation and leads the Company toward a larger role inthe enrollment application. IDVS works in concert with other aspects of oursolution such as our DL Imaging Capture Suite.The Capture Suite enables secure ID and driver license issuers to capturehigh-quality portraits, signatures and fingerprints needed to complete theintake and enrollment process. This step is important to security and customersatisfaction, providing high-quality photos and reliable biometricverification.

*SecureProduction.**  *Once an applicant’s demographic information andimages have been captured, screened and verified, Digimarc solutions enableissuers to securely produce and personalize a secure and highly-durable driverlicense. Digimarc offers several flexible options, including secureover-the-counter instant issuance systems, central issuance systems, and hybridover-the-counter / central issue systems.

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*SecureCredential.**  *An integral part of enhancing ID security isthe design and production of the secure credential itself. Cost-effectivesecurity is achieved through a card architecture that combines multiple layeredand linked security features such as digital watermarks, special printing andKinegrams with durable, counterfeit-resistant materials in Digimarc’s line ofproprietary card products. With its industry-leading Exian card products,Digimarc has developed and incorporated many innovative security features in itsdriver license credentials. Key among these is IDMarc, a Digimarcproprietary security feature built around the Company’s proprietary digitalwatermarking technology. This feature links together elements of the ID in away that is imperceptible under normal use, can be added to existing designs,and is readily detected by enabled software and hardware. IDMarc enablespost-issuance cross-jurisdictional validation of documents.**Digimarc secure credentials often contain morethan a dozen separate overt and covert security elements that protect againsttampering or counterfeiting, and digital watermarking provides the coremachine-readable security feature.

*Point of InspectionValidation.**  *The secure ID lifecycle is not complete unlessthat document is routinely validated at the point of use. With the introductionof security features such as IDMarc, Digimarc’s secure IDs carrymachine-readable features that allow for low-cost and effective cross-jurisdictionalauthentication, augmenting visual inspection to determine if a presented driverlicense matches one of the more than 240 valid driver license designs. Digimarcconducted a pilot study on point of inspection validation with the U.S.Department of Transportation and the State of Nebraska. The project includedpilots with law enforcement and the retail sale of age-controlled products,demonstrating valuable applications to enhance citizen and traffic safety.

**Media and Entertainment**

The Companylicenses its technology and patents and otherwise fosters development of themarket for digital watermarking-based solutions for commercial as well asgovernmental uses. As of the filing date of this Annual Report on Form 10-K,these licenses have primarily involved use of our technology and patents in themedia and entertainment area. Commercial customers use secure media solutionsfrom Digimarc and its business partners 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 from PCsand mobile devices. Many movie studios, record labels, broadcasters, creativeprofessionals and other customers rely on digital watermarking as acost-effective means to:

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

·  protect entertainment content from copyrightinfringement;

·       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 partners include Activated Content,  Dolby Laboratories/Cinea, GCS Research,MediaGrid, Nielsen Media Research, Royal Philips Electronics, Signum, Thomson,Verance and Verimatrix. While each partner addresses particular customer needs,as a whole they are propagating digital watermarking in music, movies, images,and television and radio as a means to improve media rights and assetmanagement, reduce piracy losses, improve marketing programs, and provide moreefficient and effective distribution of valuable media content.

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Our business partners’ applications of digitalwatermarking include the following:

*ForensicTracking:**  *Forensictracking allows content owners to determine when and where a unit of mediacontent leaves its authorized distribution channel. The most common use offorensic tracking is in the entertainment industry, where music and movies areroutinely distributed to executives, critics and other media outlets forpromotion before they are released to the public. In recent years, copies ofthese ‘pre-release’ products have been leaked onto the Internet, or copied ontoCDs and DVDs, and sold as “bootlegs” well ahead of their commercial release.These unauthorized activities result in loss of revenues for the artists, thestudios and the music labels.

Tocombat pre-release piracy, music companies and movie studios embed pre-releasecontent with digital watermarks that are unique to each authorized recipient.This allows the content creators to forensically track the source of leaks andtake appropriate actions. As a result, recipients of pre-release music andmovies have begun to police themselves in order to avoid liability forunauthorized use.

Theuse of digital watermarking solutions from our business partners for forensictracking of pre-release movies and music has gained a strong foothold inHollywood. For instance, digital watermarking is incorporated in millions ofaudio tracks from major record labels to identify and track leaks ofpromotional, pre-release music onto the Internet. Customers of these solutionsfrom Digimarc and business partners such as Activated Content and PhilipsElectronics include SonyBMG, Universal Music Group and Warner Music, masteringstudios, disk duplicators and online business-to-business music distributors.In a similar application for movies, digital watermarking has been identifiedby representatives of the movie studios as dramatically reducing piracy ofmovies in the Academy Award screener program.

Digitalwatermarking may also play a role in the movie industry’s transition from filmreel distribution to digital file format distribution for theatrical release.In July 2005, the Digital Cinema Initiative, which is supported by Disney,Fox, MGM, Paramount, Sony Pictures Entertainment, Universal and Warner Bros.Studios, released its Digital Cinema System Specification, which detailsindustry guidelines designed to help spur deployment of digital cinema systemsfor the hundreds of thousands of movie theater screens in the United States andaround the world while establishing uniform levels of security, distribution,performance, reliability and quality control. The specification requires thatdigital cinema systems be capable of applying digital watermarks in both thevideo and audio streams of digital movies upon request of the studios or othercontent providers. The digital watermarks can be used as a forensic tool tohelp identify the theater, location, and production version and the date andtime that a film plays in a specific theater.

*Broadcast Monitoring:**  *Broadcast monitoring allows clients to identifywhere, when and how their media content is being aired. This type ofinformation is important to many different types of users. For example, everyday, thousands of advertisements run in thousands of markets across thecountry. With highly regionalized cable, satellite and terrestrial delivery,advertising agencies and their clients need to know that the advertisementsthey pay for are actually being broadcast. By using digital watermarking-basedservices, these companies can monitor broadcasts in major media markets aroundthe world, verify compliance by broadcast partners, and measure theeffectiveness of the campaign. As another example of how such information isused, advertisers such as Coca Cola and Pepsi, and broadcast networks such asABC Television Network, NBC News Channel, BBC and Reuters Television, currentlyapply solutions from Digimarc partners that enable monitoring of broadcasts onover a thousand channels in more than 50 countries worldwide, studying thedistribution of their content, verifying compliance by broadcast partners, andmeasuring the effectiveness of broadcasts.

*Copy Prevention:*   Digitalwatermarks allow companies to control the use of copyrighted image, audio andvideo content. A watermark travels with the content, persisting through thechanges in file format, and through transformation between digital and analogform and back again. This allows the content owner to specify whether or howoften the work can be legally copied or shared without visually or audiblyimpairing the work. It also allows greater and safer dissemination ofcopyrighted works while at the same time ensuring appropriate compensation tothe owners. Digital watermarking from Verance, a Digimarc 

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businesspartner, has been deployed in conjunction with licensed DVD-audioimplementations to prevent playback of unauthorized copies. Digitalwatermarking is currently under consideration as an important security layerfor additional audiovisual media content and in October of 2005, DVD CopyControl Association (DVD-CCA) issued a Request for Expressions of Interest toevaluate technologies for the purpose of selecting a technology for use inmarking audio-visual content to convey certain content control information (“CCI”). Theselected technology will be used to enhance the Content Scramble System (“CSS”)copy protection system for audio-visual content that is used to protect DVDmovies. The DVD-CCA’s earlier watermarking evaluation efforts concluded in July of2002 without selection of a watermarking technology. According to the Request,it appears that the DVD-CCA anticipates that the optimal solution foraddressing their needs is likely to be audio watermarking. More information canbe found at *www.dvdcca.org.*

*Digital Image Management:**  *Our own digital watermarking product portfolioincludes our Digimarc ImageBridge and Digimarc MyPictureMarc products, focusedon digital image management during the first half of 2005. Digimarc alsoannounced upgrades to its image protection products targeted to creativeprofessionals, and published a beta version of an enhanced desktop image searchmade possible by digital watermarking.

Inaddition to these solutions, we believe that further digital watermark mediasolutions may emerge such as the following:

*Rights Management:**  *Because digital watermarks can be applied anddetected at various points between distribution and playback, they can bevaluable for rights management and re-association. Among other things, newapplications could be developed to allow consumers to move their digitallywatermarked content through their various playback devices (e.g. personalcomputers and CD players) and different DRM encryption and decryptionenvironments while preserving the identity of the content through use of adigital watermark and enabling rights re-association as appropriate indownstream devices.

*Filtering/Classification:**  *The popularity of peer-to-peer (“P2P”) music swappingservices, such as Napster, brought the issue of content and rights managementto a crisis point. Because P2P systems have difficulty determining which media filesare copyrighted and which are not, it is relatively easy for content to beillegally distributed across these networks. Digital watermarks could allow P2Psystems to better identify and distinguish copyrighted from non-copyrightedaudio or video files and thereby facilitate legal file sharing. Digitalwatermarks could also enhance P2P systems by enabling them to collaborate withrecord labels and other audio retailers to link to and market legitimatecopyrighted songs. A June 2005 U.S. Supreme Court ruling (Metro-Goldwyn-MayerStudios vs. Grokster)  identified digitalwatermarking as one of the solutions that could help curb copyrightinfringement and illegal distribution of music or movies shared across P2Pnetworks. The ruling recognizes the possibility that digital watermarks couldbe used to identify media content and associated rights and enable downstreamconsumers and systems to act appropriately as they access such content.

Digitalwatermarking technology can also enable consumers to more easily access andeffectively control digital content. Digital watermarking can be used to sortand search through audio, image and video files. For example, digital imagescould be embedded with digital watermarks that allow devices to classify orfilter them in order to help parents better manage the media intake of theirchildren, especially over the web.

*Remote Triggering:**  *Another potential application of digital watermarkingis use as a trigger—to make a playback device, such as a cell phone or adigital video recorder, perform an automatic action. When images, audio filesor video files are distributed or received, digital watermarks can signal theseplayback devices to display notification that the content is copyrighted, tripa download counter, or display additional related content and choices toconsumers.

*E-Commerce:*   Digimarcbelieves that digital watermarking could also be used to further enhance theconsumer experience through improved electronic- and mobile-commerceapplications. For example, if a 

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digitally watermarked songis played on a cell phone, a content ID could be used to look up informationabout the artist or find other songs that can be purchased with the click of abutton. In such an application, digital watermarking has the potential to giveconsumers more choices, better access and faster delivery of the products andentertainment they want.

**Technology and Intellectual Property**

The Company uses intellectual property (“IP”) todifferentiate its products and technologies, mitigate infringement risk, anddevelop opportunities for licensing. Licensing of our digitalwatermarking and related technologies is supported by a broad patent portfoliocovering a wide range of methods, applications, and system architectures.

Mostof our patents relate to various methods for embedding digital information invideo, audio, and images, whether such content is rendered in analog or digitalformats. The digital information is generally embedded by making subtlemodifications to the fundamental elements of the content itself, generally at asignal processing level. The changes necessary to embed  this information are so subtle that they aregenerally not noticeable by people during normal use. Because the message iscarried by the content itself, it is file-format independent. The messagegenerally survives most normal compression, edits, rotation, scaling,re-sampling, file-format transformations, copying, scanning and printing.

Toprotect our significant efforts in creating these technologies, we haveimplemented an extensive intellectual property protection program that relieson a combination of patent, copyright, trademark and trade secret laws, andnondisclosure agreements and other contractual provisions. As a result, webelieve we have established one of the world’s most extensive patent portfoliosin the field of digital watermarking, holding rights in the areas of digitalwatermarking, personal identification, and related technologies, with 222 U.S.and 59 foreign issued patents and more than 500 U.S. and foreign patentapplications on file as of December 31, 2005. Separately, we ownregistered trademarks in both the U.S. and other countries and have applied forother trademarks. We continue to develop and broaden our portfolio of patentedtechnologies, including digital watermarking and related applications andsystems, and other technologies related to secure ID systems. For ID systems-related technologies, the focusof patent development has been in the areas of imaging and printing systems,card architecture and materials, and security features. Some patents relate tofuture offerings or related technologies like smart cards, laser engraving andalternative 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**

TheCompany believes that the global market for secure identity managementsolutions is in the early adoption stage characterized by a fragmented supplychain with no dominant brands, emerging standards, and increasing concernsabout national and economic security, entitlement programs, and requirementsfor controlling access to information and physical assets.

Digimarcbelieves that U.S. driver license revenues will continue to grow due tobroadening use of the driver license as a secure credential beyond itstraditional role as evidence of competence to drive a motor vehicle,technological innovation, desire among issuers to improve security andefficiency, and new governmental regulations such as the REAL ID Act. We anticipate that these regulationswill result in more opportunities for States to expand their existing driverlicense systems using Federal dollars. For example, Congress hasappropriated $40 million for the fiscal year ending September 30, 2006 forgrants to States to assist them in making necessary upgrades, and the U.S.Department of Transportation has provided funding for pilot programs todemonstrate the utility of embedded data in a number of transportation safetyscenarios.

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The Company is diligently pursuing thesefunding opportunities, working with customers who are writing grant proposalsto upgrade and expand their operations. For example, the REAL ID Act mandatescertain changes in workflow and business rules. Several states are takingadvantage of these changes to drive an upgrade of legacy mainframeapplications, and are embarking on business process reengineering and mainframemigration or data center consolidation projects. These data center moves,combined with the availability of Federal dollars are drawing new competitorsto the U.S. DL market.

The industry model for the U.S. DL marketis characterized by long-term contracts awarded through competitive bids toprime contractors who take full responsibility for delivery and maintenance ofdriver license issuance systems. The retention rate for driver licensecustomers is high. Theinflux of grant money from the Department of Homeland Security and theDepartment of Transportation for projects relating to compliance with the REALID Act, commercial driver license systems, and protection of the Homeland maycause some changes in the procurement model, but we cannot predict thelikelihood or outcome of those changes at this time.

We believe thatmany aspects of our driver license issuance solutions may have value in otherforms of credentials and secure personal identification systems.  As the global market for secure personalidentification solutions develops, the Company believes that its position asthe largest supplier of government issued citizen identification documents inthe United States and Mexico and its extensive investments in research anddevelopment provide a good foundation for participation in the global marketfor government programs in establishing the identities of citizens and issuingassociated credentials.

The Company’s technology and IP have alreadyestablished broad relevance, as they are used in various products and solutionsaffecting a variety of media objects, from movies and music, to banknotes andsecure credentials. Our vision contemplates that the aggregation of these printand digital content markets creates an enormous overall opportunity for theCompany to address. Each media object enabled by the Company’s technologycreates the potential for several applications, such as tracking and monitoring,authentication, anti-counterfeiting, or linking to networks and enhancedservices. The Company believes the market for digital watermarking applicationsis in the early stages of development and that existing solutions representonly a nominal portion of the potential market for Digimarc’s products,services, and technologies. The Company cannot provide reliable estimates ofthe size of these markets as of the date of this report.

**Competition**

**Digimarccompetes for government business with system integrators, biometrics suppliers,security printers, card manufacturers, and smart card and other securitytechnology suppliers, including companies like Viisage (biometrics), Unisys(system integration) and De La Rue (security printer).  Each of 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, the Company expectsincreasing competition.  For instance,certain aspects of the REAL ID Act may expedite an existing trend toward centalissuance of driver licenses and Smart Card (“SC”) technologies.  While the Company is proficient at centralissuance, the possible acceleration of this trend could draw new competitionfrom classic security printers such as Canadian Banknote (CBN) and Giesieke &Devrient (G&D).**

The possibility of includingSC technologies in driver licenses is generating a great deal of publicdebate.  The SC industry is generallydriven by European chip manufacturers such as Infineon and Axalto seeking tomonetize investments to create contact and contactless microprocessor packagesand embedded operating systems, as well as chips for memory cards.  While successful in bank cards, mobile phoneSIMs and phone cards, Smart Cards have only recently begun to gain distributionas government-issued credentials.  TheU.S. government is a strong advocate. Federal identity standards are embracing Smart Cards for the military,transportation workers, and government employees and contractors, and new “ePassports”will carry a portrait in an on-book chip. Despite considerable investment by the federal 

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government,we believe no States have attempted or even piloted SC DLs.  We understand that in recent years, at leasttwo States have expressly considered and rejected SC DLs.  Emerging border control and Federal travelerprograms are considering SC concepts, but have not gained traction and faceprivacy issues.  The Company anticipatesthat it will be prepared to support requirements from customers for SCtechnology if, and when, such requirements arise.  

The Company is seeingincreased interest in the U.S. market from large systems integrators such asEDS, IBM Global Services, and Bearing Point. Smaller application providers are also emerging as point-productcompetition, including Covansys and Archon. 

Internationally, Digimarcsupplies credentialing systems, components or supplies to numerous foreigngovernments, including two Canadian provinces, Latvia, Mexico, Colombia andRussia.  Competition in 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 EDS. 

In all markets, Digimarc’sproduct and account strategy is intended to protect its existing customer base,continue to expand into accounts it does not presently service, and grow itsbusiness and workflow with existing customers. The key to success is building a strong customer relationship, based ondelivery of superior solutions, excellent service and profound understanding ofcustomer needs.

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.Such alternatives include technologies and solutions based on encryption or onpattern recognition. Going forward, the Company’s competitive position withincertain markets may be affected by factors such as inertia of the status quoand, positively or negatively, by changes in government regulations.

**Employees**

As of December 31, 2005 we had 449 full-timeemployees, including 67 in sales, marketing, technical support and customersupport; 132 in research, development and engineering; 81****infinance, administration, information technology and legal; and 169 in fieldoperations, manufacturing and supply chain. We also had approximately 95 contractworkers at December 31, 2005. Our future success will depend, in part, onour ability to continue to attract, retain and motivate highly qualifiedtechnical and management personnel, for whom competition is intense. Ouremployees are not covered by any collective bargaining agreement, and we havenever experienced a work stoppage. We believe that our relations with ouremployees are good.

**AvailableInformation**

We make available through our website atwww.digimarc.com our Annual Reports on Form 10-K, Quarterly Reportson Form 10-Q, Current Reports on Form 8-K, and amendmentsto these and other reports filed or furnished by us pursuant toSection 13(a) or 15(d) of the Securities Exchange Act of 1934 assoon as reasonably practicable after we file such materials with the Securitiesand Exchange Commission.

**ITEM1A:**       RISK FACTORS

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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**ITEM2:     PROPERTIES**

Our principal administrative, sales, marketing,support, research, development and engineering facility is located inBeaverton, Oregon. Our ID systems business is headquartered in Burlington,Massachusetts, with additional space in Fort Wayne, Indiana. Information aboutour office leases is set forth below.

| ** **                 | ** ** | **Square Feet** | ** ** | **Expires** | ** ** |
|----------------------------|------------|----------------------|------------|-------------|------------|
| Beaverton, Oregon          |       |                 | 46,000     |        |       | August 2011 |   |
| Burlington,  Massachusetts |       |                 | 60,000     |        |       | October 2010 |   |
| Ft. Wayne, Indiana         |       |                 | 48,000     |        |       | January 2007 |   |

 

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 commenced against us and certain of our current andformer directors and officers by or on behalf of persons claiming to havepurchased or otherwise acquired our securities during the period from April 17,2002 to July 28, 2004. These lawsuits were filed in the United StatesDistrict Court for the District of Oregon and were consolidated into one actionfor all purposes on December 16, 2004. On May 16, 2005, plaintiffsfiled an amended complaint. The complaint asserted claims under the federalsecurities laws, specifically Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, relating to our announcement that we haddiscovered errors in our accounting for software development costs and projectcapitalization and other project cost capitalization accounting practices, andthat we likely would be required to restate our previously reported financialstatements for full fiscal year 2003 and the first two quarters of 2004.Specifically, the complaint alleged that we issued false and misleadingfinancial statements and created a misperception regarding the profitability ofthe company in order to inflate the value of Digimarc stock, which permittedinsider sales of personal holdings at inflated values, and that we maintainedinsufficient accounting controls, which created an environment where improperaccounting could be used to manipulate financial results. The complaint soughtunspecified damages.  On November 30,2005, the Court granted our motion to dismiss the amended complaint on thegrounds that plaintiffs had failed to allege facts sufficient to support theirallegation that the defendants knowingly or recklessly acted in violation ofthe securities laws. Plaintiffs filed a second amended complaint on January 17,2006. On February 14, 2006, we filed a motion to dismiss the secondamended complaint on the grounds that plaintiffs still fail to allege factssufficient to support their allegation that the defendants knowingly orrecklessly acted in violation of the securities laws. This motion is pending. Dueto the inherent uncertainties of litigation and because the lawsuits are stillat a preliminary stage, the ultimate outcome of the matter cannot be predicted.

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. On July 19, 2005, the court granted the Company’s motion to staythese consolidated actions in favor of a shareholder derivative action to befiled by plaintiffs in the Circuit Court of the State of Oregon for the Countyof Washington. On August 25, 2005, the California plaintiffs filed two newderivative lawsuits in the United States District Court for the District ofOregon. On October 17, 2005, defendants filed a motion to dismiss thesecomplaints for lack of subject matter jurisdiction and failure to state aclaim. This motion currently is pending. Separately, on November 8, 2004,a letter was mailed to the chairman of the Company’s Board of Directors by alaw firm purporting to represent a shareholder of the Company, demanding thatthe board commence a civil action against each of the directors and officers onbehalf of the Company to recover for damages alleged to have 

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been incurred as a resultof alleged breaches of fiduciary duties. On or about April 6, 2005, thisshareholder filed a purported shareholder derivative suit against certain ofthe Company’s officers and directors, naming the Company as a nominaldefendant, in the Circuit Court of the State of Oregon for the County ofWashington. On August 25, 2005, the individual defendants filed a motionto stay this state court derivative lawsuit, and on September 26, 2005,the court entered a stipulated order granting the motion and staying the casepending the outcome of an investigation by a committee appointed by the Company’sBoard of Directors of the claims asserted in the demand letter and in thederivative lawsuits. That stay expired on February 28, 2006, anddefendants have until March 31, 2006 to respond to the complaints in thislawsuit. These suits claim that certain of these officers and directorsbreached their fiduciary duties to the Company’s shareholders and to theCompany. The complaints are derivative in nature and do not seek relief fromthe Company. The Company’s Board of Directors has appointed a committee toinvestigate the claims asserted in the demand letter and in the derivativelawsuits.

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 hearinghas been set for April 26, 2006. Following the hearing, if the courtdetermines that the settlement is fair to the class members, the settlementwill be approved. There can be no assurance that this proposed settlement will beapproved and implemented in its current form, or at all. Due to the inherentuncertainties of litigation and because the settlement approval process is at apreliminary stage, we cannot accurately predict the ultimate outcome of thematter.

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The Company is subjectfrom time to time to other legal proceedings and claims arising in the ordinarycourse of business. Although the ultimate outcome of these other matters cannotbe determined, management believes that the final disposition of theseproceedings will not have a material adverse effect on the consolidatedfinancial position, results of operations, or liquidity of the Company.

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

None.

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**PART II**

**ITEM5:**               MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURTIES

Our common stock is traded on The Nasdaq National Marketunder the symbol “DMRC.” The closing price of our common stock on TheNasdaq National Market was $7.76 as of January 31, 2006. The followingtable lists the high and low sales prices of our common stock for the periodsindicated, as reported by The Nasdaq National Market.

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **     | ** ** | **High**                                   | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                          | 9.43       |   | $ | 5.82 |   | $ | 15.45 |   | $ | 11.02 |   |
| Second quarter |       | $                                          | 6.23       |   | $ | 4.48 |   | $ | 13.91 |   | $ | 9.90 |   |
| Third quarter  |       | $                                          | 7.02       |   | $ | 5.24 |   | $ | 13.81 |   | $ | 7.45 |   |
| Fourth quarter |       | $                                          | 6.88       |   | $ | 5.90 |   | $ | 10.01 |   | $ | 8.42 |   |

 

At February 28, 2006, there were 123 stockholdersof record of our common stock, as shown in the records of our transfer agent.

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

The following table sets forth information regardingthe Company’s purchases of its equity securities during the quarter endedDecember 31, 2005, all of which were shares subject to restricted stock awardsthat we purchased from five of our executive officers to cover applicable taxwithholding obligations when these 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, 2005 to  |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| October 31. 2005    |       |       | —     |                                                                       |       |                                                                      | —     |                                                                                                                                                       |       |                                                                                                                                                                                                        | —     |   |   |   | — |   |   |
| Month 2             |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| November 1, 2005 to |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| November 30, 2005   |       |       | —     |                                                                       |       |                                                                      | —     |                                                                                                                                                       |       |                                                                                                                                                                                                        | —     |   |   |   | — |   |   |
| Month 3             |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| December 1, 2005 to |       |       |       |                                                                       |       |                                                                      |       |                                                                                                                                                       |       |                                                                                                                                                                                                        |       |   |   |   |   |   |   |
| December 31, 2005   |       |       | 19,484     |                                                                       |       |                                                                      | $          | 5.90                                                                                                                                                       |       |                                                                                                                                                                                                        |       | — |   |   |   | — |   |   |
| Total.              |       |       | 19,484     |                                                                       |       |                                                                      | $          | 5.90                                                                                                                                                       |       |                                                                                                                                                                                                        |       | — |   |   |   | — |   |   |

 

**ITEM 6:**               SELECTEDFINANCIAL DATA

The selected financialdata set forth below should be read in conjunction with the consolidatedfinancial statements and the notes to the consolidated financial statements and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” which are included elsewhere in this report. The consolidatedstatement of operations and balance sheet data as of and for each of the fiveyears in the period ended December 31, 2005, are derived from our auditedconsolidated financial statements.

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| ** **                                                       | ** ** | **Year Ended December 31,**                         | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of Operations Data:   ** |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                          |       | $                                                                  | 101,053    |   | $ | 92,947 |   | $ | 85,591 |   | $ | 86,617 |   | $ | 14,878 |   |
| Net income (loss)                                                |       | $                                                                  | (23,097    | ) | $ | (9,022 | ) | $ | 175 |   | $ | (8,689 | ) | $ | (19,158 | ) |
| Net income (loss) per  share—basic                          |       | $                                                                  | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   | $ | (0.50 | ) | $ | (1.15 | ) |
| Net income (loss) per  share—diluted                        |       | $                                                                  | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   | $ | (0.50 | ) | $ | (1.15 | ) |
| Weighted average  shares—basic                              |       | 20,485                                                             |       | 20,326 |   | 18,572 |   | 17,361 |   | 16,704 |   |
| Weighted average  shares—diluted                            |       | 20,485                                                             |       | 20,326 |   | 19,351 |   | 17,361 |   | 16,704 |   |

 

| ** **                                    | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|
| ** **                                    | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                    | ** ** | **(in thousands)** | ** ** |
| **Consolidated Balance Sheet Data:**          |       |                    |       |   |   |   |   |   |   |   |   |
| Total assets                                  |       | 140,239                 |       | 163,287 |   | 161,153 |   | 132,467 |   | 129,367 |   |
| Long-term obligations, net of current portion |       | 969                     |       | 1,112 |   | 1,286 |   | 7 |   | 33 |   |

 

In December 2001, weacquired the assets and assumed certain liabilities of LGP. LGP provided securepersonal identification card systems to the majority of state departments ofmotor vehicles in the United States, as well as to various non-U.S. governmentagencies. Following the acquisition of LGP, the personal identification systemsbusiness has become our dominant source of revenue.

**ITEM7:**               MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contains forward-lookingstatements relating to future events or the future financial performance ofDigimarc, which involve risks and uncertainties. Our actual results coulddiffer materially from those anticipated in these forward-looking statements.Please see the discussion regarding forward-looking statements included in thisItem 7, under the caption “Safe Harbor Statement under the PrivateSecurities Litigation Reform Act of 1995.”*

*Although Digimarc believes that the expectationsreflected in such forward-looking statements are reasonable, it cannot give anyassurances that these expectations will prove to be correct. Such statements bytheir nature involve substantial risks and uncertainties that couldsignificantly affect expected results. Actual future results could differmaterially from those described in such forward-looking statements, andDigimarc does not intend to update or revise any forward-looking statements asa result of new information, future events or otherwise. Readers are urged tocarefully review and consider the various disclosures made by us which attemptto advise interested parties of the factors which affect our business,including without limitation the disclosures made under the caption “FactorsAffecting Forward Looking Statements” in this Item 7, the auditedconsolidated financial statements and related notes included in this AnnualReport on Form 10-K, and other reports and filings made with theSEC.*

*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**

The Company has madesignificant progress in developing the market for digital watermarking in itsfirst decade. Digimarc and its business partners have enabled digitalwatermarking to be deployed in billions of media objects (including banknotes,government-issued credentials, music, movies, photographs and other digitalimages, and television and radio broadcasts) and hundreds of millions ofdigital devices around the world.

We anticipate futureopportunities to license our digital watermarking patents for use in variousapplications and we view these potential opportunities as an important elementof our long-term shareholder value proposition. At present, the greatestinterest in digital watermarking is in the 

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entertainmentfield. The Company and its business partners plan to continue efforts topropagate digital watermarking in music, movies, television and radiobroadcasts, images and printed materials. The majority of the major music labels are using digital watermarkingsolutions for forensic tracking of pre-release music. They are obtaining thetracking solutions directly from Digimarc and from our licensees. Motionpicture studios have begun following suit, using forensic tracking based ondigital watermarking as part of increased piracy deterrence measures in theAcademy Award screener program. In the television business, three companieshave licensed our patents either directly or through sublicenses and deployedmonitoring systems to track radio and television programs and advertisements inmajor media markets around the world. In the fourth quarter of 2005, weannounced new license agreements with Thomson and with Dolby and its Cineasubsidiary—two of the leading providers of digital watermarking solutionsdesigned to improve the management, distribution and protection of digitalmedia content, including digital cinema.

Certain other marketdevelopments are encouraging for our strategy as well. The influx of imaging inmobile devices—mainly cell phones and PDAs—is inspiring a renewed interest indigital watermarking as the means of linking printed materials to Internetservices, an initiative that we launched in 2000. We believe that a highlysupportive change in market dynamics is underway. A number of companies,ranging from start-ups to industry leaders Nokia and NTT have announcedinitiatives aimed at using various signaling means, including bar codes, RFID,and digital watermarking to simplify the user interface for mobile deviceaccess to Internet services.  

Since inception, we haveinvested a significant portion of our resources and capital in attracting topsenior management, in developing our products and technology, and in buildingour sales and marketing organizations. We incurred significant losses frominception through the fiscal year ended December 31, 2002 and during 2004and 2005. As of December 31, 2005, we had an accumulated deficit of$88.0 million. We expect to continue to invest significant financial andmanagement resources in the acquisition and development of new governmentcustomers and in the development of new market opportunities for digitalwatermarking.

**Products andServices**

The scope of proprietarytechnologies supporting the Company’s products, services and licensing isgetting broader, expanding beyond digital watermarking; and deeper, as thenumber of Digimarc’s patents continues to grow. Digital watermarking remains atthe heart of the business, as a strategic component of nearly all of theCompany’s product offerings. It has already proven to be a powerfuldifferentiator in banknote security, giving rise to a long-termrelationship with an international consortium of leading Central Banks. We areworking to develop a similar success in secure identity management systems. Asof the end of 2005, the technology is under contract to be deployed by 15 StateDL Issuers, representing more than 40% of the annual U.S. driver licenseissuance volume, and one foreign issuer. The United States Department ofTransportation provided a grant to Digimarc to pilot improvements in trafficsafety through the authentication of driver licenses using digitalwatermarking-based security features. Workingwith the State of Nebraska, the project included pilots with law enforcementand the retail sale of age-controlled products, demonstrating valuableapplications to enhance citizen and traffic safety.

With respect to secure IDsystems, we have obtained extensions and upgrades from a number of governmentcustomers in 2005, including a long-term contract with substantial upgrades inTexas, contract term extensions in California and Kansas, and a new IDVScontracts in Massachusetts. In foreign markets, we entered into an agreement,funded by the Organization for American States (OAS), to produce more than 3million voter ID cards for use in the recent Haitian election. This was thefirst ever photo identification card for Haitian citizens. We produced thesecards in our secure factories in Mexico. In addition, we won contract awardsfor the issuance of voter ID cards in Yemen and Liberia, and continued toproduce voter ID cards for Mexico and to provide card consumables, maintenanceand operations support for ongoing projects in the United Kingdom (the “UK”),Latvia, Russia, Botswana, Lesotho, Philippines and New Zealand. In February2006, the UK Driver Vehicle Licensing Agency (“DVLA”) 

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awardedDigimarc a contract extension to June 2007, with an estimated value of $4.3million, to provide card consumables, maintenance and operations support forproduction of the UK driver license. The DVLA has entered into a contract witha consortium led by IBM to implement a new driver license system. Implementationof the replacement system is running behind schedule, but is expected to beginproducing licenses sometime in the second half of 2007. The Company continuesto market its products and services for possible use in the new system. However,there can be no assurance that Digimarc will have a continuing role in theproduction of UK driver licenses after the replacement system is implemented.

We are seeing anincreasing recognition of the broad security value of the driver license in theU.S. and are encouraged by developments such as the REAL ID Act and Congress’recent appropriation of $40 million in Federal funding in the fiscal yearending September 30, 2006 for grants to States to assist them in makingnecessary upgrades to their driver license systems. The availability of fundingfrom the Department of Homeland Security for pilot programs is dependent on theStates’ ability to present a plan consistent with achieving REAL ID compliancein 2008. We believe that our newest products—IDVS and IDMarc—will enable us tocompete effectively for upgrades and add-on business that may result from theheightened importance of security features in U.S. DLs. We also anticipateopportunities to win new business in several foreign markets.

**CriticalAccounting Policies and Estimates**

The preparation ofconsolidated financial statements in accordance with U.S. generally acceptedaccounting principles requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to bad debts, inventories,intangible assets, income taxes, restructuring, long-term service contracts,warranties, investments, and contingencies and litigation. We base ourestimates on historical experience and on various other assumptions we believeto be reasonable under the circumstances. Actual results may differ from theseestimates under different assumptions or conditions.

Certainof our accounting policies require higher degrees of judgment than others intheir application. These include revenue recognition on long-term servicecontracts, impairments and estimation of useful lives of long-lived assets,inventory valuation, reserves for uncollectible accounts receivable, andcontingencies and litigation. We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements:

**Revenuerecognition 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. Revisions to our estimates have been lessthan 0.5% of total revenue in every period reported in 2005, 2004 and 2003. Anyestimated amounts are included in unbilled receivables on the balance sheetuntil the actual production information is available and the billing occurs.Any estimation process involves inherent risk. We reduce the inherent riskrelating to production estimation through our approval and monitoring processesrelated to accounting estimates. We also evaluate contracts for multipleelements and account for these items under the appropriate accountingliterature.

Revenue from professionalservices arrangements is generally determined based on time and material or acost plus a profit margin measure. Revenue for professional services isrecognized as the services 

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are performed. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the consolidatedbalance sheets.

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically assess long-lived assets forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable, in accordance with theprovisions of Statement of Financial Accounting Standards (“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,depending on the nature of the asset. If our estimates of projected future cashflows were too high by 10%, we believe there would be no material impact on thereported value of intangible assets on our Consolidated Balance Sheet. Also, weperiodically review the useful lives of long-lived assets whenever events orchanges in circumstances indicate that the useful life may have changed. If theestimated useful lives of such assets do change, we adjust the depreciation oramortization period to a shorter or longer period, based on the circumstancesidentified.

**Inventoryvaluation:****  **Inventoryconsists primarily of consumable supplies that are used in the production ofdriver licenses and products held for resale to customers. We value inventoryat the lower of cost or market value (which lower amount is the net realizablevalue). We reduce the value of our inventory for estimated obsolescence orunmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand andmarket conditions. If actual market conditions are less favorable than thoseprojected by management, additional inventory write-downs may berequired.

**Reservesfor 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. If ourestimate of uncollectible accounts were too low by 10%, we believe there wouldbe no material impact on the reported value of accounts receivable on ourconsolidated balance sheets.

**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 losscontingency because one or both of the conditions pursuant to SFAS No. 5are not met, but the probability of an adverse outcome is at least reasonablypossible, we will disclose the nature of the contingency and provide anestimate of the possible loss or range of loss, or state that such an estimatecannot be made.

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**Stock-basedcompensation:****  **TheCompany has various stock-based compensation plans, including stock incentiveplans and an employee stock purchase plan.  In 2005, the Company continued to apply therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees,*and related interpretations including FinancialAccounting Standards Board (“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. Generally, under APB Opinion No. 25,stock-based compensation expense is recognized only for stock awards grantedwith an exercise price below fair market value on the date of grant.

On December 15, 2005, theBoard of Directors of the Company approved the acceleration of vesting of theCompany's outstanding stock options with option exercise prices equal to orgreater than $9.00. The acceleration applies to all options outstanding as ofDecember 31, 2005 under the Company's Restated 1999 Stock Incentive Plan and2000 Non-Officer Employee Stock Incentive Plan, except for options held bymembers of the Company's Board of Directors. Options to purchase 422,248 sharesof the Company's common stock, or 6% of the Company's total outstandingoptions, with a weighted average exercise price of $11.51 and varying remainingvesting schedules, are subject to this acceleration and become immediatelyvested and exercisable as of December 31, 2005. Of these 422,248 options,120,972 options are held by the Company's executive officers.  As a result of this acceleration, the Companyreduced its exposure to the effects of the Financial Accounting StandardsBoard's Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment (SFAS 123R), which requires the Company to recognizestock-based compensation expense associated with stock options based on thefair value method for periods beginning after December 31, 2005.  The incremental pro forma expense as a resultof the acceleration was $1,362.  Thisamount represents our best estimate of the reduced exposure under SFAS 123Rwith respect to this acceleration. 

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. Theacceleration applied to all options outstanding under the Company’s Restated1999 Stock Incentive Plan and 2000 Non-Officer Employee Stock Incentive Planthat would not have otherwise vested in full by June 30, 2005 inaccordance with their terms. The effective date of the vesting acceleration isDecember 31, 2004. The $15.00 exercise price was selected because it washigher than (i) the price at which the Company’s stock had traded duringthe period prior to the announcement of the restatement of prior financialresults, (ii) the average trading price of the Company’s common stock forthe last two years, and (iii) the purchase price per share of theCompany’s common stock in the Company’s private placement in August 2003.Options to 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. Accelerating the vesting ofthe Company’s options prior to the time at which these new accounting changesbecome effective accelerates the recognition of any remaining expensecalculated under Statement 123 associated with these options. No additionalcompensation expense was recorded in the statement of operations as the optionsthat were accelerated had an exercise price greater than the fair market valueof the shares underlying the options on the date of the modification. Theincremental pro forma expense as a result of the acceleration was $1,138.  This amount represents our best estimate ofthe reduced exposure under SFAS 123R with respect to this acceleration.  Of these 310,057 options, approximately 50,000options are held by the Company’s executive officers.  Other than the Company’s chairman and chiefexecutive officer, no director of the Company holds any options subject to theacceleration.

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**Results of Operations**

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

| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                       | 84         | % |   |   | 80 | % |   |   | 84 | % |   |
| Product and subscription                         |       |                                       | 16         |   |   |   | 20 |   |   |   | 16 |   |   |
| Total revenue                                    |       |                                       | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                       | 61         |   |   |   | 51 |   |   |   | 48 |   |   |
| Product and subscription                         |       |                                       | 7          |   |   |   | 13 |   |   |   | 9 |   |   |
| Total cost of revenue                            |       |                                       | 68         |   |   |   | 64 |   |   |   | 57 |   |   |
| Gross profit                                     |       |                                       | 32         |   |   |   | 36 |   |   |   | 43 |   |   |
| Operating expenses:                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                                       | 16         |   |   |   | 14 |   |   |   | 15 |   |   |
| Research, development and engineering            |       |                                       | 13         |   |   |   | 9 |   |   |   | 9 |   |   |
| General and administrative                       |       |                                       | 21         |   |   |   | 19 |   |   |   | 13 |   |   |
| Amortization of intangibles                      |       |                                       | 4          |   |   |   | 3 |   |   |   | 4 |   |   |
| Intellectual property                            |       |                                       | 2          |   |   |   | 2 |   |   |   | 2 |   |   |
| Total operating expenses                         |       |                                       | 56         |   |   |   | 47 |   |   |   | 43 |   |   |
| Operating income (loss)                          |       |                                       | (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 |       |                                       | (23        | ) |   |   | (10 | ) |   |   | 1 |   |   |
| Provision for  income taxes                      |       |                                       | —     |   |   |   | — |   |   |   | (1 | ) |   |
| Net income (loss)                                |       |                                       | (23        | )% |   |   | (10 | )% |   |   | — | % |   |

 

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

*Revenue*

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

 

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Total revenue increased $8.1 million from 2004 to 2005.The increase resulted primarily from additional government programs added inlate 2004 and early 2005, such as Florida, Alabama, Mexico, Latvia and Ohiothat were either at or near full production by the end of 2005.

*Service.**  *Service revenue consists primarily of cardrevenues from government-issued credentials that are produced with our issuancesystems and billed and recognized on a price-per-card basis, softwaredevelopment services, and hardware and software maintenance. The majority ofservice revenue arrangements are typically structured as price-per-card productagreements, time and materials consulting agreements, or fixed price consultingagreements.

The $10.8 million increase in Service revenue wasprimarily due to issuance revenue from new programs for Mexico and Latvia,which started generating revenue in the second quarter of 2004; Florida, whichstarted in the third quarter of 2004; Ohio, which started in the first quarterof 2005; and Alabama, which started in the second quarter of 2005, offsetpartially by contracts that ended and contracts that converted to consumablesales.

*Productand subscription.**  *Productand subscription revenue consists primarily of revenue from the sale ofequipment and consumables related to government-issued credential issuancesystems, patent and software licensing, and subscriptions related to varioussoftware products.

The $2.7 million decrease in product andsubscription revenue was primarily related to the timing of large non-recurringsales to domestic and foreign customers that occurred in 2004, partially offsetby smaller non-recurring sales to domestic and foreign customers that occurredin 2005.

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 31,2005 will generate approximately $230 million in revenue during the nextseven years. We expect approximately $70 million of this amount to berecognized as revenue during 2006. This amount includes production volumesreasonably 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, 2004 was $260 million.

Factors that leadto increased backlog include:

·       competitivebid wins;

·       renewalswith current customers;

·       add-onsales to current customers; and

·       contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Factors that leadto decreased backlog are:

·       recognitionof revenue associated with backlog currently in place;

·       periodsfollowing low bid activity;

·       contractswith shorter contractual periods replacing contracts with longer contractualperiods;

·       customersextending or renewing contracts on a year to year basis; 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,in the fourth quarter of 2005 we received notice of a competitive bid win andan extension, which added approximately $40 million to our backlog. Overthe next year or so, we anticipate 

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several States may requestbids on their driver license issuance system programs. If this results inunusually high bid activity and we are successful with our bids, backlog couldgrow significantly, particularly if we acquire new accounts through competitivewins. On the other hand, two of our recent domestic driver license issuancesystem contracts did not follow the prevailing industry price-per-card model,but were structured instead as hardware and consumable sales. Although suchsales are positive growth indicators for our business, they can lead to lowerreported backlog. Likewise, when our customers choose not to open a contractrenewal for competitive bid because of high satisfaction and instead renew ourcontract on a sole source basis (typically, one to three years), our backlogmay decline because the renewal terms may be shorter than typical initial terms(typically, five years) following competitive bids.

Therecan be no assurance that our backlog will result in actual revenue in anyparticular period, because the orders, awards and contracts included in ourbacklog may be subject to modification, cancellation or suspension. We may notrealize revenue on certain contracts, orders or awards included in our backlogor the timing of such recognition may change.

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

 

In non-U.S. markets, where we provide driver license,national identification, and voter identification systems, services, andcomponents in partnership with local card producers, security printers, systemintegrators, and others, we may be responsible for delivering hardware,software, or consumables to the prime contractor; whereas, in the United Stateswhere we generally service as prime contractor, we are responsible forintegrating the components of the system to the customer’s specifications. Internationalrevenue in 2005 was essentially the same as in 2004 because incrementalissuance revenue from Mexico and Latvia largely offset a one time sales ofproducts that occurred in 2004. International sales for us have typically takenthe form of an outright sale of equipment and/or consumables to non-U.S.government agencies or their prime contractors. These sales often can be large,carry relatively low margins and may cause noticeable spikes in quarterly revenueand variations in gross profit trends. We enter into such contracts from timeto time to maintain market presence and customer and partner relationships, assuch programs often transition to more profitable digital technologies overtime. Due to the nature of such international programs and customers, thetiming of these sales is somewhat less predictable than are service revenuesprovided by domestic customers and, consequently, international sales can occurunevenly during the course of a year. We believe that international growthopportunities exist for us and we expect to continue to invest in personnel andresources to support our potential revenue growth outside of the U.S.

We had no customer thataccounted for more than 10% of our revenue in 2005, 2004 or 2003.

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*Cost of Revenue*

| ** **                                             | ** ** | **Twelve Months Ended** | ** ** | **Percent**  | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|
| ** **                                             | ** ** | **December 31,**             | ** ** | **Increase** | ** ** |
| ** **                                             | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                                       |       |                              |       |         |       |   |   |   |   |
| Service                                                |       | $                                 | 61,465     |         | $          | 47,591 |   |   | 29 | % |   |
| Product and subscription                               |       | 6,707                             |       | 11,784       |       |   | (43 | %) |   |
| Total                                                  |       | $                                 | 68,172     |         | $          | 59,375 |   |   | 15 | % |   |
| Cost of revenue  (as % of related revenue components): |       |                              |       |         |       |   |   |   |   |
| Service                                                |       | 73%                               |       | 64%          |       |   |   |   |   |
| Product and  subscription                              |       | 41%                               |       | 62%          |       |   |   |   |   |

 

The cost of service revenueprimarily includes costs of consumables used in delivering a service,compensation for software developers, quality assurance personnel, productmanagers, field operations personnel, business development personnel andoutside contractors, depreciation charges for machinery, equipment andcapitalized software, deployment costs used specifically for service delivery,provisions for obsolete and excess inventories, travel costs directlyattributable to service and development contracts, and charges forinfrastructure and centralized costs. The $13.9 million increase wasprimarily the result of higher consumables and general support costs related tothe higher revenue identified above, higher depreciation on revenue-generatingassets, increased costs to deliver support and maintenance for new and existingprograms, and increased freight costs related to higher shipping activity,partially offset by lower charges for inventory reserves.

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 the services offered to our subscription customers. The$5.1 million decrease was a combination of lower revenues and lower costson the 2005 revenue mix.

*Gross Profit*

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

 

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The $0.7 million decrease in gross profit for the yearended December 31, 2005 compared to the prior year was largely for thereasons stated above under the “Cost of Revenue” section.

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

| ** **                                | ** ** | **Twelve Months Ended** | ** ** | **Percent**  | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|--------------|------------|
| ** **                                | ** ** | **December 31,**             | ** ** | **Increase** | ** ** |
| ** **                                | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** |
| Cost of revenue                           |       |                              |       |         |       |   |   |   |   |
| Variable                                  |       | $                                 | 28,083     |         | $          | 29,253 |   |   | (4 | )% |   |
| Fixed field support and manufacturing     |       | 25,997                            |       | 21,511       |       |   | 21 | % |   |
| Program depreciation                      |       | 14,092                            |       | 8,611        |       |   | 64 | % |   |
| Total                                     |       | $                                 | 68,172     |         | $          | 59,375 |   |   | 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 of revenue, we have experienceda slight reduction in our variable costs to deliver incremental revenue.  Such costs include the price of materials andlabor to produce an identification card, direct costs of hardware and softwaredelivered and other costs having a variable component to our costs. Theimprovement relates to continued pricing improvement with vendors and improvedyields during the manufacturing process.

Fixed field support andmanufacturing is a category that includes field operations, field support,manufacturing, and supply chain costs. These costs are considered fixed with respect to supporting currentcontracts.  As new contracts are enteredinto and delivered, the overall level of fixed costs increases.  The increase in fixed costs are primarily dueto newer contracts requiring additional headcount as well as travel costs tosupport them.

Program depreciation showed the largest increase ofthe three components of cost of revenue. This element of cost consists ofamortization and depreciation of costs incurred during the delivery process,where such costs are capitalized and then amortized or depreciated over thelife of the useful lives of the assets to which the costs relate. The currenthigher fixed costs as a percentage of revenue are a result of a severalfactors. The primary factor relates to some new programs involving competitivewins, where we have provided a complete system replacement using advancedtechnologies. These programs have recently been completed and transitioned fromdeployment to revenue production, and thus are now affecting margins. Theseinstallations were particularly challenging for us, representing a stretch interms of scope from our historical system deliveries. We were successful indelivering these programs, but at higher costs than have been customary. In oneother case, we bid a program aggressively as part of a broader marketdevelopment strategy that we believe will yield good long-term performance. Thefixed costs for these systems, which include amortization and depreciation ofcosts capitalized during the delivery process as well as field service and operationalcosts to manage and maintain them, are higher than average and, thus, reducereported margins. We anticipate that we will be able to improve margins inthese accounts over time and earn a good return on investment over the life ofthe account relationship.

We have observed seasonality in the production ofdriver license issuances and corresponding revenue in the United States, withlarger volumes in the second and third quarter of 2005, and generally lowervolumes in the first and fourth quarters. The fourth quarter is usually theseasonally lowest quarter each year. We use the straight line method ofdepreciation and amortization for program-related assets. The combination ofseasonality and straight line depreciation and amortization can cause significantvariations 

27

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in quarterly gross margintrends, generally increasing margins as a percentage of revenue in the secondand third quarters of 2005 and decreasing margins as a percentage of revenue inthe first and fourth quarters of 2005, while having a neutral effect on ayearly basis.

We are engaged in ongoingstudy of the predictability of seasonal trends and the productivity of programassets and and are evaluating potential changes in our depreciation andamortization methods and estimates to more closely match costs to the usefullives of program assets and seasonality in our business.

*Operating Expenses*

*Sales and marketing*

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

 

Sales and marketing expenses consist primarily ofcompensation, benefits and related costs of sales and marketing employees,product managers and sales engineers, as well as recruiting, travel, marketresearch, costs associated with marketing programs, such as trade shows, publicrelations and new product launches, and charges for infrastructure andcentralized costs.*  *

The increase insales and marketing expenses of $2.9 million resulted primarily from thefollowing:

·       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;

·       partiallyoffset by an impairment charge of $0.5 million taken in 2004 with no suchcharge in 2005 related to investments in companies licensed to market ourdigital watermarking technology.

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

*Research, development and engineering*

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

 

Research, development and engineering expenses consistprimarily of compensation, benefits and related costs of software developersand quality assurance personnel and payments to outside contractors, thepurchase of materials and services for product development, primarily in thecard systems area, and charges for infrastructure and centralized costs.

28

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The increase inresearch, development and engineering expenses of $4.8 million resultedprimarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, and incentiveplans increased $2.5 million due to personnel mix for higher level focus ongovernment program activities, and higher benefit program costs, offset by adecrease in contract labor of $2.2 million as we transitioned contractors tofull 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

·       increasedallocated infrastructure and centralized costs of $0.5 million.

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

*General and administrative*

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

 

General and administrative expenses consist primarilyof compensation, benefits and related costs of executive, finance andadministrative personnel, legal, human resources and other professional fees,and charges for infrastructure and centralized costs.

The increase ingeneral and administrative expenses of $4.4 million resulted primarilyfrom 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 andsoftware upgrades; and,

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

We anticipate that we willinvest below our current run rate of dollars in general and administrative inthe near term. We are examining means to gain efficiencies to reduce generaland administrative spending as a percentage of revenue in the longer term.

29

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*Amortization ofintangible assets*

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

 

We recorded a “customer relationship” intangible assetfrom the 2001 LGP acquisition. The accounting for this intangible asset is donein accordance with Financial Accounting Standards Board (“FASB”) Statement Nos.141, *Business Combinations* and 142, *Goodwill and Other Intangible Assets*. These statementsrequire the recording of intangible assets under purchase accounting rules, andrequire the amortization of such intangible assets over their expected usefullife. As a result, in December 2001 we recorded $29.5 million ofintangible assets related to the acquisition of certain assets and assumptionof certain liabilities from Polaroid and affiliates. These intangible assetswere set up to amortize over a 12-year period, representing the expecteduseful life at the date of the acquisition. Changes in contract status andcustomer relationships may lengthen or shorten the expected useful life of suchintangible assets, or cause an impairment charge related to the intangibleasset, so some variability is expected to exist related to intangiblesdepending on internal and external factors. Amortization expense increased in2005 due to the loss of certain contracts with relatively high intangiblebalances, and the reassessment of useful lives for certain internationalcustomers.

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

| ** **                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Amortization of  intangibles |       | $        | 2,500      |     | $          | 1,900    |       | $        | 1,900      |     | $          | 1,900 |   | $ | 1,900 |   |
|                              |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

*Intellectual property*

| ** **                                     | ** ** | **Twelve Months Ended** | ** ** | **Percent**                      | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **December 31,**             | ** ** | **Increase**                     | ** ** |
| ** **                                     | ** ** | **  2005  **  | ** ** | **  2004  ** | ** ** | **(Decrease)** | ** ** |
| Intellectual  Property                         |       |                              | 2,014      |                             |       |   | 2,162 |   |   |   | (7 | )% |   |
| Intellectual Property  (as % of total revenue) |       |                              | 2%         |                             |       |   | 2% |   |   |   |   |   |   |

 

Theintellectual property costs primarily consist of employee-related expenses suchas salaries, benefits, recruiting costs, and incentive plans as well as costsassociated with documenting, applying for, and maintaining patents. Thedecrease of $0.1 million was primarily due to consulting fees paid tothird-party attorneys related 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 being recognized over the four-year vestingperiod of the related restricted stock using the straight-line method. 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,**                        | ** ** |
| ** **                             | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Sales and  marketing                   |       |                                         | $          | — |   |   |   | $ | — |   |   |
| Research,  development and engineering |       |                                         | —     |   |   |   | — |   |   |
| General and  administrative            |       |                                         | 506        |   |   |   | — |   |   |
|                                   |       |                                         | $          | 506 |   |   |   | $ | — |   |   |

 

30

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OnDecember 16, 2004, the FASB issued Statement No. 123(R), *Share Based Payment*, which is a revision of StatementNo. 123 and supersedes APB Opinion No. 25. StatementNo. 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be valued at fair value on the date ofgrant, and to be expensed over the applicable vesting period. Pro formadisclosure of the income statement effects of share-based payments is no longeran alternative. In addition, companies must recognize compensation expenserelated to any awards that are not fully vested as of the effective date.Compensation expense for the unvested awards will be measured based on the fairvalue of the awards previously calculated in developing the pro forma disclosuresin accordance with the provisions of Statement No. 123. The effective datefor this pronouncement is for the next fiscal year beginning afterDecember 15, 2005. The Company has adopted SFAS 123(R) effectiveJanuary 1, 2006. The Company is evaluating the requirements of SFAS 123(R) andexpects that the adoption of SFAS 123(R) will have a material impact onthe Company’s results of operations. The Company has not yet determined themethod of adoption or the effect of adopting SFAS 123(R), and it has notdetermined whether adoption will result in amounts that are similar to thecurrent pro forma disclosures under SFAS 123.

*Totalother income (expense), net.**  *Other income (expense), net consists primarilyof interest received and paid. The relatively flat difference resulted fromlower average cash balances and higher average interest rates during themajority of fiscal 2005.

*Provision for incometaxes.**  *Dueto the Company’s domestic losses for the years ended December 31, 2005,2004 and 2003 there was no provision for federal or state income taxes. As theCompany was profitable in some foreign jurisdictions during 2005, 2004 and 2003we provided for income taxes expected to be paid on our internationaloperations. At December 31, 2005, the Company had net operating losscarryforwards for federal, state and foreign income tax reporting purposes ofapproximately $98.5 million and research and experimentation credits ofapproximately $2.2 million which expire through 2025 if not utilized. Approximately$26 million of the net operating losses is related to the tax benefit from theexercise of stock options and thus will be allocated to contributed capital ifsubsequently recognized. Under the Tax Reform Act of 1986, the amounts of andbenefits from net operating loss carryforwards may be impaired or limited incertain circumstances, including a change of more than 50% in ownership.

**Years Ended December 31, 2004 and 2003**

Revenue for 2004 was up from the prior year. Revenuerelated to services, which include the issuance of driver licenses, increasedby approximately 3% while revenue related to product and subscription salesincreased approximately 36% because of delivery of a large, internationalfilm-based system to a customer, the sale of equipment to a domestic customer,and the license and related revenues for intellectual property rights to internationalcustomers.

Operating expenses in total increased by $5.8 millionor 15% for the year ended December 31, 2004 compared to the year ended December 31,2003. The majority of the increase came from the general and administrativefunction as a result of several factors. One such factor was the cost relatedto the restatement activities we were undertaking during 2004, which includedlegal, accounting, and consulting fees. A second factor is the increased costof our efforts to document, evaluate, and test our internal controls inaccordance with the Sarbanes-Oxley Act of 2002. We also had increased costsrelated to impairment charges, litigation settlement charges, increased baddebt expense, charges for vacating our old building, and increased costsrelated to higher financial staffing and consulting fees. Our sales andmarketing and research, development, and engineering costs increased onlyslightly. As of the end of 2004, we increased the number of our full timeemployees by 20 and increased the number of our contractors by 92 since the endof 2003. The increased workforce resulted from the high demand of deliveryprograms during the year and increased resources for our finance group.

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We had a net loss of $9.0million compared to our net income of $175,000 in 2003. The decrease in netincome came as a result of a decrease in margins of $3.7 million and anincrease in operating expenses of $5.8 million, as described above.

*Revenue*

| ** **                       | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Revenue:                         |       |                                                 |       |                  |       |   |   |   |   |
| Service                          |       | $73,919                                              |       | $71,588               |       |   | 3 | % |   |
| Product and subscription         |       | 19,028                                               |       | 14,003                |       |   | 36 | % |   |
| Total                            |       | $92,947                                              |       | $85,591               |       |   | 9 | % |   |
| Revenue (as % of total revenue): |       |                                                 |       |                  |       |   |   |   |   |
| Service                          |       | 80%                                                  |       | 84%                   |       |   |   |   |   |
| Product and subscription         |       | 20%                                                  |       | 16%                   |       |   |   |   |   |
| Total                            |       | 100%                                                 |       | 100%                  |       |   |   |   |   |

 

The$7.4 million increase in total revenue resulted primarily from an increase****in our product and subscription revenues.

| ** **                       | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Revenue by  geography:           |       |                                                 |       |                  |       |   |   |   |   |
| Domestic                         |       | $72,173                                              |       | $71,542               |       |   | 1 | % |   |
| International                    |       | 20,774                                               |       | 14,049                |       |   | 48 | % |   |
| Total                            |       | $92,947                                              |       | $85,591               |       |   | 9 | % |   |
| Revenue (as % of total revenue): |       |                                                 |       |                  |       |   |   |   |   |
| Domestic                         |       | 78%                                                  |       | 84%                   |       |   |   |   |   |
| International                    |       | 22%                                                  |       | 16%                   |       |   |   |   |   |
| Total                            |       | 100%                                                 |       | 100%                  |       |   |   |   |   |

 

The $2.3 million increase in service revenue wasthe result of increased issuance revenue from program transitions (the additionof programs based in Mexico, Florida, and Latvia offset by the loss of programsbased in Oklahoma, Alaska and Maryland), in addition to****increasedservices provided under our long-term contract with the internationalconsortium of central banks.

The $5.0 million increasein product and subscription revenue was primarily related to the delivery of alarge, international film-based system to a customer, the sale of equipment toa domestic customer, and the license and related revenues for intellectualproperty rights to international customers.

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*Cost of Revenue*

| ** **                                             | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Cost of revenue:                                       |       |                                                 |       |                  |       |   |   |   |   |
| Service                                                |       | $                                                    | 47,591     |                  | $          | 40,808 |   |   | 17% |   |   |
| Product and subscription                               |       | 11,784                                               |       | 7,524                 |       |   | 57% |   |   |
| Total                                                  |       | $                                                    | 59,375     |                  | $          | 48,332 |   |   | 23% |   |   |
| Cost of revenue  (as % of related revenue components): |       |                                                 |       |                  |       |   |   |   |   |
| Service                                                |       | 64%                                                  |       | 57%                   |       |   |   |   |   |
| Product and  subscription                              |       | 62%                                                  |       | 54%                   |       |   |   |   |   |

 

The $6.8 million increase in service cost ofrevenue was primarily the result of increased international operations costs of$2.0 million, an increase of program-related depreciation costs of $3.7million, and an increase of $1.8 million in domestic field operations costs, inventoryand program asset charges of $1.1 million related to excess, obsolete, andslow-moving inventory, partially offset by a decrease of $2.2 million relatedto costs of consumables related to issuances and additional allocatedinfrastructure and centralized costs of $0.5 million. In 2004, we began tooutsource much of our field operations and maintenance activities on newcontracts to third parties, and therefore the increase in spending is not theresult of the increase in the total number of our full-time employees during2004. We were active in negotiating volume discounts, decreasing storage costs,and consolidating operations when necessary among other actions. Fieldoperations employees totaled 142 and 147 at December 31, 2004 and 2003,respectively.

The $4.3 millionincrease in product and subscription cost of revenue was primarily the resultof increased material costs in connection with the delivery of the largeinternational film based system to one customer during the year ended December 31,2004. This large delivery had particularly low margins. We also sold quantitiesof older or expiring film and equipment to a domestic customer at low marginsor no margin during the year which drove up costs and reduced margins for theperiod.

*Gross Profit*

| ** **                                         | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Gross profit                                       |       |                                                 |       |                  |       |   |   |   |   |
| Service                                            |       | $                                                    | 26,328     |                  | $          | 30,780 |   |   | (14 | %) |   |
| Product and subscription                           |       | 7,244                                                |       | 6,479                 |       |   | 12 | % |   |
| Total                                              |       | $                                                    | 33,572     |                  | $          | 37,259 |   |   | (10 | %) |   |
| Gross profit (as % of related revenue components): |       |                                                 |       |                  |       |   |   |   |   |
| Service                                            |       | 36%                                                  |       | 43%                   |       |   |   |   |   |
| Product and subscription                           |       | 38%                                                  |       | 46%                   |       |   |   |   |   |
| Total                                              |       | 36%                                                  |       | 43%                   |       |   |   |   |   |

 

The $3.7 million decrease in gross profit for the yearended December 31, 2004 compared to the prior year was primarily relatedto the following factors:

·        Inventoryand program asset charges of $1.1 million related to excess, obsolete, andslow-moving inventory;

·       increasedinternational operations costs of $2.0 million related to the ramp up of twolarge new programs;

33

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·       increaseddomestic field operations costs of $1.8 million;

·       anunfavorable revenue mix during the first half of the year, including low marginrevenues from follow-on film sales into an international voter identificationproject and some domestic equipment sales;

·       costoverruns related to the sale of a driver license issuance system in the firsthalf of the year; and

·       higherdepreciation charges of $3.7 million originating from the capitalized costsrelated to hardware, software, and delivery activities in the deployment of newcontracts and upgrades to existing contracts.

·       Theseitems were partially offset by a decrease of $2.2 million related to costs onconsumables related to issuances.

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

| ** **                               | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Cost of revenue                          |       |                                                 |       |                  |       |   |   |   |   |
| Variable                                 |       | $                                                    | 29,253     |                  | $          | 26,620 |   |   | 10 | % |   |
| Fixed field support and manufacturing    |       | 21,511                                               |       | 16,343                |       |   | 32 | % |   |
| Program depreciation                     |       | 8,611                                                |       | 5,369                 |       |   | 60 | % |   |
| Total                                    |       | $                                                    | 59,375     |                  | $          | 48,332 |   |   | 23 | % |   |
| Cost of revenue (as % of total revenue): |       |                                                 |       |                  |       |   |   |   |   |
| Variable                                 |       | 32%                                                  |       | 31%                   |       |   |   |   |   |
| Fixed field support and manufacturing    |       | 23%                                                  |       | 19%                   |       |   |   |   |   |
| Program depreciation                     |       | 9%                                                   |       | 7%                    |       |   |   |   |   |
| Total                                    |       | 64%                                                  |       | 57%                   |       |   |   |   |   |

 

In particular, the highlevel of new programs exerted operational pressures on our identificationsystems business during 2004 as the organization incurred higher expenses aspart of the upfront implementation costs associated with making these newprograms operational.

*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Sales and  marketing                         |       | $                                                    | 12,908     |                  | $          | 12,709 |   |   | 2 | % |   |
| Sales and marketing (as %  of total revenue) |       | 14%                                                  |       | 15%                   |       |   |   |   |   |
|                                              |            |                                                      |            |                       |            |  |  |  |  |  |  |

 

Sales and marketingexpenses remained relatively flat for the year due primarily to lower headcountfor sales and marketing employees and spending controls offset by increasedimpairment charges of approximately $0.5 million related to investments inprivate, technology-related companies. Starting in 2003, we reduced many of theoverhead and variable costs within sales and marketing by consciously makingstrategic spending decisions. These efforts resulted in targeted spending forcritical areas, yielding lower overall spending within the function. Sales andmarketing employees totaled 50 and 55 as of December 31, 2004 and 2003,respectively.

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*Research, development and engineering*

| ** **                                                                    | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                    | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Research,  development and engineering                                        |       | $                                                    | 8,327      |                  | $          | 7,992 |   |   | 4 | % |   |
| Research, development  and engineering (as % of total revenue) |       | 9%                                                   |       | 9%                    |       |   |   |   |   |
|                                                                               |            |                                                      |            |                       |            |  |  |  |  |  |  |

 

The overall increase inresearch, development and engineering expenses of $0.3 million resultedfrom higher headcounts, partially offset by cost control measures taken by usduring 2004 and 2003, such as restructuring the business, consolidatingoperations, centralizing certain services, and standardizing products.Research, development and engineering personnel totaled 137 and 115 as of December 31,2004 and 2003, respectively

*General andadministrative*

| ** **                                          | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| General and  administrative                         |       | $                                                    | 17,150     |                  | $          | 11,629 |   |   | 48 | % |   |
| General and  administrative (as % of total revenue) |       | 19%                                                  |       | 13%                   |       |   |   |   |   |
|                                                     |            |                                                      |            |                       |            |  |  |  |  |  |  |

 

The overallincrease in general and administrative expenses of $5.5 million primarilyresulted from:

·       incrementalthird party legal and accounting costs related to our restatement activities of$1.4 million;

·       incrementalcosts related to third party services in support of our efforts to comply withthe Sarbanes-Oxley Act of 2002 of $0.7 million;

·       incrementalcharges related to the provision for uncollectible accounts receivable anduncollectible notes receivable of $0.5 million;

·       incrementalcharges related to the settlement of litigation of $0.4 million;

·       incrementalfacility costs of $0.3 million due to dual rent costs for four months inaddition to increased amortization and depreciation on the facility build out;offset by

·       adecrease by $0.8 million in stock-based compensation related to stock-basedemployee compensation arrangements.

The remaining $3.0 million of the increase in generaland administrative expenses is primarily the result of increases in headcount,consulting fees and other general costs related to compliance andadministrative activities.

In addition, we addedheadcount and consulting resources to our infrastructure, including our financeand information technology groups, in order to meet the normal responsibilitiesof these functions in addition to the increased demands of our restatement andongoing compliance activities. General and administrative employees totaled 65and 57 as of December 31, 2004 and 2003, respectively.

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*Amortization of intangible assets*

| ** **                                           | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2004**                                             | ** ** | **2003**              | ** ** | **(Decrease)** | ** ** |
| Amortization of  intangibles                         |       | $                                                    | 2,536      |                  | $          | 3,152 |   |   | (20 | %) |   |
| Amortization of  intangibles (as % of total revenue) |       | 3%                                                   |       | 4%                    |       |   |   |   |   |
|                                                      |            |                                                      |            |                       |            |  |  |  |  |  |  |

 

We account for intangibleassets resulting from acquisitions in accordance with Financial AccountingStandards Board (“FASB”) Statement Nos. 141, *BusinessCombinations* and 142, *Goodwill and OtherIntangible Assets*. These statements require the recording ofintangible assets under purchase accounting rules, and require the amortizationof such intangible assets over their expected useful life. As a result, in December 2001we recorded $29.5 million of intangible assets related to the acquisition ofcertain assets and assumption of certain liabilities from Polaroid andaffiliates. These intangible assets were set up to amortize over a 12-yearperiod, representing the expected useful life. Changes in contract status andcustomer relationships may lengthen or shorten the expected useful life of suchintangible assets, or cause an impairment charge related to the intangibleasset, so some variability is expected to exist related to intangiblesdepending on internal and external factors. The change resulted from extensionsof certain useful lives during 2004 and the completion of acceleratedamortization in late 2003 and early 2004.

*Intellectual property.*

| ** **                                     | ** ** | **Twelve Months Ended  December 31,** | ** ** | **Percent  Increase**            | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **  2004  **                     | ** ** | **  2003  ** | ** ** | **(Decrease)** | ** ** |
| Intellectual  property                         |       |                                                 | 2,162      |                             |       |   | 1,846 |   |   |   | 17 | % |   |   |
| Intellectual property  (as % of total revenue) |       |                                                 | 2%         |                             |       |   | 2% |   |   |   |   |   |   |   |

 

The increase of $0.3 million was primarily due toconsulting fees paid to third party attorneys related to patent work.

*Stock-based compensation.**  *Stock-based compensation expense includescosts relating to stock-based employee compensation arrangements. Stock-basedcompensation expense is based on the difference between the fair market valueof our common stock and the exercise price of options to purchase that stock onthe date of grant, and is being recognized over the vesting periods of therelated options, usually four years. No stock-based compensation expense wasrecorded in 2004 while $1.3 million was recorded for the year ended December 31,2003, and is included in the respective statements of operations expensecategories for the employees to which it applies, as set forth in the tablebelow.

| ** **                             | ** ** | **Twelve Months Ended  December 31,**     | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** |
| Sales and  marketing                   |       |                                                     | $          | — |   |   |   | $ | 277 |   |   |
| Research,  development and engineering |       |                                                     | —     |   |   |   | 254 |   |   |
| General and  administrative            |       |                                                     | —     |   |   |   | 760 |   |   |
|                                   |       |                                                     | $          | — |   |   |   | $ | 1,291 |   |   |

 

*Totalother income (expense), net.  *Other income (expense),net consists primarily of interest received and paid. Other income (expense)was $0.9 million and $0.6 million for the years ended December 31,2004 and 2003, respectively. The $0.3 million or 51% increase came as aresult of higher average cash balances that originated from the privateplacement offering in the third quarter of 2003 and higher interest ratesduring the majority of fiscal 2004.

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*Provision for income taxes.  *Forthe years ended December 31, 2004 and 2003, the Company was profitable insome foreign jurisdictions. Therefore, during 2004 and 2003 we provided forincome taxes expected to be paid on our international operations.

**Liquidity and Capital Resources**

As of December 31, 2005, we had cash and cashequivalents, restricted cash, and short-term investments of $32.0** **million, representing a decrease of $19.8****million from****$51.8** **million at December 31, 2004. As of December 31,2005, $7.3** **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. Theletters of credit must be renewed yearly if they are expected to continue, andtherefore the need for restricted cash is renewed yearly. However, our bankshave required us to restrict this cash until we return to profitability for oneyear. Accordingly, restricted cash is classified as a non-current asset.Working capital at December 31, 2005 was****$31.4** **million, compared to working capital of $48.9** **million****at December 31,2004. The majority of the decrease in cash and working capital primarily relatesto investments made in the Florida, Mexico, and Alabama programs that weanticipate will contribute to revenue growth in 2006 and beyond.

*OperatingCash Flow.*   The $3.2 million of cash used inoperations for the year ended December 31, 2005 resulted from net loss of$23.1 million which includes non cash items related to depreciation,amortization, and stock-based compensation aggregating to $20.2 million.Items positively impacting operating cash flow were decreases in restrictedcash of $1.0 million and in inventory of $1.4 million, and increases indeferred revenue of $2.0 million and in accrued payroll and related costsof $1.6 million. Negatively impacting operating cash flow was an increase intrade and unbilled accounts receivable, net of $1.0 million and in othercurrent assets of $1.0 million, along with a decrease in accounts payable of$4.7 million. The $4.7 million of cash provided by operations for the yearended December 31, 2004 resulted from net loss of $9.0 million whichincludes non cash items related to depreciation and amortization of$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 $8.8 million of cashprovided by investing activities for the year ended December 31, 2005primarily related to $24.3 million in net sales of short-term investments,partially offset by $15.5 million for the purchase of property andequipment, including capitalized labor costs. We also acquired approximately$0.3 million of fixed assets during 2005 through capital leasearrangements. The $21.7 million of cash used in investing activities forthe year ended December 31, 2004 primarily related to $39.7 millionfor the purchase of property and equipment, including capitalized labor costs,partially offset by $18.0 in net sales of short-term investments. We alsoacquired approximately $0.1 million of fixed assets during 2004 throughcapital lease arrangements.

*FinancingCash Flow.*   The $0.2 million of cash used infinancing activities for the year ended December 31, 2005 primarilyrelated to $0.5 million of principal payments under capital leases, offsetby proceeds from the issuance of stock for $0.3 million related to the employeestock option and employee stock purchase plans. The $1.9 million of cashprovided by financing activities for the year ended December 31, 2004primarily related to the issuance of stock for $2.1 million related to theemployee stock option and employee stock purchase plans, offset by$0.2 million of principal payments under capital leases.

*Commitments andContingencies.*   Our significant commitmentsconsist of obligations under non-cancelable operating leases, which totaled $9.0** **million as of December 31, 2005, and are payablein 

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monthlyinstallments through October 2010. Our obligations under non-cancelablecapital leases, which totaled $1.1****million as of December 31,2005, are payable in monthly installments through 2007. We are contractuallyobligated to make the following payments as of December 31, 2005:

**ContractualObligations **

| ** **                     | ** ** | **Payment Due by Period (in 000’s)** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                                         | ** ** | **Less  than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| ** **                     | ** ** | **Total**                                                          | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **5 years** | ** ** |
| Capital leases                 |       | $                                                                  | 1,068      |   | $ | 555 |   |   | $ | 513 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating leases               |       | 8,955                                                              |       | 2,260 |   |   | 4,643 |   |   |   | 2,052 |   |   |   | — |   |   |
| Total contractual  obligations |       | $                                                                  | 10,023     |   | $ | 2,815 |   |   | $ | 5,156 |   |   |   | $ | 2,052 |   |   |   | $ | — |   |   |

 

Wehave driver license contracts with various jurisdictions that are not yet fullydeployed for which we have estimated the amounts to complete. In order tocomplete these contracts, we estimate we will incur approximately $16 millionof expenditures. The estimates are derived from information known to theCompany at the time the estimates were prepared. Actual expenditures may varyfrom our estimates. These expenditures are recouped through receipts from thelong-term price-per-card agreements.

Ourplanned operating expenses and capital expenditures may constitute a materialuse of our cash resources. In addition, we expect that we will continue toutilize cash in the upcoming few quarters. We may utilize cash resources tofund acquisitions or investments in complementary businesses, technologies orproduct lines.

TheCompany from time to time experiences delays in identification systemimplementation, timely acceptance for identification systems programs, concernsregarding identification system program performance, and other contractualdisputes. Customershave asserted, and may in the future assert, compensatory or liquidateddamages, breach of contract, or other claims alleging that we have failed tomeet timing or other delivery requirements and milestones pursuant to the termsof such contracts. From time to time, customers have given notice oftheir intention to assert claims for liquidated damages. Management believesthat these assertions are part of the resolution process involving commercialdisagreements over the delivery terms of these contracts. Such disputes are notuncommon and tend to be resolved over time. To date, we have not paid anymaterial contractual damages in connection with a customer dispute. While thereis always risk that damages could be assessed in the future, management cannotpredict, as of December 31, 2005, whether any material damages will beimposed in the future or what the amount of any such damages would be if theywere to be imposed. However, ourfailure to meet contractual milestones or other performance requirements aspromised, 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.

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*Future Cash Expectations.*   Webelieve that our current cash, cash equivalents, and short-term investmentbalances will satisfy our projected working capital and capital expenditurerequirements for at least the next 12 months. In addition, we expect togenerate positive cash flow from operations in 2006 which will fund a largeportion of our capital needs. Thereafter, we anticipate continuing to use cash,cash equivalents, and short-term investment balances to satisfy our projectedworking capital and capital expenditure requirements. We have taken andcontinue to take steps to manage our expenses and align our cost structure toour revenues. These steps include, among other things, considering and/ortaking steps, as needed, to restructure our business, consolidating ouroperations, negotiating volume pricing with vendors, centralizing certainservices, and standardizing products. Our operating expense levels, includingresearch, development, engineering, selling, marketing, general andadministrative expenses, depend on anticipated business activity levels. Whileresearch, development, engineering and marketing expenses are based onanticipated investment levels in technology development, product developmentand market development activities, the appropriate expense levels in selling,general and administrative expenses are dependent on the level ofinfrastructure required to support our anticipated business volume. We reviewour business plans periodically to determine the appropriate level of suchexpenses based on various business factors. In the past we have takenappropriate measures to control our expenses based on business circumstances.In the future we will continue to review our business plans from time to timeand make appropriate changes to our expense levels, as we have in the past, toreduce operating expenses where it is advantageous to do so to improveoperational efficiencies.

In order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, orcredit facilities. However, we do not believe at this time that our long-termworking capital and capital expenditures would require us to take steps toremedy any such potential deficiencies. As an example, in the event that wewere to win contracts requiring significant capital investment, we may need toseek additional financing. If it were necessary to obtain additional financingsor credit facilities, we may not be able to do so, or if these funds areavailable, they may not be available on satisfactory terms.

**Off-BalanceSheet Arrangements**

We do not have any off-balance sheet arrangements, assuch term is defined in recently enacted rules by the SEC, that have orare reasonably likely to have a current or future effect on our financialcondition, changes in financial condition, revenue or expenses, results ofoperations, liquidity, capital expenditures or capital resources that arematerial to investors.

**RecentAccounting Pronouncements**

In November 2004, theFASB issued SFAS No. 151, *Inventory Costs, anamendment of ARB No. 43, Chapter 4* (FAS 151). FAS 151 clarifiesthat abnormal inventory costs such as costs of idle facilities, excess freightand handling costs, and wasted materials (spoilage) are required to berecognized as current period charges. The Company is currently evaluating theprovisions of FAS 151 and does not expect that the adoption will have amaterial impact on its consolidated financial position or results ofoperations. The Company will implement the statement in the first quarter of2006.

On December 16, 2004, the FASB issued Statement No. 123(R) *Share-Based Payment*, which is a revisionof Statement No. 123 and supersedes APB Opinion No. 25. Statement No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be valued at fair value on the date of grant, and to be expensedover the applicable vesting period. Pro forma disclosure of the incomestatement effects of share-based payments is no longer an alternative. Inaddition, companies must also recognize compensation expense related to anyawards that are not fully vested as of the effective date. Compensation expensefor the unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123. The effective date for thispronouncement is for the next fiscal year beginning after December 15,2005. The Company has adopted SFAS 123(R) effective January 1, 2006. TheCompany is 

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evaluating therequirements of SFAS 123(R) and expects that the adoption of SFAS 123(R)will have a material impact on the Company’s results of operations. The Companyhas not yet determined the method of adoption or the effect of adopting SFAS 123(R),and it has not determined whether adoption will result in amounts that aresimilar to the current pro forma disclosures under SFAS 123.

**SafeHarbor Statement under the Private Securities Litigation Reform Act of 1995**

Because this Annual Report on Form 10-Kcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995, any of the risk factors set forthabove or elsewhere in this Annual Report on Form 10-K 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 trends and expectations in revenue growth, including,but not limited to, statements regarding anticipated growth in U.S. DL revenuesdue to broadening use of the DL as a secure credential, statements regardingopportunities to facilitate efforts of State government agencies to comply withthe REAL ID Act, statements regarding the success of new products, such asIDVS, statements regarding the Company’s ability to support customerrequirements for Smart Card technologies, statements regarding the Company’sfuture level of investment in its business, including investment in developmentof products and technology, acquisition of new customers and development of newmarket opportunities, statements regarding our ability to improve margins, statementsregarding the expected deployment of programs in 2006, statements regardinganticipated expenses, costs, margins and investment activities in theforeseeable future, statements regarding anticipated revenue to be generatedfrom current contracts and as a result of new programs, statements regardingthe investments required to complete certain driver license programs and theCompany’s ability to recoup those expenses under the relevant contract,statements regarding our profitability in future periods, statements regardingthe development and growth of the market for digital watermarking technology,statements regarding momentum in the recognition of the benefits offered bydigital watermarking and in the adoption of digital watermarking, statementsregarding business opportunities that could require that we seek additionalfinancing, statements regarding opportunities for increased participation inthe global market for ID systems, statements regarding the size and growth ofthe Company’s markets, including the U.S. DL market, statements regarding theexistence of international growth opportunities and our future investment insuch opportunities, statements regarding the continuance of operationalpressures on our identification systems business in future quarters, statementsregarding the source of a majority of our future revenue, statements regardingthe contribution of new sales channels in domestic and foreign markets to ourfuture results, statements regarding future effects on our business inconnection with the continuing implementation of our new accounting andmaterial requirements planning systems and modifications to our inventorymanagement and controls systems and procedures or other review processes,statements regarding the timing of the completion of the design andimplementation of new and enhanced controls and procedures, statementsregarding our expected short-term and long-term liquidity positions, statementsregarding the Company’s ability to fund its capital needs through cash flowfrom operations, statements regarding our use of cash in upcoming quarters,statements regarding anticipated levels of backlog in future periods,statements regarding anticipated extensions of the term of our contract withthe Central Banks, statements regarding the likelihood or outcome of legalproceedings and claims and their effect on the Company’s business, and 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, the Company’s failure to becomeprofitable, the failure of the potential markets for the Company’s digitalwatermarking technology to develop as anticipated, the adoption of alternativetechnologies within these markets, as well as changes in economic, business,competitive, technology and/or regulatory factors and trends, and the otherfactors described in this 

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Form 10-K or inour other documents filed with the SEC. All forward-looking statements arenecessarily only estimates of future results and there can be no assurance thatactual 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 above 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.

**FactorsAffecting Forward Looking Statements**

Our business, financial condition, results ofoperation and cash flows may be impacted by a number of factors, including thefactors set forth below.

*Givenour history of losses, we cannot guarantee sustained profitability,particularly if we were to lose large contracts.*

We incurred significant net losses from inceptionthrough the fiscal year ended December 31, 2002, and during 2004 and 2005.Our accumulated deficit as of December 31, 2005 was $88.0 million. Inorder to attain sustained profitability, we will need to generate higherrevenue than we have in prior years while controlling expenditures. Achievingprofitability will depend upon a variety of factors, including the impact ofnew financial accounting mandates requiring us to expense stock options, aswell as expenses related to litigation and other proceedings that have arisenas a result of our prior year restatement. 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. Accordingly, inthe short term we may focus more on growing our revenue and taking advantage ofmarket opportunities than an immediate return to profitability. Finally,various adverse developments including the loss of large contracts or costoverruns on our existing contracts could have a negative impact on our revenueor our margins. Accordingly, increases in our expenses may not be offset byrevenue increases and as a result we may not be able to regain and/or sustain profitability.

*Theloss of any large contract may result in loss of revenue and potentialacceleration of amortization expense or impairment of intangible assets.*

Contracts between government agencies and Digimarchave varying duration, generally five or more years in length. Some contractswe enter into contain cancellation clauses. In addition, after a contractperiod expires, generally the government agency can re-open the contract forcompetitive bidding. If we were to lose a contract due to cancellation or in acompetitive bidding situation, then, in addition to the loss of revenue andmargin 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. The Company has not experienced theearly termination of any driver license issuance contracts and is not aware ofany early terminations of such contracts of its competitors.

*Themarket for our products is highly competitive, and as a result, alternativetechnologies or larger companies may undermine, limit or eliminate the marketfor our products’ technologies, which would decrease our revenue and profits.*

Themarkets in which we compete for business are intensely competitive and rapidlyevolving. We expect competition to continue from both existing competitors andnew market entrants. We face competition from other companies and fromalternative technologies. The potential for an influx of federal funds into ourcore U.S. driver license market is likely to draw new competition. As we expandthe applications for our technologies, we will experience more competition fromproducts and services that are substitutes for our applications. Because ourdigital watermarking business is new and emerging, we also may face competitionfrom unexpected sources. Alternative technologies that may directly orindirectly compete with particular applications of our watermarkingtechnologies 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 are expected to continue, and wecannot assure you that discoveries by others, including current and potentialcompetitors, will not render our services and products noncompetitive. Moreover,because of rapid technological changes, we may be required to expend greateramounts of time and money than currently anticipated to develop new productsand services, which in turn may necessitate us to require greater revenuestreams on such products and services to cover developmental costs. Many of thecompanies that currently compete with us for some of our business, as well asother companies with whom we may compete in the future, are larger and nationalor international in scope and may have greater technical, financial, marketing,and political resources than we do. These resources could enable thesecompanies to initiate severe price cuts or take other measures in an effort togain market share or otherwise impede our progress. We cannot assure you thatwe will be able to compete successfully against current or future participantsin our market or against alternative technologies, nor can we assure you thatthe competitive pressures we face will not decrease our revenue and profits inthe future.

*Ourproducts could have unknown defects or errors, which may give rise to claimsagainst us or divert application of our resources from other purposes.*

Products and systems ascomplex as those we offer or develop may contain undetected defects or errors. Furthermore,we often provide complex implementation, integration, customization, consultingand other technical 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, failure toachieve market acceptance, 

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diversionof development resources, injury to our reputation, increased insurance costs,increased service and warranty costs and warranty or breach of contract claims.Although we attempt to reduce the risk of losses resulting from warranty orbreach of contract claims through warranty disclaimers and liability limitationclauses in our sales agreements when we can, these contractual provisions aresometimes not included and may not be enforceable in every instance. If a courtrefuses to enforce the liability-limiting provisions of our contracts for anyreason, or if liabilities arose that were not contractually limited or adequatelycovered by insurance, the expense associated with defending such actions orpaying the resultant claims could be significant.

*If leading companies inour industry or standard-setting bodies or institutions downplay, minimize, orreject the use of digital watermarking, its deployment may be slowed and we maybe unable to achieve revenue growth - particularly in the media andentertainment sector.*

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 weare unable to respond to regulatory or industry standards effectively, or if weare unable to develop and integrate new technologies effectively, our growthand the development of our products and services could be delayed or limited.*

Our future success willdepend in part on our ability to enhance and improve the responsiveness,functionality and features of our products and services in accordance withregulatory or industry standards. Our ability to remain competitive will dependin part on our ability to influence and respond to emerging industry andgovernmental standards, in a timely and cost-effective manner. If we are unableto influence these or other standards or respond to such standards effectively,our growth and the development of certain products and services could bedelayed 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.

We cannot assure you that we will be successful inresponding to these technological and industry challenges in a timely andcost-effective manner. If we are unable to develop or integrate newtechnologies effectively or respond to these changing needs, our margins coulddecrease, and our release of new products and services and the deployment ofour watermarking technology could be adversely affected.

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

We are likely to experience variability in grossmargins on our government contracts due to numerous factors, including, amongother things, the following:

·       delaysin project implementation;

·       failureto achieve add-on sales to existing customers;

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·       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; and

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

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. Weare continually refining our predictive tools and increasing our understandingof what drives these various factors. For reasons such as those listed above,we expect that there will be fluctuations in our future operating results as aresult of the variability in margins from period to period in the secure IDsystems business.

*The majority of our revenue is subject to governmentprocurement processes that may involve unpredictable delays and otherunexpected changes which might limit our actual revenue 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. Inaddition, 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. DL market that may delaypurchase decisions by government customers. Any shift in the governmentprocurement process, which is outside our control and may not be predictable,could result in delays in bookings forecasted for any particular financialperiod, could impact the predictability of our quarterly results, and mightlimit our actual revenue in any given quarter, resulting in reduced and lesspredictable revenue and lower profitability.

*Ourfuture growth will depend to some extent on our successful implementation ofour intellectual property in solutions provided by third parties, includingpartners and suppliers.*

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 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 partners 

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areunsuccessful 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 revenue models relating to anticipatedproducts and services are under development. If these revenue models andpricing structures do not gain market acceptance, the corresponding anticipatedproducts and services may fail to attract or retain customers and we may not beable 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.

*The security systems used in our product and serviceofferings may be circumvented or sabotaged by third parties, which could resultin the disclosure of sensitive government information or private personalinformation or cause other business interruptions that could damage ourreputation 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.

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*As international customers have accounted forapproximately 21% of our total revenue during the year ended December 31,2005, the loss of these customers or the failure to find new customers may resultin a decline in our international revenue, which could lower our profitabilityand 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.

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, terminate or delay the implementation of our productsand services, we may have limited recourse against them to recover anypotential 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 significant portion of our business depends oncontracts that are subject to a variety of terms and conditions, includingdamage payment obligations, as well as a variety of other provisions that maycause our quarterly results to fluctuate and our anticipated revenue topotentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and related products typically include termsrelating to, time-based performance, development and delivery schedulescustomer 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.

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A significant portion ofour 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. 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. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain largerestricted cash reserves as a guarantee, reducing our ability to use thesefunds for 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 our ability to bid on new governmentcontracts or maintain our existing contracts for their full terms. The size,nature and purpose of, and the risks and uncertainties associated with, publicsector contracts can potentially cause our quarterly results to fluctuate andanticipated revenue to decrease significantly.

*A significant portion of our business depends oncontracts with fixed price terms. In the event of cost overruns in connectionwith such contracts, our margins may be adversely 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 to pursue new, or renew existing,business opportunities in secure ID systems markets due to objectionable termsrequired by the contracting agencies, or we may agree to objectionable contractterms for competitive reasons.*

Government agencies sometimes insist on unduly onerousterms in their contracts with vendors of secure ID issuance systems. Forexample, it is customary for state agencies to require that a vendor fund thecapital-intensive initial deployment of a driver license issuance system (thecosts of which the vendor normally recoups over the life of the contract inper-card fees), while reserving the right to terminate the contract forconvenience. Similarly, in connection with intellectual property rights, acontract may require that our pre-existing issuance system software be writtenin a different language and a state may then argue that it falls within theclass of works for which it owns the copyright, enabling the state to turn theDigimarc-authored software over to one of our competitors, dedicate it to thepublic domain, or otherwise use the software in a manner detrimental to ourbusiness. Objectionable contract terms may lead us to decline to bid onidentification issuance systems to new customers, or to decline to retainbusiness with customers we have historically served, which could reduce ourmarket share and lower our revenues or profits. In addition, if we decline toretain business with customers we have historically served, it could result inthe accelerated depreciation of intangible assets. Alternatively, we may decideto accept at least some level of objectionable terms rather than cede animportant contract to a competitor, which could also lower our revenues orprofits.

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*A loss of a material supplier could have a materialadverse effect on our ability to perform effectively under some of ourcontracts.*

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 to risks encountered by companiesdeveloping and relying upon new technologies, products and services forsubstantial amounts of their growth or revenue.*

Our business andprospects must be considered in light of the risks and uncertainties to whichcompanies with new and rapidly evolving technologies, products and services,such as digital watermarking, are exposed. These risks include the following:

·       Wemay be 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;

·       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 reduce or eliminate our profitability.

*We may not be able to protect adequately ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could adversely affect our business.*

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 the Company.

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 governmental entitiesthat might infringe our intellectual property rights may enjoy sovereignimmunity from such claims. Failure to reliably enforce our patent rightsagainst infringers may make licensing more 

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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.

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 our patentportfolio, 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.

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*Products that we are developing for new secureidentification markets and components and subsystems markets may not beaccepted as quickly as we have projected or at all, which may negatively impactour revenues, margins, earnings and stock price.*

We have invested significant time and resources inproduct development activities for new secure identification markets, includingdesigning and developing numerous enhancements to our driver license systemsand improving our cards’ ability to withstand intrusions or alterations withoutdetection. At present, our new products include Digimarc ID Validation Suite (IDVS)and Digimarc IDMarc. If we do not experience a timely, positive reaction fromissuing authorities to our new offerings, our projected revenues, margins andearnings may be negatively impacted.

In addition, we aredeveloping new sales channels in domestic and foreign markets for certaincomponents and subsystems of our domestic driver license solutions. We believethese new sales channels may contribute significantly to our future results, asour products get placed into other programs and start generating recurringrevenue streams. However, given that this is an emerging area of our business,involving significant time and effort in connection with the development of newproducts and distribution relationships, there are ongoing risks that thesemarket areas will not develop in the manner or along the timeline that we areprojecting, or at all, resulting in significant costs and expenses withoutcorresponding increases in any revenues and profits.

*Recent and ongoing leadership, staffing andorganizational changes may result in disruptions and inefficiencies in ourbusiness during transition periods, may require process changes in ourbusiness, and will likely cause additional costs to our business beforebenefits from such changes may be realized.*

During the second quarterof 2004, we made significant changes in our management and staff as a result ofa detailed review of our business processes. Many of these changes wereinitiated following the hiring of our new Chief Financial Officer in June 2004and other senior managers, and in conjunction with the continuingimplementation of our new accounting and material requirements planning systemsand work on Sarbanes-Oxley compliance. In 2005, we made certain organizationalchanges designed to better consolidate the secure ID systems and digitalwatermarking groups into a single business unit and thereby improve ourbusiness execution and operational efficiencies. In addition, we appointed anew President of Government Programs and made considerable changes to themanagement team that reports to him. While we anticipate that these changes inleadership and staffing will improve operations, there is a risk that thesechanges may disrupt the operations of our business and, consequently, mayresult in some short-term inefficiencies as personnel complete theirtransitions and new leaders implement their new plans and procedures. We alsoexpect that these changes may require further modifications of our finance andbusiness processes and will likely cause additional costs to our business inthe short term before any benefits from such changes, if any, may be realized.

*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 a significant extent on theperformance and continued service of our senior management. Except for ourChief Executive Officer, our senior management does not have employmentagreements. The loss of the services of any of our senior management coulddelay 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 

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obligationsand operate successfully as a public company may be limited. We believe ourfuture success will depend in large part upon our ability to retain our currentkey employees and our ability to attract, integrate and retain such personnelin the future. It may not be practical for us to match the compensation certainof our employees could garner at other employment. In addition, we mayencounter difficulties in hiring and retaining employees because of concernsrelated to our shareholder litigation and financial performance. In addition,these circumstances may have a negative impact on the market price of ourcommon stock, and employees and prospective employees may factor in theuncertainties relating to our stability and the value of any equity-basedincentives in their decisions regarding employment opportunities and decide toleave our employ. In addition, our business is based in part on patentedtechnology, which is unique and not generally known. New employees requiresubstantial training, involving significant resources and management attention.Competition for experienced personnel in our business can be intense. If we donot succeed in attracting new, qualified personnel or in integrating, retainingand motivating our current personnel, our growth and ability to deliverproducts and services that our customers require may be hampered. Although ouremployees generally have executed agreements containing non-competitionclauses, there is no assurance that a court would enforce all of the terms ofthese clauses or the clauses generally. If these clauses were not fullyenforced, our employees could be able to freely join our competitors. Althoughwe generally attempt to control access to and distribution of our proprietaryinformation by our employees, there can be no assurances that the confidentialnature of our proprietary information will be maintained in the course of suchfuture employment. Any of these events could have a material adverse effect onour financial and business prospects.

*We are engaged in several lawsuits alleging violationsof securities law and cannot predict the outcome or ultimate cost of theseactions 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. Such litigation is expensive andlengthy. These matters are discussed in greater detail in Item 3 (LegalProceedings) of this Annual Report on Form 10-K and in Note 8(Commitments and Contingencies) of the Notes to Consolidated FinancialStatements included in this Annual Report on Form 10-K. We haveincurred significant costs relating to these matters, and expect that we willcontinue to do so. Due to the inherent uncertainties of such litigation, theultimate cost and outcome cannot be predicted.

*If a judgment were to be entered against the Companyand our director and officer liability insurance was inadequate or unavailable,the obligation to pay the judgment may materially harm our business andfinancial condition.*

Our director and officerliability insurance policies provide protection against certain liabilitiesrelating to the securities class action and derivative lawsuits  against us and certain of our officers anddirectors up to prescribed policy limits. If these policies do not adequatelycover expenses and certain liabilities relating to these lawsuits, ourfinancial condition could be materially harmed. In addition, if this insurancecoverage becomes unavailable to us or premiums increase significantly in the future,it could make it more difficult for us to retain and attract officers anddirectors and could expose us to potentially self-funding certain futureliabilities ordinarily mitigated by director and officer liability insurance.

*We may be required to invest significant additionaltime and resources to comply with the requirements of Section 404 of theSarbanes-Oxley Act of 2002, which may increase our operating expenses andreduce our profitability in the near future.*

In 2004, we discovered certainmaterial weaknesses in our internal controls and procedures and since then havedeployed significant resources to design and implement new and enhancedcontrols and 

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procedures.As we monitor the regulatory requirements in the future, we may discover additionalproblems that require further modifications to our controls, review processesand financial management, which could result in our company experiencingadditional costs and expenses that may reduce our profitability in the nearfuture.

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

Our exposure to market risk for changes in interestrates relates primarily to the increase or decrease in the amount of interestincome we can earn on our investment portfolio and on the increase or decreasein the amount of any interest expense we must pay with respect to outstandingdebt instruments. The risk associated with fluctuating interest expense islimited, however, to the exposure related to those debt instruments and creditfacilities that are tied to market rates. We do not plan to use derivativefinancial instruments in our investment portfolio. We plan to ensure the safetyand preservation of our invested principal funds by limiting default risk,market risk and investment risk. We plan to mitigate default risk by investingin low-risk securities. At December 31, 2005, we had an investmentportfolio of money market funds, commercial securities and U.S. Governmentsecurities, including those classified as cash and cash equivalents, restrictedcash, and short-term investments, of $27.2 million. The originalmaturities of our investment portfolio range from 4 to 184 days with anaverage interest rate of 4.1%. We had capital lease obligations ofapproximately $1.1****million at December 31,2005. If market interest rates were to increase immediately and uniformly by10% from levels as of December 31, 2005, 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, 2005 and 2004 and for the three year period endedDecember 31, 2005 and the independent registered public accounting firmreports thereon are set forth on the F pages of this Annual Report on Form 10-Kand are 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 disclosurecontrols and procedures, and changes in internal control over financialreporting, referred to in paragraph 4 of the certifications. This Item 9Ashould be read in conjunction with the officer certifications for a morecomplete understanding of the topics presented.

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**(1)**          Management’s Report on 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. generally accepted accountingprinciples (“U.S. GAAP”). Our internal control over financial reportingincludes 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 material effecton the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

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 Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission. Based on thisevaluation, our management has concluded that our internal control overfinancial reporting was effective as of December 31, 2005.

Management’s assessment ofthe effectiveness of our internal control over financial reporting as of December 31,2005 has been audited by Grant Thornton LLP, an independent registered publicaccounting firm. Their attestation report is included herein.

**(2)**          Remediationof Prior Year Material Weaknesses

As previouslydisclosed in our Form 10-K/A for the year ended December 31,2004 (filed on June 1, 2005), our management concluded that our internalcontrol over financial reporting was not effective as of December 31, 2004due to the following identified material weaknesses.

·       Inadequatesupervision and technical accounting expertise within the accounting andfinance department.

·       Inadequatedesign and implementation of new accounting system.

·       Inadequatequarterly and year-end financial statement close and review process.

·       Insufficientcontrols both for determining the nature and types of costs that should becapitalized and for ensuring allocation of costs to particular projects areappropriate.

·       Insufficientcontrols to ensure that various international, state and local tax exposureswere quantified and properly accrued on a timely basis.

·       Insufficienttraining and inadequate reconciliation processes for complex revenuerecognition requirements primarily related to international transactions.

·       Insufficientcontrols related to system access and segregation of duties.

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·       Inadequaciesrelated to entity-level controls.

The Public Company Accounting Oversight Board (“PCAOB”)has defined “material weakness” as a “significant deficiency, or combination ofsignificant deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected.” As a result of the above material weaknesses, theCompany restated the financial results as of and for the fiscal year ended December 31,2003 and each quarter therein as well as the quarterly periods ended March 31,2004 and June 30, 2004.

Throughout 2005,numerous enhancements have been made to our controls over financial reporting,including the following activities:

·       Wehave hired several new employees into the finance and accounting organizationto improve the overall quality and level of experience in the organization. Weare continuing to actively recruit and hire new employees to add further depthto the finance and accounting organization.

·       Wehave made changes in our finance and accounting processes to provide clearersegregation of responsibilities and supervision. Of particular significance isour monthly and quarterly close process which has been enhanced to includeadditional analysis and support for the financial accounts as well as improveddocumentation supporting controls over compilation and preparation of ourquarterly financial statements.

·       Weimplemented steps, including changes to our processes and systems, to improvethe information flow among the various personnel that have a role in thedetermination of proper cost capitalization as well as to improve the reviewand approval process relating to such determination, and we are implementingprocesses to improve communication among our various functional groups, whichinclude sales, manufacturing, customer support, engineering, accounting, andlegal, during the contract negotiation, implementation and fulfillment phases.

·       Weimplemented preventive control procedures related to system access to monitorand control access to system modules in accordance with appropriate guidelinesin order to ensure safeguarding of assets. In addition, we have implementeddetective controls such as the enhanced review of accounting transactions andfinancial statements.

·       Wehave implemented formal procedures to estimate and document international taxexpense and established a procedure to true up prior filings. In addition, wehave established procedures to estimate and record our state and local taxexpense and exposure.

·       Wedeployed significant internal and external resources directed at documentingand testing our internal control over financial reporting as contemplated by Section 404of Sarbanes-Oxley, and such efforts have been helpful in improving our overallprocess and control environment.

With the implementation of the above activities andother measures taken throughout the year, we have significantly improved ourinternal control environment and reduced to a remote likelihood the possibilityof a material misstatement that would not be prevented or detected.

Management is committed tocontinue monitoring our internal controls over financial reporting and willmodify or implement additional controls and procedures that may be required toensure the ongoing integrity of the Company’s financial statements.

**(3)**          Evaluation Process; Conclusion on Effectiveness of Disclosure Controls andProcedures at December 31, 2005

Our current management, with the participation of ourprincipal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls and 

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procedures (as defined in Rules 240.13a-15(e) and240.15d-15(e) of the Securities Exchange Act of 1934) as of December 31,2005, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Managementis responsible to maintain disclosure controls and procedures that are designedwith the objective of providing reasonable assurance that information requiredto be disclosed in the reports we file under the Securities Exchange Act of1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms. Further, suchinformation is to be accumulated and communicated to our management, includingour principal executive officer and principal financial officer, to allowtimely decisions regarding required disclosure. Based on the evaluation of theeffectiveness of our disclosure controls and procedures as of December 31,2005, our principal executive officer and principal financial officer haveconcluded that our disclosure controls and procedures were effective.

Notwithstanding thisevaluation, our internal controls and procedures may not be capable ofpreventing all instances of error or fraud. Any control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are knowledge andresource constraints in any such system, and a large number of complexpermutations of facts, circumstances, accounting policies, proceduralimplications and business practices that must be considered. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and breakdowns can occur because ofsimple error or mistake. Additionally, controls can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the controls. The design of any system of controls alsois based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Over time, the controlsystems we develop may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

**(4)**          Changes to Internal Controls

Other than as describedabove for the completed remediation of previously disclosed material weaknessof the prior year, there have not been any changes in our internal control overfinancial reporting that occurred during the Company’s fiscal quarter ended December 31,2005 that have materially affected or are reasonably likely to materially affectour internal control over financial reporting.

**Reportof Independent Registered Public Accounting Firm**

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Controls Over FinancialReporting, that Digimarc Corporation maintained effective internal control overfinancial reporting as of December 31, 2005, 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 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 effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial 

55

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reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with accounting principles generally accepted in theUnited States of America. A company’s internal control over financial reportingincludes those policies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions 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 inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that DigimarcCorporation maintained effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based oncriteria established in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission. Also in our opinion, Digimarc Corporation has maintained inall material respects, effective internal control over financial reporting asof December 31, 2005, based on criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheet ofDigimarc Corporation and subsidiaries as of December 31, 2005, and therelated consolidated statements of operations, stockholders’ equity, and cashflows for the year then ended and our report dated March 13, 2006 expressed anunqualified opinion on those financial statements.
| /s/ Grant Thornton LLP |
|------------------------|
| Portland, Oregon       |
| March 13, 2006         |

 

**ITEM 9B:**      OTHERINFORMATION

None.

56

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**PART III**

Certain informationrequired by Part III is omitted from this Annual Report on Form 10-Kin that we will file the Proxy Statement no later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K,and certain information included therein is incorporated by reference into Part IIIof this Annual Report on Form 10-K.

**ITEM 10:**        DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

**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 these codes available in theCorporate Governance section of our website at www.digimarc.com.  This section is included within the “AboutCompany” section on the home page of our website. If we waive, or implicitlywaive, any material provision of the codes, or substantively amend the codes,we will disclose that fact on our website within five 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,” “Relationships Among Directors orExecutive Officers,” “Management,” “Report of the Nominating Committee of theBoard of Directors,” “Report of the Corporate Governance Committee of the Boardof Directors,” and “Section 16(a) Beneficial Ownership ReportingCompliance.”

**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,” and “Executive Compensation.”

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

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 Certain BeneficialOwners and Management” and “Equity Compensation Plan Information.”

**ITEM 13:**        CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

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 “Certain Relationships and Related Transactions.”

**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 Fees and Non-Audit Fees.”

57

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**ITEM 15:**        EXHIBITS,FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

**(a)(1)** FinancialStatements

The following financial statements are set forth on pages F-1to F-34 attached to the Annual Report on Form 10-K filed withSecurities and Exchange Commission on March 13, 2006:

(i)             Report of IndependentRegistered Public Accounting Firm—Grant Thornton LLP

(ii)         Reportof Independent Registered Public Accounting Firm—KPMG LLP

(iii)     ConsolidatedBalance Sheets as of December 31, 2005 and 2004

(iv)       ConsolidatedStatements of Operations for the years ended December 31, 2005, 2004 and2003

(v)           Consolidated Statementsof Stockholders’ Equity for the years ended December 31, 2005, 2004 and2003

(vi)       Consolidated Statements ofCash Flows for the years ended December 31, 2005, 2004 and 2003

(vii)   Notes to Consolidated FinancialStatements

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

All schedules have beenomitted since they are not required or are not applicable or the requiredinformation is shown in the financial statements or related notes.

**(a)(3)** Exhibits

See Exhibit Index.

58

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                           |   | DIGIMARC CORPORATION                                                                                                        |
|---------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------|
|                      |   | /s/  Michael McConnell                                                                                                      |
| Date: March 13, 2006 |   | 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 13, 2006 |
| Bruce Davis                  |          |  of the Board of Directors  (Principal Executive Officer) |       |           |
| /s/ Michael McConnell        |          | Chief Financial  Officer and Treasurer                         |       | March 13, 2006 |
| Michael McConnell            |          | (Principal Financial and  Accounting Officer)                  |       |           |
| /s/ Robert Chamness          |          | Chief Legal  Officer and Secretary                             |       | March 13, 2006 |
| Robert Chamness              |          |                                                           |       |           |
| /s/ Philip  Monego, Sr. |          | Director                                                       |       | March 13, 2006 |
| Philip Monego, Sr.      |          |                                                           |       |           |
| /s/ Brian J. Grossi          |          | Director                                                       |       | March 13, 2006 |
| Brian J. Grossi              |          |                                                           |       |           |
| /s/ Peter W. Smith           |          | Director                                                       |       | March 13, 2006 |
| Peter W. Smith               |          |                                                           |       |           |
| /s/ Jim Roth                 |          | Director                                                       |       | March 13, 2006 |
| Jim Roth                     |          |                                                           |       |           |
| /s/ James T. Richardson      |          | Director                                                       |       | March 13, 2006 |
| James T. Richardson          |          |                                                           |       |           |
| /s/ William J. Miller        |          | Director                                                       |       | March 13, 2006 |
| William J. Miller            |          |                                                           |       |           |
| /s/ Bernard Whitney          |          | Director                                                       |       | March 13, 2006 |
| Bernard Whitney              |          |                                                           |       |           |
| /s/ Lloyd G. Waterhouse      |          | Director                                                       |       | March 13, 2006 |
| Lloyd G. Waterhouse          |          |                                                           |       |           |

 

 

59

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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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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors andStockholders of Digimarc Corporation:

We have audited the accompanying consolidated balancesheet of Digimarc Corporation and subsidiaries as of December 31, 2005,and the related consolidated statements of operations, stockholders’ equity,and cash flows for the year then ended. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards 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 financial statementsreferred to above present fairly, in all material respects, the financialposition of Digimarc Corporation and subsidiaries as of December 31, 2005,and the results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

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, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated March 13, 2006 expressed an unqualified opinion on management’sassessment, and an unqualified opinion on the effective operation of internalcontrol over financial reporting.

/s/ Grant Thornton LLP

Portland, OregonMarch 13, 2006

F-2

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors andStockholders of Digimarc Corporation:

We have audited theaccompanying consolidated balance sheet of Digimarc Corporation andsubsidiaries as of December 31, 2004, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of theyears in the two-year period ended December 31, 2004. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits 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 the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor 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, 2004,and the results of their operations and their cash flows for each of the yearsin the two-year period ended December 31, 2004 in conformity with U.S.generally accepted accounting principles.

/s/ KPMG LLP

Portland, OregonMay 27, 2005

F-3

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

| ** **                                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                                                                    |       |                  |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                                                               |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                     |       |                  | $          | 23,964                |       |   |   | $ | 18,489 |   |   |
| Short-term investments                                                                                                                                                                                        |       |                  | 739        |                  |       |   | 25,068 |   |   |
| Trade accounts receivable, net                                                                                                                                                                                |       |                  | 9,469      |                  |       |   | 9,666 |   |   |
| Unbilled trade receivables                                                                                                                                                                                    |       |                  | 6,228      |                  |       |   | 5,008 |   |   |
| Inventory, net                                                                                                                                                                                                |       |                  | 7,451      |                  |       |   | 8,858 |   |   |
| Other current assets                                                                                                                                                                                          |       |                  | 2,828      |                  |       |   | 1,779 |   |   |
| Total current assets                                                                                                                                                                                          |       |                  | 50,679     |                  |       |   | 68,868 |   |   |
| Restricted cash                                                                                                                                                                                               |       |                  | 7,279      |                  |       |   | 8,279 |   |   |
| Property and  equipment, net                                                                                                                                                                                  |       |                  | 64,108     |                  |       |   | 63,975 |   |   |
| Intangible  assets, net                                                                                                                                                                                       |       |                  | 17,164     |                  |       |   | 21,162 |   |   |
| Other assets, net                                                                                                                                                                                             |       |                  | 1,009      |                  |       |   | 1,003 |   |   |
| Total assets                                                                                                                                                                                                  |       |                  | $          | 140,239               |       |   |   | $ | 163,287 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                 |       |                  |       |                  |       |   |   |   |   |
| Current  liabilities:                                                                                                                                                                                         |       |                  |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                              |       |                  | $          | 6,722                 |       |   |   | $ | 11,424 |   |   |
| Accrued payroll and related costs                                                                                                                                                                             |       |                  | 3,731      |                  |       |   | 2,161 |   |   |
| Deferred revenue                                                                                                                                                                                              |       |                  | 6,809      |                  |       |   | 4,854 |   |   |
| Other current liabilities                                                                                                                                                                                     |       |                  | 2,032      |                  |       |   | 1,492 |   |   |
| Total current liabilities                                                                                                                                                                                     |       |                  | 19,294     |                  |       |   | 19,931 |   |   |
| Other long-term  liabilities                                                                                                                                                                                  |       |                  | 969        |                  |       |   | 1,112 |   |   |
| Total liabilities                                                                                                                                                                                             |       |                  | 20,263     |                  |       |   | 21,043 |   |   |
| Commitments and  contingencies (Note 8)                                                                                                                                                                       |       |                  |       |                  |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                                                                                   |       |                  |       |                  |       |   |   |   |   |
| Common stock,  $0.001 par value; 100,000,000 shares authorized at December 31, 2005 and  2004; issued and outstanding 20,808,994 and 20,453,429 shares at  December 31, 2005 and 2004, respectively |       |                  | 21         |                  |       |   | 21 |   |   |
| Additional  paid-in capital                                                                                                                                                                                   |       |                  | 209,337    |                  |       |   | 206,979 |   |   |
| Deferred stock  compensation                                                                                                                                                                                  |       |                  | (1,519     | )                     |       |   | — |   |   |
| Accumulated other  comprehensive income                                                                                                                                                                       |       |                  | 137        |                  |       |   | 147 |   |   |
| Accumulated  deficit                                                                                                                                                                                          |       |                  | (88,000    | )                     |       |   | (64,903 | ) |   |
| Total stockholders’ equity                                                                                                                                                                          |       |                  | 119,976    |                  |       |   | 142,244 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                              |       |                  | $          | 140,239               |       |   |   | $ | 163,287 |   |   |

 

See accompanying notes to consolidated financial statements.

F-4

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

| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                          |       |                                       |       |   |   |   |   |
| Service                                           |       | $                                          | 84,691     |   | $ | 73,919 |   | $ | 71,588 |   |
| Product and subscription                          |       | 16,362                                     |       | 19,028 |   | 14,003 |   |
| Total revenue                                     |       | 101,053                                    |       | 92,947 |   | 85,591 |   |
| Cost of revenue:                                  |       |                                       |       |   |   |   |   |
| Service                                           |       | 61,465                                     |       | 47,591 |   | 40,808 |   |
| Product and subscription                          |       | 6,707                                      |       | 11,784 |   | 7,524 |   |
| Total cost of revenue                             |       | 68,172                                     |       | 59,375 |   | 48,332 |   |
| Gross profit                                      |       | 32,881                                     |       | 33,572 |   | 37,259 |   |
| Operating  expenses:                              |       |                                       |       |   |   |   |   |
| Sales and marketing                               |       | 15,777                                     |       | 12,908 |   | 12,709 |   |
| Research, development and engineering             |       | 13,131                                     |       | 8,327 |   | 7,992 |   |
| General and administrative                        |       | 21,524                                     |       | 17,150 |   | 11,629 |   |
| Amortization of intangibles                       |       | 4,035                                      |       | 2,536 |   | 3,152 |   |
| Intellectual property                             |       | 2,014                                      |       | 2,162 |   | 1,846 |   |
| Total operating expenses                          |       | 56,481                                     |       | 43,083 |   | 37,328 |   |
| Operating loss                                    |       | (23,600                                    | )          | (9,511 | ) | (69 | ) |
| Other income  (expense):                          |       |                                       |       |   |   |   |   |
| Interest income                                   |       | 1,095                                      |       | 905 |   | 687 |   |
| Interest expense                                  |       | (203                                       | )          | (104 | ) | (14 | ) |
| Other                                             |       | (41                                        | )          | 53 |   | (106 | ) |
| Total other income, net                           |       | 851                                        |       | 854 |   | 567 |   |
| Income (loss)  before provision for income taxes  |       | (22,749                                    | )          | (8,657 | ) | 498 |   |
| Provision for  income taxes                       |       | (348                                       | )          | (365 | ) | (323 | ) |
| Net income (loss)                                 |       | $                                          | (23,097    | ) | $ | (9,022 | ) | $ | 175 |   |
| Net income (loss)  per share—basic           |       | $                                          | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   |
| Net income (loss)  per share—diluted         |       | $                                          | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   |
| Weighted average shares outstanding—basic    |       | 20,485                                     |       | 20,326 |   | 18,572 |   |
| Weighted average  shares outstanding—diluted |       | 20,485                                     |       | 20,326 |   | 19,351 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTSOF 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, 2002**                                      |       | 17,640,698            |       |                    | $18        |                |       |             | $176,002       |                                          |       |            | $(1,332                                     | )                             |       |   | $675 |   |   |   | $(43 | ) |   |   | $(56,056 | ) |   |   | $119,264 |   |   |
| Exercise of stock options                                                       |       | 622,108               |       |                    | —     |                |       |             | 3,567          |                                          |       |            | —                                      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,567 |   |   |
| Issuance of employee stock purchase plan shares                                 |       | 81,044                |       |                    | —     |                |       |             | 862            |                                          |       |            | —                                      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 862 |   |   |
| Issuance of common stock and warrants through  private placement, net |       | 1,785,996             |       |                    | 2          |                |       |             | 22,569         |                                          |       |            | —                                      |                          |       |   | 881 |   |   |   | — |   |   |   | — |   |   |   | 23,452 |   |   |
| Expired warrants and options issued to non-employees                       |       | —                |       |                    | —     |                |       |             | 675            |                                          |       |            | —                                      |                          |       |   | (675 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock-based compensation expense                                                |       | —                |       |                    | —     |                |       |             | (41            | )                                             |       |            | 1,332                                       |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,291 |   |   |
| Foreign currency translation gain                                               |       | —                |       |                    | —     |                |       |             | —         |                                          |       |            | —                                      |                          |       |   | — |   |   |   | 139 |   |   |   | — |   |   |   | 139 |   |   |
| Net income                                                                      |       | —                |       |                    | —     |                |       |             | —         |                                          |       |            | —                                      |                          |       |   | — |   |   |   | — |   |   |   | 175 |   |   |   | 175 |   |   |
| **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 gain                                               |       | —                |       |                    | —     |                |       |             | —         |                                          |       |            | —                                      |                          |       |   | — |   |   |   | (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 |   |   |
|----------------------------------------------|--------|------------|--------|--------|---|----|--------|--------|--------|---|---------|--------|--------|--------|---|--------|---|--------|--------|---|--------|--------|--------|--------|---|-----------------------------|--------|--------|--------|---|---------|---|--------|--------|---|---------|--------|--------|

 

See accompanying notes to consolidated financial statements.

F-6

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

| ** **                                                                                          | ** ** | **Twelve Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                          | ** ** | **December 31,  2005**       | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
| Cash flows from operating activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                                   |       |                              | $          | (23,097 | ) |   |   | $ | (9,022 | ) |   |   | $ | 175 |   |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                      |       |                              | 19,700     |   |   |   | 13,490 |   |   |   | 10,780 |   |   |
| Stock-based compensation  expense                                                                   |       |                              | 506        |   |   |   | — |   |   |   | 1,291 |   |   |
| Impairment of  investments                                                                          |       |                              | —     |   |   |   | 465 |   |   |   | — |   |   |
| Issuance of common stock  for litigation settlement                                                 |       |                              | —     |   |   |   | 348 |   |   |   | — |   |   |
| Increase (decrease) in  allowance for doubtful accounts                                             |       |                              | 25         |   |   |   | 263 |   |   |   | (171 | ) |   |
| Other non-cash charges                                                                              |       |                              | (64        | ) |   |   | 703 |   |   |   | 379 |   |   |
| Changes in operating assets and liabilities:                                                        |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Restricted cash                                                                                     |       |                              | 1,000      |   |   |   | (6,303 | ) |   |   | 13,726 |   |   |
| Trade and unbilled  accounts receivable, net                                                        |       |                              | (1,048     | ) |   |   | (1,448 | ) |   |   | 1,815 |   |   |
| Inventory, net                                                                                      |       |                              | 1,407      |   |   |   | (2,605 | ) |   |   | (1,162 | ) |   |
| Other current assets                                                                                |       |                              | (1,049     | ) |   |   | 273 |   |   |   | 1,055 |   |   |
| Other assets, net                                                                                   |       |                              | (6         | ) |   |   | (253 | ) |   |   | (309 | ) |   |
| Accounts payable                                                                                    |       |                              | (4,702     | ) |   |   | 4,840 |   |   |   | (1,424 | ) |   |
| Accrued payroll and  related costs                                                                  |       |                              | 1,570      |   |   |   | 1,092 |   |   |   | (318 | ) |   |
| Deferred revenue                                                                                    |       |                              | 1,955      |   |   |   | 1,694 |   |   |   | (572 | ) |   |
| Other liabilities                                                                                   |       |                              | 606        |   |   |   | 1,142 |   |   |   | 57 |   |   |
| Net cash provided by  (used in) operating activities                                                |       |                              | (3,197     | ) |   |   | 4,679 |   |   |   | 25,322 |   |   |
| Cash flows from investing activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Purchase of property and  equipment                                                                 |       |                              | (7,575     | ) |   |   | (27,247 | ) |   |   | (7,402 | ) |   |
| Capitalization of labor  costs                                                                      |       |                              | (7,932     | ) |   |   | (12,444 | ) |   |   | (6,609 | ) |   |
| Sale or maturity of  short-term investments                                                         |       |                              | 180,568    |   |   |   | 193,355 |   |   |   | 39,786 |   |   |
| Purchase of short-term  investments                                                                 |       |                              | (156,239   | ) |   |   | (175,392 | ) |   |   | (63,027 | ) |   |
| Net cash provided by  (used in) investing activities                                                |       |                              | 8,822      |   |   |   | (21,728 | ) |   |   | (37,252 | ) |   |
| Cash flows from financing activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Net proceeds from  issuance of common stock                                                         |       |                              | 333        |   |   |   | 2,117 |   |   |   | 27,881 |   |   |
| Principal payments under  capital lease obligations                                                 |       |                              | (483       | ) |   |   | (205 | ) |   |   | (7 | ) |   |
| Net cash provided by  (used in) financing activities                                                |       |                              | (150       | ) |   |   | 1,912 |   |   |   | 27,874 |   |   |
| Net increase (decrease)  in cash and cash equivalents                                               |       |                              | 5,475      |   |   |   | (15,137 | ) |   |   | 15,944 |   |   |
| Cash and cash  equivalents at beginning of year                                                     |       |                              | 18,489     |   |   |   | 33,626 |   |   |   | 17,682 |   |   |
| Cash and cash  equivalents at end of year                                                           |       |                              | $          | 23,964 |   |   |   | $ | 18,489 |   |   |   | $ | 33,626 |   |   |
| Supplemental disclosure of cash flow information:                                                   |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Cash paid for interest                                                                              |       |                              | $          | 203 |   |   |   | $ | 104 |   |   |   | $ | 14 |   |   |
| Cash paid for income  taxes                                                                         |       |                              | $          | 139 |   |   |   | $ | 400 |   |   |   | $ | 136 |   |   |
| Summary of non-cash investing and financing  activities:                                            |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Equipment acquired or  exchanged under capital lease obligations                               |       |                              | $          | 274 |   |   |   | $ | 77 |   |   |   | $ | 1,464 |   |   |
| Grant of restricted stock                                                                           |       |                              | $          | 2,025 |   |   |   | $ | — |   |   |   | $ | — |   |   |

 

See accompanying notes to consolidated financialstatements.

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 is a supplier of secure identitysolutions and advanced technologies for use in media management. Our solutionsenable governments and businesses around the world to deter counterfeiting andpiracy, enhance traffic safety and national security, combat identity theft andfraud, facilitate the effectiveness of voter identification programs, andimprove the management of media content. The Company is a supplier of driverlicenses in the United States, producing nearly two-thirds of all driverlicenses issued.

Digimarc also is a pioneer and leading owner ofintellectual property in a signal processing technology innovation known as “digitalwatermarking,” which allows imperceptible digital codes to be embedded in allforms of media content, including personal identification documents, financialinstruments, photographs, movies, music and product packages. The embeddedcodes within various types of media content can be detected and read bysoftware or hardware detectors in personal computers and other digital devices.As of December 31, 2005, the Company held rights in 222 issued U.S.patents and 59 issued foreign patents on this technology and relatedtechnologies, applications, systems, and processes and had more than 500 U.S.and foreign applications pending.

Digimarc’s solutions and technologies are deployed bythe Company and its business partners in media objects and digital devicesaround the world. The substantial majority of the Company’s revenues arise fromprovision of critical infrastructure pursuant to long-term contracts withgovernment agencies—primarily U.S. state government agencies engaged in theissuance of driver licenses, a consortium of leading Central Banks, andnational governments of certain foreign countries. The remainder of ourrevenues is generated primarily from patent and technology license fees paid bybusiness partners, providing media and rights management solutions to majormovie studios and music labels, television and radio broadcasters, creativeprofessionals and other customers around the world.

In December 2001, theCompany acquired the assets and assumed certain liabilities of the U.S. large governmentprograms identification systems and international digital identificationsystems businesses of Polaroid and certain other affiliated entities ofPolaroid. The acquisition was accounted for using the purchase method ofaccounting.

*Use of Estimates*

The preparation ofconsolidated financial statements in accordance with U.S. generally acceptedaccounting principles requires Digimarc to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenue and expenses, andrelated disclosure of contingent assets and liabilities. Certain of the Company’saccounting policies require higher degrees of judgment than others in theirapplication. These include revenue recognition on long-term service contracts,impairments and estimation of useful lives of long-lived assets, inventoryvaluation, reserves for uncollectible accounts receivable, and contingenciesand litigation. Digimarc bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates under differentassumptions or conditions.

F-8

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

*Reclassifications*

Certain amounts in the 2004 and 2003 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.

Certain costs were reclassified from general andadministrative to cost of revenue, sales and marketing, research, developmentand engineering, intellectual property and amortization of intangibles as shownon the consolidated statement of operations. The amortization of intangiblescategory includes amortization costs related to intangible assets, primarilycustomer relationship intangibles recorded in December 2001. Theintellectual property category includes costs associated with documenting,applying for, and maintaining patents generated through the Company’s researchand development efforts. The infrastructure category includes rent, leaseholdimprovements amortization, insurance expense and infrastructure depreciation. Thecentralized cost category includes centralized departments that serve alloperations such as our information technology department. The methods employedwere based on headcount, square footage or a combination of both asappropriate. The table below shows the effects of these reclassifications onprior period numbers:

| ** **                                  | ** ** | ** ** | ** ** | **Amortization** | ** ** | **Intellectual**        | ** ** | ** **   | ** ** | **Centralized**    | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------|------------|-------------------------|------------|--------------|------------|--------------------|------------|------------|------------|
| **Year ending December 31,** | ** ** | ** ** | ** ** | **Before**       | ** ** | **of Intangibles** | ** ** | **Property** | ** ** | **Infrastructure** | ** ** | **Cost**   | ** ** | **After** | ** ** |
| **2004**                                    |       |       |       |             |       |                    |       |         |       |               |       |       |       |   |   |   |   |   |   |   |   |
| Cost of revenue—service                |       | $          | 45,663     |             |       | $                       | —     |         |       |               | $          | —     |       |   |   | $ | 528 |   |   |   | $ | 1,400 |   |   | $ | 47,591 |   |
| Total cost of  revenue                      |       | 57,447     |       |             | —     |                    |       |         | —     |               |       |       | 528        |   |   |   | 1,400 |   |   | 59,375 |   |
| Gross profit                                |       | 35,500     |       |             | —     |                    |       |         | —     |               |       |       | (528       | ) |   |   | (1,400 | ) |   | 33,572 |   |
| Sales and  marketing                        |       | 11,919     |       |             | —     |                    |       |         | —     |               |       |       | 472        |   |   |   | 517 |   |   | 12,908 |   |
| Research, development and engineering  |       | 7,229      |       |             | —     |                    |       |         | (1,200     | )                  |       |       | 1,070      |   |   |   | 1,228 |   |   | 8,327 |   |
| General and  administrative                 |       | 25,863     |       |             | (2,536     | )                       |       |         | (962       | )                  |       |       | (2,070     | ) |   |   | (3,145 | ) |   | 17,150 |   |
| Amortization of  Intangibles                |       | —     |       |             | 2,536      |                    |       |         | —     |               |       |       | —     |   |   |   | — |   |   | 2,536 |   |
| Intellectual  Property                      |       | —     |       |             | —     |                    |       |         | 2,162      |               |       |       | —     |   |   |   | — |   |   | 2,162 |   |
| Total operating  expenses                   |       | 45,011     |       |             | —     |                    |       |         | —     |               |       |       | (528       | ) |   |   | (1,400 | ) |   | 43,083 |   |
| **2003**                                    | ** ** | ** ** | ** ** |             |       |                    |       |         |       |               |       |       |       |   |   |   |   |   | ** ** | ** ** | ** ** |
| Cost of revenue—service                |       | 39,412     |       |             | —     |                    |       |         | —     |               |       |       | 496        |   |   |   | 900 |   |   | 40,808 |   |
| Total cost of  revenue                      |       | 46,936     |       |             | —     |                    |       |         | —     |               |       |       | 496        |   |   |   | 900 |   |   | 48,332 |   |
| Gross profit                                |       | 38,655     |       |             | —     |                    |       |         | —     |               |       |       | (496       | ) |   |   | (900 | ) |   | 37,259 |   |
| Sales and  marketing                        |       | 11,854     |       |             | —     |                    |       |         | —     |               |       |       | 539        |   |   |   | 316 |   |   | 12,709 |   |
| Research, development and engineering  |       | 7,137      |       |             | —     |                    |       |         | (1,058     | )                  |       |       | 1,178      |   |   |   | 735 |   |   | 7,992 |   |
| General and  administrative                 |       | 19,733     |       |             | (3,152     | )                       |       |         | (788       | )                  |       |       | (2,213     | ) |   |   | (1,951 | ) |   | 11,629 |   |
| Amortization of  Intangibles                |       | —     |       |             | 3,152      |                    |       |         | —     |               |       |       | —     |   |   |   | — |   |   | 3,152 |   |
| Intellectual  Property                      |       | —     |       |             | —     |                    |       |         | 1,846      |               |       |       | —     |   |   |   | — |   |   | 1,846 |   |
| Total operating expenses                    |       | 38,724     |       |             | —     |                    |       |         | —     |               |       |       | (496       | ) |   |   | (900 | ) |   | 37,328 |   |
|                                             |            |            |            |                  |            |                         |            |              |            |                    |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Principles ofConsolidation*

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

F-9

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

*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 $19,171 and $11,606 at December 31, 2005 and2004, respectively. Cash equivalents are carried at cost or amortized cost,which approximates market.

*Restricted Cash*

Restricted cash of $7,279and $8,279 at December 31, 2005 and 2004, respectively, consists of cashand cash equivalents that are primarily held as a guarantee for certainperformance bond obligations that the Company is obligated to maintain inconnection with some of its long-term contracts relating to the secure IDsystems business. The Company supports the performance bonds with letters ofcredit, which may or may not require restricted cash. The letters of creditmust be renewed yearly if they are expected to continue, and therefore the needfor restricted cash is renewed yearly. However, the Company’s banks haverequired the Company to restrict this cash until it returns to profitabilityfor one year. Accordingly, restricted cash is classified as a non-currentasset.

*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-maturity as of the balance sheet date and are reported atamortized cost, which approximates market. The Company also holds marketauction preferred investments in its portfolio, which are classified asavailable-for-sale. The book value of these investments approximates fairmarket value and, accordingly, no amounts have been recorded to othercomprehensive 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 on 

F-10

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

relevantmarket information about the financial instrument when available. Theseestimates are subjective in nature and involve uncertainties and matters ofsignificant 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, trade and unbilled accountsrecievable. 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. As a result, the credit riskassociated with cash and investments is minimal. At December 31, 2005, theCompany had one customer which accounted for 11% of trade and unbilled accountsreceiveable.  At December 31, 2004,the Company had no customer which accounted for more than 10% 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 suppliers provide it with many of its products, a loss of oneor more of such suppliers could have a material adverse effect on the Company’sability to perform effectively, if at all, for some of its long-term contracts.

*Trade AccountsReceivable*

Trade accounts receivable are recorded at the invoicedamount and do not bear interest. Revenue earned which has not been invoiced isclassified as unbilled trade receivables in the consolidated balance sheets.The allowance for doubtful accounts is the Company’s best estimate of theamount of probable credit losses in the Company’s existing accounts receivable.The Company determines the allowance based on historical write-off experienceand current 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:

| ** **                        | ** ** | **2005** | ** ** | **2004**   | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|------------|------------|----------|------------|
| Balance—beginning  of period |       | $        | 316        |       | $          | 53       |       | $ | 224 |   |
| Provision  (recovery)             |       | 184      |       | 263        |       | (96      | )          |
| Charge offs                       |       | (159     | )          | **—** |       | (75      | )          |
| Balance—end of period        |       | $        | 341        |       | $          | 316      |       | $ | 53 |   |

 

F-11

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

*Inventories*

Inventoryconsists primarily of the consumable materials used to manufactureidentification cards, such as inks, laminates, and adhesives (considered rawmaterial), equipment held for sale (considered finished goods) and deferredcontract costs (considered either finished goods or in-process). Inventoriesare valued on a first-in, first-out basis at the lower of cost or market value(net realizable value).

| ** **                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Equipment and deferred contract costs |       | 899      |       | 1,033    |       |
| Consumable  materials                                     |       | 6,552    |       | 7,825    |       |
| Inventory, net                                            |       | 7,451    |       | 8,858    |       |

 

The reserve for slow moving and obsolete items was$240 and $271 at December 31, 2005 and December 31, 2004,respectively. While we do not currently expect to be able to sell or otherwiseuse the reserved inventory we have on hand based upon our forecast and backlog,it is possible that a customer or customers will decide in the future topurchase a portion of the reserved inventory.

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:

| ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  Beginning of Period        |       | $        | 271        |     | $          | 70       |       | $ | 330 |   |
| Charges to  Provision for Obsolescence |       | 288      |       | 726      |       | 75       |       |
| Deductions  against Balance            |       | (319     | )          | (525     | )          | (335     | )          |
| Balance at End of Period               |       | $        | 240        |     | $          | 271      |       | $ | 70 |   |

 

*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 and maintenanceare 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 five years. Property and equipmentheld under capital leases are amortized by the straight-line method over theshorter of the lease term or the estimated useful life. Amortization ofproperty and equipment under capital lease is included in depreciation expense.Assets specifically used to provide services under long-term contracts aredepreciated over the shorter of the contract term or estimated useful life.

*Pre-contract Costs*

Costs related to pre-contract activity are expensed asincurred in accordance with the American Institute of Certified PublicAccountants (“AICPA”) Statement of Position (“SOP”) No. 98-5, *Reporting on the Costs of Start-Up Activities*.The Company begins capitalizing costs when it receives notification that acontract will be awarded.

F-12

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

*Software Development Costs*

UnderStatement of Financial Accounting Standards (“SFAS”) No. 86, *Accounting for the Cost of Computer Software to BeSold, Leased, or Otherwise Marketed,*software development costs areto be capitalized beginning when a product’s technological feasibility has beenestablished and ending when a product is made available for general release tocustomers. To date, the establishment of technological feasibility of theCompany’s products has occurred shortly before general release and, therefore,software development costs qualifying for capitalization have been immaterial.Accordingly, the Company has not capitalized any software development costs andhas charged all such costs to research and development expense.

Internal use software development costs are accountedfor in accordance with AICPA SOP No. 98-1, *Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*. Costs incurred in thepreliminary project stage are expensed as incurred and costs incurred in theapplication 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 stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to cardmanufacturing and control systems software.

*Intangible Assets*

Intangible assets relateto the value of customer relationships acquired when the Company purchasedcertain assets of Polaroid and other technology and intellectual propertyrights. Customer relationships are generally being amortized on a straight-linebasis over an estimated useful life of 12 years and the other technologyand intellectual property rights are being amortized over an estimated usefullife of five years. The useful life of the individual asset is evaluated andadjusted when warranted by changes in the contractual arrangement or otherevidence indicates a change in useful life. The gross assets and accumulatedamortization for intangibles are as follows:

| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Gross intangible  assets  |       | $        | 29,906     |     | $          | 29,869 |   |
| Accumulated  amortization |       | (12,742  | )          | (8,707   | )          |
| Intangible assets, net    |       | $        | 17,164     |     | $          | 21,162 |   |

 

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:

| ** **                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Amortization of  intangibles |       | $        | 2,500      |     | $          | 1,900    |       | $        | 1,900      |     | $          | 1,900 |   | $ | 1,900 |   |
|                              |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

*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 

F-13

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

assetsto be held and used is measured by a comparison of the carrying amount of anasset to future net undiscounted cash flows expected to be generated by theasset. 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. Assets to be disposed of are reported at the lower of the carryingamount or fair value less costs to sell. During 2004, the Company recordedimpairment charges of $465 related to investments in early-stage technologycompanies. These charges are reflected as sales and marketing expenses in theconsolidated statement of operations.

*Contingencies andFactors that Could Affect Future Results*

A portion of the Company’s revenue each year isgenerated from licensing of technology. In the competitive environment in whichthe Company operates, product generation, development and marketing processesrelating to technology are uncertain and complex, requiring accurate predictionof demand as well as successful management of various development risksinherent in technology development. In light of these dependencies, it ispossible that failure to successfully manage future changes in technology withrespect to the Company’s technology could have a long-term impact on theCompany’s growth and results of operations.

Our contracts fordriver license and other identification issuance systems and their related productstypically include terms relating to supplier dependencies, time-basedperformance, development and delivery schedules and milestones, and othercontract terms that may create situations where a customer may assert that weare late in meeting our delivery obligations and that we owe them latepenalties, charges or other damages. Such provisions are common in large scalegovernment contracts at the state and federal levels. These contracts includeinstallation, customer acceptance and testing, and other delivery and relatedprocedures. Because procedures often require compliance over extended periodsof time, they give rise to an increased risk that we may fail to meet timing orother delivery requirements and milestones pursuant to the terms of such contracts.If we failed to meet such requirements or milestones, customers may assertagainst us compensatory or liquidated damages, breach of contract, or otherclaims. From time to time, customers have given notice of their intention toassert claims for liquidated damages. Management believes that these assertionsare part of the resolution process involving commercial disagreements over thedelivery terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. To date, we have not paid any material contractual damagesin connection with a customer dispute. While there is always risk that damagescould be assessed in the future, management cannot predict, as ofDecember 31, 2005 whether any material damages will be imposed in thefuture or what the amount of any such damages would be if they were to beimposed. However, our failure to meet contractual milestones or otherperformance 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.

In addition to our normal price-per-card issuance contracts,we occasionally enter into fixed price contracts. Fixed price contractstypically consist of agreements to sell entire systems or portions of a systemfor an agreed upon price. These contracts normally do not have clauses thatallow for recovery of cost 

F-14

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

overruns. Under fixedprice contracts, we provide specific tasks for a specific price and aretypically paid on a milestone basis. We have experienced low margins or losseson such contracts in the recent past. Such contracts involve greater financialrisks because we bear the risk if actual project costs exceed the amounts weare paid under the contracts. A material percentage of our revenues are derivedfrom fixed price contracts and our reliance on fixed price contracts may grow.

A significant portion of our business depends on a limited number oflarge, public-sector contracts, which are generally subject to termination forconvenience, as determined by the subject agency, or for lack of budgetaryappropriation provided for the subject agency. Some government contracts alsomay be one-time events, such as in the case of some personal identificationsystems in non-U.S. markets involving voter registration programs. In suchcases, we may generate substantial revenue that may not be subject to futurerenewal. Further, we may face competitive bids for a number of our majoraccounts in 2006. Moreover, government contracts result from purchasingdecisions made by public sector agencies that may be subject to politicalinfluence, unusual procurement procedures, strict legal requirements, budgetchanges and cutbacks during economic downturns, variations in appropriationscycles, and protests of contract awards. Additionally, some governmentalauthorities require performance bonds that we are obligated to maintain duringthe life of the contract. Often, the terms of these bonds require that wemaintain large restricted cash reserves as a guarantee, reducing our ability touse these funds for our other business purposes. Even with the availability ofsuch cash reserve guarantees, we may not be able to obtain such performancebond underwriting at a favorable rate or at all. Our failure to be able toprovide such performance bonds may preclude our ability to bid on newgovernment contracts or maintain our existing contracts for the entirety oftheir full terms. The size, nature and purpose of, and the risks anduncertainties associated with, public sector contracts can potentially causeour quarterly results to fluctuate and anticipated revenue to decrease significantly.

*Revenue Recognition*

Revenue from the Company’s government-issuedcredential systems is generally billed and recognized on a per card producedbasis. The Company recognizes revenue on these contracts based on the actualmonthly production, if available, and in limited situations on estimated volumeinformation. When actual production information becomes available, typicallywithin one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Differences to date have not been significant. Revenue earned which has notbeen invoiced is classified as unbilled trade receivables in the consolidatedbalance sheets. Revenue related to an enhancement of or upgrade to an existingsystem is deferred and recognized over the remaining life of the contract.

Revenue for sales of consumables and equipment notrelated to a driver license production contract is recognized when the productshave been shipped, ownership has been transferred, evidence of an arrangementexists, the sales price is fixed and determinable, and collectibility isreasonably assured.

F-15

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

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. Progress towards completion is measured using costs incurredcompared to the budgeted amounts contained in the contract. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the consolidatedbalance sheets.

Royalty revenue is recognized when the royalty amountsowed to the Company have been earned, are determinable, and collection isprobable. Subscriptions are paid in advance and revenue is recognized ratablyover the term of the subscription.

Maintenance revenue is recognized when the maintenanceamounts owed to the Company have been earned, are determinable, and collectionis probable. Maintenance contracts are, at times, paid in advance and revenueis recognized ratably over the term of the service period.

Deferred revenue consists of payments received inadvance for professional services, subscriptions and hardware for which revenuehas not been earned.

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorized duplicationor alteration of high-value documents, for use in communicating copyright,asset management and business-to-business image commerce solutions, and for usein connecting analog media to a digital environment. Software revenue isrecognized in accordance with AICPA SOP No. 97-2, as amended byAICPA 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.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence exists only for undelivered elements. Under the residualmethod, revenue is recognized as follows: (1) the total fair value ofundelivered elements, as indicated by vendor specific objective evidence, isdeferred and subsequently recognized in accordance with the relevant sectionsof AICPA SOP No. 97-2, and (2) the difference between the totalarrangement fee and the amount deferred for the undelivered elements isrecognized as revenue related to the delivered elements.

Certain customer arrangementsencompass multiple deliverables, such as hardware sales,consumables sales, maintenance fees, and software development fees. The Companyaccounts for these arrangements in accordance with Emerging Issues Task ForceIssue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If the deliverables meet the criteria inEITF Issue No. 00-21, the deliverables are divided into separateunits of accounting and revenue is allocated to the deliverables based on theirrelative fair values. The criteria specified in EITF Issue No. 00-21are as follows (i) the delivered item has value to the customer on astand-alone basis, (ii) there is objective and reliable evidence of thefair value of the undelivered item, and (iii) if the arrangement includesa general right of return relative to the delivered item, delivery orperformance of the undelivered item is considered probable and substantially inthe control of the vendor. For our purposes, fair value is generally defined asthe price at which a customer 

F-16

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

could purchaseeach of the elements independently from other vendors or as the price that theCompany has sold the element separately to another customer. Applicable revenuerecognition criteria is considered separately for each separate unit ofaccounting. Management applies judgment to ensure appropriate application ofEITF Issue No. 00-21, including value allocation among multiple deliverables, determination of whether undelivered elements areessential to the functionality of delivered elements and timing of revenuerecognition, among others.

*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*

The Company has various stock-based compensationplans, including stock incentive plans and an employee stock purchase plan. In2005, the Company continued to apply the recognition and measurement principlesof Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, *Accounting forCertain Transactions involving Stock Compensation, an Interpretation of APBOpinion No. 25*, as allowed by FASB Statement No. 123, *Accounting for Stock-Based Compensation*.FASB Statement No. 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. Generally,under APB Opinion No. 25, stock-based compensation expense is recognizedonly for stock awards granted with an exercise price below fair market value onthe date of grant.

SFASNo. 123 defines a fair value based method of accounting for an employeestock option and similar equity instrument. As is permitted under SFASNo. 123, the Company has elected to continue to account for itsstock-based compensation plans under APB Opinion No. 25. The Company hascomputed the value of all options granted during 2005, 2004 and 2003 using theBlack-Scholes option pricing model as prescribed by SFAS No. 123 with thefollowing weighted average assumption for grants:

| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate  |       | 4.50     | %          | 4.00     | %          | 4.00     | %          |
| Expected dividend  yield  |       | —   |       | —   |       | —   |       |
| Expected life (in  years) |       | 4        |       | 4        |       | 4        |       |
| Expected volatility       |       | 50       | %          | 50       | %          | 50       | %          |

 

Using the Black-Scholes methodology, the total valueof options granted during 2005, 2004, and 2003 was $4,490, $9,387 and $8,516,respectively, which would be amortized on a pro forma basis over the vestingperiod of the options. The weighted average fair value of options grantedduring 2005, 2004, and 2003 was $3.64, $6.56 and $7.81 per share, respectively.

F-17

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

The effects of applying SFAS No. 123 in this proforma disclosure are not indicative of future amounts.

TheCompany has computed the estimated fair value of purchase rights granted underthe Purchase Plan on the date of grant using the Black-Scholes option pricingmodel with the following weighted average assumptions for the years endedDecember 31, 2005, 2004 and 2003:

| ** **                | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Risk-free  interest rate  |       | 4.50%       |       | 4.00%       |       | 4.00%       |       |
| Expected dividend  yield  |       | —      |       | —      |       | —      |       |
| Expected life (in  years) |       | 0.5  to 2.0 |       | 0.5  to 2.0 |       | 0.5  to 2.0 |       |
| Expected volatility       |       | 50%         |       | 50%         |       | 50%         |       |

 

The weighted-average fairvalue of the purchase rights granted under the Purchase Plan during fiscal2005, 2004 and 2003 was $1.88, $4.01and $6.24, respectively.

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation for the years ended December 31,2005, 2004 and 2003, respectively (in thousands, except per-shareamounts):

| ** **                                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income  (loss), as reported                                                                                   |       | $                                          | (23,097    | ) | $ | (9,022 | ) | $ | 175 |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       | 506                                        |       | — |   | 1,291 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards |       | (7,170                                     | )          | (12,834 | ) | (14,121 | ) |
| Pro forma net  loss                                                                                               |       | $                                          | (29,761    | ) | $ | (21,856 | ) | $ | (12,655 | ) |
| *Earnings  per share:*                                                                                            |       |                                       |       |   |   |   |   |
| Basic—as reported                                                                                            |       | $                                          | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   |
| Diluted—as  reported                                                                                         |       | $                                          | (1.13      | ) | $ | (0.44 | ) | $ | 0.01 |   |
| Basic—pro forma                                                                                              |       | $                                          | (1.45      | ) | $ | (1.08 | ) | $ | (0.68 | ) |
| Diluted—pro forma                                                                                            |       | $                                          | (1.45      | ) | $ | (1.08 | ) | $ | (0.68 | ) |

 

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  applies to all optionsoutstanding as of December 31, 2005 under the Company’s Restated 1999Stock Incentive Plan and 2000 Non-Officer Employee Stock Incentive Plan, exceptfor options held by members of the Company’s Board of Directors. Options topurchase 422,248 shares of the Company’s common stock, or 6% of the Company’stotal outstanding options, with a weighted average exercise price of $11.51 andvarying remaining vesting schedules, are subject to this acceleration andbecome immediately vested and exercisable as of December 31, 2005. Ofthese 422,248 options, 120,972 options are held by the Company’s executiveofficers. As a result of this acceleration, the Company reduced its exposure tothe effects of the Financial Accounting Standards Board’s Statement ofFinancial Accounting Standards 

F-18

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

No. 123 (revised2004), Share-Based Payment (FAS 123R), which requires the Company to recognizestock-based compensation expense associated with stock options based on thefair value method for periods beginning after December 31, 2005. Theincremental pro forma expense as a result of the acceleration was $1,362 andhas been included in the table above as a result of this acceleration.

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 haveotherwise vested in full by June 30, 2005 in accordance with their terms.The effective date of the vesting acceleration is December 31, 2004. The$15.00 exercise price was selected because it was higher than (i) theprice at which the Company’s stock had traded during the period prior to theannouncement of the restatement of prior financial results, (ii) theaverage trading price of the Company’s common stock for the last two years, and(iii) the purchase price per share of the Company’s common stock in theCompany’s private placement in August 2003. Options to purchase 310,057shares of the Company’s common stock, or 5% of the total number of options ofthe Company outstanding as of December 31, 2004 with remaining vestingschedules, were accelerated. Accelerating the vesting of the Company’s optionsprior to the time at which these new accounting changes become effectiveaccelerates the recognition of any remaining pro forma expense calculated underStatement 123 associated with these options. 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. The incrementalpro forma expense as a result of the acceleration was $1,138 and has beenincluded in the table above as a result of this acceleration. Of these 310,057options, approximately 50,000 options are held by the Company’s executiveofficers. Other than the Company’s chairman and chief executive officer, nodirector of the Company holds any options subject to the acceleration.

On December 16, 2004, the FASB issued Statement No. 123(R) *Share-Based Payment*, which is a revisionof Statement No. 123 and supersedes APB Opinion No. 25. Statement No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be valued at fair value on the date of grant, and to be expensedover the applicable vesting period. Pro forma disclosure of the incomestatement effects of share-based payments is no longer an alternative. Inaddition, companies must recognize compensation expense related to any awardsthat are not fully vested as of the effective date. Compensation expense forthe unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123. The effective date for thispronouncement is for the next fiscal years beginning after December 15,2005. The Company will adopt SFAS 123(R) effective January 1, 2006. TheCompany is evaluating the requirements of SFAS 123(R) and expects that theadoption of SFAS 123(R) will have a material impact on the Company’sresults of operations. The Company has not yet determined the method ofadoption or the effect of adopting SFAS 123(R), and it has not determinedwhether adoption will result in amounts that are similar to the current proforma disclosures under SFAS 123.

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

F-19

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

*Non-Employee StockCompensation*

The Company accounts forstock issued to non-employees in accordance with the provisions of SFAS No. 123and EITF Issue No 96-18, *Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services*.

*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 or settled.The effect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date. Valuationallowances are established when necessary to reduce tax assets to the amountexpected to be realized.

*Net Income (Loss)Per Share*

Net income (loss) pershare 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, 2005** | ** ** | **Year  Ended December 31, 2004** | ** ** | **Year  Ended December 31, 2003** | ** ** |
|----------------|------------|------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **     | ** ** | **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 |   |   | $      | (23,097 | )      |   |   | 20,485 |   |   |   | $      | (1.13  | )      |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $      | (0.44  | )      |   |   | $      | 175    |   |   |   | 18,572 |   |   |   | $ | 0.01 |   |   |
|----------------------------------------------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|------|--------|--------|
| **Effect of Dilutive Securities**            |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options                                      |   |   |   |    |   |   | — |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   | 778    |   |   |   |   |   |   |
| Warrants                                     |   |   |   |    |   |   | — |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   | 1      |   |   |   |   |   |   |
| **Diluted EPS**                              |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income available to common stockholders      |   |   | $      | (23,097 | )      |   |   | 20,485 |   |   |   | $      | (1.13  | )      |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $      | (0.44  | )      |   |   | $      | 175    |   |   |   | 19,351 |   |   |   | $ | 0.01 |   |   |

 

Common stock equivalentsrelated to stock options and warrants of 6,203,114, 5,893,251 and 3,942,393were excluded from diluted net income per share calculations for 2005, 2004,and 2003, respectively, as their exercise price was higher than the averagemarket price of the underlying common stock for the period. Common stockequivalents related to stock options and warrants of 425,249 and 308,944 areantidilutive in a net loss year and, therefore, are not included in 2005 and2004 diluted net loss per share, respectively.

F-20

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

*ComprehensiveIncome (Loss)*

Comprehensiveincome (loss) is defined as changes in stockholders’ equity exclusive oftransactions with owners. To date, only foreign currency translationadjustments are required to be reported in comprehensive income (loss). Comprehensiveincome (loss) for the years ended December 31 is as follows:

| ** **                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income (loss)                        |       | $        | (23,097    | )        | $          | (9,022   | )          | $ | 175 |   |
| Foreign currency  translation adjustment |       | (10      | )          | 51       |       | 139      |       |
| Comprehensive income  (loss)             |       | $        | (23,107    | )        | $          | (8,971   | )          | $ | 314 |   |

 

*Recent AccountingPronouncements*

In November 2004, the FASB issued SFASNo. 151, *Inventory Costs, an amendment of ARBNo. 43, Chapter 4* (FAS 151). FAS 151 clarifies thatabnormal inventory costs such as costs of idle facilities, excess freight andhandling costs, and wasted materials (spoilage) are required to be recognizedas current period charges. This prouncement is effective for the Company in thefirst quarter of 2006. The Company is currently evaluating the provisions ofFAS 151 and does not expect that the adoption will have a material impact onits consolidated financial position or results of operations.

**(2)**          Propertyand Equipment

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Office furniture  and equipment                 |       | 4,999                 |       | 3,815 |   |
| Production  equipment                           |       | 96,770                |       | 82,028 |   |
| Leasehold  improvements                         |       | 1,738                 |       | 1,901 |   |
|                                            |       | 103,507               |       | 87,744 |   |
| Less accumulated  depreciation and amortization |       | (39,399               | )          | (23,769 | ) |
|                                            |       | $                     | 64,108     |   | $ | 63,975 |   |
|                                                 |            |                       |            |  |  |  |  |

 

**(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 $1,068 and $1,541 at December 31,2005 and 2004, respectively, and accumulated amortization was $954 and $463 at December 31,2005 and 2004, respectively.

F-21

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

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** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| 2006                                        |       | $          | 606        |                |       | $                     | 2,260      |   |   |
| 2007                                        |       | 454        |       |                | 1,610      |                  |       |
| 2008                                        |       | 75         |       |                | 1,492      |                  |       |
| 2009                                        |       | 4          |       |                | 1,541      |                  |       |
| 2010                                        |       | —     |       |                | 1,465      |                  |       |
| Thereafter                                  |       | —     |       |                | 587        |                  |       |
| Total minimum lease payments                |       | 1,139      |       |                | $          | 8,955                 |       |   |
| Less amount  representing interest          |       | (71        | )          |                |       |                  |       |
| Net obligation  under capital leases        |       | 1,068      |       |                |       |                  |       |
| Less current  portion                       |       | (555       | )          |                |       |                  |       |
| Non-current portion                         |       | $          | 513        |                |       |                  |       |   |

 

Rent expense on theoperating leases for the years ended December 31, 2005, 2004 and 2003totaled $2,546, $2,998 and $2,863, respectively.

**(4)**          DefinedContribution Pension Plan

The Company sponsors anemployee savings plan (the “Plan”) which qualifies as a deferred salaryarrangement under Section 401(k) of the Internal Revenue Code.Employees become eligible to participate in the Plan at the beginning of thefollowing quarter after the employees’ hire date. Employees may contribute upto 20% of their pay to the Plan, subject to the limitations of the InternalRevenue Code. Company matching contributions are discretionary. For the yearsended December 31, 2005 and 2004, the Company made discretionary matchingcontributions in the aggregate amount of $479 and $70, respectively. For theyear ended December 31, 2003 the Company made no discretionary matchingcontributions.

**(5)**          Stockholders’Equity

*Preferred Stock*

In December 1999, alloutstanding preferred stock of the Company was converted to common stock uponthe closing of the Company’s initial public offering. The authorized preferredstock of the Company following its re-incorporation and the initial publicoffering consists of 5,000,000 shares of undesignated preferred stock.

*Common Stock*

In August 2003, the Company completed a privateplacement of 1,785,996 units, with each unit consisting of one share of commonstock and warrants exercisable for 0.15 shares of common stock, resultingin net proceeds of $23,450, after deducting commissions and offering expenses.

F-22

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

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 circumstances described in the Rights Agreement. The purchaseprice, the number of units of preferred stock and the type of securitiesissuable upon exercise of the rights are subject to adjustment. The rights willexpire at the close of business November 16, 2014 unless earlier redeemedor exchanged. Until a right is exercised, the holder thereof, as such, willhave no rights as one of our stockholders, including the right to vote or toreceive dividends. The rights are not immediately exercisable. Subject to theterms and conditions of the Rights Agreement, they will become exercisable tenbusiness days after a person or group acquires, or commences a tender orexchange offer which would lead to the acquisition of beneficial ownership of15% or more of Digimarc’s outstanding common stock, subject to prior redemptionor exchange and subject to exceptions specified in the Rights Agreement,including an exception for certain existing large shareholders that havehistorically held ownership positions in excess of 15 percent. Subject to theseexceptions, once a person or group acquires beneficial ownership of 15% or moreof Digimarc’s outstanding common stock, each right not owned by that person orgroup or certain related parties will entitle its holder to purchase, at theright’s then-current purchase price, units of Series A preferred stock or,at Digimarc’s option, shares of common stock or cash, property or othersecurities of our company having a market value equal to twice the then-currentpurchase price, subject to terms and conditions of the Rights Agreement.

*Restricted Stock*

On February 23, 2005,the Compensation Committee of the Board of Directors approved the form of therestricted stock agreement to be used in connection with restricted stockawards to be granted to officers of the Company under the terms of the Company’s1999 Stock Incentive Plan. The agreement provides, among other things, that theshares will vest in full upon the termination of the officer’s employmentwithout cause or the officer’s resignation for good reason following a changein control of the Company. Notwithstanding the foregoing, the planadministrator has discretionary authority, among other things, to determine theterms and conditions of any award granted under the Plan. The CompensationCommittee approved grants of restricted stock awards to certain of its namedexecutive officers, effective as of March 1, 2005, totaling 270,000shares. One-quarter of the restricted shares granted to these executiveofficers will vest each December 31 beginning on December 31, 2005.

*Deferred StockCompensation*

For 2005, stock-basedcompensation expense relates to restricted stock granted in the current year,is based on the fair market value of the Company’s common stock on the date therestricted stock was granted (measurement date), and is being recognized overthe vesting period of the related restricted stock using the straight-linemethod. For prior years, deferred stock compensation expense is based on thedifference between the fair market value of the Company’s common stock and theexercise price of options to purchase that stock on the date of grant, and wasrecognized over the vesting period of the related options, generally fouryears. For the year ended December 31, 2005, $506 of stock-basedcompensation 

F-23

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

expensewas recorded. No stock-based compensation was recorded as expense in 2004 while$1,291 was recorded for the year ended December 31, 2003.

*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. Optionsare contingent upon continued employment with the Company and, unless otherwisespecified, expire ten years from the date of grant. The Company has reserved2,800,000 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 10,113,414 shares of its common stock for issuance under the 1999Plan bringing the total reserved under the 1999 plan to 11,613,414 shares, andthe total reserved under the 1995 Plan and the 1999 Plan combined to 14,413,414shares. 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”). Under the DirectorPlan, an automatic option grant to acquire 10,000 shares will be given to eachnon-employee director then-existing or first elected to the Company’s Board ofDirectors which vest in three annual increments on the anniversary date of thegrant date. Additionally, an annual option grant of 10,000 shares is given toeach non-employee director on the date of the Company’s annual stockholders’meeting if certain conditions are met. These options vest on the firstanniversary of the grant date. The exercise price of the options under theDirector Plan is the fair market value on the date of grant. In 2002, theDirector Plan was further amended to allow for 20,000 shares to be granted tonon-employee directors elected or appointed to the Board of Directors for thefirst time on or after March 29, 2002. These options vest and becomeexercisable in 36 equal installments on each monthly anniversary of the grantdate, such that the stock options will be fully exercisable three years afterthe grant date. Upon the date of each annual stockholders meeting, eachnon-employee director who has been a member of the Company’s Board of Directorsfor at least six months prior to the date of the stockholders meeting willreceive an automatic grant of options to acquire 12,000 shares of the Company’scommon stock at an exercise price per share equal to fair market value of thecommon stock at the date of grant. These 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 grant date.The Director Plan was also amended to allow for the grant of optionsexercisable for 3,000 shares of common stock at an exercise price equal to thefair market value of the common stock at the date of grant to each non-employeedirector who serves as a member of a committee of the Board of Directorsimmediately following each 

F-24

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

annual meeting of theCompany’s stockholders, provided such non-employee director has been a memberof the Company’s Board of Directors for at least six months prior to the dateof 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 and2005 under the Director Plan for service on each standing committee of theBoard of Directors.

In June 2000, the 2000 Non-Officer Employee StockIncentive Plan (the “2000 Plan”) was approved by the Company’s Board ofDirectors. The Company initially reserved 275,000 shares of its common stockfor issuance under the 2000 Plan. Options from the 2000 Plan cannot be grantedto officers or directors of 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.

Transactionsinvolving the stock incentive plans are summarized as follows:

| ** **                                   | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| Options  outstanding, December 31, 2002 |       | 6,632,889                  |       |                                           | $          | 16.31 |   |   |
| Granted                                      |       | 1,090,887                  |       |                                           | 15.19      |   |   |
| Exercised                                    |       | (622,108                   | )          |                                           | 5.73       |   |   |
| Canceled                                     |       | (793,130                   | )          |                                           | 17.74      |   |   |
| 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 |   |   |

 

F-25

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

| ** **                                  | ** ** | **Outstanding** | ** ** | **Exercisable**                | ** ** |
|---------------------------------------------|------------|-----------------|------------|--------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **      | ** ** | **Number of Shares** | ** ** | **Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Price** | ** ** | **Number of Shares** | ** ** | **Weighted  Average  Price** | ** ** |
| $ 0.50 – $  6.15        |       |            | 921,108    |                           |       |   | 8.33 |   |   |   | $ | 5.09 |   |   |   | 246,120 |   |   |   | $ | 2.86 |   |   |
| $ 6.19 – $  9.85        |       |            | 776,162    |                           |       |   | 8.70 |   |   |   | $ | 7.88 |   |   |   | 400,138 |   |   |   | $ | 8.88 |   |   |
| $10.12 – $12.25                        |       |            | 800,868    |                           |       |   | 7.96 |   |   |   | $ | 11.59 |   |   |   | 799,201 |   |   |   | $ | 11.59 |   |   |
| $12.40 – $13.25                        |       |            | 757,304    |                           |       |   | 7.12 |   |   |   | $ | 12.83 |   |   |   | 757,003 |   |   |   | $ | 12.83 |   |   |
| $13.38 – $14.13                        |       |            | 1,125,726  |                           |       |   | 5.22 |   |   |   | $ | 14.05 |   |   |   | 1,125,726 |   |   |   | $ | 14.05 |   |   |
| $14.18 – $15.24                        |       |            | 778,743    |                           |       |   | 6.99 |   |   |   | $ | 15.11 |   |   |   | 778,743 |   |   |   | $ | 15.11 |   |   |
| $15.25 – $17.00                        |       |            | 958,031    |                           |       |   | 6.90 |   |   |   | $ | 16.30 |   |   |   | 958,031 |   |   |   | $ | 16.30 |   |   |
| $17.13 – $26.25                        |       |            | 874,644    |                           |       |   | 5.44 |   |   |   | $ | 20.67 |   |   |   | 874,644 |   |   |   | $ | 20.67 |   |   |
| $27.50 – $35.13                        |       |            | 121,050    |                           |       |   | 4.36 |   |   |   | $ | 31.40 |   |   |   | 121,050 |   |   |   | $ | 31.40 |   |   |
| $53.94 – $53.94                        |       |            | 255,000    |                           |       |   | 4.08 |   |   |   | $ | 53.94 |   |   |   | 255,000 |   |   |   | $ | 53.94 |   |   |
| $ 0.50 – $53.94                   |       |            | 7,368,636  |                           |       |   | 6.85 |   |   |   | $ | 14.74 |   |   |   | 6,315,656 |   |   |   | $ | 16.16 |   |   |
|                                             |            |                 |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2005,3,833,378 shares were available for grant. At December 31, 2004, 5,385,824options were exercisable at a weighted average price of $17.50. AtDecember 31, 2003, 3,675,637 options were exercisable at a weightedaverage price of $18.22.

*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, 1,384,549 of whichare available for purchase at December 31, 2005. 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, not toexceed $21 per year, including commissions, bonuses and overtime, at a priceequal to 85% of the lower of the fair value at the beginning or end of eachenrollment period.

The Company delayed the purchase of shares under thePurchase Plan that would have occurred on November 30, 2004 until May 31,2005. The purchase was delayed because the Company’s failure to timely file itsthird quarter Form 10-Q caused the registration statements on Form S-8on file with the SEC for the Purchase Plan to not reflect current information.As a result of the delay, participants were provided with the opportunity towithdraw all of the accumulated payroll deductions credited to their accountunder the Purchase Plan, or terminate future payroll deductions.

*Warrants*

The Company has in the past issued warrants amdoptions for the purchase 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’ for the 2003 and 2004 fiscal years,accounting rules require that we include in these notes certaininformation concerning these warrants.

In October 1999, the Company entered into atwo-year agreement with Hearst Communications, Inc. (Hearst) in which theCompany and Hearst would jointly promote Internet-enabled advertising. Inconnection with the Hearst agreement, the Company issued a warrant to purchase150,000 shares of common stock to Hearst at $20 per share. Of the 150,000shares, 62,500 vested upon the Company’s initial 

F-26

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

public offering, another62,500 shares were to vest based on the achievement of certain milestoneswithin the first year of the agreement, and the final 25,000 were to vest uponreaching the one-year anniversary of the commercial availability date forDigimarc MediaBridge. The warrant was exercisable for three years after eachvesting date.

The Company recorded $633 of sales and marketingexpense during 1999 that related to the vested portion of the warrant. During2000 and 2001, the specified milestones for vesting were not met and theagreement with Hearst was terminated prior to the one-year anniversary of thecommercial availability date for Digimarc MediaBridge. Therefore, no additionalwarrant expense was recorded as no additional vesting occurred. As of December 31,2002, no portion of the warrant had been exercised. As of December 31,2002, these warrants had expired.

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 will expire in July of2006.

In August 2003, the Companyissued an aggregate of 267,899 warrants with an exercise price of $14.00 pershare as a part of a private placement of 1,785,996 units, with each unitconsisting 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,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic   |       | $                                          | (21,491    | ) | $ | (7,226 | ) | $ | 374 |   |
| Foreign    |       | (1,258                                     | )          | (1,431 | ) | 124 |   |
| Total      |       | $                                          | (22,749    | ) | $ | (8,657 | ) | $ | 498 |   |

 

F-27

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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, 2005, 2004 and 2003, the Company wasprofitable in some foreign jurisdictions. Therefore, a provision for currentforeign tax of $348, $365 and $323, 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,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income taxes  computed at statutory rates      |       | $                                          | (7,734     | ) | $ | (2,943 | ) | $ | 169 |   |
| Increases (decreases) resulting from:          |       |                                       |       |   |   |   |   |
| State income taxes, net of federal tax benefit |       | (930                                       | )          | (270 | ) | 41 |   |
| Change in valuation allowance                  |       | 8,220                                      |       | 3,524 |   | 328 |   |
| Recharge expenses                              |       | —                                     |       | 381 |   | 290 |   |
| Amortization expenses                          |       | 323                                        |       | — |   | — |   |
| Other non-deductible                           |       | 81                                         |       | — |   | — |   |
| Generated research credits                     |       | —                                     |       | (273 | ) | (558 | ) |
| Foreign rate differential, net of credits      |       | 169                                        |       | 89 |   | (13 | ) |
| Meals and entertainment                        |       | 116                                        |       | 78 |   | 65 |   |
| Other                                          |       | 103                                        |       | (221 | ) | 1 |   |
| Total                                          |       | $                                          | 348        |   | $ | 365 |   | $ | 323 |   |

 

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,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax  assets:                |       |                  |       |   |   |
| Net operating loss carryforwards     |       | $                     | 37,708     |   | $ | 31,490 |   |
| Research and experimentation credits |       | 2,183                 |       | 2,617 |   |
| Accrued expenses and allowances      |       | 1,672                 |       | 1,030 |   |
| Deferred revenue                     |       | 1,475                 |       | 1,177 |   |
| Deferred compensation                |       | 272                   |       | 643 |   |
| Foreign tax credit                   |       | 331                   |       | 331 |   |
| Impairment of investments            |       | 192                   |       | — |   |
| Other                                |       | 1                     |       | 2 |   |
| Total gross deferred tax assets      |       | 43,834                |       | 37,290 |   |
| Less valuation allowance             |       | (41,825               | )          | (34,571 | ) |
| Net deferred tax assets              |       | 2,009                 |       | 2,719 |   |
| Deferred tax liabilities:            |       |                  |       |   |   |
| Tax depreciation and amortization    |       | 2,009                 |       | 2,719 |   |
| Total deferred tax liabilities       |       | 2,009                 |       | 2,719 |   |
| Net deferred tax  asset (liability)  |       | $                     | —     |   | $ | — |   |

 

F-28

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**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, 2005, 2004 and 2003 was an increase of $7,254,$3,617 and $368, respectively. Included in the valuation allowance atDecember 31, 2005 is $10,051 for deferred tax assets for whichsubsequently recognized tax benefits, if any, will be allocated to contributedcapital.

At December 31, 2005, the Company had netoperating loss carryforwards of approximately $98,500 to offset against futureincome for foreign, federal and state tax purposes, and research andexperimentation credits of $2,183. Approximately $26,205 of the net operatingloss carryforward will be allocated to contributed capital if subsequentlyrecognized. These carryforwards expire through 2025.

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.

United States taxes havenot been provided on undistributed earnings of international subsidiaries. TheCompany’s intention is to reinvest these earnings and repatriate only when itis tax efficient to do so. Accordingly, the Company believes no federal orstate 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.

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

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| **Revenue:**  | ** ** | ** **                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States |       | $                                           | 80,119     |   | $ | 72,173 |   | $ | 71,542 |   |
| International |       | 20,934                                      |       | 20,774 |   | 14,049 |   |
|          |       | $                                           | 101,053    |   | $ | 92,947 |   | $ | 85,591 |   |
|               |            |                                             |            |  |  |  |  |  |  |  |  |  |

 

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

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| **Long-lived tangible assets:** | ** ** | ** **            | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States                             |       | $                     | 60,675     |   | $ | 59,683 |   |
| International                             |       | 3,433                 |       | 4,292 |   |
|                                      |       | $                     | 64,108     |   | $ | 63,975 |   |
|                                           |            |                       |            |  |  |  |  |  |  |

 

F-29

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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:** | ** ** | ** **            | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States                         |       | $                     | 16,829     |   | $ | 19,903 |   |
| International                         |       | 335                   |       | 1,259 |   |
|                                  |       | $                     | 17,164     |   | $ | 21,162 |   |
|                                       |            |                       |            |  |  |  |  |  |  |

 

*Major Customers*

No single customeraccounted for 10% or more of the Company’s revenues for the year ended December 31,2005, 2004 or 2003. There was one customer that accounted for 11% of theCompany’s trade and unbilled accounts receivable for the year ended December 31,2005. No customer accounted for more than 10% of trade and unbilled accountsreceivable at December 31, 2004.

**(8)**          Commitmentsand Contingencies

Beginningin September 2004, three purported class action lawsuits were commencedagainst us and certain of our current and former directors and officers by oron behalf of persons claiming to have purchased or otherwise acquired oursecurities during the period from April 17, 2002 to July 28, 2004. Theselawsuits were filed in the United States District Court for the District ofOregon and were consolidated into one action for all purposes on December 16,2004. On May 16, 2005, plaintiffs filed an amended complaint. Thecomplaint asserted claims under the federal securities laws, specificallySections 10(b) and 20(a) of the Securities Exchange Act of 1934,relating to our announcement that we had discovered errors in our accountingfor software development costs and project capitalization and other projectcost capitalization accounting practices, and that we likely would be requiredto restate our previously reported financial statements for full fiscal year2003 and the first two quarters of 2004. Specifically, the complaint allegedthat we issued false and misleading financial statements and created amisperception regarding the profitability of the company in order to inflatethe value of Digimarc stock, which permitted insider sales of personal holdingsat inflated values, and that we maintained insufficient accounting controls,which created an environment where improper accounting could be used tomanipulate financial results. The complaint sought unspecified damages.  On November 30, 2005, the Court grantedour motion to dismiss the amended complaint on the grounds that plaintiffs hadfailed to allege facts sufficient to support their allegation that thedefendants knowingly or recklessly acted in violation of the securities laws. Plaintiffsfiled a second amended complaint on January 17, 2006. On February 14,2006, we filed a motion to dismiss the second amended complaint on the groundsthat plaintiffs still fail to allege facts sufficient to support theirallegation that the defendants knowingly or recklessly acted in violation ofthe securities laws. This motion is pending. Due to the inherent uncertaintiesof litigation and because the lawsuits are still at a preliminary stage, theultimate outcome of the matter cannot be predicted.

Onor about October 19, 2004, two purported shareholder derivative lawsuitswere filed against certain of the Company’s officers and directors, naming theCompany as a nominal defendant, in the Superior Court of the State ofCalifornia for the County of San Luis Obispo. These lawsuits were consolidatedinto one action for all purposes on March 14, 2005. On July 19, 2005,the court granted the Company’s motion to stay these consolidated actions infavor of a shareholder derivative action to be filed by plaintiffs in theCircuit Court of the State of Oregon for the County of Washington. On August 25,2005, the California plaintiffs filed two new derivative lawsuits in the UnitedStates District Court for the 

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

District of Oregon. On October 17, 2005,defendants filed a motion to dismiss these complaints for lack of subject matterjurisdiction and failure to state a claim. This motion currently is pending.Separately, on November 8, 2004, a letter was mailed to the chairman ofthe Company’s Board of Directors by a law firm purporting to represent ashareholder of the Company, demanding that the board commence a civil actionagainst each of the directors and officers on behalf of the Company to recoverfor damages alleged to have been incurred as a result of alleged breaches offiduciary duties. On or about April 6, 2005, this shareholder filed apurported shareholder derivative suit against certain of the Company’s officersand directors, naming the Company as a nominal defendant, in the Circuit Courtof the State of Oregon for the County of Washington. These suits claim that certainof these officers and directors breached their fiduciary duties to the Company’sshareholders and to the Company. The complaints are derivative in nature and donot seek relief from the Company. The Company has appointed a committee toinvestigate the claims asserted in the demand letter and in the derivativelawsuits. On August 25, 2005, the individual defendants filed a motion tostay this state court derivative lawsuit, and on September 26, 2005, theCourt entered a stipulated order granting the motion and staying the casepending the outcome of an investigation by a committee appointed by the Company’sBoard of Directors of the claims asserted in the demand letter and in thederivative lawsuits. That stay expired on February 28, 2006, and defendantshave until March 31, 2006 to respond to the complaints in this lawsuit.

Beginningin May 2001, a number of substantially identical class action complaintsalleging violations of the federal securities laws were filed in the UnitedStates District Court for the Southern District of New York namingapproximately 300 companies, including the Company, certain of its officers anddirectors, and certain underwriters of the Company’s initial public offering asdefendants. The complaints have since been consolidated into a single action,and a consolidated amended complaint was filed in April 2002. The amendedcomplaint alleges, among other things, that the underwriters of the Company’sinitial public offering violated securities laws by failing to disclose certainalleged compensation arrangements (such as undisclosed commissions or stockstabilization practices) in the Company’s initial public offering registrationstatement and by engaging in manipulative practices to artificially inflate theprice of the Company’s stock in the after-market subsequent to the Company’sinitial public offering. The Company and certain of its officers and directorsare named in the amended complaint pursuant to Section 11 of theSecurities 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 

F-31

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

modifications to the settlement and certifying thesettlement classes. The court also appointed the Notice Administrator for thesettlement and ordered that notice of the settlement be distributed to allsettlement class members beginning on November 15, 2005 and completed by January 15,2006. The settlement fairness hearing has been set for April 26, 2006.Following the hearing, if the court determines that the settlement is fair tothe class members, the settlement will be approved. There can be no assurancethat this proposed settlement will be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation and becausethe settlement approval process is at a preliminary stage, we cannot accuratelypredict the ultimate outcome of the matter.

TheCompany from time to time experiences delays in identification systemimplementation, timely acceptance for identification systems programs, concernsregarding identification system program performance, and other contractual disputes.Customers haveasserted, and may in the future assert, compensatory or liquidated damages,breach of contract, or other claims alleging that we have failed to meet timingor other delivery requirements and milestones pursuant to the terms of such contracts.From time to time, customers have given notice of their intention toassert claims for liquidated damages. Management believes that these assertionsare part of the resolution process involving commercial disagreements over thedelivery terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. To date, we have not paid any material contractualdamages in connection with a customer dispute. While there is always risk thatdamages could be assessed in the future, management cannot predict, as of December 31,2005, whether any material damages will be imposed in the future or what theamount of any such damages would be if they were to be imposed. However, our failure to meet contractualmilestones or other performance requirements as promised, or to successfullyresolve customer disputes, could result in our having to incur liability fordamages, as well as increased costs, lower margins, or compensatory obligationsin addition to other losses, such as harm to our reputation. Such circumstancescould have a material adverse effect on our business and financial results. Weanticipate that future contracts will continue to have such provisions unlessand until industry practices change. The Company is subject from time totime to other legal proceedings and claims arising in the ordinary course ofbusiness. Although the ultimate outcome of these matters cannot be determined,management believes that the final disposition of these proceedings will nothave a material adverse effect on the consolidated financial position, resultsof operations, or liquidity of the Company. No accrual has been recordedbecause the amounts are not probable or reasonably estimatable in accordancewith SFAS No. 5, *Accounting forContingencies*.

Certainof the Company’s product license and services agreements include anindemnification provision for claims from third parties relating to the Company’sintellectual property. Such indemnification provisions are accounted for inaccordance with SFAS No. 5, *Accountingfor Contingencies*. To date, there have been no claims made undersuch indemnification provisions.

The Company is subject from time to time to otherlegal proceedings and claims arising in the ordinary course of business.Although the ultimate outcome of these matters cannot be determined, managementbelieves that the final disposition of these proceedings will not have amaterial adverse effect on the consolidated financial position, results ofoperations, or liquidity of the Company. No accrual has been recorded becausethe amounts are not probable or reasonably estimatable in accordance with SFAS No. 5,*Accounting for Contingencies*.

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

**(9)**          RelatedParty Transactions

In2005, 2004 and 2003, the Company entered into services and licensingarrangements with a holder of common stock. The Company recognized $486, $638and $118 in revenue for the years ended December 31, 2005, 2004 and 2003,respectively, in connection with these arrangements. At December 31, 2005and 2004, net accounts receivable from this customer were $231 and $202,respectively. At December 31, 2005 and 2004, deferred revenue from thiscustomer was $320 and $480, respectively.

During the quarter endedSeptember 30, 2005, the Company entered into a relocation agreement withan executive officer. As part of the relocation package, the Company purchasedthe personal residence of that officer. The purchase price was based on independentappraisals and totaled $825. The Company has assumed all rights and obligationsrelated to the residence and is actively marketing it for sale. The carryingcost of this asset is included on the balance sheet in the Other Current Assetsline.

**(10)**   SubsequentEvents

On January 3, 2006,the Compensation Committee of the Board of Directors granted options topurchase 515,000 shares of the Company’s common stock and awarded 105,000restricted stock shares and 105,000 performance vesting shares under its 1999Stock Incentive Plan, as amended, to named executive officers. The options weregranted with an exercise price equal to the market price on the date of grant. Theoptions and the shares subject to the restricted stock awards will vest over afour-year period following the date of grant. The performance vesting shareswill vest in full (or terminate) based on the achievement within three years ofthe date of grant of a specified performance goal related to the price pershare of the Company’s common stock. Specific terms of the option grants aregoverned by a Stock Option Award Agreement between the Company and each namedexecutive officer. Specific terms of the restricted stock awards andperformance vesting share awards are governed by a Restricted Stock Agreementand Performance Vesting Share Agreement between the Company and each namedexecutive officer.

F-33

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

**(11)**   QuarterlyFinancial Information—Unaudited

Asdiscussed in Footnote 1, the Company reclassified certain costs related toamortization of intangibles, intellectual property, infrastructure, andcentralized costs. The table below shows the effects of these reclassificationson prior quarterly numbers:

| ** **                                | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-------------------------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| **Quarter ended:**                   | ** ** | ** **        | ** ** | **Before**       | ** ** | **After**             | ** ** | **Before**           | ** ** | **After** | ** ** | **Before** | ** ** | **After** | ** ** | **Before** | ** ** | **After** | ** ** |
| **2005**                                  |       |              |       |             |       |                  |       |                 |       |   |   |   |   |   |   |   |   |
| Total revenue                             |       | $                 | 24,379     |             | $          | 24,379                |       | $                    | 24,753     |   | $ | 24,753 |   | $ | 26,781 |   | $ | 26,781 |   | N/A |   | $ | 25,140 |   |
| Total cost of revenue                     |       | 15,493            |       | 16,077           |       | 15,967                |       | 16,560               |       | 16,494 |   | 17,043 |   | N/A |   | 18,492 |   |
| Sales and marketing                       |       | 3,815             |       | 3,777            |       | 3,898                 |       | 3,889                |       | 4,291 |   | 4,295 |   | N/A |   | 3,816 |   |
| Research, development and engineering     |       | 2,483             |       | 2,908            |       | 3,001                 |       | 3,428                |       | 2,898 |   | 3,199 |   | N/A |   | 3,596 |   |
| General and administrative                |       | 7,004             |       | 5,497            |       | 6,999                 |       | 5,521                |       | 6,234 |   | 4,852 |   | N/A |   | 5,654 |   |
| Amortization of intangibles               |       | 811               |       | 811              |       | 1,339                 |       | 1,339                |       | 1,147 |   | 1,147 |   | N/A |   | 738 |   |
| Intellectual property                     |       | —            |       | 536              |       | —                |       | 467                  |       | — |   | 528 |   | N/A |   | 483 |   |
| Operating income (loss)                   |       | (5,227            | )          | (5,227           | )          | (6,451                | )          | (6,451               | )          | (4,283 | ) | (4,283 | ) | N/A |   | (7,639 | ) |
| Net income (loss)                         |       | (5,120            | )          | (5,120           | )          | (6,217                | )          | (6,217               | )          | (4,228 | ) | (4,228 | ) | N/A |   | (7,532 | ) |
| Net income (loss) per share—basic    |       | (0.25             | )          | (0.25            | )          | (0.30                 | )          | (0.30                | )          | (0.21 | ) | (0.21 | ) | N/A |   | (0.37 | ) |
| Net income (loss) per share—diluted  |       | (0.25             | )          | (0.25            | )          | (0.30                 | )          | (0.30                | )          | (0.21 | ) | (0.21 | ) | N/A |   | (0.37 | ) |
| **2004**                                  | ** ** | ** **        | ** ** | ** **       | ** ** | ** **            | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenue                             |       | $                 | 23,658     |             | $          | 23,658                |       | $                    | 23,474     |   | $ | 23,474 |   | $ | 23,520 |   | $ | 23,520 |   | $ | 22,295 |   | $ | 22,295 |   |
| Total cost of revenue                     |       | 14,844            |       | 15,275           |       | 14,764                |       | 15,222               |       | 13,730 |   | 14,199 |   | 14,109 |   | 14,679 |   |
| Sales and marketing                       |       | 2,563             |       | 2,781            |       | 2,840                 |       | 3,062                |       | 3,090 |   | 3,376 |   | 3,426 |   | 3,689 |   |
| Research, development and engineering     |       | 1,722             |       | 1,935            |       | 1,550                 |       | 1,771                |       | 1,931 |   | 2,259 |   | 2,026 |   | 2,362 |   |
| General and administrative                |       | 5,465             |       | 3,506            |       | 5,579                 |       | 3,558                |       | 7,436 |   | 5,160 |   | 7,383 |   | 4,926 |   |
| Amortization of intangibles               |       | —            |       | 642              |       | —                |       | 547                  |       | — |   | 688 |   | — |   | 659 |   |
| Intellectual property                     |       | —            |       | 455              |       | —                |       | 573                  |       | — |   | 505 |   | — |   | 629 |   |
| Operating income (loss)                   |       | (936              | )          | (936             | )          | (1,259                | )          | (1,259               | )          | (2,667 | ) | (2,667 | ) | (4,649 | ) | (4,649 | ) |
| Net income (loss)                         |       | (786              | )          | (786             | )          | (1,271                | )          | (1,271               | )          | (2,467 | ) | (2,467 | ) | (4,498 | ) | (4,498 | ) |
| Net income (loss) per share—basic    |       | (0.04             | )          | (0.04            | )          | (0.06                 | )          | (0.06                | )          | (0.12 | ) | (0.12 | ) | (0.22 | ) | (0.22 | ) |
| Net income (loss)  per share—diluted |       | (0.04             | )          | (0.04            | )          | (0.06                 | )          | (0.06                | )          | (0.12 | ) | (0.12 | ) | (0.22 | ) | (0.22 | ) |
|                                           |            |                   |            |                  |            |                       |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-34

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**EXHIBIT INDEX**

| Exhibit   Number | ** ** | **Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  2.1        |       | Asset Purchase Agreement  among Polaroid Corporation, Polaroid ID Systems, Inc. and Digimarc  Corporation (incorporated by reference to Exhibit 2.1 to the  Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on January 3, 2002)                                                                                                                                                                                                                                                                                |
|  3.1        |       | Second Amended and  Restated Certificate of Incorporation of the Registrant, as amended                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|  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                                                                                                                                                                                                                                                                                                                                                                                                            |
|  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                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.2             |       | Registrant’s 1995 Stock  Incentive Plan, as amended                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 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                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.5             |       | Registrant’s 1999 Employee Stock Purchase Plan, as  amended and restated on February 19, 2004, including forms of agreements  thereunder (incorporated by reference to Exhibit 99.1 to the  Registrant’s Registration Statement on Form S-8 (Commission File  No. 333-115074) which became effective on April 30, 2004)                                                                                                                                                                                                                             |
| 10.6             |       | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Macrovision Corporation                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.7             |       | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Koninklijke Philips Electronics N.V.                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 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 on March 10, 2004  (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on May 10, 2004)                                                                                                                                                                                                                                                                                |
| 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)                                                                                                                                                                                                                                                                                            |

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| 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                                                                                                                                                                                                                                                                                                           |
| 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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